CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
The roles of commercial banks play in the process of economic development in every country are crucial. They through financial intermediation increase the levels of national savings and investments by mobilising idle funds from surplus spending units (savers) and channel them to deficit spending units(borrowers) for investments in the economy . (UGBAJA 1999)
By playing these roles within a particular country, the independence of global economics created the need for global interbanking, a trend which in turn emphasizes the need for the stability of the banks involved in intercontinental banking transactions.
Also, banking business carries a lot of risks and banking public needs assurance about the safety of their confidence in the banking institutions.
The need for supervision and control of commercial banks activities is to ensure that they adhere to the stipulated monetary policies, rules and regulations as well as accepted ethical conducts. However the major contributing factor that has led to the failure of Nigerian banks in the past can be described as moral hazard (adverse incentives)
Moral hazards or adverse incentives are a concept with relevance to a variety of principal agent relationships characterized by asymmetric information. The moral hazard concerns the adverse incentives on banks chief executives to act in ways which are contrary to the interests of the banks creditors (mainly depositors or the government if it explicitly or implicitly insures deposits) by undertaking risky investment strategies (such as lending at high interests rates to high risk borrowers) which, if successful, would ` jeopardise the solvency of the bank. Bank owners have incentives to undertake such strategies because with limited liability, they bear only a portion of the downside risk but stand to gain through higher profits, a large share of the upside risk. In contrast, the depositors (or the deposit insurers) gain little from the upside risk but bear most of the downside risk.
The inability of depositors to adequately monitor bank directors, because of the asymmetric information allows the latter to adopt investment strategies while entail higher levels of risks.
Moral hazard on bank executives can be exacerbated by a number of factors
Firstly, an increase in the interest rate may lead borrowers to choose investments with higher returns when successful but with lower probabilities of success (Stieglitz and Weiss 1989) hence a rise in deposit rates could induce banks to adopt more risky investment strategies. A rise in bank lending rates can have a similar incentive effects on the banks borrowers.
Secondly, macroeconomic instability can also worsen adverse incentive if it were to affect the variance of the profits of the bank borrowers especially when there is a co-variance between borrower’s profits. (E.g. if a large share of borrowers are in the same industry) or if loan port folios are not well diversified among individual borrowers.(McKinnon 1988)
Thirdly, the expectation that the government will bail out a distressed bank may weaken incentives on bank executives to manage their asset port folio prudently and incentives on depositors to monitor banks and choose only banks with a reputation of prudent management. Deposit insurance also reduces incentives for depositors to monitor banks.
Fourthly, moral hazard is inversely related to bank capital. The owners of poorly capitalized banks have little of their own money to loose from risky investment strategies. By implication, financial distress in the bank itself worsens moral hazard because, as the value of the bank’s capital falls, the incentives on its owners to pursue strategies which might preserve its solvency are reduced (Berger et al.1995 pp 398-99) for similar reasons intensified competition in banking market can also encourage moral hazard by reducing the franchise value of banks future profits.
Moral hazard becomes even more acute when the bank lends to projects connected to its own directors or managers (insider lending). In such cases the incentives for imprudent and fraudulent bank management are greatly increased in that all of the profits arising from the project are internalized.(in the case of loans unconnected borrowers the project returns are split between lender and borrowers)whereas that part of the losses borne by depositors or task payers are externalised. Not surprising, insider lending is a major cause of bank failure around the world.
These ills going on in the commercial banks, as stated above make it imperative for the central bank of Nigeria (CBN) to be on the watch at all times through their supervisory and control functions so as to protect them from going insolvent which usually impacts negatively on the economy in general.