CHAPTER ONEINTRODUCTION1.1 BACKGROUND OF THE STUDYThe roles of commercial banks play in the process of economic development inevery country are crucial. They through financial intermediation increase thelevels of national savings and investments by mobilising idle funds from surplusspending units (savers) and channel them to deficit spending units(borrowers) forinvestments in the economy . (UGBAJA 1999)By playing these roles within a particular country, the independence of globaleconomics created the need for global interbanking, a trend which in turnemphasizes the need for the stability of the banks involved in intercontinentalbanking transactions.Also, banking business carries a lot of risks and banking public needs assuranceabout the safety of their confidence in the banking institutions.The need for supervision and control of commercial banks activities is to ensurethat they adhere to the stipulated monetary policies, rules and regulations as well2as accepted ethical conducts. However the major contributing factor that has ledto the failure of Nigerian banks in the past can be described as moral hazard(adverse incentives)Moral hazards or adverse incentives are a concept with relevance to a variety ofprincipal agent relationships characterized by asymmetric information. The moralhazard concerns the adverse incentives on banks chief executives to act in wayswhich are contrary to the interests of the banks creditors (mainly depositors orthe government if it explicitly or implicitly insures deposits) by undertaking riskyinvestment strategies (such as lending at high interests rates to high riskborrowers) which, if successful, would ` jeopardise the solvency of the bank.Bank owners have incentives to undertake such strategies because with limitedliability, they bear only a portion of the downside risk but stand to gain throughhigher profits, a large share of the upside risk. In contrast, the depositors (or thedeposit insurers) gain little from the upside risk but bear most of the downsiderisk.The inability of depositors to adequately monitor bank directors, because of theasymmetric information allows the latter to adopt investment strategies whileentail higher levels of risks.3Moral hazard on bank executives can be exacerbated by a number of factorsFirstly, an increase in the interest rate may lead borrowers to choose investmentswith higher returns when successful but with lower probabilities of success(Stieglitz and Weiss 1989) hence a rise in deposit rates could induce banks toadopt more risky investment strategies. A rise in bank lending rates can have asimilar incentive effects on the banks borrowers.Secondly, macroeconomic instability can also worsen adverse incentive if it wereto affect the variance of the profits of the bank borrowers especially when thereis a co-variance between borrower’s profits. (E.g. if a large share of borrowers arein the same industry) or if loan port folios are not well diversified amongindividual borrowers.(McKinnon 1988)Thirdly, the expectation that the government will bail out a distressed bank mayweaken incentives on bank executives to manage their asset port folio prudentlyand incentives on depositors to monitor banks and choose only banks with areputation of prudent management. Deposit insurance also reduces incentives fordepositors to monitor banks.Fourthly, moral hazard is inversely related to bank capital. The owners of poorlycapitalized banks have little of their own money to loose from risky investment4strategies. By implication, financial distress in the bank itself worsens moralhazard because, as the value of the bank’s capital falls, the incentives on itsowners to pursue strategies which might preserve its solvency are reduced(Berger et al.1995 pp 398-99) for similar reasons intensified competition inbanking market can also encourage moral hazard by reducing the franchise valueof banks future profits.Moral hazard becomes even more acute when the bank lends to projectsconnected to its own directors or managers (insider lending). In such cases theincentives for imprudent and fraudulent bank management are greatly increasedin that all of the profits arising from the project are internalized.(in the case ofloans unconnected borrowers the project returns are split between lender andborrowers)whereas that part of the losses borne by depositors or task payers areexternalised. Not surprising, insider lending is a major cause of bank failurearound the world.These ills going on in the commercial banks, as stated above make it imperativefor the central bank of Nigeria (CBN) to be on the watch at all times through theirsupervisory and control functions so as to protect them from going insolventwhich usually impacts negatively on the economy in general.5Confidence plays a key role in bank operations. Any information whatsoeverimplying that the financial position of a bank has worsened can have a negativeimpact on all the cash flow in that bank. Therefore, every bank will attempt toconceal the problem of insolvency. Banks are highly successful in this respect andtherefore, the problem of insolvency is often not recognised in time by thegovernment agencies entrusted with bank supervision.Problems in the banking system or in the economy as a whole occur when anumber of banks become insolvent, or when a relatively large share of theliabilities of the banking system is not covered by good assets. The occurrence ofsuch problems indicates that the efficient asset and liability management ispresent in a significant portion of banking, if a large part of banks asset isallocated to unprofitable projects. There will be a reduction in investmentefficiency and thereby a slowdown on economic growth.These could be decrease or seizure of loans grants to the public when theproblems of bank insolvency begin to be resolved. When banks attempt to restoresolvency by ceasing to grant loans to bad clients and raising the interest speeds,there is less available loan and they are more expensive. One consequent can bethe negative selection of clients. Enterprises that do not have alternative sources6of financing will be ready to accept higher bank interests rate independently ofwhether the projects to be financed are profitable or less profitable. Such a trendcould also exert a negative impact upon investment efficiency.If banks attempt to solve the problems of insolvency by raising additional funds,interest’s rates will rise and there will be pressure to conduct a softer monetarypolicy. Banks also seize additional liquidity in foreign countries which affects thetrends in the balance of payments.The right which the central bank of Nigeria has to supervise and control thebanking industry is backed by the CBN Act no 24 of 1991 now CBN ACT 2007 andthe banks and other financial institution Act no 25 of 1991 (now BOFIA 2004).These laws empowers the CBN to carry out a supervisory and control functions onall commercial banks and other banks in the countryThe powers as specified by section 39 of the CBN Act which may be expressed bythe CBN from time to time in the supervisory and controlling functions include thepowers to specify critical ration to call for information from banks and to inspectthe books of any bank to under condition of secrecy.(Afolabi 2000: 10s)Section 30and 7 and 8 of the banks and other financial acts no. 25 of 1991 (nowBOFIA 2004) stipulates that every banks shall produce on demand all the books,7accounts documents and information as the CBN examiners may deem fit in theexercise of his functions. It also stipulates as punishable the wilful refusal of anybank to produce such documents as well as negligence or wilful furnishing of falseinformation to CBN.The control of the banking industry by CBN is carried out in partnership with thefederal government, which has the overall authority over the system. Thus theCBN initiates the guiding policy measure and implements them only as approvedby the government. The CBN measures to control the banks through a number ofstages which include the identification of the objectives and targets of policy.Policy formulation, policy implementation and review as well as other extrameasures for commercial banks (ogwuma 2004:2).Supervision and control by the CBN impact significantly on the activities andperformance of commercial banks between 1986 and early 2010, the supervisoryand control measures of the CBN seemed ineffective on a number of occasionsand this contributed to the hitherto, distress in the banking sector. Since 2004,there has been series of new supervisory and control measures introduced by theCBN into the banking system with the aim of improving the performance of thebanking sector.8Against this background, however the study, however, the study is gearedtowards examining the impact of supervision and control of CBN on commercialbanks in view of how their performance is affected from the negative and thepositive perspectives with concentration on the roles that CBN played from 2004to 2011.1.2 STATEMENT OF THE PROBLEMThe supervision and control of commercial banks by CBN sometimes impactadversely on the operations and performance of the former. This is as a result ofdifficulties associated with the supervision and control mechanism.With respect to supervision, it appears that the CBN apparatus are not effective.Banks examination are often not timely, not regularly carried out or haphazardlydone.Secondly, some of the CBN examiners are not sufficient competent and thirdly,they are not large enough to supervise all the commercial banks effectively. Theresult is that deficiencies to the operations of these banks are not timelydiscovered and adequately controlled. All these adversely affect the commercialbanks.9With regard to the control, often times the measures are too stringent foreffective operations and performance of the commercial banks. Restrictivemonetary control measures limit the liquidity and capacity of commercial banksto grant loans or credit. Besides, direct interactions in banking activities by theCBN, sometimes have adverse effects too.In the light of the aforementioned, attempt will be made to appraise the impactof central banks supervision and control on the performance of commercialbanks.1.3 OBJECTIVES OF THE STUDYIn lieu of the problems stated above, the objectives of the study are1. To analyse the objectives of supervision and control of commercial banks inview of the existing monetary policies of the CBN.2. To examine the effectiveness of the supervisory and control techniques ofthe CBN specifically the ability detects malpractice on time.3. To assess the impact of supervision and control on the performance ofcommercial banks with regards to liquidity.4. To appraise the ongoing reforms of the CBN.