CHAPTER ONE

1.0 INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Non-performing loans and advances have been a major problem affecting the banking industry.  It creates problem of liquidity into the system and also is a sign that a bank is unhealthy.  

As at the end of March, 2004, the CBN’s ratings of all the banks classified 62 as sound/satisfactory, 14 as marginal and 11 as unsound, while 2 of the banks did not render any returns during the period.  The weakness of some ailing banks are manifested by their overdrawn positions with the CBN, high incidence of nonperforming loans, capital deficiencies, weak management and non corporate governance.

A further analysis of the returns of the marginal and unsound banks reveals that they account for 19.2 percent of total assets of the banking system, 17.2 percent of total deposit liabilities while the industry non-performing assets account for 19.5 percent.  Although below the trigger points for declaring the system as distressed, they are nevertheless of major supervisory concern (Soludo 2004).

Banks consolidation and 25bn recapitalization in Nigeria reduces the number of deposit money banks from 89 as at end-June 2004, to 25 banks as at January 2006.  The reform is designed to ensure a diversified strong and reliable banking sector which will ensure the safety of depositors’ money, play active developmental roles in Nigerian players in the African Regional and Global Financial system.

In the United States of America, there had been over 7000 cases of bank mergers since 1980.  In Korea, for example, the system was left with only 8 commercial banks with about 4,500 branches after consolidation.  A bank in South Africa – Amalgamated Banks of South Africa (ABSA) has asset base larger than all of the Nigerian commercial banks put together (Soludo 2004)

The Central Bank of Nigeria removed 5 Banks’ Chief Executive

Directors (CEO) and their Executive Directors on 14^th of August, 2009 for excessive high level of non-performing loans in five banks which was attributable to poor corporate governance practices, lax credit, administration processes and absence or non-adherence to banks credit risk management practices.  Thus, the percentage of non-performing loans to total loans ranged from 19% to 48% (Vanguard Online, 14 August, 2009).

Furthermore, additional three Banks’ Managing Directors and Executive Directors were also fired on 2^nd October, 2009 for the same offences.  The huge provisioning for the non-performing loans have virtually eroded the shareholders fund.  Thus, the banks are under-capitalized for their current levels of operations and are required to increase their provisions for loan losses, which impacted negatively on their capital (Sanusi 2009).

In other words, these banks were unable to meet their maturing obligation as they fall due without resorting to the CBN or Inter Bank market.  Their liquidity ratios ranged from 17.65% to 24% as at May 31, 2009 (Regulatory minimum is 25%).  Hence, the need to identify the factors contributing to non-performing credits in Nigeria Banking Industries.

In furtherance of the efforts of the Central Bank of Nigeria (CBN) to assist the banks affected by the outcome of the recent CBN/NDIC Special Examination, published the list of non-performing loans of

N100m and above for Bank PHB, Spring Bank, Unity Bank, Wema Bank and Equitorial Trust Bank on The Nation Newspaper.  The number of the non-performing loans of N100m and above for the banks stated above respectively are 149, 221, 120, 79 and 45 (The

Nation, October 14, 2009)

The banking sector reform is valid for now.

1.2     DISCRIMINANT FUNCTION ANALYSIS AS A

MULTIVARIATE TECHNIQUE

Multivariate analysis can be referred to as all statistical methods that simultaneously analyze multiple measurements on each individual or object under investigation.  Any simultaneous analysis of more than two variables can be loosely considered as multivariate analysis.  As such, multivariate techniques are extensions of univariate analysis (analysis of single-variable distributions) and bivariate analysis (cross-classification correlation).

However, to be considered truly multivariate all of the variables must be random variables that are interrelated in such ways that their different effects cannot be meaningful interpreted separately.

Discriminant analysis is a multivariate technique concerned with separating distinct set of objects or observations and with allocating  new objects to previously defined groups.

It can be referred to as a statistical technique by which we can make decisions to categorise groups or classify individuals (objects) into their respective groups usually on the basis of some measurement observed on the individuals (objects).  This implies that the basic problem of discriminant analysis is to assign an observation, X, of unknown origin to one of two (or more) distinct groups on the basis of the value of the observation.

In some problems, fairly complete information is available about the distribution of X in the two groups.  In this case we may use this information and treat the problem as if the distribution are known.  

1.3           STATEMENT OF PROBLEM

The Central Bank of Nigeria is saddled with the responsibility to act and protect all depositors and creditors and ensure that no one loses money due to bank failure.  The commercial banks give out depositors money as loan and advances which should be paid back at expiration of such facilities.

The basic question is what factors contribute or identifies  nonperforming  loans or performing loans.  What factors or indices should be looked into, to avoid non-performing loans which can eventually make a bank to have liquidity problem which can culminate to classify a bank as distressed and depositors losing their hard-earned money.  Hence, the research is focused on Discriminant Function analysis of performing loans/advances and non-performing loans/advances.

1.4            LIMITATION AND SCOPE

This project work is limited to commercial loans and advances granted by commercial banks in Nigeria between 2006 and 2008, both year inclusive.  Consumer loans are not included in this analysis.

1.5            AIMS AND OBJECTIVES

The study is aimed at performing a discriminant analysis on performing loans/advances and non-performing loans/advances.  Using data compiled from schedules received from 5 randomly selected commercial Banks (Skye Bank, Intercontinental Bank,

Union Bank, UBA Bank, and Bank PHB) through their

Account/Credit officers.  The project seeks to achieve the following sets of objectives:

1.  To identify the socio-economic characteristics that discriminate between performing loans/advances and nonperforming loans/advances;

2.  To be able to predict the likelihood that loans/advances given out by a bank will belong to a group of performing or not based on the rule to be derived with Fisher’s Discriminant Analysis.

1.6            SIGNIFICANCE OF THE STUDY

Non-performing loans/advances cause liquidity problems in the banking industry whereby banks were unable to meet up with their obligations as they fall due.  This study is justified in that it will add to the body of knowledge pertaining to factors contributing to nonperforming loans/advances.

The inferences from the research will enable the management of various banks to restructure their loans and advances to address the socio-economic characteristics that contributed to nonperforming loans.

1.7            PURPOSE OF DISCRIMINANT ANALYSIS

Ø To classify cases into groups using a discriminant prediction equation.

Ø To investigate independent variable mean difference between groups formed by the dependent variable.

Ø To assess the relative importance of the variable in classifying the dependent variable.

Ø To discard variables which are of little discriminating power to the group distinctions.

1.8            CLASSIFICATION PROBLEMS EXAMPLES

Instances of classification problems can be applied in many field of endeavour such as the following:

1.          A medical practitioner who intends to classify new born babies into different categories of blood groups, based on measurements obtained from the blood samples of the babies.

2.          A geologist can as well wish to classify fossils into their respective categories of fossils-groups on the basis of measurements on the ages, size and shapes of the fossils.

3.          A guidance and counselling consultant might desire to categorise students with different course in a university, for which they are best-suited based on measured scores of the students in related subjects in the J.M.E results.

4.          A biochemist might desire to classify foods into the distinct categories of food nutrients as protein, fat and oil, vitamin, carbohydrates, minerals and water based on measurement of the comparative amount of different nutrients in the food.

5.          An agronomist can as well be faced with the problem to classify a particular breed of animal or plant into its proper class.

6.          An automobile engineer might as well decide to classify an engine into one of the several categories of engine on the basis of measurements of its power output, shape and size.

All the above related problems of classification can be effectively solved by discriminant analysis. 

1.9      DEFINITIONS OF TERMS

a)           Performing credit: A credit facility is deemed to be performing if payments of both principal and interest are up-to-date in accordance with agreed terms.  The borrower must effect payment such that outstanding unpaid interest must not exceed 90 days.

b)           Distress Institution: is a financial institution with several financial operational and management weakness which have

rendered it difficult to meet its obligation to its customers, owners and economy as at when due.

c)           Non-performing credit: a credit facility should be deemed as non-performing when any of the following conditions exists:  (i) interest or principal is due and unpaid for 90 days or more; 

(ii)   interest payments equal to 90 days interest or more have been capitalised, rescheduled or rolled over into a new loan

(except where facilities have been reclassified as specified in (iii) below); 

(iii) the practice whereby some licensed banks merely renew, reschedule or roll-over non-performing credit facilities without taking into consideration the repayment capacity of the borrower is objectionable and unacceptable.

Consequently, before a credit facility already classified as “non-performing” can be reclassified as “performing” the borrower must effect cash payment such that outstanding unpaid interest does not exceed 90 days. 

Non-performing credit facilities should be classified into three categories namely, sub-standard, doubtful or lost on the basis of criteria below: 

(d)         Sub-Standard :    The following objective and subjective criteria should be used to identify sub-standard credit facilities: 

( i) Objective Criteria: facilities as defined in c(ii) on which unpaid principal and/or interest remain outstanding for more than 90 days but less than 180 days; 

(ii) Subjective Criteria: credit facilities which display welldefined weaknesses which could affect the ability of borrowers to repay such as inadequate cash flow to service debt, under-capitalisation or insufficient working capital, absence of adequate financial information or collateral documentation, irregular payment of principal and/or interest, and inactive accounts where withdrawals exceed repayments or where repayments can hardly cover interest charges. 

(e)         Doubtful :   The following objective and subjective criteria should be used to identify doubtful credit facilities: 

(i)    Objective Criteria: facilities on which unpaid principal and/or interest remain outstanding for at least 180 days but less than 360 days and are not secured by legal title to leased assets or perfected realisable collateral in the process of collection or realisation. 

(ii)   Subjective Criteria: facilities which, in addition to the weaknesses associated with sub-standard credit facilities, reflect that full repayment of the debt is not certain or that realisable collateral values will be insufficient to cover bank’s exposure. 

(f)           Lost Credit Facilities:   The following objective and subjective criteria should be used to identify lost credit facilities: 

(i)    Objective Criteria: facilities on which unpaid principal and/or interest remain outstanding for 360 days or more and are not secured by legal title to leased assets or perfected realisable collateral in the course of collection or realisation. 

(ii)   Subjective Criteria: facilities which in addition to the weaknesses associated with doubtful credit facilities, are considered uncollectible and are of such little value that continuation as a bankable asset is unrealistic such as facilities that have been abandoned, facilities secured with unmarketable and unrealisable securities and facilities extended to judgment debtors with no means or foreclosable collateral to settle debts. 

   Provision should be made for non-performing credit facilities as follows: 

(i)      Sub-Standard Credit Facilities: 10% of the outstanding balance; 

(ii)    Doubtful Credit Facilities: 50% of the outstanding balance; 

(iii)  Lost Credit Facilities: 100% of the outstanding balance.