Basel / Macro-Prudential Tools And Financial System Stability In Nigeria

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Abstract

This study aimed to determine the level of post-consolidation financial stability in Nigeria and the effect of the Basel I Accord implementation on this stability. Secondary data on post-consolidation aggregate bank profits and liquidity (measures of financial stability) and post-consolidation aggregate capitalization of banks (made in compliance with Basel I Accord) obtained from the Statistical Bulletin, 2014 were analysed using the GARCH model. Research results show that there exists volatility in bank profits (indicating long-term financial instability), withthe relationship between both variables positive; and there exists no volatility in aggregate bank liquidity indicating the existence of financial system stability (short-term/liquidity stability)with a significant relationship existing between Basel I Accord and the bank liquidity. These findings necessitate the immediate implementation of Basel II, II.5 and III with improved supervisory review process, disclosures and market disciplines, enhanced minimum capital and liquidity requirements, enhanced supervisory process for firm-wide risk management and capital management and capital planning, enhanced risk disclosures, market discipline, required liquidity standard, leverage ratio and minimum total capital ratio to check excessive risk taking by DMBs, transmit the positive stability in liquidity to stability in profits of DMBs to improve Nigeria’s short-term and long-term financial system stability, and shield the system from external shocks and cross-border contagion. Aggregate bank capital, bank consolidation, Basel I Accord, bank profits, financial stability, macro-prudential tools, liquidity.

Chapter One

1.0. Introduction

1.1 Background to the Study

The adoptions of the Basel Accord by the G-10 countries had as its aim, the promotion of sound financial systems in these countries and strengthen the existing stability in the international financial system. The achievement of these goals necessitated the establishment of an equitable and consistent international banking system. With a sound and stable banking system, banks will be able to finance corporate expansions and growth, and foster economic growth and development. The Basel I Accord determined adequate capital for banks using the capital adequacy ratio of 5% of capital considering the percentage of risk-weighted assets to guard against banking risks. Hussain et al (2011) argued that concerns of possible negative effects of capital deficiencies in banks exists as evident in the G-10 countries at the implementation of the Accord with attendant financial system regulation.

Financial system regulation, according to Llewellyn (1986) is increasingly accepted as a tool to ensure soundness in the system and maintain safety. Research results by Oloyede (1994) showed that the banking industry unlike others, are prone to volatility and fragility from either exogenous or endogenous shocks making the industry amenable to regulation and supervision. Ezike and Oke (2013) opined that stability and consistency (as evidenced in the implementation of the Basel I) is imperative in the banking sector as surveillance and regulatory measures of the Central Bank of Nigeria (CBN), have unfortunately been unable to keep pace with the rapidity of the changes in the financial system. On the necessity of regulation in the banking sector, Ogunleye (2005) noted that regulation is necessary to ensure efficiency, diversity of choice, competition, stability of the financial system, macroeconomic stability and development, and the attainment of social objectives. Arguments by Mbizi (2012) supports financial system regulation as, according to him, “they serve as prudential measures that mitigate the effects of economic crisis on the stability of the banking system and subsequent accompanying macroeconomic results; cautioning that excessive regulation may increase the cost of intermediation, and reduce profitability of banks, creating instability in the banking system. Rhetorically, he questioned “what benchmarks of regulations are right?”

From theory and empirical analysis, Hussain et al (2011) noted that capital requirements leads to sudden contraction of bank lending, with negative effects on the economy, bank incomes and financial stability of the financial system. This assertion was supported by Naceur and Kandil (2013). Internationalization and integration of the banking system of less developed countries to the banking systems of developed countries increased banking risks in less developed countries. Furthering, Hussain et al (2011) argued that debts in less developed countries, growth in off-balance sheet activities, deregulation of deposit interest rates, rapid technological change and international bank competition, eroded capital bases of international banks of these countries. Findings by Wagster (1999) of credit crunch in relation to changes in balance sheet accounts and systematic risks of G-10 countries showed that between 1989 and 19992, banks in the United states, United Kingdom and Canada experienced asset reallocation from loans to securities and an increase in systematic risk.

The implementation of the Basel I Accord, he added, gave a competitive edge to banks to banks in Canada, the United Kingdom and Germany improving returns to deposit money banks (DMBs). The Central Bank of Nigeria introduced the Basel I Accord in 2004 resulting in increase in capital base of banks to N25 billion. The exercise reduced the number of banks to 25 with all financially stable and sound with more funds to finance economic growth (CBN, 2007). How has the introduction of the Basel I Accord affected financial performances of deposit money banks (DMBs)and overall financial system stability?

1.2 Problem Statement

In Nigeria, the jury is yet to be out on the trickle down path of the application of macro prudential instruments, neither are the magnitudes of impact clearly understood making the policy framework rather contingent on the prevailing conditions. Several studies such as CBN (2010) have examined the traditional channels of monetary policy transmission in Nigeria. However, given the combined use of monetary policy and macroprudential policy in recent times to achieve key objectives of monetary policy, it is quite imperative to shed light on the transmission path of macroprudential policy. This study provides a pioneering effort in this direction given the country’s susceptibility to shocks such as capital flows and exchange rate volatility.

1.3 Objective of the Study

The Basel I Accord has been successfully implemented in Nigeria with expectations as contained in the Accord. This paper aims to determine the effectiveness of macro-prudential tools in the Basel I Accord in entrenching and maintaining financial stability in the Nigerian financial system. Provision of adequate capital to forestall illiquidity in the financial system and boost bank customer confidence necessitated the bank consolidation exercise in 2004 in Nigeria. This exercise increased the capital base of each bank to N25 billion. Thus, banks in Nigeria had adequate capital to cover total credit advanced and sustain liquidity in the banking system.

1.4 Justification for this Study

Studies on the impact of Basel I on micro and macroeconomic variables within and across countries are rife in literature. Peek et al (1995) investigated the short-run impact of Basel I on credit. Berger et al (1994) investigated the long-run impact of Basel I on bank credit in the United States. Hassain et al (2011) tested the impact of the Basel I Accord on credit expansion in developing countries.

Nwidobie (2014) investigated the effect of bank credit and GDP in Nigeria. Studies by Ho and Sasaki (1998), Kim and Moreno (1994), Woo (1999) and Honda (2002) were on the impact of Basel I Accord on bank credit. Chiuri et al (2001) focused on Basel I and bank credit in 16 emerging market economies. Barajas et al (2005) conducted similar study on the impact on Basel I Accord on credit crunch in Latin America. Aggarwal et al (2001, 1988) and Jacques et al (1997) investigated the effect of the imposition of capital base regulations on banks through the Accord on banks in developed economies. Husaain and Hassan (2004) conducted similar study on Basel I and risk-taking by DMBs and capital ratio. Study on basel I and financial stability seems non-existent necessitating this study.

1.5 Research Hypotheses

To determine the effectiveness of the macro-prudential tools in the Basel I Accord on financial stability in Nigeria, the following hypotheses is tested in this study:

Ho: Implementation of the macro-prudential requirements in the Basel I Accord has not improved aggregate bank profitability (financial system stability)

H0: Implementation of the macro-prudential requirements in the Basel I Accord has not improved aggregate bank liquidity (financial system stability)

1.6 Scope and Limitation

This study takes into strict consideration the Deposit Money Banks (DMBs) and macro prudential model. The study however, was limited by literatures as there were few literatures on the subject of discourse. Also, the methodology used was quite uncommon in this study.

1.7 Definition of Terms

Macro-Prudential Policy:

Is a novel way of looking into financial regulation. As defined by European Central Bank, macro prudential policies aim to: prevent the excessive build-up of risk, resulting from external factors and market failures, to smoothen the financial cycle (time dimension); make the financial sector more resilient and limit contagion effects (cross-section dimension)

Financial System:

A financial system can be defined at the global, regional or firm-specific level and is a set of implemented procedures that track financial activities.

Stability:

Ability of a substance to remain unchanged over time under stated or reasonably expected conditions of storage and use. Usually the conditions that may cause instability (such as humidity, shock, or temperature) are identified in the MSDS for the substance.

1.8 Organization of Study

This study is organized in five chapters. The first chapter lays the background to the study as well as stating the problem of study and the hypotheses for testing. The second chapter is structured to give the study a literature review. This review is divide into the theoretical framework, Empirical framework and the conceptual framework. Chapter three deals with research methodology including the research design, sampling method, Data collection and the research instruments employed. Chapter four seek to analyze the result, it is also made up of detailed analysis of data collected and presentation of information with the aid of quantitative and statistical models. The fifth chapter covers the summary, conclusion and recommendation

Chapter Five

Summary, Conclusion and Recommendation

One of the key policy objectives of the Central Bank of Nigeria is to promote and maintain a safe and sound financial system that can enhance overall macroeconomic development.

Against the implications of the findings on the impacts of macro- prudential policy shocks on the economy, there are some important intuitions that can be gleaned with potential attributes that can inform management decisions on policies aimed at guaranteeing a safe and sound financial system. First, it highlights the importance of macro- prudential measures in ensuring the soundness of the entire financial system. Second, the work identified the key channels and measures their potential impacts on the economy-wide range. Third, the papers succinctly relate the impact of shocks to these macro-prudential instruments on the stability of the entire financial system.

Consequently, the three key channels: capital, credit and liquidity provide eclectic mechanisms for tracking the dynamics of capital adequacy ratio, loan to value and liquidity in the banking system, respectively on the health of the economy. Therefore, this paper suggests among other things that;

From time to time, macro-prudential analysis should be carried out to keep an eye to the behaviour of these important variables and other variables that affect the prudential variables and guidelines.
There is the need to link these prudential variables to on-site and off-site supervision by the bank examiners.
A Macro-prudential Unit or Office or desk should be set up to systematically monitor these critical variables; and
There is the need to strengthen both micro and macro-prudential based supervision to forestall systemic risks that can spillover the economy and mitigate such risks with appropriate prudential guidelines.

Conclusion

This work has examined the transmission channel of macro-prudential policy instrument on the Nigerian economy. It attempted to identify the links and how the shocks (impulses) from these prudential instruments are transmitted to the economy. Following a critical search of the literature on the subject, three key channels have been identified: the capital, credit and liquidity channels. Using a structural VAR (SVAR) framework to examine the impact of macro-prudential shocks based on the identified channels, the result depicts the impact of different macroeconomic variables and show that generally a one unit innovation in the reserve ratio statistically and significantly affects most of the variables adversely in the contemporaneous period.

Specifically, it is found that the loan to value which is the credit channel is the main link in which prudential weakness can trigger systemic crisis in Nigeria. for instance, a unit increase in reserve requirement significantly affect interest rate spread positively by 0.04 units, indicating the impact of contracting monetary policy stance on interest rate spread in the economy, measured by the spread. The negative impact of reserve requirement increase on loan to value ratio and interest rate spread contemporaneously satisfies the theoretical expectations as they simultaneously worsened significantly at one per cent. This indicates that a shock to the loan to value ratio affects the stock market indicator adversely and by extension, the corporate earnings of banks and firms would be negatively affected.

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