AN ANALYSIS OF THE EFFECT OF RISK MANAGEMENT ON THE FINANCIAL PERFORMANCE OF DEPOSIT MONEY BANKS IN NIGERIA

CHAPTER ONE

INTRODUCTION

1.1 Background Of The Study

Numerous financial institutions have either failed or are on the verge of failure as a result of subprime mortgage lending to businesses and individuals with poor and unreliable credit. Nigerian banking crises have demonstrated that not only do banks frequently undertake exorbitant risks, but the nature of those risks also varies between institutions. The majority of banks' asset quality has declined due to the substantial decline in equity market indices. In 2009, the governor of the CBN asserted that certain institutions were experiencing liquidity constraints. As a result, their endeavours were curtailed due to their apprehension regarding the potential dangers of lending to one another while expecting returns to be negatively impacted. This resulted in credit and liquidity shortages, a substantial erosion of public trust in institutions, and adverse consequences for the economy and financial system as a whole. Banks continue to be catalysts for economic expansion and hold a preeminent position in the development of financial systems (King and Levine, 2020). Finance's quality control is risk management. It is a broad term that is applied differently by various organisations, but at its core, it entails identifying, analysing, and implementing strategies to minimise or eliminate a business organization's loss exposures.The most renowned scholar to formalise the definition of risk and differentiate it from uncertainty was Frank Knight in 1921. Holton (2018) defines risk as circumstances in which the probabilities of a particular action are quantifiable but the outcome is unknown. The current worldwide economic crisis has brought to light the challenge that institutions face in precisely quantifying the dangers associated with their operations. 

Risk management is of utmost importance. Instead of attempting to mitigate against risk, a strategic process is employed to identify which risks should be avoided, which should be reduced or eliminated, and which should be capitalised upon in order to better align with the organization's objectives. Increasing risk exposures are a fundamental component of achieving business success; therefore, any organisation desiring substantial returns must be prepared to assume a substantial degree of risk (Damodaran, 2019). Audu (2023) argued that it is challenging to completely disregard risk in any business endeavour, including those in which DMBs are involved, because returns from operations will undoubtedly be compromised if no risk is assumed. Therefore, Audu advocated for the maximum possible risk avoidance, stating that the most logical approach to risk is to at least limit exposure to it. Financial risks constitute a subset of the firm's overall risk. A primary objective of financial risk management is to mitigate the volatility of cash flow and earnings that may result from exposure to financial risk (Dhanini, 2020). The decrease empowers the organisation to generate more accurate predictions (Vaughan & Vaughan, 2008). Ensuring an adequate amount of funds is a prerequisite for investment and dividend disbursement within the organisation (Sarkis, 2022). An additional rationale for financial risk management is to prevent financial distress and the associated expenses (Triantis, 2019). In conclusion, management's focus on risk management may be on maintaining a consistent tax rate or ensuring earnings stability (Dhanini, 2020). Risk management can be organised in a way that either prevents significant losses or minimises volatility (Sarkis, 2022). Enhanced ability to forecast liquidity requirements is facilitated by decreased volatility in cash flows or earnings and loss prevention (Eichhorn, 2021). The principal objective of business management is to maximise anticipated profits while accounting for their volatility. Due to the fact that organisations wish to prevent low profits, which compel them to seek out external investment opportunities, risk management is crucial. This results in suboptimal investments and, consequently, a decrease in shareholder value, as the cost of external financing is greater than that of internal funds due to imperfections in the capital market.

1.2 Statement Of The Problem

Deposit money institutions are of utmost importance in facilitating the allocation of economic resources across nations. In order to endure and expand, deposit money banks must generate a profit. In addition to serving as intermediaries, the profitability of banks significantly impacts economic growth. Superior financial performance increases returns for shareholders. This results in additional investment, which stimulates economic expansion. In addition, inadequate financial performance of deposit money institutions may result in their insolvency and a subsequent financial crisis, both of which are detrimental to economic expansion. Kusa and Ongore (2013). If credit and liquidity issues are not effectively managed, they have the potential to negatively impact the financial performance and solvency of a bank. In the banking industry, credit risk management has been an integral component of the loan procedure. Deposit money institutions persist in allocating substantial resources towards credit risk management modelling in an effort to optimise their financial gains. 

Regrettably, prior investigations examining the impact of risk management on the performance of banks have yielded inconclusive findings. For instance, researchers such as Kithinji (2019), and others have found that credit risk management has an adverse effect on the profitability of deposit money banks. According to Kolapo, Ayeni, and Ojo (2022), credit risk management positively influences the performance of institutions. Furthermore, a number of additional studies have established that credit risk management contributes to the enhancement of profitability for institutions. Several scholars, including Kargi (2021), Felix and Claundine (2018), have identified credit risk, liquidity risk, and capital risk as critical factors that significantly impact the profitability of institutions. The review of relevant literature concludes unequivocally that the precise correlation between risk management (credit and liquidity) and the performance of banks remains unresolved, and researchers do not necessarily classify these risk factors into distinct categories when attempting to find a solution. Consequently, this circumstance presents an opportunity to conduct a more recent empirical inquiry in Nigeria, a nation beset by numerous recurring challenges and which has recently experienced a recession that has affected nearly all critical economic sectors. The purpose of this research is to determine the extent to which risk management practices, specifically credit and liquidity risk, have influenced the profitability of deposit money banks in Nigeria.

1.3 Objectives Of The Study

The major objective of this research is to investigate the effect of risk management on the financial performance of deposit money banks in Nigeria. The study will specifically seek to;

Investigate the correlation between liquidity risk management and financial performance of deposit money banks in Nigeria.

Investigate the correlation between credit risk management and financial performance of deposit money banks in Nigeria.

1.4 Research Questions

What is the correlation between liquidity risk management and financial performance of deposit money banks in Nigeria?

What is the correlation between credit risk management and financial performance of deposit money banks in Nigeria?

1.5 Research Hypotheses

Ho1: There is no relationship between liquidity risk management and firm’s performance 

Ho2: There is no relationship between credit risk management and firm’s financial performance

1.6 Significance Of The Study

In the theoretical contribution, the study will fill the knowledge gap on the relationship between risk management and financial performance in commercial banks. In addition to the above, the study can add more comprehensive knowledge to the readers in the financial sector. Another addition and contribution is that, the study will make the basis for other researchers who would wish to dig into further studies of the area.

From a practical area, the information in this research will offer a comprehensive guideline to bank managers, investors and other commercial banks employees, depending on the conclusions and results of this research study. Commercial bank managers could use the information and concentrate to improve banks’ performance by working on the risks in banks. Commercial banks can now better and allocate their resources in line with the position of risks.

1.7 Scope Of The Study

The study covers the effect of risk management on the financial performance of deposit money banks in Nigeria. The study covers the period of 10years from 2006 2015. The study will cover deposit money banks listed on the Nigerian stock exchange.

1.8 Limitation Of The Study

Like in every human endeavour, the researcher encountered slight constraints while carrying out the study. Insufficient funds tend to impede the efficiency of the researcher in sourcing for the relevant materials, literature, or information and in the process of data collection, which is why the researcher resorted to a limited choice of sample size. More so, the researcher simultaneously engaged in this study with other academic work. As a result, the amount of time spent on research will be reduced.

1.9 Definition of Terms 

Risk: Risk can be fined as the future impact of hazardous actions that has not been eliminated in an organization.

Risk management: Risk management consists of a series of well elaborated steps whose main objectives are to identify the risks, address, and eliminate risk items before they become either lethal to successful business organization or a major source of expensive rework of an organization processes.