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DETERMINANTS OF PROFITABILITY OF COMMERCIAL BANKS IN NIGERIA
Commercial banks are important to the financial segment, particularly in developing economies where capital markets are not well developed and strong. Commercial Banks’ profitability is important because the soundness of an industry is closely connected to soundness of the whole economy. Profitability of the banking sector is also central as the well-being of the industry is closely associated with the wellness of the whole economy in general. Thus, a proficient and productive banking sector is able and better placed to endure negative economic shocks. This study investigated determinants of profitability of Nigerian commercial banks. The study explored effect of the bank size, adequacy of capital, liquidity, credit risk and operational efficiency on banks’ profitability. The study adopted a descriptive design helped to establish the factors, which influence the Nigeria’s commercial banks profitability. The study used secondary data from 43 registered commercial banks as at 31/12/2015 from the years 2011 to 2015. The data collected was edited, sorted for completeness and then analyzed using ordinary least squares (OLS) and Pearson correlation using the statistical package for social studies and established a negative insignificant relation between bank size, operational efficiency and profitability and a significant negative relation between capital adequacy, credit risk and banks’ profitability. The study concluded that capital plays a key role in determining commercial banks profitability and higher levels of capital adequacy increases profitability of commercial banks. The study also concluded that an increase in nonperforming loans increase credit risk which adversely affects profitability. The study finally concluded that high levels of liquidity provides adequate funds to lend which in turn increase interest income hence banks’ profitability and that poor operational efficiency through poor management of expenses reduces the profitability of commercial banks. The study recommended that managers of banks to develop effected policies to to ensure they to reduce the level of nonperforming loans and that banks should effectively manage their operational expenses and costs to ensure that their banks are efficient and to maximize profits. The study also recommended that regulatory authorities like the central bank of Nigeria should develop effective policies on capital adequacy, liquidity and credit risk management to ensure that banks are in a position where they can enhance their profitability.
CHAPTER ONE: INTRODUCTION
1.1 Background of the Study
Banking industry is one of significant sectors of the financial system in most countries (San & Heng, 2013). Banks plays a crucial role of promoting the growth of economy by mobilizing savings and using the mobilized savings in financing the most productive sectors of economic (Alkhazaleh & Almsafir, 2014). As such, commercial banks are important to the financial segment, particularly in developing economies where capital markets are not well developed and strong. In economies where the capital markets are still are developing, banking institutions serve as a vital source of finances for enterprises (Ntow & Laryea, 2012). Therefore, good performance of the bank is usually measured as per its profitability levels and has been essential to shareholders, customers as well as for banks continued survival and expansion (Nkegbe & Yazidu, 2015).
Profitability of banks is important since the soundness of an industry is closely connected to the soundness of the whole economy (Lipunga, 2014). The financial strength of a banking institution is unquestionably associated to its profitability, thus, the most important need of any bank’s management and leadership is to make profits on a continuous basis since this will guarantee bank’s continuous existence. As such, achieving profitability goal is vital to any bank (Adeusi, Kolapo & Aluko, 2014). The banking sector profitability is also central as the well-being of the industry is closely associated with the wellness of the whole economy in general (Alkhazaleh & Almsafir, 2014). Thus, a proficient and productive banking sector is able and better placed to endure negative economic shocks (Ally, 2014).
The Nigerian banking industry is vital to Nigerian economy and plays a crucial financial intermediary function. Banking institutions in Nigeria play a crucial role in national growth and such roles are growing day-by-day (Wanjiru & Njeru, 2014). The Nigerian banking sector plays the function of financial intermediation between borrowers and savers that entails the mobilization of capital from individuals with surplus cash and channeling the funds to the deficit economic units (Kimutai & Jagongo, 2013). The sector has reported continuous growth in loans and profitability, assets and product offering. Moreover, banking sector’s cumulative balance sheet recorded a 3.4% growth from KES.3.26tn in December 2014 to KES.3.37tn in March 2015 (Cytonn Investments, 2015).
Profitability refers to money that a firm can produce with the resources it has. The goal of most organization is profit maximization (Niresh & Velnampy, 2014). Profitability involves the capacity to make benefits from all the business operations of an organization, firm or company (Muya & Gathogo, 2016). Profit usually acts as the entrepreneur's reward for his/her investment. As a matter of fact, profit is the main motivator of an entrepreneur for doing business. Profit is also used as an index for performance measuring of a business (Ogbadu, 2009). Profit is the difference between revenue received from sales and total costs which includes material costs, labor and so on (Stierwald, 2010).
Profitability can be expressed either accounting profits or economic profits and it is the main goal of a business venture (Anene, 2014). Profitability portrays the efficiency of the management in converting the firm’s resources to profits (Muya & Gathogo, 2016). Thus, firms are likely to gain a lot of benefits related increased profitability (Niresh & Velnampy, 2014). One important precondition for any long-term survival and success of a firm is profitability. It is profitability that attracts investors and the business is likely to survive for a long period of time (Farah & Nina, 2016). Many firms strive to improve their profitability and they do spend countless hours on meetings trying to come up with a way of reducing operating costs as well as on how to increase their sales (Schreibfeder, 2006).
In, accounting theory profitability shows the surplus of profit over expense for a specified duration that represent earning of commercial banks from the various activities they perform in a growing economy (Tariq et al., 2014). The profitability of a banking institution can thus be defined as net profit of the bank (San & Heng, 2013). A commercial bank is profitable if it has accrued more gains in financial perspective from invested capital. Thus, the bank’s success is determined from the profits it has made in a given financial year (Adeusi, Kolapo & Aluko, 2014). Profitability also shows the association between the absolute amount of income that indicates the capability of the bank to advance loans to its customers and enhance its profit. In today’s competitive environment, profitability is a key factor for smooth the running of the business and has a significant effect on performance of the bank and economic development as well (Tariq et al., 2014). Profitability is also crucial for a banking institution to maintain its ongoing activities and for shareholders to generate fair returns (Ponce, 2011).
Profitability is one of main aspects of financial reporting for many firms (Farah & Nina, 2016). Profitability is vital to the firm’s manager as well as the owners and other stakeholders that are involved or associated to the firm since profitability gives a clear indication of business performance. Profitability ratios are normally used to measure earnings generated by a firm for a certain period of time based on the firm’s sales level, capital employed, assets and earnings per share (EPS). Profitability ratios are also used to measure the firm’s earning capacity and considered as a firm’s growth and success indicator (Majed, Said & Firas, 2012).
Profitability is generally measured using accounting ratios with the commonly used profitability ratio being ROA. ROA determines the amount of the profit earned per shilling of assets. This reflects the efficiency with which the bank’s managers use bank’s investment resources or assets in generation of income (Sehrish, Irshad & Khalid, 2010). ROA simply connotes the management efficiency and depicts how effective and efficiently the bank management operate as they employ the organization’s assets into the earnings. A high ROA ratio is a clear indicator a good performance or profitability of a banking entity (Bentum, 2012).
1.1.2 Factors Influencing Profitability
Factors that influence commercial bank’s profitability are divided into internal and external. Internal factors are those factors which bank’s managers can control whereas external factors are those outside or beyond bank’s management control. External factors that influence profitability of commercial banks are related to legal and economic environment and comprises of factors like interest rates, inflation, recession, boom, regulations, market growth and market structure (Staikouras & Wood, 2011). The internal factors reflect the management policies of the banks and decisions made about the sources of funds, expenses and liquidity management (Onuonga, 2014). Information on bank specific factors that influence commercial banks profitability can be obtained from financial statements hence study will emphases on bank’s size, capital adequacy, liquidity, credit risk and efficiency in the bank’s operations.
Bank’s size specifies that the size of a bank influence performance such that larger banks perform well compared to a small-sized banks through harnessing the economies of scale in their transactions such that big banks will enjoy high profits (Sehrish, Irshad & Khalid, 2010). Large banks are assumed to have more advantages as compared to their smaller rivals and have a stronger bargaining capability and making it easier for them to get benefits from specialization and from economies of scale and scope (Alkhazaleh & Almsafir, 2014). In addition, empirical evidence indicates that size of a bank directly affects profitability by reducing the cost of raising capital for big banks (Tariq et al., 2014). Size captures the economies or diseconomies of scale of an institution and normally the natural logarithm of bank’s assets is normally used as a proxy of size (Cull et al., 2007).
Capital adequacy refers to a measurement of commercial bank`s ability or strength in financial terms. It shows the bank’s willingness and ability to tolerate with abnormal and operational losses. It indicates the firm’s ability to undertake an additional business. It also measures the commercial banks’ ability to effectively absorb risk and solvency. Therefore, the ratio is utilized in protecting the bank’s fund depositors as well as promoting efficiency and stability of financial systems (Bizuayehu. 2015).
Liquidity on the other hand is defined as the bank’s ability in meet its obligations, mainly those of depositors of funds to the bank (Ongore & Kusa, 2014). The availability of liquidity is influences profitability since it enhances the capacity of the bank to acquire cash, in order to fulfill present and essential needs. For the commercial banks to gain public assurance, they should have sufficient liquidity to meet the demands loan holders and depositors needs (Chinoda, 2014). Small liquidity level serves as ground reality of failure of a bank. Liquidity problems also lead to issues in generating funds and failure to fulfill current and unanticipated variations in the sources of financing (Tariq et al., 2014). Loan to assets ratio is normally used to calculate the liquidity position of a bank and the ratio indicates percentage of total assets used to provide loans.
Credit risk indicator can be represented by different measurements including loans loss provision to total loans ratio as well as growth in bank deposits. Higher provisions for loan losses could signals a possibility of future loss on loans, and could also be a sign of a timely recognition of bad loan by cautious banks (Munyambonera, 2011). A higher ratio of NPLs to total loans and an absolute deterioration of credit portfolio quality negatively affect commercial bank’s profitability (Roman and Tomuleasa, 2013). In addition, raise in credit risk increases the marginal cost of loans, obligations, and equity leading to the enlargement of the cost of finance for the bank (Tariq et al., 2014).
Operating costs refer to the expenses incurred in the normal functioning of the bank besides cost of obtaining funds. Empirical evidence indicates that low operating costs leads to greater profitability of commercial banks. Other costs like the provisions made towards bad debts and doubtful debts influence performance and are likely to lead to probable annual loss on assets (Chinoda, 2014). Expenses are normally the operational cost of banks and they specifies a fraction of banks earnings and have an inverse relationship with bank profit, and indicates the proficiency of the bank administration and its dealings during operations (Tariq et al., 2014). Operational efficiency indicator also referred to as expenses by management is given as cost to income ratio. The higher the ratio, the less the efficient and the bank could be adversely affected in return on assets, depending on the extent of competition in the industry (Munyambonera, 2011).
1.1.3 Commercial Banks in Nigeria
According, CBK’s directory there is forty-three commercial banks in the country some of which are internationally based. The headquarters of these banks are in Nairobi and they serve both retail and corporate customers. The banks in the country perform the following function: creation of money, community savings, ensure smooth support of payment mechanisms, ensure smooth flow of international transactions, storage of valuable goods and provision of credit services. The Central Banks of Nigeria falls under Treasury docket, is accountable for the formulation and execution of monetary policy and foster of liquidity and proper operations of Nigerian commercial banks. This policy formulation and implementation also include commercial banks financial risk management and financial performance (Central bank of Nigeria, 2015).
The Nigerian banking sector has undergone many regulatory and financial reforms in the past. Such reforms have brought in so important changes to the banking sector as well as inspiring foreign banks to enter theNigerian market (Irungu, 2013). The banking sector is governed by the Banking Act and so on including Prudential Guidelines.
Commercial banks in Nigeria are required by CBK to submit audited annual reports, which include their financial performance and in addition disclose various financial risks in the reports including liquidity risk, credit risk and so on, as well as management of credit risk. Effective management of credit risk practices involve reporting, reviewing to ensure credit risks well identified, assessed, controlled and informed responses are well in place by commercial banks. When the loan is issued after being approved by the bank’s officials, the loan is usually monitored on a continuous basis so as to keep track on all the compliance issues/terms of credit by the borrower (CBK, 2015).
1.2 Research Problem
The modalities of banking system have really changed in recent times compared to how they used to be some years back (Sehrish, Irshad & Khalid, 2010). Banking industry especially in the developing countries has witnessed momentous changes over the past few years (Al-Jarrah, Ziadat & El-Rimawi, 2010). However, compared to other sectors the banking sector has experienced weighty changes mostly due to technological innovations and the unstoppable forces of globalization have continued to create expansion opportunities as well as challenges to bank’s managers to ensure their bank remain profitable and competitive (Scott & Arias, 2011). As such, banks face more high degree of risks compared to other business. Such risks are capable of adversely affecting the bank’s profitability (Adeusi, Kolapo & Aluko, 2014).
Financial sector is highly dominated by banks in Nigeria compared to other players like SACCOs and microfinance’s. However, despite good overall performance in financial perspective, of most commercial banks, there are some banks recording losses (Ongore & Kusa, 2014). For instance, the National Bank of Nigeria reported a loss for the financial year 2014/2015 while the Cooperative bank of Nigeria had reported a drop in their profits in 2014 resulting to restructuring. In spite of strong regulatory and legal framework enforce by the Central Bank, the Nigerian banking system has experienced banking problems since 1986, which has led to the collapse of more than 40 commercial banks (Gitonga, 2014) with the recent ones in 2015 and 2016 being Imperial and Chase banks respectively. Further, based on the annual CBK Supervision Reports, the pace of growth of commercial banks in Nigeria has been on a decline and as such, the growth in profitability has been on the declined (Sawe, 2011).
Several studies have also been done on determinants of banks’ profitability locally and across the globe. Globally, a study by Athanasoglou and Delis (2005) evaluated impact of industry-specific, bank-specific and macro-economic determinants of commercial banks profitability and established that all bank-specific determinants, apart from size, influence banks profitability. In addition, Roman and Tomuleasa (2013) evaluated the effect of specific internal and external factors on profitability of the banks in the new European Union member states and established that both bank specific factors like capital adequacy, NPL, income and external factors, like GDP growth rate and inflation affect commercial banks profitability. However, majority of the available international studies combine both the bank specific factors with the industry and other macro-economic factors.
In Nigeria, a study by Ongore and Kusa (2014) studied the moderating impact of the ownership structure on bank performance and established that moderating impact of ownership identity on bank’s performance in financial perspective was not significant but the study focused more on the influence of ownership structure. Tsuma and Gichinga (2016) also analyzed the factors that influence the bank’s performance in financial perspective with focus on National Bank of Nigeria and found that capital adequacy, credit risk, inflation and interest rates influenced financial performance but the study focused on a single commercial bank, which may not be representative of the whole Nigerian banking industry. Most of the available literatures on the factors that affect commercial banks profitability combine both micro, industry and micro determinants with few of them focusing on internal factors, which influence profitability. Thus, the aim of the study, which intends to investigate: which are the determinants of profitability in banking industry inNigeria?
1.3 Research Objective
To establish determinants of profitability of commercial banks in Nigeria.
1.4 Value of the study
The study will benefit the bank’s managers as they will use study findings to identify various factors that influence profitability of banking industry in Nigeria. In addition, the managers may also adopt the study recommendations to improve performance and profitability where possible. The findings will also be of value to other firms in the banking industry in Nigeria like microfinance organizations, saving and cooperative societies, insurance firms and pension fund firms who operate similarly to commercial banks to identify factors, which may influence their profitability.
The study findings will also be of value to various policy making institutions in Nigeria including the Central Bank of Nigeria, the Nigeria Bankers Association and other regulatory authorities to generate policies, which will help to enhance the profitability of banking industry in Nigeria a well as to ensure they attain their commercial objectives.
The findings will also be of importance to literature, as it will add on to the existing literature on profitability and financial performance of banking industry. Finally, future scholars and researchers may also use these findings as a basis for additional research.