CHAPTER ONE
INTRODUCTION
1.1
Background to the study
Globalization and technology have continuing speed which makes the financial arena to become
more open to new products and services invented. However, financial regulators everywhere are
scrambling to assess the changes and master the turbulence (Sandeep, Patel & Lilicare, 2002).
An international wave of mergers and acquisitions has also swept the banking industry. In line
with these changes, the fact remains unchanged that there is the need for countries to have sound
resilient banking systems with effective risk management techniques.
One major area in the aftermath of the global financial crisis is risk management among
corporate institution. Risk Management is the identification, assessment and prioritization of
risks followed by coordinated and economical application of resources to minimize, monitor, and
control the probability and/or impact of unfortunate events (Njogo, 2012). It is neither a concept
for complete risk avoidance nor its elimination. The essential functions of risk management are
to identify measure and more importantly monitor the profile of the bank. While for example,
non-performing assets are the legacy of the past in the present, risk management system is the
pro-active action in the present for the future. Managing risk is nothing but managing the change
before the risk manages (Raghavan, 2003).
Risk has a very long history as it can be said to have been in existence like human existence. It
has defiled a universal definition as every author’s attempt display a different orientation. Gallati
(2003) defines risk as a condition in which there exists an exposure to adversity, or a condition in
which there exists a possibility of deviation from a desired outcome that is expected or hoped
for. It implies exposure to uncertainty or threat (Kannan & Thangavel, 2008). Therefore, risks
can be described as the adverse impact on profitability of several distinct sources of uncertainty.
While the types and degree of risks an organization may be exposed to depend upon a number of
factors such as its size, complexity business activities and volume, it is believed that generally
the banks face credit, market, liquidity, operational, compliance / legal /regulatory and reputation
risks.
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Ozturk (2007), defines risk management as the process by which managers satisfy their risk
taking needs by identifying key risks, obtaining consistent, understandable, operational risk
measures, choosing which risks to reduce, which to increase, by what means and establishing
procedures to monitor the risk position. According to Raghavan (2003), Risk management refers
to the practice of identifying potential risks in advance, analyzing them and taking precautionary
steps to reduce the risk. Risk simply implies a possibility of unexpected outcome. It creates the
notion that future events may have some degree of uncertainty, thereby exposing an institution to
adversity.
According to Pandey (2004), the key to effective risk management is not to do away totally with
the various inherent risks. For example, lending operations of banks have the inherent risks of
possible loan losses (credit risk) but by taking the risk, banks are able to charge a premium for
their risk taking activities and earn profits. Risks are therefore, a source of profits to the bankers.
Nzotta (2002) defined risk as the exposure of loss arising from variation between the expected
and actual outcome of investment activities. According Hanssson, 2005 risk can be seen as An
unwanted event which may or may not occur; The cause of unwanted event which may or may
not occur; The probability of an unwanted event which may or may not occur; The statistical
expectation value of unwanted events which ay may not occur; The fact that a decision is made
under conditions of known probabilities (decision risk).
Capital structure is the means by which an organization is financed. It is the mix of debt and
equity capital maintained by a firm. The extent literature is full of theories on capital structure
since the seminal work of Modigliani and miller (1958). How an organization is financed is of
paramount importance to both the managers of the firms and providers of funds. This is because
if a wrong mix of finance is employed, the performance and survival of the business enterprise
may be seriously affected. Capital structure is the mixture of debt and equity capital maintained
and used by a firm to finance itself. The study of capital structure has been researched upon by
many scholars, yet it remains the most debatable topics of finance during the past half century
(Bradley, 1984).
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Capital structure is one of the most important effective parameters on the valuation and direction
of economic enterprises in the capital markets. Current changing and evolution environment
cause that rating companies also in terms of the credit depends partly to their capital structure
and strategic planning required them in order to select effective resources to achieve the goal of
"shareholders wealth maximization" (Drobetz & Fix, 2003). So, one of the most important goals
that financial managers should consider to maximize shareholders wealth is determination of the
best combination of financial resources for the company.
Moreover, financing decisions for the investment is the important duties of company in
determination of the best combination of financial resources, and another purpose of financial
manager from taking such decisions is maximization of corporate value and also in this regard,
he should determine where invest their resources. On the other hand, how to finance the
company’s assets for interested individuals and institutions is noteworthy and also how much
debt and stock the company used to finance its assets is important, Because this will impact on
corporate financing decisions (Yahyazadehfar et al., 2010).
Financial manager by taking
accurate and timely decisions can reduce capital cost of company and thereby increase corporate
value.
Therefore, adequate and appropriate financing and investment will increase corporate value and
thus will increase shareholders wealth. Since combination of various financial sources of every
company is called capital structure (Ghalibafasl, 2005), then it can be noted that the best
combination of financial resources for every company is optimal or desirable capital structure.
Since the company’s cost of capital is seen as a function of its capital structure, choice of optimal
capital structure or adequate and appropriate financing and investment reduce company’s cost of
capital and increase its market value (Modarres & Abdoallahzadeh, 2008) and thus will increase
shareholders wealth.
The deposit money bank are bank in whose business includes the acceptance of deposits
withdraw able by cheques. Deposit money banks are meant to be profit oriented and they render
resale banking services. Deposit money banks are able to provide current bank clearing house.
They can clear cheques through the clearing system. For this reason, deposit money banks are
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called clearing banks in Britain. Deposit Money Banks (DMBs) are the financial institutions that
mobilize monetary resources from the surplus and channeled the to the deficits unit for the
purposes of financial real sector for economic growth and development (IMF, 2012). Therefore,
this study aimed at determining if there is any relationship between capital structure and risk
management of deposit money banks in Nigeria.
1.2
Statement of the Research Problem
A basic concept in corporate finance is that the market value of a firm is equal to the present
value of its expected future free cash flows discounted by its weighted average cost of capital.
Managers can increase free cash flows and consequent company market value through good
capital budgeting and operating decisions. However, to assist with these decisions, it will be
necessary for managers to work out the appropriate balance between debt and ordinary share
capital in the firm’s financial structure. Typically, financing with debt increases the common
stockholder’s expected rate of return on capital provided to profitable enterprises. But, as debt
levels rise, the firm’s earnings attributable to shareholders become more volatile due to the need
to pay increasing amounts of interest before dividends. Such drives up the default risk premium
on equity, lowering the estimate of the firm’s market value (Muhammad, 2012).
Risk is defined as something happening that may have an impact on the achievement of
objectives, and it includes risk as an opportunity as well as a threat (Audit Office, 2000). The
nature of banking business contains an environment of high risk. So risky in the sense that it is
the only business in where proportion of borrowed funds is far higher than the owners’ equity
(Owojori, 2011). The banking business in comparison to other types of human endeavour is
entirely exposed to risks. Banks no longer simply receive deposits and make loans; they also
operate in a rapidly innovative sector with a lot of pressure mount for profit which urges them
for continuous product or service development to cross-sell and up sell to satisfy customers (Luy,
2010).
Schroeck (2002) and Nocco and Stulz (2006) in Ariffin and Kassim (2009) stress the importance
of good risks management practices to maximize firms’ value. While the former proposes that
ensuring best practices by instituting effective and prudent risk management practices in other to
increase earnings, the latter specifically posits that effective enterprise risk management (ERM)
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have a long-run competitive advantage to the firm (or banks) compared to those that manage and
monitor risks individually. In the light of this and as a follow-up, a holistic approach is suggested
in managing risk.
Prior studies have examined the differential impact of capital structure on risk management in
developed countries. For example Burner (2010) observed that a reduction in real risk-free rates
of interest to historically low levels led to credit expansion in a ferocious search for yield among
investors. Hence, major financial crisis around the world can also be attributed to inordinate
ambition (to return excellent return to their owners) by decision makers and the board thereby
taking excess risk to boost stock prices. The 2007 economic crisis emerging in 2007 and the
2009 financial crisis in the Nigerian banking industry are examples.
Dauda (2012) examined on the Impact of Business Risk on Corporate Capital Structure of
Publicly-Listed Nigerian Companies This paper demonstrates the extent to which changes in
business risk help predict the capital structure choices of Nigeria listed companies. The findings
support a U-shaped function between earnings volatility and total debt ratio. In normal times
when the threat of insolvency is low, firms cut their average rate of borrowing relative to total
assets by between 1 and 4 percent a year. However, they raised it by between 5 and 22 percent
during periods of heightened market anxiety. This suggests that policies which lower the
expected bankruptcy costs relative to company value will discourage an unnecessary use of debt.
Alnajjar (2015) examined on the impact of Business Risk on Capital Structure. The main
purpose is to investigate that how industrial sector firms decide about their capital structure with
reference to risk exposure. The research concluded about the manager’s behavior with respect to
business risk, profitability, firm size and sales growth. Data were collected from industrial sector
of Jordan, over the period of 2009-2011 is used for the study. Linear regression model is used for
data analysis. The results showed that industrial sectors firm’s managers are risk averse, whereas
sales growth and firm size are positively related to financial policy decision. Profitability is
negatively related with financial policy of the firm.
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There have been several presentations in different studies, on risk management practices. These
are largely empirical. This research, therefore, is aimed at filling these gaps by examining risk
management practices among deposit money banks in Nigeria with a view to relating these
practices to their capital structure using other variables. In addition to contributing to the limited
literature on risk management practices of deposit money banks in emerging economies, this
paper is also peculiar as it makes an attempt on examining risk management practices in current
years.
1.3
Objective of the Study
The aim of this study is to establish the relationship between capital structures on risk
management of deposit money banks in Nigeria. The specific objectives are to:
i.
Determine the impact of debt ratio (DR) on risk management of deposit money banks;
ii.
Determine the impact of debt to equity ratio (DER) on risk management of deposit
money banks;
iii.
Determine the impact of long term debt (LD) on risk management of deposit money
banks
1.4
Research Hypotheses
Based on the objectives of the study, the following null hypotheses (HO) were formulated.
i.
There is no significant impact of debt ratio on risk management of deposit money banks;
ii.
There is no significant the impact of debt to equity ratio on risk management of deposit
money banks;
iii.
There is no significant impact of long term debt on risk management of deposit money
banks.
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1.5
Scope of the Study
This research covers the impact of capital structure on risk management of deposit money banks
(DMBs) quoted by the Nigeria stock exchange from the period of 2011 to 2015. Access bank,
Fidelity bank, First bank, Guarantee trust bank and UBA were drawn as a sample size out of the
listed banks in the Nigerian stock exchange. The dependent variable is loan loss provision (LLP)
used as a proxy of risk management while the independent variables are debt ratio (DR), debt to
equity ratio (DER) and long term debt ratio (LD) used as a proxy of capital structure. These
variables were used to assess the impact of capital structure on risk management using
correlation and regression statistical tools in SPSS version 17th
1.6
Significance of the Study
Previously studies have been conducted on effective risk management in firms but few
researches has been done on the relationship between capital structure on risk management with
specific reference to deposit money banks in Nigeria. In view of the fact that the banking sector
contribute towards the country’s growth in GDP, the study shall be of great benefit to various
stakeholders i.e.
The management and shareholders in the banking sector in Nigeria shall obtain guidance on the
optimal level of risk management that will in turn boost profitability. The Government can use
the findings of the study to understand the factors that impact on the capital structure of the
various deposit money banks in Nigeria. It will assist the Government in determining what
mechanisms and regulatory measures should be put in place that will assist in growth of the
sector. Findings from this study will sensitize the Government on the importance of
understanding the right mix of capital structure that in turn assist in boosting profitability and
hence reduce risk.
The study findings will be of utmost importance to potential investors who will be able to
understand the banking sector, how to manage their risk and in turn increase shareholders wealth.
The study will sensitize investors on the determinants of capital structure and how best
maximization of shareholders wealth can be achieved. Findings from this study will in the long
run lead to increase in profitability and efficiency in the banking sector will lead to a creation of
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more jobs and which will consequently contribute to the increase and sustenance of high
standards of living in Nigeria.
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