Impact Of Bank Competition On The Nigerian Banking System

Project and Seminar Topics with material for Banking and Finance

Impact Of Bank Competition On The Nigerian Banking System


Abstract


This study seeks to determine the relationship between bank competition and banking system stability in the Nigerian banking industry. Annual data were employed in the course of this research. The sources of the data employed were the Central Bank of Nigeria and Nigeria Stock Exchange Fact Book. Three macroeconomic variables and the entire banks quoted in the Nigerian Stock Exchange. The dependent variable for the study is Z-Index. While concentration ratio of the first three largest bank, concentration ratio of the first five largest bank, Herfindahl-Hirschman Index, Lerner Index, gross domestic product, interest rate and inflation rate, return on asset, capital structure, operating leverage and non- performing loans to total asset ratio were the independent variables. The study employed the use of panel data regression in its analysis. The study found that capital structure, CR5, HHI, GDP, interest rate, operating leverage and Lerner Index all have positive signs were positively related to bank stability. The study revealed that competition, Bank risks and returns on asset were the only variables significant at the 5% significant level. The instability in Nigerian banking system is as a result of competition among banks, and inefficient use of the bank’s assets.


Chapter One


Introduction

1.1 Background of the Study

The banking industry plays a very important role in the economic growth of any country; it acts as an intermediary between the lenders and the borrowers of funds in the economy. It also provides financial resources to other industries and hence facilitating production (Kocabay, 2009). Stability in the banking system is also important, since any instability in the banking system has the potential to lead to a financial instability and economic crisis. Hence, a well- functioning banking system is regarded as the thrust of a market economy. These specific features make the banking system important to the economy and hence distinguish it from other industries in an economy. As banking system is a development vehicle in any economy and hence its stability is very important, its primary aim of establishment by their owners is to generate and maximize profit. Every bank in the banking system tries to make more profit than the others. In a bid to make more profit by the individual banks, they embark on fierce competition among themselves.

Competition is the process of trying to outwit and win others for the aim of having an edge over them in the same business. Competition is desirable for the maximization of social welfare and the existence of an economic equilibrium in which it is impossible to change the allocation of resources without improving the lot of one agent at the expense of another; this leads to Pareto efficiency (Whish, 2005). In a competitive market setting, there is allocative and productive efficiency as well as dynamic efficiency (Motta, 2004). As in other industries, competition in banking system is also needed for efficiency and maximization of social welfare.

The banking industry needs to be competitive and efficient in order to provide its services judiciously. On the other hand, the Policymakers try to ensure that banking system is stable besides ensuring that it is competitive and efficient (Kocabay, 2009). Financial system stability is the resilience of the financial system to internal and external shocks, be it economic, financial and political (Lakers, 1999). It can also be described as the presence of excessive fluctuations in the macro economy which will lead to changes in the macroeconomic costs of disturbances in the system of financial exchanges between households, businesses and financial institutions. Therefore stable banking system efficiently allocates resources, assesses and manages financial risks, maintains employment levels to close eliminate relative price movements of real and financial assets to stabilize monetary and economic levels.

However, there has been a conventional wisdom among policy-makers and academicians that more competition in the banking system is associated with greater instability; hence there exists a trade-off between competition and banking system stability. This is the so-called “competition-fragility” or “concentration-stability” view (Kocabay, 2009). This view is supported theoretically by a great number of studies. The supporters of this view believe that higher competition erodes profit margins causing banks’ franchise value to drop, thus reducing incentives for prudent behavior and leading to more aggressive risk taking in an attempt to earn higher profits (Kocabay, 2009).

There is another school of thought in the literature with a view that greater competition among banks contributing to banking system stability and hence there exists no trade-off between competition and stability in the banking system. This is the so-called “competition-stability” or concentration-fragility” view (Kocabay, 2009). This view is mainly built on the “risk shifting paradigm” which states that increase in market power and the resulting higher loan rates have the potential to negatively affect the stability of banks due to moral hazard and adverse selection problems on the part of borrowers. Another argument supporting the competition-stability view is mainly based on the positive impact of competition on regulation and supervision of banks. The final argument is about the effect of “too-big-to-fail or too-important-to-fail policies” in concentrated banking systems on risk taking incentives of banks and borrowers and hence on the stability of banking system (Levy and Micco, 2007).

This research aims to draw together these different strands of literature to provide a more comprehensive framework for the analysis of the mechanism by which bank competition enhance banking system stability in Nigeria.


1.2 Statement of the Problem

The importance of the banking system in any economy cannot be over emphasized; the banking system provides a junction for those that need financial support and those that have excess finance to give out. The system is a cornerstone for the growth and development of any economy (Kocabay, 2009). In any dynamic economy where there is growth and development, there is always an increase in the number of banks in the system. The increase in the number of banks leads to competition in a bid to increase their share of the market with the aim of making more profits (Whish, 2005). Competition leads to innovation, growth, development, professionalism among others.

In the literature, a school of theoretical studies is of the opinion that more competition in the banking system is associated with greater instability; hence there exists a trade-off between competition and banking system stability. This is the so-called “competition-fragility” or “concentration-stability” view (Motta, 2004).

Another school of theoretical studies is of the view that greater competition among banks contributes to banking system stability and hence there exists no trade-off between competition and stability in the banking system, this is the so-called “competition-stability” or “concentration-fragility” view (Whish, 2005).

Some other theoretical studies did not propose a clear view of a positive or negative links between competition and stability. Hence, besides the competition-fragility and competition- stability views, there is a view stating that the relation between market structure and stability of banking sector is not straightforward. They argued that this relation is complex and has important interactions with macroeconomic, regulatory and institutional framework of countries and changes with different model specifications (Levy and Micco, 2007).

Surprisingly, more competition in the banking industry has led to competition for deposit, which drove nominal interest rates up and eventually could not ensure a cheaper cost intermediation. The incidence of fraud and of non-performing loans in Nigeria has also increased. The quality of management is a major determinant of a bank’s long-term survival and the death of qualified management personnel to meet the challenges of sudden growth in the industry contributed to the instability in the banking industry.

Going by the different schools of thought in the literature concerning bank competition and banking system stability, the statement of research problem of this thesis will be to determine the relationship between bank competition and banking system stability in the Nigerian banking industry.


1.3 Objectives of the Study

In line with the statement of research problems the objectives of the study are to determine the relationship between bank competition and banking system stability in Nigerian banking industry.

The objectives therefore are:

  1. To determine the relationship between bank competition and banking system stability in Nigeria.
  2. To access the impact between macroeconomic indicators and banking system stability in Nigeria.
  3. To evaluate the relationship between banking industry specific factors and banking system stability in Nigeria.

1.4 Research Questions

The following research questions have been constructed to guide the study and enhance proper assessment of the work.

  1. Does bank competition leads to banking system stability in Nigeria?
  2. Does the macroeconomic indicators leads to banking system stability in Nigeria?
  3. Does the banking industry specific factors leads to banking system stability in Nigeria?

1.5 Hypothesis of the Study

In line with the statement of research problems and the objectives of this thesis, the following hypothesis will be tested: Null hypothesis will be denoted by Ho.

Ho1. Bank competition has no significant impact on banking system stability in Nigeria.

Ho2. Macroeconomic indicators has no significant impact on banking system stability in Nigeria.

Ho3. Banking industry specific factors has no significant impact on banking system stability in Nigeria.


1.6 Scope of the Study

This study focuses on bank competition as a measure in ensuring stability in the banking industry in Nigeria. The work will make use of secondary data collected from CBN report, all the listed banks in the Nigeria capital market and statistics analysis will be done to see the relationship of these variables. The study will be reviewed commercially between the periods of 2004 to 2013 to ensure proper assessment.


Chapter Five


Summary and Conclusions

This study analyzes the relationship between bank competition and banking stability for banks in Nigeria. The banking system in Nigeria indicate a low level of market concentration but the concern is that it is increasing in the post crisis period. At the same time, it has achieved a quite satisfactory performance in terms of financial stability, as shown during the global financial crisis. Given this motivation, we investigate how the nexus between competition and stability works for the banks in Nigeria. In particular, we provide two main contributions with respect to the previous literature. First, we explore whether and how competition may affect stability with regard to three different types of bank risk at the institution level—solvency, and credit risk— and we show that the heterogeneous effects observed in the existing literature may be explained in terms of different types of risk. Second, we examine how market entry, bank regulation, and bank supervision may shape, or change, the impact of competition on different sources of bank risk.

The empirical results suggest that the effects of bank competition on stability may differ depending on the type of risk. In particular, we observe that competition has a positive effect on bank liquidity, while it may have a potentially negative impact on solvency and credit quality. Price competition improves the liquidity position of a bank by inducing a self-discipline mechanism on the choice of bank funding sources. If banks are subject to strong competition, they get lower profit margins and are then unable to afford costly funding sources; for this reason, they prefer to keep larger buffers of liquid assets. Capital regulation may strengthen the liquidity-enhancing effect of price competition, while deposit insurance may reduce such incentives.

Also, price competition may reduce bank profits and then imply a possibly negative effect on solvency. In general, if banks pursue active management of their capital, they may respond to a decrease in profitability by increasing their capital base so as to improve their resilience. In such a case, competition may have a positive effect on bank solvency if the increase in bank capital is sufficiently large to compensate for the reduction in bank profits. Then, a country’s regulatory framework may affect the incentives of banks in various ways. On one hand, the presence of a deposit insurance scheme reduces the opportunity cost of a potential insolvency for competitive banks and so the rationale for a capital increase. On the other hand, prudential requirements may provide an effective mechanism for banks with market power to safely manage their additional profit margins and increase their capital buffers.
Price competition may increase the credit risk of the loan portfolio if banks are induced to take on additional risks to improve their profitability. In such a case, the effect of an increase in bank risk taking from the lender’s side would be more relevant than the effect of a potential decrease in credit risk from the borrower’s side. As also observed for solvency, capital regulation may provide the appropriate incentives for prudent management of banks with market power.


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