CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

The roles of commercial banks play in the process of economic development in

every country are crucial. They through financial intermediation increase the

levels of national savings and investments by mobilising idle funds from surplus

spending units (savers) and channel them to deficit spending units(borrowers) for

investments in the economy . (UGBAJA 1999)

By playing these roles within a particular country the independence of global

economics created the need for global interbanking a trend which in turn

emphasizes the need for the stability of the banks involved in intercontinental

banking transactions.

Also banking business carries a lot of risks and banking public needs assurance

about the safety of their confidence in the banking institutions.

The need for supervision and control of commercial banks activities is to ensure

that they adhere to the stipulated monetary policies rules and regulations as well

2

as accepted ethical conducts. However the major contributing factor that has led

to the failure of Nigerian banks in the past can be described as moral hazard

(adverse incentives)

Moral hazards or adverse incentives are a concept with relevance to a variety of

principal agent relationships characterized by asymmetric information. The moral

hazard concerns the adverse incentives on banks chief executives to act in ways

which are contrary to the interests of the banks creditors (mainly depositors or

the government if it explicitly or implicitly insures deposits) by undertaking risky

investment strategies (such as lending at high interests rates to high risk

borrowers) which if successful would ` jeopardise the solvency of the bank.

Bank owners have incentives to undertake such strategies because with limited

liability they bear only a portion of the downside risk but stand to gain through

higher profits a large share of the upside risk. In contrast the depositors (or the

deposit insurers) gain little from the upside risk but bear most of the downside

risk.

The inability of depositors to adequately monitor bank directors because of the

asymmetric information allows the latter to adopt investment strategies while

entail higher levels of risks.

3

Moral hazard on bank executives can be exacerbated by a number of factors

Firstly an increase in the interest rate may lead borrowers to choose investments

with higher returns when successful but with lower probabilities of success

(Stieglitz and Weiss 1989) hence a rise in deposit rates could induce banks to

adopt more risky investment strategies. A rise in bank lending rates can have a

similar incentive effects on the banks borrowers.

Secondly macroeconomic instability can also worsen adverse incentive if it were

to affect the variance of the profits of the bank borrowers especially when there

is a co-variance between borrower’s profits. (E.g. if a large share of borrowers are

in the same industry) or if loan port folios are not well diversified among

individual borrowers.(McKinnon 1988)

Thirdly the expectation that the government will bail out a distressed bank may

weaken incentives on bank executives to manage their asset port folio prudently

and incentives on depositors to monitor banks and choose only banks with a

reputation of prudent management. Deposit insurance also reduces incentives for

depositors to monitor banks.

Fourthly moral hazard is inversely related to bank capital. The owners of poorly

capitalized banks have little of their own money to loose from risky investment

4

strategies. By implication financial distress in the bank itself worsens moral

hazard because as the value of the bank’s capital falls the incentives on its

owners to pursue strategies which might preserve its solvency are reduced

(Berger et al.1995 pp 398-99) for similar reasons intensified competition in

banking market can also encourage moral hazard by reducing the franchise value

of banks future profits.

Moral hazard becomes even more acute when the bank lends to projects

connected to its own directors or managers (insider lending). In such cases the

incentives for imprudent and fraudulent bank management are greatly increased

in that all of the profits arising from the project are internalized.(in the case of

loans unconnected borrowers the project returns are split between lender and

borrowers)whereas that part of the losses borne by depositors or task payers are

externalised. Not surprising insider lending is a major cause of bank failure

around the world.

These ills going on in the commercial banks as stated above make it imperative

for the central bank of Nigeria (CBN) to be on the watch at all times through their

supervisory and control functions so as to protect them from going insolvent

which usually impacts negatively on the economy in general.

5

Confidence plays a key role in bank operations. Any information whatsoever

implying that the financial position of a bank has worsened can have a negative

impact on all the cash flow in that bank. Therefore every bank will attempt to

conceal the problem of insolvency. Banks are highly successful in this respect and

therefore the problem of insolvency is often not recognised in time by the

government agencies entrusted with bank supervision.

Problems in the banking system or in the economy as a whole occur when a

number of banks become insolvent or when a relatively large share of the

liabilities of the banking system is not covered by good assets. The occurrence of

such problems indicates that the efficient asset and liability management is

present in a significant portion of banking if a large part of banks asset is

allocated to unprofitable projects. There will be a reduction in investment

efficiency and thereby a slowdown on economic growth.

These could be decrease or seizure of loans grants to the public when the

problems of bank insolvency begin to be resolved. When banks attempt to restore

solvency by ceasing to grant loans to bad clients and raising the interest speeds

there is less available loan and they are more expensive. One consequent can be

the negative selection of clients. Enterprises that do not have alternative sources

6

of financing will be ready to accept higher bank interests rate independently of

whether the projects to be financed are profitable or less profitable. Such a trend

could also exert a negative impact upon investment efficiency.

If banks attempt to solve the problems of insolvency by raising additional funds

interest’s rates will rise and there will be pressure to conduct a softer monetary

policy. Banks also seize additional liquidity in foreign countries which affects the

trends in the balance of payments.

The right which the central bank of Nigeria has to supervise and control the

banking industry is backed by the CBN Act no 24 of 1991 now CBN ACT 2007 and

the banks and other financial institution Act no 25 of 1991 (now BOFIA 2004).

These laws empowers the CBN to carry out a supervisory and control functions on

all commercial banks and other banks in the country

The powers as specified by section 39 of the CBN Act which may be expressed by

the CBN from time to time in the supervisory and controlling functions include the

powers to specify critical ration to call for information from banks and to inspect

the books of any bank to under condition of secrecy.(Afolabi 2000: 10s)

Section 30and 7 and 8 of the banks and other financial acts no. 25 of 1991 (now

BOFIA 2004) stipulates that every banks shall produce on demand all the books

7

accounts documents and information as the CBN examiners may deem fit in the

exercise of his functions. It also stipulates as punishable the wilful refusal of any

bank to produce such documents as well as negligence or wilful furnishing of false

information to CBN.

The control of the banking industry by CBN is carried out in partnership with the

federal government which has the overall authority over the system. Thus the

CBN initiates the guiding policy measure and implements them only as approved

by the government. The CBN measures to control the banks through a number of

stages which include the identification of the objectives and targets of policy.

Policy formulation policy implementation and review as well as other extra

measures for commercial banks (ogwuma 2004:2).

Supervision and control by the CBN impact significantly on the activities and

performance of commercial banks between 1986 and early 2010 the supervisory

and control measures of the CBN seemed ineffective on a number of occasions

and this contributed to the hitherto distress in the banking sector. Since 2004

there has been series of new supervisory and control measures introduced by the

CBN into the banking system with the aim of improving the performance of the

banking sector.

8

Against this background however the study however the study is geared

towards examining the impact of supervision and control of CBN on commercial

banks in view of how their performance is affected from the negative and the

positive perspectives with concentration on the roles that CBN played from 2004

to 2011.

1.2 STATEMENT OF THE PROBLEM

The supervision and control of commercial banks by CBN sometimes impact

adversely on the operations and performance of the former. This is as a result of

difficulties associated with the supervision and control mechanism.

With respect to supervision it appears that the CBN apparatus are not effective.

Banks examination are often not timely not regularly carried out or haphazardly

done.

Secondly some of the CBN examiners are not sufficient competent and thirdly

they are not large enough to supervise all the commercial banks effectively. The

result is that deficiencies to the operations of these banks are not timely

discovered and adequately controlled. All these adversely affect the commercial

banks.

9

With regard to the control often times the measures are too stringent for

effective operations and performance of the commercial banks. Restrictive

monetary control measures limit the liquidity and capacity of commercial banks

to grant loans or credit. Besides direct interactions in banking activities by the

CBN sometimes have adverse effects too.

In the light of the aforementioned attempt will be made to appraise the impact

of central banks supervision and control on the performance of commercial

banks.

1.3 OBJECTIVES OF THE STUDY

In lieu of the problems stated above the objectives of the study are

1. To analyse the objectives of supervision and control of commercial banks in

view of the existing monetary policies of the CBN.

2. To examine the effectiveness of the supervisory and control techniques of

the CBN specifically the ability detects malpractice on time.

3. To assess the impact of supervision and control on the performance of

commercial banks with regards to liquidity.

4. To appraise the ongoing reforms of the CBN.

10

1.4 RESEARCH QUESTIONS

The following questions will be addressed in this study

1. To what extent do the relationship between the current monetary policies

of the CBN and the performance of commercials banks as it affects granting

loans/credit?

2. To what extent do the supervisory and control techniques effectives

enough to detect misconduct on time?

3. How can these functions of the CBN have any effect on the liquidity of

commercial banks?

4. To what extent do the ongoing reforms by the CBN affect the performance

of the commercial banks?

1.5 SIGNIFICANCE OF THE STUDY

The significance of the study derives its usefulness from many respects. Firstly

the monetary authorities (CBN) and federal government will find the study very

useful. This is because the study will examine the various techniques of

supervision and control of commercial banks and identify their deficiencies and

constraints. This information will then enable the government and the CBN to

take remedial measures which will be suggested in this study.

11

This study will also be useful to the banking and non banking financial institutions.

It will provide information on why many of them operate and perform dismally

under the CBN supervisory and control functions. This will give these institutions

an understanding of their weakness and the information will enable them to take

corrective actions which again will be suggested in this study.

Again investors and banking public will appreciate this study because of the

information it contains. The study will enable them to understand the role of the

CBN in ensuring safety of their funds in the banks and this will help in sustaining

their confidence in the banking industry.

Finally the study will be useful to students who will carry out related studies; it

will serve as a relevant material to them.

1.6 SCOPE OF THE STUDY

The study focuses on the importance of the CBN supervision and control on the

performance of the commercial banks. Thus its scope covers the need for

supervision and control as well as goals techniques and effects of these exercises

on commercial banks operations and performances

1.7 LIMITATIONS OF THE STUDY.

12

The limitations of the study may include.

1. The difficulty of obtaining primary information from CBN and some

commercial bank staff their uncooperative attitude may adversely affect

primary data collection.

2. Inadequate finance which may pose a restriction with regards to travelling

outside Enugu to include many more commercial banks for an extensive

study. Therefore the study may be restricted to Enugu metropolis only.

3. The difficulty of combining the research with other academic works in the

school.

1.8 DEFINITION OF TERM

1. BOFIA- Bank and other financial institution act

2. NDIC- National deposit insurance corporation.

3. AMCON- Asset management corporation of Nigeria

4. CBN- Central bank of Nigeria.

5. NSE- Nigerian stock exchange.

13

REFERENCES

Alhanasogbu pp Brissmis S.N and Delis M.D (2005) Bank specific

industry specific and macro Economic Determinants of Banking

profitability Bank of Greece working paper no 25

Ayodele Thompson and Olusegun Sotala: AMCON Is CBN Intervention in

public interest Opinion columnist August 18 2010.

Bankers and other financial institution Act No 25 of 1991 section 30 (7)

and (8)

14