EQUITY OWNERSHIP STRUCTURE AND OPERATING PERFORMANCE OF COMMERCIAL BANKS IN AN EMERGING MARKET EVIDENCE FROM THE NIGERIAN BANKING INDUSTRY

ABSTRACT

This study investigates  the influence of equity ownership structure on  the operating performance of quoted Nigerian banks from 1998 to 2007.

A  dataset  on  bank  equity  ownership  structure  and  bank  profitability,  covering  one hundred and eighty observations from eighteen out of the presently quoted twenty one banks was used for the study. A non probability sampling method was applied to select the banks used in the study. Overall, the study provided strong empirical validation of the link between equity ownership structure and bank’s operating performance. Using pooled cross sectional regression techniques for the entire sample for the ten-year period with ROA, ROE, and NIM/TA, as alternate measures of performance, the signs of the regression coefficients and their significance levels are almost consistent across the different measures of profit. The results challenge many of the widely held opinion concerning the impact of equity ownership structure on bank profitability. First, there is no discernible or systematic relationship between directors’ equity ownership structure and bank profitability. The results remained robust to alternative measures of operating performance. Further analyses of the sub sample provided limited evidence supporting the alignment or convergence of interest hypothesis propounded by Jensen and Meckling (1983). Secondly, the results are not consistent with the theoretical framework evidenced in the earlier work of Sanda, et. al. (2003), that ownership concentration enhances corporate performance and differed significantly from the empirical work of Adenikinju et. al. (2003). This intriguing result suggests that, though the Nigerian banking industry is highly concentrated, with only five percent of the shareholders controlling two out of every three shares in the industry, it does not result to superior returns on total assets or shareholders equity. This unusual result has been attributed to the events that shaped banks operations during the study period, especially the bank recapitalization exercise. Banks’ total assets and capitalization increased significantly during this period without sufficient commensurate investment windows to enhance their profitability. In addition, the results give confirmation to the fact that mutual and equity investment trusts are not well established in Nigeria. The result of the relationship between ownership mix and bank profitability yielded mixed results. The coefficient of government equity holding is rightly signed,  indicating that  with  government  equity holding in  Nigerian  banks  at approximately four per cent,` the theoretical negative expectation is confirmed by this study. Again, this result indicates that there is negative, rather than a positive impact of foreign equity ownership on bank profitability. However, the alternative estimation method used in the study, yielded a rightly signed relationship between equity ownership of foreigners and bank profitability. This confirms generally accepted belief that foreign direct investment has significant and positive impact on the economy.

The result supports the apex bank’s policy of limiting government’s equity interest in any bank to a maximum of ten per cent.

The  study  recommends  policy  initiatives  that  would  fast  track  the  growth  and development of institutional investors in Nigeria as well as enhancement in corporate governance practices to sustain the financial health of the banking sector.

1.1 Background of The Study

CHAPTER ONE

INTRODUCTION

The relationship between equity ownership structure and firm operating performance has become  a  vital  issue  in  understanding  the  effectiveness  of  alternative  corporate governance mechanisms. Since the seminal work of Bearle and Means (1932), the notion that the characteristics of a firm’s ownership can affect operating performance of the firm has received considerable attention in recent literature (Cornett et al, 2008; Barros et al,

2007; Micco et al, 2007; Cornett et al, 2007; Iannotta et al, 2007; Wang, C, 2005; Cho,

1998; Hermalen and Weisbach, 1991; and McConnell and Searves, 1990).

There  is  consensus  these  among  empiricists  that  the  role  of  ownership  structure  in shaping the operating performance of firms is more pronounced in developing countries than in developed countries, as a result of the relatively undeveloped structure of the capital market in emerging economies (Kim, et al, 2004; and Wang, 2005). This submission appears to have informed the continuous efforts by governments in emerging economies to encourage the reorganisation of corporate ownership structure for enhanced efficiency  and  effectiveness.  In  Nigeria,  this  restructuring  has  taken  the  form  ofindigenization,  divestiture of government  holding,  privatisation,  conversion  to  public limited liability company and subsequent quotation on the Nigerian stock Exchange. Ownership structure covers both the ownership mix and ownership concentration. The broad  spectrum  of  ownership  encompasses  government,  institutions,  management, individuals, and foreigners. The ownership mix will ultimately have consequence on managerial behaviour and corporate performance.

Ownership concentration refers to the degree to which ownership of a firm revolves around a few closely knit people or otherwise. The implication is that the higher the percentage of shareholding in the hands of one or a few dominant shareholders, the higher the concentration and vice versa. There are realistic reasons for the departure of ownership structure from the small diversified shareholding structure recommended by economic theory, especially where legal protections are weak. Dyck (2000) posits that ownership concentration and ownership structure in general can fill the gap by providing the functions of corporate governance, enhance the fulfilment of promise, management monitoring and lower costs of resolving competing claims.

Claessens et al. (2000), for example examined corporate ownership in East Asian firms and found that owners exert significant control over their firms which is not surprising given that managers and owners are often the same people. This is likely the same scenario in Nigeria, where original owners by arrangement still retain significant control over their firms even after public offers.

Again, as a result of the relatively undeveloped market structure in emerging markets, the degree of information asymmetry among participants is usually high; thus granting influential manager-owners greater latitude to engage in and act upon their desires.

Hence, significant managerial ownership in a developing economy may support both managerial alignment effects and entrenchment effects.

Jensen and Meckling, (1976) posits that agency costs will be mitigated as a result of the existence of significant managerial ownership.

The higher degree of information asymmetry between managers and outside shareholders in an emerging market compels a greater need for alignment of managerial interests with shareholders interest.

Accordingly,  the  study  investigated  the  relationship  between  bank  equity ownership structure and bank operating performance, using Nigerian commercial banks.

Again, paraphrasing Alchian (1965), how does it happen that millions of individuals are willing to turn over a significant portion of their wealth to organisations run by managers who have so little interest in their own welfare? What is even more astonishing is that they are willing to make these commitments as residual claimants, that is, on the expectation that managers will operate the firm so that there will be earnings which accrue to the shareholders. The residual claimants here connote the income that will come to the shareholders, after other prior claims have been settled.

The emphasis in this thesis is the banking sector. This is because of our firm belief in the critical role of this sector of the economy. The banking sector is strategically important to all sectors of the economy. Consequently, the desired overall development of the country demands that the sector remains healthy. This will translate to good returns to all stakeholders in the industry. Besides, the recent history of the banking industry in Nigeria makes it an attractive laboratory to examine the impact of equity ownership structure on bank operating performance. In particular, the cycle of boom, bust and distress syndrome which necessitated the recent recapitalisation programme readily comes to mind. Another issue that makes a study in this sector relevant is the active and well regulated corporate control mechanism in the banking sector. This has developed to the extent that corporate governance expectations have been codified by the Central Bank of Nigeria. The code, among other things, emphasizes that good corporate governance rests ultimately with the board of directors. A list of practices and omissions considered unethical/unprofessional as  well  as  procedures  and  sanctions  for redressing them  are amongst  its  significant highlights.

Perhaps more importantly, it is worthwhile to note that the banking firm has significant differences with respect to corporations in other economic sectors and this justifies a special academic interest in its governance challenges. For instance, banks face a clear conflict of interest arising from differences between the interests of shareholders and the interest of depositors. While shareholders are willing to encourage stakes in high –risk projects that increase share value at the expense of deposits, the depositors, if anything,

are interested in the security of their deposits. This becomes especially important in this study,  as  IPO’s  and  other  means  of  ownership  restructuring  frequently  result  to significant heterogeneous shareholding structure, which can impact board membership and managerial selection.

1.2       Statement of the Problem

In Nigeria, several bank crises, inefficiencies, and eventual distress are linked to the ownership structure of such banks. This is mainly the consequence of management- shareholder conflict or agency conflict. Specifically while shareholders want long term maximization, managers self interest is in the maximization of their compensation and power (larger enterprises). Furthermore, the agency problem in bank governance arises because of considerable information asymmetry between shareholders and managers and uncertainty about strategic decisions. In respect of the former, managers have a lot more information than shareholders have about the organisation, which makes it difficult for the shareholders to determine if the organisation is being governed in their interests. Distinct indices of agency problems include executive pay that is not related to performance, decisions that might increase the power of executives but which disregard the long-term interests of the company, excessive diversification where no value is added, and paying too high a price for acquisitions, Gupta, et al (2007). Despite the volume of empirical evidence, there has been no unanimity on how to resolve the problem. The lack of consensus has led to a variety of mechanisms on how to deal with the problem of agency. These include promoting managerial share ownership, encouraging ownership concentration, and discouraging government ownership. The government and regulatory authorities have continuously encouraged  the restructuring of ownership structure of banks to enhance efficiency and profitability as one way of dealing with the problem. The uncertainty surrounding the outcome of these options may have further made banks vulnerable to decline in profits, due to existing uncompetitive ownership structure. The plan by the CBN in its reform agenda to limit government’s ownership in any bank to a maximum  of  10  percent  may not  be  unconnected  with  the  Apex  banks’  belief  that ownership of financial institutions matter. Besides, the possible impact of initial public offers, conversion to Plc, and mergers on ownership structure and the subsequent impact

on the operating performance of companies, is an issue which has not received sufficient conclusive empirical attention in Nigeria. The consequences of these ownership restructuring exercises on the ownership structure and its impact on bank profitability are the major issues addressed by this thesis.

1.3       Objectives of the Study

The overall objective of this study is to evaluate the effect of equity ownership structure on the operating performance of commercial banks. Specifically the objectives of the study are:

i.          To  determine  the  nature  of  the  relationship  between  Managerial  ownership structure and operating performance of Nigerian commercial banks.

ii.        To  find  out  the influence  of  concentration  of  shareholding  on  the  Operating performance of Nigerian commercial banks.

iii.       To  determine the impact  of ownership  mix  on  the operating performance of

Nigerian commercial banks.

In  addition  to  the  above,  the  study considered  the  influence  of  other  bank  specific determinants of performance such as banks’ capitalization, the size of banks, the age of Nigerian commercial banks and the number of bank branches, and financial leverage.

1.4       Research Questions

The following research questions provided robust guides for solving the problems under investigation.

I. What is the nature of the relationship between Managerial Ownership Structure and operating performance of Nigerian banks?

2. In what ways does concentration of shareholding affect operating performance of

Nigerian banks?

3.  What  is  the impact  of ownership  mix  on  the operating  performance of  Nigerian

Commercial Banks?

The  influence  of  bank  capitalization,  the  size  of  banks,  and  the  age  of  Nigerian commercial banks on the operating performance of Banks in Nigeria, were considered as control and explanatory variables.

1.5       Research Hypotheses

The following hypotheses were tested in this study.

1.   There is no positive and significant relationship between Managerial ownership structure and bank operating performance.

2.   Concentration of shareholding does not result to positive and significant impact on bank operating performance.

3.   Ownership mix has no positive and significant impact on bank performance.

The variables included and the relationship indicated, were chosen on the basis of their role in explaining operating performance of banks , their role in banking theory, their use in previous studies, and the availability of relevant and usable data.

1.6       Significance of the Study

The banking sector is currently undergoing phenomenal structural changes as a result of the ongoing reforms in the banking sector. The first phase of this reforms demanded that banks shore up their capital base to a minimum of 25billion Naira on or before 31st December 2005. According to the CBN, the new capitalization level would foster consolidation of the banking industry through mergers and acquisitions.

The  recapitalisation  requirement  compelled  most  of  the  banks  to  seek  fresh  capital through the capital market. The capital market has since then been inundated by banks quest to outgrow each other.

Accordingly, the significance of this study includes:

1.   The advantage that this study will provide to bank owners regarding the impact of public issues on shareholding mix and concentration, which in turn will assist them, consider alternative finance options.

2.   Regulatory and oversight bodies like the Securities and Exchange Commission, Nigerian Stock Exchange, etc will profit from this work in the sense that the

outcome will assist them create a better regulatory framework that will protect the interest of capital market stakeholders, especially minority interests.

3.   This work will also provide an empirical evaluation of claims by the monetary authorities  that  bank  distress  is  connected  to  an  uneven  ownership  structure, which according to the proponents promotes weak corporate governance.

4.   The outcome of this study will grant bank stakeholders to evaluate the impact of various corporate governance mechanisms on profitability.

5.    Next to these are potential investors who will be better armed to invest in IPO’s, public offers, or seasoned equity offerings.

6.   The study will be beneficial to the original owners, who will now be armed with the information on the consequences of dilution of ownership structure on operating performance.

7.   The academic community and researchers at large will also benefit since this study is perhaps the first attempt, at correlating ownership structure and performance, after the conclusion of the first phase of banking reforms in Nigeria.

1.7       Scope of the Study

This study covers a period of ten years, from 1998 to 2007. The choice of the time frame requires an explanation. The new civilian regime came on board by the middle of 1999. The first full financial year after the new government was in  year 2000. Following section 9 of the Banks and Other Financial Institutions Act (BOFIA) 1991 as amended, which requires the Central Bank of Nigeria (CBN) to determine from time to time the minimum paid-up capital of banks, two different capitalisation thresholds were set for banks. Banks licensed with effect from 2001 were required to provide a minimum paid up capital of two billion Naira while the banks existing before then were expected to shore up their capital base to ten billion Naira by the end of 2002. Efforts were made by banks to satisfy these requirements. As at December 2004, six (6) banks had not met that requirement. Other significant developments took place in the banking sector of the economy which includes bank distress, its resolution, introduction of code of corporate governance for banks and the recapitalisation directive issued by the Central bank of Nigeria. The study focused on banks that are currently quoted on the Nigerian stock

exchange  provided  that  their  two  year  post  quotation  operating  performance  were available latest by 2007. This is to enable us to fully study the impact of ownership structure on the operating performance of the concerned banks. These reasons explain the cut-off point used in this study.

A total of eighteen banks out of the presently quoted twenty one banks met the study requirements and were included in the study.

1.8       Limitations of the Study

The major limitation of this research was financial constraints. A considerable fortune was committed to this work especially with regard to data gathering and assembling of literature review materials via the internet. Access to some secure internet sites, like Elsevier and Science Direct could not be obtained due to prohibitive access charges. Connected to this is the time limitation, as the work had to be completed within a specified  time frame.  Nevertheless,  research  visits were made to  Lagos,  Abuja,  and Onitsha to gather available data in respect of the sampled banks.

Another research constraint is that complete data could not be obtained in respect of variables for the entire period of the study, even when efforts were made to access vital data from regulatory authorities like the Securities and Exchange Commission and the Nigerian Stock Exchange.

1.9       Definition of Terms

I)         Active/Efficient Monitoring Hypothesis

This hypothesis suggests that block shareholders have incentives to monitor and influence management appropriately in order to safeguard their considerable investment. This monitoring role of the external block investor(s) lower direct agency conflicts with the management by reducing the scope of managerial opportunism.

11)      Alignment of Interest Hypothesis

This hypothesis was coined by Jensen and Meckling (1976) to portray the synergy that would result from the convergence of the interests of agents and principals in a public corporation. The hypothesis proposes that an organisation’s corporate goals would be advanced,   as   reflected   by   enhanced   performance,   where   there   is   alignment   or convergence of interests. The hypothesis further argues that managerial share ownership can reduce managerial incentives to consume perquisites, expropriate shareholders wealth and to engage in other non-maximizing behaviour

111)    Autocorrelation

Auto  correlation  exists  in  multiple  regression  analysis,  when  the  economic  data generating process is such that errors in a linear regression model are correlated

IV)      Corporate Governance

The OECD (1999) defines corporate governance as “the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and as well spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.” Some academic researchers, such as Shleifer and Vishny (1997), define corporate governance more broadly as “… ways in which suppliers of finance to corporations assure themselves of getting a return on their investment,” whereas the Financial Times advances a more practical definition by stating that it “[…] can be defined narrowly as the relationship of a company to its shareholders or, more broadly, as its relationship to society.

V)       Dummy Variable

These are explanatory variables that take one of two values, usually 0 or 1. They are used to capture qualitative characteristics of firms, gender, etc.

V1).    Emerging Stock Market

This is a stock market located in a developing country that is included in the current major database of the International Financial Corporation (IFC) of the World Bank. The

criterion for inclusion is related to an increase in market capitalisation which must have reached a minimum threshold.

The time of emergence is defined as the first date at which an index is computed.

The term emergent market was coined by the IFC in 1981. The IFC defined it as a market located in a developing country. Using the World bank’s definition, this includes all countries with a GNP per capita, less than $8,625 in 1993.The IFC (1995) states that although IFC has no predetermined criteria for selecting an emerging market for IFC index  coverage,  in  practice  most  markets  added  have  had  at  least  30  to  50  listed companies with market capitalization of US $1billion or more and an annual trading value of US $100Million or more at the start of IFC index coverage.

V1I)    Entrenchment Hypothesis

The entrenchment hypothesis is the alternate hypothesis to the convergence of interest hypothesis. It propounds that agents, represented by managers in a public corporation, as a result of separation of owners and management will indulge in excess perquisite consumption, which will hurt operating performance. It further suggests that rather than promote performance, managerial share ownership may have adverse effects on agency conflict between management and share ownership. They argue that instead of reducing managerial incentive problem, managerial share ownership may entrench the incumbent management team, leading to an increase in managerial opportunism.

V11I). Flippers

Flippers are temporary investors who purchase shares at the IPO and quickly turn around to sell their shares.

IX).     Holding Period Return

This is the return measured from the closing market price on the first day of public trading to the market price on the 3 year anniversary.

X).      Initial Public Offer

Initial public offering (IPO) is the first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking capital for expansion. It can also be done by large privately-owned companies expecting to have their shares publicly traded on the stock exchange market.

X1)     Issue by Prospectus

This is a means of raising capital whereby the company extends an open invitation to the investing public, through the medium of an issuing house, to subscribe to the issue. The invitation is usually by means of advertisement in the national dailies which incorporates detailed prospectus on the issue.

XI1)    Managerial Self Interest Hypothesis

This hypothesis contends that the possibility of losing employment if the company should fail  places  a responsibility on  risk-averse  managers  to  lower unemployment  risk  by ensuring continued viability of the firm.

X11I)  Market Capitalisation

This refers to the value of a firm as determined by the market price of its issued ordinary shares.

XIV)   Micro minority Controlled Banks

This refers to banks whose substantial outstanding shares are held by closely knit units like families and institutional investors. They are otherwise called family owned banks. XV)    Offer for Sale

This is a means of raising capital which involves an open invitation to the public. The

difference here however is that unlike in an issue by prospectus, the issuing house is the principal rather than the agent of the issue. The offer for sale is also incorporated in a prospectus and widely advertised in national newspapers.

XVI).  Ownership Concentration

This  refers  to  the  distribution  of  shares  owned  by a  certain  number  of  individuals, institutions or families. Ownership concentration measures the influence or power of shareholders as well as their peculiar incentive mechanisms and preferences.

XV1I).            Ownership Mix

Ownership mix is related to the identity of the owners. It further refers to the presence of certain institutions or groups such as government or foreign partners, among the partners. Ownership mix highlights the identity of shareholders as well as their unique incentive mechanisms and preferences.

XVI1I). Ownership Structure

This refers to the ownership concentration and ownership mix, with respect to majority shareholding.

XIX).  Private Placing

This is an approach used by unquoted companies or in supplementary issues to increase their capital base. Usually institutional investors are contacted to acquire the securities. The minimal legal formalities and low floatation costs is a major attraction for the use of this avenue.

XX) Stock Exchange Introduction

Stock Exchange introduction is a means of obtaining quotation of a security as no extra capital is raised in the process. Once the correct fees are paid and other listing requirements met then the introduction is normally allowed

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