CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The efficiency of the banking system has been one of the major issues in the new monetary and financial environment. The competitiveness of financial institutions is stirred up by their efficiency levels, since their products and services are of an intangible nature. Efficiency in banking can be distinguished between allocative and technical efficiency. Wherein, allocative efficiency is the extent to which resources are being allocated to the use with the highest expected value. A firm is technically efficient if it produces a given set of outputs using the smallest possible amount of inputs (Falkena et al, 2004). Efficiency in the banking system is important at both macro and micro levels and in order to allocate resources effectively, banks should be sound and efficient (Hussein, 2000).

One of the most important economic dimensions for ensuring the success of a company is the efficiency with which it uses its resources. An efficient banking system is a sine-qua-non for efficient functioning of a nation’s economy. Thus, for the industry to be efficient, it must be regulated and supervised in view of the failure of the market system to recognize social rationality and the tendency for market participants to take undue risks which could impair the stability and solvency of their institutions (Thatcher, 2002; Onyido, 2004; Lemo, 2005; Balogun, 2007; Alao, 2010).

Bank efficiency and its determinants are vital issues confronting the public and policy makers. The banking industry in Nigeria plays a very significant role in the economic development of the country. According to Nzotta (2004), banks as part of the Nigerian financial system channel scarce resources from surplus economic units to deficit units and they exert a lot of influence on the pattern and trend of economic development through their lending and deposit mobilization activities. This is why Abdullahi (2002), states that the banking industry in particular play a crucial role in the economic development by mobilizing savings and channeling them for investment especially in the real sector which increases the quantum of goods and services produced in the economy, thus national output increases and the level of employment improves. The banking industry in Nigeria is able to play the positive role only if it is functioning efficiently. However if it is repressed, inefficient and incapable of providing timely and quality services, the banking system could become a major hindrance to economic growth and development. Nigerian banking industry suffered a historic retrogressive trend in both profitability and capitalization. In 2009 just 3 out of 24 banks declared profit, 8 banks were said to be in “grave” situation due to capital inadequacy and risk asset depletion; the capital market slummed by about 70 percent and most banks had to recapitalize to meet the regulatory directive (CBN, 2010).

This now makes bank efficiency analysis very essential for the evaluation of banks’ performance and its efficiency. Bank efficiency is the capacity to generate sustainable profitability (European Central Bank, 2010). In recent years, the intensive and continuously increasing competition in the financial services market creates a need for an access to informa­tion that would allow the evaluation of these commer­cial banks operating in this market; therefore, it is of considerable interest to measure the efficiency of evolving institutions. Creditors and investors use such efficiency evaluations to judge past performance and current position of banks. Due to the growth of competition, management of banks is interested in enhancing efficiency. According to Baten and Kamil (2010), bank efficiency studies are of crucial importance for operational purposes and it links an organization’s goal and objectives with organization decisions.

According to Uboh (2005), financial performance failure in Nigerian banks resulted to loss of public confidence in the banking sector and that bank efficiency can be grouped into two basic types; those that relate to results, output or outcomes such as competitiveness and profit; and those that focus on determinants of results such as prices or products. The assertion above suggests that efficiency can be based on results and determinants and hence the importance of efficiency analysis. As observed by Casu et al. (2006), bank efficiency analysis is an important tool used by various agents operating either internally to the bank or who form part of the banks external operating environment, This is why investors in share and bonds issued by banks consider the investment outcome based on the performance before forming an opinion about the ability of its management.

The bank rating system referred to as CAMEL (represents Capital, Assets, Management, Earnings and Liquidity) rating according to the Central Bank of Nigeria CBN (2003), is designed to be used by bank supervisors in evaluating the performances and efficiency of banks. It serves as an “early warning device” to detect emerging problems of banks. The rating system provides a more scientific basis for supervisory actions such as preliminary management discussions and priority scheduling of on-site examinations. These on-site examinations are designed to identify  problems  in  individual  banks  and  to  ensure  banks’  compliance  with  existing laws  and regulations. It is a qualitative and a quantitative approach of evaluating the factors that materially affect the condition and development of banks. The quantitative approach is undertaken by evaluating Capital Adequacy, Asset Quality, Management, Earnings and Liquidity (CAMEL parameters). Examiners score each of  these  factors  as a  single  number from 1 to 5,  with  1  being the  strongest rating,  and develop  an  overall  CAMEL rating  from  1  to 5 from the  factor  scores.  As  a rule  of thumb,  banks  with  a  CAMEL rating  of 4  or 5  are considered  to be problem banks.  In evaluating the CAMEL parameters, weights have been allocated to each parameter. Each parameter is subdivided into components and credit points assigned based on performance of such components. A composite rating of all the parameters is worked out and a bank is rated very sound, satisfactory, marginal or unsound. A bank rating could be reduced from “sound” to “unsound” if certain judgemental factors observed so dictate. With respect to the concept of efficiency the ratio of total expenses to total income (efficiency ratio) is first of all computed. For a ratio of 100% or more, the credit point is zero. Qualitative factors that should be considered are compliance with laws and regulations and other fundamental factors. The rating of Nigerian banks between 2001 and 2009 are as illustrated below;Figure 1: Rating of Nigerian banks using the CAMEL parameters.

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