This paper unmasks the impact of banks characteristics, financial structure and macroeconomic indicators on banks’ Capital base in the Nigerian banking industry. The study does not account for ratio analysis in the computation of capital adequacy but rather it examines the determinant of Capital adequacy in Nigeria during the period 1980 – 2008 within an error correction framework. Co-integration technique revealed that economic indicators such as rate of inflation, real exchange rate, demand deposits, money supply, political instability, and return on investment are most robust predictors of the determinants of capital adequacy in Nigeria.
After the global credit crunch capital adequacy, being critical for banks, led the study to examine the relationship between bank capital base and macroeconomics variables. This implies that political stability may reduce financial distress and bankruptcy why foreign investment will affect Banks capital in most developing economy in the period of financial crisis. However, the study also establishes that there is a negative relationship between inflation and banks capital base as inflation erode banks capital in most developing economy. This simply means that Nigerian government should regulate investment policy why banks regulators should strive to keep inflation rate at a minimum level, if possible below 5% for them to be more efficient so as to be globally competitive.

One of the biggest achievements in the financial sector of the Nigeria economy in 2005 was the reform of the Banking Sector. It was an achievement via the Central bank of Nigeria increase in bank capital above 1000 percent. It was an exercise that resulted in the reduction of Nigeria motley group of mainly anaemic 89 banks to 25 bigger, stronger and more resilient financial institutions. The reforms engineered a revolution in the financial services industry leading to an increase both in the quality of service and quantity of financial products available to Nigerians and to checkmate the capital adequacy of the banks. Capital Adequacy can be percentage ratio of a financial institution's primary capital to its assets (loans and investments), used as a measure of its financial strength and stability. According to the Capital Adequacy Standard set by Bank for International Settlements (BIS), banks must have a primary capital base equal at least to eight percent of their assets: a bank that lends 12 dollars for every dollar of its capital is within the prescribed limits. However, the assessment of capital adequacy for precautionary purposes is problematic at best due to rapidly changing economic and financial services industry. Another role of capital is the fact that the viability of a bank depends to a critical extent upon public confidence. There is a strong public relation aspect to capital adequacy also. It is generally recognized that the availability of capital is neither a perfect indicator of the state of health of a bank nor a sufficient condition to ensure the maintenance of confidence by depositors and creditors, but no doubt, it represents a major element in shaping their perception of the solidity of an institution. Capital level is used by most regulators to restrict credit expansion. That explains why banks management are inspired to determine the correlation between variables like Total credit loan, Demand deposit, Inflation rate, Political instability, Money supply, Liquidity risk, Investment and Capital etc and hence indicate whether large capital are negatively or positively compel banks to meet the capital adequacy requirement or seek additional capital so as to meet their credit expansion target. By looking at banks role as a financial intermediary, capital adequacy and macroeconomic variables has become a key indicator of a bank capital whereby inflation erodes banks capital in most developing countries. Indeed, several studies have found evidence that the development of the banking sector is related to economic growth. The importance of capital adequacy in the banking sub-sector of the Nigeria economic and financial development directs us to investigate which economic- macro or micro, banks ratios and balance sheet and institutional factors that give rise to a vibrant capital adequacy.

Therefore, the problem here is to use co-integration to determine whether there is a linear relationship between banks capital and macroeconomics variables and if there is, whether the degree of linearity is such that capital adequacy issues could be largely a matter of bank failure or business exigencies as opposed to the current flex of legal muscle by the regulatory authorities. Against this backdrop, the objectives of the study are to empirically investigate the determinants of capital adequacy with respect to economics variables. To analyze the various issues involved in capital adequacy debate. To examine the components of bank capital and bank consideration in selecting capital mix. To expound the diverse measurements of capital adequacy particularly, the CAMELS is the acronym for Capital (adequacy), Assets, Quality, Management, Earnings, Liquidity, and Sensitivity to market risks. Furthermore, capital adequacy in the banking sector model is to permit forecasting of capital adequacy pattern, which is useful for both policy makers and the banking sector in general for formulating informed course of action.

In spite of the importance of banks as financial intermediaries, capital adequacy modelling has not been in the mainstream of econometric research into the financial sector in Nigeria. Analyses of the banking sector have so far focused on qualitative assessment of growth trends and sectoral behaviour patterns in the industry. Discussion in those studies has, for instance, suggested a number of factors that may influence the failure pattern of banks, bank products and management. There has been no model designed to determine the relative impact of banks capital and macroeconomics variables and their possible linkages between the banking sector and the real sector of the economy. Since independence, no consensus has been reached by different Scholars as regards the determinants of capital adequacy with macroeconomics variables in Nigeria.

Opinion differs among experts in banking and finance as to what constitutes adequate capital but they all agree that it is an age long issue for which there do not seem to be any consensus in sight. Thus, as noted by Nwankwo (1990), Adegbite (2010), the issue of what constitutes an adequate capital for banks has a long history. It is in fact, almost as old as banking itself.

Sanusi (2010) was even more satirical in answering the question of how much capital a bank needs to ensure the confidence of depositors, creditors, investors and regulators in a country of high inflation rate and economic instability, when he noted “that in banking and finance literature, this question is noted as the issue of capital adequacy. Anyone who knows the answer can gain instant notoriety in the banking, financial and regulatory communities.

The battle line appears drawn between the regulators and the bankers. Regulators concerned with the safety of banks, the viability of insurance funds and stability of financial markets prefer more capital. This reduced the likelihood of failure and increases bank liquidity. Bankers on the other hand generally prefer to operate with less capital. The smaller banker equity base the greater the financial leverage and equity multiplier. High leverage converts a normal return on assets unto a high return on equity- Koch (2004). The complexity of the problem brings to the fore the following questions: what is capital? What are its components? What amount is adequate? Who determines it and what methodology is appropriate in measuring bank capital? And what factors determine capital adequacy?
However, the battle between the banks and regulatory authorities is centered after a prolonged period of recession and macro-economic instability. Hitherto, several studies have emphasized the importance of capital adequacy and there is need to review related studies in order to gain more understanding of the subject.

Mpuga (2002) argued that the inadequacy of minimum capital standards in accounting for risks in banks assets portfolio could be one of the major factors leading to bank failures. He studied the 1998-99 banking crisis in Uganda and how the new banking guidelines in Uganda was to increase bank solvency and capital adequacy by shifting their portfolio towards lower risk assets, in an effort to meet the new requirements Marc J Epstein. (2005) studied on capital adequacy failures and concludes that capital adequacy and ratio analysis (CA&R) are failed strategies. However, analysis of the causes of failure has often been shallow and the measures of success weak.

Yu Min-The (2006), defined the adequate capital for banks as the level at which the deposit insuring agency would just breakeven in guaranteeing the deposits of individual banks with premium the banks pay. An option of theoretical framework was employed in his study for measuring fair capital adequacy holdings for a sample of depository institutions in Taiwan, during 1985-1992. Except for the 1989, most banks in their sample proved to be inadequately capitalized so that capital infusion is required.
George E Halkos & Dimitrios (2004) applied non-parametric analytic technique (data envelopment analysis, DEA) in measuring the performances of the Greek banking sector with respect to capital adequacy. He proved that data envelopment analysis can be used as either an alternative or complement to ratio analysis for the evaluation of an organization's performance with attention to macroeconomics indicators.

Morris Knapp, Alan Gart & Mukesh Chaudhry (2006) research studies examine the tendency for serial correlation in bank holding company profitability, finding significant evidence of reversion to the industry mean in profitability. The paper then considers the impact of mean reversion on the evaluation of post-merger performance of bank holding companies. The research concludes that when an adjustment is made for the mean reversion, post-merger results significantly exceed those of the industry in the first 5 years after the merger.

Ping-wen Lin (2002) findings proves that there is a negative correlation and statistical significance existing between cost inefficiency index and bank capital; meaning banks engaging in low capital tend to improve cost efficiency. However, the data envelopment analysis empirical analysis found that bank capital did not improve significantly to cost efficiency of banks. In another study, he found that (1) generally; banks capital tend to upgrade the technical efficiency, a locative efficiency, and cost efficiency of banks; however a yearly decline was noted in allocative efficiency and cost efficiency. (2) In terms of technical efficiency and allocative efficiency improvement, the effects of banks mergers were significant; however, in terms of cost efficiency improvement, the effect was insignificant.

Robert DeYoung (1997) estimated pre- and post-merger X-inefficiency in 348 mergers approved by the OCC in 1987/1988. Efficiency improved in only a small majority of mergers, and these gains were unrelated to the acquiring banks efficiency advantage over its targets. Efficiency gains were concentrated in mergers where acquiring banks made frequent acquisitions, suggesting the presence of experience effects.
Chol(2000), studied the credit crunch in the banking sector in Korea in year 1997, found the replacement of an old capital standards with risk based and macro economics based variables RBC & MBC 1997, increased banks below the regulatory capital requirements from 0-14, and a number reduced to 7 in 1998 and the bank’s capital deficiency amounted to 59 percent of the total Korea asset in 1997.

Hassan (2008) mentioned that banks had been exposed to standby letters of credit (SLC) and off-balance sheet activities, which has become a major concern to regulators. This means that macroeconomic variables such as inflation play a greater role in the determinants of capital adequacy in most developing countries like Nigeria.
Ajayi (2008), the macroeconomic indicators (i.e. inflation and economic growth) are significant in spread, bank capital adequacy and profit regressions. This may suggest that banks tend to not being profitable in inflationary environment. In addition, economic growth does not reflect any aspects of banking regulations and technology advance in the banking sector with require pressing attention.

Adegbite (2010), a cursory look at the Nigerian financial system shows that the system has been performing its expected functions albeit at less – than – optimal levels. The incidence of recurring financial systems crisis is testimony to the fact that the financial system’s performance still leaves much to be desired. The apex regulatory/supervisory body in the Nigerian financial system is the Central Bank of Nigeria (CBN) which came into being in 1959 as a result of the CBN Act of 1958. Over the years the CBN 1958 Act has been amended and in 1969 there was another CBN Act and another in 1991 and another in 2007. Charged with the responsibilities of “Promoting monetary stability, emphasis on capital adequacy and sound financial structure in Nigeria the CBN Act of 2007, requires that the CBN must be banker to other banks, “and must in cooperation with the other banks promote and maintain adequate banking services for the public. The CBN according to the CBN Act 2007 is also expected to ensure high standard of conduct and management throughout the banking system”.

Ojo J. A. & Adegbite (2010), Macroeconomic stability as an ingredient of financial stability requires that macroeconomic policies must be antitypical, dousing excessive trend in any direction, maintaining stable prices, ensuring that public sector deficits are minimal and external debt is sustainable. A stable macroeconomic framework is one where the level of national saving is high enough to prevent undue reliance on foreign borrowing. For macroeconomic stability needed to maintain financial stability, macroeconomic policy instruments must be adequate and consistent with the exchange rate regime if not inflation will erode banks capital. The framework for maintaining financial stability requires that if the financial institutions are stable and macroeconomic is stable then nature of regulatory and supervisory policies should be preventive. If however the institutions are at the brink or border of stability and many any moment plunges into instability, then the nature of regulatory/supervisory policies should be remedial. If however the institutions have become instable already then the policies should be Resolution policies.

Newman L. (2010), banks capital may be affected In face of declining foreign exchange earnings the naira depreciated against the dollar and foreign reserves fell remarkably from $67 bill in June 2008 to $57 billion by December 2008.

Kweme (2003) also noted that changes in the structure and stability of banks profit have sometimes been motivated by statutory reserves. In other to maintain confidence in the banking system, banks which are subject to minimum capital may cause banks to change their business mix in favour of activities and assets that entail a lower capital requirement.

Nnanna (2003), the international financial crisis of the second half of the 1990s provoked more reflection on ways to strengthen the global financial system. The international community identified a number of priorities, including the need to enhance its own ability to monitor the health of the financial system. The ability to monitor the financial sector soundness presupposes the existence of valid indicators which can measure the health and stability of financial systems. The general macro-prudent indicators as developed by the IMF for assessing and supervising banks are embedded in the CAMELS framework. CAMELS is the acronym for Capital (adequacy), Assets, Quality, Management, Earnings, Liquidity, and Sensitivity to market risks.

In 2009 the Central bank of Nigeria declared 5 banks in Nigeria as insolvent. The banks were Afribank, Union Bank, Oceanic Bank, Bank PHB and Intercontinental Bank. In 2011 the Central Bank of Nigeria declares the take-over of Bank PHB, Sterling Bank and Afribank by investors or in other word call for the nationalization of those banks. Before the establishment of Central Bank of Nigeria in 1958 there have been serious cases of Bank failures and unhealthy capital adequacy base resulting to uncountable reasons of Bank failures. One of the crucial reasons of bank failure is inappropriate determinants of capital adequacy. The first bank failure and unhealthy capital adequacy in Nigeria can be traced to 1930s when 21 Banks were identified as bankrupt. The second Bank failure in Nigeria can be traced to 1989 where 8 Banks were identified to be weak and in the year 1998 total bank distress were up to 31. Third Bank failure in Nigeria was in the year 2004 where 89 banks were reduced to 25 banks that is to say that 64 banks were regarded to be in distressed state. The reason behind this is the inability of regulators to oversee the activities of these Banks. The causes of Bank failures cannot be underestimated hence proper attention should be given to this sector.

        I.            MATERIALS AND METHODS
 This applies to the error correction methodology to a regression model based on the traditional determinants of capital adequacy in the banking sub-sector of the Nigeria economy distilled from the literature. The idea is to subject the variables to stationary test and subsequently remove the non- stationary trends by differencing before regressing. This removes the possibility of the so-called spurious regression. Any previous studies on the determinants of capital adequacy in the banking sub-sector of the Nigeria economy if there exist any in Nigeria may not have considered the problem of unit roots in the determinants of capital adequacy and macroeconomics variables. As a result, the econometric methodology used in those studies did not account for non-stationarity in the data. The analysis here is primarily based on Engle and Granger (1987), and Engle and Yoo (1987). The idea is to determine the order of integration of the variables, that is, we test whether they are stationary in their levels or whether they have to be differenced once or more before they become stationary. Testing for unit roots is carried out by using an Augmented Dickey-Fuller (ADF) test.
In order to account for the determinants of capital adequacy in the banking sub-sector of the Nigeria economy, the model for the study is hereby specified as follows:
The above model is hereby written in log —linear form as:
(L) CAB= bo + b1TCL(L) + b2MS(L) + b3DIR(L) + b4INFL(L) + b5DL(L) + b6POL(L) + b7ER(L) + b8LQ(L) + b9OPEN + b10INV + μt ……………………………………………………………………….…….E(1)
 apriori, b1> 0, b2> 0, b3> 0, b4<0, b5> 0, b6<0, b7> 0, b8> 0, b9> 0, b10 > 0
                     YEARS, 0 OTHERWISE
   INV = INVESTMENT proxy by long US interest rate
Capital adequacy being the dependent variable is the total asset of banks deflated by total number of capitalize banks operating in the economy while the independent variables such as demand deposit is total deposits including private and public, investment include both local and foreign direct investment while others variables includes total loans, money supply and interest rate (real), exchange rate, inflation rate (nominal), political instability –including civilian and military regime. Ut = Captures other variable not included in the model and it takes care of other factors that cannot be observed or computed due to lack of data. Ut is referred to as error term, residual or stochastic term.
“The Data Analysis technique consists of an approach designed to capture the long-run relationship between the dependent and independent variables, while avoiding spurious influences. This is the co-integration and error correction techniques which have received prominent attention in literature (see Adam, 1992, Engle and Granger, 1987, Gilbert, 1986, Hendry and Richard 1983 and Thomas 1993).
The aim of the new framework was to ascertain the time characteristics of data, overcome the problems of spurious correlation often associated with none —stationary time series data, and generated long —run variable relationship simultaneously. Within this dispensation, an important starting point for research is an assessment of the degree of integration of the relevant variables and to check whether they are co-integrated or not. It should be noted that an important issue in econometrics is the need to integrate short-run dynamics with long-run equilibrium. The analysis of short-run dynamics is often done by first eliminating trends in the variables, usually by differencing. The theory of co-integration development in Granger (1981) and elaborated in Engle and Granger (1987) addressed this issue of integrating short-run dynamics with long-run equilibrium.
Similarly, it is important to note that the usual starting point of ECM modeling is to assess the order of integration of both the dependent and independent variables in the model. The order of integration ascertains the number of time a variable will be differentiated to arrive at stationary. Dickey-fuller (DF), Augmented Dickey-Fuller (ADF) and Sargan - Rhargava Durban- Watson (SRDW) are the widely used test for stationary for both individual time series and residual from OLS regressions. Co-integration is based on the properties of the residuals from regression analysis when the series are individually non-stationary.
The original co-integration regression is specified as follows:
            …………………….       (1)
Where A represents the dependent variables,   stands for the independent variable, and   e is the random error term. 0 and  1 are intercept and slope coefficients respectively. To include the possibility of bi-directional causality, the reverse specification of equation 1 is considered. To provide a more defensive answer to the non-stationarity in each time series, the Dickey-Fuller (1979) regression is estimated as follows for a unit root:

                       …………………………….. (2)
If X Equals zero e is non-stationary. As a result, A and B are not co-integrated. In other words, if X is significantly different from zero A and B is found integrated individually.
Given  the inherent  weakness of  the root  test  to  distinguish  between  the  null and  the alternative  hypothesis, it  is desirable that  the Augmented  Dickey-Fuller  (ADF) (1981)  test  be applied. The desirability is warranted because it corrects for any serial correlation by incorporating logged changes of the residuals. To be co-integrated, both A and B must have the same order of integration (Eagle and Granger, 1987 and Granger, 1986).
The ADF regression is specified as follows:
…………………. (3)
Where ∆ is the first different operator and μt is the new random error term. M is the optimum number of lags needed to obtain “white noise” This is approximated when the DW value approaches 2.0 numerically.  The null hypothesis of non-co-integration is rejected, if the estimated ADF statistics is found to be larger than its critical value at 1 or 5 or 10 per cent level of significance.
If At and Bt are found to be co-integrated, then there must exist an associated error-correlation Model (ECM), according to Engle and Granger (1987). The usual ECM may take the following form:
                 ……… (4)
Where ∆ denotes the different operator et-1 is the error correction term, T is the number of lags necessary to  obtain  white noise and  Vt  is another  random  disturbance term σoet-1  is significantly different from zero, then A and B have long-Run relationship. The error-correction term (et-I) depicts the extent of disequilibrium between A and B The ECM, reveals further that the change in At not only depends on lagged changes in Bt, but also on its own lagged changes. It is appealing due to its ability to induce flexibility by combining the short-run and long-run dynamics in a unified system. Also, the estimates of the parameters of the ECM are generally consistent and efficient (Ilendry and Richard, 1983).


ADF Test
Order of Integration
0.04925 (-29969)
1 (1)
-3.7333 (-3.0114)
1 (0)
-3.6876 (-2.9798)
1 (0)
Log ER
-2.0299 (-2.9798)
1 (1)
Log ER
-3.5063 (-2.9850)
1 (0)
-4.2833 (-2.9798)
1 (0)
-3.3697 (-2.9798)
1 (0)
-1.3068 (-2.9969)
1 (1)
-40706 (-3.0038)
1 (0)
0.8224 (-2.9798)
1 (1)
-4.1436 (-2.9850)
1 (0)
Log MS
-1.1022 (-2.9798)
1 (1)
A Log MS
-3.0994 (-2.9850)
1 (0)
Source: Computed

SAMPLE: 1980- 2008
Series: log CAB, Log ER, Log INFL, Log OPEN, Log MS
Eigen Value
Likelihood Ratio
5% Critical Value
1% Critical Value
Hypothesized No. of CE (s)
Note:* (**) denotes rejection of the hypothesis at 5% (1%) significance level
L.R. test indicates 2 co-integration equation(s) at 5 % significance level.
Lag interval: 1to I
Source: computed.

TABLE III: Long-run capital Adequacy Determinants Model Estimates:
                        Modeling Log (CAB) by OLS
Sample: 1980 – 2008
Log ER
Log MS
NOTES: Adjusted R2 = 0.72 F= 21.327 a= 0.45
                                    R2=0.75 Prob (F—statistic) = 0.00000
                                    DW=1.87 Schwarz information Criterion 1.561
*significant at 1% level
*significant at 5% level
***significant at 100% level
a= S.E. of regression
Source: computed
TABLE IV:  Short-run over parameterized Capital Adequacy
  Determinants Model.
Model Estimates Log (CAB) of OLS
Sample: 1980-2008
Δ Log CAD (-1)
Δ Log INFL (-1)
Δ Log ER
Δ Log ER (-1)
Δ DIR (-1)
Δ Log INV (-1)
Δ Log OPEN (-1)
Δ Log MS
Δ Log MS (-1)
ECM (-1)
Notes: R2= 0.97                    F= 10.61       a=0.215
            Adj R2 = 0.88            Prob(F-statistic) = 0.007975
DW= 146                   Schwarz Information Criterion =0.713
Source: Computed

TABLE V: Short- run Parsimonious Model Estimates Modeling
                        Log(CAB) by OLS
Sample: 1980-2008

Log CAD (-1)
Log ER
Log DIR (-1)
Log OPEN (-1)
Log MS (-1)
ECM (-1)
Notes: R2= 0.92               F=10.09         a=0.26
*** Significant at 1%   Adj R2= 8.83 Prob (F-statistic)=0.0002770
** Significant 5%           DW=2.08      Schwarz  Information Criteria =1.10
* Significant at 10%
Source: Computed
The thrust of the study was to investigate empirically the determinants of Capital Adequacy in the Banking Sub-sector in Nigeria, and to test for the validity of some conjectures that have been advanced for the determinant of Capital Adequacy in Nigeria. The study was motivated by its importance and contribution to economic growth and development in the banking sub-sector of the Nigeria economy instead of using the usual balance sheet ratio computation or single equation analysis, an error correction model (ECM ) was adopted. This approach was preferred because according to past studies, an Error Correction Model yields a better result that are more reliable and unspurious than those reported for single equation models. The regression model results obtained from the study are used as the effect of each variable. It was discovered through this study that, there were long run relationship between Exchange rate, Inflation rate, Political Instability, and Money Supply. Also, all the variables employed in this study were all stationary at their first difference except rate of real domestic interest rate and return on investment that were stationary at their levels. There are some major findings that this study has revealed.
These findings include:
1.         From the result of the study, one could see that money supply is an important determinant of capital adequacy base in Nigeria. Its high coefficient and very strong level of significance even at one percent suggests that increase in Money leads to an increase in Bank capital base. The increase in CAB could also have a feedback effect on economic growth.
2.         The real domestic interest rate is also an important determinant of Bank capital adequacy base in Nigeria, since it is statistically significant at one percent level of significance, although it is inversely related to CAB which suggests that the rise in real cost of capital, informed by an increase in real interest rate would tend to dampen CAB especially those requiring some degrees of domestic capital.
3.         The real exchange rate is another significant determinant of CAB in Nigeria. Although, the coefficient is not as expected, but existing literature emphasized an inverse relationship which implies that an increase, in the real exchange rate will reduce the flow of Foreign direct investment and so reducing CAB in Nigeria and vice versa.
4.         The return on investment in the rest of the world proxied by long- run US interest rate is not a strong or significant determinant of CAB in Nigeria while Inflation rate erodes CAB but existing literature has shown that foreign direct investment has negative impact in developing economy during period of financial crisis.
5.         The Deposit liabilities and liquidity risk variables are not correctly signed and are not statistically significant but may increase CAB via increase in money supply.
6.         As can been seen, the coefficients that appears on the INV have his theoretically predicted signs and in general are statistically significant. The, result indicated that Investment increases CAB via inflow of Foreign direct investments into Nigeria.
7.         Lastly, the political dummy used as proxy for political instability was appropriately signed indicating that intermittent coup d’etat and incessant political upheaval may serve to scare away potential foreign investors thereby, reducing CAB in Nigeria.

The aim of this empirical study is to investigate the determinants of capital adequacy patterns in the Banking sub-sector with respect to the effect of increased capitalization on the soundness of financial system in Nigeria. The study applied the Error Correction Model (ECM) and found empirical support for some conjectures made in the literatures. Given the importance of Capital adequacy in any economy and the likely economic effects on banks’ capital on growth and development, it becomes expedient to examine how Capital adequacy in Nigeria can better be improved if attention is given to some macroeconomic variables.

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