i

ASSESSMENT OF THE IMPACT AND CHALLENGES OF BASEL II

IMPLEMENTATION ON THE RISK MANAGEMENT PRACTICES

IN NIGERIAN BANKS

BY

SALAMI, SIKIRU ADIO

MATRIC NO: 129022064

A RESEARCH PROJECT SUBMITTED TO THE SCHOOL OF POST

GRADUATE STUDIES DEPARTMENT OF ACTUARIAL SCIENCE AND

INSURANCE, UNIVERSITY OF LAGOS, IN PARTIAL FULFILLMENT

OF THE REQUIREMENTS FOR THE AWARD OF THE MASTERS OF

RISK MANAGEMENT

DECEMBER, 2014

ii

CERTIFICATION

This is to certify that this project entitled:

ASSESSMENT OF THE IMPACT AND CHALLENGES OF BASEL II

IMPLEMENTATION ON THE RISK MANAGEMENT PRACTICES

IN NIGERIAN BANKS

was carried out by

SALAMI, SIKIRU ADIO

with Matriculation No: 129022064

under my supervision.

PROF. J. N. MOJEKWU DATE

Supervisor

PROF. R. O. AYORINDE DATE

Head of Department

iii

DEDICATION

All praises and adoration are due to the Almighty Allah whose dominion transcends all

limitations. I dedicate this research project to the Almighty Allah for His grace and

mercy upon my life and family. The project is further dedicated to the memory of my late

sister Halimah Salami. May Allah accept her to the fold of the righteous.

To Allah alone be all thanks and glory!

iv

ACKNOWLEDGMENTS

In conducting this research, I received assistance from a number of people and various

banks. In particular, I want to express my sincere gratitude to my supervisor, Professor

J.N. Mojekwu whose guidance and demand for thoroughness made this research a

successful adventure. I also want to specially thank Mr. Jide Oyewo, Mrs. Juliet Ibili of

H. Pierson, and Mr. George Okonkwo CFA, FRM for their input into this research effort.

Thanks are also due to all my friends and associates in some of the sampled banks

because they saw to the response to my questionnaires.

v

ABSTRACT

Risk management plays an important role in ensuring the safety and survival of banking

institutions. Basel II Accord is an international regulatory attempt aimed at

strengthening the risk management practices in the internationally active banks. The

Basel II Accord is the framework developed in 1999 by the Central Banks of G10

countries to regulate the risk management process in large internationally active banks

in their domains and in the Organization for Economic Cooperation and Development

(OECD) member countries. The framework was issued principally to address the issue of

the minimum capital requirements that have to be kept aside by banks, to be able to face

any economic stress, and for protecting the international financial system from financial

crises that could lead to the collapse of banks. This research examines the impact and

challenges of Basel II on the risk management practices in Nigerian banks, and the extent

of progress the banks have made in implementing the Accord within the milieu of the

Central Bank of Nigeria’s guidelines. The sample population comprised all the banking

institutions in Nigeria, including commercial banks, mortgage banks, finance houses and

merchant banks. A random sample of 15 commercial banks was taken from which

sampling units of 60 respondents with risk and control functions were purposively

selected from each of the sampled banks. What informed the choice of the commercial

banks as the sample source was because the Central Bank of Nigeria appeared to have

considered the commercial banks as the centre focus of Basel II implementation for a

start. Four hypotheses were formulated to validate the observations that necessitated the

study. All the hypotheses were tested at 0.05 level of significance using the ANOVA,

regression and t-test models. The following findings were made from the study after

vi

testing the hypotheses formulated for the study: All the Nigerian banks face almost the

same sets of challenges in implementing Basel II requirements; the Basel II Accord

caused significant change in capital measurement and allocation; the Accord has

improved the risk management practices in Nigerian banks, and Nigerian banks have

made some progress in Basel II implementation project. At the end of the research, it was

recommended that the Central Bank of Nigeria increase the level of awareness on Basel

Accord; that the CBN should immediately enforce the Basel II regulations on all

operators in the banking industry rather than focusing on commercial banks; that the

banks should enlighten their Boards and senior management staff on the implications of

Basel Accord on the banks’ businesses, and finally that the banks should find smarter

ways to raise further capital in response to Basel II requirement.

vii

TABLE OF CONTENT

Content Page

Title Page i

Certification ii

Dedication iii

Acknowledgment iv

Abstract v

Table of Content vii

List of Tables ix

Chapter One – Introduction 1

1.1 Background to the Study 1

1.2 Statement of the Problem 4

1.3 Purpose of the Study 5

1.4 Research Questions 5

1.5 Research Hypotheses 6

1.6 Significance of the Study 7

Chapter Two – Literature Review 8

2.1 Introduction 8

2.2 Review of Related Studies 8

Chapter Three – Research method 49

viii

3.1 Introduction 49

3.2 Research Design and Instrument Used 49

3.3 Population of the Study 50

3.4 Sample and Sampling Technique 50

3.5 Method of Data Collection 51

3.6 Method of Data Analysis 52

Chapter Four – Presentation and Analysis of Data 53

4.1 Presentation of Data 53

4.2 Data Analysis 63

Chapter Five – Summary, Conclusion and Recommendation 68

5.1 Summary of findings 68

5.2 Conclusion 70

5.3 Recommendation 71

References 74

Appendix 79

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LIST OF TABLES

Table 4.1 Age of the Respondents Classified by their Qualification 53

Table 4.2: Qualification of the Respondents Classified by their length of Service 53

Table 4.3: Qualification of the Respondents Classified by their Departments 54

Table 4.4: Respondents Classified by License Categories of their Banks 54

Table 4.5: Impact of Basel II Accord on Risk-Based Capital 55

Table 4.6: Impact of Basel II Accord on Risk Organization in Nigerian Banks 57

Table 4.7: Cadre of the Banks’ Chief Risk Officers 58

Table 4.8: Impact of Basel II Regulation on Capital Allocation and Consumption 58

Table 4.9: Descriptive Statistics on Priority Given to Basel II Regulations 59

Table 4.10: Descriptive Statistics on Risk Reporting 60

Table 4.11: Descriptive Statistics on Spending Areas for Basel II Implementation 61

Table 4.12: Descriptive Statistics on Compliance with BASEL II Accord 62

Table 4.13: Descriptive Statistics on BASEL II Implementation challenges 62

Table 4.14: Impact of Basel II on Capital Adequacy Ratio Computation 64

Table 4.15: Opinion on Challenges of Basel II Implementation Relative to Banking

License Category 64

Table 4.16: ANOVA Results on the Extent of Implementation of BASEL

Requirements 65

Table 4.17: Correlation and Regression Results on the Impact of Basel II on Risk

Management Practices in Banks 66

Table 4.18: ANOVA Results on the Impact of Basel II on Risk Management Practices in

Banks 67

1

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

The survival of any organization in the 21st century depends to a large extent on its ability to

anticipate and prepare for the disruptions in the business environment, rather than waiting for

those changes and reacting to them. This reality underscores the very essence of risk

management in the modern age. The primary objective of risk management is not to deter an

organization from taking risk, but to ensure that it takes such risk consciously with appreciable

knowledge, purpose and firm resolve so that such risks can be adequately measured and

mitigated. Risk management also prevents an institution from suffering unacceptable loss that

may cause the institution, especially a bank here, to not only lose its competitive position, but

also impoverish the interest of key stakeholders in the entity. Functions of risk management in

a bank should be dictated by the balancesheet size, structure and quality, complexity of

functional activities, technical manpower, and more importantly, IT infrastructure put in place

in that bank.

Banking is a highly regulated business endeavour, and risk management in banks is an area

that has in recent times enjoyed strong regulatory enforcement supports. To this effect, we

have Basel Capital Accord aimed at instilling risk management practices in banking

institutions across the world. According to Akinyooye (2006), Basel II Accord is a regulatory

framweork developed in 1999 by the Central Banks of G10 countries to regulate the risk

management functions in international banks in their respective domains and, including other

2

interested countries. The author noted that the focus of the new Accord is on the provision of

risk-based regulatory capital for all the exposures of these systemic banks to enable them

withstand any threat to their solvency.

Banking is the financial bedrock of any nation‟s economy and the business of banking is built

around the concepts of financial intermediation, asset transformation, and money creation. The

three banking roles are interwoven. Financial intermediation means that a banking institution

acts as an intermediary between the surplus spending units and the deficit spending units in an

economy. This process involves a bank taking deposits from the economic agents with surplus

and channelling same to those running deficits. Financial intermediation function inheres a

whole lot of risks, and when such risks crystallize, not only would the banking entity bleed, the

risks could also affect the economy where the entity is located, including several other

stakeholders with vested interest in therein.

Another role that a bank plays is asset transformation, and this is a process of creating new risk

assets such as loans and advances from deposit liabilities. By this, a bank runs the risk that a

sudden and massive change in market interest rates may impoverish the profit it makes on its

loan assets since such a bank must charge a lending rate that is higher than the interest it pays

on its deposits (Moghalu, 2012). Money creation is the third banking function, which relates to

the process of generating additional money in the financial system through the continual

lending of an initial deposit in a bank in line with the principle of fractional reserve. This

practice, according to Moghalu (2012), can create macroeconomic risks because the amount of

money created in a fractional reserve banking system depends on the level of reserves banks

3

are required to maintain from deposits. It suffices to therefore to note that risk taking is an

integral part of banking business.

It is important that the concept of risk be defined at this early stage. The word “risk” derives

from an Italian word “Risicare” which means “To Dare”. It is an expression of danger of an

adverse deviation from any expectation, which may be positive or negative outcome of an

event. Risk has been variously defined by several authorities. According to Wikipedia, risk is

the possibility of losing something of value, relative to the chance of gaining things of value.

The Webster‟s comprehensive dictionary perhaps gives a more precise definition of risk as “a

chance of encountering harm or loss, hazard, danger” or “to expose to a probable event of

loss”. Banks for International Settlement (BIS) appears to give a more practical and robust

view of risk as the threat that an event or action will adversely impact a bank‟s ability to

achieve its objectives and give effect to its strategies.

Risk Management on the other hand is a planned method of handling the potential loss or

damage arising from sudden change in expectations and this can be regarded as an ongoing

process of appraising risk using various methods and tools which continuously identify what

could go wrong. Risk management can also be used to ascertain which risks should be given

priority in the scale of events and the strategies required to deal with those risks. In other

words, risk management involves identifying, assessing, and rating risks through a proper

deployment of resources in a way that helps monitor, control and reduce the probable

occurrence of downside events, and optimise business opportunities.

4

The consideration of the concepts of Risk and Risk management above now lays bare the role

that Basel II Accord could play in the Nigerian Banking Industry. Basel regulations are

essentially an attempt to give genuine effect to risk management practices in banking

institutions. The extent, to which this lofty purpose has been achieved in the Nigerian banking

sector, is a subject of interest to this research study.

1.2 Statement of the Problem

Basel norms, at least a watered down version of them, have been in existence in the Nigerian

banking environment since the early days of Basel I, and the CBN for instance, through its

circular BSD/11/2003 of August 4, 2003 (effective January 2004) re-calibrated the capital

adequacy measurement of the Basel 1 Accord in an effort to make it fit into the Nigerian

business environment. Basel II was however introduced as an attempt to reduce the systemic

effect of banking failures in the nation‟s economy as was witnessed recently, and such failures

are suspected to be mostly due to regulatory laxity on one hand and poor risk management

practices in banking institutions on the other. The implementation of Basel II in Nigeria is

aimed at broadening and deepening risk management practices in the Nigerian banks, which

seem to be lacking in depth for a long period of time in the industry. It is meanwhile believed

that the regulatory attempt at enforcing Basel II implementation in Nigeria may not be an easy

task.

To the best of our knowledge, no adequate study has thus far been carried out to identify the

factors suspected to be responsible for the implementation challenges and how Basel II norms

have affected the risk management practices in Nigerian banks.

5

1.3 Purpose of the Study

The general objective of the study is to assess the extent to which Nigerian Banks have

implemented Basel Capital Accord as part of their risk management processes and practices.

More specifically, the study is an attempt to:

i. identify major areas of risks that Nigerian banks are exposed to;

ii. identify major aspects of Basel II Accord;

iii. assess the impacts of Basel II implementation on the risk management processes in

Nigerian banks;

iv. identify the challenges facing the implementation of Basel II norms by Nigerian banks;

v. assess the impact of Basel II Accord on capital measurement, management and

allocation in Nigerian banks.

1.4 Research Questions

In order to address the areas of concerns on Basel II implementation by Nigerian banks, the

study seeks to answer the following questions:

i. What are the categories of deposit money banks in Nigeria?

ii. What are the areas of risk confronting Nigerian banks?

iii. What are the areas of risk management practices in Nigerian banking industry?

iv. What are the key areas of Basel II Accord?

v. How does Basel II implementation influence risk management practices in Nigerian

banks?

vi. What are the key aspects of Basel II implementation?

6

vii. What are the challenges faced by Nigerian banks in implementing Basel Capital

Accord?

viii. What is the impact of Basel II implementation on Banks‟ capital measurement?

ix. How are Nigerian banks responding to the possible impact of Basel II

implementation?

x. What are the roles of external ratings agencies in Basel II Accord implementation?

1.5 Research Hypotheses

The need to validate the observations noted on the challenges and impact of Basel II

implementation in Nigeria is imperative. In view of this, the study seeks to test the following

hypotheses:

i. Pre-Basel II Capital adequacy ratio is not significantly different from Basel II

Capital ratio.

ii. Implementing Basel II Accord does not pose challenge to the Nigerian banks.

iii. There is no significant difference in the level of progress made by Nigerian banks in

Basel II implementation.

iv. Basel II Accord will not improve risk management practices in Nigerian banks.

1.6 Significance of the Study

The study evaluates the extent to which Basel II affects the risk management practices in

Nigerian banks, and level of milestones that the banks have achieved in implementing Basel II

norms. Theories typically suggest that banking institutions‟ risk portfolios and capital are often

7

interrelated. According to the Reserve Bank of India (2008), a sound risk management is the

basis for an effective assessment of the adequacy a bank‟s capital. This research work is

motivated by the desire to better appreciate the impact of Basel Capital Accord on risk

management practices in Nigerian banks. The study would be of huge relevance as it

addressed the key challenges faced by Nigerian banks in Basel implementation, and how those

challenges were dealt with.

The findings from this research work, we hope, would provide basis for policy measures

aimed at softening the Basel II implementation for industry operators, and ultimately achieving

robust risk management practices that could ensure the safety of the Nigerian banking system.

More importantly, the study became more imperative in view of the dearth amount of

professional discourse and academic writings on Basel Capital Accord in Nigeria.

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CHAPTER TWO

LITERATURE REVIEW

2.1 Introduction

In this chapter, effort was made to review various literatures, regulatory circulars and

guidelines on risk management processes and transition to Basel II; the benefits, impacts and

the challenges of Basel II implementation for the Nigerian Banks‟ risk management practices.

The Literature Review was considered in three key categories, viz: First, the study surveys

general issues in risk management processes and practices, and second, it chronicles the

theoretical background of Basel Accord, with particular emphasis on Pillar 1 of Basel II.

Finally, the study considered the peculiarities of Basel II implementation in the Nigerian

banking sector; progress recorded so far; impacts and challenges of implementation amongst

other issues.

2.2 Review of Related Studies

Risk and uncertainties are parts and parcel of business dynamics and the outcomes of most

business decisions are never certain (ACE and KPMG 2010). Moghalu (2012) in his view

noted that “the local consequences of events on a global scale, such as terrorism, pandemics

and financial market volatilities, are mostly unpredictable, and such events may also include

valuable opportunities such as sudden changes in social trends and consumer tastes”.

According to Hopkin (2010), the concept of risk derives from this unpredictability, and so

there is need for a process of identifying, measuring and managing risks. According to

9

Moghalu (2012), such process is required to ensure that an organization achieve its strategic

objectives and attain corporate sustainability.

BCSB (2010a) noted that the fluidity of the banking environment in the modern age, as

evidenced by the recent world financial crisis, has continued to put the risk management

processes in banking institutions to test. ACE and KPMG (2010) stated that more than ever

before, perhaps as a fall out of the crisis, the financial regulators across the globe are

tightening the noose of banking regulations. According to Reserve Bank of India (2008), the

lesson of the recent financial crises was that no country wished to bail out financial

“recklessness” of the so-called „too-big-to-fail‟ banks with tax-payers‟ money any more. RBI

(2008) noted that the new rule is straight-forward: To stay in business today, banking

institutions are now required to be adequately capitalized to bail out their possible future

failure. BCBS (2010a) stated that with the emerging banking regulations, banks are required to

strengthen their risk management processes to prevent banking failure, or where such failure

does eventually happen, mitigate its impact on the financial system.

According to Rodríguez (2002) and RBI (2008), risk is the potential that expected and

unexpected events may have an adverse impact on a bank‟s capital or its earnings, and the

expected loss is usually passed to the borrower through adequate loan product pricing, and

through reserves created out of the earnings. Such loss, Moghalu (2012) noted, is mostly due

to default risk and counterparty risk. The authors whereas averred that the unexpected loss

arising from the whole loan portfolios would be entirely borne by the bank itself. According to

BCSB (2006) therefore, the expected losses are covered by reserves and provisions, while the

unexpected losses require adequate capital base for coverage.

10

Dionne (2013) noted that a pure risk is a combination of the probability or frequency of an

event and its consequences, which is usually negative. The author also averred that uncertainty

on the other hand is less precise because the probability of an uncertain event is often

unknown, as is its consequence.

According to Crockford (1982), Harrington and Niehaus (2003) and Williams and Heins

(1995), the study of risk management dated back to 1955-1964, after the Word War II. Dionne

(2013) stated that the issue of risk management in the financial services sector was

revolutionized in the 1970s, when financial risk management became an issue of concern for

many banks, insurance companies, and other non-financial enterprises exposed to various

market rates volatilities such as risks related to interest rates, stock market returns, exchange

rates, and the prices of raw materials or commodities.

Risk management, according to Hopkin (2010), provides a framework for organizations to

deal with and to react to uncertainty and the modern practice of risk management is a

systematic and comprehensive approach, drawing on transferable tools and techniques. These

basic principles according to Moghalu (2012), are sector-independent and should improve

business resilience, increase predictability and contribute to improved returns. Doerig (2001)

noted that there is growing pressure to avoid things going wrong while continuing to improve

corporate performance in the new environment, and thus there is need for an uptight risk

management process. Harrington and Niehaus (2003) and Dionne (2013) in their view

however stated that an integrated risk management approach must evaluate, control, and

monitor all risks and their dependences to which the company is exposed.

11

The key functions of banking business, according to Moghalu (2012), are financial

intermediation, asset transformation and money creation, and these underscore the relevance of

banking institutions to the financial stability of any economy. Omosebi (2012) noted that,

given the nature of their business, banks are generally exposed to various risks in pursuit of

their objectives. BCBS (2006) identified the basic ones among these risk categories as credit

risk, market risk, and operational risks. Failure to properly handle these risks could expose

banks not losses that may threaten their survival and sustainability as business entities thereby

endangering the stability of the financial system (CBN, 2007; Suares-Rojaz, 2001; RBI, 2008).

CBN (2007) noted that in view of the critical role of risk management in enforcing

sustainability and resilience in banking practice and regulation, the need to issue the guidelines

for developing framework for the management of risk elements in banks, became imperative.

In the said guidelines, the CBN identified key risk types facing a bank as comprising credit

risk, market risk, operational risk, reputational risk, strategic risk, and compliance risk.

Based on Basel II Accord, CBN (2012) stated that credit risk arises when there is possibility

that an obligor (borrower or counterparty) in respect of a particular asset will default in full or

in part on the obligation to a bank in relation to the asset. Patil (2010) in other words, noted

that credit risk is the risk of loss arising from counter party or customer‟s inability or

unwillingness to meet obligations in relation to lending, trading, hedging, settlement and other

financial transactions.

BCSB (2006) observed that market risk is a risk of loss caused by changes in the key market

variables such as foreign exchange rate, interest rate, commodity price and equity price.

12

According to CBN (2012), market risk can further be categorized into interest rate risk, foreign

exchange risk, commodity price risk and equity price risk. BCSB (2006) further noted that

market risk includes the degree of volatility of market prices of bonds, securities, equities,

commodities, foreign exchange rate which will change daily profit and loss over time.

Basel Committee (2006) contended that operational risk is an important phenomenon that

impacts heavily on banking business, and this is risk of loss resulting from inadequate or failed

internal process, people and systems or from external events. According to BCBS (2006),

operational risk includes the risk of loss arising from fraud, system failures, trading error and

many other internal organizational risks as well as risk due to external events such as fire,

flood, wars, and pandemic. The losses arising from operational risk can be direct as well as

indirect, and this depend whether such loss results directly from an incident or it arises from

impact of an incident, (BCBS, 2003). Doerig (2001) in his view however noted that

operational risks are primarily institutional, bank-specific, internal, context dependent,

incredibly multifaceted, often judgemental, interdependent, and often not clearly discernible.

In specifics, Abkowitz (2008) identified failure to follow procedures, deferred maintenance,

design flaws, construction flaws, schedule constraints, inadequate training, and poor planning

as some of the events of operational risk failure. Managing operational risk is therefore very

imperative, and this is not so much about capital and models but about providing diligent and

adequate supports for the survival and stability of a firm (Doerig, 2001).

Ekpo (2013) observed that strategic risk is another notable risk that banks have to contend with

and such risk is the possibility of incurring loss on account of poor strategic business

13

decisions. The author noted that this risk is usually associated with poor implementation of

business plans and strategies. Omosebi (2012) on her part identified legal risk as another

prominent risk that bank face, and such risk relates to situations where an institution may not

be able to enforce its contract terms against counterparty. In this context, legal risk is the

possible risk of loss due to the unenforceable contract which forms the basis of banking

transactions (Ekpo, 2013).

According to Greg (2013), banks in the 21st century are hugely exposed to reputational risk

which according to Ekpo (2013), relates to potential loss due to damage or erosion of

goodwill as a result of failed risk management; weak corporate governance practices;

environmental, social and ethical performance; poor customer relationship management

practices; non-compliance with regulatory and statutory requirements. And lastly there is

compliance risk which Odutola (2013) noted to be the risk of loss in earnings or capital arising

from non-adherence to the prescribed practices, laws, regulations, or ethical standards, and

such loss could come in form of huge fines and penalties, or loss of regulatory privileges.

For a bank to maintain sound risk management practices, Odutola (2013) had a belief that such

bank must adhere to effective balancing of risk and reward by aligning business strategy with

risk appetite, pricing for risk appropriately, diversifying risk and mitigating risk through

preventive and detective controls. According to Ernst & Young (2012), banks‟ business

segments and process owners ought to take responsibility for active management of their risks,

with direction and oversight provided by the relevant Committee of the Board through the

Management and other functional departments and also carry out rigorous assessment of risks

in relationships, products, transactions and other business activities.

14

Odutola (2013) further noted that such banks must avoid activities that are not consistent with

its values, code of conduct or policies, as one of the ways of managing reputational risk.

Banks, The author averred that banks need to establish clear market segmentation into retail

banking, corporate banking, mortgage banking, investment banking etc. in order to mitigate

risks, by knowing their clients and ensuring that they provide suitable services.

CBN (2010) and Hopkin (2010) identified certain key elements of an effective risk

management process that a bank ought to implement and such elements include a risk

management structure which covers the oversight role of the Board and senior management;

processes, procedures and systems for risk identification, measurement, monitoring and

control, and risk management framework review mechanism.

According to RBI (2008), capital and risk management generally interest regulators and some

other stakeholders such as employees, depositors, bank shareholders, and other competing

lenders. This is more so as Bank‟s assets, funded by capital and deposits follow a geometric

Brownian motion characterized by a volatility level (Elizalde 2007).

According to Ashraf and Arner (2012), the Basel Committee on Banking Supervision (BCBS)

was established by the central-bank Governors of the Group of Ten countries in 1974 to serve

as global forum for regular cooperation on banking supervisory matters. The objective of the

committee is to enhance understanding of key regulatory challenges and improve the quality of

banking supervision across the globe (BIS, 2014). Dierick et al, (2005) stated that the

Committee in 1988 introduced a capital measurement process commonly referred to as the

15

Basel Capital Accord and this system provided for the implementation of a credit risk

measurement framework with a minimum capital standard of 8% by 1992.

Since 1988, this framework has been progressively introduced not only in member countries

but also in almost all other countries that have internationally active banks (Patil, 2010).

According to Aboyarin (2012), Basel I framework was initially introduced into G-10 member

countries, currently comprising Belgium, Spain, Canada, France, Germany, Japan,

Luxembourg, Netherlands, Sweden, Switzerland, Italy, United Kingdom and the United States

of America. The author further noted that most other countries, over 100 of them, have also

adopted, at least in name, some of the principles prescribed under Basel I.

According to Elizalde (2007), Basel I Accord seemed to provide a level playing field by

stipulating the amount of capital that internationally active banks need to maintain in order

ensure that the international banking system was sound and safe. Essentially, the point of

emphasis for Basel I was credit risk as it only made periphery mention of market risk; while

operational risk enjoyed no attention at all (Patil, 2010). Although Basel I was praised for

achieving its initial objectives, it has been seriously criticized for the low risk sensitiveness of

its capital requirements which may provoke further risk taking and regulatory capital arbitrage

practices by banks (BCBS, 1999, and Jones, 2000).

In Nigerian case, Aboyarin (2012) stated that the Central Bank of Nigeria in 1990 issued a

circular respect of capital adequacy computation based on the Basel I framework. According

to the author, the CBN directed the Nigerian banks to maintain a minimum of 7.25% of risk-

16

weighted assets as capital and to maintain a minimum of 8% Capital Adequacy Ratio with

effect from January, 1992.

According to Malloy (2004), the Basel Committee in 1999 issued a proposal to revise Capital

Adequacy Framework which consisted of three pillars: minimum capital requirements, which

seeks to refine the capital rules set provided for in Basel I; supervisory review of an bank‟s

risk assessment process and capital adequacy; and use of disclosures to enforce market

discipline. Patil (2010) noted that on the 26th

of June, 2004, the committee issued the final

form of the Basel II Accord after six years of continuous efforts with different stakeholders of

the banking system and central banks all over the world, to update the proposal of the accord.

According to Dierick et al, (2005), there were more than one draft of Basel II issued in 1999,

2001 and 2004 until the final form of the accord was issued under the title, “International

Convergence of Capital Measurement and Capital Standards: A revised framework”.

The Basel II Accord, according to RBI (2008), was issued principally to target the issue of the

minimum capital requirements that have to be kept aside for banks to be able to face any

economic stress, and for protecting the international financial system from financial crises that

could lead to the collapse of banks. The accord also seeks to strengthen the risk management

practices in banking institutions and provide mechanisms for capital allocation and

management (BCBS, 2006).

Basel Committee(2001) identified some objectives of Basel II as including, promoting the

safety and soundness of the financial system; aligning economic and regulatory capital closely

as much as possible; enhancing competitive equality; enhancing transparency issues

17

concerning providing customers with needed information about risks that their banks face;

creating capital adequacy assessments; focusing on internationally active banks while

following the principles to be flexible enough to have applications to a number of banking

operations, and finally encouraging continuous improvement in a bank's internal risk

assessment capabilities.

According to BCBS (2006), the Basel II framework is based on three mutually reinforcing

pillars put together to allow banks and monetary authorities to evaluate properly the various

risks that banks face and align regulatory capital more closely with underlying risk portfolios.

BCBS (2006) and CBN (2012) identified the three key pillars as Pillar I: Minimum Capital

Requirements; Pillar II: Supervisory Review Process, and Pillar III: Market Discipline.

RBI (2008) noted that the Basel II framework as detailed in BCBS (2006) seeks to strengthen

the link between capital requirements and organisational complexities of banks, exploiting

synergies in the management of those banks and in supervisory assessments and actions.

Banks‟ governing bodies, according to Odutola (2013) play a key role in risk management and

control. Nigerian banks are required by CBN (2010), inter alia, to develop risk management

strategies and policies; verify their continuing effectiveness and efficiency; outline the duties

and roles of the various departmental functions and units and, more generally, ensure that all

the risks to which they could be exposed to, are adequately covered.

According to BCBS (2006), the first pillar of Basel II sets out minimum capital requirement

for banks and the framework maintains minimum capital requirement of 8% of risk assets, and

it seeks to ensure that banks hold an amount of capital that is consistent with level of risk they

18

take. In computing capital adequacy ratio, BCBS (2006) noted that due regard has to be given

to credit risk, market risk and operational risk. In other words, economic capital charges ought

to be computed for these three classes of risk as part of the overall risk-weighted assets (RBI,

2008).

Supervisory review process which is the fulcrum of second pillar, according to Acharya

(2003), has been introduced to ensure that banks have adequate capital to support all their risk

exposures and also develop and use better risk management methodologies and techniques in

measuring, managing and monitoring their risk exposures. In other words, the supervisory

review process is key to ensuring that all risks are identified and appropriate regulatory actions

are taken in a timely manner as well as ensuring that banks and banking groups have adequate

internal capital management plans (CBN 2012; RBI 2008; BCBS 2006).

The second pillar, according to BCBS (2006) and CBN (2013), has four key principles viz:

banks should have a process for assessing their overall capital adequacy in relation to their risk

profile and a strategy for monitoring their capital levels; monetary authorities should review

and evaluate banks‟ internal capital adequacy assessments and strategies, as well as their

ability to monitor and ensure their compliance with regulatory capital ratios; monetary

authorities should expect banks to operate above the minimum regulatory capital adequacy

ratios and should have the ability to require banks to hold capital in excess of the minimum,

and finally supervisors should make effort to intervene at an early stage to prevent a bank‟s

capital from going below minimum level and should seek immediate remedial action if

shortfall is about to happen.

19

The third pillar of the Basel II captures the disclosure requirements concerning capital

adequacy, risk exposure and the features and nature of the risk management and control

processes and systems in banking institutions so as to enable key stakeholders make informed

decisions (RBI 2008, CBN 2013). According to Dierick et al. (2005), market discipline

compels banks to carry out their business in a safer, sounder and more effective manner, and it

is designed to be effected through a series of disclosure requirements on capital, risk exposure,

risk limits and capacity, so that important stakeholders could assess a bank‟s capital adequacy,

risk appetite, risk capacity and exposures. The CBN (2013) required that these risk disclosures

be made at least semi-annually and more frequently if appropriate. According to BCBS (2004),

qualitative disclosures such as risk management objectives and policies, definitions etc. have

to be published annually.

According to Elizalde (2007), there are a lot of gaps in Basel I which necessitated the need for

Basel II, and Dierick et al. (2005) identified some areas of comparison between the two Basel

regulations. Basel I rules offer a simplified and rigid quantification of credit risk, while Basel

II significantly refines the framework‟s risk sensitivity by requiring higher levels of capital for

high-risk borrowers (RBI, 2008). By relating capital more closely to a bank‟s own risk

exposure, Basel II better narrows the gap between regulatory capital and economic capital than

Basel I (Dierick et al, 2005). According to Elizalde (2007), one important drawback of the

Basel I stems from its unintended incentives for capital arbitrage through techniques such as

securitisation, a challenge that Basel II has taken care.

In addition, Rojas-Suarez (2001) contended that Basel I lacks rules for proper market

disclosure and therefore does not support market discipline, and that this is in comparison to

20

Basel II which according to Dierick et al, (2005), has a framework dedicated to Market

Discipline. The author further noted that Basel I regulations offer no guidance for the

supervisory review of banks‟ risk management practices, compared to Basel II which has a

dedicated framework on supervisory review. RBI (2008) however noted that similar to what

applies under Basel I, off-balance sheet exposures are for capital purposes transformed into

assets through the application of credit conversion factors. The main changes compared to

Basel I relate to the use of external credit ratings as the basis for determining the risk weights

and the greater differentiation in the possible risk weights (Frank et al, 2005).

According to Dierick et al. (2005) and Elizalde (2007)there is now a considerable

differentiation in the risk weights applicable under Basel II and the weight for investment-

grade firms has declined considerably (e.g. to 20 % for AAA), whereas in the non-investment

grade segment, a risk weight of 150% applies to firms rated below “BB-”. Under Basel II,

unrated firms now obtain the same risk weight as that formerly obtained by all corporates

under Basel I and finally, for claims on banks, the former distinction between institutions from

OECD (20% risk weight) and non-OECD countries (100%) is no longer applicable under

Basel II (Dierick et al, 2005).

BCBS (2004) reckoned that banking regulators might want to consider certain factors when

determining the population of banks to which Basel II should apply and such factors include,

size of the bank (e.g., share of balancesheet size in the banking system); nature and complexity

of its operations; involvement in significant activities or business lines, such as settlement and

clearing activities, or possession of a sizeable retail base); international presence (e.g.,

proportion of assets held in/income from overseas offices); interaction with international

21

markets; bank's risk profile and risk management capabilities, and other supervisory

considerations, such as resources which will be available for initial validation and ongoing

monitoring, and the trade-off between the additional complexity of implementing and

validating these approaches vis-à-vis the increased sensitivity of the resulting capital

requirements.

Basel II Accord provided by BCBS (2006) provides spectrum of approaches for the

measurement of credit, market and operational risks to determine the capital required by a

bank. The spread and nature of the ownership structure of any bank plays key role in

determining the ease with which the bank could raise capital as may be required by the

regulator (Patil, 2010). While getting support from a large body of shareholders is a difficult

proposition when the bank‟s performance is poor, a smaller shareholder base constrains the

ability of the bank to garner funds (RBI, 2008).

Tier I capital is available to cover possible unexpected losses, as it is not owed to anyone and

more importantly it has no maturity or repayment requirement, and therefore, it is expected to

remain permanent as core capital of the bank (RBI, 2008). While Basel II currently requires

banks to have a capital adequacy ratio of 8% with Tier I ratio not less than 4%, the CBN

(2013) has mandated 15% capital adequacy ratio for internationally active Nigerian banks, and

10% for those with National license. Ogere et al (2013) stated that the maintenance of capital

adequacy ratio is like aiming at a moving target as the composition of risk-weighted assets gets

changed every time on account of fluctuations in the risk profile and exposure of a bank. Tier I

capital provides permanent and readily available support to the bank to meet the unexpected

losses (RBI, 2008).

22

According to Aboyarin (2012), the CBN in the recent past, had had to rescue some Nigerian

banks with over N600 billions in bail out with taxpayers‟ money and in doing so, Sharad et al

(2014) noted, the government was not acting as a prudent investor as return on such capital

was never a consideration. Beyond this, the CBN at a later date established a bad loan bank

called, Asset Management Company of Nigeria (AMCON) to acquire some of the rescued

banks on the verge of collapse. All this regulatory engineering came at a cost to the

government, and hence, the need for banks to hold enough capital for their own rescue in the

event of unexpected losses (Aboyarin 2012; Moghalu 2012).

According to Patil (2010), capital adequacy provides an economic measure of long-term

survival and soundness of banks, and the aggregate risk exposure of banks is usually estimated

using Risk-Adjusted Return on Capital (RAROC) and Earnings-at-Risk (EaR) techniques. The

author noted that RAROC method is used often by internationally active banks and the

RAROC process is used to estimate the cost of Economic Capital & the expected losses that

might arise in the worst-case scenario and then generate the capital cushion to be provided for

any potential loss. Elizalde (2007) averred that RAROC is the first step towards examining the

institution‟s entire balance sheet on a mark-to-market basis, at least, to understand the risk-

return trade-off that the bank has made.

As banks carry on the business on a wide area network basis, it is critical that they are able to

continuously monitor the exposures across spectrum of their products and processes, and

aggregate the risks so that an integrated view can be taken (Abkowitz, 2008). The Economic

Capital is the amount of the capital (besides the Regulatory Capital) that the firm has to put at

23

risk so as to cover the potential loss under the extreme market conditions (Siddiqi, 2013). This

is the difference in mark-to-market value of assets over liabilities that the bank should aim at

or target. As against this, the regulatory capital is the actual Capital Funds held by the bank

against the Risk Weighted Assets (BCBS, 2010b). After measuring the economic capital for

the bank as a whole, bank‟s actual capital has to be allocated to individual business units on

the basis of various types of risks (BCBS, 2010b).

NAIC (2014) did a comprehensive work on risk-based capital which it defines as a method of

assessing the minimum capital that is appropriate for a bank to support its overall business

operations taking account of its size and risk profile. According to Miller (2014), the adoption

of risk-based capital as a regulatory measure for financial institutions, is a consequence of

Basel II and Solvency II regulations. Miller (2014) clearly noted that regulatory capital rules

over the years have progressed from prescriptive (rule-based) to proscriptive (principles-

based) methodologies, such that banks are now required to hold capital that is consistent with

their risk profile.

Aboyarin (2013) and Miller (2014) however noted implementing risk-based capital does not

relieve monetary authorities of their supervisory oversight role. CBN (2013e) stated the

Central the banking regulator in Nigeria presently has its supervisory mechanism by way of

on-site examination and off-site monitoring on the basis of the audited balance sheet of a bank.

In order to facilitate the supervisory mechanism, the CBN (2013) has decided to put in place, a

risk-based supervision process. Under risk based supervision, monetary authorities are

expected to direct their efforts towards ensuring that banking institutions use the risk-based

capital measurement process to identify, measure and control risk exposure (BCBS, 2010). In

24

view of this change in capital measurement, the CBN is expected to focus supervisory

attention on banks based on their individual risk profile (Odutola, 2013).

According to Akinyooye (2006) and Patil (2010), the transaction based audit and supervision

is being replace with risk focused audit, and risk based supervision approach is an attempt to

overcome the deficiencies in the traditional transaction-validation and value based supervisory

system. Risk-based supervision is forward looking and proactive, as it enables the supervisors

to distinguish between banks, and to focus greater attention on those within high risk category.

According to the authors, the implementation of risk based supervision implies that greater

amount of reliance is placed on the internal auditor‟s role for mitigating risks. By focusing on

a sound risk management process, the internal auditor would offer remedial actions for

trouble-prone areas and also anticipate problems to play an appropriate role in protecting the

bank from risk hazards (Odutola, 2013).

Before the eventual release of Basel II Accord, Rojaz-Suarez (2001) had noted that the crux of

the debates among the banks and regulators was on what constitute regulatory capital, equity

only or equity plus subordinated debt. According to the author, there was also argument on

who should set the capital standards, the regulators or the markets, and whether external rating

or internal rating be used for credit assessment.

CBN‟s Guidance Notes on Regulatory Capital (2013a) establishes the procedures for

determining regulatory capital, and this is computed as the sum of Tier 1 Capital and 33.33%

of Tier 2 Capital. According to the guideline, Tier 1 Capital (Core Capital) comprises of

paid‐up share capital, perpetual non-cumulative preference shares, share premiums, retained

25

profit, general reserves, SMEEIS reserves, regulatory risk reserves and statutory reserves. The

author further stated that deductions have to be made for goodwill and increase in equity

capital resulting from a securitization; investment in own shares; losses carried forward and

losses for the current financial year; intangible assets.

Meanwhile, CBN (2013a) noted that Tier 2 Capital comprises revaluation reserves, general

provisions, hybrid (debt-equity) capital instruments, subordinated debt etc. and that certain

items are to be deducted 50% from Tier 1 and 50% from Tier 2 capital. Such items include

investments in unconsolidated banking and financial subsidiaries; investments in the capital of

other banks and financial institutions and significant minority investments in other financial

entities (CBN, 2013a).

CBN (August, 2014) has excluded the Regulatory Risk Reserve (RRR) from regulatory capital

of Nigerian banks for the purposes of capital adequacy measurement. The regulator also stated

that Collective Impairment on loans and receivables and other financial assets would no longer

form part of Tier 2 capital, and that the Other Comprehensive Income (OCI) reserves would be

recognized as part of Tier 2 capital subject to the limits set in paragraph 3.2 of the Guidance

Notes on the Calculation of Regulatory Capital earlier referred to.

In computing capital requirement for credit risk under the Basel II Accord, BCBS (2006)

makes provision for three different approaches such as Standardized Approach, Foundation

Internal Rating Based Approach and Advanced Internal Rating Based Approach.

With Standardized Approach, BCBS (2006) as well as the CBN (2013b) provided a simple

methodology for risk assessment and calculating capital requirements for credit risk.

26

Specifically, CBN (December, 2013) directed Nigerian banks and discount houses to use this

approach for credit risk. CBN (2013b) provided that under this approach, at least 10 classes of

assets can be identified viz: Exposures to Sovereigns; Exposures to Public Sector Entities;

Exposures to States & LGA; Exposures to foreign Development Banks; Exposures to Banks;

Corporate Exposures; Retail Exposures; Residential Mortgages; Commercial Mortgages;

Other Assets. According to CBN (December, 2013), Nigerian banks are to use Standardized

Approach to compute capital requirement for credit risk for the next 2 years.

CBN (2013b) discussed the standardized approach under a number of areas, such as

assignment of risk weights, which means all the exposures of a bank are first classified into

various asset or customer types as defined in BCBS (2006). Thereafter, for the purpose of

calculating risk weighted assets, standard risk weights are assigned to all assets either on the

basis of customer type or on basis of the asset quality as determined by rating of the asset.

(CBN, 2013b).

Another important area is external credit assessments, which according to CBN (2013b) means

that the risk rating has to be done by External Credit Assessment Institutions. RBI (2008)

noted that better rating means better quality of assets and lesser risk weights and thus lower

capital requirement. CBN (2013b) provided risk weights for other categories of exposures that

are not subject to external ratings. According to the author, banks that intend to use credit

assessments from ECAIs are to furnish the CBN with a list of ECAIs of their choice; banks are

not allowed to use credit assessments issued by connected ECAIs; credit assessments are to be

used consistently and banks that decide to use credit quality assessments from an ECAI for a

certain class of exposures must use them for all the exposures belonging to that class; banks

27

are to use only credit quality assessments of ECAIs that consider total exposure (both principal

and interest) in their assessment; and finally external ratings for an entity within a group

cannot be used to risk weight other companies within the same group.

According to Dierick (2005) and CBN (2013b), Basel II rules recognize collaterals and

guarantees as two key securities that banking institutions use to hedge against credit risk

associated with loans and advances, and these are often termed “Credit Risk Mitigants”. CBN

(2013b) provided certain weights for all varying classes of assets on a bank‟s balancesheet for

the purpose of computing risk-weighted assets and these weights depend on the risk potentials

of the issuers of underlying instruments. According to Patil (2010), Elizalde (2007) and

Dierick (2005), when computing risk-weighted assets, on‐balance sheet exposures ought to be

multiplied by the appropriate risk weight, while off-balance sheet exposures are multiplied by

using the appropriate credit conversion factor (CCF) before applying the respective risk

weights. CBN (2013b) however stated that all exposures that are subject to the standardized

approach should be risk‐weighted net of individual and collective impairments.

BCBS (2006) provided for Advanced Approaches for calculating capital requirement for credit

risk and these approaches rely heavily on a bank‟s internal assessment of its borrowers and

exposures. These advanced approaches according to Dierick (2005) are based on the internal

ratings of the bank and are usually called Internal Rating Based (IRB) approaches.

However, the use of the IRB approaches, BCBS (2006) noted, is subject to an explicit

supervisory approval, which depends on meeting certain minimum requirements from the

onset and on an ongoing basis. These requirements are aimed at the IRB system providing an

28

adequate assessment of the bank‟s exposures, a meaningful differentiation of risk and a

reasonably good estimate of risk (Dierick et al, 2005).

Dierick et al. (2005) noted that under the IRB approaches, the computation of required

minimum capital depends on the probability distribution of losses arising from default risk in a

portfolio of financial instruments or loans, and that the time horizon of the risk assessment is

most often pegged at one year. The author further averred that the IRB model assumes a

99.9% confidence level suggests that once in a thousand years, the actual loss would exceed

the model‟s result estimate.

According to Tetteh (2012), the calculation of capital requirements for a loan‟s default risk

under these advanced approaches requires four major input parameters to the supervisory risk

weight variables which are loss given default (LGD); probability of default (PD); exposure at

default (EAD) and effective maturity of the loan (M).

Baixauli and Alvarez (2009) define Probability of Default (PD) as the estimate of the

likelihood of the borrower defaulting on its obligations within a given horizon. PD is

computed for each of the loan customers (e.g for wholesale banking) or for a portfolio of

clients with similar attributes (e.g. for retail banking).

The LGD however is defined as the loss incurred in the event of default and it is equal to one

minus the recovery rate at default (Baixauli and Alvarez, 2009). Tetteh (2012) noted that

Moody's LGD assessments are opinions about expected loss given default on fixed income

obligations expressed as a percent of principal and accrued interest at the point of resolving the

default. The author however stated that LGD assessments are assigned to individual loans. The

29

bank-wide LGD rate is a weighted average of the expected LGD rates on its individual

liabilities, where the weights equal each obligation's expected share of the total liabilities at

default (Cantor et al., 2006).

Meanwhile according to Baixauli and Alvarez (2009), the total loan value that a bank is

exposed to at the time of default or the outstanding balance of the borrower‟s debt is what is

termed as Exposure at Default (EAD). Every loan asset that a bank has is given an EAD value

and it is identified within the bank's internal credit system (Tetteh, 2012). Using the internal

ratings board (IRB) approaches, banking institutions will often use their own risk management

default models to calculate their respective EAD systems (Dierick et al, 2005).

When using IRB Approaches, the banks can consider two possible options such as Foundation

Internal Rating Based (FIRB) Approach and Advanced Internal Rating Based (AIRB)

Approach, and the two approaches have some key areas of difference (Dierick et al, 2005).

Both the author and Patil (2010) identified some comparisons between the two approaches

such as the fact that probability of default under the two approaches is provided based on

banks‟ own estimates. The authors further stated that under the Foundation IRB, LGD

constitute the supervisory values set by the Basel Committee, while under Advanced IRB,

LGD is based on banks‟ own estimates. In addition, the authors noted that under FIRBA,

exposure at default and effective maturity are based on supervisory values set by the Basel

Committee, while under AIRBA, they are based on banks‟ own estimates.

CBN (2013c) directed that, under the Pillar 1 of Basel II, the banks and banking groups in

Nigeria were to comply on an ongoing basis with capital requirements for risks generated by

30

operations in markets for financial instruments, foreign exchange and commodities. Capital

requirements, according to BCBS (2006) and CBN (2012) may be calculated using a

standardised measurement method or an internal models approach subject to compliance with

organisational and quantitative requirements and prior authorisation by the supervisory

authority which in Nigerian case is the Central Bank of Nigeria.

The Standardized Approach, according to Dierick et al, (2005) allows banks to calculate their

total capital requirement using a building-block approach, under which the total requirement is

obtained by summing the individual capital requirements for equity position risk, interest rate

risk, foreign exchange risk and commodities risk. CBN (December, 2013) directed banks and

discount houses in Nigeria to use the Standard Approach for capital charges on market risk for

the next two years. The author provided full guidance in CBN (2013c) on how the standard

approach is to be adopted in computing capital requirement for market risk.

For the purpose of calculating capital requirements for market risks under this approach, CBN

(2013c) required that market positions be measured at fair value at the close of each business

day. CBN (2013c) noted that in the case of off-balancesheet transactions without a reference

instrument (e.g. forward rate contracts or interest rate swaps), the notional principal amount

would be used, except where one of the present values or sensitivity methods set out under the

treatment of position risk in the supervisory trading book applies. Also, the author pointed out

that for off-balancesheet transactions involving options and warrants, one of the methods set

out under the treatment of options in the relevant Guidance Notes apply. CBN (2013c) further

required that foreign exchange transactions should be converted into naira at the spot exchange

rate at the close of each business day, and un-hedged off-balancesheet transactions other than

31

unsettled spot transactions may be converted into Naira at the current forward exchange rate

for maturities equal to the residual life of the transaction.

Internal models for calculating the market risk capital requirements however, according to

CBN (2012) is based on the daily control of risk exposure, calculated using an approach based

on statistical Value-at-Risk procedures (VaR). In this case, Elizalde (2007) and CBN (2012)

noted that banks have to cover the scope of application of the internal model, both positions in

debt securities and in equity securities. The author stated that the model can be extended in

order to include commodity and foreign exchange risks. For the determination of the capital

requirement against the specific risk on debt securities, McNeil (2008) stated that a model such

as VaR may be used in order to encompass at least the idiosyncratic risk, but it may not fully

account for the qualitative and quantitative standards that are consistent with the IRB

approach. To be able to use this approach, a bank must obtain regulatory approval from the

CBN, after having certain quantitative and qualitative requirements. Currently however,

Nigerian banks are not allowed to use this approach (CBN, 2013c).

According to Dierick (2005), CBN (2012), Sundmacher (2007), Basel II Accord makes

provision for three key approaches for computing capital requirement for operational risk,

which include Basic Indicator Approach (BIA), The Standardized Approach (TSA), and

Advanced Measurement Approach. While the Advanced Measurement Approach relies on a

financial institution‟s internally generated loss data and internally developed measurement and

management methodologies, the first two approaches are often used as directed by regulatory

authorities (Sundmacher, 2007).

32

CBN, (2013d) noted that under the basic indicator approach (BIA), the Nigerian banks are

required to hold capital for operational risk equal to 15% (denoted as alpha) of the average of

Annual Gross Income for three years. The BCBS (2006: 145) defines GI as “… net interest

income plus net non-interest income”. According to Sundmacher (2007), this income figure is

gross of operating expenses, provisions; income from investment, realised profits or losses

from the sale of securities in an institution‟s banking book, and any irregular items. CBN

(2013d) however defined Gross Income as net interest income plus net non-interest income,

excluding realized profit/losses from the sale of securities in the banking book and

extraordinary and irregular items. CBN (2013) directed Nigerian banks to use this approach

for computation of capital requirement for operational risk, and this is to be used for the next

two years.

According to Tarantino (2008), a banking institution that uses the Standardized Approach

(TSA) will usually map its overall annual GI into eight business lines, which are pre-defined

by the Basel Committee. BCBS (2006) divided banks‟ activities into such eight business lines

as retail banking, corporate finance, trading and sales, commercial banking, agency services,

payment and settlement, asset management and retail brokerage. Within each business line,

Tarantino (2008) noted, gross income is considered as a broad indicator for the likely scale of

operational risk, and capital charge for each line of business is computed by multiplying gross

income by a factor (often denoted as beta) assigned to that business line. According to CBN

(2013d) and Sundmacher (2007), total capital charge for operational risk is computed as the

three-year average of the simple summations of the regulatory capital across each line of

business in a year.

33

According to Sundmacher (2007), CBN (2013d) and BCBS (2006), certain betas are assigned

to the 8 business lines as follows: trading and sales (18%); retail banking (12%); corporate

finance (18%); commercial banking (15%); agency services (15%); payment and settlement

(18%); asset management (12%), and finally, retail brokerage (12%). The total capital charge

under TSA may be expressed as follows: KTSA = {∑years1-3 max[∑(GI1-8 * β1-8), 0]}/3 (Where:

KTSA = Capital charge under TSA; GI1‐8 = Annual gross income in a given year for the eight

business lines; β1-8 = The fixed percentages for the 8 business lines).

The advanced measurement approach (AMA) requires banking institutions to develop and

deploy their own methodologies based on internal loss data and risk rating systems

(Sundmacher 2007, Tarantino 2008). Under this approach, CBN (2012) and Patil (2013) noted

that the regulatory capital should be consistent with the risk measures generated by the bank‟s

internal risk measurement process and system using the prescribed quantitative and qualitative

parameters. Dierick et al (2005) stated that with this approach, banks have to take account of

actual internal, external loss data, as well as scenario analyses and factors relating to their

business and control environments.

BCBS (2006) and Tarantino (2008) noted that before this approach can be approved by

monetary authorities in relevant jurisdictions, the model has to achieve certain level of

statistical soundness that is fairly comparable to that of the Internal Rating Based approach,

where capital charges are based upon a one-year time horizon and a 99.9% level of confidence.

Banks that use the AMA, are at least in principle able to mitigate capital charge for operational

34

risk, by improving their operational risk management, for instance by introducing enhanced

controls into the business process (Dierick et al, 2005).

Dierick et al. (2005) contended that there are open methodological questions still remain with

respect to how AMA can be used in a sound and practical manner. Sundmacher (2007) in

particular concluded that it is not possible to apply the AMA to annual report data as the

approach is based on internally-gathered data, validated by external data and are further reliant

on internally-developed measurement methodologies. In general however, Sundmacher (2007)

stated that it is often assumed that banking institutions which move along this spectrum of

approaches benefit from a decreasing capital charge. The author also said that the use of

sophisticated approaches is assumed to bring about a better alignment of actual risks taken by

the institution and the minimum capital the institution is required to hold.

According to Patil (2010), Capital Adequacy Ratio (CAR) is the ratio of regulatory capital to

the total weighted assets and it is a measure of financial stability of a banking institution.

Ogere et al (2013) also stated that Capital adequacy ratio is an important metric for assessing

the safety and soundness of banks and other depository institutions as it serves as a buffer or

cushion for absorbing losses. CAR, according to Kolathunga (2010) and RBI (2008), serves as

a key metric monetary regulators use to measure the long-term solvency and sustainability of a

bank. Under Pillar 1 of Basel II Accord, banking institutions are expected to keep a minimum

capital adequacy ratio of 8% just as it was applicable under Basel I (Dierck et al (2005). CBN

(2013a) however, required minimum of 15% CAR for internationally active Nigerian banks

and banking groups, and 10% for those with National license, considering the Nigerian

economic status.

35

The computation of Capital Adequacy Ratio under Basel I is that Qualified Capital and

Reserves represent the nominator, while total risk weighted assets constitute the denominator

(BCBS (1988). Under Basel II however, CBN (2013a), BCBS (2006) and Dierick et al (2005)

stated that capital adequacy ratio can be computed as sum of Tier 1 capital and Tier 2 capital

(subject to regulatory restriction) as numerator, and sum of credit risk-weighted assets and

12.5 of the sum of the required capital for both operational risk and market risk as

denominator.

According to Sommer and Spielberg (2011), the Pillar 2 of Basel II Accord is structured along

two separate but complementary stages viz: The Internal Capital Adequacy Assessment

Process (ICAAP) and The Supervisory Review and Evaluation Process (SREP). The general

idea of Basel Accord, according to RBI (2008) and CBN (2013e) is that banking institutions

should capital buffers that are consistent with the quantum of risk taken. RBI (2008) noted that

adequacy of capital can never be a substitute for a bank‟s faulty risk management processes.

The ICAAP therefore requires banks to institute adequate corporate governance mechanisms,

an organisational framework with clear lines of responsibility, and effective internal control

systems (CBN, 2013e).

CBN (2013) required Nigerian banks to ensure that they document their ICAAP and subject it

to independent internal review. CBN (2013e) noted that the respective banks‟ boards are

entirely responsible for the ICAAP, and are expected to independently establish the design and

organisation in line with the bank‟s risk appetite. The author further stated that the banks‟

Boards of Directors are responsible for the implementation and annual update of the ICAAP

36

document and the resulting calculation of internal capital in order to ensure it is still in

conformity with the banks‟ operations and environment.

According to Pfetsch et al (2011), an ICAAP addresses such issues as comprehensive

identification of risks; risk appetite and philosophy; sound capital assessment; stress testing;

corporate governance; monitoring and reporting and internal control review. Sommer and

Spielberg (2011) stated an ICAAP report should enable the monetary supervisor to conduct a

complete and documented assessment of the key qualitative features of the capital planning

process, the overall exposure to risks and the consequent calculation of total internal capital.

CBN, (2013e) stated that the ICAAP report is to be transmitted by the Nigerian banks along

with the relevant board resolutions and senior management reports containing their comments

on the ICAAP, in accordance with their respective roles and functions.

Sommer and Spielberg (2011) stated that a country‟s monetary supervisor usually conducts

Supervisory Review and Evaluation Process (SREP) on banks and banking groups on an

annual basis in order to verify that they have established capital and organisational

arrangements that are appropriate for the risks they face and ensures overall operational

equilibrium. According to CBN (2013e), it is the responsibility of the board and senior

management of banks to ensure that their banks maintain capital adequacy, but BCBS (2006)

however noted the supervisor (in this case, the CBN) has the prerogative to take early

interventionist step to prevent a bank‟s capital from dropping below the required level.

In the event that a bank is not able to maintain adequate capital, the CBN may have to take

remedial action to save the financial system (Moghalu, 2012). CBN (2013e) provided such

37

remedial actions as including, altering the risk profile of the bank through business or

operational restrictions; directing banks to raise additional capital; strengthening of the

systems, procedures and processes concerning risk management, control mechanisms and

internal assessment of capital adequacy; prohibition of distribution of profits or other elements

of capital; directing the bank to hold an amount of regulatory capital greater than the legal

minimum for credit risk, counterparty risk, market risk and operational risk; using other

measures as contained in the CBN Supervisory Intervention Framework (SIF) and the BOFIA.

According to Cardiou and Mars (2013), policy makers such as the International Accounting

Standards Board (IASB) and the Basel Committee on Banking Supervision (BCBS) have

made significant efforts to improve market reporting with the introduction of IFRS 7 and Pillar

3 of Basel II respectively. Rodríguez (2002) stated that the third pillar of the three-pronged

approach of the Basel II Accord is market discipline, which according to BCBS (2006) seeks

to deepen disclosures that could enable market participants to adequately assess the capacity

and strength of individual banks. Cardiou and Mars (2013) averred that Pillar 3 has introduced

substantial new public disclosure requirements, which represent a huge increase in the amount

of information that banks make publicly available, on capital structure, capital adequacy, risk

management and risk measurement.

According to CBN (2013f), Pillar 3 requires that Nigerian banks put in place appropriate

internal controls and independent validation process over the generation of financial and risk

disclosures, and to achieve this, Cardiou and Mars (2013) noted that appropriate independent

skilled resources need to be put in place. According to BCBS (2006), banks need to establish

a coherent disclosure and communication strategy around their risk management processes so

38

as to enforce market discipline. For banks to therefore present a clear and credible picture of

their risk profile and capital positions to the financial markets, Hassan et al (2010), Cardiou

and Mars (2013) and CBN (2013f) stated that they need to ensure consistence between their

IFRS risk and capital management disclosures and the corresponding Pillar 3 disclosures.

Considering the consequences and impacts of implementing Basel II Accord, Patil (2010)

noted that change in Capital Risk Weighted Assets Ratio (CRAR) of banks is an immediate

possibility. Basel I focused mainly on credit risk, whereas Basel II considers three key risks

such as credit risk, operational risk and market risks, and as Basel II Accord factor in all these

three risks in determining capital requirements, there is possibility of a decline in the Capital

Adequacy Ratio (Chronican, 2011; Helmreich and Jäger, 2008). Renaissance Capital (2014)

for instance averred that compliance of most Nigerian lenders with Basel II has seen their

capital levels drop by 100-400 basis points to near the regulatory minimum of 15 percent,

further noting that some of the banks would have to actually reduce dividend payments and

loan growth in the year 2014 in order to conserve cash.

FBN Capital (2014) stated that given the possible impact of Basel II on their Capital Adequacy

Ratios, a couple of Nigerian banks, have been making efforts to raise more capital, both Tier 1

and Tier 2. Orija (2014) estimated that some top Nigerian banks might raise as much as N405

billion ($2.5 billion) this year 2014 compared to N342 billion ($2 billion) raised in 2013.

Egwuatu (2014) reported in the Vanguard Newspaper that Nigeria's Access Bank met with

domestic investors recently to gauge interest in a possible rights issue of N60-70 billion naira

($369-$431 million) by the fourth quarter of 2014 to bolster its core capital.

39

According to Afrinvest (2014), the impact of the ongoing Basel II implementation on capital

management and allocation in Nigerian banks might be massive, given the recent policy

introduced by the CBN. According to Proshare (2014b), the CBN vide its circular dated 5th

August 2014 has now excluded the Regulatory Risk Reserve from regulatory capital for the

purpose of assessing the capital adequacy ratio. The author further quoted the CBN as noting

that Collective Impairment on loans and receivables and other financial assets would no longer

form part of Tier 2 capital, and that the Other Comprehensive Income (OCI) Reserves will

now be recognized as part of Tier 2 capital subject to the limits set in paragraph 3.2 of the

Guidance Notes on the Calculation of Regulatory Capital.

Proshare (2014b) noted that according the CBN circular, the total Tier 2 capital (including OCI

Reserves) is now limited to 33.33% of total Tier 1 capital, and that unaudited Other

Comprehensive Income (OCI) gains will no longer be recognized as part of equity while

unaudited OCI losses will be fully deducted from the banks‟ capital in arriving at total

regulatory capital. Afrinvest (2014) stated in view of these new stringent capital rules,

Nigerian banks would now be strategically reviewing their capital management priorities

across geographic and political boundaries, legal entities and business lines. FBN Capital

(2014) corroborated this, contending that in view of the new capital rules, aligning economic

capital with regulatory requirements and reallocating capital based the new risk-weights are

now the key drivers of changes in capital management in Banks.

According to Akinyooye (2006) and Oracle Financial Services (2009), full implementation of

the Basel II framework will require up-grade of the bank-wide IT infrastructure and this would

entail huge budget and may also raise IT-security concerns. Patil (2010) noted that the

40

implementation of Basel II can also raise the need for improved HR skills and a sound

database management. Akinyooye (2006) however noted small and medium sized banks in

Nigeria may lack the financial muscle to acquire required technology, as well as to train staff

in terms of the risk management activities. The author averred that Nigerian banks might

spend heavily in deploying sophisticated risk software, especially as they start implementing

internal models. On the flipside however, local IT companies, with expertise in finance

software, stand to gain a lot if they venture into risk modelling software, as for now huge

amount of foreign exchange would be lost to foreign risk software providers (Patil, 2010).

Akinyooye (2006) and RBI (2008) averred that one of the key impacts of Basel II

implementation is that it will tighten the risk management processes, improve regulatory

capital and ultimately strengthen the global banking system. Patil (2010) and Miller (2014)

noted that Basel II may have discriminant impact on the banking system as higher cost of

capital for smaller banks may queer the pitch in favour of the bigger banks and therefore give

the big players undue advantage in raising capital in the capital markets.

According to Rojas-Suarez (2001), Basel II requires a higher risk weight for project finance

and this will obviously discourage banks from advancing loans for critical real estate and

infrastructural projects. BCBS (2010a) and Acharya (2003) contended that the long-term

impact of this could be disastrous, as it may slow down growth in the real sector of the

economy.

Fischer (2002) stated that in principle, the three-pillar structure of the new Accord will provide

stronger incentives to strengthen domestic supervision and for banks to be more sophisticated

41

in the management of their risk portfolios. The author however noted that the supervisory

agencies in several emerging market and many developing economies are understandably

concerned that Basel II sets a standard that they cannot reasonably hope to meet.

Ernst and Young (2012) stated that Basel II Accord may impact on the risk management

processes of banks in a number of ways, and one such ways is the increase in Board of

Directors oversight on the banks‟ risk profile and culture. The author noted that based on

recent research, the amount of time banks now devote to risk issues may have increased, as did

the range of risk reports provided to the Boards. Ernst and Young (2012) further noted skill

level and experience in banking and risk are some of the criteria banks now should use in their

Board appointments, and that the Boards now appears to focus on such important areas as risk

appetite, liquidity, culture and compensation. The author however stated that Board members

complain of too much undigested material, high expectations from regulators and difficulties

challenging business models.

Ernst and Young (2012) further stated that the breadth and scope of responsibilities of the

Chief Risk Officers in banks appear to have expanded well beyond the traditional focus areas

of credit and market risk, as CROs now appear to be involved throughout the chain of

decisions from new product throughput to strategy formulation and implementation. Miller

(2014) also stated with increasing sophistication in risk management practices in banks, many

of the big banks now have specialized sub-units within their risk management department

manned by specialists.

42

On the comparison between Basel I and II, McNeil (2008) stated that the economic capital

models in place before Basel II implementation often underestimated the size and risk of

certain exposures, particularly across business units. Elizalde (2007) noted that correlations

were far too optimistic and many models ignored important risk types under Basel I, and this

according to Aboyarin (2012) perhaps partly explained why some Nigerian banks failed in

2009. With Basel II framework, there is now much more coverage of business risks and risks

not in VaR, consolidation across groups and conservatism in correlations (Dierick et al, 2005).

Under Basel II Accord, Engelmann and Rauhmeier (2011) stated that increasing the internal

transparency in banks is now a heightened area of focus with stress testing, stress VaR,

counterparty risk and liquidity risk which will enjoys critical attention in years ahead.

Ernst and Young (2012) noted that with Basel II regulations, banks may now be required to

increase their buffers of liquid assets; enhance liquidity stress testing; introducing more

rigorous internal and external pricing structures; elevate the discussion and approval of

liquidity risk appetite and contingency planning to the board level; and give the CRO more

responsibility and involvement in liquidity management.

According to CBN (2013e), stress testing procedures required under Basel II are central to

improving risk governance, and the evolving regulatory environment in Nigeria is expected to

raise bank managements‟ attention towards strengthening internal stress testing strategies and

processes. CBN (2013) required Nigerian banks to carry out Internal Capital Adequacy

Assessment Process on an annual basis as at 31st December, and forward copies of such report

to the CBN for review, not later than 30th

April of the following year. Pfetsch et al (2011)

averred that ICAAP process involves some challenges, the most prominent of which is the

43

sheer amount of time it takes to conduct bottom-up stress testing. Many banks are still

struggling with resource constraint in executing manual process of conducting stress tests and

generating results across their various business portfolios (Ernst & Young 2012; Sommer and

Spielberg, 2011).

Doerig (2003) noted that operational risk which was missing in the Basel I, and is now gaining

huge attention among banks at the twilight of Basel II adoption. This, the author noted, is due

to increasing complexities of operations, systems, people and processes in financial

institutions. Abkowitz (2008) stated that operational risk management is taking centre stage in

recent times in view of the increasing incidence of banking failures attributable to inadequate

business process, people and systems.

According to Patil (2010), Basel II Accord confers a whole lot of benefits to all relevant

stakeholders in the banking system and this includes ensuring better allocation and

management of capital and reduced event of moral hazard effected through measures aimed at

limiting the scope of regulatory arbitrage. By aligning the amount of capital required for each

risk exposure, the Advanced Approaches under Basel II don‟t have to use the simplistic risk

weights applicable under the Basel I capital rules (Acharya, 2003; Dierick, 2005).

RBI (2008) noted that Basel II is a framework that is designed to more accurately align

regulatory capital with risk, and thus leads to improved quality of capital. In reality however,

BIS (2010) noted that this may not necessarily be so, and this is the more reason why Basel III

that emphasises on liquidity is being enforced too. In addition, Rojas-Suarez (2001) averred

that Basel II will ensure improved credit risk management in banks as a result of improved risk

44

rating exercise recommended by the framework. The author noted that one of the principal

objectives of the Basel II is to more closely align capital charges with risk bearing in mind that

as a bank‟s risk exposure increases, either the loss given default (LGD) or the probability of

default (PD) increases.

According to Miller (2014) and Fischer (2002), Basel II will ensure more efficient use of

required bank capital, and increased risk sensitivity and improvements in risk assessment will

enable regulators achieve their prudential objectives more efficiently. Another important point

noted by Patil (2010) is that Basel II recognizes and accommodates continuing innovation in

financial products by focusing on the fundamentals behind risk rather than on static product

categories.

In addition, Basel II according to CBN (2012) is expected to enhance supervisory feedback as

all the three pillars of the Basel II framework aim to engender end-to-end feedback from banks

and banking groups on their risk positions. Proshare (2014a) noted this is what the yearly

filing of ICAAP report by Nigerian banks may help address, as enhanced feedback could

further strengthen the Nigerian banking system.

Another salient point CBN (2012) noted about Basel II is market discipline, which according

to Illing and Pauling (2005), may be achieved through improved disclosure. More specifically,

CBN (2013f) required Nigerian banks to make specific disclosures relating to their risk

measurement and risk management in their annual reports as this would enable the banks key

stakeholders make informed decisions.

45

Fischer (2002), Akinyooye (2006), BCBS (2004), Oracle Financial Services (2009) and Patil

(2010) carried out extensive studies on the challenges of implementing Basel II. According to

Oracle Financial Services (2009), the most major impact of Basel II is lies in the improved risk

management and measurement systems and this seeks to give impetus to the use of internal

rating system by the banks. Akinyooye (2006) and Patil (2010) however noted that

implementing some of these sophisticated systems can be very costly, especially for small and

medium scale banks.

According to Layegue (2013), many banks and even the regulators still face lack of adequate

internal expertise to assess and assist in Basel II implementation, in view of the complexities

inherent in banking regulations and Basel II framework. The author noted that dearth of skilled

personnel is a major impediment for many banks in Nigeria in spite of the considerable efforts

made by them and the CBN to bridge the competence gap.

According to Fischer (2002), Basel II does not create a level playing field, but rather an

uneven one, as bigger banks are more able to implement to sophisticated risk systems than

smaller ones, and thus able to raise more capital. BIS (2010), Miller (2014) and Dierick et al

(2005) noted that increased pro-cyclicality is another important challenge that Basel II

implementation may pose, because increased importance attached to credit ratings under Basel

II could actually imply that the minimum requirements would become pro-cyclical as banks

would naturally be required to raise more capital for loan creation in times of economic

meltdown. Saunders and Wilson (2001) observed some level of sensitivity of business-cycle in

the relationship between bank charter value and capital for risk-taking incentives, and this

shows direct relationship between capital adequacy and economic cycles.

46

Gottschalk (2006) noted that low degree of corporate rating penetration is another key

challenge of Basel II implementation in low-income countries. According to the author, only

internationally active banks, institutional fund managers and foreign investors usually show

interest in corporate ratings, thus making the use of rating less common in developing

economies. Layegue (2013) expressed this same sentiment about Nigeria where he stated that

the activities of external credit rating agencies are still very low, making the use Standardized

Approach recommended by the CBN for credit risk a bit difficult.

Another challenge Layegue (2013) noted about Basel II implementation in Nigeria is that, we

still have asymmetric supervision process, making different market participants are regulated

by separate supervisors. The author averred that the fact only banks in Nigeria are required to

comply with Basel II, and not the other financial services providers might make it difficult to

maintain comparable levels of vigilance and quality of objectives in policy formulation.

Patil (2010) stated that as Basel II is being implemented across the world major economies, the

banks with foreign branches or subsidiaries would likely be required to compute their capital

adequacy ratios in line with the multiple regulatory guidelines as prescribed by the monetary

authorities in all countries where they operate. These jurisdictional guidelines, according to the

author, can differ with respect to implementation timelines and formalities, and compliance

with Basel II regulations, and will understandably impose considerable pressure on the banks.

Oracle Financial Services (2009) however suggested that an integrated data warehouse system

with in-built capacity to support multiple jurisdictional guidelines on Basel II Accord should

help achieve multijurisdictional capital adequacy computations in an efficient manner.

47

According to Layegue (2013) and Akinyooye (2006), data may be a significant challenge for

Nigeria banks because Basel II is a data-intensive framework and Basel II Pillar I requires data

on credit risk, market risk and operational risk at varying levels of granularity. In Oracle

Financial Services (2009)‟s view, these challenges include issues surrounding data availability

and quality, and data collection and storage. To ensure that the issues are properly addressed,

the author suggested that a detailed data-gap analysis study be completed in the initial phases

of the Basel II implementation project. The author averred that when the banks implementing

the framework fail to carry out this initial gap analysis exercise, they may experience time and

cost overruns.

Layegue (2013) stated that prior to the CBN‟s preliminary attempt at bringing Basel II

principles into the consciousness of the banking sector operators in Nigeria, with the

document, “New Regulatory Framework for Prudential Supervision of Nigerian Banking

System”, issued in 2012, a number of internationally active Nigerian banks had expressed their

willingness to implement some advanced risk-based capital methodologies. According to the

author, there had been varying degree of readiness among Nigerian banks, as the common

approach has mainly been that of a phased implementation of Basel II requirements.

Rodríguez (2002) averred that Basel II leaves so much discretion to supervisory authorities on

the areas of the framework to be implemented. In view of this, CBN (2013) itemised the areas

of national discretion concerning Basel II implementation, as shaped by Nigerian sovereignty

and economic policy choices and priorities. The areas of national discretion on Basel II as

noted by CBN (2013) include non-recognition of Tier 3 capital such as short term

48

subordinated debts, as part of the components of regulatory capital; non-recognition of all

exposures to export credit agencies in the computation of capital requirement; exposures to

banks whose maturity is 3 months or less attract 20% risk weight, and the exposures to

securities firms, however credible and solvent such firms are, have a minimum risk weight of

100%. According to Proshare (2014a), the CBN didn‟t accede to Basel II proposition that all

corporate exposures be subject to a blanket risk weight of 100% without regard to external

rating, but it did accede to increase in risk weight for claims secured by residential mortgages,

and that unsolicited ratings may be used.

49

CHAPTER THREE

RESEARCH METHOD

3.1 Introduction

This chapter gives a brief description of the research design adopted; the population

considered as well as discusses the sample and sampling procedures used. It also discusses the

sources of data; the data collection procedures and the type of research instrument used. The

chapter also captures the type of data and data techniques and analysis adopted for the study.

For the purpose of the study, grounded theory was adopted as philosophical basis of the

research methodology. According to Glasser and Strauss (1967), the knowledge that is

acquired from any scientific enquiry is grounded in the data the researcher is able to gather,

and as such, the findings of such research depend largely on the analysis of the results

achieved. Descriptive and qualitative study approaches which involve intensive review of

literature and collection of primary data were adopted. More facts and data were obtained from

journals, banks annual reports, CBN reports and circulars, textbooks; materials sort from

internet, Newspaper articles and seminars papers. The data collected were properly classified,

grouped and summarized for ease of analysis.

3.2 Research Design and Instrument Used

In this study, we gathered both the quantitative data and qualitative from primary and

secondary sources for our analysis.

50

A qualitative approach will typically enable a researcher obtain relevant information from the

sample subjects without colouring their response choices on the issues raised in the research

instrument used. Both questionnaire and interview methods were used in collecting the

required information. Other relevant data were obtained from annual reports, government

briefs, regulatory circulars, Newspapers, Journal materials, as well as various published and

unpublished articles and papers on the subject.

In this study, the Questionnaire Method was adopted in eliciting relevant information from

staff in some of the Nigerian banks, whose work involve risk and control functions. The

questionnaire was divided into eight sections. Section A consisted of the demographic

information about the respondents. Section B consisted of items on institutional information of

banking institutions where the sample subjects work. The section C consisted of items on

awareness about Basel II regulations. The sections D and E consisted of items on risk

organogram and reporting structures in Nigerian banks. The sections F and G contained issues

of compliance and impact of Basel II implementation. Finally, both sections H and I consisted

of issues of Basel II action plan and implementation challenges.

3.3 Population of the Study

The population of the study consisted of all the banks that make up the Nigerian banking

system. The Nigerian banking industry is made up of 21 commercial banks, 36 newly

recapitalized mortgage banks, 1 fully Interest-free bank, 64 finance houses, 2 merchant banks,

and 794 microfinance banks.

3.4 Sample and Sampling Technique

51

The study took a random sample of 15 banks from which sampling units of 60 respondents

who handle risk and control functions, were purposively selected from each of the commercial

banks. What informed the choice of the commercial banks as the sample source was because

the Central Bank of Nigeria appeared to have considered the commercial banks as the centre

focus of Basel II implementation for a start. The study used purposive sampling technique in

drawing the sampling units. The choice of the this technique was motivated by the fact that the

information on Basel II implementation is specific and only those whose job is directly related

to Basel II regulations may be able to give information or opinion that is relevant and reliable.

It was in view of this that the research instrument was administered to respondents whose roles

cut across risk and control functions at the sampled banks.

3.5 Method of Data Collection

The primary data were results from responses to issues raised in the questionnaire

administered to a sample space of purposive but randomly selected respondents. Prior to the

administration of the research instrument, the researcher made personal contact to some of the

respondents to seek their understanding and gain their confidence. The researcher also used

online platform to administer the questionnaire to some banks personnel who could not be

reached physically. For the personnel whom the questionnaires were personally administered,

the researcher made persistent calls and visits to them for the questionnaires to be completed

and recovered.

In view of time constraint, the researcher gave one week time frame for the completion of the

research instrument. A total of 60 questionnaires were administered after which 44 were

recovered. This represented 73.3% percent recovery rate. The secondary data are classified

52

data extracted from annual reports, journals and regulatory reports and circulars and other

relevant publications.

3.6 Method of Data Analysis

Data obtained from copies of the research instrument retrieved were subjected to both

descriptive and inferential analysis techniques with the aid of the SPSS software (version

17.0). Statistics such as percentage analysis, range (R), Mean (M), Standard Deviation (SD)

and cross tabulation were used to explore the characteristics of variables.

Inferential statistics such as Analysis of Variance (ANOVA), correlation and regression

analysis were also utilised, deducing inferences at 5% level of significance. The Analysis of

Variance (ANOVA) was used to examine the differences in the opinion of respondents on the

various issues on risk management captured in the research instrument, using parameters such

as: educational qualification, length of work experience, department and size of business

(proxied by banking license categories) as grouping variables. The correlation analysis was

used to examine the nature of relationships (direction of relationship-either positive or

negative; strength of relationship-weak, semi-strong or strong; and statistical significance of

the relationship) subsisting among study variables. The Ordinary Least Square (OLS) multiple

regression technique was used to develop a model for the adoption of the BASEL risk

management model. Test such as model ANOVA, VIF, co-efficient of determination (r-

square), and regression co-efficient significance were used to analysis the fitness and

appropriateness of the model.

53

CHAPTER FOUR

PRESENTATION AND ANALYSIS OF DATA

4.1 Presentation of Data

Table 4.1 Age of the Respondents Classified by their Qualification

Qualification of respondents

Total

Below

Degree

Degree/HND Post graduate

and above

Age of respondents Below 30 2 4 8 14

30-50 0 14 10 24

Below 50 2 2 2 6

Total 4 20 20 44

Source: Study Questionnaire

Table 4.1 shows the age distribution of the respondents relative to their qualifications. As the

table shows, 40 of the 44 respondents hold at least a degree or HND, and 24 of these are aged

between 30 and 50. 14 of the respondents are aged below 30, and 12 of them hold at least a

Degree or HND.

Table 4.2: Qualification of the Respondents Classified by their length of Service

Length of service Total

0-3 Yrs 4-7 Yrs 8-10 Yrs Over 10 Yrs

Qualification

of respondents

Below Degree 0 0 4 0 4

Degree/HND 2 2 12 4 20

Post graduate

and above

8 8 0 4 20

Total 10 10 16 8 44

Source: Study Questionnaire

Table 4.2 shows the qualifications of the respondents relative to their years of experience. Out

of the 44 respondents, 30 hold a minimum of Degree or HND and also have at four years‟

54

work experience. This represents 68.2% of the respondents. 2 of the respondents that hold less

than a Degree are however well experienced.

Table 4.3: Qualification of the Respondents Classified by their Departments

Departments of respondents Total

Internal

Audit

Enterprise

Risk Mgt

Credit

Control

Financial

Control

Others

Qualificatio

n of

respondents

Below

Degree

0 2 0 2 0 4

Degree/HN

D

0 8 8 2 2 20

Post

graduate and

above

8 2 2 2 6 20

Total 8 12 10 6 8 44

Source: Study Questionnaire

Table 4.3 shows the qualifications of the respondents relative to their departments at the

sampled banks. Out of the 44 respondents, 20 hold at least a Degree or HND and also work in

either Enterprise Risk Management or Credit Control department. This represents 45.5% of the

respondents. 20 of the respondents that hold above a Degree are spread across all the

departments under study.

Table 4.4: Respondents Classified by License Categories of their Banks

Frequency Percent Valid

Percent

Cumulative

Percent

Valid

International

License

14 31.8 31.8 31.8

National License 29 65.9 65.9 97.7

Regional License 1 2.3 2.3 100.0

Total 44 100.0 100.0

Source: Study Questionnaire

55

Table 4.4, shows the distribution of the research instrument among the banks, classified into

the three tiers according to the licenses given. 31.8% of the instruments were administered to

staff of internationally licensed banks, 65.9% to nationally licensed banks, and 2.3% to

regionally-licensed banks.

Table 4.5: Impact of Basel II Accord on Risk-Based Capital

STATEMENTS YES NO NOT

SURE TOTAL MEAN

Your bank has done a gap analysis

between current risk management

practice and new capital requirement

for credit risk.

34 6 4 44 2.68

Your bank has done a gap analysis

between current risk management

practice and new capital requirement

for market risk.

12 16 16 44 1.91

Your bank has done a gap analysis

between current risk management

practice and new capital requirement

for Operational risk.

26 14 4 44 2.50

Your bank has established an action

plan to achieve the Basel II

requirements for credit risk.

36 4 4 44 2.73

Your bank has established an action

plan to achieve the Basel II

requirements for market risk.

12 22 10 44 2.05

Your bank has established an action

plan to achieve the Basel II

requirements for operational risk.

24 14 6 44 2.41

Source: Study Questionnaire

In Table 4.5, when the respondents were asked if their banks have carried out gap analysis in

respect of credit risk, 77% of the respondents answered in the affirmative, while 14% said No.

The mean value of 2.68 suggests that majority of the sampled banks have carried out gap

analysis in respect of capital requirement for credit risk.

56

In Table 4.5, when the respondents were asked if their banks have carried out gap analysis in

respect of capital requirement for market risk, 27% of the respondents answered in the

affirmative, while 36% said No, and 36% were not sure of the status. The mean value of 1.96

suggests that only a few of the sampled banks have carried out gap analysis in respect of

capital requirement for market risk. It thus appears not so much progress have been made in

respect of market risk.

In Table 4.5, when the respondents were asked if their banks have carried out gap analysis in

respect of capital requirement for operational risk, 59% of the respondents answered in the

affirmative, while 32% said No, and 9% were not sure of the status. The mean value of 2.50

suggests that a good number of the sampled banks have carried out gap analysis in respect of

capital requirement for operational risk. It thus appears some progress is being made in respect

of operational market risk.

In Table 4.5, when the respondents were asked if their banks have an action plan in respect of

Basel II requirement for credit risk and operational risk, 82% and 55% of the respondents

answered in the affirmative respectively, while 9% and 32% said No. The mean values of 2.73

and 2.41 respectively suggest that majority of the sampled banks have an action plan in respect

of capital requirement for credit risk and operational risk. However, there appears to be slow

progress in the area of market risk as only 27.2% of the sampled banks have an action plan for

capital requirement on market risk.

57

Table 4.6: Impact of Basel II Accord on Risk Organization in Nigerian Banks

STATEMENTS YES NO NOT

SURE TOTAL MEAN

Your bank has a Chief Risk Officer

(CRO). 44 0 0 44 3.00

Your bank has a distinct Board Risk

Committee. 40 4 44 2.91

Your bank has separate manager

handling Credit risk roles. 44 0 0 44 3.00

Your bank has separate manager

handling Market risk roles. 20 22 2 44 2.41

Your bank has a separate manager

handling Operational risk roles. 30 10 4 44 2.59

Source: Study Questionnaire

In Table 4.6, when the respondents were asked if their banks have own Chief Risk Officer

(CRO), all the respondents answered in the affirmative. The mean value of 3.00 suggests that

all the sampled banks have own Chief Risk Officers.

In Table 4.6, when the respondents were asked if their respective banks have a distinct Board

Risk Committee, 91% of the respondents answered in the affirmative, while 9% said No. The

mean value of 2.91 suggests that majority of the sampled banks have own Board Risk

Committee.

In Table 4.6, when the respondents were asked if their banks have separate manager handling

each of the risk areas, all the respondents answered in the affirmative in respect of credit risk,

while 45% did in respect of market risk, and 68% noted that their banks have Operational Risk

Managers. The average mean value of 2.67 suggests that majority of the sampled banks have

58

separate managers handling each of the risk areas, except for market risk. This suggest many

banks don‟t have separate managers handling market risks.

Table 4.7: Cadre of the Banks Chief Risk Officer?

Frequency Percent Valid

Percent

Cumulative

Percent

Valid

Below General

Manager

9 20.5 20.5 20.5

General Manager 31 70.5 70.5 90.9

Above General

Manager

4 9.1 9.1 100.0

Total 44 100.0 100.0

Source: Study Questionnaire

Table 4.7 contains responses on the cadre of Chief Risk Officers in banks. The result shows

that 70.5% of the CROs in sampled Nigerian banks are of General Manager cadre; 20.5%

Below General Manager cadre, and only less than 10% are Above General Manager level.

Table 4.8: Descriptive Statistics on Priority Given to Basel II Regulations

N Minimum Maximum Mean Std.

Deviation

Credit Risk -What degree of priority

does your bank give to the new

Basel regulatory framework?

44 3 5 4.95 .302

Market Risk -What degree of

priority does your bank give to the

new Basel regulatory framework?

44 3 5 3.14 .510

Operational Risk -What degree of

priority does your bank give to the

new Basel regulatory framework?

44 1 5 3.23 .774

How does your bank view Basel II

regulation

44 3 5 4.95 .302

Source: Study Questionnaire

Table 4.8 contains result on priority Nigerian banks give to the BASEL II regulation. The

degree of priority given to the Basel II regulatory framework in the area of Credit Risk is

59

topmost M= 4.95, SD=.302) because it has the highest mean and the lowest dispersion (SD),

meaning that the opinion of all respondents is almost unanimous on this, as this area of credit

risk has the lowest SD. This is followed by operational risk, and then the market risk.

Also, almost all respondents view the Basel II regulation as an opportunity to enhance risk

management (M= 4.95, SD=.302), rather than mere regulatory constraint.

Table 4.9: Impact of Basel II Regulation on Capital Allocation and Consumption

STATEMENTS YES NO NOT

SURE TOTAL MEAN

Given your bank's risk profile as at

date, there is an unavoidable need

for increased capital requirement

under Basel II.

40 4 0 44 2.91

The idea behind the Basel 2 Accord

is that once regulatory capital was

strong and kept strong consistently,

it could act as a buffer to a

commercial bank during economic

downturns.

38 0 6 44 2.73

As at date, your bank has had cause

to estimate the regulatory capital

required for each of its business

lines.

18 22 4 44 2.32

Your bank allocates or intends to

allocate economic capital for credit

risk by business lines.

34 10 0 44 2.77

Your bank allocates or intends to

allocate economic capital for market

risk by business lines.

14 24 6 44 2.18

Your bank allocates or intends to

allocate economic capital for

operational risk by business lines.

20 10 14 44 2.14

Your bank will close activities with

high capital consumption. 4 30 10 44 1.86

Your bank is likely hedge against

selected Risk. 10 24 10 44 2.00

Source: Study Questionnaire

60

In Table 4.9, when the respondents were asked if their banks now have an unavoidable need to

increase their capital base to meet increased risk profile, 91% answered in the affirmative. This

is further supported by a mean value of 2.91. Also with a mean value 2.73, majority of the

respondents that once regulatory capital is strong and kept strong consistently, it could act as a

buffer to a commercial bank during economic downturns.

In table 4.9, when respondents were asked if their banks allocate regulatory capital for all lines

of their business, a 41% affirmative response suggests that no many have seen or realized the

need to allocate regulatory capital according to business lines.

And as the responses suggest, many of Nigerian banks lack the sophistication required to

isolate areas of business with huge capital consumption and take decision either to close such

business line or hedge against the identified risk. The hedging instruments are understandably

scarce in Nigerian banking sphere, and this creates another challenge.

Table 4.10: Descriptive Statistics on Risk Reporting

N Minimum Maximum Mean Std.

Deviation

Credit Risk- What purpose drives

you risk reports?

44 5 5 5.00 .000

Market Risk - What purpose

drives your risk reports?

44 1 5 3.32 .857

Operational Risk - What purpose

drives your risk reports?

44 3 5 4.95 .302

How frequent is your Credit Risk

reporting?

44 3 3 3.00 .000

How frequent is your Market

Risk reporting?

44 3 5 3.32 .740

How frequent is your Operational

Risk reporting?

44 3 3 3.00 .000

Source: Study Questionnaire

61

Table 4.10 shows how Basel II impacts on risk reporting in banks. The first item of the table

suggests that business decisions and not fear of regulatory sanction significantly drive the

purpose of credit and operational risk reports in banks. This is evidenced by mean of 5.00 and

4.95 for credit risk and operational risk respectively. The market risk reports are majorly

generated for market monitoring purpose other than regulatory compliance. This is why the

mean is 3.32, and Standard Deviation is 0.857.

On the frequency of risk reporting, majority of the respondents noted that their banks generate

risk reports majorly on monthly basis across all risk areas, as furnished by requisite statistics

including; Credit Risk (M= 3.00, SD=.000), Market Risk (M= 3.32, SD=.740), and Operational

Risk (M= 3.00, SD=.000).

Table 4.11: Descriptive Statistics on Spending Areas for Basel II Implementation

Frequency Percent Valid

Percent

Cumulative

Percent

Valid

IT systems 4 9.1 9.1 9.1

Training 39 88.6 88.6 97.7

Human capital 1 2.3 2.3 100.0

Total 44 100.0 100.0

Source: Study Questionnaire

In Table 4.11, 88.6% of the respondents noted that training constitutes the highest spending

area banks‟ Basel II implementation project.

62

Table 4.12: Descriptive Statistics on Compliance with BASEL II Accord

N Minimu

m

Maximum Mea

n

Std.

Deviation

Credit Risk -Which approach does your

bank currently use in computing capital

requirement?

44 3 3 3.00 .000

Market Risk -Which approach does

your bank currently use in computing

capital requirement?

44 3 3 3.00 .000

Operational Risk -Which approach does

your bank currently use in computing

capital requirement?

44 1 1 1.00 .000

Source: Study Questionnaire

Table 4.12 shows the response on the compliance with the provisions of Basel II Accord as

recommended by the Central Bank of Nigeria. As the mean figures for the first and second

items on the table suggest, all the banks use Standardized Approach for the computation of

capital charges on credit risk and market risk. In the same vein, all banks use Basic Indicator

Approach for the computation of capital charge for operational risk (M= 1.00, SD=.000). This

is obviously due to regulatory requirement. Nigerian banks are required to use these

approaches for the next two years.

Table 4.13: Descriptive Statistics on BASEL II Implementation challenges

N Minimum Maximum Mean Std.

Deviation

Challenges

System Integration issues 44 5 5 5.00 .000

Database Design Issues 44 5 5 5.00 .000

Faulty Models 44 3 5 4.95 .302

Limited Budgets 44 3 5 4.75 .651

Data gathering Issue 44 3 5 4.95 .302

63

Limited Human resources 44 3 5 4.95 .302

Non-availability of IT

infrastructure

44 1 3 2.91 .421

Scarcity of credible rating

agencies

44 5 5 5.00 .000

Lack of top level

management support

44 1 5 4.50 1.303

Low awareness level

amongst staff

44 1 5 4.73 1.020

Source: Study Questionnaire

Table 4.13 shows the key areas of challenges that banks appear to be facing in Basel II

implementation. As the mean and standard deviation figures for majority of the items on the

table suggest, all the banks see the various implementation issues as high risk for the project,

except for non-availability of IT infrastructure.

4.2 Data Analysis

A hypothesis is a conjectural statement made about an event or feature of a population that can

be proved or disproved based on available sample data. According to Kothari (2004),

hypothesis is a proposition made as an explanation for the occurrence of phenomenon either

asserted merely as a provisional conjecture to guide some investigation or accepted as highly

probable in the light of established facts. For the purposes of this study work, hypothesis

chosen are deemed true before the conduct of the study. They are then subjected to tests that

may prove them untrue.

In order to test the hypothesis which states that pre-Basel II capital adequacy ratio is not

significantly different from Basel II ratio in the Nigerian banks, t-test for equality of means

was applied and the results are shown on Table 4.14 below:

64

Table 4.14: Impact of Basel II on Capital Adequacy Ratio Computation

t-test for Equality of Means

t df Sig. (2-

tailed)

Mean

Differenc

e

Std. Error

Difference

95% Confidence

Interval of the

Difference

Lower Upper

CAR

Equal variances

assumed

3.004 14 .009 6.02375 2.00512 1.72318 10.32431

Equal variances

not assumed

3.004 11

.

.012 6.02375 2.00512 1.61226 10.435235

Source: Secondary Data

From the table 4.14 above, the calculated p-value of 0.009 is less than the critical value of

0.05. This shows that the null hypothesis is rejected, while the alternate hypothesis is accepted.

This therefore implies that there is significant difference between Pre-Basel Adequacy Capital

Ratio and Basel Capital Ratio.

Furthermore, in order to test the hypothesis which states that implementing Basel II Accord

does not pose challenge to the Nigerian banks, Analysis of Variance (ANOVA) was adopted

and the results are shown on table 4.14 below:

Table 4.15: Opinion on Challenges of Basel II Implementation Relative

to Banking License Category

Sum of

Squares

Df Mean

Square

F Sig.

Between

Groups

.055 2 .028 .370 .693

Within Groups 3.067 20 .075

Total 3.123 22

Source: Study Questionnaire

From the table 4.15 above, the calculated p-values of 0.693 is greater than the critical value of

0.05. This shows that the null hypothesis is accepted, while the alternative hypothesis is

65

rejected. This therefore implies that there is no significant difference in the implementation

challenges faced by all banks, irrespective of license category.

In addition, in order to test the hypothesis which states that there is no significant difference in

the level of progress made by Nigerian banks on Basel II implementation, Analysis of

Variance (ANOVA) was also adopted and the result is shown on table 15 below:

Table 4.16: ANOVA Results on the Extent of Implementation of BASEL

Requirements

Sum of

Squares

df Mean

Square

F Sig.

Credit Risk - How far

has your bank gone in

the implementation of

Basel II action plan?

Between

Groups

.240 2 .120 .344 .711

Within

Groups

14.305 41 .349

Total 14.545 43

Market Risk - How far

has your bank gone in

the implementation of

Basel II action plan?

Between

Groups

.012 2 .006 .250 .780

Within

Groups

.966 41 .024

Total .977 43

Operational Risk -

How far has your bank

gone in the

implementation of

Basel II action plan?

Between

Groups

.463 2 .231 .885 .421

Within

Groups

10.719 41 .261

Total 11.182 43

Source: Study Questionnaire

Since P value for Credit risk (P=.711), Market risk (P=.780) and operational risk (P=.421) is

greater than 0.05 in all cases, there is no statistically significant difference in the extent of the

BASEL II implementation among Nigerian Deposit Money Banks; then we conclude on

average that Nigerian banks are at the same stage in the implementation of Basel II.

66

Finally, in order to test the hypothesis which states that Basel II Accord will not improve risk

management practices in Nigerian banks, correlation and regression techniques and Analysis

of Variance (ANOVA) were adopted and the results are shown on tables 4.17 and 4.18 below:

Table 4.17: Correlation and Regression Results on the Impact of Basel II on Risk

Management Practices in Banks

Model Unstandardized

Coefficients

Standardized

Coefficients

T Sig.

B Std.

Error

Beta

1

(Constant) 10.500 .000 60620402.9 .000

Does your bank have Chief

Risk Officer?

-1.000 .000 -.518 -

46778526.9

.000

Given your bank‟s risk

profile as at date, do you see

an unavoidable need for

increased capital requirement

under Basel II?

-.500 .000 -.877 -

44174925.1

.000

Does your bank have own

Board Risk Committee?

1.100E-

013

.000 .000 .000 1.000

CHALLENGES -1.161E-

013

.000 .000 .000 1.000

a. Dependent Variable: Impact of Basel II on risk management practices in Nigerian

banks

Source: Study Questionnaire

Table 4.18: ANOVA Results on the Impact of Basel II on Risk Management Practices

in Banks

Model Sum of

Squares

df Mean

Square

F Sig.

1

Regression 14.545 4 3.636 2255774927

881694.000

.000b

Residual .000 39 .000

Total 14.545 43

a. Dependent Variable: Impact of Basel II on risk management practices in Nigerian banks

b. Predictors: (Constant), Does your bank have Chief Risk Officer? Given your bank‟s risk

profile as at date, do you see an unavoidable need for increased capital requirement under

Basel II?, Does your bank have own Board Risk Committee?

Source: Study Questionnaire

67

From the tables 4.17 and 4.18 above, the calculated p-value of 0.000 is less than the critical

value of 0.05. This shows that the null hypothesis is rejected, while the alternate hypothesis is

accepted. This therefore implies that Basel II Accord will improve risk management practices

in Nigerian banks.

68

CHAPTER FIVE

SUMMARY, CONCLUSIONS AND RECOMMENDATIONS

5.1 Summary of the Study

The following findings were made after analysing the research questions and the hypotheses

formulated for the study:

The study observed that the Nigerian banks faced a number of challenges in the course of

implementing Basel II requirements to their risk management processes. Such challenges

include data gathering issue, scarcity of local rating agencies, faulty risk models, limited

expertise in risk models, database design issues, and limited budget. It was observed that under

Basel II models, capital adequacy ratio of Nigerian banks reduced, thus leading increased

capital raising exercise by the banks whose capital ratio fell short of the regulatory threshold.

The drop in capital adequacy ratio was largely explained by the changes in the composition of

regulatory capital and increased capital requirements for each of the risk areas.

A number of Nigerian banks have reached an advanced stage in implementing Basel II

requirements for credit risk and operational risk, except for market risk, where not much

progress has been made. The slow progress made in implementing Basel II for market risk was

largely due to lack of depth in the Nigerian financial markets. The Nigerian secondary debt

market is still not fully developed. For example, only the Federal Government Bonds and

Treasury Bills appear to be the only liquid debt instruments in the secondary financial markets

for now. State and Corporate Bonds are most often held till maturity. Therefore, they are not

often factored into the computation of capital requirement for market risk.

69

The study further revealed that Basel II implementation is changing the face of the risk

management processes and practices in the Nigerian banks. The Basel regulations allow banks

to introduce substantial improvements in their overall risk management capabilities, improving

risk based performance measurement, capital allocation and consumption, and increased

market disclosures.

The increasing demand on banks to maintain strong capital to be able to withstand economic

stress as required by Basel II now appear to limit dividend pay-out. As an alternative to capital

raising exercise with its attendant troubles sometimes, Nigerian banks now appear to be

considering building up reserves from their annual profits.

Further findings revealed that the Boards in many of the Nigerian banks are becoming

stronger, and issue of risk is now taking front burner at the Board discussions. Majority of

these banks respectively have a dedicated Board Risk Committee. This thus indicate that such

matters as risk appetite and risk capacity are now enjoying mentions within the sphere of

Nigerian banks‟ corporate strategy. In addition, the Chief Risk Officers in many of these banks

are senior management staff who are now involved in various key decisions of the banks.

Finally, the study also observed that with the ongoing Basel II implementation in Nigeria,

banks are fast changing their risk models. The economic capital models in place before Basel

II implementation often underestimated the size and risk of some exposures, particularly

across business units. With Basel II framework, there is now much more coverage of key

business risks. Increasing internal transparency has also been a heightened area of focus with

stress testing, stress VaR, counterparty risk and liquidity risk which would enjoy critical

attention in years ahead. Some of the Nigerian banks used VaR in the early part of 2014 to

70

stress test their performances, and this trend is expected to follow upward pattern in years

ahead.

5.2 Conclusion

The important thing that this research has brought to focus is the relevance of Basel II

regulations to the risk management practices in Nigerian banks. Banking is the financial

bedrock of any nation‟s economy and the business of banking is built around the concepts of

financial intermediation, asset transformation, and money creation. Each of these areas of

banking business bears huge amount of risks. The failure of any major banking entity to

manage these risks could cause serious damage to the confidence reposed in the country‟s

financial system. The ultimate losers in any banking failure are the deposit customers who are

mostly not privy to the decisions that often account for such failure. In view of this, the need

for Nigerian banks to adopt sound risk management practices has been established by this

research. Therefore, strengthening the risk management processes in banks is exactly what the

Basel II Accord seeks to achieve.

Basel II Accord is an international banking regulation which seeks to ensure that banks

maintain adequate capital that is consistent with the level of their risk exposures. The Central

Bank of Nigeria has issued several guidelines and circulars to enforce the Basel regulations in

the Nigerian banking space. The banks in Nigeria, mostly commercial banks, have achieved

some milestone in the implementation of key requirements of Basel II Accord. Many of these

banks are however still lagging in some aspect of market risk requirements. The

implementation effort has not been without some institutional, structural and operational

71

challenges. Regulatory arbitrage remains an important challenge to the financial system, as

Basel II has not yet been seriously enforced on other key players in the system other than the

commercial banks.

The new regulation has heavily impacted the capital measurement, management and allocation

in the Nigerian banking industry. Lastly, the study concludes that the Basel II regulations have

significantly improved the risk management practices and processes in the Nigerian banks, just

as it is putting the banks under increasing pressure to strengthen their core capital in order to

withstand economic stress.

5.3 Recommendations

Based on the above conclusions, the following policy recommendations are suggested:

The Central Bank of Nigeria should enlighten the public more on the implications of Basel II

framework on the financial system. The regulator could achieve this by sponsoring policy and

academic papers on the subject of risk management and Basel II Accord. In addition, CBN

should partner with professional bodies such as Chartered Institute of Bankers of Nigeria

(CIBN), Institute of Chartered Accountants of Nigeria (ICAN), and Risk Managers

Association of Nigeria (RIMAN) to widen the scope of their syllabi to cover key aspects of

Basel Accords.

Basel II Accord typically requires banks to make volumes of disclosures on their various risk

decisions for the benefit of their stakeholders. These disclosures include some sophisticated

risk models and assumptions which underlie the decisions being taken. Therefore, Nigerian

72

banks should educate their Boards and senior management staff on the implications of Basel II

on their key business functions especially in such areas as capital requirements, capital

allocation and consumption, risk models and disclosures.

In view of the recent closure of Quantitative Easing Programme in the United States which

appeared to be driving out foreign investors from the Nigerian capital markets; recent

unsavoury drop in the crude oil prices, followed by contractionary monetary policy decisions

of the CBN, Nigerian banks should consider exploring alternative credible channels for raising

capital. The option of foreign corporate bonds may not be advisable at this critical time. The

banks may consider the option of private placement to raise more capital in compliance with

Basel II requirement. They may also consider issuing some exotic hybrid or convertible debt

securities that can favourably compete with government bonds.

While the current regime where Nigerian banks are required to file Internal Capital Adequacy

Assessment Process (ICAAP) report annually should be maintained, the CBN should further

require the banks to carry out stress test on their performance at least on a quarterly basis, with

a view to recognising potential future losses and provisioning for them early enough. The

purpose of this regular exercise is to ensure banks report more objective and realistic profit

figures. The implication of this is that banks would be able to withstand the future shocks and

economic stress, and thus, there might be less incidence of banking failures.

The regulatory authorities should immediately take active steps to enforce Basel II regulations

on other specialized banks such as mortgage banks, microfinance banks, finance houses rather

than focusing on only commercial banks and discount houses. The CBN should also encourage

73

other regulators such as Securities and Exchange Commission (SEC), National Insurance

Commission (NICOM), Pension Commission (PENCOM) etc., to enforce the aspects of Basel

Accord or Solvency II applicable to their domains. By this effort, there would be lower

incidence of regulatory arbitrage.

Market discipline is the third pillar of Basel II Accord, and it requires increased level of risk

disclosures on the part of the banks. International Financial Reporting Standards (IFRS) also

mandates entities to make huge level of financial disclosures. Nigerian banks should

adequately align the disclosure requirements of both Basel II and IFRS in order to ensure that

only relevant information and details are made available to the stakeholders. The CBN may

need to strictly enforce the Guidance Notes issued in this regard, so as to avoid a situation

where banks burry important information into needless disclosure details.

74

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79

APPENDIX 1

QUESTIONNAIRE

I am Sikiru Salami Adio, a Masters of Risk Management (MRM) student at University of

Lagos. I am working on a research project titled “ASSESSMENT OF THE IMPACT AND

CHALLENGES OF BASEL II IMPLEMENTATION ON RISK MANAGEMENT

PRACTICES IN NIGERIAN BANKS”. In this regard, I request you to kindly spend your

valuable time to fill this questionnaire. The information gathered with this instrument will be

used only for academic purpose and will be kept confidential.

Key terms

Basel Accord: A set of agreements set by the Basel Committee on Bank Supervision (BCBS),

which seek to ensure that financial institutions have enough capital on account to meet

obligations and absorb unexpected losses.

Credit risk: This refers to the risk that a borrower will default on his obligations by failing to

make required payments as and when due.

Market Risk: This refers to risk of loss arising from changes in market rates or prices.

Operational Risk: This refers to risk of loss arising from inefficient or failed systems, people

and processes in an organization.

A. DEMOGRPAHIC INFORMATION

Kindly check the appropriate box (double click the appropriate option)

Age

Below 30 years ( ) 30-50 Years ( ) Above 50 Years ( )

Department

Internal Audit/control ( ) Enterprise Risk Management ( ) Credit Control ( )

Financial Control ( ) Others ( )

Qualification

Below Degree ( ) Degree/HND ( ) Post graduate and above ( )

Length of experience

80

0-3 yrs ( ) 4-7 yrs ( ) 8-10 yrs ( ) over 10years ( )

B. INSTITUTIONAL INFORMATION

1. What banking license does your bank have?

International License National License Regional

License

2. What tier does your bank fall into based on balancesheet size?

First tier (Above N1.5

trillion)

Second (N800Billion-

1.5trillion)

Third tier (Below

N800 Billion)

C. AWARENESS OF BASEL II REGULATIONS (Kindly check each box as appropriate:

double click the appropriate option)

1. What is your assessment of your bank‟s readiness for the Basel II with respect to capital

requirements?

Fully

Prepared

Partially

Prepared

Not Yet

Prepared

Credit Risk

Market Risk

Operational Risk

2. Has your bank done a gap analysis between current risk management practice and new

capital requirements?

Yes No Not Sure

Credit Risk

Market Risk

Operational Risk

3. What degree of priority does your bank give to the new Basel regulatory framework?

Very Important Not sure

81

Important

Credit Risk

Market Risk

Operational Risk

4. How does your bank view Basel II regulation: as an opportunity to enhance the risk

management process, or as a mere regulatory requirement or Not sure?

D. ORGANISTIONAL STRUCTURE

1. Does your bank have a Chief Risk Officer (CRO):

2. If yes, what‟s the cadre of your bank‟s CRO?

3. Who does the Chief Risk Officer (CRO) report to in your institution?

Executive Director Board and CEO

CEO only Directly to the Board Only

4. Does your bank have a distinct Board Risk Committee?

5. Does your bank have separate manager handling each of Credit risk, Market risk and

Operational risk roles in your bank?

Yes No Not Sure

Credit Risk

Market Risk

Operational

Opportunity to

enhance risk mgt

Regulatory

constraint

Not Sure

YES NO NOT SURE

Above General Manager General Manager Below General

Manager

YES NO NOT

SURE

82

Risk

6. How many people work in each of these departments?

None 1-5 6-10 >10

Credit Risk

Market Risk

Operational

Risk

ERM

E. REPORTING ABILITY

1. What purpose drives your risk reports in each of these risk areas?

Regulatory

purpose

Monitoring Business

decisions

Credit Risk

Market Risk

Operational Risk

2. How frequent is your internal risk reporting? (Tick as many as applicable)

Daily Weekly Monthly Annually

Credit Risk

Market Risk

Operational

Risk

ICAAP

F. COMPLIANCE WITH BASEL II ACCORD

1. Which approach does your bank currently use in computing capital requirement?

Basic

Indicator

Approach

Standardized

Approach

Foundation

IRB

Advanced

Approaches

Credit Risk

Market Risk

Operational Risk

83

2. Given your bank‟s risk profile as at date, do you see an unavoidable need for increased

capital requirement under Basel II?

YES NO NOT SURE

3. The idea behind the Basel 2 Accord is that once regulatory capital was strong and kept

strong consistently, it could act as a buffer to a commercial bank during economic downturns.

Do you agree with this notion?

YES NO NOT SURE

G. IMPACT OF BASEL II ON CAPITAL ALLOCATION

1. As at date, has your bank ever had cause to estimate the regulatory capital required for each

of its business lines?

YES NO NOT

SURE

2. Will your bank outsource or close activities with high capital consumption?

YES NO NOT

SURE

3. Is your Bank likely securitize or hedge against selected Risk?

YES NO NOT

SURE

4. Does your Bank allocate or intend to allocate economic capital by Business lines?

Yes No Not Sure

Credit Risk

Market Risk

Operational Risk

84

H. BASEL II ACTION PLAN

1. Has your bank established an action plan to achieve the Basel II requirements?

Yes No Not Sure

Credit Risk

Market Risk

Operational Risk

2. How will (or has) your bank executed this action plan?

Internal

Resources

External

Resources

Both

Credit Risk

Market Risk

Operational Risk

3. In your bank‟s Basel implementation project, what has (or will) the largest spending area

be?

Options

IT systems

Training

Human capital

Service

outsourcing

Specify other, if any……………………

4. How far has your bank gone in the implementation of Basel II action plan?

Not

Realized

Partially

Realized

Fully

Realized

Credit Risk

Market Risk

Operational Risk

85

I. IMPLEMENTATION CHALLENGES

What difficulties do you foresee (or already faced) in implementing this Basel II risk? Kindly

rate as appropriate.

Challenges/Rating High Medium Low

System Integration issues

Database Design Issue

Faulty Models

Limited Budgets

Data gathering Issue

Limited Human resource

Non-availability of IT

infrastructure

scarcity of credible rating agencies

Lack of top level management

support

Low awareness level amongst staff