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THE CAUSES AND CONSEQUENCES OF BANK FAILURE ON NIGERIAN ECONOMY

CHAPTER ONE

INTRODUCTION

1.1      BACKGROUND OF THE STUDY

Financial instability has been in the scene of Nigerian economy for a long time. It is obvious that the financial instability is an important topic to develop. The cost burden associated with bank failure is so disturbing that the need for continued study of causes of banking financial instability on both the practical and theoretical level cannot be overemphasized. Some years back, Nigeria witnessed numerous bank failures. Example Savannah bank, All State Trust Bank, Bank of the North, Ganji bank of Niger limited, Owena bank, Lion bank of Nigeria limited, etc.

The central bank of Nigeria (CBN) has said that the only way the nation’s consolidated banks could be insulated from failure if through adoption and enforcement of corporate governance culture. Sanusi Lamido however, pointed out that the recent failures of high profit institutions around the world such as Enron, Parmalat, World comm., Barings bank among others, have shown that no company can be too big to fail, stressing that a common trend that runs through these monumental failures was poor corporate governance culture, exemplified in poor management, fraud and insider abuse by both management and board members, poor asset and liability management and poor regulation and supervision among others.

Banks play very crucial roles in the process of economic development of any country, by mobilizing funds from the surplus units of the economy and the lending of these funds to deficit units for investment. There has been a growing consensus among economists on the proposition that financial institutions and particular commercial banks contribute the real development of the economy. The process of expansion might occur due to the improvement in the financial system as potential savings is matched with investment. This reasoning which is supported by both the Keynesian and the classical models of economic development implies the need for adequate financial intermediation. Therefore, an efficient banking system implies availability of credit for capital formulation and investment.

Bank failures are usually followed by unfavourable consequences on stock-holder outside then failed banks themselves. Sometimes, consequences are felt by the non-banking system as a whole. A failure can result in much harms to employment earnings, financial development and other associated public interests, Smiths and Walter (1997: 158). According to Hooks, (1994: 99) and Beston and Kaufman (1996: 105), the failure of a bank has a great adverse effect on the economy and so it is considered very important.

Bank failure means different things to some people. To some people, a bank fails only when it ceases operation even if it has not been liquidated. In a wider context, a bank is said to have failed if it has not succeeded in achieving any objectives for which it was established.

A bank is considered a failure not only when it ceases operation but also when it cannot meet any of its objectives or obligations. The cessation of operation may constitute a serious mild or negligible bank failure depending on the circumstance. The cessation of independent operation or continuance without the assistance of relevant authorities such as deposit insurance institutions can be associated with distress. Bank failure therefore will occur when a fairly reasonable proportion of banks in the economy as a whole lack capital assets. As Selgin concludes that regulation in respect of branching limited contribute to the possibilities of bank failure by supporting bank risky operation. According to him, the worst regulation is branch restriction. The lower a bank’s capital, the higher the probability of its failure. Goodhart et al (1998: 49) agree with the statements and adds that as bank’s capital decreases, the higher its motivation for action towards survival. This leads to more dangerous taking operations. Therefore the risk of failure rises with the decline in equity.

Moreso, bank failure is seen as a declaration of insolvency by the chattering agency or as a reorganization to avoid dejure. Failed banks tend to be less efficient and make fewer investments (grant more loans especially bad loans) than non-failed banks. Thus, bank failure occurs when net cash is greater than the bank’s capital funds. This implies that a problem bank is one that in the eyes of the federal banking authorities has violated a law or regulation or engaged in an unsafe or unsound banking practice to such an extent that the present or future solvency of the bank is in question (Sinkye, 1975).

There is no evidence that bank failure is the thing of the past in Nigeria because it is still on the economic scene. Bank distress has become a common lexicon in Nigeria, given many bank failures till date. Ebhodaghe (2001) states that when a firm which is either a bank or not is liquidated for its inability to meet its obligation to creditors, it can be described as having failed. Thus we could use bank failure to describe a situation where, as a result of irremediable bank distress, a bank’s license is revoked and the bank subsequently liquidated. Liquidation is thus, an aftermath of bank failure. In fact, if revocation of license is seen as the death of a bank, liquidation is its burial.

Bank distress is the fore runner of bank failure. Whereas a bank in distress could have chances of regaining health, a failed bank loses every chance of life. Its final destination is the mortuary of Nigerian deposit insurance corporation (NDIC) from where it will proceed to its final resting place – liquidation – courtesy of the undertakers. Bank failure also is when the bank system fails, which means when all the bank ATMs and the bank eft pos machine fails to work. When the banks have to shut for a while because the machines that are inside the bank are broken. Corruption in the banking sector, so-called rich men making deals with bank managing directors (MDs) and taking loans without paying back. See what is happening to some commercial banks and micro-finance banks in Nigeria. Banks that lent money to people with little or no credit and those people cannot afford what was purchased, then they file bankrupt.

Also, reserve requirement is a position of cash to total deposit which banks are obliged to maintain. This ensures prudential and fiscal control of activities of banks. White (1999: 11) adds that government obliges banks to reserve funds in order to improve the actual need for base money. Friedman (1960: 122) stated that bank failure arises because banks do not keep all their deposit in a statutory reserve fund. Hempel and Simonson (1999: 18) noted that some regulatory bodies exercise forbearance. This action contributes to banks crises by permitting distressed banks to continue their operations instead of liquidating them. This action aims at assisting banks in  making profits. Its effect is rather disadvantageous to banks because usually when banks lack adequate funds and remain in operation, their capital situation deteriorates. The government uses the lender of last resort mechanism to help some stakeholders of banks which are falling.

The adverse effect of bank failure on the economy of any nation is not a respecter of the level of development. Ebhodaghe (1997: 100) whether a country is industrialized, developed, big or small, underdeveloped, bank failure affects the economy if not well managed. When a bank is distressed, many are unemployed and people’s money is tied down. Financial distress/failure reduces the number of qualified borrowers, the contraction in bank’s net worth forced reduction in the supply of bank loans to qualified borrowers, even those with a strong balance sheet. The bank failures of 2009 led to an expansion of the discount window and 420 billion naira bail out fund which would have been channeled to other critical needs of the economy.

1.2     STATEMENT OF THE PROBLEM

Available literature has identified a long list of potential causes of failure in a financial system to include weak management, inadequate capital base, fraudulent and corrupt practices of owners and managers, poor assets and liability management, macroeconomic instability, political instability/ interference and inadequate legal framework and structure (CBN/NDIC).

Adewunmi (1991: 2) states that bank failure emanates from a number of exogenous and endogenous factors. Exogenous factors which include adverse economic condition, inhibition policy, environmental management interference, impact of deregulation, inadequate supervision and regulation. Endogenous factors include undercapitalization, manpower problem, mismanagement, fraud, etc. hooks, (1994:5) points out that deteriorating local economic condition, inflation, interest rate and exchange rate may cause bank failure. He further stated that macroeconomics such as adverse movement in a country’s term of trade, sharp fluctuation in the world interest rate, real exchange rate and inflation worsened by regulations that are imposed on the banks result in bank failure. He stated further that a limit on deposit interest rate motivate banks to make risky investment. This is because banks often try to overrule ceiling imposed by the regulatory authority in higher transaction costs andx lower income. Instead of decreasing the prospect of bank failure, the ceiling on deposit and bank interest rate therefore is argued to cause bank failure.

White (1999:84) states that the government uses the lender of last resort mechanism to help some banks that are failing or sometimes debt cancellation  as experienced when the Central Bank of Nigeria governor cancelled the debt of Bank of the North. Sometime in August 2009, the governor of CBN noticed some inadequacies in the banking sector, which was traced to years of consistent manipulation, irregularities and sharp malpractices in the banking sector. It was revealed that dirty business deals, short-sighted investments and lack of respect for basic banking procedures were some of the reasons the apex used to hang five chief executive officers and their boards to dry on Friday, August 15, 2009. One of such instances was a case where one of the banks gave an unsecured loan to the turns of N17 billion to a notable business mogul, a practice that is not only supposed to involve just the decision of the CEO.

Major reasons for bank failure include economic, political and institutional factors. Economic factors arise from negative economic conditions in the macro-economy. Such adverse economic conditions include; high and rising inflation rate, high and increasing foreign exchange rate, subsisiting huge foreign debts, huge and expanding fiscal deficits, inadequacy of foreign exchange, monetary policy changes, inconsistent or unstable economic policies, unguided economic reform programmes e.g deregulation, low capacity utilization in the industries, low per capita income, high domestic debts, dwindling national income. For example, the combination of high inflation and exchange rates reduce the capacity of bank customers to save. Thus, deposit mobilization becomes a subject of intense competition with consequences for higher operational and financial costs. On the other hand, low capacity utilization and low income per capita reduce the ability of borrowers to repay their financial obligations. Thus, bad debts develop with serious consequences for increased provisions, which lead to reduced profits or increased losses.

Political factors are politically induced issues, which turn out to have adverse consequences on the effective management of banks. For instance, political instability and indeed uncertainty associated with the annulled June 12, 1993 presidential election, engendered fear in the populace. That led to unanticipated massive withdrawal of funds from the bank. More so, many debtors either neglected or refused to repay their borrowings while fraud and forgeries became the order of the day. Again, on political interference on the management of banks is that most government owned banks were politically influenced to grant loans and overdrafts, which soon after became hard core and remained unpaid. Furthermore, appointment of board and management members of such banks were mainly politically influenced, many a time resulting to using unqualified and / or inexperienced person to manage banks.

Institutionally, there are numerous internal causative factors of bank failure. These include; boardroom squabbles arising from ownership structure, insider abuse, frauds and forgers, weak / ineffective internal control systems, poor asset quality, lack of adherence to CBN prudential guidelines, inadequate capita, poor management and other internal factors. For this reason, consolidation and increase in bank capital base with the view to strengthening Nigerian banks, and also making them more reliable was the idea of Professor Charles Chukwuma Soludo (the then CBN governor).

1.3     OBJECTIVES OF THE STUDY

a.     To know the causes of bank failure in Nigeria.

b.    To determine its impact on the Nigerian economy.

c.     To proffer possible strategies to prevent bank failures in Nigeria.

d.     To determine the shortcomings or constraint facing banks and how it inhibits growth on the Nigerian economy.

1.4     STATEMENT OF HYPOTHESIS

The following hypothesis are tested on this study;

H0:       Bank failures do not have any negative impact or effect on the   growth of Nigeria.

H1:     Bank  failures have negative impact on the Nigerian economy.

1.5     SIGNIFICANCE OF THE STUDY

The relevance of the study is moved by the fact that most banks fail to perform to the expected standard thereby contributing low to economic growth and development. This means that bank failure causes crystallization of risks.

The usefulness of this research is highlighted in the following ways:

i.      It will highlight to the nation as a whole on how best to manage banks.

ii.    It will state categorically the major causes of bank failure and their impacts on the economy thereby providing solution to such problems.

iii.  It will give the appropriate authorities an overview of the key to economic growth.

iv.  It will suggest useful measures by which funds can be managed or handled in banks.

v.    It will help various authorities in providing adequate policies which will guide the operation of banks in Nigeria.

1.6     SCOPE AND LIMITATION OF THE STUDY

This work covers the causes and consequences of bank failure on nigerian economy. The limitations of this study range from data collection and high costs involved as briefly x-rayed below.

i.        Inadequate finance has also limited the researcher from studying the activities of all the banks in Nigeria and also limits the volume of data collected.

ii.       Time constraint has limited the researcher in arriving at more balanced conclusion, the research was carried out under a short period.

iii.      Inability to get access to some banks’ library to get more about the records and some other useful information about the work also limit the researcher form data collected.

1.7 DEFINITION OF TERMS

Bank: A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets.

Bank Failure: A bank failure occurs when a bank is unable to meet its obligations to its depositors or other creditors because it has become insolvent or too illiquid to meet its liabilities.

Nigeria Economy: The economy of Nigeria is a middle-income, mixed economy and emerging market with expanding manufacturing, financial, service, communications, technology, and entertainment sectors. It is ranked as the 39th-largest economy in the world in terms of nominal GDP, the second largest in Africa and the 27th-largest in terms of purchasing power parity.

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