CHAPTER TWO
2.0 Literature Review
2.1 Conceptual Review
2.1.1 Regulation and Supervision
Bank regulation is a form of government regulation which subjects’ banks to certain
requirements, restrictions and guidelines, designed to create market transparency between
banking institutions and the individuals and companies with whom they conduct business, among
other things. Regulation means an official rule made by government or some other authority. It is
a set of specific rules or agreed behavior either imposed by some government or external agency
or self- imposed by explicit agreement within the industry to achieve a defined objective (Chris,
2023).
Uche (2021) opined that “regulation generally suggest some form of intervention in any activity
and ranges from explicitly legal control to informal peer group control by government or some
authoritative bodies, sometimes it stems from market transactions giving rise to spillover effects
(or externalities) or third parties, or when there is information inefficiency in the market”. Okaro
(2018) defined regulation as government enforcements of permissible and non-permissible
business operations in Nigeria. Financial system is a composition of various institutions, markets,
instruments and operators that interact within an economy to provide financial services (Uffot,
2023). As stated by Idam (2021), there are two types of regulations in financial institutions. They
are:
External Regulation
This is a situation where governments establish some bodies to regulate the activities of
financial institutions to avoid distress.
The bodies charged with these functions in Nigeria are:
Central Bank of Nigeria (CBN)
Nigeria Deposit insurance corporation (NDIC)
Internal Regulation
Internal regulation is a situation where banks are regulated at the branch level. Internal
regulation are policies , procedures, practices and organizational structures implemented to
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provide reasonable assurance that an organization’s business objectives will be detected and
corrected, based on either compliance or management initiated concerns (Awe et al., 2023).
According to Nagy (2021) internal regulation consists of collection of measures at management’s
disposal intended to ensure bank’s proper functioning of a correct management of bank’s assets
and liabilities, and a true recording in accounting evidence.
2.1.2 Banking Supervision
Supervision involves assessing the safety and soundness of regulated financial
institutions, providing feedback to the institutions, and using supervisory power to intervene in a
timely manner to achieve supervisory objectives. The goal is to prevent avoidable losses that
could result in the failure of a bank and loss of confidence in the banking system.
Accordingly, the Basel Committee on banking supervision has proposed the Basel III (or the
Third Basel Accord) as a global regulatory standard on bank capital adequacy, stress testing and
market liquidity risk which is scheduled to be introduced from 2018 until 2022.
2.1.3 Deposit Money Banking and Financial Performance
Deposit Money Banking was adopted from all Commercial and Merchant banks operating in
Nigeria during the universal banking era of 2001. These banks owe some basic responsibilities in
form of financial intermediation which must be efficiently delivered to retain the confidence of
their customers and ensure a smooth financial system. These banks provide retail and wholesale
financial services to their customers which could comprise the opening of accounts, insurance,
pension, mobilizing savings and investments, lending for investments, and financing economy
activities to mention but few. These banks play a significant role in providing an efficient
payment system and facilitating the implementation of monetary policies of the government,
hence to encourage competition among DMBs, protection against systemic risk, unprecedented
collapse and effectiveness, these banks must be regulated and supervised to protect both
shareholders, government and bank customers via financial measurement. Financial
measurements are tools that revealed the strength, weaknesses, opportunities and threats of
banks. The examination and supervision of the performance of DMBs are essential for
managerial and regulatory purposes. The CBN is concerned with the safety and soundness of
banks and depositors’ funds while shareholders are interested in the financial performance of
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their banks as per their liquidity and profitability levels. Ongore and Kusa (2019) explained that
the poor financial performance of DMBs can lead to failure and financial crunch which have
undesirable impacts on economic growth while Mishkin (2019) as cited in Lisa and Sandy
(2020) argued that the financial performance of banks can be measured in various ways
including ROI, ROA as well as an estimation based on value addition.
2.2 Review of Empirical Study
2.2.1 Capital adequacy ratio and financial performance
The capital adequacy ratio (CAR) is an important parameter used by the apex bank of a
country to measure and regulate the capital adequacy of banks operating in the country. In
Nigeria, in line with the Basel Accord guidelines and recommendations of the BCBS, the CBN
requires DMBs to increase and maintain a certain level of capital adequacy to ensure stability in
the banking industry (Ikpesu & Oke, 2022). However, when a bank cannot meet the specified
capital adequacy level, it would be required to reduce its loan assets (Abba et al., 2019; Leila,
Hamidreza & Farshid, 2020). But reducing the loan assets of DMBs may affect their profitability
negatively since they earn interest income from their loan assets (Abba et al., 2019; Aldhaheri &
Nobanee, 2020). Previously, Abdul (2019) argued that adequate capital directly and
automatically influences the amount of funds available for loans, which invariably affects the
level and degree of risk DMBs can absorb. Following Abdul's (2021) submission on
capitalization, Aliyu, Abdullyhi, and Bakare (2020) and Ikpesu and Oke (2022) found a positive
association between capital adequacy and profitability, indicating that capital adequacy could
invariably translate to improved earnings and performance of DMBs. However, an earlier study
by Onaolapo and Olufemi (2019) reported an adverse effect of capital adequacy on profitability.
In a comparative study on the interrelationship between capitalization and profitability in the
banking sector of BRICS countries, Singhal et al. (2022) reported that capitalization has a
detrimental effect on profitability in China and South Africa when considered in light of the
agency theory and not in Brazil, Russia, and India when considered in light of the signalling and
bankruptcy cost hypotheses. Theoretically, many scholars regard capital adequacy as a
significant factor in fostering risk management efficiency. However, there is no consensus in the
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literature on its effect on the financial performance of DMBs. Therefore, there is a need to
provide further insight into the ongoing capitalization-profitability debate.
2.2.2 Loan-to-deposit ratio and financial performance
The loan-to-deposit ratio (LDR) is another significant measure used by central banks of
countries to assess the liquidity position and associated risks of DMBs and their ability to meet
the liquidity needs of depositors (Iwedi, 2020; Trefis, 2019). It indicates the capacity of the banks
to meet customers' cash demands with minimal or no loss. As earlier argued, banks make credit
facilities available to borrowers from depositors’ funds to earn interest income (Ikpesu & Oke,
2022). Previous research suggests that DMBs give more credit facilities to investors from whom
they can get a high-interest income, not minding the associated risks (Aldhaheri & Nobanee,
2020; Ennis & Walter, 2019). But to keep depositors' funds safe and reduce the risk of illiquidity,
central banks of many countries determine and regulate the LDR of banks. In Nigeria, the CBN
requires DMBs to maintain a minimum LDR of about 65% (Obioma & Charles, 2019) and to
make more credit facilities available to the real sector and small businesses at a regulated interest
rate determined by the CBN. Though some economic experts argue that higher credit facilities
could translate to higher profitability (Ikpesu & Oke, 2022), critics believe higher credit facilities
expose DMBs to illiquidity risks, not having enough liquid resources to cover unforeseen fund
requirements, which could invariably affect their financial performance adversely. Hitherto, the
association between LDR and profitability has remained controversial among economic experts.
For example, Hadian (2021) reported that LDR has a positive effect on profitability, which
contrasts the negative impact on profitability documented by Ajayi and Lawal (2021) and Suroso
(2022) and the insignificant effect reported by Anggari and Dana (2020) and Saleh and Winarso
(2021).
2.2.3 Asset quality ratio and financial performance
Besides having adequate capital, asset quality is essential for survival since asset quality
involves the examination of the bank asset in a bid to ascertain the size and level of credit risk
linked with its activities (Ikpesu & Oke, 2022). Regulators are concerned about the asset quality
of DMBs since a weak asset quality not only affects profitability and operations but also affects
the financial stability of the economy (Ikpesu & Oke, 2022; Richard & Prakash, 2019). Unlike
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nonfinancial companies, where loans are regarded as liabilities, bank loans to customers are
categorized as loan assets. The interest earned on loan assets forms a significant part of the
income of DMBs, referred to as interest income. But while DMBs may aim at giving out more
loans, they are confronted with the risk of default and failure of borrowers to pay back the loans
(Rostami, 2019). According to Trefis (2019) and Obioma and Charles (2019), when the credit
risk of a DMB increases, its loan quality or asset quality deteriorates due to upward movement in
the ratio of non-performing loans. Accordingly, a decreasing asset quality compels DMBs to
hold more capital and make provisions for losses (Rostami, 2020). Previous literature suggests
that a low liquidity ratio and even poor asset quality could lead to the failure of DMBs. For
example, between 2018 and 2019, many DMBs in Nigeria failed due to poor asset quality
management, high non-performing loans and insider lending (Obioma & Charles, 2019; Udeh,
2020). Though previous studies suggest a strong correlation between AQR and financial
performance, Trefis (2016) argues that since the activities of DMBs are now diversified, asset
quality alone should not be a key determinant of their financial performance. However, because
of the need to remain in business and to meet regulatory requirements, some bank managers
make irregular provisions and use different impairment models to manage the quality of their
loan assets to conform with the regulatory guidelines (Obioma & Charles, 2019). Considering the
possible interaction between AQR and profitability, as previous literature suggests, the current
study provides further insight into the ongoing debate on the effect of AQR on the financial
performance of DMBs.
2.3 Theoretical Review
This study employs the liquidity preference theory (Maynard Keynes, 1936) and capital
adequacy theory (Berger & DeYoung, 1997) as complementary means of examining the impact
of banking regulations and supervision on the financial performance of DMBs.
In 1936, John Maynard Keynes introduced the liquidity preference theory as a novel way
of understanding the connection between interest rates and the supply-demand of liquidity. The
theory asserts that holding liquid assets is desirable to expedite transactions, act prudently, and
take advantage of investment opportunities in the financial market (Lavoie & Reissl, 2019; Ugwu
et al., 2020). Keynes notes that focusing on interest rates alone as a reward for saving is improper
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(that is, the interest rate is not the motive) because a person can hoard his savings in cash in a
piggy bank without any interest and yet would have refrained from consuming all his current and
available income (Culham, 2020; Keynes, 1936; Ugwu et al., 2020). Liquidity in the context of
Keynes (1936) is based not on the demand for money or the most tradable asset but on
priceprotected (capital-safe) assets, most directly inside and outside money (Culham, 2020).
The theory assumes that the public is willing to forgo interest income for short-term
price-protected assets due to capital and price uncertainties associated with market liquidity. It
holds that the interest rate is a monetary phenomenon determined independently of saving and
investment (Bonizzi & Kaltenbrunner, 2020; Culham, 2020; Keynes, 1936).
In keeping with the liquidity preference theory, this study holds that DMBs enable clients
to access liquid cash for transactional, speculative, and preventative objectives, and the capacity
to generate credit and increase liquidity boosts the competitive position of DMBs (Sugeng,
2019). The study expects DMBS to understand the rationales for tying down liquid capital and
the implications on their profitability. And since the CBN regulates the liquidity position, capital
requirement and LDR of DMBs, they must consider that low liquidity jeopardizes their ability to
meet the liquidity requirements of their clients (Thi, 2020). Though excess liquidity may expose
DMBs to fraud risk, being liquid helps them deal with and survive financial difficulties (Godwin
& Comfort, 2019). On account of the liquidity preference theory, this study argues that though
the CBN regulations may aim to promote a sound financial system with sufficient liquid assets,
they may limit the profit-making drive of DMBs. Thus, with the CBN liquidity regulations,
DMBs must consider the risks of low or excess liquidity and the effects on their profitability.
The capital adequacy theory is also a valuable theoretical lens through which to assess the
impact of bank regulations on the profitability of DMBs. The theory requires DMBs to have
certain assets, which can be shifted to the central bank when liquidity needs arise (Aliyu,
Abdullyhi, & Bakare, 2020). Therefore, compliance with regulatory requirements may affect the
financial performance of DMBs (Milne & Wiley, 2001; Simeneh, 2020; Sugeng, 2019). In
keeping with the capital adequacy theory, this study assumes that holding large capital allows
DMBs to explore future investment opportunities, boost performance, and avoid regulatory
penalties (Berger & DeYoung, 2020). Therefore, it is expected that DMBs would increase their
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capital to avoid compliance penalties by the regulators when their CAR falls below the required
ratio (Ikpesu & Oke, 2022; Sugeng, 2019). As noted by Simeneh (2020), during the financial
crisis, banks with low capital may increase systemic risk and undermine financial stability,
which could prompt the regulators to modify the capital requirements. Hence, complying with
the required minimum capital and keeping excess capital will reduce the likelihood of bank
capital falling during a general economic or financial crisis (Ugwu et al., 2020). Akin to the
capital adequacy theory, this study expects an association between the CBN regulation on capital
adequacy and the financial performance of DMBs.
2.4 Summary of Literature Review and Research Gap
The review of existing literature reveals that banking regulation and supervision play a
significant role in shaping the financial performance of Deposit Money Banks (DMBs) in
Nigeria. Prior studies have highlighted how variables such as Capital Adequacy Ratio (CAR),
Asset Quality Ratio (AQR), and Loan-to-Deposit Ratio (LDR) affect profitability, stability, and
risk management in the sector.
However, the review also exposes several gaps:
1. Limited recent data: Most empirical studies use data that ends before or around 2018,
despite significant regulatory developments and market shifts occurring between 2019
and 2025.
2. Fragmented analysis: Many studies analyze the effects of only one or two regulatory
variables rather than adopting a holistic approach that combines multiple indicators like
CAR, AQR, and LDR.
3. Lack of longitudinal analysis: There’s a shortage of panel data studies that track multiple
banks over several years to understand trends and causality better.
4. Contextual limitation: While similar studies exist in other developing economies, fewer
studies focus on the unique regulatory environment of Nigeria post-2019, especially
under the evolving CBN supervision policies and reforms.
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Contribution to Knowledge
This study seeks to address these gaps by:
- Employing recent panel data (2019–2025) from listed DMBs.
- Simultaneously analyzing CAR, AQR, and LDR to determine their joint and individual effects
on financial performance.
- Providing updated evidence to guide policymakers, regulators, investors, and bank management
in optimizing regulation for improved performance.