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RELATIONSHIP BANKING AND PERFORMANCE OF MANUFACTURING SECTOR FIRMS: EVIDENCE FROM NIGERIA

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Topic Description

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Banking is an Economic activity of intense interest to public policy. Banks are subject to extensive prudential and conduct of business regulation. The public sector can also exercise direct and indirect influence over banks’ business decisions through outright ownership. The objective is basically to achieve public goals such as the channeling of funds to vulnerable economic sectors to borrowers with limited access to credit. Public sector involvement can be expressed through financial support, in cases where banks run into trouble, this support can be explicit or implicit in the markets’ expectation that some banks will not be allowed to fail.

Commercial banks have increasingly played a major role in financing public and private entities. Lending which may be on short, medium or long-term basis is one of the services that deposit money banks do render to their customers. In other words, banks do grant loans and advances to individuals, business organizations as well as government in order to enable them embark on investment and development activities as a means of aiding their growth in particular or contributing toward the economic development of a country in general (Bologna, 2011). Deposit money banks are the most important savings, mobilization and financial resource allocation institutions. Consequently, these roles make them an important phenomenon in economic growth and development. Therefore, no matter the sources of the generation of income or the economic policies of the country, deposit money banks would be interested in giving out loans and advances to their numerous customers bearing in mind, the three principles guiding their operations which are, profitability, liquidity and solvency (Adolphus, 2011). However, deposit money banks decisions to lend out loans are influenced by a lot of factors such as the prevailing interest rate, the volume of deposits, the level of their domestic and foreign investment, banks liquidity ratio, prestige and public recognition. The CBN require that their total value of a loan credit facility or any other liability in respect of a borrower, at any time, should not exceed 20% of the shareholders’ funds unimpaired by losses in the case of commercial banks (Bologna, 2011).

Manufacturing sector plays catalytic role in a modern economy and has many dynamic benefits crucial for economic transformation. In a typical advanced country, the manufacturing sector is a leading sector in many respects. It is an avenue for increasing productivity related to import replacement and export expansion, creating foreign exchange earning capacity; and raising employment and per capita income which causes unique consumption patterns. Furthermore, it creates investment capital at a faster rate than any other sector of the economy while promoting wider and more effective linkages among different sectors. In terms of contribution to the Gross Domestic Topic (GDP), the manufacturing sector is dominant and it has been overtaken to the services sector in a number of organizations for Economic Co-operation and Development (OECD) countries (Anyanwu, 2003).

Obamuyi (2013)affirms that banks with high deposits and loans perform better in terms of profitability than banks with low deposits and loans. The author suggested that, since high deposits and loans enhance profitability, policy makers must make savings attractive in order to positively influence the liquidity position of the banks and their lending behaviour. The author further argues that, Nigerian commercial banks observed an era of remarkable profitability, characterized by high competition, huge deposits and varied investment opportunities. This development in the banking industry suggests that banks with well efficient deposits mobilization drive with high-quality lending behaviour will be the most profitable. Since the profitability and survival of businesses depend largely on availability of funds, and deposits constitute the major source of bank financing, it is apparent that there exist a relationship among efficient deposit mobilization, bank lending behavior, and profitability (Bologna, 2011). This explains why most banking firms have put in place aggressive deposit mobilization strategies with focus on customer need identification and offering of sophisticated banking products.

Banking relationships can influence syndicated loans terms. However, the role of lending relationships in syndicated loans remains virtually unexplored. When banks develop a long-term relationship (called a banking relationship, or a lending relationship) with their customers in a syndicated-loan market with repeated transactions, they gather information about the firms. The relevance of financial markets and financial institutions occurs, when they arise to help solve some of the frictions that could be found in real markets. Banks serves multiple purposes such as transforming short term liquid investments such as deposits into long term illiquid assets such as loans, (Diamond &Rajan, 2008). They also economize on collecting and processing the information necessary to make investment and lending decisions. According to these authors, the idea that banks can provide a service in the form of a lending relationship arises out of the value, that firms place on these relationships. This relationship critically depends on the competitiveness of the capital markets. Lending relationships should be most valuable where the information about a firm and its potential investment opportunities are most uncertain.

The development of long-term bank-firm relationships provided benefits, such as reducing information asymmetries, particularly when the borrowers are smaller. Syndicated loans are thus referred to as a hybrid of transactional and relationship banking, (Lee &Mullineaux, 2004).  A small business lending can enhance bank value through relationship lending, unlike the transactional lending, the bank can also benefit from its opportunities to cross-sell additional products and services. The firm has an incentive to remain with the relationship bank rather than to defect and begin new relationship with another lender. In any case, because it is costly and time consuming to establish new lending relationships, firms are subject to a lock-in effect with their current relationship lender, which in turn enhances the banks’ profits. When the credit market is competitive and creditors cannot hold equity claims, the lender cannot expect to share in the future surplus of the firm. Since uncertainty about a firm’s prospects is high when the firm is young or distressed, creditors may be forced to charge a high interest rate until the uncertainty is resolved.Banking power at firm and market level is detrimental to the firm, as it increases the probability of credit constraints.

Multiple banking choices, larger, riskier, less profitable and more opaque firms prefer more lending ties, and the number of relationships is also positively correlated with credit market concentration.However, firms that engages in multiple relationships, benefits from competition among lending banks in terms of a lower probability of tightening, though such competition does not fully outweigh the marginal effect of local banking market power.In addition, the impact of competition on access to finance, depends on the quality and scope of credit information sharing mechanisms and better credit information, mitigates the damaging impact of low competition.

Harjoto (2006) and Bosch (2007) try to confirm if banking relationships matter by asking whether commercial and investment banks adopt the same tariff policies. They however, confirmed that in the syndicated loan market, commercial banks are more likely to develop a banking relationship. In contrast, investment banks are more likely to adopt arm’s length transactions, called the transaction banking, so commercial banks could gather information about firms and charge a reduced spread. Harjoto (2006) find that the investment banks charge higher spreads, and they thus provide the first evidence that banking relationships matter. Bosch (2007) also investigates the role of banking relationships in the determination of the spread. He shows that, whereas information asymmetries between the debtor and the lender increase the spread, a preexisting banking relationship reduces it. His result confirms the reasoning of Harjoto (2006) that banking relationships provide information to the banks, decrease the information asymmetries, and therefore allow a reduction of the spread.Banking relationships could have negative consequences for firms, via the so-called hold-up effect. Indeed, banking relationships in loan market, offer banks a competitive advantage because of the private information that banks have about firms. Thus, lending relationships can create switching costs for firms, and banks can charge an information rent.

Mattes(2012) show that if firms suffer from important switching costs, banks exploit their advantage and charge a higher spread. Therefore, banking relationships can offer an information rent to the banks, and can present drawbacks to the firms. Credit extension is essential function of banks and bank management because it strives to satisfy the legitimate credit needs of the community it tends to serve. The Central Bank of Nigeria established a credit act in 1990, which empowered banks to render returns to the credit management system in respect to its entire customers with aggregate outstanding balance of one million naira and above, (Ijaija&Abdulraheem, 2000).This made Nigerian Banks to universally embark on upgrading their control system and risk management, in order to avoid industry financial risk.

 

1.2 Statement of the Problem

In the history of development of the Nigerian Banking Industry, most of the failures experienced in the industry prior to the consolidation era were results of imprudent lending that finally led to bad loans and some other unethical factors, (Ogundepo&Olanirul, 2008).

Complexity experienced in banking industry today makes bank managers to be desperate, and therefore see each other as competitors. Bank services are increasing in Nigeria, yet the level of failure in their services indicate that ineffective relationship with customers seems to be pronounced. This level of competition has made bank managers to focus on how to be in a close contact with their customers in order not to lose their active customer to their presumed competitors.

Furthermore, competition in banking has implications for other sectors of the economy. Thus, higher competition in the banking sector is found to be associated with a faster growth of other sectors of the economy that rely on external financing. This is because banks advance credit or loans to both firms and consumers and an uncompetitive banking sector will lead to under-provision of such credit, (Adebiyi&Obasa, 2004).Competition in the banking sector will promote the efficiency required to create a fully functional credit system, and according to the competition-stability theory, will help improve the stability of the system, (Degryse& Mitchell, 2004).

High concentration in banking is negatively related to industrial growth in low-income countries but not in high-income ones, suggesting that emerging economies need a relatively more competitive banking sector in order to promote growth. Hence, company relationship with more than one bank, means there will be competition among the participating banks, if there is; it is expected of the company to do better, in the presence of a lead bank(Chodechai, 2004). In the existence of other market imperfections, it’s not always true that competition among participating banks lead to greater output and lower prices of the company. Therefore, in Nigeria, it is somewhat possible for performances to be effective using one bank, this research is to see if the performance can be used in one or more banks.

 

1.3 Objective of the Study           

The main objective of this study is to provide an analysis of Relationship banking and its implications on the performance of Nigerian Manufacturing Industries. The specific objectives are to:

  1. examinetrends in number of banking relationships overtime within Nigerian Manufacturing Industries and
  2. examinethe effect of number of banking relationships on firm performance withinNigerian Manufacturing Industries.

1.4 Research Question

The following is the research question that addresses the research objectives;

  1. What effect does number of banking relationships have on the performance of Nigerian Manufacturing Companies?

1.5 Hypothesis

The following is the research hypothesis for the study:

HO1:Number of banking relationships does not have effect on the performance of Nigerian Manufacturing Companies

1.6 Scope of the Study

The study covers a period of 5years, which is from 2010-2014, for twelve manufacturing companies in Nigeria, and the data to be used for this research were obtained from the audited financial statement of the firms listed on the Nigerian Stock Exchange. The variables of interest for this study are profit margin, optimal number of banks and leverage, these variables were chosen because previous literatures made emphases on performance only, and hence this study used other proxies to show the effect of an increase or decrease in the number of banking relationship.

 

1.7 Significance of the Study

The goal of every organization is to remain in business through profit making. It is also worth mentioning that granting of loan contributes to the profit of banks through the charging of interest. Loans given to borrowers, shareholders’ and depositors’ money and hence should be critically evaluated before they are being granted and they should be continuously checked to for proper management.The effect of lending in the Nigerian economy today is that, it has tightened up the global credit on the primary market and the secondary market, thereby reducing the volume of the investors in the secondary syndicated loan market in Nigeria and bringing down the value of shares in the stock market.There is a possibility that there’s implicit syndication between the banks and their customer borrowers. This benefit allows the relationship banks to provide loans for them during crisis, Due to the services they provide; operating costs of relationship-banks are higher than those of transaction banks. One of the advantages of these relationships is that, they may allow the lender to collect information about a borrower, which is not easily reproduced by financial institutions, this in turn, can give the lender a competitive advantage. The explicit syndication is not really observable.

1.8Justification for the Study

The relevance of this study is to examine financial institutions and loan syndication in Nigerian manufacturing sector. If a manufacturing industry does not have more than more relationship, the bank can  try to hold the company hostage in terms of acting like a monopolist by charging the company higher interest rate on their loans.

1.9 Operational Definition of Terms

  1. Transactional Lending: A loan extended by a bank for a specific purpose.
  2. Lock-in Effect: is a term, which is typically used to explain a practice, where a company makes it extremely hard for their customers to leave them, even if the customer wants to.
  3. Informational rent: is the rent an agent derives from having information not provided to the principal.

Relationship Banking: A long, intimate and relatively opened relationship established between a corporation and its bank, on the basis of

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