stress test seminar

8/8/2019 Stress test seminar

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SCHOOL OF GRADUATE STUDIES

UNIVERSITY OF PORT HARCOURT

RIVERS STATE, NIGERIA

10

APPLICATION OF STRESS TEST AS A RISK MANAGEMENT TOOL IN

NIGERIA DEPOSIT MONEY BANKS.

OKUNLOLA, ABIODUN .F


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Okunlola, Abiodun F. G2008/MBA/Fin/FT/430 Page 2

SECTION ONE

INTRODUCTION

In May 2004, the Committee on the Global Financial System (CGFS) initiated an exercise on

stress tests undertaken by banks and securities firms. The exercise had two main aims. The first was

to conduct a review of what financial institutions perceived to be the main risk scenarios for them at

that time, based on the type of enterprise-wide stress tests that they were running. The second aim

was to explore some of the more structural aspects of stress testing and examine how practices had

evolved, particularly over the period since the previous CGFS survey, the results of which were

published in A survey of stress tests and current practice at major financial institutions in April

2001. 1. There were two main parts to the latest exercise. The first part involved a survey of stress

tests being conducted at banks and securities firms. The survey asked respondents to list details of

the stress test scenarios and associated risk factors that were in use as at the end of May 2004. Sixty

four banks and securities firms from 16 countries participated in the survey, with the reporting

institutions selected by their national central banks. 2. Firms participating in the survey reported to

their national central bank; the data were then submitted on a no -name basis to the BIS-based CGFS

secretariat and entered into a database. Around 960 stress tests were reported and more than 5,000

risk factors were listed. 3. Reflecting a desire to focus on the range of scenarios being employed and

confidentiality concerns, survey respondents were not asked to report the results of any scenario

runs. In the second stage, national central banks conducted follow-up meetings with institutions that

had participated in the stress test survey. National central banks met to discuss the results of the

survey and these interviews. As part of this meeting, senior risk managers from several large complex

financial firms were invited to discuss stress test practice. Both the follow -up meetings and the group

discussion with risk managers made clear that risk measurement and the role of stress testing in risk

management vary widely across firms, reflecting differences in both the complexity of risks faced by

firms and the breadth and scale of the different businesses.

The output of the group is a synthesis of observations based on the survey, interviews with

respondent firms and discussion with market participants. The exercise illustrated the wide range of

practices and risk management frameworks at firms. This reflected, inter alia, the heterogeneous

business models that are being employed by firms. The use of stress tests has expanded from the

exploration of exceptional but plausible events, to encompass a range of applications. It has met with

wider acceptance within firms because it is a flexible tool which can adapt quickly and efficiently to


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the changing environment and specific needs of a firm and provide important information on the risk

exposures of firms. Notwithstanding this positive development, a number of challenges remain, most

notably in the areas of stress testing credit risks, integrated stress testing and the treatment of

market liquidity in stress situations (BIS, 2009).

Also, in their survey, the Bank for International Settlement BIS (2009) accessing the principles for

sound stress test practices and supervision opined that stress testing is a tool that supplements other

risk management approaches and measures. It plays a particularly important role in:

y Providing forward-looking assessments of risk;

y Overcoming limitations of models and historical data;

y Supporting internal and external communication;

y feeding into capital and liquidity planning procedures;

y Informing the setting of a banks risk tolerance; and

y Facilitating the development of risk mitigation or contingency plans across a range of stressed

conditions

However, as the world is now made a global village, it is imperative to admit and submit that

whatever happens in one sector of it will automatically affect the other no matter how plausible we

may think. To this end, the recent global crisis phenomenon has its relative impact on the Nigerian

economy especially on the banking industry. In one of his speeches, Sanusi, 2010 explained that

though Nigerian banking sector witnessed dramatic growth post-consolidation, neither the industry

nor the regulators were sufficiently prepared to sustain and monitor the sectors explosive growth.

Prevailing sentiment and economic orthodoxy all encouraged this rapid growth, creating a blind spot

to the risks building up in the system. The following eight (8) main interdependent factors he believed

created an extremely fragile financial system that was tipped into crisis by the global financial crisis

and recession. These are:

a) Macro-economic instability caused by large and sudden capital inflows

b) Major failures in corporate governance at banks

c) Lack of investor and consumer sophistication

d) Inadequate disclosure and transparency about financial position of banks


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e) Critical gaps in regulatory framework and regulations

f) Uneven supervision and enforcement

g) Unstructured governance & management processes at the CBN/Weaknesses within the CBN

h) Weaknesses in the business environment

Each of these factors is serious on its own right. Acted together they brought the entire Nigerian

financial system to the brink of collapse.

This paper intends to unveil the stress test volatility and risk management tool indicators of

the Nigerian Deposit Money Banks. Structurally, the paper is organized into five sections including the

introduction. Section two, presents the literature review. It examines the issues in stress test and risk

management in details, globally and the case of Nigeria. Section three, reveals the methodology and

the model formulated to support our findings. Section four, analyse and interprets data. Finally,

section five contains the summary of major findings and policy recommendations

SECTION TWO

LITERATURE REVIEW

What is Stress Test?

Stress testing has been adopted as a generic term describing various techniques used by

financial firms to gauge their potential vulnerability to exceptional but plausible events. The most

common of these techniques involve the determination of the impact on the portfolio of a firm or

business unit of a move in a particular market risk factor (a simple sensitivity test) or of a

simultaneous move in a number of risk factors, reflecting an event which the firms risk managers

believe may occur in the foreseeable future (scenario analysis). The scenarios are developed either

by drawing on a significant market event experienced in the past (historical scenarios) or by thinking

through the consequences of a plausible market event which has not yet happened (hypothetical

scenarios). Other techniques used by some firms to capture their exposure to extreme market events

include a maximum loss approach, in which risk managers estimate the combination of market

moves that would be most damaging to a portfolio, and extreme value theory, which is the statistical

theory concerned with the behaviour of the tails of a distribution of market returns (BIS, 2000).

Since the start of the global financial crisis, stress testing has received increased attention by

regulators, rating agents, bank management, etc. Stress testing is not new. It has been a very


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important tool in the arsenal of risk management for many years. However, banks have not been

very successful in implementing effective stress testing systems in the past. The reasons for this are

lack of data, complexity and quantitative models capability required and inability to integrate the

results of stress testing with the risk management decision process. According to Blaauw, 2008,

another way of defining stress testing is that stress testing is the process of achieving the following:

a) Defining potential extreme adverse future economic scenarios,

b) Measuring the sensitivity of the bank's credit, market, investment and operational risk

portfolios to changes in economic variables resulted under extreme scenarios defined under a

c) Aggregating the results of b and quantifying the overall negative impact on planned

profitability, capital levels, liquidity position, etc.

d) Comparing the results of c to board approved risk appetite levels and implementing risk

reduction business strategies, policy changes, etc. should the results of the stress test exceed

risk appetite.According to him, Step d is considered the most important in implementing an effective stress

testing framework. During the current global financial crisis, many international banks ran into

trouble because their stress testing frameworks omitted this important step. Senior management

failed to adjust their risk taking strategies and risk management policies based on the stress testing

results and continue to do business as usual in the hope that the stress scenario will never realize. As

we now know, extreme scenarios have a habit of occurring more frequently than popular belief,

causing these banks to be bailed out to survive.

What is Risk Management?

Also there exist series of sectorial viewpoint to the term risk management. For the purpose of

this paper keen interest will be on the deposit money banks with little emphasise on the security

sector.

Sectoral Emphases on Risk

One of the primary concerns of any supervisor or regulator is that supervised institutions are

able to meet their financial promises to customers as and when they fall due. However, the nature of

these promises can differ greatly: from obligations to repay fixed amounts of deposits and other

borrowings along with interest calculated at a pre-determined rate (as is common in banking and


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securities firms), to obligations to make payments in which the rate of return involved is determined

by the performance of financial markets (such as a unit linked life insurance product), to obligations

in which the contractual payments are contingent on some future event (for example, under a

general insurance policy). Because the nature of these financial promises differs, the risks which

might cause a supervised institution to be unable to meet its financial obligations can arise from quite

different sources.

In describing the major risks and business activities of sum selected three sectors (banks

inclusive) however, BIS, (2001) considered their st ylised balance sheets for each sector and concluded

as follows:

Banking Sector

Credit risk has long been identified as the dominant risk for banking firms and is an inherent

part of their core lending business. Loans extended to customers and customer deposits generally

represent, respectively, the most significant asset and liabilities classes of a banks balance sheet. This

is reflected in the stylised bank balance sheet shown in Annex 2. In this case, loans make up

approximately two-thirds of the assets. For most banks, loans will make up between 25 percent and

75 percent of total assets, although there are some exceptions. Loan loss reserves are shown on the

stylised balance sheet as a contra-asset item, reflecting their treatment in a number of juri sdictions.

Such reserves can range from less than one percent of loans outstanding to much larger

amounts in some cases. An important off-balance-sheet source of credit risk for many banks relates

to their provision of lines of credit and other forms of l ending commitments. For many banks, these

loan commitments are half again as large as their total assets, although naturally there is a wide

range of variation across banks. This further underscores the continuing importance of credit risk as

the primary risk for the majority of banks. Interbank activities, securities holdings, and other traded

assets tend to make up the bulk of a banks assets not devoted to customer loans. The share of these

types of assets may be larger than 25 percent for banks that are more active in money market and

other trading activities. Depending on the size and scale of these activities, banks are exposed to

market risks, including foreign exchange risk, interest rate risk, and other risks associated with 11

holding traded securities. Similarly, banks have in many cases become significant users of derivative

instruments. For most banks, the notional value of derivative contracts outstanding is less than 10

percent of assets, but for those banks that act as dealers, it can exceed 10 times total assets. Of

course, notional value is not a good measure of exposure. Even for the largest dealer banks,


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derivative-related credit exposure tends to make up considerably less than half of all loan-related

exposure and a significant portion of such exposure may be collateralized. On the liability side, the

stylised balance sheet suggests that customer deposits remain the largest source of bank funding.

Such deposits still represent more than half of all liabilities for many banks, although a trend

towards other forms of funding has been apparent in a number of countries. Interbank liabilities and

other forms of short-term wholesale funding are also important, particularly for banks active in

trading activities. Importantly, the structure of banks liabilities relative to its assets can give rise to

both funding liquidity risks and to interest rate risk if the underlying maturity of a banks assets and

liabilities do not match. Capital issued by the bank tends to make up between 5 and 15 percent of

assets depending on the bank and on how capital is defined. For example, for the bank shown on the

stylised balance sheet, equity capital makes up 5.5 percent of assets, while subordinated debt eligible

for regulatory capital makes up another 4.5 percent. In considering the activities that banks are

substantially engaged in, it is also important to mention that many banks have increasingly been

seeking opportunities to earn fees from customers without taking substantial assets onto the balance

sheet. Examples of fee-based businesses include asset management, advisory, payments and

settlement, and other processing-related businesses. While such business lines typically do not result

in the acquisition of substantial assets or in substantial credit exposur e, they often contain important

elements of operations-related risks.

Securities Sector

Securities firms2 also bear risks as an ongoing part of their business activities, but the stylised

balance sheet for a securities firm shown in Annex 2 makes clear that the nature of these risks is

somewhat different than for banks. For securities firms, the majority of assets are receivables fully

secured by securities. These receivables are either related to financing arrangements (i.e. securities

borrowed and reverse repurchase transactions) with other nonretail market participants or to margin

loans made to retail customers. Generally, the former is 100% collateralized, while the latter are

collateralized well in excess of 100%. The next largest asset category for securities firms is financial

instruments owned at market value. In other words, securities firm balance sheets tend to reflect

relatively little unsecured credit exposure (roughly ten percent of assets). As with banks, many

securities firms are active participants in derivative markets where both market and credit risk may be

present. On the liability side of the balance sheet, the largest item are generally payables to

customers (largely arising from customer short positions) and obligations arising fr om selling

securities short. In addition, securities firms tend to rely o n wholesale funding sources such as the

descriptions here focus primarily on those firms that are active securities market participants. They


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may be less relevant to firms engaged primarily in futures trading. In addition, the analysis tends to

focus on the characteristics of the largest securities firms, many of which are based in the US.

Therefore, the descriptions may not be applicable to all securities firms in all jurisdictions. 12 as

securities loaned and repurchase transactions to finance part of their proprietary and customers

securities positions. Most of the risk in a securities firm balance sheet derives from the differential

price sensitivity and liquidity characteristics o f the different long and short positions.

The maintenance of a large and actively managed securities portfolio is critical to a number of

business lines in which securities firms engage, including investment banking, brokerage, and

proprietary trading. In addition, similar to banks, securities firms also engage in fee driven activities

such as asset management, advisory and research services, and trade processing. Operational risks

form a key risk for such activities. Securities firms issue debt and maintain capital as a means to

protect against risk. As the stylised balance sheet suggests, equity capital makes up approximately 5

percent of the firms liabilities, with long-term debt frequently making up 10 percent and short -term

debt another 10 percent of total liabilities.

STRESS TEST AS AN INTEGRAL OF RISK MANAGEMENT TOOL

BIS, (2005) opined that stress testing is a risk management tool used to evaluate the potential

impact on a firm of a specific event and/or movement in a set of financial variables. Accordingly,

stress testing is used as an adjunct to statistical models such as value-at-risk (VaR), and increasingly it

is viewed as a complement, rather than as a supplement, to these statistical measures. Stress tests

generally fall into two categories: scenario tests and sensitivity tests. In scenarios, the source of the

shock, or stress event, is well defined, as are the financial risk parameters which are affected by the

shock. In contrast, while sensitivity tests specify financial risk parameters, th e source of the shock is

not identified. Moreover, the time horizon for sensitivity tests is generally shorter - often

instantaneous - in comparison with scenarios. The survey and follow-up discussions revealed a wide

range of uses of stress tests. These uses, which are not mutually exclusive, included:

Capturing the impact on a portfolio of exceptional but plausible large loss events

Unlike VaR, which reflects price behaviour in everyday markets, stress tests simulate portfolio

performance during abnormal market periods. Accordingly, they provide information about risks

falling outside those typically captured by the VaR framework. These risks include those associated


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with extreme price movements, and those associated with forward-looking scenarios that are not

reflected in the recent history of the price series that are used to compute VaR.

Understanding the Risk Profile of a Firm

Firms are using stress tests to better understand their own risk profiles. A stress test of a corporate

customer, for example, may reveal exposures which at the individual business unit level are not

significant, but which, in aggregate, may have a large negative effect on the overall business.

Alternatively, it may highlight offsetting positions in other parts of the business. In addition, firms

are using stress tests - mainly sensitivity tests - to calculate the sensitivity of a firms portfolio to

changes in risk factors, such as an upward shift in a yield curve. Some institutions are using stress

tests to verify the distribution assumed in their VaR models. If a loss computed by a stress test

exceeds its VaR equivalent, the risk manager may need to modify the assumed distribution. Firms are

also using stress tests to evaluate risks where VaR is of limited use. Examples include markets where

the price impact of shocks is non-linear, such as options. Stress testing is also used to set limits for

markets with low historical volatility but which may be subject to large discrete movements, such as

for pegged currencies. Risk managers have also found it useful for setting limits and monitoring new

products where no historical data are available. Thus stress testing is considerably enhancing firms

overall risk management frameworks.

Limit/Capital Allocation or Verification

At some institutions, stress testing is used by senior management as a basis for informed

decisions about how much risk they are willing to take and identifying where the vulnerabilities in

their portfolios actually lie. In other words, it helps them to ev aluate their tolerance for risks - at both

the firm and division level - and understand the combinations of risks that can produce large losses.

This is then being linked, both directly and indirectly, to capital allocations. The small numbers of

firms which are using it as a direct input to the allocation of economic capital are generally adopting

two different approaches. The first approach takes the form of constructing scenarios with the input

of business units, and ranking them according to their relevance and plausibility. The output of this

exercise then forms the basis for decisions about the allocation of economic capital. Alternatively,

firms will focus on worst case scenarios, owing to concerns about the possibility of scenario

manipulation and difficulties with aggregation and the distribution of the diversification benefit. This

process is more objective, though judgments still have to be made about such things as the


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periodicity and span of the historical data. But even in this more quantitative exercise, the eventual

allocation of capital is not formulaic, with a number of further judgments being made before capital

is allocated.

A much larger number of firms are using stress tests as a diagnostic tool to verify the adequacy of

established limits and assigned capital across portfolios and enterprises. Thus while some other

methodology, such as VaR, is used in the initial allocation of economic capital, stress testing is

employed to ensure that due consideration is given to the impact of a stress-type event. A number of

reporting firms described how stress test reports had contributed in some way to changes in firm

policy and/or modifications of risk exposures.

Similarly, stress tests are also used as triggers or soft limits, whereby the breach of a

predetermined level initiates a discussion among senior management, risk managers and the affected

business units. The purpose of the discussion is to make sure that the relevant people are aware of

the possibility of significant losses an d to determine the appropriate actions, if any.

Evaluation ofBusiness Risks

One of the innovations in stress testing is its application to business plans. In some firms, a

stress event is looked at in the context not only of changes in the value of on - and off-balance sheet

items of the firm, but also of the effect that it has on revenue sources over subsequent years. This

overlay assists management in deciding whether this type of event is a threat to their underlying

business and whether the capital supporting the business is appropriate. One firm, for example, is

testing the effect on its profitability of a long period of low interest rates. Stress tests are also being

used to evaluate new business plans by stressing the scenarios which underpin these plans. This

normally takes the form of examining the impact of an event on the net interest income of a firm.

THE ISSUES OF THE NIGERIAN DEPOSIT MONEY BANKS

The Nigerian banking sector witnessed dramatic growth post-consolidation. However, neither the

industry nor the regulators were sufficiently prepared to sustain and monitor the sectors explosive

growth. Prevailing sentiment and economic orthodoxy all encouraged this rapid growth, creating a

blind spot to the risks building up in the system (Sanusi, 2010). According to Sanusi, 2010 he believes

the following main interdependent factors created an extremely fragile financial system that was

tipped into crisis by the global financial crisis and recession. These are:


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1. Macro-economic Instability caused by Large and Sudden Capital Inflows:

As oil price increasesteadily between 2004 and 2008, Government spending tracked the price of

oil, making fiscal policy highly pro-cyclical and adding to this volatility. Variations in monthly

disbursement of oil revenues made it difficult for governments to manage economic development

and caused tremendous instability as these varying amounts entered the banking sector.

Simultaneously, the lack of an effective fiscal quarantining mechanism meant that the fiscal

authorities failed to prevent this excess liquidity from reaching the domestic banking system. Banking

sector activity closely mirrored the price of oil and its volatility. As amounts held in Nigerian deposits

increased, banks were able to increase their lending. Consolidation in the domestic banking sector

and along with abundant capital increased the speed of credit creation. Bank deposits and credit,

tracking the price of oil, grew four-fold from 2004 to 2009 and banking assets grew on average at

76% per annum since consolidation. There was a belief that financialisation would drive economic

growth. However, the reality is more complex. While many developing countries have followed this

path, Nigerias financialisation was far too rapid for the real economy to benefit. The economy was

not able to absorb of the excess liquidity from oil revenues and foreign investments in productive

sectors. This resulted in significant flows to non-priority sectors and to the capital markets, mostly in

the form of margin loans and proprietary trading camouflaged as loans. As a result, market

capitalisation of the NSE increased by 5.3 times between 2004 and its peak in 2007, and the market

capitalisation of bank stocks increased by 9 times during the same period. This set the stage for a

financial asset bubble particularly in bank stocks. The rapid rise in asset prices and the over

concentration of bank shares in the stock market index were clear indications of an accident waiting

to happen. Instead of raising concern among regulators, these developments were cheered by most,

and voices of protest were waved aside with arrogance. In 2007, the Nigerian Stock Exchange was

the best performing bourse in the world even though there was no evidence to suggest a

commensurate improvement in the fundamentals of real sector corporations. Countries that have

experienced an equally rapid financial asset growth crashed and suffered years of low or negative

growth. As credit levels rose and stock prices inflated, the CBN failed to halt this vicious circle and

foresee the consequences.

The CBN did not highlight or failed to communicate the problem to fiscal authorities and the

market in general. The sad story in all this is that we now have evidence that junior officers in the

CBN did document their concerns to CBN top management at that time, b ut no action was taken.

We also have evidence that the NDIC documented its concerns but its efforts to get the CBN


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leadership to act quickly were rebuffed. Also, during this period, CBNs macro -prudential

management did not sufficiently address the impact of these oil-related inflows, and with the

fiscal policy being pro-cyclical, this exacerbated the crisis.

2. Corporate Governance at Banks:

The huge surge in capital availability occurred during the time when corporate governance

standards at banks were extremely weak. In fact, failure in corporate governance at banks was

indeed a principal factor contributing to the financial crisis. Consolidation created bigger banks but

failed to overcome the fundamental weaknesses in corporate governance in many of these banks. It

was well known in the industry that since consolidation, some banks were engaging in unethical and

potentially fraudulent business practices and the scope and depth of these activities were

documented in recent CBN examinations. Governance malpractice within banks, unchecked at

consolidation, became a way of life in large parts of the sector, enriching a few at the expense of

many depositors and investors. Corporate governance in many banks failed because boards ignored

these practices for reasons including being misled by executive management, participating

themselves in obtaining un-secured loans at the expense of depositors and not having the

qualifications to enforce good governance on bank management. In addition, the audit process at all

banks appeared not to have taken fully into account the rapid deterioration of the economy and

hence of the need for aggressive provisioning against risk assets. As banks grew in size and

complexity, bank boards often did not fulfil their function and were lulled into a sense of well-being

by the apparent year-over year growth in assets and profits. In hindsight, boards and executive

management in some major banks were not equipped to run their institutions. The bank

chairman/CEO often had an overbearing influence on the board, and some boards lacked

independence; directors often failed to make meaningful contributions to safeguard the growth and

development of the bank and had weak ethical standards; the board committees were also often

ineffective or dormant. We have already published details of the extent of insider abuse in several of

the banks. CEOs set up Special Purpose Vehicles to lend money to themselves for stock price

manipulation or the purchase of estates all over the world. One bank borrowed money and

purchased private jets which we later discovered were registered in the name of the CEOs son. In

another bank the management set up 100 fake companies for the purpose of perpetrating fraud. A

lot of the capital supposedly raised by these so called mega banks was fake capital financed from


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depositors funds. 30% of the share capital of Intercontinental bank was purchased with customer

deposits. Afribank used depositors funds to purchase 80% of its IPO. It paid N25 per share when the

shares were trading at N11 on the NSE and these shares later collapsed to under N3. The CEO of

Oceanic bank controlled over 35% of the bank through SPVs borrowing customer deposits. The

collapse of the capital market wiped out these customer deposits amounting to hundre ds of billions

of naira. The Central Bank had a process of capital verification at the beginning of consolidation to

avoid bubble capital. For some unexplained reason, this process was stopped. As a result, we have

now discovered that in many cases consolidation was a sham and the banks never raised the capital

they claimed it did.

3 Investor and Consumer SophisticationBank boards are hardly the only ones to blame for failure to deal with the sudden surplus in

capital. A lack of investor and consumer sophistication also contributed to the crisis by failing to

impose market discipline and allowing banks to take advantage of consumers. Investors, many new

to investing, were unaware of the risks they were taking and consumers were often subjected to poor

service and sometimes hidden fees. Nigeria does not have a tradition of consumer activism or

investor protection and as a consequence many Nigerians made investments without a proper

understanding the risks. The limited consumer protection framework did exist in Nigeria. However,

the framework was inadequate and as a result consumers rights were not sufficiently protected.

4 Disclosure and TransparencyGiven the low sophistication among many consumers and investor, inadequate disclosure by the

banks was another major contributing factor to the crisis. Bank reports to the CBN and investors

often were inaccurate, incomplete and late, depriving the CBN of the right information to effectively

supervise the industry and depriving investors of information required to make informed investment

decisions. The CBN did not act to enforce the data quality in banks to ensure their reports were

accurate. The CBNs internal reporting system could not serve as an effective warning system for

bank surveillance. In addition, banks made public information on their operations on a highly

selective basis and investors were unable to make informed decisions on the quality of bank earnings,

the strength of their balance sheets or the risks in their businesses. Without accurate information,

investors made ill-advised decisions regarding bank stocks, enticed by a speculative market bubble


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this was allegedly partly fuelled by the banks through the practice of margin lending. Some banks

even engaged in manipulating their books by colluding with other banks to artificially enhance

financial positions and therefore stock prices. Practices such as converting non-performing loans into

commercial papers and bank acceptances and setting up off-balance sheet special purpose

vehicles to hide losses were prevalent. Recently the CBN put an end to these practices and the

collapse of the equity markets effectively put an end to alleged stock price manipulation.

5 Regulatory Framework and Prudential RegulationsNow I will turn to the failure of the authorities, the CBN and other government bodies with

oversight for the financial sector. Lack of co-ordination among regulators prevented the CBN from

having a comprehensive consolidated bank view of its activities. In addition, regulations concerning

the major causes of the crisis were often incomplete. There is little co-ordination among the FS

regulators. In spite of the widespread knowledge of bank malpractice and propensity for regulatory

arbitrage, the FSRCC, the coordinating body for financial regulators did not meet for two years during

this time. Whilst excess capital gave rise to strong growth in lending, banks were also allowed to use

the capital to enter many other non-lending activities such as stock market investments, most of

which were hived off in subsidiaries thus escaping the ongoing supervisory scrutiny by the CBN. The

CBN did not receive examination reports from the SEC covering bank subsidiaries, nor was there a

framework for consolidated bank examination. Regulations governing the issues that caused the

crisis were incomplete. In fact, of the 373 circulars issued by the CBN since January 2008, only 44

addressed issues relating to the crisis and none addressed the issue of corporate governance. A

comparison of Nigerian regulations with those of international regulators indicated the Nigerian set

of regulations was not as comprehensive. An example was the lack of a legal and regulatory

framework governing the margin lending activity.

6 Supervision and EnforcementUneven supervision and inadequate enforcement also played a significant role in exacerbating the

problems associated with the crisis. Regulators were ineffective in foreseeing and supervising the

massive changes in the industry or in eliminating the pervasive corporate governance failures.

The Supervision Department within the CBN was not structured to supervise effectively and to

enforce regulation. No one was held accountable for addressing the key industry issues such as risk

management, corporate governance, fraud, money laundering, cross-regulatory co-ordination,


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enforcement, legal prosecution or for ensuring examination policies and procedures were well

adapted to the prevailing environment. Moreover, the geographic separation of on-site and off-site

examiners hindered the building of integrated and effective supervisory teams. Critical processes, like

enforcement, pre-examination planning and people development were not delivering the results

required to effectively supervise and engage banks to enforce good conduct. There were many

instances of weaknesses in the supervision and enforcement process. For example, bank

examinations were not conducted on a bank consolidated basis. Pre-examination planning did not

question banks use of the Expanded Discount Window nor did it include a review of prior SEC or

NAICOM reports (if any) on bank subsidiaries. In addition, the CBN did not provide input to the SEC in

planning its examinations of bank activities. Also, the ratings and depth of analysis wasnt sufficient

to capture the issues. For example, CAMEL ratings did not differentiate the performance of successful

and failed banks. While some examinations identified critical risk management issues, many issues

that caused the crisis escaped examination, though they were well known in the industry. Sense of

urgency was low with some examinations taking between nine months to more than a year to

complete enforcement was the biggest failure among surveillance processes, despite the CBN having

all the powers it needed to enforce examination recommendations. Financial penalties are

inadequate to enforce bank compliance. By paying fines, banks effectively annulled key aspects of the

examination reports. With examination cycles between 6 and 12 months, follow-up on examination

recommendations rolled into the following years examination. The prevailing views that the sector

was healthy, a culture of tolerance, and acceptance of the status quo and the shortage of specialist

skills compromised supervisions effectiveness. There was insufficient discipline in holding the banks

to clear remedial programmes. While banks responded to examination reports, they seldom

committed to specific deliverables, timing or executive responsibility for implementation. Hence it

was difficult to measure bank progress against compliance with some of the major

recommendations. Banks compliance record was poor. They frequently ignored the examiners

recommendations in spite of the seriousness of the issues. The consequence to the banks of

noncompliance was not sufficient to change behaviour. Directors faced no personal consequences for

non-compliance. The CBN allowed this practice and behaviour to go unchecked, establishing a way of

doing business that compromised the supervision process.


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7 CBN Governance and Management ProcessesStill on the role of the authority in this crisis, the governance and management processes at the

CBN also had a significant impact on its ability to deliver its mandate adequately. Governance and

internal processes were unstructured and this compromised the CBNs ability to supervise the

industry. Corporate governance at the CBN was laissez-faire. Board agendas were set by the

Governor and consequently reflected his priorities, and there were inadequate committee structures

and processes to ensure the CBN Boards independence in assessing whether the CBN was fulfilling

its mission. Issues concerning the stability of the financial sector and economic development were

not discussed comprehensively at the CBN Board meetings these risks include for example, global

economic risks, federal /state economic development strategies and fiscal policies, formation of asset

bubbles, exchange rate risk, capital market depth, informal sector economy etc.

The CBN was not organised to monitor adequately and analyse the macroeconomic issues and

systems risks inherent in the financial sector. There is no overarching architecture to manage the

risks in the banking system, linking economic indicators to macro-prudential guidelines and to

individual bank prudential guidelines. As a consequence, managing the risks to the banking system

from the impact of oil price volatility, cross-border capital flows, asset price bubbles and weak

corporate governance did not have the necessary urgency at the CBN board or within the CBN itself.

Management information to analyse the risks in the banking system was inefficient. There were

also data quality issues with the CBNs internal reporting system and the research department at the

CBN is under-equipped to access the latest economic data and analysis. Leadership and culture issues

included an apparent lack of political will to enforce the sanctions for infractions and a belief,

supported by the IMF that the sector was sound and that growth was a healthy development blunted

the understanding of the real risks threatening the economy and the banking system. It was almost as

if, having made consolidation the hallmark of success, there was a desperate need to remain in a

state of denial rather than recognise that mistakes had been made and take corrective action.

8 Business EnvironmentFinally, a lack of a sufficiently developed infrastructure and business environment has had a

negative influence on the banking industry. The legal process, an absence of reliable credit rating

agencies and poor infrastructure all contributed to non-standard banking practices. Nigerias legal

process is long and expensive and banks seldom pursue borrowers in court. Few banks were able to

foreclose on borrowers, and this led to borrowers abusing the system. Basic lack of credit information


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on customers, largely because there is no uniform way to identify customers, has held back the

development of credit bureaus and hampered customer credit assessment at banks, increasing the

stocks of bad debt in the system.

All of these lead to the development of a blueprint for reforming the entire financial system

which is anchored on what is called the the Four Pillar. That is

(a) Enhancing the quality of banks

(b)Establishing the financial stability

(c) Enabling healthy financial sector evolution

(d)Ensuring the financial sector contribute to the real economy

Section 3

RESEARCH METHODOLOGYThis study unveils data covering deposit money banks total liabilities, loan to deposit ratio and

liquidity ratio as measure of stress test to risk prevention of the deposit money banks. The data

covers a period of twenty eight years (28years) that is, from 1980 to 2008. The data sourced mainly

from the secondary sources. The choice of the sources is based on their authenticity and reliability.

They include the Central Bank of Nigeria statistical bulletin and Bullions, National Bureau of Statistics,

published articles and journals, World Bank Agricultural Reports, and the Bank for International

Settlements

The hypothesis tested is stated in the null form and asked whether there is a significant

relationship between multiple stress test dimensions as proxy by loan to deposit ratio and liquidity

ratio against the total liabilities of the deposit money banks. In providing the answer to determine

how the former contribute to the latter, the Ordinary Least Square Regression (OLS) was employed

for the period mentioned.

Using this statistical tool for empirical testing however, the following formula is derived:

------------------ (1)

Where: Y = dependent variable

X = independent variable

a = general constant

b = slope of gradient of the line


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SECTION FOUR

DATA PRESENTATION AND ANALYSIS

Table 4.0. Data for the study

Year CBN

MPR

(per

cent)

DMBs Liquidity

Ratio(Actual) percent

DMBs

CRR (%)

Loan to Deposit

Ratio(Actual) percent

Savings/Time Deposit

with DMBs (#M)

DMBs Total

Liabilities

1980 6.00 47.6 10.6 66.7 5,163.2 16,340.4

1981 6.00 38.5 9.5 74.5 5796.1 19,477.5

1982 8.00 40.5 10.7 84.6 6,338.2 22,661.9

1983 8.00 54.7 7.1 83.8 8,082.9 26,701.5

1984 10.00 65.1 4.1 81.9 9,391.3 30,066.7

1985 10.00 65.0 1.8 66.9 10,550.9 31,997.9

1986 10.00 36.4 1.7 83.2 11,487.7 39,678.8

1987 12.75 46.5 1.4 72.9 15,088.7 49,828.4

1988 12.75 45.0 2.1 66.9 18,397.2 58,027.2

1989 18.50 40.3 2.9 80.4 17,813.3 64,874.0

1990 18.50 44.3 2.9 66.5 23,137.1 82,957.8

1991 14.50 38.6 2.9 59.8 30,359.7 117,511.9

1992 17.50 29.1 4.4 55.2 42,438.8 159,190.8

1993 26.00 42.2 6.0 42.9 60,895.9 226,162.8

1994 13.50 48.5 5.7 60.9 78,127.8 295,003.2

1995

13.50

33.

15.8

73.3

93,327.8

385,

14

1.8

1996 13.50 43.1 7.5 72.9 115,352.3 458,777.5

1997 13.50 40.2 7.8 76.6 154,055.7 584,375.0

1998 14.31 46.8 8.3 74.4 161,931.9 698,615.1

1999 18.00 61.0 11.7 54.6 241,604.7 1,070,019.8

2000 13.50 64.1 9.8 51.0 343,174.1 1,588,838.7

2001 14.31 52.9 10.8 65.6 451,963.1 2,247,039.9

2002 19.00 52.5 10.6 62.8 556,011.7 2,766,880.3

2003 15.75 50.9 10.00 61.9 655,739.7 3,047,856.3

2004 15.00 50.5 8.6 68.6 797,517.2 3,753,277.8

2005 13.00 50.2 9.7 70.8 1,316,957.4 4,516,177.6

2006 10.00 55.7 2.6 63.6 1,739,636.9 7,172,932.1

2007 9.00 44.9 2.8 83.3 2,693,554.3 10,981,693.6

2008 9.75 37.4 30.00 88.3 4,118,172.8 15,919,559.8

SOURCE: Central Bank of Nigeria Statistical Bulletin December, 2008


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From the table above, the loan to deposit ratio showed a cyclical fluctuation from 1980 up to

1993 without recourse to deposit money banks total liabilities. The obvious, if right may be largely

due to early learning of the sector as a virtue of it been n ewly an independent nation. However, as a

result of deregulations in the banking sector, more banks came on stream. This proliferation lead to

the increase in loan granted by these banks and attention was strictly on how to make more money,

increase shareholders wealth and expand without limit. As a result recklessly was observed in the

manner in which these banks transacts business , and due attention was not prioritized (i.e. the extent

to which depositors money loan against total liabilities) . These became obviously clear to the boom in

the sector post consolidation era and eventually, after proper scrutiny by the new CBN governor,

some of the backs were classified as sick banks.

Analysis of the Results

Table 2: Regression coefficient: Loan-to-deposit ration on DMBs total liabilities

COEFFICIENT STD ERROR t Significant Prob.

C (1) = -4530751

C (2) = 93221.886

4324766754

61505.246

-1.048

1.516

0.304

0.141

R = 0.280, R Square = 0.78, Ad R2

= 0.44, DW = 0.168

Source: E view output

From Table 2, it is quite evident that, the null hypothesis of no significant relationship

between the dependent and independent variable should be rejected and the alternative accepted.

That is, there is no significant relationship between stress test and risk management tool in the

Nigerian deposit money banks. That is as a result of the P Value of 0.3 which is lower than 5% level

of significant but with high variability. Hence, we can say that application of stress test as proxy by

loan to deposit ratio and other ratios has a considerable impact on the risk volatility of the deposit

money banks proxy by their total liabilities. The value of coefficient of correlation (r) is 0.280 which

shows as a relatively weak correlation. The coefficient of determination (r2) stood at 0.78. This shows

that about 78% of the total variation in the dependent variable is accounted for by the independentvariable, while the remaining 22% is accounted for by other variables. The relationship also noted to

be negative, the value of the correlation coefficient shows that there is a weak relationship in

explaining the variable dimensions.


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SECTION FIVE

SUMMARY OF MAJOR FINDINGS

The study examines the application of stress test as a risk management tool in the Nigerian

Deposit money Banks between the period of 1980 and 2008. The study, from the regression results,

confirms that there exists a negative relationship between the measures used. Moreso, this

relationship is negative and statistical significant in measuring the volatility that eventually crop up

from the sector.

This is in agreement with Sanusi (2010) assertion about the Nigerian banking industry what

went wrong and the way forward.

Policy Recommendations

The findings from this study raise some policy issues and recommendations, which will

reinforce the link between the dimensions stated. Given that the banking industry is the engine of

growth of any economy and operates in a macroeconomic environment, it is in this wise pertinent

that supervisory authorities must be on their toes to allow for strict compliance of necessary

guidelines. Bearing in mind also that the demand for funds from the deposit money banks is a derived

demand that fuels growth, hence its operating formalities must be without blemished. In addition

priority must be given to qualified/experienced staffing and not just experience with regular

supervision, inspection and monitoring by the apex regulatory body.


21/22


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stress test seminar

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