i

ONYEBUCHI SABINUS EZE

PG/MBA/08/47550

RISK MANAGEMENT IN BANK LENDING:

A CASE STUDY OF EQUITORIAL TRUST BANK

PG/M. Sc/09/51723

RISK MANAGEMENT IN BANK LENDING:

A CASE STUDY OF EQUITORIAL TRUST BANK

BUSINESS ADMINISTRATION

A THESIS SUBMITTED TO THE DEPARTMENT OF BANKING AND FINANCE,

FACULTY OF BUSINESS ADMINISTRATION, UNIVERSITY OF NIGERIA ENUGU

CAMPUS

Webmaster

Digitally Signed by Webmaster’s Name

DN : CN = Webmaster’s name O= University of Nigeria, Nsukka

OU = Innovation Centre

MARCH, 2012

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TITLE PAGE

RISK MANAGEMENT IN BANK LENDING: A CASE STUDY OF EQUITORIAL TRUST BANK

BY

ONYEBUCHI SABINUS EZE

PG/MBA/08/47550

RESEARCH PROJECT SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENT FOR THE AWARD

OF MASTER OF BUSINESS ADMINISTRATION (MBA)

DEPARTMENT OF BANKING AND FINANCE FACULTY OF BUSINESS ADMINISTRATION

UNIVERSITY OF NIGERIA ENUGU CAMPUS

SUPERVISOR DR. J.U.J ONWUMERE

MARCH 2012.

iii

DEDICATION

To my parents, Mr. and Mrs. Edwin O. Eze for their Love,

Concern and passion for their children.

iv

CERTIFICATION

This is to certify that this research work by Onyebuchi

Sabinus Eze, Reg. No. PG/MBA/08/47550 presented to the

department of Banking and Finance, University of Nigeria,

Enugu Campus is original and has not been submitted for

award of any degree or diploma either in this or any other

tertiary institution.

…………………………… ………………………… Onyebuchi Sabinus Eze PG/MBA/08/47550 This is to certify that this study:RISK MANAGEMENT IN BANK LENDING,carried out by Onyebuchi Sabinus Eze under supervision,has satisfied the necessary requirements for the award of Business Administration degree in Banking and Finance of the University of Nigeria. ……………………………. DR. J.U.J ONWUMERE Date Project Supervisor

…………………………… ………………………… DR. J.U.J. ONWUMERE Date Head of Department

…………………………..

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…………………………… ………………………… External Supervisor Date

ACKNOWLEDGMENTS

My immense appreciation to the Almighty God for his mercies

upon this generation irrespective of our shortcomings.

I owe a lot of thanks to my supervisor, Dr. J.U.J Onwumere,

for his invaluable and dedicated guidance throughout this

research process. I also appreciate his able leadership of the

department of Banking and Finance, which encourages zeal

and passion for academic excellence.

For the encouragement and support in the course of this

program I feel a sense of gratitude:

To my sister, Mrs. Ifeoma Isiwu, for living a life of

integrity and service and for supporting my desire for

academic growth and development. It’s easy to teach

principles loved ones live.

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To my brothers, Uchechukwu, Chijioke, Chinedu and

Cosmas for their constant love, interest,insights and

purity of soul.

To my younger sisters, Nneka and Obioma for their

constant demonstration of love.

To my grandmother for her many living descendants and

for her constant demonstration of love.

To my nephews Chiamaka, Chidiebere, Chinaemerem,

Chinagorom and Chikamso for their inspiration.

To my friends, Uchechukwu Gregory, Obinna Otti, Agbo

Philip, Ogechukwu Ugwu, Chibogwu Nnaji and Onyeka

for their encouragement and assistance.

To all my friends and classmates in MBA class

2008/2009 session.

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ABSTRACT

The emergence of Banks owned by the local private sector began in the mid-1970s. Financial markets in the period since independence have been dominated by foreign and government owned commercial banks. But deficiencies in financial intermediation provided an opportunity for local private investors to enter financial markets. Between the late 1970s and the mid-1980s, 13 local Banks were set up in Nigeria. The growth of local banks accelerated dramatically in the second half of the 1980s, with 70 Commercial and Merchant Banks established between 1986 and 1991 when the Central Bank of Nigeria suspended issuing new licenses: almost all of these were wholly owned by local investors. In Nigeria, the rising cases of bank distress have also become a major source of concern for policy makers. As a result of attractive interest rate on deposits and loans, credits were given out indiscriminately without proper credit appraisal. The resultant effects were that many of these loans turn out to be bad. It is in realization of the consequence of deteriorating loan quality on the banking sector and the economy at large that this paper is motivated. This paper, therefore, attempts to evaluate the effect of risk management in bank lending, using Equitorial Trust Bank as a case study.

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TABLE OF CONTENTS

Title Page … … … … … … … … … i

Dedication … … … … … … … … ii

Certification … … … … … … … … iii

Acknowledgment … … … … … … … iv

Abstract … … … … … … … … … vi

Table of Contents … … … … … … … vii

List of Table … … … … … … … … x

CHAPTER ONE: INTRODUCTION

1.1 Background of the Study … … … … … 1

1.2 Statement of the Problem … … … … … 8

1.3 Research Questions … … … … … … 10

1.4 Objectives of the Study … … … … … 11

1.5 Research Hypothesis … … … … … … 12

1.6 Scope of the Study … … … … … … 13

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1.7 Significance of Study … … … … … 14

1.8 Operational Definitions of Terms … … … 15

References … … … … … … … … 18

CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction … … … … … … … 20

2.2 Types of Bank Credits … … … … … 22

2.2.1 Overdraft… … … … … … … 23

2.2.2 Loans and Advances … … … … 24

2.2.3 Special Credits … … … … … … 27

2.3 Constraints on Bank Credit Portfolio … … 29

2.4 Management of Portfolio … … … … … 30

2.5 Bank Consolidation in Nigeria … … … … 33

2.6 Credit Analysis … … … … … … … 35

2.7 Credit Risk Management and Prudential Regulation 40

2.8 Types, Analysis and Evaluation of Risk … … 43

References … … … … … … … … 52

CHAPTER THREE: RESEARCH METHODOLOGY

3.1 Introduction … … … … … … … … 53

3.2 Research Design … … … … … … … 53

3.3 Procedure for Data Collection … … … … 54

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3.4 Population of the Study … … … … … 54

3.5 Validity and Reliability of Measuring Instruments 55

3.6 Data Analysis Technique … … … … … 55

References … … … … … … … … 58

CHAPTER FOUR: DATA PRESENTATION AND ANALYSIS

4.1 Introduction … … … … … … … … 59

4.2 Data Presentation … … … … … … 60

4.3 Test of Hypothesis … … … … … … 62

References … … … … … … … … 74

CHAPTER FIVE: SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATION

5.1 Summary of Findings … … … … … … 75

5.2 Conclusion … … … … … … … 77

5.3 Recommendation … … … … … … 79

Bibliography … … … … … … … … 81

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LIST OF TABLES

Table I: Equatorial Trust Bank Asset Quality between 2003-2007… … … … … … … 60 Table II: Percentage of Equitorial Trust Bank Performing and Secured Loans to Total Loans and Advances 61 Table III: Equitorial Trust Bank Income Distribution (2003-2007) … … … … … … … 61

Table IV: Regression Table … … … … … … 62

Table V: Calculation of Standard Error of Coefficient 66

Table VI: Regression Table … … … … … 69

Table VII:Calculation of Standard Error of Coefficient 71

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RISK MANAGEMENT IN BANK LENDING (A CASE STUDY OF EQUITORIAL TRUST BANK)

BY

ONYEBUCHI SABINUS EZE PG/MBA/08/47550

DEPARTMENT OF BANKING AND FINANCE FACULTY OF BUSINESS ADMINISTRATION

UNIVERSITY OF NIGERIA ENUGU CAMPUS

JULY, 2010.

xiii

CHAPTER ONE

INTRODUCTION

1.5 BACKGROUND OF THE STUDY

The Nigerian financial institutions have faced difficulties over

the years for a multitude of reasons but the major cause of

serious banking problems in recent times continues to be

directly related to lax credit standards for borrowers and

counterparties, poor portfolio risk management or a lack of

attention to changes in economic or other circumstances that

can lead to a deterioration in the credit standing of a bank’s

counterparties. Credit risk is most simply defined as the

potential that a bank borrower will fail to meet the obligations

in accordance with agreed terms. The goal of risk management

in bank lending is to maximize a bank’s risk adjusted rate of

return, maintaining risk exposure with acceptable parameters.

The problem of Bank distress in the Nigerian Banking Sector

has been observed since 1930s. In fact, between 1930 and

1958, over 21 Bank failures were recorded. The Bank failures

during the time were attributed to the domination of foreign

Banks in terms of the exclusive patronage by British firms.

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Other factors that led to mass failure of the indigenous banks

were low capital base, lack of managerial expertise and

untrained personnel.

The deregulation of the financial system was embarked upon

by the military administration in 1986 as part of the

Structural Adjustment Programme (SAP). The deregulation

witnessed sharp changes in banks’ operations, regulatory

environment and the distress syndrome resurfaced again in

Nigeria. The changes brought about by SAP included the

liberalization of the foreign exchange and money markets, the

introduction of prudential guidelines and accounting

standards, increase in minimum paid-up capital,

establishment of Nigerian Deposit Insurance Corporation

(NDIC), relaxation of mandatory sectoral allocation of credits,

etc.

The Late 1980s and early 1990s were years of financial boom,

as the number of players increased substantially in the

system? For instance, between 1986 and 1989, about 38 new

commercial and merchant banks were created. The increase in

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the number of banks over-stretched the existing human

resources capacity of banks which resulted to many problems

such as poor credit appraisal system, financial crimes,

accumulation of poor asset quality, among others. The

consequence was increase in the number of distress banks.

During 1994 alone, two banks had their licenses suspended

(Republic Bank Ltd and Broad Bank of Nigeria Ltd). Another

four banks has their licenses revoked. Also in 1994, the

number of banks adjudged distressed by the Central Bank

rose by 10 to 42, excluding the four banks that were closed

during the year. By the end of year in 1994, non-performing

loans and advances constituted about 60.33 percent of the

total deposits of the entire banking industry. Furthermore, the

ratio of non-performing loans and advances to the total loans

and advances in the entire banking industry was 43.03

percent while that for the distressed banks was 64.5 percent

according to CBN Annual Report 1994. By the year 1998, up

to 31 banks were being liquidated.

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The Global Financial crisis is yet to run its full course, but is

already one of the largest crises ever experienced according to

the existing literature. With its roots in banking, the sub-

prime mortgage crisis that commenced in the United States in

2007 soon resonated in other sectors of its financial system,

and the economy at large. The crisis later spread to Europe

and now has become a global phenomenon. The emerging

economies were not isolated. In the wake of the United State

Government bid to boost housing was a policy error that

permitted sub-prime clientele unrestricted access to mortgage

finance. Combined with the thriving derivative market, the

horizon for credit expansion widened to unprecedented levels.

The result was private over-borrowing accompanied by an

internal debt crisis. As long as capital flows and credit

expansion grew unchecked, lending expectedly spilt over from

financing safe and productive investments to risky and

speculative assets. Housing prices had trended upwards for

ten consecutive years up to 2004, enticing speculators.

Mortgages perfected imprudent lending practices.

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The cannons of basic lending were never followed in credit

creation. Credits were generally not collaterized in the

mortgage sub-sector.

Credits, especially in mortgage finance and commercial real

estates were excessive to the repayment ability of the

borrower. The housing market was overpriced. Investors

borrowed to enter the booming overpriced market without a

thought that the market could ever crash. It crashed

unexpectedly and commercial loan defaults became

widespread. Financial institutions gradually became illiquid.

Available stocks were dumped on the capital market to shore

up liquidity. Banks became unwilling to lend to one another.

The financial system was weakened by runs, bankruptcy,

takeovers, job losses and bail-outs. United State financial

institutions failed to honour maturing investments, especially

placed by foreign investors.

The Nigerian economic recession of 1982 could not have

dragged the rest of the world into a global recession because

the quantum of foreign investments in the Nigerian economy

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was minimal. Although there were defaults in the return of

deposits, it was an internal affair. Nigeria was in it alone and

had to steer to good financial health on its own accord. There

is hardly any bank anywhere in the world that does not have

correspondence arrangement with a bank in the USA, at least

for the confirmation and settlement of letters of credit as well

as for the transfer of funds. By arrangement, all such idle

funds are invested in the American financial system, especially

on high-yielding derivatives.

According to October 2008 IMF World Economic Outlook, the

global financial crisis did not have any direct and serious

consequences on sub-Saharan African, of which Nigeria is

one. However, Nigeria feels the pinch in various ways such as

difficulty in sourcing new credit lines by banks and real-sector

operators from abroad, possibility of non-renewal of expiring

credit lines to banks sourced from abroad, withdrawal of liquid

assets and other investment portfolio by foreigners, reduced

inflow of foreign direct investments etc.

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As at third quarter of 2009, there was a shift in the Nigerian

banking system as a result of audit carried out by the central

bank of Nigeria, the apex regulatory body, on Nigerian banks.

Consequent upon their findings, the CBN replaced the

leadership of Eight (8) Nigerian banks and injected N620

billion of liquidity into the sector for a rescue. This was a

natural consequence of bad lending decisions by banks

leading to huge provisions and erosion in their capital. A bulk

of depositor’s money was lent for speculative purposes in the

capital market. The attitude of some borrowers who are

unwilling to repay even when they are known to have the

means to service their debts. Such borrowers seek refuge

under the inadequate legal framework and cumbersome loan

recovery processes which make it difficult for the lending bank

to foreclose collaterals. Obtaining judgment when a loan

defaulter is sued is often lengthy, thereby increasing the cost

of banking business in Nigeria. In the case of some small

borrowers particularly in priority sector of agriculture and

small and medium scale enterprise, they willfully defaulted on

the wrong notion that the bank loans are part of their share of

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the “national cake”. There are also borrowers who through

connivance with some banks’ staff take bank loans with no

intention to repay such loans. These problems greatly

impaired the quality of banks’ assets as non-performing loans

and advances become unbearable and turn out to be a high

burden on many of them.

Insider abuse by bank owners, directors and management

staff is another factor which exacerbated loan defaults in some

weak banks. Insider in those banks obtained loans and

advances without adequate collaterals in contravention of

banking regulations. Sometimes, the loan applications were

poorly appraisal with inadequate documentation. Poor lending

and borrowing culture was contributory to distress in the

system.

1.6 STATEMENT OF THE PROBLEM

The banking sector has a crucial role to play in the growth of

Nigeria economy. A strong and viable banking industry which

can facilitate local and international transactions is a

necessary mechanism that any international investor would

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consider amongst other things prior to taking such investment

decisions.

The cornerstone upon which every successful financial

institution is built is nevertheless, a strong and effective credit

management process. A process which reinforces and

complements corporate objectives and goals. Managing risk

requires a top down approach. If the board and bank

executives are not supportive of the efforts, it will be difficult to

assemble the resources to control the risks deemed

acceptable. Wanting to manage the risks identified must be a

part of a corporate culture. As risks are identified and a means

to control those risks is also enacted, the organization has to

have the ability to adapt.

It is in view of these, however, that this research paper

undertakes to examine banks and the strategies in place to

stem the tide of non-performing loans. The statement of

problem is to critically appraise risk assessment techniques

and suggest measure(s) that improve the quality of risk assets

in banks.

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The outcome of this research study is expected to assist

stakeholders in the Nigerian baking industry in addressing the

following inherent problems;

Reliance on the financial statements of the borrowers as

a basis for lending which is fraught with serious danger.

Lack of understanding of the borrower’s business skills

and credibility

Adequate collaterization of credits

Subvention of regulatory guidelines on credit creation

Lack of data/information concerning the economic and

political situation that impact negatively on the debtor

Creation of new loans in total disregard to the

performance of the existing ones.

1.7 RESEARCH QUESTIONS

It is widely believed that the major cause of distress in the

banking system is as a result of poor risk management. To

establish this premise, it is important that we find answers to

the questions below;

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Do the board of executive directors, credit review

committee and others concerned in credit administration

function effectively?

Are there established risk management procedures and

programmes that are well documented and entrenched in

Nigeria banks?

Are credits limits set, and are these limits strictly

monitored to avoid extension of excessive credit to a

specific counterparty?

Do the volumes of the banks’ risk asset have impact on

its gross earnings?

1.4 OBJECTIVES OF THE STUDY

The extent of distress in banks in Nigeria has become a source

of worry to the banking public. This, to a great extent, has

eroded the confidence of the public in the financial system. It

has always been asserted that the major cause of failures in

the system was as a result of non-performing credits

engendered by insider abuse by bank owners, management

staff, willful defaults by borrowers, etc.

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In view of the risks prevalent in the credit risks management

in Nigerian banks, this study is meant to:

Identify lapses in the management of credit risk and

proffer corrective measure(s) to enhance the banks

overall credit quality.

Ascertain the bank’s capacity to assess risk with regards

to the analysis and monitoring of the dynamics in the

operating environment with a view to evaluating its

impact on the bank’s past, present and future credit

decisions.

Assess the role played by the regulatory authorities in

enhancing bank’s risk management.

Identify if the perceived risk in a credit are matched by

commensurate return through appropriate pricing of

facility.

1.5 RESEARCH HYPOTHESIS

The hypothesis to be tested in the course of this research is

related to research Question One and the last question: Do the

board of directors, credit review committee and all concerned

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in credit creation function effectively and do the volume of

banks’ risk assets has impact on its gross earning? This leads

us to the following hypotheses:

HYPOTHESIS

H1: The volume of the bank’s risk asset has no outstanding

impact on its gross earnings.

H2: There is no correlation between the bank’s risk asset

portfolio and the effectiveness of its credit risk

management system.

1.7 SCOPE OF THE STUDY

This study is set to analyze the credit risk that is inherent in

Nigerian banking system. This is prompted by the need to

have an efficient and effective risk management

program to stem the tide of distress in Nigerian banking

industry. Data from both qualitative and quantitative sources

will be used to gain an insight and knowledge of the Nigerian

banking industry.

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1.7 SIGNIFICANCE OF STUDY

Sequel to the enormous challenges before the banking

institution in Nigeria in the management of their credit

portfolio in ensuring minimal loan loss through maintenance

of high quality risk assets while optimizing returns, this study

is focusing on the potential financial loss resulting from the

failure of customers to honour fully the terms of a loan. The

paper will also examine the role played by the regulatory

authorities in enhancing bank’s overall risk management

through checks on compliance to credit policies in the system.

This research, however, will help the bank constitute an

effective risk management program with an oversight from the

board and senior management. Managing risk requires a top

down approach. The quality of bank management and

especially, the risk management process are key in ensuring

the safety and stability in the banking system. It is the aim of

this research work to encourage the strict adherence to the

rules and policies by the operators and regulatory authorities

alike.

xxvii

1.8 OPERATIONAL DEFINITIONS OF TERMS

It is the intention of this portion of the study to define some of

the terms used in the work:

Credit: This involves the transfer of money or other property

on promise of repayment, usually at a fixed future date.

Risk: Uncertainty of future outcome or the possibility of loss

Portfolio: The Securities held by an investor or the

commercial paper held by a bank

Risk Assets: These relate basically to loans or facilities

granted to customers

Credit Analysis: A systematic examination or an inquiry that

can enhance the decision to lend.

Performing Credit: These are facilities having the payments of

both principal and interest repayments as at when due.

Non-Performing Credit: These are facilities that are not

serviced according to the terms of the agreement.

Doubtful Credit: A situation where the principal and/or

interest remained unpaid for more than 180 days but less

than 360 day

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Lost Credit: Facilities with unpaid principal and/or interest

remaining outstanding for 360 days or more and are not

secured by realizable collateral.

Substandard Credit: Those with unpaid principal and/or

interest remaining outstanding for more than 90 days but less

than 180 days.

Profitability Ratio: This ratio measures the firm’s ability to

earn a fair return from its investment

Efficiency Ratio: Used to calculate a bank’s efficiency

Liquidity Ratio: Measures the firm’s ability to meet its short-

term financial obligations as at maturity

Debt Management: This consist of all the activities involved in

obtaining funds from depositors and other creditors and

determining the appropriate mix of funds for a particular

bank.

Asset Management: This comprises the allocation of funds

among various investment alternatives.

Prudential Guideline: The guidelines were issued on

November 7th, 1990 by the CBN as an offshoot of the

statement of accounting standard No 10 on banks and other

financial institutions. The guidelines were to be strictly

adhered to by all banks in reviewing and reporting the

performance.

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REFERENCES

Anthony, O.B. (2009). “Nigerian Banking Crisis: from Irrational Market Exuberance to Regulatory Exuberance”, http://www.articlebase.com/banking-articles/nigeria

Donli, J.G. (2004). “Causes of Bank Distress and Resolution

Options”, CBN Quarterly, Vol. 28 No. 1. January/March

Fiakpa, Luky, A. Adekoya, H. Igbkiowubo (2008). “Nigeria: Global Financial Meltdown Country Panics”, htt://allafrica.com.

Freixas, X. and J. Rochet (2008). “Microeconomics of Banking”

(2nd Edition), MIT Press, London.

Haynes, C. (2003). “The Emerging Regulatory and Supervisory Framework for Managing Risks in the Carribbean Banking

Sector”, Paper presented at the Seminar on Risk Management and Investment in the Caribbean, Organized by Caribbean Centre for Monetary Studies.

Idehai, S.A.(1996). “Effect of Deregulation on Commercial Banking Activities in Nigeria, An Analytical Framework”, Journal of Economics Department, Ambrose Ali University, Ekpoma.

Nnanna, O.J (2003). “Today‟s Banking Risks and Current Regulatory and Supervisory Framework”, CBN Quarterly, Vol. 27 No.3, July/September.

Sanusi, L.S. (2010). “The Nigeria Banking Industry-What Went Wrong and the Way Forward”, Paper presented at The

xxx

Annual Convocation Ceremony of Bayero University Kano, 26th February.

Sere Ejemba, A.A. (2008). “Nigeria Stock Market Reflection of the Global Financial Crisis: An Evolution”, CBN Quarterly, Vol.32, No.4 October/ December.

Quintyn, M. (2002). “Banking Intervention and Resolution in a Crisis Environment, Issues and Principles”, Paper Presented at IMF International Seminar on Legal and Regulatory Aspects of Financial Stability.

Van Greuning, H. and Bratanoic, S.B. (2003). “Analyzing and Managing Banking Risk: A Framework for Assessing Corporate Governance and Financial Risk”, the World Bank, Washington, D.C.

xxxi

CHAPTER TWO

LITERATURE REVIEW

2.2 INTRODUCTION

Available record shows that Nigeria has had a bitter

experience of bank failures in the past. There was a rapid

growth in the number of indigenous banks in late 1940s and

early 1950s. It is evident from the available record that banks

more or less collapsed with the same rapidity with which they

were established. As at 1954, 17 out of the twenty-one (21)

indigenous banks collapsed owing to inadequate capital, lack

of skilled personnel and moreover corporate governance. These

failures did not augur well with the banking public. The

failures recorded in the sector can also be attributed to the

domination of foreign banks in term of exclusive patronage by

British firms (Soyibo and Adekanye, 1992). Ebodaghae (1977)

noted that few years have been traumatic for the Nigerian

banking industry. Although distress is not a new phenomenon

in the Nigerian banking sector, the manifestation of some of

the problems became discernable with some policy changes. In

1988, the CBN directives to banks that naira backing for

xxxii

foreign exchange application be lodged with CBN. The sudden

withdrawal of public sector deposits to CBN in 1989, and the

use of stabilization securities by the CBN to mop up excess

liquidity in the system. All these developments exposed the

imprudent practices and significance weakness in credit

control in several banks. It became noticeable that there are

problems in the liquidity positions of some banks. This

encouraged inter-bank borrowings in form of overdrafts at a

high cost. Failure of some of these banks to honour the

overdrafts lead the entire system into stress and it resulted to

defaults as transaction were truncated midstream.

What was thought to be a temporary liquidity problem for a

few banks soon caught up with a lot more banks. With the

identification of eight distressed banks worsened gradually

with 31 banks being liquidated by 1998 (Nnanna 0.J, 2003).

NDIC (1995) classified about one (1) out of every two (2) banks

in the industry as distressed. Thus, the 1990s can be rightly

characterized as a period of upheaval for baking industry.

Before the end of 2009, the apex regulatory body, CBN sacked

the management and board of eight (8) banks in Nigeria as a

xxxiii

result of poor credit risk practices in the industry which

resulted in illiquidity problem. Sanusi Lamido (2010) asserted

that the economy faltered and the banking system experienced

a crisis in 2009 and this resulted in the injection of N620

billion into the sector to stabilize the system and return

confidence to the markets and investors.

Elmer F.K , described credit risk as the potential financial loss

resulting from the failure of customers to honour fully the

terms of a loan or contract. Increasingly, this definition is

being expanded to include the risk of loss in portfolio value as

a result of migration from a higher risk grade to a lower one.

2.2 TYPES OF BANK CREDITS

Over the years several attempts have been made to offer a

comprehensive and acceptable definition of a bank or a

banker. Starting from the time of J.W. Gilbart, he regarded a

banker as a dealer in money. Banks is regarded as

intermediate parties between the borrower and lender (Iganiga,

1998). This is because the banks borrow from one party and

lend to another. It will be observed that this definition

xxxiv

emphasizes the two traditional functions of a bank, i.e. the

mobilization of deposit and the granting of loans and

advances.

The deposits kept in banks need not be left idle, because from

experience banks are aware that depositors may not need all

the deposits at a time. It is therefore prudent of the banker to

lend such money to investors at a higher rate which brings

some revenues to them. They achieve this through overdraft,

loan, bills discounting or through direct investment (Idahosa

2000). Traditionally, bank lending could in broad term be

categorized into two, that is, overdraft and which could further

be split or analyzed on the type or purpose or tenor. Overdraft

and loan would be discussed followed by the other types of

credit which have become available overtime.

2.2.1 Overdraft

This is the most common form and simple type of credit

facility. It is usually granted for working capital purpose and

the amount outstanding is expected to fluctuate over the life of

the facility, depending on the borrower’s working capital

xxxv

financial needs. Usually, the customer is given a limit up to

which he may draw beyond his deposit with the obligation to

repay on demand or at least subject to review or termination

within a comparatively short time period. However, unless the

account develops unusual features, overdraft is normally

reviewed annually and in every practical sense it has acquired

the nature of long term financing. It has the virtue of being self

liquidating by normal turnover of the account and interest is

charged on only amount overdrawn. The amount is expected

to be swinging into both debits and credits, as much as the

limit is reasonably observed, but in most cases this was an

illusion because there is a tendency for account to remain

perpetually in debit.

2.4.2 Loans and Advances

Loans are the type of credit which a specified amount is

placed at customer’s disposal by passing it to the credit of the

current account. The customer thus has the opportunity to

draw out his own deposit plus the loan without the account

being overdrawn unless an overdraft arrangement is also in

force. Unlike in overdraft where the customer pays interest on

xxxvi

overdrawn balances, the borrower pays interest on the whole

amount standing to his debit in the loan amount.

Loan is more suitable in circumstance when the purpose is

well identified and not under such blanket request as “working

capital finance”. The amount required as well as the timing is

known with reasonable precision and repayments are effected

as agreed, usually monthly, quarterly or annually. A distinct

feature of loan is that it is unlike overdraft where the

overdrawn balance is shown in red as an apparent indication

of debt, the current account of the borrower under loan

arrangement is not in red, despite the loan. For control and

statutory returns, loans are usually categorized according to

their tenor and here their maturity periods, short terms,

medium term and long term loan are usually identified but

there has been no generally agreed standard as to the

duration of each. In general terms, however, loan of one year

maturity and below are usually categories as short term, while

those of up to five years are seen as medium term and long

term if more than five years.

xxxvii

Bank loans are also categorized according to purpose. This

would normally include term loan, agricultural loan,

educational finance, personal loan, car loan, amongst others.

Some of the short term loans are “bridge loan,” that is,

providing short term facility until an asset is disposed of or

money realized from other sources. An example is the

temporary financing of a fixed capital development pending the

raising of finance from other sources.

Advances, however, is a short term credit granted to a

customer for a definite period, usually between 30 and 180

days. It is actually a type of loan but given to finance a specific

project and the most important distinction is that the

repayment normally is on en bloc. An example of this type of

credit is Advance against Architect’s Certificate granted to

construction companies through the discounting of certificates

of value (of work done) issued to them by their Client’s

Supervising architects.

Unlike normal loan where repayment is programmed from

other sources, repayment of advance is usually from the

xxxviii

project finance. This type of finance is suitable for production,

licensed buying agents and all credits that are in the nature of

seed time to harvest period though must be comparatively of

shorter duration usually not exceeding six months.

2.4.3 Special Credits

Special credits that have mixed Characteristics of either

instruments. This type of credit includes the following:

Hire Purchase Facility

This is used in financing assets with installmental

repayment plan or agreement over a specified period of

time. In the repayment plan, the cost of asset and the

interest on it are usually calculated over the agreed

period and divided by the number of the installments.

The fund is usually not given to the hirer but the vendor.

Lease Financing

This facility is available for usage of an asset for a

specified period of time, the outright acquisition of which

is capital- intensive in nature and cannot be made

available by the borrower for an immediate purchase. The

borrower, while enjoying this facility, can have usage of

xxxix

the asset while the payments are handled by the lender.

The lease agreement may or may not be the type that

permits the transfer of ownership to the borrower at the

end of the lease period, i.e. operating or finance lease.

Account Receivable/Inventory Financing

This is also called working asset financing because it is a

source of working capital for a growing concern. Here

funds are raised by the assignment of inventory or

receivable to a bank in return for financing. The facility is

then paid down as the firm collects on the receivables or

sells down as the inventory. In spite of the arrangement

here, the day-to-day management of these assets remains

with the company.

Factoring

This is an outright sale of receivable to a factor without

recourse to the borrower (i.e. the seller) if the purchaser

of the goods does not pay. The role of banks, as with

most credit instruments, is financial intermediation

between the selling company and the factor to facilitate

the transaction. However, a bank may be a factor itself

xl

when it contrasts to discount or purchase some of the

bills of the customer and relaying principally on the

quality of the bills. In this case, the bank provides funds

to the customer in return for bills, while the bank

reimburses itself from the proceeds of the bills when

collected from the third party debtors who issued the

bills.

2.5 CONSTRAINTS ON BANK CREDIT PORTFOLIO

Constraints in credit creation in banks are the factor that

banks do not have limitless capacity for the creation of risk

assets. Several factors determine bank’s ability to expand its

credit portfolio. The factors that determine bank’s capacity to

lend include;

Macro-Economic Environment

This could affect the bank’s lending portfolio since the

state of the economy determines the investments and

viabilities of businesses.

Capital Adequacy

Bank’s risk asset, apart from being constrained by the

restrictions on liquid assets is, on the other hand, limited

xli

by the availability of capital. Capital may be viewed as

shareholder’s fund and defined as equity plus reserves.

Credit Policy

Banks capacity to create risk assets is constrained by

requirement to keep high cash ratio’s, to meet demand

for withdrawals by depositors, liquidity ratios,

stabilization by the effect of policy reversal and counter

reversals.

Capacity for Liability Generation

The bulk of the funds banks use in creation of credit are

depositor’s funds. Therefore, the extent to which bank

expands its credit portfolio depends largely on the level of

its deposit. Shrinkage in credit portfolio through loans

could occur if there is a reduction in deposit base. This

was visible in the Late 1980s when accounts of

parastatals and government agencies were withdrawn by

the government.

2.6 MANAGEMENT OF PORTFOLIO

Mismatching is inherent in banking. In fact, it is the essence

of maturity transformation, borrowing short and lending long.

xlii

If maturities are badly mismatched with short term liabilities

financing long term assets, a bank becomes illiquid. If interest

rate terms are badly mismatched a bank can incur large losses

when market rate change. If currency denominations of assets

and liabilities are badly mismatched, a bank can make large

losses if exchange rate varies.

The need to avoid or minimize the above and other banking

risks calls for a system approach to banks’ funds

management. It comprises a series of techniques whereby

holdings of remunerative assets (loans, advances and

investments of various kinds) are funded by related liabilities

and, or the other liabilities may be accepted in advance of

commitments and these liabilities subsequently deployed in

the acquisition of remunerative assets(Wilson 1987).

Assets and liability management is the primary focus of banks

fund management. It deals with the acquisition of funds

(liability management) and the allocation of funds (asset

management), the basic objective being maximization of

profitability consistent with liquidity, solvency and regulatory

constraints.

xliii

The essence of asset/liability management is the co-ordination

of the interrelationships between the sources and uses of

funds in short term financial planning and decision making. It

views the bank as a set of interrelationship that must be

identified, coordinated and managed as a system if the

decision made are to be consistent with the basic objectives of

maximum profitability consistent with liquidity, solvency and

regulatory constraints.

Assets and liability management incorporates features of other

approaches to bank funds management such as pool of funds,

asset allocation, shiftability approaches and liability

management. It also incorporates management experiences

and judgment into the decision process.

Assets and liability management consist of successful

execution and identification of key decision areas that impinge

on profitability such as gap management, liquidity and cost

control, etc. It also requires an analysis of the banking and

economic environment to identify opportunities and threats.

For instance, in the budget, which should be recognized,

xliv

provided for or taken advantage of, decisions backed by

management experiences and judgment consistent with the

overall objective of profit maximization with the constraints of

liquidity, solvency and regulatory requirement.

2.5 BANK CONSOLIDATION IN NIGERIA

The Central Bank of Nigeria, in 2004, increased the minimum

capital base of banks from N2 billion to N25 billion. The banks

were given 31st December, 2005 as the deadline for

compliance. The CBN also stated that by end of October, 2005,

banks which fail to secure final merging approval from it

would stop operating. The banks were given guideline and

were expected to submit monthly returns of their consolidation

activities.

The Major Objectives of the reform are:

To enhance the compatibilities of banks to finance large

projects.

To ensure a capital base that can support service delivery

channels.

xlv

Size is a key factor in the banking sector that determines the

ability of the banks to provide funds to borrowers and

indication of stability to depositors. The recapitalization was

expected to enhance an effective provision of banking services

to customers by deploying various capital-intensive service

delivery channels. The over-dependence on cheap public

sector funds has negatively affected the drive of Nigerian

banks to provide these alternative service delivery channels

and therefore, undermined the need for banks to increase

their capitalization.

The CBN at this stage of the banking reform exercise may have

placed too much emphasis on the N25 billion capitalization

requirements at the expense of all supervisory, legal and

regulatory frameworks but a stronger and healthier banking

system.

There is no doubt that banking, like other economic activities,

needs sufficient capitalization to grow and stabilize. But the

risk inherent in the sector requires effective supervision on the

part of the regulatory authorities while ensuring that operators

xlvi

adhere strictly to ethical and institutional guidelines, as well

as credibility and transparency in service delivery to the

public.

Consolidation represents one of the most significant

developments in banking globally and the trend will

undoubtedly lead to a continuous reduction in the number of

banks. The capitalization policy would continue to encourage

mergers and acquisitions that would result in the emergence

of stronger banks with a pool of resources and increased

branch network.

2.6 CREDIT ANALYSIS

Credit analysis is a process of inquiry in making the decision

to lend, (Hale 1988). In the course of inquiry, the banker does

his best to replace emotional feelings such as hopes and fears,

with reasoned arguments based upon a careful study of

borrowers’ strength and weakness. The fundamental of

modern credit analysis are two folds; first is the examination

of the nature of the borrower’s business in the context of its

industry, and second is the analysis of cash flow.

xlvii

Nwankwo (1991) noted that credit analysis is a loan function

that is basis to minimizing loan losses. Thorough credit

analysis, the bank attempts to determine the ability of the

borrowers to repay legitimate loans extended to him. By

refusing credit to potential borrower whose analysis reveals

insufficient financing strength, the bank hope to improve on

its chances to avoid unnecessary losses in its loan portfolio.

Apart from financial statement and security analysis and

evaluation, this section of the loan policy sets out what

lending officers should learn such as environmental

appreciation, judgment ability, and what they should know,

for example, concepts of credit decision making.

H. Pierson Associations (1996) noted that fundamental credit

analysis is a thorough understanding of the various industry

groups which the bank chooses to operate in-market

identification and analysis, achieved through periodic detailed

and extensive industry studies. Poor or weak analysis leads to

bad decision and in time, to problem portfolio. Credit analysis

is the action of analytically reviewing and reporting on the risk

inherent in credit product and the repayment thereof. While

xlviii

the type of analysis may take many forms, it must be

continuous, performed not only at the credit time extended

but also throughout the life of the credit.

For the average bank, Net Interest Income (NII) provides the

lion’s share of the net revenue base. Similarly, as most

bankers would tell you, credit risk is the most significance

factor to the net revenue base.

NII is largely the compensation for the credit assumed by a

bank. From a managerial point of view, the turn factors should

be maximized (except for loan loss provision which should be

minimized). The risk factors on the other hand, should be

minimized by appropriately controlling credit risk and interest

rate risk, as well as operating and other risks. However, it is

important to note that it is market’s perceptions of the bank’s

risk that drives shareholder’s equity. Therefore, it is not

important for a bank to try control the various risk factors, but

also to make sure that the information is disseminated to

investors.

xlix

H. Pierson Associate (1997) identified three categories of bank

customer and basis of loan pricing.

(A) Prime Customer: Who

Are bank’s largest and most credit worthy customers.

Often call the shots as they have alternative sources of

funds

Cause banks to offer competitive lending rate

Often therefore difficult to bundle their pricing of loan

and services together for them

Loan pricing here is clearly straight forward as it is

directly tied to market sources of funds.

Are prime customers, but not necessarily prime rate

customers as market base-rate pricing could be below

prime

Pricing Model

Borrow at bank’s lowest rate or base loan (i.e. just above an

open market rate of interest)

l

(B) perceiving-Value Customer (poor elasticity of demand

for funds related to price)

These are:

Customers lacking alternative borrowing sources

Customer who views a loan as part of a total and larger

banking relationship. E.g. high wire transfer changes vs.

perceived value of relationship.

Pricing Model:

Here pricing is set on the basis of marginal benefit of loan to

customer.

(C) Relationship Customers

Majority of borrowers fit here

Range from between prime to weak marginal borrowers

Customers here often are using broad range of banking

services

Customers here borrow regularly and are strong source

of loan demand.

Strong relationship exists

li

Pricing Model:

Loan rates = base cost + spread with total focus on total

amount of profitability and yield.

A bank must determine the minimum account profitability

levels for various grades of risk assets. Profitability per

transaction is determined against this benchmark.

There are different models for measuring return on risk assets.

These include Gross Yield Approach, Net Borrowed Fund

Approach and ROE Approach.

2.7 CREDIT RISK MANAGEMENT AND PRUDENTIAL

REGULATION

Harrington (1987) observed that credit risk is inherent in

banking. All lending involves the risk that the borrower will

pay back or will not pay on time. In view of the risk inherent in

bank lending and the need to minimize or contain the risk

since they cannot be entirely avoided, and in view of liquidity

and profitability consistence with safety and regulatory

policies, the central issue in managing the lending portfolio is

balancing the potential risk with return. The borrower’s ability

to repay the loan has to be determined. This involves

lii

familiarity with the type of lending and the economic activity

involved-whether agriculture, real estate, manufacturing or

residential statement and security analysis to project the

income and cash flows, assess the source of repayment and

the economic and technical feasibility of the project. It also

requires the assessment and forecast of the economic and

political environment to ascertain not only whether the project

to profitable.

The introduction of the prudential guidelines attempts to bring

order and harmony in the reporting of loan provisioning and

classified risk assets. The prudential guidelines issued by the

CBN in November 1996 were aimed at proper loan asset

classification and income recognition. Before the introduction

of the prudential guidelines, banks had their individual

methods of classifying accounts, rating credit and categorizing

account as performing or non-performing. They treat accrued

interest on non-performing accounts as income.

The implications of their actions were the declaration of high

level of profit that was not actually realized.

liii

Also, before the guidelines, banks were guided in their

provisioning by Statement of Accounting Standard (SAS) 10.

Under the SAS 10, some banks charged interest income on

non-performing loans into interest suspense account, while

others recognized it as income thereby overstating their

profits. This allowed overstatement of unearned profit by

banks that enabled them to declare huge dividend eroding

their capital base. This abnormal situation became a serious

concern and regulatory authorities.

The prudential guidelines stipulate that under credit portfolio

classification system, banks are expected to review their credit

portfolio continuously with a new to recognizing any

deterioration in credit quality. Such reviews should be done

systematically and realistically so that classified banks’ credit

exposures are based on the perceived risk of default.

There are many effects of the guidelines:

Provisions for doubtful debts are to be made out of profits and

interest earned on these assets is to be suspended. Under the

new dispensation, non-performing assets are dying or dead

liv

assets and not yield any income; rather costs such as

administrative expenses incurred on bad debt are to be

incurred at the banks expense. As a result, many banks’ asset

kept dwindling as well as their profits.

Some of these banks which had not diversified their asset

portfolio had nothing to fall back except shareholders funds

and reserved and these were not enough to meet their

depositors claims (Ojo, 1993).

2.9 TYPES, ANALYSIS AND EVALUATION OF RISK

The following are some of the risk associated with banking:

Business Risk

This risk is associated with changes in the earning power of a

project. It has to do with the inability of a company to

maintain its competitive position in the market as well as

earnings, growth and stability. A fluctuation in industrial

output caused by an unexpected recession is an example of

business risk.

lv

Liquidity Risk

This is the possibility of loss that may arise from the inability

of a company to meet its obligation as they fall due. In the

case of a bank, it is a risk of loss from the bank not having

adequate funds to meet the deposit withdrawals and loan

demands of its customers. This risk is very serious because it

involves the credibility and confidence reposed in the bank.

Financial Risk

This form of risk affects a company that is highly geared. A

bank under this condition is said to be contending with the

menace of capital inadequacy. It occurs when a bank is unable

to generate sufficient funds to service its debt. Consequently,

the working capital assumes a negative position.

Earning Risk

Earning risk is concerned with the factors which may threaten

the achievement of a satisfactory margin between the incomes

anticipated on assets and the interest outflow on liabilities.

The problem is the ability to match accurately the inflow of

interest earnings and the outflow of interest earning and the

lvi

outflow of interest payments by level and maturity terms. As

far as banks are concerned, earning risk assumes a

substantial proportion of total risk.

Regulatory Risk

Banking industry is the most regulated industry. It is therefore

subjected to enactment of new laws and regulation or strict

enforcement of existing laws thereby limiting the bank’s

earning capacity or ability to reduce risks exposure by earning

new market or developing services.

Fraud Risk

This occurs when someone through deceit or trick gains

advantage he could not otherwise have gained through just or

normal process. The resultant effect of this on the bank is loss

of revenue, liquidity and increase in bad and doubtful loans.

Credit Risk

This is the possibility that the bank could sustain loss from its

loans and advances portfolio. It is the risk of default by credit

beneficiaries in the repayment of principal and interest as they

lvii

fall due. Credit risk is the risk with the largest loss in Nigerian

bank.

Exchange Rate Risk

Unpredictable changes in the rate of exchange between foreign

and local currencies bring about this form of risk. If a banker

lends money in a project and agrees to collect repayment in

foreign currencies under a “forward deals” at the time it agrees

on the contract with the importer. Such customer would have

paid the local currencies equivalent at the time the contract is

made. To avoid a situation of spending more local currency in

case of a fall in exchange rate, a rational banker would buy in

advance the total foreign currency required for the

transaction.

Risk Analysis and Control

Identification of risk inherent in a credit request is a key issue

in the sustenance of a healthy assets portfolio. However, its

analysis and evaluation is of great importance. Risk analysis

entails principally the appraisal of the statement of a

prospective borrower while risk evaluation assists in the

lviii

application of these appraisals for projecting future

occurrences and by extension arriving at the best decision.

These could be done under two main headings:

1. Risk analysis from financial statements

2. Qualitative risk analysis

Risk analysis from financial statement of the prospective

borrower employed expensive ratios and comparison of values

obtained with known or acceptable industry standard. On the

other hand qualitative risk analysis, also referred to as non-

financial risk factors, deals with a whole lot of variable which

are not analyzed solely by computation of ratios. These include

industry risk analysis, market position of the borrowing

enterprise. Its management adequacy, shareholders support

for its operations, political and legal risk and earning stability.

Risk Analysis from Financial Statement

In view of the increasing complexity of the credit decision, the

known basic factors credit analysis needs to be supplement

with other considerations. Credit officers do subject loan

application to rigorous ratio analysis. Ratio is mathematical

lix

aids used for the analysis of financial statement in order to

establish a relationship between two variables thereby

facilitating comparison.

Commonly used ratios in credit analysis are grouped into four

main types

1. Leverage Ratios

These ratios generally measure the relationship between

liabilities and shareholders funds. It shows the extent to which

company’s operations have been funded by external financing.

The level of debt ratios will provide idea as to the capacity of

the company to attract/absorb additional debt

finance/borrowing.

Debt Ratio = Total Debt Total Assets Debt Equity Ratio = Prior Charge Capital Shareholders Funds Debt Coverage Ratio = Total Tangible Assets Total Debt

Financial Leverage Ratio = Total Tangible Assets Shareholder’s Fund

lx

2. LIQUIDITY RATIO

This measures the firm’s ability to meet its maturing

obligations. This may be from liquid resources or from all of its

current assets

Current Ratio = Current Asset Current liabilities

Acid Test Ratio = Current Assets – Stock And Prepayment Current Liabilities

3. EFFICIENCY RATIOS

These measures how effective a firm’s assets are employed.

Days sales in inventory = Average Inventory x 365 Cost of goods sold 1

Debt days on hand = Trade Debtors x 365 Credit Sales 1

Credit days on hand = Trade Creditors x 365 Credit Purchases 1

4. PROFITABILITY RATIO

These ratios measure the firm’s ability to earn a fair return

from its investment.

Gross profit margin = Profit Before Tax Sales

Return on capital employed =

Profit before interest and taxes x 100 Capital employed

lxi

It is widely agreed that sufficient information can only be

contained for the purpose of making reasonable judgment on

the financial condition and performance of a company by

considering a group of ratios. Ratio analysis can be quite

informative as it adds meaning to trends within a company

and also shows areas of strength and weakness.

However, caution must be exercised in the use of ratio

analysis because of the identified shortcomings as it is only

historical, whereas, the past may not necessarily be a

reflection of the future, hence the need for a banker to look

beyond the ratios in order to enhance the quality of his credit

judgment.

QUALITATIVE RISK ANALYSIS

The basic consideration here is the industry which has to do

with determination of the risk sensitive pictures of industry in

which the company operates.

It covers such areas as;

Economic considerations which highlights the

vulnerability of the company to economic cycles,

lxii

technological changes, regulatory control and effect of

government spending.

Level of competition by which identification is made of

market and basis of competition among existing firms.

Nature of the product can equally define level of

competition

Management adequacy defines the competition of the

enterprises management as it affect production/services

delivery techniques and internal control.

Political/legal risk analysis focuses on the extent to

which the fortune of the firm could be affected by

changes in political and legal environment.

Generally, the whole exercise of risk analysis and evaluation is

to ensure that among other things that sound collectible loan

has been booked, profitable investment outlet for the bank has

been developed and that the credit granted meets the

legitimate needs of the customer.

lxiii

REFERENCES

Adam, J.A. (2005). “A Banking Sector Reform: The Policy Challenges of Bank Consolidation in Nigeria”, paper presented at the 46th Nigeria Economic Society (NES) Annual Conference, Lagos 23rd-25th August.

Al-Faki, A. (2005). “Bank Re-Capitalization and the Nigeria Stock Market”. Nigeria Securities and Exchange Quarterly Bulletin

Central Bank of Nigeria (1990). “Prudential Guidelines for Licensed Banks,” Circular Letter No. SD/DO/23 Vol. 1/11, November, 1990.

Freixas, X. and J. Rochet (2008). “Microeconomic of Banking” (2nd Edition), MIT Press, London.

Hennessy J.H (1986). “Handbook of Long-Term Financing”. Prentice Hall, New Jersey, USA.

Idahosa, N. (2000). “Principle of Merchant Banking and Credit Administration”, Rasjel Interbiz Group, Benin City.

Iganiga, A. (1998). “Contemporary Issue in Money and Nigeria Financial System”, Amtitop Book, Lagos, Nigeria.

Obamuyi, T.M. (2008). “Government Finance Liberalization Policy and the Development of Private Sector in Nigeria: Issues and Challenges”. Journal of Banking and Finance, Adekunle Ajasin University, Nigeria.

Soludo, C. (2009). “Global Financial and Economic Crisis. How Vulnerable is Nigeria?” CBN Monthly publication (online). www.cenbank.org.

Somoye & Ilo (2009). “The Impact of Macroeconomic Instability on Banking Sector Lending Behavour in Nigeria”. Journal of Money, Investment and Banking Issue (online). www.eurojournal.com.

lxiv

CHAPTER THREE

RESEARCH METHODOLOGY

3.1 INTRODUCTION

The preceding chapters have tried to evaluate the various

aspects of risk management in bank lending. However, the

rest of the chapter is to reflect the extent of the research

carried out by the researcher in an effort to prepare and

present a report worthy of reference.

3.4 RESEARCH DESIGN

Research design is the structuring of investigation aimed at

identifying variables and their relationship to one another. The

study is Ex Post Facto research. It is designed to use

mathematical models in the analysis. It is also designed to be

inductive in nature, since the researcher will be drawing

conclusion based on the analysis of the data collected.

3.5 PROCEDURE FOR DATA COLLECTION

In other to carry out the study, data was collected from the

various issues of the statement of accounts and annual report

of the chosen Bank.

lxv

Data was obtained from related textbooks, journals, and

Bank’s credit policy manual. Information for the study was

also gathered from regulatory authorities, that is, Central

Bank of Nigeria (CBN) and Nigeria Deposit Insurance

Corporation (NDIC).

3.4 POPULATION OF THE STUDY

A population consists of all conceivable or hypothetically

possible observations relating to a given phenomenon (Freund

and Williams, 1979). The researcher took for this population

Equatorial Trust Bank between 2003-2007.

3.5 VALIDITY AND RELIABILITY OF MEASURING

INSTRUMENTS

Meyer (1970) defines validity of measuring instrument as the

degree to which an instrument measures what is supposed to

measure. Reliability refers to the degree to which a test (an

instrument) consistently measures what it measures. The

research has ensured both validity and reliability of the

measuring instrument in the study noting the nature of the

study.

lxvi

3.7 MODEL SPECIFICATION

In line with the research hypotheses, models of this study are

as follows:

(1) For the relationship between the banks risk asset and

its gross earnings.

Y = a + bx

Where Y is the dependent variable representing the bank’s

gross income

a = intercept

b = the income generating capacity of the risk assets

x = bank’s assets

b and a coefficient are estimated using the following formulas

b = n Σ x y- (Σ x) Σ(y) n Σ x2- (Σ x )2

a = Σ y – b Σ x N

lxvii

To evaluate how well the regression equation explains the

observation in the total gross earnings for the period being

reviewed, we use the Standard Error of Coefficient (Sb)

Sb = Σet2

(N-K) Σ(X-X)2

(2) For the relationship between the banks risk asset

portfolio and effectiveness of its credit risk management

system.

r = n∑xy - ∑x∑y

(n∑x2 – (∑x)2 (n∑y2 – (∑y)2)

Where;

X = Independent variable

Y = Dependent variable

N = Number of observation

Σ = Summation

TEST OF RELIABILITY

t = r n -1 1 – r2

lxviii

3.8 DATA ANALYSIS TECHNIQUE

In analyzing the secondary data obtained in the course of

study, we apply regression analysis, correlation analysis and

student’s T-test. The outcome of the hypothesis test is base on

the level of the significance. This is the statistical standard

which is specified for rejecting or accepting the null

hypothesis. The rejection of the null hypothesis implies the

automatic acceptance of the alternative hypothesis. The

reverse is true when null hypothesis is accepted.

lxix

REFERENCES

Asika, N (2001). “Research Methodology in Behavioral Sciences” Longman Publishers Plc. Ikeja, Lagos.

Egbui, k.I (1998). “Groundwork of Research Methods and Procedures”. Institute for Development Studies, University of Nigeria Enugu Campus.

Ezeja, E.O (2002). “Project Writing: Aquixotic Viaticum”, Adels Publishers, Enugu.

Freund J.F and Williams, F. J. (1979) “Modern Business Statistics”. Second Edition, Pitman Ltd, London.

lxx

CHAPTER FOUR

DATA PRESENTATION AND ANALYSIS

4.1 INTRODUCTION

The purpose of this chapter is to present, analyze and

interpret the data collected in the course of this research. In

the process of answering the questions identified, this study

considers the use of regression statistics as a method to test

the hypothesis raised in this research study.

The outcome of the hypothesis test is based on the level of

significance. This is the statistical standard which is specified

for rejecting or accepting the null hypothesis. The rejection of

the null hypothesis implies the automatic acceptance of the

alternative hypothesis. The reverse is true when a null

hypothesis is accepted.

4.4 DATA PRESENTATION

In order to carry out the study, data was collected from the

various issues of the Statement of Accounts and Annual

reports of the chosen bank. The data include time series and

lxxi

cross section data on average loans and advances, income

from risk asset and income or profit of the bank.

Below are the tabular presentation of data obtained from the

Statement of Accounts and Annual Reports of Equitorial Trust

Bank.

Table I: Equatorial Trust Bank Asset Quality between

2003-2007

BILLION

2007 2006 2005 2004 2003

Performing loan 32.40 25.39 16.99 20.83 18.13

Secured loan 38.29 36.28 22.59 22.38 18.92

Total loan & advances 39.89 37.10 22.53 22.63 19.08

Source: Equitorial Trust Bank Annual Report (2003-2007)

Table II: Percentage of Equitorial Trust Bank Performing

and Secured Loans to Total Loans and Advances

BILLION

2007 2006 2005 2004 2003

Percentage of

Performing Loans

81.22% 68.43% 72.21% 92.05% 95%

Percentage of

Secured Loans

96% 97.8% 96% 98.91% 99.15%

Source: From table 1 above

lxxii

Table III: Equitorial Trust Bank Income Distribution (2003-

2007)

BILLION

2007 2006 2005 2004 2003

Gross Income (y) 19.39 17.04 13.89 8.07 7.54

Income from risk assets (y1) 12.21 13.50 11.13 6.46 5.66

Income from non-risk

assets( Y2

7.18 3.54 2.76 1.61 1.88

Total loans & advances (X) 39.89 37.10 23.53 22.63 19.08

Source: Equitorial Trust Bank Annual Report (2003-2007)

Table IV: Regression Table

Year Y1 X XYl X2

2007 12.21 39.89 487.06 1, 591.21

2006 13.50 37.10 500.85 1, 376. 41

2005 11.13 23.53 261.89 553.66

2004 6.46 22.63 146.19 512.13

2003 5.66 19.08 107.99 364.06

Total 48.96 142.23 1, 503.98 4, 397.46

Source: From table III above

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4.5 TEST OF HYPOTHESIS

We are testing two hypotheses.

TEST ONE

For the purpose of testing, this hypothesis is restated into null

and alternative hypotheses as follows:

H0: The volume of the bank’s risk asset has no

outstanding impact on its gross earnings.

H1: The volume of the bank’s risk asset has outstanding

impact on its gross earnings.

This will be tested using regression analysis. The regression

equation is expressed as:

Y = a + bx

We can now solve for constants a, and b from the equation:

b = nΣxy – ΣxΣy nΣx2 – Σ(x)2

To substitute the value, we refer to table IV above

Substituting the values:

Y1 = 48.96; X = 142.23; XY = 1, 503.98; X2 = 4, 397.46;

n = 5, we have

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b = 5 (1, 503.98) – (142.23) (48.96) 5 (4, 397.46) – (142.23)2 = 7, 519.9 – 6, 963.58 21, 987.3 – 20, 229.37

= 556.32 1, 757.93 = 0.317 b = 0.317 a = Σy – bΣx n

= 48.96 – (0.317) (142.23) 5 = 48.96 – 45.07 5 = 3.89 5 = 0.778 a = 0.778

Substituting the values a, and b in the equation:

Y = 0.778 + 0.317x

However, Equatorial Trust Bank Income equation in the five

years under review could be stated thus: Yc =0.778+ 0.317x

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Where 0.778 (a) represents the average income of the bank,

0.317 (b) represent the average income generating capacity of

the risk assets, and x denotes the total risk assets.

TEST OF SIGNIFICANCE OF ESTIMATED PARAMETERS

We now determine the reliability of the estimated value of

coefficient b or how well does the estimated regression line fit

to the observed data. This is, however, referred to as test of

statistical significance. The level of significance is determined

on the basis of the standard error and t-ratio to t statistic.

Standard error (Sb), we use

Sb = Σ (yt – yte) 2 (N-K) Σ (Xt – X)2

Sb = Σet

2

(N-K) Σ (Xt – X) 2

Where X and Y1 are the actual sample values for the year t, Yc

is the estimated value of y in year t, X is the mean value of X, N

is the number of observation and et = y1 – yc is the error term

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and k is the number of estimated coefficients (2 in the case of

a bivariate regression equation, a and b). In fact, N-K is the

degree of freedom. From the table, the degree of freedom

equals N-K, i.e., 5 -2 = 3.

Table V: Calculation of Standard Error of Coefficient

Year X Y1 Yl Y-Yl (et) et2 (X-X)

2

2007 39.89 12.21 13.42 -1.21 1.46 130.87

2006 37.10 13.50 12.54 0.96 0.92 74.82

2005 23..53 11.13 8.23 2.9 8.41 24.21

2004 22.63 6.46 7.95 -1.49 2.22 33.87

2003 19.08 5.66 6.83 -1..17 1.37 87.80

142.23 48.96 14.38 439.37

N = 5, Σ X = 142.23, Σy1 = 48.96, Σet2 = 14.38

X = 28.45 Y = 9.8 Σ(X-X) = 439.37

Sb = Σet

2 (N-K) Σ(X-X)2

= 14.38 14.38

(5-2) (439.37) = 3 x 439.37

= 14.38 1, 318.11 = 0.01091 = 0.105 Sb = 0.105

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Having calculated the value of Sb, we calculate next the t-ratio.

The t-ratio (t) is defined as b/sb

Thus t = b/sb = 0.317 = 3.019 0.105 Conclusion

Using t-test, the test criterion is to reject the null hypothesis

H0 if tc > t, that is, the H0 States that the volume of the bank’s

risk assets has no outstanding impact on its gross earnings

and income against the alternative hypothesis H1 which states

that the volume of the bank’s risk asset has outstanding

impact on its gross earnings and income.

The tc is t value calculated while t is critical t obtained from

student’s t- distribution statistical table.

Result: Degree of freedom (df) = 3; table or critical t (t) at 5

percent, for a two-tail test is 2.365. Calculated t value (tc) =

3.019.

Decision: Under the two-tail test, the calculated t is greater

than the table or critical t; hence we reject the null hypothesis.

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TEST TWO

The second hypothesis is restated into null and alternative

hypothesis as follows:

H0: There is no correlation between the bank’s risk-asset

portfolio and the effectiveness of its credit risk

management system.

H1: There is a correlation between the bank’s risk-asset

portfolio and the effectiveness of its risk management

system.

This will be tested using Pearson Correlation Coefficient

denoted by:

r = n∑xy - ∑x∑y

(n∑x2 – (∑x)2 (n∑y2 – (∑y)2)

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Table VI: CORRELATION COEFFICIENT TABLE

Year Y X XY X2 Y2

2007 32.40 39.89 1, 292.44 1, 591.21 1, 049.76

2006 25.39 37.10 941.97 1, 376.41 644.65

2005 16.99 23.53 399.78 553.66 288.66

2004 20.83 22.63 471.38 512.12 433.89

2003 18.13 19.08 345.92 364.05 328.70

113.74 142.23 3,451.49 4,397.45 2,745.66

r = n∑xy - ∑x∑y

(n∑x2 – (∑x)2 (n∑y2 – (∑y)2)

= 5(3,451.49) – (142.23) (113.74)

(5(4,397.45) - (142.23)2) (5(2,745.66 – (113.74)2)

= 17,257.45 – 16,177.24

(21,987.25 – 20,229.37) (13,728.3 – 12,936.79)

= 1, 080.21 1,179.57 r = 0.92

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Result: The relationship between X and Y is positive and is of

a high correlation. This implies that increase in one variable X

will automatically increase the other variable Y.

TESTING THE SIGNIFICANCE OF A CORRELATION

Having computed the correlation, we determine the probability

that the observed correlation did not occur by chance. That is,

we conduct a significant test. We apply test statistics thus;

t = r n -2 1 – r2 Where; r = 0.92 n = 5

∴ t = 0.92 5-1

1-(0.92)2 = 0.92 3

1- 0.8464 = 0.92 3 0.1536

= 0.92 19.53125

= 0.92 x 4.419417382 = 4.06

t = 4.06

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Decision: Table or Critical t at 5 percent for a 3 degree of

freedom is 2.353. Calculated t value tc = 4.06. Under the two

tail test, the calculated t is greater than the table or critical t.

However, we reject the null hypothesis.

Conclusion

The null hypothesis (H0) is rejected, which states that there is

no correlation between the bank’s risk asset portfolio and the

effectiveness of its credit risk management system. However,

the alternative hypothesis (H1), which states that there is a

correlation between the bank’s risk-asset portfolio and the

effectiveness of its risk management system, is accepted.

This indicates that there is a correlation between the bank’s

risk-asset portfolio and the effectiveness of its credit risk

management system.

lxxxii

REFERENCES

Dwivedi, D.N (2006). „Managerial Economics‟, New Delhi-India, Vikas Publishing House PVT Ltd.

Eqbui, K.I (1998). “Groundwork of Research Methods and Procedures”, Institute for Development Studies, University of Nigeria, Enugu Campus

KPMG, (1998). Loan Analysis System (http://www.kpmgconsulting.com)

Newbold, P. et al, (2007). “Statistics for Business, and Economics” (Sixth Edition), Pearson Education Inc., Upper Saddle River, New Jersey, USA.

Sharpe, W. (1963). “A Simplified Model for Portfolio Analysis”, Management Science, New York.

Ugbam, O. (2001). “Quantitative Techniques – An Introductory Text”, Chirol Publishers Enugu.

lxxxiii

CHAPTER FIVE

SUMMARY OF FINDINGS, CONCLUSION AND

RECOMMENDATION

5.1 SUMMARY OF FINDINGS

Evidence from this research study reveals the following:

That Equatorial Trust Bank experienced an appreciable

increase in the quantity of its risk assets. This is evident

in the consistent increase on the amount of total loans

and advances within the period (2003-2007).

Another major implication of the findings was the growth

in the rate of secured loans to total loans and advances.

This could be attributed to the efficiency and

effectiveness of the banks’ credit risk management

system.

The statistical result also showed that the average

income generating capacity of the bank’s assets relative

to the banks’ gross earnings remained appreciable during

the period, thus implying a positive relationship between

a banks’ gross income and the volume of its risk assets,

and more so the quality of its risk management system.

lxxxiv

There was also a noticeable variation in the percentage of

the performing loans and advances within the period

which the analysis could not provide an insight into some

of the causes and implications. It is invariably unclear

what could be responsible for the unstable rate of the

performing loans. This is, indeed, an issue necessitating

further study.

Finally, we have been able to identify the credit risk

management process adopted by Equitorial Trust Bank.

Although Equitorial Trust Bank appears to be gaining

grounds in terms of consistent improvement in the

quantity and quality of its risk assets, due to the

strengthening of its credit risk management system. It is

also encouraging that the income generating capacity of

these risk assets has remained high during the five years.

The implication here is that large portion of the bank’s

income is from risk asset. However, is prudent for the

bank to de-emphasize greater efficiency on its performing

loan which appears to be inconsistent.

lxxxv

5.3 CONCLUSION

The purpose of this research study was to discuss the risk

management in banking. This has become necessary because

the present financial crisis in the Nigeria banking industry has

been attributed to a lot of factors. The characteristics features

of the Nigerian banks show that the banking sector before the

global financial crisis was sound and vibrant enough to

support the nation’s economic growth and development.

Banks have good reason to worry about risk management;

they cannot continue to be caught by dramatic turns in the

economic cycle that arrive without warning. Even if these

turns could be predicted in advance, many activities are not

yet liquid enough to remove or hedge the risk. The recent

crisis in the emerging markets such as Nigeria indicates that

banks worldwide continue to have difficulty in dealing with

illiquidity.

Moreover, they appear to be caught in a vicious cycle that

moves between rapid growth in the good times and virtual

standstill when a crisis hits.

lxxxvi

Despite the growing emphasis on risk and return analysis as a

basis for facility pricing in Nigerian banks, a major problem

has been the ability to design a risk-rating system that would

be consistent in measuring risk profile of prospective

borrowers. Typically, the decision to participate in a particular

business and allocate resources to that business assumes a

large part of the risk. Once that decision is made, the bank

should be prepared to incur stress-related loses from time to

time.

However, there was some suggestion that competitive

pressures within the industry are inducing banks to assume

more risk in a bid to maintain market share. This view was

prefaced by the evidence that banks are becoming increasingly

lenient in their lending standards. Concern about “excessive

competition” was thought to be the primary factor driving this

trend; banks are lending large amounts to lower-quality

counterparties because of fears about loosing market share. It

was argued that a paradox was emerging. Specifically, where

there seems to be a fairly common perception amongst the

lxxxvii

public and consumer bodies that there is not enough

competition within the financial services industry, for industry

participants, competition is quite intense. Many participants

questioned the view that excessive competition is driving down

credit standards in Nigeria. While there is plenty of competition,

it was generally agreed that banks are reasonably cautious in

their lending strategies, particularly with regard to the middle

market where most uncertainty was thought to exist.

5.3 RECOMMENDATION

Risk management has undergone significant evolution over the

last decade. Twenty years ago a bank’s risk management

function was almost non-existent. Since that time, banks have

experienced an influx of mathematicians, actuaries,

behavioural scientists and marketers which have changed

banks’ approaches to managing risk. Whilst the industry has

come a long way, there is still further to go. The continually

changing dynamic of banking activities, the business

environments in which they operate and volatile nature of the

world economy, imply that the nature of risk, and its

lxxxviii

measurement and management, must also evolve over time.

Risk management should focus most attention on the tail of

the loss distribution. To develop an understanding of what

might happen under extreme circumstances; banks need to

adopt a stress-testing regime that systematically analyses the

impact of different scenarios on their earnings.

Finally, it is pertinent that the regulatory agencies strengthen

bank regulation and supervision in Nigeria. This is to sterm

the tide of recurrent bank failure in the country. They should

firm up prudential guidelines and encourage market

discipline. Well-trained on-site inspectors are important to

ensuring that banks comply with regulations, thus, strong

supervision must ensure that banks conduct careful credit

analysis of their borrowers to avoid bad loans.

lxxxix

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