INTEREST RATE REFORMS AND BANK PROFITABILITY: THEORY AND EMPIRICAL EVIDENCE FROM NIGERIA.

• Author: Ezirim, Chinedu B.

INTRODUCTION

The Nigerian financial sector is the most regulated sector of the economy with regulations covering almost every facet and fabric of the sector. These include regulations on its product offerings, prices of its services, licensing and entry, geographical spread and other dimensions. Among all these, the price or interest rate regulations appear to be more pervasive and penetrating. Interest rate regulation has been implemented on such regulating items as the monetary policy rate, interest rate margin or spread, margin requirements, lending rates, and deposit rates. The main burden bearers in the economy are the banking institutions, who appear to groan ceaselessly under the burden of the impositions. It must, however, be pointed out that at various times, the monetary authorities have had to ameliorate the burden of the regulatory policies by introducing nominated deregulatory reforms. The economy had over-time witnessed times of interest rate deregulation, with concerted tinkering on monetary policy rates, stated lending rates, stated deposit rates, and by default, interest rates' spread. The adjustments and amendments are prescribed by the Monetary Policy Committee (MPC) of the Central Bank of Nigeria (CBN) during their quarterly and extra-ordinary meetings.

The major rationale for the implementation of the regulatory and or deregulatory reforms is to align the operations of the banks in the country to be in consonance with the nominated economic objectives of the country. It is also central for the regulatory authorities to aim at protecting the interest of the various bank publics that are interested in the operations of the institutions, especially the customer. The integrity of the banking industry is also uppermost in the minds of the regulators. However, what does not seem to be a major object of the policy makers is the effect of such policy adjustments and redirections on the profitability of the concerned banks. It is yet to be deciphered, fully, whether the financial sector reforms along the lines of price regulation/deregulation affect the profitability of banks in Nigeria. It is also not yet clear as to which of the regulatory tools or variables affect banking sector profitability the most.

It behooves us to examine and determine the extent and direction of the effect of interest rate reformatory tools on banking profitability using the Granger causality techniques, among others. The results of the study, hopefully, will assist policy makers and implementers to know whether or not they should continue to engage in their chosen interest rates policy reforms mix, and whether or not they should do so as regularly as they are doing. The study's results are expected to also justify the continued relevance, or otherwise, of the Monetary Policy Committee.

BACKGROUND OF THE STUDY

Theoretical Background

There have been worrisome controversies regarding the avowed effects of interest rates' or price reforms on the profitability of banks. Some commentaries like Ezirim (2013) were of the contention that reforms are policy creations of governments who have diverse publics or interest parties and welfare to protect. By their nature, banks are under the duty of maximum compliance to the regulatory and deregulatory policies that are imposed on them by the monetary authorities. Being so designed to accommodate all possible interests of their publics, would it not be a plausible argument that the attendant policies would be in keeping with the maximization of profit principle or even the maximization of the owners' wealth; even when these principles (though not contradicting in the sense that they flow from the profitability axiom) are not exactly the same? That there may be some restrictions inherent in the reforms that may, in turn, reduce the tempo of profitable operations, implies that the financial reforms would not have a full effect of maximizing profits or value.

A second school of thoughts, as in Ezirim (2013), argues that reforms that are meted out without prejudice, but with recourse to fairness and objectivity, have the character of improving profitability, and by extension maximizing profits, in the course of time. Since the government is the best guardian of the state and guards the interest of all economic units operating in the ecosystem, of which banks are an integral part, its policies will serve the best interest of the units to which they are directed. A frontline objective in the ranks of these interests is profitability. Thus, the profitability of banks are incorporated in the hearts of the monetary policies of government, ab initio. Thus, even when the profitability is not immediately harnessed at any present time of policy application, it will be harnessed and guaranteed eventually in time to come, cetaris paribus (Ezirim, 2013).

The counter-balance theory of Ezirim (2013), maintains that governmental reforms and attendant policies have pre-intended multiple purposes with conflicting directions. Since they are targeted to protect divergent bank publics with seemingly conflicting expectations and thus were not intended to always move in tandem, ab initio. Thus, whereas some would encourage profitability, others may favor other objectives like liquidity, which would bring about conflict of objectives. It is advanced that governments, or its monetary authorities, have a way of introducing such conflicting policies that would eventually counteract the effects of one against the other, in an attempt to cover and relate fairly with all parties of interest (Ezirim, 2013).

Thus, within the range of interest rate or price reforms, for instance, the counter-balance theory would argue that there are policy thrusts that would attempt to promote profitability such as increasing the stated lending rate and monetary policy rate. There are also those that may reduce profitability, such as increasing the stated deposit rates. What usually happens, however, is that the authorities would increase the state lending rate, while at the same time increase the stated deposit rate in order to reduce the interest rate spread? The two policies counter-balance each other and moderate their possible effects.

A policy of increasing the reserve requirements--liquidity and cash ratios - of banks would have the effect of reducing the lendable funds of the banks, while at the same time a policy of increasing the stated lending rates would produce a counteracting and counterbalancing effect. Because of the divergent interest it serves, it is in the character of the monetary authorities to make counter-balancing policies. Noteworthy, in spite of any seeming counterbalance effects, the individual policies possess their individual effects on the performance of the target institutions such as banks (Ezirim, 2013). These individual effects are far from being determined in Nigeria.

Empirical Background

Empirically, this study draws from and extends two previous studies by Ezirim and Muoghalu (2003, 2004). Ezirim and Muoghalu (2003) empirically investigated the impact of the legal and regulatory environments on financial intermediation in an emerging sub-Saharan economy, with evidence drawn from the Nigerian Commercial banks. Use was made of econometric modeling and estimation against annual time-series data (1970-1998) to determine the relationships between the nominated financial intermediation indices (financial interrelation ratio, FIR and the commercial banking ratio, CBR), and the indicators of the legal environment, geographic, price, and product regulation/deregulation. Results showed that the legal and regulatory environments exert a very significant effect on financial intermediation operations of commercial banks in Nigeria. Particularly, the legal environmental index and the index of geographic regulation, individually, affected financial intermediation significantly, as expected. The results suggested programs aimed at reducing banking density in the country; enhancing the legal structures and system; and the promulgation of amiable laws and regulations that would encourage intermediation activities.

The second paper by Ezirim and Muoghalu (2004) analyzed the impact of the reforms instituted in the banking sector on the operational performance of commercial banks in Nigeria during two decades of varying policy shifts. More specifically, the study sought to determine which reform thrust (regulatory or deregulatory) affected commercial banks operations more significantly during the nominated decades. The analysis utilized such financial indicators as return on assets, return on equity, deposit-asset-ratio, total-asset-ratio, investment ratio, loans and advances ratio, total deposit ratio, and total investment ratio. The results revealed that the reforms significantly affected the intermediation performance of commercial banks. The evidence shows that the performance of these banks during the period described as regulatory was significantly different from their performance during the period referred to as deregulatory. The evidence also indicates that deregulatory reforms favored commercial banks in their intermediation function than the regulatory reforms.

Quite remarkably, the present study differs from both studies of Ezirim and Muoghalu (2003, 2004) in the sense that it does not focus on reform effects on financial intermediation index, per se, but on the effects of the price regulatory/deregulatory indices on profitability of insured banks in Nigeria. It specifically addresses the impact of interest rate reforms on bank profitability. Also, It does not seek to dissect between the influences of all regulatory and deregulatory reforms as was the case in Ezirim and Muoghalu's (2004) study, but concentrates on the influence of price-or-interest-rate-related reforms on bank profitability. Again, apart from the identified different thrusts, the present study updates the data and methodology...