DETERMINANTS OF BANK PROFITABILITY: NEW EMPIRICAL EVIDENCE FROM NIGERIA.

BY

BUBA, MUHAMMAD MAMMAN

MSC/ADMIN/6302/2009-2010

BEING A SEMINAR PAPER PRESENTED AT THE DEPARTMENT OF ACCOUNTING, AHMADU BELLO UNIVERSITY ZARIA, IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE COURSE WORK IN THE MSC ACCOUNTING AND FINANCE DEGREE, 2009-2010 SESSION

MARCH, 2011
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DETERMINANTS OF BANK PERFORMANCE IN NIGERIA: EVIDENCE FROM BANK-SPECIFIC CHARACTERISTICS.

ABSTRACT This paper aims at examining the level of influence some factors have on the profitability of commercial banks in Nigeria. Specifically, the study seeks to find if branch network (proxied by number of branches) and bank age have any impact on bank profitability. The study covers the year 2008. The methodology of data analysis is that of multiple regressions in which Return on Equity was used as dependent variable. The results obtained show that branch network has no significant impact on profitability of banks while age has significant influence on profitability. The findings thus suggest that having a large number of branches does not necessarily mean having numerous profit outlets. The paper therefore recommends for proper conduct of viability studies before any additional branch is opened. In the same vein, given the significant impact age exerts on profitability, it is recommended that investors should consider age, among other factors, while making decisions as to which bank to invest their funds.

Introduction

Profitability of corporate organizations has been one of the major concerns of management experts, investors and academic researchers. Performance of

commercial banks in particular is of great concern because of the role s they play in any economy, even though the degree of reliance on banks as drivers of economy differs from country to country. In the last two decades, the banking sector all around the world has experienced major transformations in its environment, resulting in significant impacts on its performance. Thereby, both factors that are under the control of management and ones which are beyond its influence have been affecting the profitability of banks over time. Identifying the key success factors of commercial banks allows formulating policies for improving the profitability of the banking industry. Therefore, the determinants of bank prof itability have attracted the interest of academic research as well as of bank management, financial markets and bank supervisors. The study of bank performance becomes even more important also in view of the ongoing financial and economic crises, which ha ve a fundamental impact on the banking industry in many countries around the globe. This provides explanations as to why the federal government of Nigeria and the Nigerian bank regulatory authorities are not relenting in seeking permanent measures that will enhance the profitability and stability of banks operating in the country. Financial sector reforms in Nigeria were aimed at promoting competition in the sector by way of mobilising savings to stimulate efficient allocation of resources, interest
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liberalization and prudential regulation to tackle bank distress. For instance, between 1990 and 2004, Nigerian banks regulators increased the minimum share capital five times (1991, 1997, 2000, 2001 and 2004). I t is because of the central roles bank plays in moving the Nigerian economy forward that it featured prominently when the nation adopted IMF induced Structural Adjust ment Programme in 1987 which sees banks serving as authorised dealers in all the foreign exchange regimes implemented by the Central Bank of Nigeria. A study of the determinants of banks profitability in Nigeria, therefore, could serve as an indispensable planning tool for managers, investors, and government. It could assist management to see factors that positively or negatively influence their corporate performance and thus hedge against adverse factors. Moreover, it would enable investors identify which bank is potentially profitable and be able to measure the performance of their portfolios and proceed with readjustments as required, whi le economic policy makers would also be able to measure the impact of the corporate performance on the economy and its implications on the issues of policy. There are quite a good number of factors that affect profitability of banks. Some of these factors are specific to banks while others are exogenous or beyond the control of management. Features such as branch network (proxied by number of branches), ownership structure, bank size, loan loss provision over total loans, funding costs, bank age and many more are normally characterised as bank -specific features, on the ground that they are factors which can be manipulated by management decisions.
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Identifying key success factors of commercial banks in Nigeria allows for formulating policies aimed at improving the profitability of the banking industry. Between 2005 and 2008 the Nigerian banks witnessed phenomenal growth in terms of volume of risk assets (loans) translating into huge profit part of which is expropriated to reserves and expansion in branch networks, Somoye (2008). The banking public witnessed phenomenal increase in the number of branches since 2006 when the recapitalisation came into effects. In spite of impressive profit occasioned by sharp surge in the volume of loans portfolio and geometric increase in branch network across nooks and corners of Nigeria, between 2006 and 2008, good number of banks in the country declared losses at the end of 2009. Bank regulatory bodies, investors and management experts wonder as to what levels are bank age and the increase in the number of branches exert influence on the profitability of these banks. Does number of branches really influence profitability of banks? One would also like to know if bank age is also a factor that determines profitability of banks in Nigeria. Identifying the determinants that influence profitability of these banks is therefore desirable if not necessary.

The primary concern of this paper is to examine the impact of branch network (proxied by number of branches) and bank age on the profitability of commercial banks in Nigeria. We therefore hypothesized that branch network and bank age have no significant impact on profitability of banks in Nigeria. To the best of our
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knowledge no econometric research was conducted to determine the level of influence branch network and bank age have on the profitability of banks in Nigeria. Even in other economies, to date, there have been little published studies to explore the impact of these factors on the financial performance, of commercial banks. The researcher is therefore propelled by the virginity of these factors (branch network and age) in determining profitability of banks in the Nigerian financial market.

Literature Review and Theoretical Framework

Generally, the financial performance of banks and other financial institutions has been measured using a combination of financial ratios analysis, benchmarking, measuring performance against budget or a mix of these methodologies. As it is

known in accounting literature, there are limitations associated with use of some financial ratios Medhat (2006) . To guard against most of these limitations , researchers on measure of profitability of banks focused on the return on assets and return on bank equity Guven & Onur (2009). Molyneux and Thorton (1992) used the same dependent variables to proxy profitability of banks. However, the recent work of Schumacher et al (2009) added net interest rate margin as dependent proxy for measuring profitability. To the best of authors knowledge, apart from Schumacher et al no other studies that used net interest rate margin to stand for regressand in determining the influence of explanatory variables macroeconomic factors). (either bank-specific or

Al-Tamimi (2009) conducted a study in United Arab Emirate (UAE) to examine factors influencing profitability of banks (both conventional and Islamic banks). One of the independent variables used was number of branches. The study revealed an interesting result; while number of branches had insignificant impact on profitability of conventional banks, it was positive and statistically significant at 1 percent level in the case of Islamic banks. However, note should be taken that the UAE financial environment is different from Nigeri an financial markets in terms of size, complexities and stability. For instance, Islamic banks and conventional banks coexist in UEA which is not the case in Nigeria. Therefore the findings of the study might not be applicable to Nigerian environment.

In somewhat similar effort of Al-tamimi (2009), Holden and El-Bannany (2006) carried out a research in the UK to find o ut whether investment in IT systems affected bank profitability during the period 1976 1996. Findings of their studies showed that investment in IT systems represented by number of automated teller machines (ATM), influenced bank performance in a positive way. Holden and ElBannany (2007) also stated that Abdullah (1985) conducted a similar study in Malaysian economy and put forward that the deployment of ATMs by banks results in greater turnover in services without needing to recruit more staff and open more branches, thereby reducing transaction costs and ultimately improving profitability. Though number of ATMs is closely related to number of branches but one can not be an absolute substitute of the other. Even where it can, UK economy is more advanced
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and more sophisticated than Nigerian. If

branch network were used it would

probably have been better and provide basis of comparison.

Dietrich & Wanzenried (2009) conducted study in Switzerland similar to the one being undertaking, using bank age as one of the independent variables. It was revealed that bank age has no significant effects on profitability of banks. In deed the result showed that new entrants are more profitable than the old ones. However, It must pointed out that Switzerland has long standing banking history and well streamlined banking culture than Nigeria. Ther efore the need to study this factor (bank age) in a developing economy, such as Nigeria. Athanasoglou et al.,( 2005) also found that newly established banks are not particularly profitable (if at all profitable) in their first years of operation, as they place greater emphasis on increasing their market share, rather than on improving profitability. The study was conducted long ago before the consolidation reform in Nigeria covering 41 sub saharan African countries and at the time Nigeria along had 89 money deposit banks, most of which were terminally ill at the time of the research. The results cannot be relied upon for prediction.

Various studies have been carried out to offer answers to question such as what determine profitability of banks in Nigeria. Aburime (2004) attempted to see if ownership structure affects bank profitability in Nigeria. Ownership structure was categorised into whether a bank is domestically owned or has foreign ownership
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(where foreign investor controls more than 50% of the shares). A study was also conducted to find out if ownership spread, private or state owned, influence bank performance. The regression analysis showed that ownership structure had no significant effect on bank profitability in Nigeria. Though the study did not mention the policy implications of the findings, but is suggestive that the regulatory authorities need not bother about ownership structure of banks given that it does not influence performance. Going by Aburime (2004) empirical result, the traditional belief that ownership structure enhances performance is not justified in Nigerian Banking sector. This result also holds true in Greek banking sector, Mamatzakis and Remoundos (2003).

Other interesting studies on the performance of Nigerian banks were conducted in which it was revealed that bank regulation and supervision has insignificant impact on bank profitability, Osabuohien and Egwakhe (2009) which also corroborate with results obtained by Sobodu and Akiode (1998). However, Naceur (2003) got contrary results from his research work in which it was found that regulatory and institutional variables seem to have influence on bank performance . More often than not, rationale for government intervention into the affairs of banks does not hinge on profitability. Strong arguments for state intervention in the banking sector can be broadly classified into four groups: Preserving the safety and soundness of the banking system; guarding against market failures due to the presence of asymmetric information; financing socially valuable (but financially unprofitable) projects; and
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encouraging financial development and giving access to competitive banking services to residents of isolated areas.

Study of Swiss banks was conducted by Dietrich and Wanzenried (2009) which was acclaimed to be the first econometric research in the country on bank profitability determinants. The two researchers carried out a multi-regression analysis using as much as more than 15 independent variables, all, in order to empirically find out factors that determine bank profitability in Switzerland. Mixed results were obtained; some confirm findings of studies done in other countries while others remained unique to Swiss banks. For instance, regression results on state ownership show that is in line with Micco et al (2007) who point that government owned banks exhibit a lower profit than privately owned banks. Demirguc-kunt and Huizinga (2000) corroborate this result by revealing that foreign owned banks operating in developed countries are less profitable. However, these results, in a way, contradict Aburime (2008) findings in Nigeria which point out that ownership structure has insignificant impact of performance of banks. One fact that stands clear is that the research works of Demirguc-kunt and Huizinga(2000) and that of Dietrich and Wanzenried (2009) were both focused on developed countries with long banking history. The findings in these developed economies could ha rdly be applicable in less developed countries.

Naceur (2003),

Mamatzakis and Remoundos (2003),

Aburime(2008) and

Athanasoglou et al (2008) all focused their analysis on single countries. The

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empirical results of the aforementioned studies differ, given that datasets, time period and investigated environments as well as countrie s vary. However, there exist common grounds, particularly on the influence of capital size on profitability. Aburime (2009) took an interesting dimension in his study of determinants of bank performance when he examines the influence of political affiliation on profitability of Nigerian banks. The empirical result reveals that political affiliation has positive though insignificant role on bank profitability. The study covered the period 1999 to 2007 and recommends that banks may consider political affiliation strategy in order to maximise profitability.

A large number of researches have been carried out on factors influencing bank profitability. However, most of the previous studies centred on developed economies and far fewer studies covered emerging economies. This observation was corroborated by Al-Tamimi (2009)

There are three theoretical approaches to explaining bank profitability: the structure conduct-performance (S-C-P) hypothesis, the relative efficiency Structure hypothesis and portfolio theory. The S-C-P hypothesis focuses on market structure and states that a higher degree of market concentration enhances the probability of effective collusive behaviour, be it explicit or tacit. This should ultimately be translated into higher profitability. Market concentration is usually measured by the concentration

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ratio, the proportion of the total market controlled by a small number of firms, Holden and El-Bannany (2007)

Atemnkeng and Nzonzang (2006) state that the theoretical underpinning of S-C-P commonly known as the collusion hypothesis rests on the pioneering works of Bain (1950, 1951) which were applied to the manufacturing sectors. According to Holden and El-Bannany (2006), the model was later introduced into the banking indus try following work of Schweiger and Mcgee (1961) and to provide impetus for empirical tests on the impact of market concentration on bank profitability. The economic theory surrounding the hypothesis is that certain market compositions are favourable to monopolistic conduct, and this element is common in highly concentrated markets, enabling firms to raise prices above costs thereby making abnormal profits. The immediate effect of these monopolistic tendencies is reduced competition. However, several interpretations have come up that do not support the SCP hypothesis following the fact that existing studies do not provide unique empirical conclusions or results.

The efficient market or efficient Structure (E.S) hypothesis tends to challenge SCP approach. Proponents of E.S. hold that market concentration is not a random event but rather the result of firms with superior efficiency obtaining a large market share. They have attempted to demonstrate that no relationship exist between concentration and profitability, but rather between bank market share and bank profitability.
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The portfolio theory approach which is what underpins this paper argued, in essence, that profitability of banks is a function of decisions by the management. The approach fits this paper in the sense that bank-specific characteristics refers to those factors which are within management control. Atenmkeng and Nzonzang (2006)

used the same theoretical framework in their studies of factors affecting commercial banks in Cameroun. Sinkey (1992) also lent credence to this idea where he discussed causes of problem banks.

RESEARCH METHODOLOGY Research Design

The study adopts after- the -fact (ex-post factor) design under the general parasol of descriptive research method. It makes use of annual reports and accounts of the sampled banks. The use of secondary data provides justification for adoption of ex post research design for this study.
Population and sample of the study

The population of this study consists of all the 21 listed banks operating in Nigeria and the sample size is 11. The sampling technique is purely based on availability of data. The financial data used were of secondary nature obtained from annual reports. Secondly, for a bank to meet the condition of inclusion in the study, mention must have been made of the number of branches it has as a t 2008.The choice of 2008 was based on the fact that it was the cut off time when Nigerian banks published their
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annual reports on dates order than 31st December. This was done in order to have uniform reporting period for the purpose of comparability. 2009 financial reports were not used because a t as December, 2009 banks reported their financials for different number of months (some for 15 months others for 9 months and some in cases 6 months) so as to comply with the Central bank of Nigerias directive on uniform reporting period. 2010 reports were not used either because as at the time of this studies, no bank has published its 2010 annual report.
Techniques of Data analysis

The study makes use of multiple regression technique of data analysis. From the discussion of the literature, it is clear that there are many variables which can be used to explain profitability of banks. However, this study only takes into account t he effects of branch networks and bank age as the explanatory variables. Taking into account of these points and also of the data that are available, the model Proposed is: ROEit= 0 + 1BNit +
2

BAit + i

Where i refers to the bank and t to the year. ROE it = profits of bank i in year t measured as after tax return on equity, BN it= Branch network for bank i in year t, BAit=the age for bank i in year t, i= Stochastic Error term

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Results and Discussions

TABLE 1: The regression model of bank profitability using ROE as a function of branch network and bank age, using the standardized data. Variables Intercept BA BN R-Squared Adjusted R-Squared Durbin-Watson F-Change F-Sig
Source: Output of data analysis by author using SPSS

Coefficient -.414 .483 .163

Standard error .294 .169 .104 .510 .388 2.197 4.169 .057

t-test -1.407 2.855 1.579

Sig. .197 .021 .153

Regression Model:
ROE=-0.414+0.483BN+0.163BA

The data used for the analysis was transformed for standardization using a log transformation method. The regression model is significant at 10% level as shown by the F statistic value (Table 1, F = 4.169, P = 0.057). The measure of variability (RSquare) in the ROE as explained by both the branch network and bank age is 51.0% which means that about 49% of the variation cannot be explained by the model. The adjusted R2 (38.8%) tries to reduce the inclusion of variation of the extra independent
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variable(s). The Durbin Watson statistic value, Dw = 2.197, is an indication of no autocorrelation i.e. independent observation is assume d. The result also shows that bank age has a significant impact at 5% level of significance on profitability of commercial banks in Nigeria . This outcome contradicts the findings of Dietrich and Wanzenried (2009) which revealed that bank age has no significant influence on bank performance in Switzerland and indeed their study revealed that new entrants are more profitable than the old ones. From the table 1 above it can be seen that branch network (represented by number of branches) has no significant effect on profitability. The result contrasts the findings of Demirguc and Huizinga (2000) and Atemnkeng and Nzongzang (2006) which indicated t hat number of automated teller machines (serving similar purpose as branches) have significant role in profitability of commercial banks in Switzerland and Cameroun respectively. However the outcome of this study is in tandem with the result obtained by Al-Tamimi (2009) which showed that number of branch es of conventional banks (non-islamic banks) in UAE has no significant impact on profitability. Table 2: Correlation ROE ROE Bank Age Branch Network
Source: Output of data analysis by author using SPSS

Bank Age .598 1

Branch Network .106 -.417 1

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In the fitted model, profitability proxied by return on equity has a positive relationship with both branch network and the age of the bank, which means that the higher either of the independent variabl es the higher the profitability.

Conclusion and Recommendation

The paper tries to find the extent by which number of branches and age of bank influence profitability of banks in the Nigerian market. The paper finds that branch network has no significant influence on profitability. However bank age was found to have significant impact on profitability using Return on Equity as a measure of performance. The result also reveals that positive relationship exists between number of branches and age of bank, and bank profitability. The regression results confirm some findings in earlier research. For instance, the study confirms the findings of Al-Tamimi (2006) that branch network has no significant impact on profitability of conventional banks. Other important determinants of bank profitability, such as cost of income, loan loss provision over total loans, yearly growth of deposits, funding costs, bank concentration and many others have not been considered in this study. From the findings it is recommended that bank management should take decision in opening new branch based on viability instead of competing on absolute number of branches while investors should consider age in their investment decision. We also suggest further studies be undertaken to determine the degree of impact, factors such as the ones mentioned above have on bank profitability.
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