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The Effect of Monetary Policy on Bank Risk-taking in Nigeria

 Format: MS WORD   Chapters: 1-5

 Pages: 68   Attributes: COMPREHENSIVE RESEARCH

 Amount: 3,000

 Feb 13, 2020 |  03:45 pm |  1119

CHAPTER ONE

INTRODUCTION

MONETARY POLICY AND BANKS’ RISK-TAKING.

 

1.1 BACKGROUND TO THE STUDY

          Banks generally (Deposit Money Banks [DMBS] especially) thrive on the wings of the numerous services rendered by them. These services range from the primary deposit taking (majorly by commercial banks), to other functions such as lending services (Loans and Advances), leasing, provision of financial and professional advices, brokerage services amongst others. Banks’ engagement in many of these services is directly tantamount to risk-taking i.e banks take risk in the course of providing financial services e.g Loan granting and other nominal or real investments (short or long term).

        There has been a great deal of interest in exploring banks’ risk-taking incentives because of their important role in the stability of the financial system. Researchers have unveiled evidence linking banks’ appetite for risk to their ownership structures (Saunders, Strock and Travlos, (1990)), competition in the banking sector (Keeley (1990)), the presence of deposit insurance (Hovakimian and Kane (2000)), government bailout policies (Gropp, Hakenes and Schnabel, (2011)), and the compensation of bank managers (DeYoung, Peng and Yan, (2012)). More recently, researchers have focused on monetary policy as yet another potential driver of banks’ incentives to take on risk. This study is an attempt to empirically contribute to the ongoing debate on the effects of monetary policy on banks’ risk-taking. There are different ways by which banks take risk, prominent of which is granting of loans and advances to their customers. For the purpose of this study, we will dwell on and analyze the relationship between the two opposite ends of monetary policy and banks’ risk-taking, specifically in the area of lending.

          Monetary policy is one of the macroeconomic instruments with which nations (including Nigeria) manage their economies (Ajie and Nenbe, 2010). Also, According to Ubi, Lionel and Eyo (2012), monetary policy is an aspect of macroeconomics which deals with the use of monetary instruments designed to regulate the value, supply and cost of money in an economy, in line with the expected level of economic activity. It covers gamut of measures or combination of packages intended to influence or regulate the volume, prices as well as direction of money in the economy per unit of time. Specifically, it permeates all the sophisticated efforts by the monetary authorities to control the money supply and credits conditions for the purpose of achieving diverse macroeconomic objectives.

          In Nigeria, the responsibility for monetary policy formulation rests with the Central Bank of Nigeria (CBN) and the Federal Ministry of Finance(FMF) (Ajie and Nenbe, 2010; Ajayi and Atanda, 2012; Abata, 2012). In Nigeria as in other developing countries, the objectives of monetary policy include full employment, domestic price stability, adequate economic growth and external sector stability. The supplementary objectives of monetary policy include smoothening of the business cycle, prevention of financial crisis and stabilization of long term interest rates and real exchange rate (Mishra and Pradhan, 2008). In pursuing these objectives, the CBN recognises the existence of conflicts among the objectives necessitating at some points some sort of trade-offs (Uchendu,2010). Central Bank of Nigeria (CBN), manipulates the operational target (monetary policy rate, MPR) over which it has substantial direct control to influence the intermediate target (broad money supply, M2) which in turn impacts on the ultimate objective of price stability and sustainable economic growth (Okafor, 2009; Uchendu, 2009).

          Monetary policy and Commercial Banks’ risk-taking attitude are inextricably linked together. In fact, the assessment of the Banking System (particularly in the area of loans and advances) can be evaluated through the performance of monetary policy tools. Olokoyo (2011)expressed that commercial banks decisions to lend out loans are influenced by a lot of factors such as the prevailing interest rate, the volume of deposits, the level of their domestic and foreign investment, banks liquidity ratio, prestige and public recognition to mention a few. Many developing countries, including Nigeria have adopted various policy measures to achieve targeted objectives. Ajie and Nenbee (2010) contended that reserves of the banks are influenced by the Central Bank through its various instruments of monetary policy. These instruments include the cash reserve requirement, liquidity ratio, open market operations and primary operations to influence the movement of reserves. All these activities affect the banks in their operations and thus influence the cost and availability of loanable funds. Thus, monetary policy instruments are critical in the demand for and supply of reserves held by depository institutions and consequently on availability of credit.

          The potential effects of monetary policy on banks’ risk-taking incentives have received wide attention recently, following claims that the accommodative policies by the monetary authority saddled with such responsibility, would definitely spur risk-taking among financial intermediaries. Low interest rates can lead banks to take on more risk for a number of reasons. They may cause banks to make risky investments in a “search for yield” (Rajan (2006)). Financial institutions often enter into long-term contracts that commit them to producing high nominal rates of return. In periods of low interest rates, these contractual rates may exceed the yields available on safe assets. To earn excess returns, banks may turn to risky assets. Dell′Ariccia and Marquez (2009) point out that if low interest rates reduce adverse selection in credit markets they will decrease banks’ incentive to screen loan applicants. Akerlof and Shiller (2009), on the other hand, suggest that investors take higher risks to increase returns in periods of low interest rates due to money illusion. Also, according to Adrian and Shin (2009) low short-term rates may lead to more risk-taking because they improve banks’ profitability and relax their budgetary constraints.

          Excess liquidity created by loose monetary policy may have encouraged banks to increase their actual risk positions in at least two ways. First, low interest rates affect valuations, incomes and cash flows, which in turn can modify how banks measure estimated risks (Adrian and Shin, 2009a; 2009b; Borio and Zhu, 2008). Second, low returns on investments, such as government (risk-free) securities, coupled with the lower cost of obtaining new debt for borrowers may increase incentives for investors (including banks) and borrowers to take on more risk. These incentives can be due to behavioral, contractual or institutional reasons, for example to meet a target nominal rate of return or misperceptions about the actual risk undertaken (Brunnermeier, 2001; Rajan, 2005). It is also likely that the closer relationship between bank funding needs and financial markets conditions have enhanced the impact of monetary policy changes on banks’ risk positions. In this respect, it is likely that credit intermediaries have probably shortened their investment horizons as they obtain a larger percentage of their profits linked to financial market activities, such as proprietary trading and investment banking activities which are more dependent on market signals including the monetary policy rate. It is only appropriate to note at this point that, relaxing restrictions on banking activities, generally, may encourage bank risk-taking by expanding a bank’s range of activities. Yet tightening restrictions may also increase opportunities for bank diversification, and thereby reduce risk-taking. When these two contrary options are open, regulators will want to analyze bank risk-taking incentives because the ultimate consequence of expanding the range of activities allowed to banks will depend on these incentives.

          There is no way the concept of risk-taking channel would not be captured in the purview of this study. Risk-taking channel is conceptualized as the impact of a change in interest rates on risk-tolerance and risk perception, triggering a change in credit supply and started to draw attention only after its plausible fallouts had already materialized. Empirical studies had rapidly developed and confirmed the existence of this channel. Rajan (2005) sheds light on the search-for-yield mechanism, Borio and Zhu (2008) show that monetary policy affects risk-taking channel through its communication policies and Adrian and Shin (2010) examine that the mechanism relating leverage and bank’s balance sheet may lead financial institutions to take on more risk. Also, according to the study of Vasso et.al (2014), the risk-taking channel of monetary policy in Bolivia, a dollarized country where monetary changes are transmitted exogenously from the US. It was found that a lower policy rate spurs the granting of riskier loans, to borrowers with worse credit histories, lower ex-ante internal ratings, and weaker ex-post performance (acutely so when the rate subsequently increases). In this study we analyze empirically the relationship between monetary policy and risk-taking by banks and also augment the claim that prolonged periods of eased monetary conditions increase bank risk taking.

1.2  STATEMENT OF THE PROBLEM

          Monetary policy has proven potent in the area of influencing or regulating the volume, supply and direction of funds in the economy at any given period of time. However, Monetary Policy (contractionary or expansionary) could also prove disastrous in its implementation unless an appropriate trade-off is established between these two opposite ends.

Contractionary policy increases banks risk alertness. Banks become cautioned of granting risky loans (loans to below-investment grade borrowers), the interest rate is also increased exorbitantly, thereby denying petty investors access to funds which also means lesser profit for banks that are profit-oriented by nature.

          Expansionary or monetary easing on the other hand will make banks indulge in risky investments. It may cause banks to make risky investments in a “search for yield” (Rajan (2006)). This is in line with the fact that when bank reserves and bank deposits are on the increase, the quantity of loans available is directly enhanced. Dell′Ariccia and Marquez (2009) point out that if low interest rates reduce adverse selection in credit markets, they will decrease banks’ incentive to screen loan applicants. Also, according to Adrian and Shin (2009) low short-term rates may lead to more risk-taking because they improve banks’ profitability and relax their budgetary constraints. This can make banks give out loans indiscriminately with less or without monitoring, the resultant effect of which is increased amount of non-performing loans, inability to recover granted loans and usually insolvency and/or bankruptcy on the part of the hapless banks. Generally, a proper trade-off is yet to be established between policy rate and risk-taking attitudes of banks.

          Generally speaking, relaxing restrictions on banking activities may encourage bank risk-taking by expanding a bank’s range of activities. Yet tightening restrictions may also increase opportunities for bank diversification, and thereby reduce risk-taking. When these two contrary options are open, regulators will want to analyze bank risk-taking incentives because the ultimate consequence of expanding the range of activities allowed to banks will depend on these incentives. This is a major lacuna which needs the attention of policy makers and finance scholars.

 

 

1.3 RESEARCH QUESTION

In spite of the various contributions by different scholars who had at a time or the other attempted to analyze the somewhat ambiguous relationship between the monetary policy of the regulatory authority at any given time and the consequential risk-taking attitude on the part of the banks who are affected by the policy rate, some questions still need to be asked for the purpose of this study, viz;

  • What is the nature of the relationship between the monetary policy rate and bank lending in Nigeria?
  • What is the influence of CBN’s liquidity ratio (LR) on banks’ loans in Nigeria 

1.4 STATEMENT OF HYPOTHESIS

The following hypothesis will be tested at 5% level of significance; 

Ho; There is no relationship between monetary policy rate and Bank lending in Nigeria.

H1; There is a relationship between monetary policy rate and Bank lending in Nigeria.

Ho; monetary policy rate cut increases the quantum of Non-performing loans in Nigerian Banks

H1; monetary policy rate cut does not increase the quantum of Non-performing loans in Nigerian Banks         

 

1.5 RESEARCH OBJECTIVES

The purpose of this study is to provide reliable answers to the questions above and also;

To determine the nature of the relationship which subsist between monetary policy and Banks’ risk-taking attitude especially in the area of loan granting and making available all other credit options open to these banks.

To augment the claim that easy monetary conditions increases Banks’ risk appetite.

To independently test the influence of contractionary and expansionary policy rate on Banks’ risk-taking attitude with the aim of arriving at a probable trade-off between the variables in view and to cushion the effect of Non-performing loans on the banks and the economy as a whole.

1.6 SIGNIFICANCE OF THE STUDY

          This study will aid in the investment decision making process of individuals and corporate investors. It will prove essential in the understanding of the investment timing i.e when to invest and when not to invest.

          This study attempts to expose the influence of various monetary policy measures on the banks’ risk appetite. This makes it expedient in the formulation of policies as they affect the operations of banks in Nigeria by the government or bodies saddled with such responsibility. Since the activities of banks always have a generic effect on the economy growth and development, this study will also aid in the formulation of an optimum monetary policy mix which is economically healthy. This research will also serve as a veritable aid to the policy makers in formulating and implementing sound monetary policy that takes its resultant influence on the risk-taking attitude of Banks into consideration.

          This study will also serve as a point of reference for other researchers of studies of this nature and for the knowledge pleasure of those who wish to have a random knowledge about the subject matter.

 

1.7 SCOPE AND LIMITATION OF THE STUDY

In any study of this nature, the researcher is always enthusiastic to touch as many areas as possible which might be related and expedient to the subject matter. However, since the study of this nature can only achieve a minimal feat, the scope will also be minimal and limited to the observation of the activities of all the Nigerian Deposit Money Banks (DMBs) with respect to the subject matter of this study. The observation of these banks shall be carried out over the period of operational 30 years.

1.8 OPERATIONAL DEFINITION OF TERMS

Monetary Policy: This refers to the specific actions taken by the Central Bank to regulate the value, supply and cost of money in the economy with a view to achieving government’s macroeconomic objectives.

Money supply: This is the sum of all money or monetary assets that can easily be converted to cash in an economy at a specific time. It is often referred to as money stock since it is measured at a particular point in time.

Monetary Easing: This is a policy in which central bank lower interest rates and deposit ratios to make credit more easily available. This makes borrowing easier for businesses, which stimulates investment and expansion of operations.

Monetary Tightening: A situation where monetary policy is used restricts money supply, and reduces the amount of money banks have to lend.

Risk: The probability that an actual return on an investment will be lower than the expected return.

Risk-taking:  This is any consciously or non-consciously controlled behavior with a perceived uncertainty about its outcome, and/or about its possible benefits or costs for the physical or economic well-being of an individual or organization.

Risk Appetite: This is defined as the amount of risk a bank is prepared to take on at a given time and it is often a direct reflection on its strategic objectives.

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