LIQUIDITY MANAGEMENT AND FINANCIAL PERFORMANCE OF THE NIGERIA INSURANCE INDUSTRY
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
This section conducts an evaluation of literature which forms the framework of the research. It starts by presenting the theoretical framework, discusses the financial performance determinants, empirical reviews, presents the conceptual framework, and finally provides the literature summary.
2.2 Theoretical Framework
The Liquidity Preference Theory, the Shiftability Theory, and the Modern Portfolio Theory guided the study.
2.2.1 Liquidity Preference Theory
In “The General Theory of Employment Interest and Money”, Keynes (1936) introduced the theory which describes to the total money the public can hold given the level of interest rates. Holding liquid assets can be explained by 3 reasons; First, for ordinary transactions, second, for precautionary purposes against emergencies, and third they are employed for speculative purposes. Keynes showed that transaction deposits are inversely proportional to the rate of interest (Ferrouhi & Lehadiri, 2013). The main argument in this theory is that an increase in money supply at low interest rates will lead to increase in cash balances and discourage savings and investment. The reason is that economic entities expect the interest rates to rise later in the future.
The theory further argues that the volatility in interest rates in the various economies triggered this push for an avenue that was seen in the development of this theory. The theory suggested that the financial institutions did not have to maintain old liquidity standards as they have no impact on asset stability in a bank. Diamond and Rajan (2001) posit that this theory focused on delivering abilities to meet the needs of liquidity. There is a correlation between management of liability and liquidity. It is a core tool to make decisions setting out to utilize the value of stakeholders. Asset liability management (ALM) entails managing the elements of balance sheet which mainly entails assessing and quantifying risks and with regard to the structure of asset/liabilities implemented by financial firms to alleviate the eminent risks.
The relevance of the theory to the research is that is gives firms a chance to alleviate risk and to overcome the inconsistencies of interest income after accounting for interest expense for the short term period and overall value of firms is sustained for a long period (Ferrouhi & Lehadiri, 2013). The advocates of the theory posit that an appropriate ALM liquidity, solvency and profitability of financial firms enables firms’ credit risk to be managed and reduced. Financial firms’ liabilities have various differing costs which is dependent in the pattern of maturity and tenor. The same way, these are made up of various categories with different yield relying on the factors of risks and maturity. The main goal of the theory is to connect assets and liabilities in hedging liquidity risk.
2.2.2 Shiftability Theory of Liquidity Management
This theory was propagated by Morton (1939), and later coined by Bhattacharyya (2011), states that the defensible level of financial institution liquidity management is having possession or investing in capital capable of shifting solely to other investments to meet liquidity requirements. Loan receivable for instance becomes secondary back up while secondary back up shifts to become primary back up. According to this theory insurance companies maintain liquidity if they hold assets that are marketable.
During a liquidity crisis, such assets are easily converted into cash. As such, the theory explains that marketability/shiftability/transferability of assets of firms is grounds for attaining effective management of liquidity. Supposing when there is no hard cash, financial institutions tend to sell off certain assets in order to obtain adequate cash. This situation happens when collateral which is illiquid turns into a liquid asset. Besides, they also often sell marketable securities like super
common stock (Mugenyah, 2015). As a result, the Shiftability theory is comprehended to give description and confidence of management of financial institutions until certain degree of transferable asset is needed to fulfill liquidity requirements.
The relevance of the theory to this research shows that firms are able to protect themselves from large deposit withdrawals by withholding credit for there exists a liquidity research as a secondary market. The theory highlights that the effectiveness of assets for the purpose of liquidity disappears since they do not have a market. In the event that all firms are in the search for assets that are liquidated, that represents a systemic issue affecting many entities which brings with it too much supply of assets and little demand hence lowering the selling price. This implies that lower asset prices would result as compared to stress-free market situations. The practice of firm’s loan commitment as it is done and prevails today is because of the shiftability theory of liquidity (Mugenyah, 2015).
2.2.3. Modern Portfolio Theory
In the 1950s Harry Markowitz introduced this theory. This theory examines how a portfolio of assets can be managed and how risk can be reduced under a set of assumptions. It is founded on the belief which tries to understand the market in total. It offers a broad background for the interraction of systematic risk and profit. Thus, one can say that risk and return on a spread portfolio rely on local and foreign economic and financial variables. Barad (2013) notes that the MPT explains how investors that oppose risk are able to develop portfolios that maximize and optimize the intended return on the grounds of different market risk levels, making the emphasis that risk is a critical aspect of a greater reward. The theory shows the possibility of developing an “efficient frontier” of favourable portfolios that offer maximum returns with regard to a specific risk level.
A core insight by MPT is that a risk investment and characteristics of return ought not to be perceived alone, but should be assessed on the influence of the investments, and the complete return and risk of the portfolio. The theory indicates that an investor is able to develop a multiple asset portfolio that maximizes the returns for a specific risk level. Similarly, provided an intended return level, an investor is able to develop a low risk portfolio (Berrios, 2013). With respect to statistical measures (correlation and variance), single investment return is not as crucial as the behaviour of the investment in respect to the context of the whole portfolio.
The theory is vital to this research since it assesses how financial institutions can pool assets together to reduce the liquidity management exposure. Further, the theory investigates how the risks associated with the unforeseen economic changes can be minimized by having an asset backup. Risk reduction helps firms to maintain their strong point in the economy as well as capture more customers. The MTP assumes that investors averse risk, implying that they would prefer a portfolio with a low risk level to one that is risky for a particular return level. This means that an investor is willing to take a greater risk provided that a greater reward is expected.
Portfolio theory has been a breakthrough in the management of financial economics. The theory assesses the stock market and evaluates the rate of returns and how the financial institutions can assess and manage risks. An effective management system checks on how risks can be minimized. The use of diversification helps lay a foundation for systematic management of the risks that may arise. Further, risks can be minimized through an integrated element of creative formulation of strategies to minimize effects of such risks. The major factors that influence the state and strength of a risk is the domestic and overseas financial elements such as imports and exports (Stals, 2015). The theory was meant to shed light on the management of financial institutions assets. The theory was later complemented by Tobin (1958).
2.3 Determinants of Financial Performance of Firms
The following are the financial performance determinants of firms:
2.3.1 Asset Quality
Saunders and Cornett (2015) explain that the origin of asset quality is the ideology of effective asset management within financial firms. Bhattacharyya (2011) explain that financial firms’ solvency is essentially at risk in instances where their assets are deemed as impaired, as such it is critical to observe quality indicators of their assets with regard to over-exposure to particular trends of risk in NPL and borrowers’ profitability and health. Credit risk is immanent in lending; it’s a core aspect of banking. It comes up when a borrower does not meet the agreements on loan repayments. A financial firm with defaulting borrowers may incur cash flow difficulties, which ultimately impacts its position of liquidity. In the end, this has a negative impact on the capital and profitability through to particular bad debts provisions (Saunders & Cornett, 2015).
Companies’ assets entail investments, current and non-current assets and credit portfolios. Usually, an expanding the size of assets is associated with the period the financial institution has been in existence (Athanasoglou et al., 2015). In conventional financial institution operations set-up, the loans of a financial institution encompass a huge chunk of its assets that earns the biggest share of the financial institution income in form of interest income. This assertion implies that the superiority of loan portfolio defines the level of financial firm’s financial performance. According to Dang (2011), the highest deterrents to profitability of financial institutions are the losses arising from ‘bad’ loans. Hence, financial institution ought to keep the level of non-performing loan ratios minimal as they are key indicators of the financial institution’s asset quality. The measurement metric used was gross NPL to gross loans ratio.
2.3.2 Firm Size
Among the initial academicians who postulated a direct connection between the how large a of firm is and profitability was Smirlock (2010). The researcher explained that a firm that is large in size records high profits. The organization’s size directly impacts its profitability; this is accomplished by reducing the costs associated with raising capital as was recorded by Short (2009). In addition, Smirlock (2010) finds a direct connection between the size of firms and their profitability. Notably an indirect connection between bank’s size and its profitability exists. The size of a bank has an inverse correlation with firms that are large in sizes and a direct link with the profitability of smaller firms but an intermediate firm size records high investment return. According to Black (2010) in the negative link exists between the size of firms and the return while considering product mix and scale showed that organization size and its profitability were not correlated, as such a small reduction in cost is attainable by raising the operational magnitude of a firm.
Firms that are small in size are a main source of financing for small businesses which form a critical engine of productivity in many countries. Regulating for the concentration of the market and a difference of other indicators can affect yields. A study by Davis (2012) revealed that there is an existence of an inverse link between the size of a firm and the net return with regards to the lending of small businesses, implying that firms that are small in size perform well in developing such loans.
2.3.3 Liquidity Management
Banks are frequently assessed based on their liquidity/capability to meet the collateral and cash requirements without enduring any losses (Bodla & Richa, 2010). The management of liquidity is critical in making decisions that bank managers use. It references the management of liquidity and
in particular the assessment of their needs in association to the loans and deposits process. The benefits of liquidity supersede a single bank since a shortfall in liquidity in a single bank can precipitate systemic consequences. Dang (2011) argues that in instances when a bank has a greater liquidity, they attain this at the opportunity cost of a specific stake giving rise to high returns.
According to Uzhegova (2010) an adequate liquidity level positively correlates to banks’ profitability. The commonly used financial ratios mirroring the position of bank’s liquidity include deposits of clients to all assets and deposits of clients to all loans. The trade-offs existing between liquidity risk and return are highlighted by assessing that a move from short to long term loans/securities results is an increase in the banks’ returns and in the rise of liquidity risk and the vice versa is also applicable. Hence, a rise in ratios of liquidity indicates a less profitable and risky bank. As observed by Uzhegova (2010), the bank managers are stuck in a delicate trade-off of firm profitability and liquidity.
2.3.4 Capital Adequacy
The functions of capital in financial institutions include risk sharing function and other mitigation functions. Capital adequacy is a financial firm’s ability to withstand abnormal losses (Saunders and Cornett, 2015). Due to the debt-like nature of liabilities in financial institutions, they tend to practice shifting of risk or substitution of assets. To avoid this, regulators require them to hold a minimum capital to assets to reduce their sensitivity to risk (Kongiro, 2012).
Profitable institutions which have a considerably more capital adequacy level are shown to have higher sustainability, efficiency and business reach. Shareholders who are the external suppliers of company’s capital entrust their money to company’s managers in the hope that the latter will increase the shareholders’ value (Phani, et.al, 2000). Olalekan and Adeyinka (2013) revealed that
capital adequacy positively impacts financial corporations’ profitability in Nigeria. This shows that capital adequacy is a prerequisite for a firm’s financial health.
Adequate capital ought to be available as it supports the continued functioning of the bank; in terms of offering its mandated services to the public. Capital acts as a cushion during undesirable financial conditions. The bank capital forms bank liquidity due to the fragility and vulnerability of deposits to bank runs. In spite of capital being an imperative source of liquidity, it has limitations as it creates low liability demand which encompasses the least expensive sources to adequate capital to sustain financial institutions operations. CAR is adopted to evaluate the level of capital available in a bank (Dang, 2011). CAR represents the capacity of the financial institution in question to meet demand deposits as well as profitably run its operations.
2.4 Liquidity Management Practices
In the event that the risk liquidity has been analyzed at all levels, a firm’s managers may make the decision to implement effective actions to minimize its vulnerability of liquidity risk. One action that managers can take is cash flow matching. According to Eljelly (2014) ladder asset maturities helps in matching the maturities of liabilities to the payments expected. This results in an increase in the opportunities that cash in hand will be available to meet the demand of cash within the firm. Diversifying assets entails an asset portfolio that is differentiated from all its aspects and is not vulnerable to situations of stress market conditions. An issuer, region, sector and asset class can diversify assets.
Diversifying liabilities means diversifying the portion of liabilities by product, channel and market; it can result in low vulnerability to liability risk. Moreover, with the increasing rate of liability maturing dates, a firm must not “flood” the business market with new sales to sustain its existing
levels of operations. Dong and Su (2014) observe that during bank runs, a firm may be in a position to issue new debts on unfavourable terms.
Back up surplus/capital with no Liquid assets; its sets up these assets for situations of market turmoil and tight liquidity conditions. These assets are able to cover the variation between the asset value at stress and the value of liability expected at an intermediate time such as 90 days. However, there exists a price value associated to buffer surplus. Reserves, are not normally intended to cater for tail type, and extreme events (Bhunia, 2012).
Issuing commercial paper: when operations are normal, a firm has access to short haul markets by offering commercial paper. The use of repurchase agreements (repos) helps in solving short haul needs for cash. Using repos enables organizations to hang onto liquid assets required for a period matching goals and hence allowing for liquidation of assets that are less liquid in an orderly manner for a long period. According to Akter and Mahmud (2014), the shortfall to this in a scenario that involves stress liquidity risk is that repos normally combine liquid assets so it is not applicable to offer solutions for the long term for stress liquidity risk
2.5 Empirical Review
This part highlights literature from other studies and work by other scholars. This will be used to make a comparison and establish variations and similarities between this study’s findings and what other literature say.
2.5.1.International Studies
Shukla (2012), carried out an examination of the effect of management of liquidity on commercial banks’ financial performance in Rwanda. A descriptive design was employed. The findings revealed that holding decisions on liquidity, management of cash, non-core investment, and loan
repayment constant, financial performance would increase. However, the findings focused on commercial banks in Rwanda and thus cannot be contextualized to insurance firms in Nigeria.
Alshatti (2014) on liquidity management influence on banks’ profitability in Jordan used 13 banks as the research population. A stationary test model was employed in testing a unit root using a time series of study variables and in hypothesis testing through regression analysis. The research revealed that a rise in the quick ratio and ratio of investments of funds available results in a growth in profitability, whereas a rise in the ratio of capital and liquid assets /results to low banks’ profitability in Jordan. The outcomes, however were grounded on banks’ profitability in Jordan, hence could not be applicable to insurance organizations in Nigeria.
In the same way, Konadu (2009) assessed the liquidity and profitability connection of banks listed in Ghana. The research employed a descriptive design and a panel method. The researcher employed a document analysis in gathering secondary data covering the years 2005-2010. The outcomes showed no positive link between the trend of liquidity and the banks’ profitability in Ghana. Akter and Mahmud (2014), studied the connection of liquidity and banks’ profitability in Bangladesh. 12 banks in 4 varying sectors were used to gather data. Linear regression was employed and found no relevant link between liquidity and the studied banks’ profitability. The findings targeted Ghana banking sector which have different operating environment with insurance firms in Nigeria
On the other hand, Olagunju. (2011), in their study in Nigeria on effective management of liquidity and commercial banks’ performance revealed that the survival and successful operations of commercial banks relies on the lack of compromise by the banks on effective management of liquidity. The study also revealed that among the financial ills in the environment include excess liquidity and illiquidity.The findings focused on commercial banks in Nigeria which have different operating environment with insurance firms in Nigeria
2.7 Summary of Literature Review
Liquidity position and regulation is a concern and challenge for effective and efficient running of financial institutions on national and global fronts. Satisfaction and meeting customer’s needs has been at forefront for every financial institution and hence the necessity of optimal liquidity is to such institutions. Cut-throat competition for customers for deposits and savings has pushed lenders to embrace changing liquidity management tools that shape the general trends of liquidity and the transactional needs and repayment of short term loans.
Despite many research studies on firm value and capital structure, there were few research on liquidity management and its impact on the financial health of insurance entities. Conflicting findings have been recorded both negative and positive connections between the research variables have been established. From these findings, it is clear that a big literature gap exists in insurance companies, which has to be covered by research.
Most of the research have targeted the banking sub-sector, yet insurance companies that contribute a considerable share in the financial ecosystem has not been studied. Hence the lack of a related research in insurance companies, thus the generalizations present are non-comprehensive on the basis of context. A severe liquidity management crisis would lead to a wider crisis in the financial system in the form of a run on the financial institutions in a particular country.