CREDIT RISK MANAGEMENT TECHNIQUES AND LOAN PORTFOLIO QUALITY OF NIGERIAN COMMERCIAL BANKS

CHAPTER ONE

 INTRODUCTION

1.1  Background to the Study

This study is based on the effect of various credit risk management techniques deployed by Nigerian commercial banks on the quality of their loan portfolio.  Banks are very important to economic growth and development all over the world, in view of the financial services they render. They act as financial inter-mediators, mobilizing deposits from surplus units of the economy and channeling the funds to deficit units by way of loans to finance projects and transactions that drive economic growth.  According to Kithinji (2010), the role of commercial banks is very critical to the success of every economy, commercial banks play an intermediation role between the surplus and deficit units of the economy. They constitute the foundation upon which the payment system is built. They also stimulate the financial system by engendering stability and effective delivery of financial transactions

Credit plays a prominent role in the financing of economic activities all over the world.  Credits are granted to finance various production, investment and consumption activities, across various sectors of the economy.  Credits therefore constitute critical tools for economic growth (Ugoani 2013). However, once credits are created, credit risk exposure has commenced and if not carefully handled, it could spiral into monumental global financial crisis, such as was witnessed in year 2006, arising from concentration of financial institutions’ loan portfolio on overvalued sub-prime mortgage-related assets which were built up over time.  By mid-2007, most of the underlying assets in the sub-prime mortgage crisis had suffered default (CBN 2015).  North America and Europe instantly felt the impact as it manifested in form of a drastic reduction in available credit and the consequential slump in aggregate demand.  The crisis spread like wild fire, cutting across one economy after another, in both developed and developing nations.  The Nigerian economy, being a mono-product economy in foreign exchange earnings, was touched through the oil slump, erosion of foreign direct investment, pressure on foreign reserves and a sharp decline in the performance of the stock market.  The global economic melt-down affected the Nigerian banking industry, particularly, those that had large portfolio exposure to the oil and gas industry, the capital market and through paucity of off-shore credit lines

Global economic growth, according to WEO (2016) and CBN (2016), was marginal over the years of this study, dropping from 5.2% in 2007 to 3.1% in 2015 due to the sub-prime mortgage crisis, low energy and commodity prices, weak demand, bearish capital markets in America and Africa, capital reversal from emerging markets and high volatility in currencies of developing economies.  Chimkono, Muturi and Njeru (2016); Llaudes, Salman and Chivakul (2010) posited that, evidence of questionable credit risk management practices manifested world over particularly, during and after the sub-prime mortgage crisis and the global economic melt-down of 2006 and 2007. Klein (2013); Chimkono et al (2016) agreed that, Central, Eastern and South Eastern Europe (CESEE) suffered growth in non-performing loan ratio from 3 percent in 2007 to 11 percent in 2011 and this caused a devastating effect on bank performance, bank lending and the economy as a whole.

A review of the American economy over the period showed growth in non-performing loan ratio from 3 percent in 2008 to 7.5 percent in 2010 (WEO, 2016).  Major South American economies comprising of Argentina and Brazil enjoyed low non-performing loan ratio of 3 percent, while Columbia and Mexico witnessed marginal non-performing loan growth rate from 1.9 percent in 2012 to 2.1 percent in 2013 and 2.5 percent in 2012 to 3.4 percent in 2013 respectively. In 2009, during the Asian banking crisis, Asia witnessed a huge NPL growth rate of 75% leading to the collapse of over 60 banks, while in Singapore and Malaysia, economic growth was constrained by accumulated NPLs which eroded the capital base of the banks. Chimkono et al (2016).  According to Kolapo, Ayeni and Oke (2012), the development, growth and sustained stability of the economy of any country is substantially a function of the volume of credit availed by banks to fund production and commercial activities that add value to the economy. Abdulraheem, Yahaya and Aliu (2011); Bashir and Kadir (2007); Yanfei (2013) aligned with these views, stressing that, the role of commercial banks in an economy is indispensable. Commercial banks facilitate the development, expansion and growth of a nation’s economy by making funds available for investment in the economy through the use of various financial instruments to mobilize surplus funds from those that forego current consumption for the future and they make same funds available to the deficit unit, by way of lending, for production, investment and consumption purposes.

Beck, Dewatripont, Freixas, Seabright and Coyle (2010) asserted that the financial intermediation role of banks involves three basic functions and these include, making means of payment available to economic agents, this makes transfer of property rights more efficient and transactions become more cost effective. Casu, Girardone and Molyneux (2006); Pyle (1971) shared same opinion.  Banks handle asset transformation to match short-term supply of funds in little volume (from their depositors) as well as the long-term demand in large amounts from their borrowers.  Banks also handle screening of potential borrowers, monitoring of their activity and enforcement of repayments.  Beck et al (2010) established the relationship between these three functions, arguing that efficient linkage of deposits to the payment system and careful lending of the funds collected through deposit, brings about economies of scale. 

The history of banking is traceable to the Italian merchants.   Adekanye (1986) traced the origin of the term “bank” to Italian language that simply means: ‘Bench or Benco’; the study argued that the process emanated from the ingenuity of the then blacksmith of Italy whose job specialization was building of boxes for safe keeping of ornaments and jewelries, the safe keeping of money and other valuables was later added to the process.  Banking operation in Nigeria has come a long way.  Somoye (2008) traced the commencement of banking operation in Nigeria to 1892 when it was under the control of the expatriates and banks owned by some Nigerians and Africans did not come on stream until the year 1945.  In the opinion of Akinyooye (2008), the use of silver coins in Nigeria was introduced by the British and this came on the platform of African Banking Corporation in 1892, the company was founded by Elder Dempster Company and it was exclusively saddled with the responsibility to issue legal tender, which was the British silver coins, then, the only money in circulation.  In 1893, the then newly established British Bank for West Africa took over its business operations and that culminated in the birth of present day First Bank of Nigeria Plc.  The monopoly remained intact until the West African Currency Board was created in 1912, in order to stimulate the British-West African trade. It was saddled with the responsibility to issue and it did issue a West African currency convertible to British Pound Sterling.

Literatures revealed that before the Central Bank of Nigeria (CBN) was established in 1959, the banking system was relatively unorganized as the system rode through the rough tide of uncoordinated markets, paucity of financial instruments, manual processes and all attributes of an underdeveloped financial system.  This view was corroborated by Somoye (2008), who asserted that the financial system was not well organized and it was bereft of sufficient financial instruments to trade or invest in, as a result, banks only focused on investing in real assets which were not liquid and could not be quickly converted to cash when needed, without a drop in value.

Promulgation of the Ordinance of 1958 which established the CBN was an outcome of the Loynes commission instituted by the Nigerian Federal Government in September 1958.  This was followed by enactment of the Treasury Bill Ordinance in 1959, the first Treasury Bill was issued in April 1960, formal money and capital markets were established and the Companies Act was enacted in 1968.  These marked the commencement of serious banking regulations in Nigeria.  The financial system then began to witness series of reforms following the Structural Adjustment Programme (SAP) of 1986.  Iganiga (2010) posited that the Structural Adjustment Programme (SAP) which kicked off in 1986 was an offshoot of the financial sector reforms. The components of the reforms included, fixing of the minimum paid up capital for banks at N400,000 (USD480,000).  In January 2001, the banking sector came under full deregulation with the adoption of universal banking system in Nigeria which led to merger of merchant and commercial banking operations and prepared the grounds for the consolidation programme of 2004.

On September 7, 2010, the CBN repealed the Universal Banking regime and licensed banks to perform commercial banking (regional, national and international authorization), merchant banking and specialized banking (Microfinance Banking, Mortgage Banking, Non-Interest Banking and Development Finance Institutions).  The same circular also prohibited banks from undertaking non-banking activities (CBN 2010). Following multiple licensing and influx of banks in Nigeria between years 1986 and 1989, when about 38 new commercial and merchant banks were created, there was mass bank failure and this preceded another round of recapitalization exercise that saw bank capital increased to N500Million in 2002, followed by another increase to N2Billion in January 2004 and subsequently to N25Billion in July 2006.  The deregulation and recapitalization exercises culminated in change in number of banks from time to time, the number had earlier increased from 66 to 107 in 1990, it further increased to 112 in 1996. The number of banks reduced to 110 in 2002, 89 in 2003 and 25 in July 2004.

 According to Iganiga (2010), the Nigerian nation witnessed arrival of the mother of reforms in July 2004, during which 89 banks were forced to merge and this culminated in 25 universal banks which was further reduced to 24 at the end of December 2007. Altunbas and Marques-Ibanez (2008); Donli (2003) noted that, on the average such mergers result in improved performance.  This position was also supported by Amel, Barnes, Panetta and Salleto (2002); Goldstein & Turner (1996). Ojo (2008).  Adam (2009) reviewed the deregulation process and noted that it brought about an array of sharp changes in the operations of banks and the regulatory environment while Nigeria once again witnessed another round of distress syndrome.  The changes witnessed in banking operations included; liberalization of the foreign exchange regime and money market, the CBN Prudential Guidelines were introduced, the minimum paid-up capital was increased, the Nigerian Deposit Insurance Corporation (NDIC) was established, the mandatory sector allocation of credits was relaxed to boost credit growth, a new legal framework was adopted to enrich the legal process while the autonomy and supervisory responsibilities of the CBN was enhanced to impact the health of the financial system. 

Adam (2009) examined the factors responsible for the substantial increase in number of players in the industry in the late 1980s and 1990s and attributed it to the economic boom of that period, which expanded business scope and financial capacity across the industries, leading to wider business opportunities, wider margins and resultant increase in number of financial institutions across board.  These views were shared by Onaolapo (2007); Sanni (2009); Subaru, Nafiu, Omankhanlen (2011); Udom (2011).  Sanusi (2002) however, was of the opinion that many of the problems that befell the financial system then, such as, financial crimes, poor credit analysis system, accumulation of poor risk asset quality, were attributable to the increase in number of banks, as this caused an over-stretching of  the existing human resource capacity of banks.

A good number of eminent scholars have examined the concept and theory of credit risk management in banks in various jurisdictions.   Mavhiki, Mapetere and Mhonde  (2012) described credit risk as risk that emanates from uncertainty of a given counter party  meeting his/her obligation.  It can also be described as the risk of loss occasioned by a debtor defaulting on a loan obligation or credit line.  Mavhiki et al (2012) dwelled further on the possibility of losses occurring from reduction in value of portfolio due to actual or perceived deterioration in quality of credit. Due to increasing spate of non-performing loans, the Basle II Capital Accord emphasized on the importance of entrenching sound credit risk management practices. This position was buttressed by Kolapo, Ayeni and Oke (2012), who also emphasized on the need for dynamic credit risk management structures, policies and procedures in the lending value chain.   Kithinji (2010) reviewed the scope of credit risk management and asserted that it involves the processes of identification, monitoring, measurement, control and reporting of risk arising from possibility of default in loan repayment obligations.  This study has reviewed a good number of definitions of credit risk management as provided in existing literatures. The study has chosen to take it a step further by describing credit risk as the risk of loss occasioned by a debtor or borrower defaulting on a loan obligation, either in part or whole, as at when due, resulting or capable of resulting in a reduction in the bank’s earnings, margins, capital, asset base and asset quality.

In the course of this study, a number of gaps were identified in the literatures reviewed which mostly pointed in the direction of a need for further research into various credit risk management techniques that have the ingredients and capacity to impact the loan portfolio quality of commercial banks, with focus on the Nigerian financial institutions sector and this constitutes the primary objective of this study. Further studies in the area of credit risk management, including that of Awojobi, Amel and Norouzi (2011) questioned and expressed doubt on the adequacy of Basel Accord principles for risk management, because of volatility of asset quality with business cycles. In view of this, there is need for further research in the area of effective and sufficient credit risk management principles that have capacity to address variations in asset quality with business cycles.

Commenting on the impact of the business and risk environment on credit risk management, Kolapo, Ayeni and Oke (2012) were of the opinion that a number of factors constitute triggers of credit risk and these include, limitation in the capacity of the institutions, irregularities in promulgation and implementation of credit policies, interest rate volatility weak management, weak legal system, weak capital base, weak liquidity base, insider  lending, excessive licensing of banks, poor credit analysis, laxity in credit administration, poor lending culture, government interference and weakness of supervisory system.  All these informed the call for further studies into; identification of sound credit risk framework and strategies, as measures for avoiding or minimizing the adverse impact of credit risk. 

In relation to credit risk management, existing literatures have also examined how banks are managing credit and by extension, risk in a hostile operating environment.  Aremu, Suberu and Oke (2010) argued that credit risk may arise from various forms of risk events such as management risk, business risk, financial risk and industrial risk. The probable occurrence of partial or total default requires a thorough risk assessment prior to granting of loans.  Further stressing the importance of a conducive environment for credit risk management to thrive, Waweru and Kalani (2009) asserted that, at present, banking crisis is being experienced by several developed countries including the USA.  For example more than $39billion has been written off by the Citibank Group in losses. However, despite the myriad of problems confronting the global financial market, Canadian banks have been witnessing relative stability. Chimkono et al (2016) attributed the stability to a combination of key factors such as regulatory diligence and disciplined cultural mindset among Canadian banks.

In the Credit Risk Management value chain, the process of credit analysis takes the pride of place because, this is the process that leads to a final decision as to whether to lend or not.  According to Awojobi et al (2011), the structure of a credit is akin to the structure of a building, the architect designs, the quantity surveyor quantifies how much it will cost to put the building in place in Naira terms and the civil engineer constructs. In all, there must be a meeting of minds among all the parties. The right materials, ingredients and workforce are found in what is popularly referred to as 7 Cs of credit namely; Capital, Capacity, Character, Collateral, Condition, Connection and Consideration. Olokoyo (2011) called for a high level of care and caution in bank lending decisions, as these  generally involve  a great deal of risk taking, a wrong lending decision may invariably portend a creation of bad asset, right from the beginning. Thus, for every lending activity to be a success, the process of credit analysis, presentation, structuring and reporting must be skillfully and diligently handled.

Credit Administration is another crucial function in the credit risk management process             cycle. It has to do with establishment and implementation of infrastructures and resources for early detection of warning signals in the credit portfolio, through effective loan monitoring, review, management reporting, limit setting, portfolio administration and credit referencing system.  kithinji (2010) went a step further by identifying weak credit administration as a major problem militating against the development of banks in Nigeria and resulting in abuse of the system by borrowers.. The concluded that an effective credit administration system can add value to the entire credit risk management process through adequacy in scope, content and capacity to detect and report early warning signals.

Credit control is another fundamental credit risk management technique that has a far reaching effect on loan portfolio quality of commercial banks all over the world. Credit Control entails entrenchment of checks and balances by way of policies and procedures to ensure prevention and early detection of fraud, error, unauthorized lending and other credit abuses or credit breaches. It involves having in place, control systems that are proactive enough to prevent or detect violations of credit policies, risk acceptance criteria, bank risk appetite, target market and regulatory measures.   Kithinji (2010) observed that, financial institutions are being forced to rely on managerial competencies and other intra-organizational factors for survival and success rather than effective risk analysis and control techniques.

The impact of regulatory and supervisory intervention on loan portfolio quality of banks cannot be overemphasized. Lending credence to this assertion, Etale, Ayunku and Etale (2016) observed that the Nigerian banking regulators namely, the Central Bank of Nigeria and Nigeria Deposit Insurance Corporation must also begin to direct more resources in terms of human, material and technological resources, to ensure that banking supervision in the new dispensation, is more dynamic, more preventive in terms of proactivity and increased transparency.  The foregoing analysis show that a remar