THE RELATIONSHIP BETWEEN CORPORATE GOVERNANCE AND FINANCIAL PERFORMANCE OF BANKS 2006-2010
CHAPTER ONE
INTRODUCTION
Background of the study
The Banking industry plays a vital role in the growth and development of any economy. The soundness or health of the Banking sector of a nation determines the health or well-being of the nation (Osaze, 2000). The Nigerian Banking industry has witnessed tremendous changes and transformation since 1892, right from when the African Banking Corporation (ABC) was set up, to today’s era of Mergers, Acquisitions and consolidation. The Nigerian financial sector has also gone through
Eras such as free- Banking Era, emergence of Banking regulations or pre-central Banking (1952-1958), era of consolidation Growth following the establishment of central Bank of Nigeria or era of banking legislation (1959-1970), Era of indigenization (1970-1976), post-Okigbo Era (1977-1986), Era of deregulation (1986-2005) and Era of Bank consolidation (2006 till date) (Nwankwo, 1990).
In Nigeria, the reforms in the Banking sector stem against the backdrop of Banking crisis as a result of undercapitalization of deposit money banks, weakness in both the supervisory and regulatory framework , weak management practices and the tolerance of deficiencies in the corporate governance behaviours of banks (Uchendu, 2005). The Consolidation in the banking industry is geared towards fine-tuning it to meet the challenges for economic stability and development goals which are not only limited to domestic savings mobilization and financial intermediation but also the elimination of inefficiency to enhance performance.
Given the fury of activities that have affected the efforts of banks to comply with the various consolidation policies and the antecedents of some operators in the system, there are concerns on the need to strengthen corporate governance in banks. This will boost public confidence and ensure efficient and effective functioning of the banking system (Soludo, 2004a). According to Heidi and Marleen (2003:4), banking supervision cannot function well if sound corporate governance is not in place. Consequently, banking supervisors have strong interest in ensuring that there is effective corporate governance at every banking organization. As opined by Mayes,
Halme and Aarno (2001), changes in bank ownership during the 1990s and early 2000s substantially altered governance of the world’s banking organization. These changes in the corporate governance of banks raised very important policy research questions. The fundamental question is how do these changes affect bank performance?
It is therefore important to point out that the concept of corporate governance of banks and very large firms have been a priority on the policy agenda in developed market economies for over a decade. Further to that, the concept is gradually warming itself as a priority in the African continent. Indeed, it is believed that the Asian crisis and the relative poor performance of the corporate sector in Africa have made the issue of corporate governance a catchphrase in the development debate (Berglof and Von -Thadden, 1999).
Several events are therefore responsible for the heightened interest in corporate governance especially in both developed and developing countries. The subject of corporate governance leapt to global business limelight from relative obscurity after a string of collapses of high profile companies. Enron, the Houston, Texas based energy giant and WorldCom the telecom behemoth, shocked the business world with both the scale and age of their unethical and illegal operations.
These organizations seemed to indicate only the tip of a dangerous iceberg. While corporate practices in the US companies came under attack, it appeared that the problem was far more widespread. Large and trusted companies from Parmalat in Italy to the multinational newspaper group Hollinger Inc., Adephia Communications Company, Global Crossing Limited and Tyco International Limited, revealed significant and deep-rooted problems in their corporate governance. Even the prestigious New York Stock Exchange had to remove its director (Dick Grasso) amidst public outcry over excessive compensation (La Porta, Lopez and Shleifer 1999).
In developing economies, the banking sector among other sectors has also witnessed several cases of collapses, some of which include the Alpha Merchant Bank Ltd, Savannah Bank Plc, Societe Generale Bank Ltd (all in Nigeria), The Continental Bank of Kenya Ltd, Capital Finance Ltd, Consolidated Bank of Kenya Ltd and Trust Bank of Kenya among others (Akpan, 2007). In Nigeria, the issue of corporate governance has been given the front burner status by all sectors of the economy. For instance, the Securities and Exchange Commission (SEC) set up the Peterside Committee on corporate governance in public companies. The Bankers Committee also
set up a sub-committee on corporate governance for banks and other financial institutions in Nigeria. This is in recognition of the critical role of corporate governance in the success or failure of companies (Ogbechie, 2006:6). Corporate governance therefore refers to the processes and structures by which the business and affairs of institutions are directed and managed, in order to improve long term share holders value by enhancing corporate performance and accountability, while taking into account the interest of other stakeholders (Jenkinson and Mayer, 1992). Corporate governance is therefore, about building credibility, ensuring transparency and
accountability as well as maintaining an effective channel of information disclosure that will foster good corporate performance.
Jensen and Meckling (1976) acknowledged that the principal-agent theory which was also adopted in this study is generally considered as the starting point for any debate on the issue of corporate governance. A number of corporate governance mechanisms have been proposed to ameliorate the principal-agent problem between managers and their shareholders. These governance mechanisms as identified in agency theory include board size, board composition, CEO pay performance sensitivity, directors’ ownership and share holder right (Gomper, Ishii and Metrick, 2003). They further suggest that changing these governance mechanisms would cause
managers to better align their interests with that of the shareholders thereby resulting in higher firm value. .
1.2 Statement of Research Problem
Banks and other financial institutions are at the heart of the world’s recent financial crisis. The deterioration of their asset portfolios, largely due to distorted credit management, was one of the main structural sources of the crisis (Fries, Neven and Seabright, 2002; Kashif, 2008 and Sanusi, 2010). To a large extent, this problem was the result of poor corporate governance in countries’ banking institutions and industrial groups. Schjoedt (2000) observed that this poor corporate
governance, in turn, was very much attributable to the relationships among the government, banks and big businesses as well as the organizational structure of businesses. In some countries (for example Iran and Kuwait), banks were part of larger family-controlled business groups and are abused as a tool of maximizing the family interests rather than the interests of all shareholders and other stakeholders. In other cases where private ownership concentration was not allowed, the banks were heavily interfered with and controlled by the government even without any ownership share (Williamson, 1970; Zahra, 1996 and Yeung, 2000). Understandably in either case, corporate governance was very poor. The symbiotic relationships between the government or political circle, banks and big businesses also contributed to the maintenance of lax prudential regulation, weak bankruptcy codes and poor corporate governance rules and regulations (Das and Ghosh, 2004; Bai, Liu, Lu, Song and Zhang, 2003).
In Nigeria, before the consolidation exercise, the banking industry had about 89 active players whose overall performance led to sagging of customers’ confidence. There was lingering distress in the industry, the supervisory structures were inadequate and there were cases of official recklessness amongst the managers and directors, while the industry was notorious for ethical abuses (Akpan, 2007). Poor corporate governance was identified as one of the major factors in virtually all known instances of bank distress in the country. Weak corporate governance was seen manifesting in form of weak internal control systems, excessive risk taking, override of internal control measures, absence of or non-adherence to limits of authority, disregard for cannons of prudent lending, absence of risk management processes, insider abuses and fraudulent practices remain a worrisome feature of the banking system (Soludo, 2004b). This view is supported by the Nigeria Security and Exchange Commission (SEC) survey in April 2004, which shows that corporate governance was at a rudimentary stage, as only about 40% of quoted companies including banks had recognized codes of corporate governance in place. This, as suggested by the study may hinder the public trust particularly in the Nigerian banks if proper measures are not put in place by regulatory bodies.
The Central Bank of Nigeria (CBN) in July 2004 unveiled new banking guidelines designed to consolidate and restructure the industry through mergers and acquisition. This was to make Nigerian banks more competitive and be able to play in the global market. However, the successful operation in the global market requires accountability, transparency and respect for the rule of law. In section one of the Code of Corporate Governance for banks in Nigerian post consolidation (2006), it was stated that the industry consolidation poses additional corporate governance challenges arising from integration processes, Information Technology and culture.
The code further indicate that two-thirds of mergers world-wide failed due to inability to integrate personnel and systems and also as a result of the irreconcilable differences in corporate culture and management, resulting in Board of Management squabbles.
Despite all these measures, the problem of corporate governance still remains un-resolved among consolidated Nigerian banks, thereby increasing the level of fraud (Akpan, 2007). He further disclosed that data from the National Deposit Insurance Commission (NDIC) report (2006) showed 741 cases of attempted fraud and forgery involving N5.4 billion. Soludo (2004b) also opined that a good corporate governance practice in the banking industry is imperative, if the industry is to effectively play a key role in the overall development of Nigeria. This study will also investigate if there is any statistically significant difference between the profitability of the healthy and the rescued banks in Nigeria as listed by CBN in 2009.
1.3 Objectives of Study
Generally, this study seeks to explore the relationship between internal corporate governance
structures and firm financial performance in the Nigerian banking industry. However, it is set to
achieve the following specific objectives:
1. To examine the relationship between board size and financial performance of banks in Nigeria.
2. To investigate if there is any significant relationship between directors’ equity interest and the financial performance of banks in Nigeria.
3. To empirically determine if there is any significant relationship between the level of corporate governance disclosure and the financial performance of banks in Nigeria.
1.4 Research Questions
This study addressed issues relating to the following pertinent questions emerging within the
domain of study problems:
1. To what extent (if any) does board size affect and the financial performance of banks in Nigeria?
2. Is there a significant relationship between directors’ equity holdings and the financial performance of banks in Nigeria?
3. To what extent does the level of corporate governance disclosure affect the performance of banks in Nigeria?
1.5 Hypotheses
To proffer useful answers to the research questions and realize the study objectives, the
following hypotheses stated in their null forms will be tested;
H0: There is no significant relationship between board size and financial Performance of banks in Nigeria.
H0: There is no significant relationship between directors’ equity holding and the financial performance of banks in Nigeria.
H0: There is no significant relationship between the governance disclosures of banks in Nigeria and their performance.
1.6 Significance of the Study
This study is of immense value to bank regulators, investors, academics and other relevant stakeholders. By introducing a summary index that is better linked to firm performance than the widely used G-index, the study provides future researchers with an alternative summary measure. This study provides a picture of where banks stand in relation to the codes and principles on corporate governance introduced by the Central Bank of Nigeria. It further provides an insight into understanding the degree to which the banks that are reporting on their corporate governance have been compliant with different sections of the codes of best practice and where
they are experiencing difficulties. Boards of directors will find the information of value in benchmarking the performance of their banks, against that of their peers. The result of this study will also serve as a data base for further researchers in this field of research.
1.7 Justification of Study
Generally, banks occupy an important position in the economic equation of any country such that its (good or poor) performance invariably affects the economy of the country. Poor corporate governance may contribute to bank failures, which can increase public costs significantly and consequences due to their potential impact on any applicable system. Poor corporate governance can also lead markets to lose confidence in the ability of a bank to properly manage its assets and liabilities, including deposits, which could in turn trigger liquidity crisis. From the preceding discussions, it is evident that the question of ideal governance mechanism
(board size, and director’s equity interest) is highly debatable. Since performance of a firm, as identified by Das and Gosh (2004), depends on the effectiveness of these mechanisms, there is a need to further explore this area. Although researchers have tried to find out the effects of board size and other variables on the performance of firms, they are mostly in context of developed markets. To the best of the researcher’s knowledge based on the literature review, only few studies were found in the context of Nigerian banks. Due to neglect of banking sector by other studies and with radical changes in Nigerian banking sector in the last few years, present study
aims to fill the existing gap in corporate governance literatures.
1.8 Scope and Limitation of the Study
Considering the year 2006 as the year of initiation of post consolidation governance codes for the Nigerian banking sector, this study investigates the relationship between corporate governance and financial performance of banks. The choice of this sector is based on the fact that the banking sector’s stability has a large positive externality and banks are the key institutions maintaining the payment system of an economy that is essential for the stability of the financial sector. Financial sector stability, in turn has a profound externality on the economy as a whole.
To this end, the study basically covers the 21 listed banks out of the 24 universal banks, operating in Nigeria till date that met the N25 billion capitalization dead-line of 2005. The study covers these banks’ activities during the post consolidation period i.e. 2006-2010. The choice of this period allows for a significant lag period for banks to have reviewed and implemented the recommendations by the CBN post consolidation code. Furthermore, we focused only on banking industry because corporate governance problems and transparency issues are important in the banking sector due to the crucial role in providing loans to non-financial firms, in transmitting the effects of monetary policy and in providing stability to the economy as a whole. The study therefore covers three key governance variables which are board size, directors’ equity interest and governance disclosure level. This study is not immune to problems that are capable of affecting results but not potentially damaging to the reliability of the result for analytical and predictive purposes.One of the constraints to this study is finance. The researcher is a student and has single-handedly financed this work. The accessibility to important and vital documents due to the bureaucratic nature of some institutions when it comes to the release of such document also
poses a challenge.
1.9 Summary of Research Methodology
This study made use of secondary data in establishing the relationship between corporate governance and financial performance of 15 out of the 24 banks that emerged from the consolidation. The secondary data was obtained basically from published annual reports of these banks. Books and other related materials especially the Central Bank of Nigeria bullions and the Nigerian Stock Exchange Fact Book for 2010; Vol.2 were also reviewed. In analyzing the relationship that exists between corporate governance and the financial performance of the studied banks, a panel data regression analysis method was adopted.
However, the proxies that were used for corporate governance are: board size, directors’ equity interest and corporate governance disclosure index. Proxies for the financial performance of the banks also include the accounting measure of performance; return on equity (ROE) and return on asset (ROA) as identified by First Rand Banking Group (2006). To examine the level of corporate governance disclosures of the sampled banks, the content analysis method was used.
Using the content analysis, a disclosure index was developed for each bank using the Nigerian post consolidation code and the Organization for Economic Cooperation and Development (OECD) code of corporate governance as a guide. This was used alongside with the papers prepared by the UN Secretariat for the nineteenth and the twentieth session of International Standards of Accounting and Reporting (ISAR), entitled “Transparency and Disclosure Requirements for Corporate Governance” and “Guidance on Good Practices in Corporate Governance Disclosure” respectively.
1.9 Sources of Data
This study employed only the secondary data derived from the audited financial statements of the sampled banks listed on the Nigerian Stock Exchange (NSE) in analyzing the relationship between our dependent and independent variables. The secondary data covers a period of five years i.e. 2006 to 2010. This study also made use of books and other related materials especially the Central Bank of Nigeria bullions and the Nigerian Stock Exchange Fact Book (2010; Vol.2).
Some of the annual reports that were not available at the NSE were collected from the head offices of the concerned banks in addition to the downloaded materials from the banks’ websites.
The data that was used in analyzing the disclosure index was derived using the content analysis method to score the banks based on their disclosure level. This was done using the disclosure items developed through the use of the CBN and the OECD codes of corporate governance
