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). These services among others include resource mobilization, allocation, financial
intermediation and facilitation of foreign exchange transactions to boost international trade
(Olorunshola, 2023). Buhari (2019) defined financial regulation as the process of ensuring that
cash and other financial resources of government are in accordance with the legislation,
regulation and accounting manual which constitute legal and administrative framework of a
particular entity. Specifically, in the case of banks regulation, it is necessary to maintain safe and
sound banking system that can meet its obligations without difficulty hence a high solvency and
liquidity level is expected of individual banks than they would ordinarily maintain.
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.

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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
provide reasonable assurance that an organization’s business objectives will be detected and
corrected, based on either compliance or management initiated concerns ( Awe,2021; Mordi,
2020; Jimmy 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.

2.2 The Concept of Bank Lending, Monetary Policy and Profitability

2.2.1 The Concept of Bank Profitability
The issue of profitability is a contentious subject that a bank has to consistently face.
Profit is the disparity between expenses and revenue over a period of time, normally one year. As
explained by Heibati, Nourani & Dadkhah (2019), a business is organic; it survives and grows.
Therefore, it is important that a bank earns profit for its long term survival and growth. It is also
necessary that enough profit must be earned to maintain the activities of the business to be able
to obtain funds for expansion and growth of the bank.

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Agbada &Osuji (2020) argued that corporate profit planning remains one of the most difficult
and time consuming aspects of bank management because of many variables involved in the
decision, which are outside the control of the bank, itis even more difficult if the bank is
operating in a highly competitive economic environment, such as that of Nigeria.
The term profitability refers to the ability of the business organization to maintain its profit year
after year. Profitability, according to Sanni, (2020) is a situation where the income generated
during a given period exceeds the expenses incurred over the same length of time for the sole
purpose of generating income. He further assert, a sound and profitable banking sector is better
able to with stand negative shocks and contribute to the stability of the financial system.
Although various authors have given different definition, basically, it is about sustaining the
ability of having excess income over expenses. Profitability is therefore important because it is
the main purpose of any business.
According to Tabari, Ahmed & Emami (2021) the profitability variable is represented by
two alternatives measures: the ratio of profits to assets, i.e., the return on assets and the returns to
equity ratio (ROE). In principle, return on assets reflects the ability of a bank’s asset to generate
profit, although it may be biased due to off-balance sheet activities. ROE indicates the returns to
shareholders on their equity and equals ROA times the total assets-to equity ratio.
Nwankwo (2020), feels that like other items in the balance sheet- capital reserves, investments
etc., the importance of loan portfolio derives from the functions lending performs for banks. It is
for instance the highest earning asset in the banks’ balance sheet. It contributes materially to the
banks achievement and fulfillment of the objectives of profitability by providing a higher return
than other financial assets. It helps banks management to satisfy the legal and other regulatory
objectives of monetary authorities. The importance of lending in banking cannot be over-
emphasized. All the technical training a banker receives is heavily geared towards lending. When
it is said that one is a good or an astute banker, what in fact is meant is that one is a shrewd
lender- one who lends money safely and profitable.
Monetary policy rate is the rate at which the Central Bank, as a lender of last resort, lends to the
banking system. This is normally done through discounting of bills. The monetary policy rate of
the Central Bank affects other interest rates in the country. If the level of money supply in the
economy is very high, the central Bank increases the discount rate as a means of reducing

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inflationary pressures, but when the level of money supply is low, the rate is increased as a
means of reducing the liquidity of the banking system.
The current study used the four measures of profitability indicators including: Earning per share
(EPS), Return on Assets (ROA), Net profit Margin (NPM) and Return on equity (ROE). They
are widely used to determine bank profitability, evaluate performance of banking industry and
predict the market structure trend.
The focus on profitability for DMBs is underscored by the fact that Nigeria has a bank- based
financial system, because of the nature of her financial system; the success of these banks
measured in terms of profitability determines the level of financial development which is a major
prerequisite for economic growth.
2.2.2 Corporate governance requirements for Deposit Money Banks include:
 To be a body corporate (i.e. not an individual, partnership, trust or other
unincorporated entity)
 To be incorporated locally, and /or to be incorporated under as a particular type of
body corporate, rather than been incorporated in a foreign jurisdiction
 To have a minimum number of directors
 To have an organizational structure that includes various offices and officers, e.g
company secretary, treasurer, auditors, Asset liability management committee,
Compliance officer etc.
 To have a constitution or articles of associations that is approved.
 Or contains or does not contain particular clauses, e.g. clauses that enable directors to
act other than in the best interest of the company (e.g. in the interest of a parent
company) may not be allowed.

2.2.3 Credit Rating Requirement

Siddiqi (2019) states that Banks may be required to obtain and maintain a current credit
rating from an approved credit rating agency, and to disclose it to investors and prospective
investors.
Here, banks are required to maintain a minimum credit rating.

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2.2.4 Large Exposures Restrictions
According to S.21 (4) of BOFIA, Banks may be restricted from having imprudently large
exposures to individual, counterparties or groups of connected counterparties. This may be
expressed as a proportion of the bank’s assets or equity not encumbered by any loss (single
obligor limit), and different limits may apply depending on the security held/or the credit rating
of the counterparty.

2.2.5 Positive Implication of Regulation

Impact of the Reform
Soludo (2021) maintained that the current banking reforms have yielded the following
results among others:
1. The reforms have brought about a new mindset to the industry as banks are putting in
place best practices in the areas of corporate governance and risk management. Transparency
and public disclosure of transactions have remarkably improved.
2. A number of banks have returned to the profit-making path and improved their balance
sheets, as the recent results of their financial statements have shown.
3. Banks are gr adually resuming lending to the private sector with the additional liquidity
of more than N1.7 trillion injected into the banking system through the issuance of AMCON
bonds, and significant progress in re-directing credit to the power sector and SMEs at single digit
interest rates. These initiatives have saved and helped create thousands of jobs in the economy.
4. A new code of corporate governance has been issued by the Central Bank of Nigeria. The
CEO of banks shall serve a maximum tenure of 10 years. Furthermore, all CEOs who would
have served for 10 years by July 31, 2010 ceased to function in that capacity and have handed
over to their successors.
5. Nigerian Banks are now key players in the global financial market with many of them
falling within the Top 20 banks in Africa and among Top 1000 banks in the world.

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2.2.6 Challenges of the Banking Regulation/ Supervision in Nigeria
Okonjo-Iwela (2019) states that the Nigerian banking reform, despite its laudable
achievements is confronted with certain challenges. Some of the challenges that have faced
regulatory/supervisory authorities include:
(a) Quality of Data
The rendition of false, incomplete and / or inaccurate returns to the regulatory authorities has
been a persistent hydra- headed monster that has continued to bedevil the banking industry for a
very long time. The anomaly has persisted notwithstanding the zero-tolerance policy on the
issue. There have been established cases of concealment of material information and in other
instances outright falsification of assets and liabilities balances in the financial statements and
statutory returns to the authorities.
(b) Legal and Regulatory Framework
A necessary prerequisite for an efficient bank regulatory system is the existence of a sound legal
and regulatory system for banking supervision. Although, some of the in adequacies in the
regulatory framework that have hampered the achievement of supervisory objectives had been
addressed with the enactment of the CBN Act in 2007, there is a need to accelerate the passage
of new Banks and Other Financial Institution Acts currently before the National Assembly to
bring banking regulations in line with Nigeria’s growing financial sector
(c) Ensuring Independence of Supervisors
Effective supervision requires strong and independent supervisors, shielded from political
pressures. This is achieved when supervisors have clear mandate, legal protection and political
support to do their job. Getting bankers to follow rules is very important for high- quality
supervision. Supervision becomes ultimately ineffective if supervisors do not have the clout to
enforce laws and levy fines and other punishments.
(d) Resources

Banking regulation is costly, requiring enormous investments in upgrading regulatory agencies in

order to effectively regulate the institutions under their purview. To begin with, regulators must
operate on the same pedestal with bankers regarding knowledge of banking business, risk
management and contemporary trends. Adequate resources are required to upscale the skills of
bank regulators. Regulators and supervisors must therefore be well equipped to be able to

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engage financial institutions and craft the most appropriate regulations that would effectively
address the risk. The ability of the regulatory agencies to deliver on these factors which are
intrinsically linked to their mandates requires the commitment of enormous resources.

[Link] Financial Performance

The index that quantifies the financial healthiness of an entity over a specific period of
time which involves the up to date presentation of the outcome of an organisation’s activities and
operations in financial terms are referred to as financial performance. These financial
performance metrics are also referred to as financial ratios which can be used to compare similar
organisations from same industry as well as compare industries in aggregation (Farah et al.,
2019). Financial ratios can show the relationship between financial data of the financial
statements expressed as a quotient of two mathematical expressions (Abdulraheem, 2021). For
the purpose of this study, firm’s value and capital adequacy are the two measure of financial
performance adopted. Firm’s value as a Measure of Performance: Firm’s value can be defined as
the total worth of an asset. It is an entity’s net worth arrived at by aggregating its outstanding
stocks in the market usually referred to as market capitalisation (Fidelity, 2022). Normally,
firm’s value is greater than a company’s book value because firm’s value captures both tangibles
and intangibles such as goodwill, reputations, profitability, as well as prospective future growth.
There are several methods of computing the firm’s value of a bank. Some scholars use Tobin’s Q
(Q- ratio), others use the price to book value (PBV) ratio. Yet others prefer the price to earnings
ratio (PER). Tobin’s Q is used to compute the firm’s value of an entity in terms of its
replacement value while the PER is normally measured as an aggregate of cost of equity,
expected earnings growth and the pay-out Ratio (Jason, 2024) . Meanwhile PBV is the measure
of the market capitalisation of the entity to its book value. Therefore, the price earnings ratio
(PER) is adopted for the purpose of this study, as it takes into account the value of the banks
from the point of view of the investors.

[Link] Capital Adequacy Ratio as a Measure of Performance

Capital adequacy can be defined as the amount of capital necessary to be held by a
financial institution in other to prevent the entity from becoming insolvent and also promote the
safety and stability of the banking system as a whole. It is one of the important metrics of the

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safety, soundness, stability and solvency of banks by acting as a buffer to cushion or absorb
losses. Capital adequacy is usually computed as a percentage of risk weighted average of its
cumulative total credit exposures (Obiakor & Adeleke, 2019; Yaaba & Sanusi, 2020). Regulators
mandated banks to maintain a level of capital adequate for the level of its activities usually
referred to as regulatory capital. CAR therefore measures the level of protection a bank has
against excess leverage and insolvency by acting as a hedge during business difficulties and
prevent banks’ run. CAR matches a bank’s capital with its current liabilities and its risk weighted
asset. Meanwhile the risk weighted assets can be described as a measure of the amount of assets
of a bank after adjusting for the various risks it carries (Obiakor & Adeleke, 2019; Thumbi,
2021; Yaaba & Sanusi, 2020). Thus for Nigeria DMBs, the CBN after its breakfast meeting with
banks CEOs on 29th, January 2019 published a circular for the guidance of banks on the
computation of the CAR which is the asset ratio of the total qualifying capital to the total risk
weighted asset (CBN, 2019). Previous reviews in the field of risk management and performance
had identified some theories that are related to this study such as: Stewardship theory,
stakeholder’s theory, agency theory, moral hazard theory, business continuity theory, and risk
versus returns trade off of modern portfolio theory. However, for the purpose of this study the
stakeholder theory and the moral hazard theory were found to have more bearing to the study.
Stakeholder theory is a theory of organizational management and business ethics that focused on
morals and values in managing an organization. The theory proposed that successful managers
despite the fact that they are faced with several risk and uncertainties must systematically focus
on the interests of various stakeholder of the organization as there are other divers interest groups
whose interest should be taken into consideration in managing the affairs of a corporate entity.
Thus stakeholder’s theory focus on maximising values for the benefits of the various
stakeholders (Battilossi, 2023; Freeman, 1984; Klimczak, 2024). Meanwhile, Macey and
Maureen (2023), further noted that managers should manage the company through various risks
and uncertainties by taking decisions and actions that will benefit its stakeholders and to ensure
their rights and their participation in decision making as well as act as the shareholder’s agent to
ensure the shareholders interest and the survival of the company is achieved and maintained.
Moral hazard theory describes a situation where managers and directors takes very high risk with
the understanding that the consequences of taken such high risk where they crystallise to losses
would not be borne by them but by other stakeholders such as deposit insurance companies or

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the owners and in some cases where there is anticipation of government bailouts. (Krugman,
2019; Omanufeme, 2023). It is of note nevertheless that an effective and good risk management
cannot be explained by just one theory but a combination of several of the theories. However,
this study finds the stakeholders theory and moral hazard theory to have most bearing with the
current review. Okonkwo and Nwokeji (2019) studied Credit risk management and financial
performance of (DMBs) in Nigeria. The study adopted non-performing loans, nonperforming
loans to total loans ratio, non-performing loans to shareholders' fund, loan to deposit ratio
together with Herfindahl Hirschman index as independent variables. The study used secondary
data to conduct regression analysis. The finding from the study revealed that credit risk has
significant positive effect on financial performance measured with ROA. The study differs from
the current study in the methods adopted to measure the IVs and adoption of ROA as the
performance measurement matrix. Similarly, Okere et al. (2019) studied credit risk management
effects on performance of Nigeria DMBs using data from ten sampled banks to conduct panel
regression analysis and Hausman test. The study found that credit risk management revealed a
positive relationship between risk management and financial performance measured with ROA.
However, the research only considered ROA as financial performance index thereby differs from
this current study. Adesina et al (2020) studied market risk and financial performance proxied
with price to earnings ratio of 20 listed Nigerian banks covering from 2016 to 2022. GLS
regression analysis model was utilized and findings from the study revealed a positive
relationship between market risk hedging strategy and financial performance of the banks. Also,
Kassi et al (2019) examined the effect of market risk on the financial performance of 31 non-
financial companies listed on the Casablanca Stock Exchange (CSE) over the period 2000 to
2019. Using ROA, ROE and profit margin as profitability ratio while market risk was proxied by
financial leverage, book-to-market and gearing ratio. The study employed the pooled OLS
model, fixed and random model, and difference-GMM and system-GMM models. The results
revealed that the various measures adopted as proxy for market risk produced a significant but
negative effect on financial performance. Further, Igbinosa et al (2020) investigated the effect of
market risk factors on banks' performance in ECOWAS region using a Panel data of five
ECOWAS countries covering a period of 20 years from 1996 to 2016 was sourced from the
World Bank database. The investigation used panel data random effect in which the findings
showed that exchange rate risk is the most significant market risk factor that has positive effect

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on bank performance in ECOWAS region. Obi-Nwosu et al (2019) also studied the effect of
liquidity risk management on the performance of DMBs in Nigeria performance proxied with
ROE and ROA covering a period of fifteen (15) years from 2000 to 2015. The study employed
Augmented Dickey Fuller Unit Root Test, OLS regression and Granger Causality test and the
findings revealed that liquidity risk do not have a significant relationship with the performance of
the DMBs. Again, Muriithi and Waweru (2019) examined the effect of liquidity risk on financial
performance of commercial banks in Kenya over a nine-year period from 2005 to 2014 using.
Data was sourced from all the 43 banks in Kenya as sample. Secondary data was tested using
Panel data random effects. Findings revealed an overall negative effect on financial performance.
The study was carried out under a setting different from that of Nigeria necessitating the need to
carry out similar study within the Nigeria context. Toufaili (2021) reviewed the effect of
solvency risk as one of the risk management variables on the financial performance of Lebanon
banks using primary data collected from over 123 interviewees, analysed using the multiple
regression analysis and found that management of solvency risk among others has a positive and
significant relationship with performance measured with ROE. The only shortfall of the study is
that it was conducted on banks outside the Nigeria jurisdiction using primary data unlike this
current study which uses secondary data. Again, Përvetica and Ahmeti (2023) studied the effect
of Solvency risk among other IVs on the financial performance proxied with ROA and ROE of
banks in western Balkan. Using a panel data fixed effect regression analysis, the study revealed
that solvency risk has positive and significant effect on the performance of the banks. The
shortfall of this approach is that it was carried out outside the Nigeria jurisdiction and that the
performance metrics adopted differs from the one being adopted in this current study.

2.3 Theoretical Review

This study employs the liquidity preference theory (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

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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
(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

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penalties (Berger & DeYoung, 2020). Therefore, it is expected that DMBs would increase their
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 Hypotheses Development

2.4.1 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

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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
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. In light of previous
empirical literature and the theoretical discussion on capital adequacy, this study hypothesizes
that:

H1: CAR and the financial performance of DMBs are positively associated.

2.4.2 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). Based on previous literature and the theoretical discussion on liquidity preference, the
current study intends to provide further insight into the possible interaction between LDR and
profitability by hypothesizing that:

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H2: LDR and the financial performance of DMBs are positively associated.

2.4.3 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
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. Thus, the study hypothesizes that:

H3: AQR and the financial performance of DMBs are positively associated.

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