EFFECT OF CORPORATE GOVERNANCE ONDISCRETIONARY LOAN LOSS PROVISION OF LISTED DEPOSIT MONEY BANKS IN NIGERIA

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EFFECT OF CORPORATE GOVERNANCE ONDISCRETIONARY LOAN LOSS PROVISION OF LISTED DEPOSIT MONEY BANKS IN NIGERIA

ABSTRACT

This dissertation investigates the relation between Corporate Covernance and discretionary loan loss provision of Nigerian Deposit Money Bank, using institutional shareholding, managerial ownership, board size and audit committee size to proxy for Corporate Covernances and Discretionary Loan Loss Provision was used as dependent variable. The relation was tested using OLS Multiple Regression for 10 years during the period 2007-2016 and based on correlation research design. Empirical result indicates that managerial ownership, audit committee and institutional shareholders are posively related, but board size is negatively related with discretionary loan loss provision. Next to this, findings indicate that it can be expected that an increase in the percentage of shares held by managerial ownership and moderate board size and audit committee will reduce manipulating loan losses. Overall, this study concludes that institutional shareholding, managerial ownership and audit committee positively influence bank Loan Loses while board size value negatively related to discretinary loan losses. Therefore, the study recommend that manager should participate in buying more shares in their banks and board size and audit committee size should be based on CBN and code of corporate governance guidelines.

TABLE OF CONTENTS

Page

Title Page- – – – – – – – – – i

Declaration – – – – – – – – – – ii

Certification – – – – – – – – – – iii

Dedication – – – – – – – – – – iv

Acknowledgement – – – – – – – – – v

Table of Content – – – – – – – – – vi

List of Tables – – – – – – – – – ix

List of Appendices – – – – – – – – x

Abbreviations- – – – – – – – – xi

Abstract – – – – – – – – – – xii

CHAPTER ONE: INTRODUCTION

1.1 Background to the study – – – – – – – – 1

1.2 Statement of the Research Problem- – – – – – 6

1.3 Objectives of the study- – – – – – – – 8

1.4 Hypotheses of the study – – – – – – – – 8

1.5 Scope of the study- – – – – – – 9

1.6 Significance of the study – – – – – – – 9

CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction – – – – – – – – – 11

2.2 Concept of Corporate Governance – – – – – 11

2.3 Concept of Earnings Management – – – – – 14

2.4Empirical Studies Corporate Governance and Bank EM – – 19

2.5Theoretical Framework- – – – – – – – 43

CHAPTER THREE: RESEARCH METHODOLOGY

3.1 Introduction- – – – – – – – – 52

3.2 Research Design – – – – – – – – – 52

3.3 Population and Sampling of the study – – – – – – 52

3.4 Sampling Techniques- – – – – – – – 53

3.5 Source and Method of Data Collection- – – – – – 54

3.6 Techniques ofData Analysis – – – – – – – 54

3.7Variable Measurement and Model Specification – – – – 55

CHAPTER FOUR: DATA PRESENTATION AND ANALYSIS

4.1 Introduction- – – – – – – – – 57

4.2 Descriptive Statistics- – – – – – – – 57

4.3 Correlation Matrix- – – – – – – – 58

4.4 Robustness test- – – – – – – – – 59

4.5 Presentation and analysis of Regression results – – – – – 62

4.6 Hypothesis Testing and Discussion of Result – – – – 66

CHAPTER FIVE: SUMMARY, CONCLUSIONS AND RECOMMENDATIONS

5.1 Summary- – – – – – – – – – 70

5.2 Conclusions- – – – – – – – – 71

5.3 Recommendations – – – – – – – – 72

5.4 Limitations of the Study – – – – – – – – 73

5.5 Future Research Areas- – – – – – – – 74

Reference – – – – – – – – – – 75

Appendix – – – – – – – – – 88

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

The banking crisis being experienced highlights the unstable nature of banking. Following the failure of Lehman Brothers in September 2008, many banks went bankrupt. Although it all started in the United States, Europe and Africa were affected as well. During 2007-2008, the European banks wrote down a total of $200 billion in bad debts (Haq& Heaney, 2012). At the end of 2007, most of the banks had leveraged up 30 times their equity (Carmassi, Gros&Micossi, 2009). On the other hand, banks and governments are considering about new proposals that will increase the health and soundness of the banking sector. These proposals were designed to strengthen bank capital and liquidity regulation with a view to increase the stability of the banking sector (Hag & Heaney, 2012).

To increase the stability of the banking sector, banks are required by regulators to make provision which is known as loan-loss provisions (LLP) against expected credit losses. This right is exercised by the corporate executives of banks. Such discretion being exercised by bank executives are apparently misused for other purposes that could be of benefit to the banks executives and consequently, it will create information asymmetric thereby sending misleading information which could mislead the user of such information in terms of decision making. Banks executive use this LLP to increase loan loss reserves during good times, and draw resources from these reserves when the economy slows down and potential defaults become real.

In light of the above, Loan Loss Provisions (LLPs) are one of the banks‟ main accrual. From the perspective of banking system soundness and stability, they are to be set aside in order to cover future deterioration of the credit portfolio quality. In theory, from the perspective of the banking supervisory authorities, loan-loss provisions should be used only to face expected credit losses, but in many countries they are left to the judgment of the bank manager, thus becoming a tool that managers can rely on to pursue various other goals. Even if banks‟ financial reporting system is highly regulated, managers still hold some discretion, for example, in determining when a loan can be considered impaired. This discretionary power gives them the opportunity to substantially influence a bank‟s reported net income, sending distorted signals to a bank‟s stakeholders, hiding the true economic substance of a bank‟s activity, and the actual value of the bank.In order to better understand the role that loan loss provisions play in modern banking activity, it must be highlighted that this statement of financial position account merges different information and behaviors (Bouvatier&Lepetit, 2008). Typically, accounting practice distinguishes between specific provisions and general provisions. The amount of specific provisions depends on credit losses and it increases specific reserves, which are deducted from the asset value. Specific provisions are also known as non-discretionary provisions and are used to cover expected losses in a bank‟s loan portfolio. General provisions are set aside against not yet identified losses and are added to general reserves on liabilities. Since they are linked to the expansion of customer loans, general provisions are highly judgmental and prone to be manipulated by bank managers for discretionary purposes.

The causes for loan default vary in different countries and have multidimensional aspects both in developing and developed nations. Some of these include depressed economic conditions, high real interest rate, inflation, and lenient terms of credit, credit orientation, high credit growth, risk appetite, and poor monitoring among others. Loan loss provisioning is a key accounting choice that directly influences the volatility of bank earnings, as well as information properties of banks‟ financial reports with respect to reflecting loan portfolios ‟risk attributes. While the precise form that more forward-looking provisioning should take remain an open question, proposals to date generally incorporate a broader range of information and create an expanded role for managerial discretion in assessing future expected losses. However, accounting discretion is regarded as double-edged sword (Dechow& Skinner, 2000). While increased discretion may facilitate in corporation of more information about future expected losses into loan provisioning decisions, it also increases potential for opportunistic or misguided accounting behavior by managers that can degrade bank transparency and lead to negative consequences along other dimensions (Wall & Koch, 2000).

Loan Loss Provisions (LLPs) is calculated based on an incurred loss approach and reflects the expected losses arising from their lending business. Banks‟ incentives to engage in earnings management with LLPs depend on their business objectives, governance, and performance. Especially the level and volatility of earnings and the need to build up capital reserves through retained earnings play an important role (Fan and Wong, 2002; Ahmed, Takeda, and Shawn1998; Liu, Ryan and Wahlen, 1997). On the one hand, banks might use the LLPs to stabilize earnings levels, to reduce the volatility in earnings, and to implement the desired payout policy. Hence, too high LLPs lower the reported profitability but increase the buffer against expected losses.

On the other hand, low LLPs increase the reported profitability but also increase the chance that a bank must use its capital to cover large losses. (Laeven&Majnoni, 2003). A key feature of LLPs, unlike accruals of non-financial firms, is that they simultaneously influence bank profitability and bank risk, which results in a trade-off (Bushman & Williams, 2012; Beatty & Liao, 2011).

According toSanusi (2012) and Brownbridge (1996) among others have provided some evidences of earnings manipulation in the Nigerian banking sector.Sanusi (2012) in particular,explained that one of the eight reasons for banking crisis in 2008 was “inadequate disclosure and transparency about financial position of banks.” Various terms have been used to describe “inadequate disclosure and transparency”. Among the terms used are accounts manipulation, income smoothing, big bath accounting, creative accounting and earnings management. Whatever the term adopted, the whole essence is to mislead users of financial statements and to render financial reports unreliable with the motive of some private gains. However, Hassan (2011) stated that financial statement is misleading if it lacks the qualities of accuracy, relevance, comparability and it contains fundamental errors or is prepared with the intention to deceive/confuse users.

Conversely, the weakness of existing corporate governance mechanisms could facilitate process of earnings management in banks. However, the existence of strong corporate governance mechanisms in banks can lead to improvements in professional conduct in business transactions and limit the opportunities for earnings management. In contrast, the existence of weak corporate governance may encourage manipulation, corruption and mismanagement in the business (Leventis&Dimitropoulos, 2012; Vafeas, 2005).

Most of the previous accounting scandal that led to collapse of several banks was traced to earnings management and this have raised serious concerns about corporate governance practices in general and brought into sharp focus on the issues relating to the weak internal control systems in corporate firms (Rusmin, 2010). The collapses of such large corporations in the past have highlighted the intentional misconduct of managers. However, there is the need for sound corporate governance in other to forestall the frequent collapse of banks. Corporate governanceis one important monitoring system. Its primary objective is not to directly improve corporate performance, but to resolve agency problems by aligning management‟s interests with the interests of shareholders (Demsetz& Lehn, 1985). However, Gulzar and Wang ( 2011) support the effectiveness of corporate governance as a monitoring system. Also, Xie, Davidson and DaDalt (2003)and Klein (2002), among others, show that corporate governance reduces management‟s ability to manage earnings. Among the corporate governance variables institutional shareholding, managerial ownership, board size and audit committee are perceived to be important monitoring system that may help to align the interests of managers and shareholders and reduce the potential for opportunistic managers‟ behaviour.

Institutionalshareholding is argued to perform a monitoring role which reduces the opportunities available to managers to reported earnings (Jensen & Meckling, 1976). Managers will be more likely to engage in opportunistic activities in the absence of such monitoring activities. According to Moyer (1990), institutional‟ monitoring acted as an efficient device to reduce agency costs associated with the separation of ownership and control. Lang, Raedy, and Wilson (2006) argue that the monitoring activities of institutional shareholders motivate managers, thus reducing agency costs.

Managerial ownership represents the interest of managers in the equity shareholding of a firm is also considered in this study as a variable which may perform a great monitoring role of manipulating tendencies of managers. The reason behind the rise of this monitoring variable is rooted in the agency theory, which assumes that managers‟ equity holdings encourages them to act in a way that maximizes the value of the firm (Kantudu & Samaila, 2015) . However, Friend and Lang (1988) stated that if the management of a company owns shares in the same company, it becomes more efficient and effective in discharging its obligations and may translate to higher quality reporting for the firm. Also, the monitoring role of managerial ownership is also exercised through their numbers of shares and can use their voting right to align managers interest with that of the banks. Thus, it is assumed that the more managers own shares the more they make decision that would minimize earnings manipulations.

It is not only themanagerial ownership that enhances corporate governance monitoring role but the size of the board of directors. For the board of directors, the code of corporate governance recommends a board size of not more than 15 and not less than 5 including executive and non-executive directors. The minority shareholders are also fully represented by at least one director on the board. An active board size is essential characteristics of effective corporate governance monitoring. Where there is larger board size, there is tendency of effective managers monitoring.

Studies of Lipton and Lorsch (1992), Jensen (1993) and Yermack (1996), suggest that the audit committee size affects management financial decision. Bédard, Chtourou, Courteau(2004) argue that the larger the audit committee, the more likely it is to disclose and resolve potential problems in the financial reporting process because it is likely to provide the necessary strength and diversity of views and expertise to ensure effective monitoring.

1.2 Statement of the Research Problem

While the debate on reasons of the severe banking crisis that burst in 2008 and plagued the economy for years to come remains unsettled, the banking sector is often presented at the centre of the events and as one of the key drivers behind the downturn. In particular, banks have been criticised for excessive loan losses, weak governance structures and lacking oversight. The study considers practices and tendencies within banks‟ corporate governance practices and changes in their ownership areas. Corporate governance should become subject to pressures from their surrounding institutions and the stakeholder society to correct practices which will safeguard depositor‟s money and give investors‟ confidence in the banking sector. The study provide an assessment of whether such a connection can be demonstrated between corporate governance and discretionary loan loss provisions and if so which influences have been most effective in driving change in bank‟s corporate governance practices.

Studies such as (Abubakar, Abdu, & bdulmarooph, 2014; Shehu and Abubakar, 2012; Shehu, 2011; Devi &Hashim, 2010; Dugan,2009;Hasan, & McCarthy, 2007; Barako, Hancock &Izan, 2006; Rahman& Ali, 2006; Anandarajan& Borgia, 2005; Sanda, Mikailu, &Garba, 2005; Adams &Mehran, 2003; Bello, 2002; Ahmed, Takeda, & Thomas, 1999; Schipper 1989;Greenawalt&Sinkey, 1988) concentrated on either the manufacturing companies or they try to establish the link between loan loss provision and discretionary accruals in banking industry but the study fail to consider a controlled mechanism that can constrain managers from manipulating loan losses. In contrast to other sectors and loan losses, there are a number of reasons why banking is particularly well appropriate for our purposes. First, the sector was subject to intense turmoil during the financial crisis which may have increased the tendency to adjust to changes in their managerial approaches. Also, banks have been under closer inspection for its approach to risk-taking, in particular through prevailing financial incentive packages for key executives, which further reinforce the linkage between corporate governance and the earnings manipulation. Moreover, banks play a central role in the financial system and any banking failures will amount to risk spilling over on depositors. This means that banks face other governance issues than most other firms. Still, the crisis has shown how some of the largest and most financially strong banks, operating in the world‟s most developed economies, were subject to some of the most severe governance issues. This raises many questions, and we hope to present an approach which brings us closer to an understanding of the interplay between corporate governance and discretionary loan loss provisions.

1.3 Objectives of the Study

The main objective of the topic is to determine the effect of corporate governance on discretionary loan loss provision of listed deposit money banks Nigerian. However, the study seeks to achieve the following objectives:

i. To determine the effect of institutional shareholdingon discretionary loan loss provision of deposit money banks in Nigeria.

ii. To determine the impact of managerial ownership on discretionary loan loss provision of deposit money banks in Nigeria.

iii. To determine the impact of board size on discretionary loan loss provision of deposit money banks in Nigeria.

iv. To determine the effect of audit committee size on discretionary loan loss provision of deposit money banks in Nigeria.

1.4 Research Hypotheses

In line with the objectives, the following hypotheses are stated in null form to guide the

study:

i. Institutional shareholdinghas no significant effect on discretionary loan loss provisionof deposit money banks in Nigeria.

ii. Managerial ownership has no significant effect on discretionary loan loss provision of deposit money banks in Nigeria.

iii. Board size has no significant effect on discretionary loan loss provision of deposit money banks in Nigeria.

iv. Audit committee size has no significant effect on discretionary loan loss provision of deposit money banks in Nigeria.

1.5 Scope of the study

This study is limited to only those Deposit Money Banks in Nigeria that are quoted on the Nigerian Stock Exchange (NSE) from January, 2007 and remain listed up till December 2016. The study is centred on corporate governance and discretionary loan loss provisions of Listed Deposit Money Banks in Nigeria.

The study covers the period of 2007 – 2016. This period is considered appropriate as it falls within the period when there was banks instability around the world which Nigerian banking sector was not completely out of it. Its further focuses on only four of the corporate governances; these are Institutional Shareholding (INS), Managerial Ownership (MRO), Board Size (BSZ) and Audit Committee (ACZ), the control variable are Log of Total Assets (FSZ) and Leverage (LEV) and the Discretionary Loan Loss Provisions (DLLP) which stand for the dependent variable.

1.6 Significance of the study

The findings of this study would have implications for users of financial statements such as shareholders, potential investors, policy makers, the regulatory bodies and also students. The study is expected to practically contribute in strengthening the areas of concern by practitioners such as external auditors and financial consultants about financial records of Nigerian DepositMoney Banks relating to the role of corporate governances on discretionary loan loss provision. And also to consider the prominent roles or activities that corporate governances play.

In particular, financial statement users wouldknowand identify income smoothing and the degree ofmanager involvement in such behavior so as to be able to make an informed decision on financial matters which relates to bank. Specifically, users would know the influence of the institutional shareholdings and the audit committee, managerial ownership and external auditors

on such behavior. Furthermore, the study will extend the existing literature by providing evidence on the determinants of Loan loss provisions in Deposit Money Bank context by utilizing some bank variables.

Apart from contributing to the literature, the study may also have important practical implications for deposit money banks managers and bank regulators in dealing with Loan loss provisions issues and coming up with policies that will safeguard depositors fund and investor‟s assets.Moreover, it may also serve as a source of reference and as a stepping stone for those who want to make further study on the issue of Loan loss provisions in the Nigeria banking context afterwards. It may provide a possible opportunity to all stake holders to gain deep knowledge about the leading cause of Loan loss provisions in Deposit Money Banks.

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