Capital Adequacy Ratio and Banking Risks in the Nigeria Money Deposit Banks

Abstract

Capital adequacy ratio is an important measure of “safety and soundness” for banks and depository institutions because it serves as a buffer or cushion for absorbing losses. Thus, it has become one of the major benchmarks for financial institutions. This study is an attempt to empirically examine the relationship between capital adequacy and banking risks. Three independent variables were used. These variables are risk-weighted asset ratio, deposit ratio and inflation rate. Twelve banks were sampled from the population of twenty-two banks in the Nigerian banking industry as at December, 2013. Secondary data were collected from the financial statements of the banks for a period of five years, from 2007 to 2011. Value at risk theory was adopted to estimate capital adequacy ratio of the banks. The hypothesis was tested using the results of the multiple regression analysis carried out. The model is fitted as there is absence of serial correlation and multicollinearity based on the Durbin Watson result of approximately 2, tolerance values of less than 1 and VIF values of less than 10 for the coefficients of the model. Changes in capital adequacy ratio are explained by changes in the independent variables, up to 35%. It was therefore, observed that there is a significant negative relationship between risk and capital adequacy ratio of banks, which means when risk level rises, capital adequacy ratio falls in the Nigerian banking industry.  In line with these findings, the study recommends that Nigerian banks should adopt a risk-based approach in managing capital instead of the present practice of focusing on the paid-up capital and retained earnings as there is significant relationship between capital adequacy ratio and banking risks. Since the research has also provided evidence of negative relationship between deposits and capital adequacy ratio, we also recommend that Nigerian banks should adopt pragmatic approaches to guarantee the safety of depositors money since increase in deposits does not necessarily result to increase in capital adequacy ratio.

Keywords: Capital Adequacy, Banking Risks, Risk Weighted Assets and Deposit-Asset Ratio