CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF STUDY

Banking is an economic activity, which deals with the intermediation of funds between the surplus units and the deficit units of an economy and the channeling of such resources to profitable investments. Banks also facilitate the provision of an efficient payment system. A sound, profitable, efficient and well managed banking system contributes to the stability of the financial system and protects a country from any undesirable crisis (Athanasoglu et. al. 2005; Aburime, 2008; and Ramlall 2009). Alper and Anbar (2011) posit that an efficient banking sector can promote economic growth, while credit insolvencies could result in systematic crisis. In Nigeria, banks are regarded as dominant financial institution thus, their health condition is crucial to the general health of the economy (Suffian, 2009). Therefore, having the knowledge of factors influencing commercial banks’ profitability is not only important but also essential in stabilizing the economy. The importance of banks’ profitability cannot be over emphasized. Profitability is considered as a crucial objective to conduct a business without which money deposit banks will not be in business. With good profit figures, banks are able to enhance the confidence of their stakeholders, maximize shareholders wealth as well as being able to stay competitive in the financial market. However, to achieve their desired level of profits, banks are confronted with several factors both internal and external. One of such external factors is the interest rate.

Interest rate is the price paid for the use of money. It is the opportunity cost of borrowing money from a lender to finance investment project. It can also be seen as the return being paid to the provider of financial resources, forgoing the fund for future consumption. Interest rates are normally expressed as a percentage rate. The volatile nature of interest is determined by many factors, which include taxes, risk of investment, inflationary expectations, liquidity preference, market imperfections in an economy etc. Banks are given the primary responsibility of financial intermediation in order to make fund available for economic agents. Banks as financial intermediaries move fund from Surplus sector/units of the economy to deficit sector/units by accepting deposits and channeling them into lending activities (Ajayi and Atanda, 2012).

The extent to which this could be done depend upon the rate of interest and level of development of financial sector as well as the saving habit of the people in the country. Hence, the availability of investible funds is therefore regarded as a necessary starting part for all investment in the economy which will eventually translate to economic growth and development. The cost of acquiring loans in Nigeria is very high, which is making borrowers shy away from taking bank loans as the interest accrued from the loan is very high coupled with the high rate of inflation in Nigeria that depreciates the value of the naira. The banking operation began in Nigeria in 1892 under the control of the expatriates and by 1945, some Nigerians and Africans had established their own banks. The first era of interest rate ever recorded in Nigeria banking industry was between 1959 -1969. This was occasioned by bank failures during 1953- 1959 due mainly to liquidity of banks. Banks, then, do not have enough liquid assets to meet customers demand. There was no well-organized financial system with enough financial instruments to invest in. Hence, banks merely invested in real assets which could not be easily realized to cash without loss of value in times of need. This prompted the Federal Government then, backed by the World Bank Report to institute the Loynes commission on September 1958. The outcome was the promulgation of the ordinance of 1958, which established the Central Bank of Nigeria.

Over the years, interest rates have remained a subject for critical assessment with diverse implications for savings mobilization and investment promotion. Generally, interest rates are the rental payments for the use of credit by borrowers and return for parting with liquidity by lenders (CBN 1997). In the Nigerian economy, the minimum rediscount rate (MRR) now monetary policy rate (MPR) is the official interest rate of the Central Bank of Nigeria (CBN), which anchors all other interest rates in the money market and the economy. Historically, the interest rate regime in Nigeria has been very stochastic. In August, 1987 the CBN liberalized the interest rate regime and adopted the policy of fixing only its minimum rediscount rate to indicate the desired direction of interest rate. This was modified in 1989 when the CBN issued further directives on the required spreads between deposit and lending rates. In 1991, the government prescribed a maximum margin between each bank’s average cost of funds and its maximum lending rates. Later, the CBN prescribed savings deposit rate and a maximum lending rate. Partial deregulation was, however, restored in 1992 when financial institutions were required to only maintain a specified spread between their average cost of funds and maximum lending rates. The removal of the maximum lending rate ceiling in 1993 saw interest rates rising to unprecedented levels in sympathy with rising inflation rate which rendered banks’ high lending rates negative in real terms. In 1994, direct interest rate controls were restored. As these and other controls introduced in 1994 and 1995 had negative economic effects, total deregulation of interest rates was again adopted in October, 1996. Over the years, the MRR/MPR has been reduced, increased, reduced and increased and presently as at February 2014 stands at 12% for private sector deposits and 75% for public sector deposits.

Deposit Money Banks (MDBs) are an important channel for transmission of CBN’s interest rate policy in Nigeria. This is because of the intermediation role which banks play in resource mobilization and allocation. Banks pay interest on deposits on one hand and on the other hand they charge interest on loans and advances lent to borrowers. The difference between these two interest rates defines the interest spread which constitutes a significant proportion of the profits of MDBs. Thus, interest rates unavoidably are an important factor in the survival of MDBs especially as it concerns their profitability. As Interest rates keeps on changing as can be seen from the unstable interest rate regime in Nigeria, such frequent changes could affect banks’ overall profitability which, in turn, could impact on the general economy of a country. In other words, the profitability of the banking sector might become a function of changing interest rates.

1.2 STATEMENT OF THE PROBLEM

The cost of acquiring loans in Nigeria is very high, which is making borrowers shy away from taking bank loans as the interest accrued from the loan is very high coupled with the high rate of inflation in Nigeria that depreciates the value of the naira. Researchers have been concerned with the chronic increase in inflation and high interest rate on loans. This has affected commercial bank lending as this is their veritable source of making profit, as borrowers shy away from taking loans, there will be increase in the excess reserve r of commercial banks and this will lead to reduction in profit made by commercial banks in Nigeria. As a result of these aforementioned problems that is the reason for this research to examine the effect of interest rate on the profitability of commercial banks in Nigeria.

1.3 AIMS AND OBJECTIVE

The main aim of the study is to examine the effect of interest rate on the profitability of commercial banks in Nigeria. Other specific objectives include:

1. to determine the relationship between interest rate and profitability in first bank Nigeria Ltd.
2. to determine the extent to which interest rate influence the profitability in first bank Nigeria Ltd.
3. to investigate the factors affecting interest rate and profitability in first bank.
4. to recommend ways to improve the profitability level in first bank.

1.4 RESEARCH QUESTION

1. what is the relationship between interest rate and profitability in first bank?
2. what is the extent to which interest rate influence the profitability in first bank?
3. what are the factors affecting interest rate and profitability in first bank?
4. what are the ways to improve the profitability level in first bank?

1.5 STATEMENT OF RESEARCH HYPOTHESIS

1. H0: interest rate has no significant effect on the profitability of commercial banks in Nigeria.

2. H1: interest rate has significant effect on the profitability of commercial banks in Nigeria.

1.6 SIGNIFICANCE OF STUDY

The findings of this study will be significant to commercial banks especially first bank on the decision making and policy formulation. The study will serve as a repository of information and material to students and other commercial Bank in Nigeria that want to know more about interest rate.

Finally, the study will contribute to the body of existing literature on the impact of interest rate and profitability of commercial banks in Nigeria.

1.7 SCOPE OF STUDY

The scope of the study will cover the effect of interest rate on the profitability of commercial banks in Nigeria (a case study of first bank).

1.8 LIMITATION OF STUDY

1. Financial constraint- Insufficient fund tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature, or information and in the process of data collection (internet, questionnaire, and interview).

2. Time constraint- The researcher will simultaneously engage in this study with other academic work. This consequently will cut down on the time devoted for the research work.

1.9 DEFINITION OF TERMS

Effect: a change which is a result or consequence of an action or other cause.

Interest rate: the proportion of a loan that is charged as interest to the borrower, typically expressed as an annual percentage of the loan outstanding.

The interest rate is the amount a lender charges for the use of assets expressed as a percentage of the principal. The interest rate is typically noted on an annual basis known as the annual percentage rate (APR). The assets borrowed could include cash, consumer goods, or large assets such as a vehicle or building.

Profitability: Profitability is a measurement of efficiency and ultimately its success or failure. A further definition of profitability is a business's ability to produce a return on an investment based on its resources in comparison with an alternative investment. It is the degree to which a business or activity yields profit or financial gain.

Commercial banks: A commercial bank is a type of bank that provides services such as accepting deposits, making business loans, and offering basic investment products that is operated as a business for profit.

REFERENCES

Ajayi, Felix O. and Atanda, Akinwande A. (2012), monetary policy and bank performance in Nigeria: A two step cointergration Approach. African Journal of scientific research vol, 9 No 1 (2012), PP. 220-233

Akanbi T. A. and Ajagbe F. A. (2012), Analysis of monetary policy on commercial banks in Nigeria. African Journal of Business Management Vol. 6 (51), pp. 12038-12042, 26 December, 2012.

Athanasoglou, P.P., Brissimis, S N. & Delis, M. D. (2005). Bank-specific, Industry Specific and Macroeconomic Determinants of Bank Profitability. MPRA Paper, No.153.

Aburime, T.U. (2008) “Determinants of Bank Profitability: Macroeconomics Evidence from Nigeria”. Lagos Journal of Banking, Finance and Economics Available at http://ssrn.com/abstract=1231064

Alper, D., Anbar, A. (2011) “Bank Specific and Macroeconomic Determinants of Commercial Bank Profitability: Empirical Evidence from Turkey” Business and Economic Research Journal Volume 2. Number 2.2011 pp.139-152 ISSN: 1309-2448 Retrieved from http://ssrn.com/abstract=1831345

CBN (2005) “Guidelines and Incentives on Interest rate in The Nigeria Banking Industry”, Press release April 11, 2005 on Banking Sector Interest rate: Special Incentive to Encourage Weaker Banks.

CBN (2016) “Central Bank of Nigeria Statistical bulletin”, vo.23

Felicia, O. O. (2011), Determinant of commercial bank lending behavior in Nigeria. International Journal of financial research, 2(2), pp. 1-12.

Furlong, Fred (1998) “New View of Bank Interest rate” FRBSF Economic Letter 98-23; July 24, (1998).

Goldfeld, S.M. and L.V. Chandler (1981)“Economics of Money and Banking” Harper International Edition Harper & Row Publisher, New York, Cambridge Hagerstown, Philadelphia, Fransisco, Eight Edition, pp.426-431.

Hughes, J.P., W. Lang, L.J. Mester and C.G.Moon (1998) “The Dollars and Sense of Interest rate” Working Study No. 98-100, Federal Reserve Bank of Philadelphia.

Newman Enyioko (2012), impact of interest rate policy and performance of deposit money banks in Nigeria; Global journal of management and business research vol. 12, pp. 1-12.

Punita, R. and Somaiya, K.J. (2006), Monetary Policy: Its Impact on the Profitability of Banks in India.Intermediate Business and Economics Research Journal; Volume 5, Number 3, Pg. 15-19.

Ramlall, I. (2009). Bank-Specific, Industry-Specific and Macroeconomic Determinants of Profitability in Taiwanese Banking System: Under Panel Data Estimation. International Research Journal of Finance and Economics, 34, 160-167.

Somoye, R.O.C.(2006) “Bank Interest rate in Nigeria: The Macroeconomic Expectation” Babcock university, Nigeria.