The reforms in the financial system in Nigeria which heightened with the 1986 deregulation, affected the level of financial deepening of the country and the level relevance of the financial system to economic development. Nnanna and Dogo (1998) However, the rapid globalization of the financial markets since then and the increased level of integration of the Nigerian financial system to the global system have generated interest on the level of financial deepening that has occurred.
The financial system comprises various institutions, instruments and regulators. According to the Central Bank of Nigeria (2003) the financial system refers to the set of rules and regulations and the aggregation of financial arrangements, institutions, agents, that interact with each other and the rest of the world to foster economic growth and development of a nation. According to Nzotta (2004:169) the financial system serve as a catalyst to economic development through various institutional structures.
The systems vigorously seeks out and attracts the reservoir of savings and idle funds and allocate same to entrepreneurs, businesses, households and government for investments projects and other purposes with a view of returns. This forms the basis for economic development. The financial system plays a key role in the mobilization and allocation of Savings for productive, use provide structures for monetary management, the basis for managing liquidity in the system.
It also assists in the reduction of risks faced by firms and businesses in their productive processes, improvement of portfolio diversification and the insulation of the economy from the vicissitudes of international economic changes. Additionally, the system provides linkages for the different sectors of the economy and encourages a high level of specialization expertise and economies of scale.
Nzotta further contends that the financial system, additionally, provides the necessary environment for the implementation of various economic policies of the government which is intended to achieve non-inflationary growth, exchange rate stability, balance of payments equilibrium foreign exchange management and high levels of employment. The Nigerian financial system can be broadly divided into two sub-sectors, the informal and formal sectors.
The informal sector has no formalized institutional framework, no formal structure of rates and comprises the local money lenders, thrifts, savings and loans associations and all forms of ‘esusu’ associations. According to Olofin and Afandigeh (2008:48) this sector is poorly developed, limited in reach and not integrated into the formal financial system. Its exact size and effect on the economy remain unknown and a matter of speculation. The formal sector, on the other hand, could be clearly distinguished into the money and capital market institutions.
The money market is the short-term end of the market and institutions here deal on short term instruments and funds. The capital market encompasses the institutions that deal on long-term funds and securities. The regulatory institutions in the financial system are the Federal Ministry of Finance, the Central Bank of Nigeria as the apex institution in the money market, the Securities and Exchange Commission (SEC) as the apex institution in the capital market, Nigerian Deposit Insurance Corporation, (NDIC), National Insurance Commission (NAICOM) and the National Pensions Commission (PENCOM).
Financial reforms have been a regular feature of the Nigerian financial system. The reforms have evolved in response to the challenges posed by developments in the system such as systemic crisis, globalization, technological innovation, and financial crisis. The reforms often seek to act proactively to strengthen the system, prevent systemic crisis, strengthen the market mechanism, and ethical standards. Financial reforms in Nigeria dates back to 1952 when the Banking Ordinance was enacted. The deregulation of banking in 1986 provided the impetus for the Structural Adjustment Programme.
The 1986 reform of the financial system saw a policy shift from direct control to a market based financial system, especially as regards monetary management, risk management and asset holding capabilities of the institutions. A number of other reforms followed including the consolidation policy in banking 2005 and insurance 2007. The capital market has also experienced a lot of reforms over the years, especially as regards the capital requirements of the operators, the operational and ethical standards of the institutions and the modalities of the market mechanism.
The reforms in the system impacted positively on the growth of the financial system. The system moved from a rudimentary one at inception to a more sophisticated one in 2009 with diverse institutions and operators, diversified financial assets and an enhanced regulatory framework. The reforms have also tried to address the financial gaps in the system, remove rigidities in the system of credit allocation and control and achieve positive real interest rates and greater efficiency by the market operators in the intermediation process.
The process of financial sector reform consists of the movement from an initial situation of controlled interest rates, poorly developed money and securities market and under-developed banking system, towards a situation of flexible interest rates, an expanded role for market forces in resource allocation, increased autonomy for the central bank and a deepening of the money and capital markets. The link between financial sector stability and growth is, explained by increased market depth, which potentially increases market efficiency.
It also reduces risks through the elimination of weak institutions. Financial sector reforms/seeks to develop an efficient framework for monetary management. This encompasses efforts to strengthen operational capacities of the banking system, foster efficiency in the money and securities markets, over-haul the payments system and ensure greater autonomy to the central bank in formulating and implementing macroeconomic policies. Thus, there is the need to deepen the financial sector and reposition it for growth and integration into the global financial system in conformity with nternational best practices. One of the most important policy concerns in most countries is the effect of consolidation of financial institutions on financial system growth and development. The first major concern is the transmission mechanism. Consolidation could alter the credit allocation of the financial system by fostering the creation of larger banks having better access to the funds market. It also affects the availability and pricing of loans in response to changes in the market dynamics and the level of economic development. 2. STATEMENT OF THE RESEARCH PROBLEM
In both developed and developing countries, the relationship between financial development and economic growth has been the subject of a growing literature in recent years. The lack of efficient financial intermediation in developing countries like Nigeria is widely evidenced by the mismatch between institutional savings and investment. It is however clear that the need for investment in the real sector in Nigeria is indisputable. In the past this has been addressed through the introduction of development finance institutions and other such vehicles to provide credit at below market rates for the purchase of capital.
This resulted in carrying out tightly regulated financial systems which were motivated in principle by prudential considerations until the 80s. The Nigerian financial system is one of the largest and most diversified in Nigeria. The system became liberalized when structural adjustment programme was introduced in the 1980s. In recent years, the system has undergone significant changes in terms of the policy environment, number of institutions, ownership structure, depth and breadth of markets, as well as in the regulatory framework.
However, in spite of the far-reaching reforms of the past 25 years, the Nigerian financial system is not yet in a position to fulfill its potential as a propeller of economic growth and development. The financial system is relatively superficial and the apparent diversified nature of the financial system is suspicious. This is because although a wide variety of financial institutions and markets exist, commercial banks overwhelmingly dominate the financial sector and traditional bank deposits represent the major forms of financial saving.
Challenges still exist in both the capital market and money market as policy environment is still plagued by incessant reversals. 1. 3AIMS AND OBJECTIVES OF THE STUDY The main thrust of this study at this level of economic development when efforts are being made to reposition the financial system to enable it play key roles in economic development shall be to evaluate the impact of financial deepening on the economy over the years in Nigeria. However, the following specific objectives would also be achieved.
To examine in an empirical manner, the nature of financial deepening in Nigeria since the onset of financial reforms within the period under study. • To ascertain the critical factors that has affected the level of financial deepening in Nigeria over the years. • To ascertain if there is observable growth in the financial deepening index (money supply to GDP) ratio in Nigeria. • To examine the interrelationship between major components of financial deepening and gross domestic product over the period under study in Nigeria. Finally, to empirically investigate the over performance of financial deepening components on Nigeria economy during the period under study 3. SIGNIFICANCE AND JUSTIFICATION OF THE STUDY The justification for this study stems from the conclusion of Nnanna and Dogo (1998), the concept of financial deepening is usually employed to explain a state of an atomized financial system, that is, a financial system which is largely free from financial repression.
And also from the conclusion of Oloyede (2008) maintained that financial deepening results from the adoption of appropriate real finance policy, namely relating real rates of return to real stock of finance. This study is also justified by the desire to add to the existing body of knowledge of the impact of financial deepening on Nigeria economy. 1. 5 RESEARCH QUESTIONS • Is there any verifiable pattern in the financial savings of the system since 1986? • Is there any relationship between the lending pattern of banks and financial deepening? Is there any relationship between the level of financial deepening and savings? • To what extent the prime lending rate impacted on gross domestic product in Nigeria within the period under study? 6. RESEARCH HYPOTHESIS The hypothesis to be tested in the course of this research work is: H0 – That financial deepening does not have significant impact on the economic growth in Nigeria. H1 – That financial deepening has significant impact on the economic growth in Nigeria. 7. SCOPE AND LIMITATION OF THE STUDY The economy is a large component with lot of diverse and sometimes complex parts.
This study will only focus on major growth components such as the gross domestic product. This study will cover all the facets that make up financial deepening, but shall empirically investigate the effect of the major ones. The empirical investigation of the impact of the financial deepening on Nigeria economy shall be restricted to the period between 1975 and 2009. The study would also examine the nature of financial deepening in Nigeria since the onset of financial reforms, and ascertain the critical factors that has affected the level of financial deepening in Nigeria over the years. . METHODOLOGY OF THE STUDY The model used in this research is a simple macro econometric model. The Ordinary Least Square (OLS) technique shall be employed in obtaining the numerical estimates. The OLS method is chosen because it possesses some optimal properties (The optimal properties are BLU that is it Best to use, Linearity and it is Unbiased in nature); its computational procedure is fairly simple and it is also an essential component of most other estimation techniques. The estimation period covers the period between 1975 and 2009.
In demonstrating the application of Ordinary Least Square method, the multiple linear regression analysis will be used with gross domestic product (GDP) as a major components of economic growth while bank lending rate(BLR), financial savings(FS), value of cheques (VOC), deposit money Bank (DMS),Currency Outside Bank (COB) which serve as components of financial deepening will be the independent variables. The method would be applied with the use of Statistical Package for Social Sciences (SPSS).
The equations model has been designed to show relationship between financial deepening and economic growth. The formal discussion of the model is presented in chapter three. 9. DATA SOURCES The data used in this study were sourced from the Central Bank of Nigeria publications and those of the Bureau of statistics. The data was for the period 1975– 2009. The period chosen for the study encompasses the phases of the major reforms in the financial system and the period of consolidation of the banking and insurance systems in Nigeria. 1 . 0 ORGANISATION OF THE STUDY This study shall contain five chapters. The first chapter contains the introduction, the statement of the research problem, the research questions, aims and objectives of research, justifications and significance of the study, research hypothesis, scope and limitation of the study, research methodology, and sources of data and organization of the study. Chapter two shall contain the theoretical framework and literature review. The research methodology shall be explained in detailed in chapter three. Chapter four hall contain the data analysis and interpretation of the data. Finally chapter five shall contain the summary, conclusion and recommendation of the study. CHAPTER TWO LITERATURE REVIEW 2. 1 HISTORICAL VIEW OF FINANCIAL REFORM At the inception of comprehensive financial sector reform in 1987, the sector was highly repressed. Interest rate controls, selective credit guidelines, ceilings on credit expansion and use of reserve requirements and other direct monetary control instruments were typical features of the pre-reform financial system in Nigeria.
Entry into banking business was restricted and public sector-owned banks dominated the industry. The reform of the foreign exchange market which hitherto was also controlled began a year ahead of the general financial sector reform. In context, the financial sector reform was a component of the Structural Adjustment Program (SAP) which kicked off in 1986. Although the policy planks of SAP in Nigeria were the prototype prescriptions of the Breton Woods institutions, the program was sold to Nigerians by government as Nigeria’s alternative to IMF loan-based adjustment.
The introduction of the program was on the heels of the rejection of IMF loan package with its conditionalities, a decision that reflected the consensus of a nationwide debate. The major financial sector reform policies implemented were deregulation of interest rates, exchange rate and entry into banking business. Other measures implemented include, establishment of Nigeria Deposit Insurance Corporation, strengthening the regulatory and supervisory institutions, upward review of capital adequacy standards, capital market deregulation and introduction of indirect monetary policy instruments.
Four highly distressed banks were liquidated while the central bank took over the management of others. Government banks were also privatized. The details and the sequencing of the reform measures are contained in the Appendix. A peculiar feature of the reform program in Nigeria is the associated inconsistency in policy implementation. The reform of the foreign exchange market started in 1986 with the dismantling of exchange controls and establishment of a market-based autonomous foreign exchange market.
Bureaux de-change was allowed to operate from 1988. However a fixed official exchange rate has continued to exist alongside the autonomous market. In 1994 the gradual market-based depreciation in the official exchange rate was truncated by a sharp devaluation in a bid to close the widening gap between the official and the autonomous exchange rate. Unsatisfied with the observed further widening of the gap between the two exchange rates, government outlawed the autonomous foreign exchange market and reintroduced exchange controls in 1994.
But after a full year of exchange controls, the autonomous market was brought back in 1995 to co-exist with the fixed official exchange rate. A foreign exchange subsidy of about 300% still exists for some government favored consumption such as pilgrimage and sporting events for which the official rate applies. The continued operation of the official exchange rate brings with it a great deal of distortions in the domestic allocation of resources within the public sector. This is very pronounced in the vertical distribution of export earnings among the three levels of government.
The revenue from this foreign exchange rent to the federal government now constitutes one of its major revenue sources (Emenuga 1996a). Fiscal gains thus appear to be an incentive factor in retaining the current structure of the foreign exchange market. A similar pattern of policy reversals applies to the reform of interest rates. First introduced in 1987, the market-determined interest rates ruled until 1991 when interest rates were capped. But after only a year of controls, market forces were permitted once more to determine all interest rates in 1992 and 1993.
Since 1994, the pre-reform policy of controls has been retained. While indirect monetary instruments (open market operations) have been initiated since 1993, some measures of controls such as sectoral credit allocation guidelines have continued to be applied. In the sphere of bank licensing and regulation, the reform was ushered in with deregulation of bank licensing in 1987. This was immediately greeted with the establishment of many new banks, leading to the doubling of the number of operating banks within three years.
When the increase in the required banks paid up capital in 1989 and the reform of their accounting procedure (990) appeared insufficient to curb the “excesses” of the sector, government placed total embargo on bank licensing in 1991. This is yet to be lifted. Privatization of banks was suspended after applying the measure to a few banks. In fact, Government has drawn up plans to buy back its stakes in the major commercial banks, apparently in sympathy with the political class who have been deprived of one of their lucrative “spoils” through the divestiture.
The “de-privatization” is already being implemented for one of the three largest commercial banks. Some of the issues highlighted above point to the disorderly manner in which the reform has been implemented in Nigeria. In effect, the reform has not been a one-shot smooth process. This therefore complicates the task of assessing its outcome. The liberalization of bank licensing at the onset of the reform resulted in the establishment of many new banks. The number of operating banks almost doubled within three years into the reform and tripled in the fifth year.
It required official re-imposition of embargo on bank licensing in 1991 to halt this growth. Profitability of investment and access to credit and foreign exchange were among the major motives for bank ownership. The growth in the number of banks appears to have had only a marginal impact on the concentration of the industry. The share of the three largest banks in the total assets of the industry decreased from 37. 3% before the reform to an average of 34. 6% over the reform period, a reduction of only 2. 7% points despite the over 200% growth of operating institutions.
The new banks were generally small and undercapitalized, a situation that later led to an upward review of banks minimum operating capital. The competitiveness that resulted from the entry of new banks and the liberalization of interest rates brought about sharp rise in nominal deposit and lending rates. The increase was however moderated by the occasional reimposition of interest rate ceilings. Nevertheless, the average deposit and lending rates doubled in the third year of the reform (Table 14. 1) Surprisingly, the competition for deposits which drove nominal interest rates up could not ensure a cheaper cost of intermediation.
The nominal interest rate spread rather worsened from 2. 9% pre-reform average to 4. 0%. This is one indication that the reform did not improve the availability of loanable funds. Higher spread was one of the strategies employed by the banks for survival. The banking environment that emerged from the reform is a lot inefficient, undercapitalized, riskier, less liquid and generated lower return on assets relative to the pre-reform period (Sobodu and Akiode 1994). The incidence of fraud, and of non-performing loans also increased with the reform.
The quality of management is a major determinant of a bank’s long-term survival (Siems 1992; Pentalone and Platt 1987) and the dearth of qualified management personnel to meet the challenges of sudden growth in the industry contributed to the poor health of the banking industry (Ikhide and Alawode 1994). It was in 1991 that government promulgated the Bank and other financial institutions Decree (No. 24) and the Central Bank of Nigeria Decree (No. 25) which spelt out comprehensive guidelines for bank regulation, supervision and liquidation.
By this time the incidence of distress in the industry was already rampant. Although interest rates responded positively to financial liberalization, real rates behaved differently. For most of the reform years, real deposit rate was negative, and averaged -13. 5% compared to -7. 65 during financial repression (Table 14. 1). The high rates of inflation during the reform coupled with reimposition of interest rate ceilings brought about the negative real deposit rate. If financial savings is interest elastic, the negative real deposit rate would lead to poorer savings mobilization.
The relationship between real savings and interest rate was recently explored for Nigeria (Soyibo and Adekanye 1992) and the empirical evidence identified only a weak influence of real interest rate on real savings. It further shows that the era of financial liberalization could not make any difference to the tenuous link. Over the reform period the rate of real resource mobilization declined. The Savings/GDP ratio dropped from 15. 4% to 12. 4%. The growth of real savings also slowed down by 7. 5% points (Table 14. 2). These developments are in harmony with the econometric evidence.
The decline in real wage income during the reform could have also contributed to the fall in real savings. For instance, the index of real wage income for the middle level public service cadre declined from 100 in 1987 to 40 in 1990 and 34 in 1992 (Federal Ministry of Finance, Approved Budget, various issues). The expected increase in financial savings during the reform was only realized in the rural areas. Measured by the share of deposits mobilized in banks’ rural branches in the total deposits, rural savings increased from 1. 9% before the reform to 10. 8%.
This trend nets off the role of community banks and the People’s bank in rural credit mobilization. The two set of institutions were established to enable rural dwellers and the poor save and have access to credit at rates lower than the high rates that came with the financial reform. The privatization exercise which required investors to pay through banks contributed much to the growing culture of financial savings in the rural areas. This is a plausible explanation since the rate of rural savings growth only rose significantly in 1989 after the start of privatization in 1988.
Good as this growing culture of rural savings may be for breaking financial dualism, the economy would have been worse for it if the informal sector in Nigeria, from where savings now move to the formal sector is more efficient in resource use. This proposition will await empirical investigation for substantiation. In the first few years of the reform, the share of the banking system’s credit to the private sector improved and superseded the flows to government for the first time in five years. Later, government’s reliance on Central Bank’s financing for the soaring deficits overturned the table to its favor.
From 50. 7% average before the reform the share of the private sector in the total credit decreased to 49. 7% after the reform. In 1993 and 1994, only 34% of the total credit went to the private sector (Table 14. 2). The bulk of the credit that was channeled to the private sector was mainly directed toward short-term investment. Between 1987 and 1994, 50% of the private sector credits went to call money, 32. 5% to lending maturing within 12 months, 12% for 1–5 years maturity (medium-term) and only 4. % for long-term commitments exceeding five years (Central Bank of Nigeria, Annual Report and Statement of Accounts, various issues). Again much of the short-term private sector credits was invested in foreign exchange speculation. Through the incentives created by the retention of the overvalued official foreign exchange market together with the parallel market rate, politically “connected” rent-seekers emerged, buying foreign exchange from the official market and reselling in the parallel market at premium that in some cases was above 200% (Emenuga 1996a).
Bank loans were largely held in speculative balances (call money) because bid for foreign exchange was required to be backed with Naira cover (Sobodu and Akiode 1994). Other reasons for the short-term lending behavior of banks were the uncertainty that surrounded lending for real investment in the face of the unstable macroeconomic environment ( Soyibo 1994b) and the policy uncertainty that characterized the reform period. The banking system’s lending to the public sector was part of the financing facility for fiscal deficits.
The Structural Adjustment Program implemented from 1986–1994 did not include fiscal reform. Nor did the financial sector component of SAP include a reform of government borrowing from the financial system. Rather the reform which led to increases in nominal interest rates prompted government to rely more on Central Bank financing than previously. Since 1987 government has abandoned the issue of Federal Government Development Stocks (FDS), government’s long-term bond in preference for treasury financing possibly due to the high cost of servicing the debt.
The share of Central bank’s credit in the total deficit financing has consequently risen from 25. 4% in 1987 to 67. 9% between 1987 and 1994 (Table 14. 3). Also, due to the absence of a stabilization program, the size of government’s deficit increased during the reform years. Confronted with increasing costs of its fixed (budgeted) commitments as a result of inflationary forces during the reform, government easily found rescue in the mint (Emenuga 1996c). This operation was made smooth by the absence of central bank independence (Emenuga 1996b).
The ratio of deficits to GDP could therefore not improve through the reform but rather increased from 7. 0% to 9. 2% (Table 14. 3). With the deteriorating fiscal balance, and worse still, with a heavy reliance on Central Bank’s financed deficit, the explanation for the inflation rates which assumed unprecedentedly high levels during the reform becomes not far fetched. The average rate of inflation doubled over the reform period, rising from 16. 0% to 33. 6%. It has been shown empirically that the Central Bank-based deficit financing has been a strong causal factor in the domestic price instability. Ndebbio 1995). Exchange rate depreciation and “appropriate pricing of petroleum products” are additional causes of inflation during the reform. The depth of the financial sector, measured by the M2/GDP ratio, contrary to expectations, was not improved by the reform. It declined. The fall in financial deepening from 32. 6% to 26% implies that the growth of the financial sector lags behind the tempo of economic activities, suggesting that the financial sector may not have been the source of real GDP growth within the period.
Interestingly, despite the dashed expectations on the developments in the financial sector, the performance of the economy improved over the reform period. Negative trends in real GDP growth were reversed. Except for the first year of financial reform which was also the first full year of implementing the Structural Adjustment Program (1987) there were positive real GDP growth in the rest of the years. Overall, the economy improved from -2. 7 average annual growth to 5. 0% during the reform but to ascribe this impressive performance to financial liberalization would be dubious.
In 1985 and 1986, the immediate years preceding the reform, real GDP grew by 9. 4% and 3. 45 respectively whereas it dropped to -0. 6% in the first year of the reform (Table 14. 3). The channels through which the reform would have led to improved growth have been shown to have deteriorated during the reform. Real deposit rate, real savings, efficiency and depth in financial intermediation and credit flow to the private sector, became poorer during the reform. The rate of inflation also worsened. The growth in real GDP must have been influenced then by forces outside the financial sector.
Since the period of implementing the Structural Adjustment Program (SAP) encompassed that of the financial sector reform, the positive economic performance might be situated within the wider adjustment package. 2. 2 THE STRUCTURE OF THE NIGERIAN FINANCIAL SYSTEM The financial sector in Nigeria is made up of a wide array of institutions and instruments. It consists of the Central Bank of Nigeria which is the apex financial institution, Commercial and Merchant Banks, Development Finance Institutions, Thrift and Insurance organizations, a Stock exchange and a Securities and Exchange Commission and a virile informal financial sector.
The number of commercial and merchant banks have increased from 12 in 1960 (at independence) to about 120 at the end of 1992 with a branch network of 2391 out of which commercial banks account for 2275 (with 774 in the rural areas). At the end of 1985, (prior to the commencement of the structural adjustment programme), the ownership structure of the share capital in commercial banks indicated dominant ownership by government (Federal and State) accounting to 58. 6 per cent followed by private shareholders (22. per cent) and foreign interests (18. 9 per cent). Today with government divestiture of its ownership in major enterprises, the ownership structure has tilted in favour of private individuals with foreign interest playing only a supporting role. Commercial Banks dominate the Nigerian Banking industry; they account for 71. 2 per cent of total credit outstanding to the private sector as at the end of 1993. The pattern of investment in recent times are concentrated in ‘other assets’ followed by loans and advances and inter bank placements1.
Whereas commercial banks concentrate on the retail end of the financial system, merchant banks are supposed to transact wholesale banking business. Recently, merchant banks have relied on short term sources of funds, which is reflected in the preponderance of short-term loans in their portfolio. In addition to these, six development finance institutions also operate in the system. These are the Nigerian Agricultural and Cooperative Bank, the Nigerian Industrial Development Bank, the Nigerian Bank for Commerce and Industry, the Federal Mortgage Bank, the Nigerian Export-Import Bank (NEXIM) and the recently established Urban Development Bank.
As their names suggest, these are development finance institutions charged with the responsibility of providing loan and industrial finance by attracting foreign resources, mobilizing domestic savings and allocating investment funds efficiently. More often than not, they are established in recognition of unfulfilled credit needs of domestic industries. As of 1992, the share of the assets of these institutions (minus NEXIM and the Urban Development Bank) in the total assets of all financial institutions in Nigeria was put at about