EFFECTS OF BANK RECAPITALIZATION ON BANK PERFORMANCE AND BANK RISK

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EFFECTS OF BANK RECAPITALIZATION ON BANK PERFORMANCE AND BANK RISK

Abstract

Increasing the minimum capital requirement of banks is a major bank policy reform tool used by the Bank of Ghana (BOG) to prevent bank insolvency and ensure robustness of the Ghanaian banking sector. The existing literature shows that increasing bank capital can be beneficial in different contexts. But very few of that literature focuses specifically on African countries and other developing economies. This research was to determine how bank recapitalization affects bank performance and bank risk. Based on the literature on the subject, the major variables used in this study were return on equity, capital adequacy ratio, return on assets, net interest margin and bank risk.

This study used the t-test of means as well as panel regressions to test the hypothesis stated in the paper. The findings revealed that bank recapitalization positively affects bank performance; this is consistent with the empirical literature. In determining the effect on bank risk taking on the other hand, the t-test of means revealed a negative effect while the regression showed a positive effect.

Table of Contents

CHAPTER 1 – INTRODUCTION……………………………………………………………………………… 7

BACKGROUND………………………………………………………………………………………. 7

PROBLEM STATEMENT………………………………………………………………………… 10

RESEARCH QUESTION………………………………………………………………………….. 12

RESEARCH OBJECTIVE……………………………………………………………………… 12

RELEVANCE OF TOPIC…………………………………………………………………………. 12

OUTLINE OF THE THESIS……………………………………………………………………… 13

CHAPTER 2 – LITERATURE REVIEW………………………………………………………………….. 15

INTRODUCTION………………………………………………………………………………………… 15

WHAT IS BANK RECAPITALIZATION?…………………………………………………. 15

THEORIES ON BANK CAPITAL………………………………………………………………….. 16

RISK AND RETURN……………………………………………………………………………… 17

THE BANK CAPITAL CHANNEL…………………………………………………………… 17

FINANCIAL INTERMEDIATION……………………………………………………………. 18

EMPIRICAL STUDIES ON BANK PERFORMANCE……………………………………….. 18

EMPIRICAL STUDIES ON BANK RISK………………………………………………………… 21

CONCLUSION……………………………………………………………………………………………. 24

CHAPTER 3 – METHODOLOGY………………………………………………………………………….. 25

INTRODUCTION………………………………………………………………………………………… 25

DATA SOURCE………………………………………………………………………………………….. 25

HYPOTHESIS……………………………………………………………………………………………… 26

HYPOTHESIS FOR BANK PERFORMANCE…………………………………………….. 26

HYPOTHESIS FOR BANK RISK……………………………………………………………… 26

POPULATION AND SAMPLING TECHNIQUE………………………………………………. 27

RESEARCH DESIGN…………………………………………………………………………………… 27

PAIRED SAMPLE T-TEST………………………………………………………………………. 28

REGRESSION ANALYSIS……………………………………………………………………… 29

REGRESSION MODEL FOR BANK PERFORMANCE……………………………….. 30

REGRESSION MODEL FOR BANK RISK………………………………………………… 31

JUSTIFICATION OF VARIABLES………………………………………………………………… 32

RETURN ON EQUITY…………………………………………………………………………… 32

RETURN ON ASSETS……………………………………………………………………………. 32

NET INTEREST MARGIN………………………………………………………………………. 33

BANK SIZE………………………………………………………………………………………….. 33

BANK LIQUIDITY………………………………………………………………………………… 34

CAPITAL ADEQUACY RATIO………………………………………………………………. 34

BANK RISK………………………………………………………………………………………….. 35

CHOW TEST………………………………………………………………………………………………. 35

LIMITATIONS OF THE METHODOLOGY…………………………………………………….. 36

CHAPTER 4…………………………………………………………………………………………………….. 38

INTRODUCTION………………………………………………………………………………………… 38

DESCRIPTIVE STATISTICS…………………………………………………………………………. 38

TEST FOR MULTICOLLINEARITY………………………………………………………………. 39

4. 4 PAIRED SAMPLE T-TEST…………………………………………………………………………… 40

FINDINGS FROM TEST OF MEANS……………………………………………………….. 41

TEST OF MEANS FOR BANK PERFORMANCE……………………………………….. 42

TEST OF MEANS FOR BANK RISK………………………………………………………… 44

HAUSMAN TEST………………………………………………………………………………….. 45

4. 5 REGRESSION RESULTS…………………………………………………………………………….. 46

REGRESSION RESULTS FOR BANK PERFORMANCE…………………………….. 46

REGRESSION RESULTS FOR BANK RISK……………………………………………… 50

THE CHOW TEST……………………………………………………………………………………….. 51

CHOW TEST RESULTS FOR BANK PERFORMANCE………………………………. 51

CHOW TEST RESULTS FOR BANK RISK……………………………………………….. 53

CHAPTER 5………………………………………………………………………………………………………… 54

INTRODUCTION………………………………………………………………………………………… 54

SUMMARY OF RESULTS AND CONCLUSION……………………………………………… 55

RECOMMENDATIONS……………………………………………………………………………….. 57

SUGGESTIONS FOR FUTURE STUDIES…………………………………………………. 57

References………………………………………………………………………………………………………….. 58

LIST OF TABLES

Table 1.0 Summary Statistics…………………………………………………………………………………. 38

Table 2 .0 Table for correlation matrix……………………………………………………………………. 40

Table 3.0 Comparison of average bank performance………………………………………………… 41

Table 4.0 Results for test of means for bank performance…………………………………………. 42

Table 5.0 Comparison of average bank risk……………………………………………………………… 44

Table 6.0 Results for the test of means for bank risk…………………………………………………. 44

Table 7.0 Results for Hausman Test……………………………………………………………………….. 45

Table 8.0 Pre-capitalization Results for ROE regression…………………………………………….. 46

Table 8.1 Post-capitalization Results for ROE regression……………………………………………. 46

Table 9.0 Pre-capitalization Results for ROA regression…………………………………………….. 47

Table 9.1 Post-capitalization Results for ROA regression…………………………………………… 48

Table 10.0 Pre-capitalization Results for NIM regression……………………………………………. 48

Table 10.1 Post-capitalization Results for NIM regression………………………………………….. 49

Table 11.0 Results for pre-capitalization bank risk regression…………………………………….. 50

Table 11.1 Results for post-capitalization bank risk regression……………………………………. 50

Table 12.0 Results of chow test for ROE…………………………………………………………………. 51

Table 13.0 Results of Chow test for Return on Asset…………………………………………………. 51

Table 14.0 Results of Chow test for Net Interest Margin…………………………………………….. 52

Table 15.0 Results of Chow test for bank risk………………………………………………………….. 53

CHAPTER 1 – INTRODUCTION

1.1 BACKGROUND

The role of banking is woven as an essential part of any economy; from facilitating local and international trade to serving as an agent of development. The activities of banks therefore have ripple effects on any nation’s progress. In Ghana, banks are important for the vitality of both financial and non-financial firms. They provide funding for businesses and even provide jobs for people in the country (Agyei & Yeboah, 2011). Nonetheless, banks can pose several risks for the economy in ways that consumers may not be able to observe. Government regulation is frequently touted as a means of reducing the risk of bank failure. This is to keep them in check and ensure that their activities create positive impact and economic growth. It cannot be assumed though, that the decisions made by the central bank always yield their expected results. What can be done instead is to study the impact of some of the regulatory actions the Central Bank has made in the past, to make informed decisions in the future.

One of the primary tools of bank regulation is capitalization requirements. Capitalization requirements can affect performance, but they can also affect risk. Although many studies examine the impact of bank capital requirement on bank performance, this study also looks at its effect on bank risk. As and when it is required, the minimum capital requirement is increased by the Central Bank, and banks must increase their capital to meet the new regulation. In Ghana, the minimum capital requirement has been increased several times over the past 20 years. This paper studies the effects of such recapitalization exercises on bank performance and bank risk in Ghana.

According to Adegbaju & Olokoyo (2008), recapitalization simply means increasing the amount of long-term finances used in financing an organization. This long-term capital can come from a variety of sources, which includes but is not limited to, issuing new shares, raising funds from existing shareholders, and through mergers and acquisitions. For banks, Rose and Hudgins (2006) make it clear that this capital is needed for the bank to cover any loses that it incurs. Bank recapitalization is therefore increasing the long-term base of the financial support of a bank. Banks stand the risk of being insolvent and illiquid if they do not have enough capital. The result of this leads to the inability to absorb losses and consequently and inability to pay back depositors, hence creating fear and panic in the nation. In a bid to correct and ensure robustness in the banking sector, banking reforms aimed at raising the capital base of the banks are implemented as banks grow their loan books and economic conditions change. According to Homar & Wijnbergen (2016), a banking crisis has negative effects on unemployment, public debt and fiscal policy but recapitalization of banks helps to shorten such crisis and speeds up economic recovery. Therefore, once a crisis or a recession is detected to be looming or any of the economic indicators are treading in a negative direction, bank recapitalization helps to mitigate the negative effects.

In 2017, the Bank of Ghana announced that the minimum capital requirement for banks had increased from GHS120 million to GHS400 million and banks had until the end of 2018 to meet this new regulation. Prior to the new regulation in 2017, the Bank of Ghana had made similar announcements in the past. In 2003, the capital requirement for banks was increased to GHS7 million (BOG, 2004), in 2009, it was again increased to GHS60 million (BOG, 2009), later it was increased to GHS120 million in 2012 and then the most

recent increase to GHS400 million in 2017, representing the largest increase of 233% (BOG, 2017).

The bank recapitalization exercise announced in 2017 was deemed a “cleanup exercise” by the Minister of Finance. One of the objectives of this exercise was to have a quality banking sector that could support the financial system in Ghana even if that reduced the number of banks in the country (Bank of Ghana, 2019). This objective is very similar to the objective of the financial sector reform implemented in Nigeria in 2004; to have a few banks that have a strong capital base (Soludo, 2004).

The 2017 recapitalization exercise, the largest increase in the minimum capital requirement, garnered a lot of public interest and raised questions regarding the Ghanaian banking sector and its ability to perform its functions properly. Out of the 34 banks that existed before the recapitalization exercise, only 23 met the new minimum capital requirement at the end of 2018: (the deadline given by the Bank of Ghana). Three mergers were approved to allow the merged banks jointly raise the new minimum capital required (Bank of Ghana, 2019).

Bank recapitalization exercises have the potential to grossly affect not only the financial system and businesses but also, the banks themselves. Some aspects of banking that can be affected include the bank’s performance as well as the ability of banks to take on more risk and cover their exposure to risk.

Several factors cause the risks that banks are exposed to in their business. One of which include the amount of capital the bank possesses. According to Furlong and Keeley (1989), incentives to increase asset risk declines as capital increaseFs. Thus, as banks’ capital

increases, it reduces the likelihood of banks taking on more asset risk. This study will examine if this statement applies in the context of Ghana, and if so, what the consequences of such actions are and what can be done to mitigate any negative outcomes.

One area that bank recapitalization could affect is bank performance. According to Allen, an increase in bank capital has the effect of increasing bank performance (Berger & Bouwman, 2013). Thus, the relationship between bank capital and bank performance is a positive one. The reason given for this is that capital improves banks chances of survival and market share and also enhances their performance.

Using Ghana as a case in point, this paper will focus on a recapitalization exercise that occurred in Ghana in 2012 to study its impact and understand the effects it had on bank performance and bank risk of Ghanaian banks. It will look at the period before the recapitalization exercise (2009 to 2012), and the period after the 2012 recapitalization exercise but before the 2017 recapitalization announcement (2013 to 2017).

1.2 PROBLEM STATEMENT

Extensive research on bank recapitalization exercises has been conducted in many places. However, the problem is that most of the research focuses on western countries like Japan (Montgomery & Shimizutani, 2011), the USA (Berger & Bouwman, 2013), and countries in Europe (Steinherr, 1997). This may be attributed to the fact that these countries have more advanced banking and financial systems than most African countries. It could also be reasoned that they have readily available and easily accessible data. For the African continent in general, this topic has been explored mostly in Nigeria by Adegbaju &

Olokoyo (2008) and Oleka & Mgbodile (2014). One research done by Rojas-Suarez (2002) with a specific focus on the African continent and other emerging markets mainly compared emerging economies to that of developed economies and how the same international capital regulations may not be applicable in the different contexts.

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