CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Corporate governance is concerned with the ways in which the shareholders of corporations assure themselves of getting a return on their investment (Shleifer and Vishny, 1997). It also deals with the mechanisms by which shareholders of a corporation exercise control over management such that the interests of the shareholders are protected (John and Senbet, 1998). The organisation for Economic Cooperation and Development (OECD) Principles of Corporate Governance (2004) define corporate governance as involving “a set of relationships between a company’s management, its board, its shareholders, and other stakeholders”. Corporate governance also provides the structures through which the objectives of the company are set, the means of determining the attainment of those objectives, and establishing performance-monitoring mechanisms. OECD (2004) also posits that good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders, and should facilitate effective monitoring. The presence of an effective corporate governance system, within an individual company and across an economy as a whole, helps to provide a degree of confidence that is necessary for the proper functioning of a market economy. Corporate governance is, therefore, about what the board of a company does and how it sets the values of the company, and is to be distinguished from the day-to-day operational management of the company by full-time executives (Financial Reporting Council, 2010).
Corporate governance research is influenced by the agency theory. The primary reason for corporate governance is the separation of ownership and control, and the agency problem it engenders (John and Senbet, 1998). Agency cost arises in organisations where the owners (shareholders) are not the managers. Usually, the interests of shareholders may not wholly match the interests of managers. Shareholders are interested in maximizing the value of the firm, but managers’ objectives may also include the increase in perquisite consumption and job security (Belkhir, 2006). Given various attributes of the management-shareholder relationship, corporate governance mechanisms such as equity ownership by managers (Jensen and Meckling, 1976); equity ownership by outside blockholders (Kaplan and Minton, 1994); executive compensation (Mehran, 1995); compensation contracts (Adams and Mehran, 2003), among others, may help align the interest of managers with those of shareholders, thereby mitigating the agency problem. In addition, the board of directors also may play a central role in monitoring managers (Fama, 1980), and minimizing losses in shareholders’ interest (Nicholson and Kiel, 2004). Hence, the board is known as one of the most important instruments of solving the corporate governance problem (Jensen, 1993).
Since the mid-1980S, the issue of corporate governance has attracted a great deal of attention both in academic research and in practice (Levrau and Van den Berghe, 2007). Corporate scandals across the world, especially in Europe and America, such as Adelphia Communications, Arthur Anderson, Enron, Health South, Tyco, WorldCom and Ahold, among others, set off a fresh round of debate on the effectiveness of corporate governance laws, which also shifted the spotlight to the board of directors (Levrau and Van den Berghe, 2007). In the wake of these series of high profile scandals, the Sabones-Oxley Act 2002 (SOX) was passed in the United States of America (Dalton and Dalton, 2007; Romano, (2005), and similar regulations in other jurisdictions.
Corporate governance has also been at the forefront of the policy agenda of international bodies. The OECD, in 1999, promulgated the Principles of Corporate Governance, which was revised in 2004 (OECD, 2004). Similarly, the European Association of Securities Dealers (EASD), in 2000, issued the Corporate Governance Principles and Recommendations, while the International Corporate Governance Network (ICGN), in 2005, issued the Statement on Global Corporate Governance Principles, revising its 1999 version (EASD, 2000; ICGN, 2005). Also, the Basel Committee on Banking Supervision promulgated a set of corporate governance principles in 1999, which was revised in 2006, following the 2005 Consultative Document (see Basel Committee on Banking Supervision, 1999, 2005, 2006). One of the major objectives of these recommendations is the design of an optimal board structure that would prevent the failure of the firms’ governance, as well as maximize their financial performance.
In Nigeria, the Central Bank of Nigeria, CBN, in 2006, responded to this trend by establishing the Code of Corporate Governance for Banks in Nigeria Post Consolidation.The major recommendations of the code include:that the board should have a minimum of four meetings in a financial year; that the number of non-executive directors should be more than that of executive directorsand that, bank board size should not be more than twenty, among others.
The rationale for these recommendations was to make commercial bank boards in Nigeria effective. However, the recent global financial crisis, which also triggered banking crisis in Nigeria, has come as a surprise to practitioners and scholars given the low level of integration of the Nigeria financial system to the global financial market. Investigation carried out by the Central Bank of Nigeria revealed that the causes of the post-consolidation crisis were as a result of macro-economic instability caused by large and sudden capital inflows; major failures in corporate governance at banks; lack of investor and customer sophistication; inadequate disclosure and transparency about financial position of banks; critical gaps in regulatory framework and regulations; uneven supervision and enforcement; unstructured governance and management processes at the CBN/weakness within the CBN; and weaknesses in the business environment (Sanusi, 2010). According to Sanusi (2010), failure in corporate governance of banks was, indeed, a principal factor contributing to the financial crisis in Nigeria. This raises an important research question on the effectiveness of the recommendations of the Code of Corporate Governance for Banks in Nigeria Post Consolidation in promoting good corporate governance among Nigerian banks.
Corporate governance of banks is important for banks themselves as well as for the whole economy (Caprio and Levine, 2002). First of all, banks are themselves corporations. Sound corporate governance is essential for banks to perform efficiently. Moreover, since banks exert a strong impact on economic development (Levine 1997), corporate governance of banks is crucial for growth and development. Banks play a central role in mobilizing the social savings and channeling them to the most productive projects. Bank lending is a major source of external finance for other firms, especially in developing and emerging economies. Sound corporate governance of banks is essential for bank managers to allocate social capital efficiently and to enhance the performance of the economy. Banks also play a critical role in the corporate governance of other firms (Franks and Mayer, 2001; Santos and Rumble, 2006), as creditors or equity holders of firms. Thus, it is also essential that banks, themselves, face sound corporate governance so that they can exert effective governance over the firms they fund.
As suggested by both practitioners and academicians, banks’ governance mechanisms are key factors influencing bank performance. Research on governance issues related to banks has been limited, as prior research tends to focus on firms in the non-financial sector (Handley-Schachler et al., 2001; Adams and Mehran, 2003). Hence, only few papers focus on bank corporate governance and its association with performance (e.g. Adams and Mehran, 2005; Caprio et al, 2007, Levine, 2004; Macey and O’Hara, 2003; Andres and Vallelado, 2008; Dahya et al., 2008).This could be attributed to the peculiar nature of bank governance problem.
The nature of corporate governance problems in banking is different from non-banking firms. Research offers several reasons which make bank corporate governance peculiar. First, banks, due to their special nature have wider stakeholders. In addition to shareholders, the interest of depositors has to be addressed (Macey and O’Hara, 2003) and, also, that of regulators who ensure sound financial system (Boot and Thakor, 1993). Hence, bank directors are accountable not only to shareholders, but also to depositors and regulators (Subrahmanyam, et al., 1997). Second, banks’ high leverage and, mismatch between term structure and liquidity of their assets and liabilities make their role in the economy very important. Third, the agency problems are particularly crucial for banks as they are informationally opaque (Levine, 2003; Caprio and Levine, 2002) largely because of information asymmetries (Furfine, 2001). Fourth, deposit insurance makes the situation worse by ameliorating the ‘moral hazard’ problem among bank shareholders and debt-holders. In the presence of deposit insurance, the depositors or debt-holders may have less incentive to monitor bank managers. Deposit insurance may similarly distort the bank’s investment and financing process as bank managers and shareholders may have added incentives to take more risks (Merton, 1977). Demirgüç-Kunt and Detragiache (2002) argue that countries with more generous deposit insurance schemes tend to have a higher likelihood of banking crises. Finally, Skully (2002) contends that bank corporate governance is particularly important because it reduces the risk of taxpayer funds being used in mitigating a crisis and helps restrain connected lending.
Among other characteristics of the board, size, composition, and activity have received special attention, in academic literature (Andres and Vallelado, 2008). An extensive body of empirical research has examined the effect of board size (Yermack, 1996; Provan, 1980; Dalton et al., 1999; Lee and Filbeck, 2006; Jensen, 1993; Fernandez et al, 1997; Adams and Mehran, 2003, 2005, 2008; Huther, 1997; Eisenberg et al, 1998), composition (Kesner, 1987; Baysinger and Butler, 1985; Hermalin and Weisbach, 1988, 1991, 2003; Weisbach, 1988; Rosenstein and Wyatt, 1990, 1997; Bhagat and Black, 1999) and number of meetings (Klein, 1998; Vafeas, 1999; Adams and Mehran, 2003) on firm performance. Empirical evidence along this line remains inconclusive. It has been argued that a larger board of directors is beneficial and will increase the collection of expertise and resources accessible to a firm (Dalton et al., 1999). Belkhir (2009) reports that a larger bank board is positively associated with firm performance as measured by return on assets and Tobin’s Q. However, Hermalin and Weisbach (2003) argue that a larger board will impair firm performance. Jensen (1993) concludes that the effectiveness of a board may decline as board size increases. On the one hand, non-executive directors could be more motivated to monitor the CEO; but on the other hand, they might also be less informed about the running of the business (Bahgat and Black, 1999; Adams and Ferreira, 2007). Regarding board activity, the frequency of board meetings is suggested to indicate active monitoring by the board (Conger et al., 1998). Contrary to this perspective, Vafeas (1999) found that frequency of board meetings is negatively related to performance, which may be the result of boards meeting more often subsequent to poor performance.
It is evident that most of the works reviewed used data from developed economies. This study presented evidence from Nigeria, one of the emerging markets in the world. Given the recent banking crisis in Nigeria and the revelation by CBN that the principal cause of the crisis is governance problem, it becomes important to evaluate the effectiveness of the major recommendations of the Code of Corporate Governance for Banks in Nigeria Post Consolidation. This study sought to fill this important research gap by evaluating the impact of board size, board composition and board activity on the financial performance of banks in Nigeria using a population sample of all the 24 commercial banks for the period 2006 – 2010.
1.2 Statement of the Problem
Less than a decade after the Enron scandal, the recent global financial crisis has raised a lot of questions on the effectiveness of the governance mechanisms in the banking industry. It has brought to bear the harmful consequences of poor governance principles in financial business. Poor corporate governance may contribute to bank failures, loss of confidence by the market, bank run or liquidity crisis which can pose broader macroeconomic implications, such as contagion risk and impact on the payment systems (Basel Committee on Banking Supervision, 2006). A bank which becomes less attractive for investment purposes will shortly lose employees and customers (Spremann, 2005 P: 39). Furthermore, it will become a candidate for acquisition.
For a developing country like Nigeria, corporate governance in the banking sector is of critical importance. This is evident in the recent banking crisis which has been arguably described as the worse in the history of the country (Uche, 2010). In 2009, following the banking system crisis which was largely caused by poor corporate governance practices, some Nigerian banks had to be rescued through the injection of N620 billion of liquidity by the CBN (Sanusi, 2010). This high-profile governance problem occurred after the CBN had adopted the Code of Corporate Governance for Banks in Nigeria Post Consolation. This raises an important question on the effectiveness of the prescriptions of such code.
It has been established that Nigeria, like most developing economies, has weak market institutions, weak external governance laws and poor implementation of promulgated laws. Thus, effective corporate governance laws must incorporate the country’s institutional specifics in making bank boardeffective. Such laws must be influenced by studies in local jurisdiction instead of wholesome adoption of the recommendations of studies in developed economies. This study fills this important research gap by estimating the effectiveness of corporate boards in the Nigerian banking industry using Nigerian data. Specifically, the study evaluated the recommendations of the Code of Corporate Governance for Banks in Nigeria Post Consolation in enhancing bank board effectiveness in Nigeria.
1.3 Objectives of the Study
The overall objective of this study is to empirically investigate the impact of board effectiveness measures on the financial performance of banks in Nigeria within the five-year period, 2006 – 2010. To achieve this objective, the study strives to accomplish the following specific objectives:
- Determine the impact of board size onbankfinancial performance in Nigeria.
- Investigate the relationship between board composition, defined by the proportion of non-executive directors, andbankfinancial performance in Nigeria.
- Assess the impact of board activity, defined by number of board meetings, on bank financialperformance in Nigeria.
1.4 Research Questions
This study strives to provide answers to the following research questions:
- What is the impact of board size on bankfinancial performance in Nigeria?
- What is the impact of the proportion non-executive directors onbankfinancial performance in Nigeria?
- What is the impact of number of board meetings on bankfinancial performance in Nigeria?
1.5 Research Hypothesis
In order to achieve the above stated objectives and also provide answers to the research questions, the following a priori assumptions are investigated:
- Board size does not have a positive and significant impact with bank financial performance.
- Proportion of non-executive directors does not have a positive and significant impact with bank financial performance.
- Number of board meetings does not have a positive and significant impact with bank financial performance.
1.6 Scope of the Study
This study looks at the impact of board effectiveness measures(size, composition and functioning) on bank financial performance in Nigeria. The study borrows extensively from previous works along this line, and makes use of three board structure variables which include: board size (number of board members),proportion of non-executive board members and number of board meetings. The study also made use of Tobin’s Q as a proxy for bank financial performance.
The study covers 20 banks in Nigeria for the period 2006 – 2010, forming a panel data for the 5-year period. This period is chosen in order to eliminate possible bias brought about by missing variables as a result of the banking consolidation exercise which ended in 2005.Data are collated from secondary sources that include annual reports of banks, the Nigerian Stock Exchange Factbooks, the Nigeria Deposit Insurance Corporation Annual Reports and the Nigerian Stock Exchange Daily Official List.
1.7 Significance of the Study
The recent global financial crisis which affected the Nigerian financial landscape underscores the importance of good corporate governance in the country. This has been further stressed by the spate of corporate governance principles and codes around the world. In the Nigerian banking sector, this came in the form of Code of Corporate Governance for Banks in Nigeria Post Consolidation prescribed by the Central Bank of Nigeria. The prescriptions of the code leaned extensively on those of developed economies, hence its practicability and effectiveness in our jurisdiction remains in doubt. Also, the lack of empirical research on corporate governance of banks in Nigeria, especially as it regards board effectiveness, stresses the significance of this research work. Hence, a study of this manner will prove to be specifically significant to both stakeholders and researchers alike in the following ways:
- Shareholders
From the agency theory perspective, shareholders use the board to mitigate the agency cost and align their interest with those of the managers. The result of this study will assist the shareholders of banking firms in understanding the impact of board size, composition and functioning on bank performance. This knowledge will help shareholders use their voting rights to insist on effective board structure that would enhance the value of the firm.
- Regulators/Policy Makers
Good corporate governance imposes appropriate standards of conduct and regulates the relationships between bank boards, management and other stakeholders. Sequel to this, the Central bank of Nigeria introduced the Code of Corporate Governance for Banks in Nigeria Post Consolidation (CBN, 2006). The code leans greatly on established models of corporate governance that function within the developed economies. Special attention needs to be given in establishing necessary codes that are tailored to the country’s specific needs and promote goodcorporate governance through empirical investigation. Hence, the results of this research will assist regulators and policy makers in reviewing the code and in future recommendations.
- Academics/Researchers
This research will contribute to the current debate on corporate governance. The study will add to the existing literature, providing evidence from the Nigerian banking industry and will be of great value to further studies on bank boards and financial performance in Nigeria.
1.8 Limitations of the Study
This research would not have been completed without some limitations. One of the limitations is the use of secondary data. Since this study relied exclusively on already existing data sources, any error or mistakes in the reporting of these data would ultimately affect the validity of the results. Also, the fact that there is no central depository for all the required data put tremendous pressure on our financial resources. Therefore, financial constraint is another limitation given the volume of data required for a study of this magnitude