Financial Liberalization and Endogenous Growth : The Case of Nigeria

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UNITED NATIONS NATIONS UNIES

AFRICAN INSTITUTE FOR ECONOMIC DEVELOPMENT AND PLANNING INSTITUt AFRICAIN DE DEVELOPPEMENT ECONOMIQUE ET DE PLANIFICATION

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FINANCIAL LIBERALIZATION AND ENDOGENOUS GROWTH. : THE CASE QF

NIGERIA

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David B. AKP AN

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Submi1ted in partial fulfilment of the l.:equirements for the awaJ;d of Master of Arts Degree in Economie Po licy and Management at the African Institut& for Economie

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June 2004

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UNITED NATIONS

AFRICAIN INSTITUTE

FOR ECONOMIC DEVELOPMENT AND PLANNING IDEP

This is to certify that

David Sassey AKPAN

Identification No 030709

has successfully defended the M.A. thesis entitled

FINANCIAL LIBERALIZA Tl ON AND ENDOGENOUS GROWTH:

THE CASE OF NIGERIA

Member

Aloysius A. AMIN ... .

Chair of'Co•fl".ll'l'llfteE!Iae!Olihi Director Chief, raining Division

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DEDICATION

TOMY SPOUSE MRS. MONICA D. AKPAN

AND

TO OUR CHILDREN:

DIANABASI, UBONG, UWEMEDIMO AND EMEDIONG.

FOR THEIR PERSEVERANCE, ENCOURAGEMENT AND INVALUABLE SUPPORT.

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ACKNOWLEDGEMENTS

The kind cooperation and valuable assistance of those who contributed in various forms in the completion of this study are gratefully acknowledged.

Specifie mention are the close guidance, encouragement and focus received from my Supervisor and Director of IDEP, Dr. Diery Seck, whose suggestions and criticisms as weil as supply of useful materials were invaluable throughout the duration of the study and remain deeply appreciated. My interaction with him has been of immense benefit from his professional knowledge and vast experience.

I am grateful to Professor A. A. Amin , the Deputy Director/Chief, Training Division whose wealth of experience has strengthen the study in many ways and has been much appreciative. I equally wish to thank other members of staff of the Training Division for their useful comments and criticisms which tend in reshaping the initial draft of this study. In this regard, I wish to thank Dr. Matar Gaye, Dr. Diakhate, Mr. Tharcisse Ntilivamunda and Mr. Mouhamadou Bamba Diop for their several contributions.

I sincerely thank the extemal examiner Dr. Roger Atindehou for his painstaking comments and observations which will be of great value for future related studies.

I am most grateful to the Management of the Central Bank ofNigeria for sponsorship and granting of study leave for my participation in the United Nations African Institute for Economie Development and Planning (IDEP) for M.A. Degree Programme. My indebtedness and gratitude to the Director of Research, Dr. O. J. Nnanna, cannot adequately be conveyed in a few sentences for his forthrightness in the conduct of affairs of the department particularly on staff training needs for which I am deeply appreciative.

To my colleagues too numerous to mention but just to mention a few, I sincerely thank Messrs Moses Otu, Bello, Abba and B.O.N. OKafor for their various contributions in academie materials and moral support.

I am highly appreciative to IDEP for their goodwill, particularly Interpretation Division;

of particular mention are Mr. Wilfred Amoako for his professional accomplishment, the Chief Librarian Mr. Nageri, and his members of staff who were of much assistance in sorting through the numerous literatures necessary for the study.

To the members of my family, I must confess that I sincerely missed you all but "TO GOD BE THE GLORY" for in Him all things are possible.

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RESUME

La présente étude examine de manière théorique et empirique l'impact de la libéralisation financière sous forme d'augmentation des taux d'intérêt réels et d'approfondissement financier (la monnaie au sens large (M2) par rapport au PIB) sur le taux de croissance économique au Nigeria, en utilisant le modèle de croissance endogène, les techniques des séries chronologiques et les données annuelles pour la période 1970 - 2002. Les résultats empiriques confirment la prévision de notre modèle théorique selon laquelle la libéralisation financière et l'augmentation des investissements dans le capital humain et physique favorisent la croissance économique. Cependant, le fait que le coefficient du taux d'intérêt réel est faible dans le modèle implique que la seule libéralisation du taux d'intérêt n'accéléra probablement pas la croissance économique au Nigeria. Par ailleurs, la monnaie au sens large en tant que mesure de 1' approfondissement financier était statistiquement peu significatif, ce qui montre un système financier intérieur peu profond, avec une préférence pour les actifs non financiers par rapport aux actifs financiers, ainsi qu'une épargne et un investissement faibles.

L'étude n'a pu constater aucun lien de causalité entre la croissance économique et la libéralisation financière, ce qui implique que pour la réussite de la libéralisation financière, celle-ci doit être accompagnée d'une politique macroéconomique, d'un développement institutionnel et d'une réforme structurelle appropriés.

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EXECUTIVE SUMMARY

CONTEXT

In 1986, consequent upon the down turn of the economy, the Nigerian government initiated a series of reform measures aimed at bringing about economie growth and stability. Paramount among these policies was the financial sector reform. The exchange rate deregulation was expected to boast the non-oil export and attract foreign investment while the relaxation of constraints and granting of licensing to new banks were to increase competition; interest rate liberalization and the abolition of credit rationing should provide incentive for economie agents to increase their rate of savings and investment.

THEPROBLEM

The aim of domestic financialliberalization is to improve economie performance through increased competitive efficiency within financial markets thereby indirectly benefiting non-financial sectors of the economy. After the prescribed financial liberalization, the domestic economy has failed to experience impressive performance such as attraction of foreign investment or halt capital flight. Evidence in Nigeria suggests that neither the domestic savings nor investment have appreciably increased since the introduction of the reform programme. More so, the banking sector has remained largely oligopolistic and uncompetitive. Few large banks control the greater segment of the market in terms of total assets, totalliabilities and total credit in the banking system.

METHODOLOGICAL FRAMEWORK

The study theoretically and empirically explores the impact of financial liberalization in the form of an increase in real interest rates and financial deepening (broad money (M2) relative to GDP) on the rate of economie growth in Nigeria using the endogenous growth madel, time series techniques and annual data from 1970 - 2002. The Error Correction Madel (ECM) is intended to capture both the short and the long run impact of the variables in the madel.

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RESULTSOFTHESTUDY

The empirical results indicate a positive impact between broad money (M2), investment and real deposit rate on economie growth. However, the low coefficient of the real deposit rate implies that interest rate liberalization alone is unlikely to expedite economie growth in Nigeria. Concomitantly, the statistically insignificant of the broad money explains the Nigeria's shallow financial system where non financial assets are preferred to financial assets. This explains the large volume of currency outside the banking system.

POLICY IMPLICATION

• The success of financial liberalization programmes depends on appropriate domestic, fiscal, monetary, exchange rate, commercial and trade policies.

According to Hanson and Neal, (1985), "negative real interest rates are generally not a problem, in and ofthemselves, but a symptom ofmuch larger problems: that the whole macroeconomie framework - monetary, fiscal, exchange rate and tariff policies, as well as the interest rate - are out of line". The strongly negative real interest rate in the Nigerian economy leaves much to be desired as it retards growth by the relative attractiveness of holding money as an asset instead of productive capital thereby depriving the economy investment capital.

• Econometrie estimates suggest that an increase in the real deposit rate of interest is associated with substantial increase in investment productivity, as measured by the incrementai capital/output ratio. The effect of financial liberalization on the rate of economie growth in the medium term can be calculated indirectly from the effects of real deposit rates on saving rates and on investment efficiency. Estimate shows a positive relationship between incrementai capital/output ratio (investment) and growth in the long run.

• Financial Liberalization must be coordinated both with policies that encourage growth and stability of the real sector. Enhancing the credit worthiness of borrowers through prudent "real sector" policies is crucial to the success of any

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liberalization. Consequently, to avoid any potential massive inefficiency costs, any deregulation of financial markets must be coordinated with the design of financial safety net.

• Financial Liberalization could weil stimulate investment more than it stimulates national savings. This implies that foreign borrowing would rise. Capital inflows require sorne tight regulation particularly short - term capital inflow to ensure that they do not disrupt export industries. Capital inflow is not objectionable so far they do not constitute a foreign debt problem.

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Governrnent should aim at creating conditions which make private investment attractive. The conditions can range from general- establishing a stable macroeconomie environrnent, provision of adequate property right- to more specifies ones, such as adequate access to credit, imported inputs by investors, stable power supply, good road network, telecommunication and provision of adequate security. Policies that promote private investment would generaily have significant benefits for long- run growth, and thus standard of living. In sorne cases, these benefits may be greater than if the same amount of investment were undertaken by the public sector. This should suit the governrnent as weil as it would release resources that could be used toward other purposes and would help control the fiscal situation. On the basis of this estimates, there is little doubt that the direct effects of private investrnent on growth outweighs the direct effect of public sector investment.

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Financial liberalization has become an increasingly important element of adjustment programme in developing countries supported by the World Bank and IMF. It encompasses much more than freeing interest rates from government control to a complete deregulation of the financial sector by moving away from direct to indirect monetary control and credit as well as movement of capital through the use of market based instruments, the liberalization of entry conditions by new firms into the frnancial system and the relaxation of ali regulatory controls that tend to inhibit the efficient operation of the financial system. Generally the trend towards financial liberalization is part of a broader tendency towards reduced direct intervention of the state in the economy.

This po licy prescription initially generated a substantial amount of controversy. However, many developing countries have adjusted their policies in the prescribed direction during recent years. Furthermore, while sorne studies have reported that certain countries experienced higher savings and investment following liberalization, others have chronicled disasters in other economies that undertook financial liberalization. Countries in the later categories experienced considerable macroeconomie instability, massive capital outflows and wide-spread bank failures.

Unfortunately, not ali the experiences with liberalization have been favorable and in severa! instances the change over was followed by a financial crisis that led to the restoration of various restrictions. As a result, a new strand of literature has explored the conditions under which financial liberalization is likely to be successful. This new literature has stressed the important roles of macroeconomie stability as weil as the

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presence of adequate supervisory and monitoring capacity on the part of the financial authorities.

Complementing these two strands of developing country literature, the recent resurgence among macroeconomists in the long-run economie growth has generated new analytical and empirical work on the relationship between financial intermediation and growth. This literature has revisited and expanded on the theme originally articulated by Mckirmon (1973) and Shaw (1973) while placing the entire discussion in the context of a new perspective on the growth process. lts empirical contributions have examined links between financial intermediation and growth in a very broad context including industrial and developing countries.

Ali of these issues are of potential great relevance for Sub-Saharan Africa, where the resurgence of economie growth experienced of late in severa! other parts of the developing world has not yet been broadly felt and where the identification of policies that can achieve such an acceleration of growth is of particular urgency in view of the region's poverty and dismal economie performance.

In Nigeria, the rapid expansion in the number of banks and the branch network of the banks has produced mixed results. lt has improved the ratio of banks per capita but has equally triggered banking distress (Nnarma and Dogo, 1998). Probably a more fundamental issue is the insiders' abuse and very poor management of sorne of the new generation financial services operators. Evident from these is the insolvency in the system which has further weakened the ability and capacity of the financial system in resources mobilization. The problem of bank distress has been traced to a number of factors, including: the non compliance to the monetary authorities' regulatory guidelines, as weil as improper risk management.

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FIGURE 1: FINANCIAL LIBERALIZATION DIAGRAM

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-From the diagrarn (Figure 1), the removal of constraints increases the incentive to save and reduces the cost of capital and rai ses the average efficiency of investment and hence economie growth.

The policy prescription m the McK.innon and Shaw model is therefore to ra1se institutional interest rates or reduce the rate of inflation. The optimal result is to abolish

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interest rate ceilings to induce investment and raise further the average efficiency of investment. This is the concept of financial liberalization which emphasizes the removal of government ceilings on interest rates and other contrais on financial intermediaries, so that real interest rates are kept positive, close to the open market levels, and attractive enough to induce financial savings into the stream of loan able funds. This involves the abolition of mandatory credit to the preferred sectors. Liberalization of the financial sector from interest rate ceilings and other restrictions promotes economie growth because market determined interest rates induce savings and more efficient allocation of capital.

1.2 STATEMENT OF THE PROBLEM

The Structural Adjustrnent Programme (SAP) which was implemented in Nigeria over the past decade incorporates strong elements of financial reform and if only for that reason, the process and results of financial liberalization in Nigerian context deserve close examination. After the prescribed financial liberalization, the domestic economy has failed to experience impressive performance such as attraction of foreign investrnent or hait capital flight. The literature of financial Iiberalization in developing countries has identified a number of mechanisms through which interest rate deregulation should affect resource allocation and growth: increase in real interest rate should induce more savings;

a relaxation of the liquidity constraint with financial deepening should facilitate private investment.

Evidence in Nigeria suggests that neither domestic savings nor the inflow of new foreign capital appears to have appreciably increased since 1986. The ratio of domestic savings as a percentage of GDP which was 11.6 in 1986 increased marginally to 19.1 in 1999.

Also the ratio of private investment as a percentage of GDP reduced from 4.6 in 1986 to 3.2 in the year 2000 while foreign direct investrnent (FDI) as a percentage of GDP declined from 13.9 in 1986 to 3.4 in 2001. On average, when the two periods are

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compared Controlled (1970-1985) and liberalization (1986-2002) most variables performed dismally.

The financial repressionist hypothesis, led by McKinnon (1973) and Shaw (1973) - often referred to as "McKinnon and Shaw hypothesis" contends that financial liberalization in the form of an appropriate rate of retum on real cash balances is a vehicle of promoting economie growth. The essential tenet of this hypothesis is that a low or negative real interest rate will discourage saving. This will reduce the availability of loanable funds for investment which in turn will lower the rate of economie growth. In Nigeria real interest rate has been strongly negative for most periods due to high rate of inflation while the margin between real deposit and lending rates continued to widen, which is an antithesis to the financial liberalization paradigm. According to the financial liberalization paradigm as postulated by Mckinnon and Shaw, a more liberalized financial system will induce an increase in savings and investment therefore promotes economie growth.

In the light of this conflicting evidence, it cornes imperative to verify the McKinnon- Shaw hypothesis with econometrie madel to establish the impact of financial liberalization on economie growth in Nigeria.

1.3 JUSTIFICATION OF THE STUDY

The aim of domestic financialliberalization is to improve economie performance through increased competitive efficiency within financial markets thereby indirectly benefiting non-financial sectors of the economy. In Nigeria, as in most developing economies, economie experts base policy decision on untested extemally received theories without reference to the socio-economic environment. Given the weak performance of the economy after more than a decade of liberalization policy, it has become imperative to assess the outcome in terms of growth and development.

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This study will attempt to assess the impact of financial liberalization policy in the Nigerian economy. It would equally fill the gap in the existing literature owing to the dearth of specifie studies on the financial liberalization and endogenous growth in Nigeria. The study will be of immense interest to my organization (Central Bank of Nigeria) as it will provide a secure knowledge on which to base policy in Nigeria.

1.4 OBJECTIVES OF THE STUDY

The main objective of the study is to investigate the impact of financialliberalization on economie growth using the extended Pagano endogenous growth model. The study will also attempt to establish granger causality between financialliberalization represented by broad money relative to GDP and economie growth in Nigeria for policy implication.

Generally, the literature thus far has implied that a more efficient financial system will provide "better" financial services which will enable an economy to increase its real GDP growth rate.

1.5 HYPOTHESES TO BE TESTED

The study is guided by the following hypotheses:

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₁ Financial liberalization increases the level of investment and impacts positively on economie growth.

H₂ The positive priee signal caused by real deposit rate can have a significant impact on economie growth.

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1.6 ORGANISATION OF THE STUDY

The study is organised into five chapters. It begins with an introduction comprising a statement of the research problem, justification of the study, objectives and the hypotheses to be tested. Chapter two examines the Nigerian economy and financial system. Chapter three deals with the theoretical background and empirical literature review in order to investi gate (1) how thoughts/thinking over the issue of financial liberalization evolved, (2) !essons of experience from Southem Corre countries, East Asian financial crises and (3) prerequisite for successful financial liberalization. In Chapter four, we present empirical analysis, the methodology, theoretical model as weil as the estimation diagnosis and the interpretation of the results. Chapter five contains policy implications and recommendations derived from the empirical results and conclusion.

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CHAPTERTWO

THE NIGERIAN ECONOMY AND FINANCIAL SYSTEM

2.1 THE PERFORMANCE OF THE NIGERIAN ECONOMY

The objective of this sub-section is to analyse the development of the Nigerian economy over the period 1960-2002 by examining changes in the sectoral contribution to growth.

The main economie sectors - primary, secondary and tertiary sectors of the Nigerian economy are examined. An examination of the sources of growth of these sectors underscores the importance of each sector in the performance of the overall economy.

Traditionally, these sectors have been represented by agriculture, industry, manufacturing, and the service sectors respectively.

The primary sources of growth of the Nigerian economy prior to the discovery of ail in the early 1970s have been agriculture, industry and service. During this period, agriculture accounted for approximately 70 percent of output and employed over 65 percent of the labour force. In addition, agricultural products accounted for a lion's share of total exports (71 %) and were thus the predominant source of foreign exchange earnings and public revenue, with the agricultural marketing boards playing a leading role.

By the early 1970s, crude ail export emerged as the leading export commodity in the Nigerian economy. Since then, its dominance and overwhelming importance as the major foreign exchange earner has left Nigeria operating as almost a mono-product economy with ail accounting for about 80 percent of federal government revenue, more than 95 percent of export earnings and about 11 percent of GDP in 2000. It also accounted for 76.5 and 71.1 percent of federal government revenue in 2001 and 2002.

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FIGURE 2 SOURCES OF GROWTH

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In the diagram (Figure 2), the main sources of growth in the Nigerian economy have been the agricultural, industrial, manufacturing and services. In the period (1960-1969), the agricultural sector played a prominent role as the main stay of the economy as well as the major source of government revenue. However, with the discovery of oil in commercial quantities in the early 1970s, the industrial sector assumed a predominant role in the economy, as a major source of government revenue and foreign exchange eamings. The dominant role of the oil sector has continued to soar up to the present period (1986 to 2002).

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2.1.1 Structure of Production of the Economy 1960-1969

At independence in 1960, Nigeria was still largely an agricultural country, producing food for its own consumption and cash crops such as groundnuts, cocoa, rubber and palm oil for export. The discovery of oil in commercial quantities came towards the end of the decade and began to bring about a sizable reduction in agricultural share of the GDP. Thus, from GDP share of almost 64 percent in 1960, agriculture accounted for 49 percent of output in 1969. For the period 1960-1969, the contribution of agriculture in total output averaged 57.3 percent ofGDP (Iyoha and Oriakhi 2002).

The industrial share in output was 7.7 percent in 1960, however with the discovery of crude petroleum, its' contribution began to significantly rise during the second half of the period. By 1969, industry accounted for 15.6 percent of output; of this total the manufacturing sub-sector accounted for 6.4 percent. The sectoral share of services in the GDP rose steadily in 1960s. From a share of 28.5 percent in 1960, the contribution of services to GDP attained a high of 37.6 percent in 1968. During this period, the average share of service in output was 32.1 percent.

2.1.2 Structure of Production ofthe Economy 1970-1985

The contribution of the petroleum to the Nigerian economy became mu ch pronounced in the 1970s. The relative importance of the sector was buoyed by many factors among which were the increase in the output and exportation of crude oil as weil as Nigeria's membership of the Organization of the Petroleum Exporting Countries (OPEC). During this period, the contribution of the industrial sector to GDP increased from 8.7 percent to 13.8 percent. The relative contribution of the manufacturing to total out averaged 4.8 percent while the share of the industrial output to total GDP averaged 27.5 percent in the review period. The rise in the relative importance of oil in the economy resulted in the relative neglect of the agricultural sector, thus, the emergence of the "DUTCH DISEASE" syndrome. Dutch disease means a reallocation of resources from tradable sector into non-tradable sectors thus resulting in a fall in the tractables output and a rise in

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the non-tradable output (Iyoha and Oriakhi, 2002). Thus as expected, in such instances, agriculture declined owing to a reallocation of resources in favour of non-tradables in the non oil sector of the economy. The relative share of agriculture to GDP feil from 41.3 percent in 1970 to 40.3 in 1985.

The oil boom impacted positive! y on the service sector as the relative share of services in output continued to soar, reaching 32.9 percent in 1970 and a high of 44.9 percent in 1974. For the period, the relative share of the services in GDP averaged 38.9 percent.

2.1.3 Structure of Production of the Economy 1986-2002

The global oil glut of the mid early 1970s and mid 1980s brought in it wakes a balance of payments disequilibrium caused by dwindling oil revenue. In order to revamp the

economy, the Federal government introduced the Structural Adjustment Progarnme (SAP) in July, 1986.

The po licy thrust of SAP included among others, the following:

• Exchange rate devaluation

• Elimination of priee distortion

• Reliance on market forces as a major determinant of economie activities

• Economie deregulation ( Libera1ization)

• Privatization and commercialization

• Economie diversification

The SAP had a favourable effect on agriculture but a negative impact on manufacturing.

SAP which entailed market determined priees (including exchange rate) led to increase in agricultural production as both priees and output expanded. As a result, the relative share of agricultural production to GDP rose from 20.0 percent in 1986 to a high of 40.6 percent in 1988. From 1986 to 2002, the relative share ofthe agricultural output averaged

40.0 percent. The period also witnessed a mild increase in the nurnber of service

providers in the banking and insurance sub-sector.

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However the expansion in the number of financial institutions did not commensurate with the growth of the private sector. This poor showing was attributable to the high lending rates and the perennial dependence of the banking sector on cheap public sector funds and foreign exchange dealing from the Central Bank. This armchair banking was made manifest when in 1996 the federal government ordered the withdrawal of public sector deposits from banks to the Central Bank; under this arrangement, most commercial banks suffered a severe set back which resulted in liquidity crises and financial sector distressed.

In Nigeria as in most African countries, SAP led to a decline in the industrialization and rising unemployment (lLO, 1996). A close study of the relative contribution of manufacturing production to GDP showed that the contribution of the sector declined significantly. In 1980, manufacturing accounted for barely 8.4 percent of GDP. Its relative share rose to 9.9 percent in 1983 and was 8.7 percent in 1986. However, with the policy of deregulation, the manufacturing sector's relative ·share in output began to fall and reached a low of 5.29 in 1989. In 1986-2002, the manufacturing sector's share to GDP was a paltry average of7.0 percent while the industrial sector recorded 12.7 percent of the total output.

The service sector was not left out in the poor performance as its share in the total output declined from 33.8 percent in 1986, to 25.5 percent in 1989. For the period 1986-2002, the relative share of services in GDP averaged 32.9 percent.

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2.2 THE NIGERIAN FINANCIAL SYSTEM

The Nigerian financial system consists of the regulatory authorities, the financial markets, the development finance institutions and other financial institutions. The major function of an efficient financial system comprising the institutions, markets and instruments is to channel savings from surplus economie units to deficit economie units for investment.

The liberalization of the financial sector witnessed a significant increased in the number of service providers in the banking and insurance sub-sector. Prior to the Iiberalization of the financial sector in 1986, the financial system consisted of the Central Bank, 28 commercial banks, 12 merchants banks, 52 bureau de change, 19 stock brokerage firms and 88 insurance companies at the end of 1985. However, by the end of 2002, the structure ¹, of the financial system comprised the Central Bank, ninety deposit money banks which together constitutes the monetary system and other financial institutions, consisting of 769 community banks, 6 development finance institutions, 1 stock exchange, 1 commodity exchange 5 discount houses, 118 insurance companies, 80 primary mortgage institutions, 102 finance companies and 83 Bureaux de change. The study will focus on the financial markets.

Financial markets are institutions which facilitate the exchange of financial assets such as deposits, loans, stocks, bonds, government securities, cheques, bills etc. The market operates through the Central Bank, commercial banks, merchant banks, non bank fmancial institutions, discount houses, mutual funds, brokers etc.

2.3 THE CENTRAL BANK OF NIGERIA

The Central Bank of Nigeria is the apex regulatory and supervisory body of the Nigerian financial system. It was established by the Central Bank of Nigeria Act of 1958 and

1 Central Bank of Nigeria Annual Report and Statement of Accounts for the year 2002

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commenced operation on July lst, 1959. The main sources of the Bank's legal authority for discharging its responsibilities are the CBN Decree No. 24 of 1991 ( amended in 1997, 1998 and 1999) and the other financial institutions Decree No. 25 of 1991 (as amended in 1997, 1998 and 1999) which superseded the CBN Act of 1958 and the Banking Decree of 1969 and later amendments. The recent laws generally gave the CBN more flexibility in regulating and supervising the banking sector and other financial institutions which hitherto operated outside any regulatory framework. Thus, the Bank was made the overall regulator of ail financial institutions in the system.

The Central Bank of Nigeria performs bath mandatory and developmental functions. The core mandate of the Central Bank of Nigeria (CBN) is derived from the provision of the CBN Decree No. 24, 1991 as amended and includes:

•!• Issuance of legal tender currency notes and coins in Nigeria

•!• Maintenance ofNigeria's extemal reserves to safeguard the international value of the legal tender currency

•!• Promotion and maintenance of monetary stability and a sound and efficient :financial system in Nigeria.

•!• Acting as banker and financial adviser to the Federal govemrnent

•!• Lender of last resort

•!• Banker to other banks: The CBN, as the banker to other banks issues directives on cash reserves and liquidity ratios, prudential requirements and other activities of the banks. This is done through its monetary policy circular which is used at the beginning of each fiscal year. Sanctions are usually imposed on banks for non- compliance with monetary po licy guidelines.

The CBN also undertakes sorne developmental functions which help in the growth of the Nigerian economy. Such a programme includes the promotion and support for specialized institutions such as the Nigerian Industrial Development Bank (NIDB), the Nigerian Agricultural and Co-operative Bank (NACB), through the promotion of agricultural credit guarantee schemes, the Nigerian Export-Import Bank (NEXIM) through the

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provision of refinancing and rediscounting facilities (RRF) and the foreign input facility assistance (FIF). The Development Finance Institutions (DFis) were in the 1970s accorded prominent role and increasingly acted as tools of development policy, channeling resources to publicly promoted or owned enterprises and to priority sectors which commerciallenders were unwilling to finance.

2.4 DEPOSIT MONEY BANKS (DMBs) 2.4.1 Commercial Banks

Commercial banks operate under the legal framework of the Banks and Other Financial Institutions (BOFID) Decree 25 of 1991 (as amended). Commercial banks perform three major functions, namely:

•!• Acceptance of deposits

•!• Gran ting of loans

•!• The operation of the payment and settlement mechanism

Since the commencement of the deregulation of the economy in 1986, the commercial bank has continued to experience rapid growth, especially in terms of the number of institutions and product innovations in the market. The number of commercial banks and branches rose from 29 and 1,367 in 1986 to 66 and 2,358 in 1993. However, the number dropped to 64 in 1996 due to distress in the financial sector and eventual liquidation of sorne banks. The commercial bank continued to dominate the banking sub-sector accounting for 54.0, and 42.2 percent of the total banking system assets in 1999 and 2000.

In order to provide a leve! playing field, the authorities adopted the concept of uni versai banking in 2001. Thus, the total number of commercial banks in operation increased from 65 in 2000 to 90 in 2001 due to the abolition of the dichotomy between the commercial and merchant banks. Under this arrangement, sorne merchant banks converted to commercial banks. However, the banking system in Nigeria remained largely oligopolistic despite the increase in the number of institutions as only very few

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banks continue to dominate the banking industry in terms of total assets, total deposit liabilities and total credit. In the year 2000, the total assets of the commercial banks was Wl,521,158.2 million, this figure dropped to W1,315,869.2 million in 2001 and increased to W1,599,494.6 in 2002 (Annex 3).

2.4.2 Merchant Banks

Merchant banks talee deposits and cater for the needs of corporate and institutional customers by providing medium and long-term loan facilities and engaging in activities such as equipment leasing, loan syndication, debt factoring, and project advisers to clients who are sourcing funds from the market. They are also referred to as wholesale banks. The first merchant bank in Nigeria was the Nigerian Acceptances Lirnited (NAL) which started operation in 1960. By 1986, there were 12 merchant banks and 27 branches. However, by the end of 1993, the number of merchant banks increased to 54 while their branch network stood at 124 (Annex 7). In 1994, the number of operating merchant banks decreased to 51 due to distress in the financial sector which resulted in the liquidation of sorne banks. The total assets of the merchant banks in 1986 stood at

N8, 445.3 million and by 1996 it recorded Will, 266.9 while the total deposit liabilities increased to N24, 924.3 in the same period. In the year 2002, the total liabilities of merchant banks increased to W 138,264.7 million while deposit liabilities stood at

N41, 245.3 (Annex 4).

2.5 OTHER FINANCIAL INSTITUTIONS

2.5.1 Community Banks

A community bank is a self sustaining financial institution owned and managed within a community to provide financial services to that community. The first community bank commenced operation in December, 1990. The total number of community banks in operation rose from 94 in 1991 to 1,368 in 1995 (Annex 8). The total assets/ liabilities of the banks increased from N4, 884.4 million in 2001 to W15,463.5 million in 2002 or an

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increase of 216.3 percent. The number of reporting community banks dropped to 316 in 2002.

2.5.2 People's Bank of Nigeria

The decision to established the People's Bank of Nigeria was announced by the Federal Governrnent in the 1989 Budget with an initial capital of N30 million. Specifically, the bank is to meet the credit need of small borrowers who cannot satisfy the stringent conditions normally demanded by the conventional banks. The bank is expected to facilitate access to credit for urban poor small scale business operators and thereby increased their self-reliance. As at 1990, the branch network had risen to 169 whi1e the total asset/liabilities increased to NI, 073.0 million. In 2000, the number of operating People's bank branches dropped to 279 (Annex 8).

2.5.3 Finance Companies

Finance companies are institutions that specialize in short-term non-bank financial intermediation. They mobilize funds from the investing public in form of borrowing and provide, among others, facilities for local purchase order (LPO) and project financing, equipment leasing and debt factoring. The Bank and other Financia1 Institutions Decree (BOFID) brought finance companies under direct supervision of the Central Bank of Nigeria. In 1992, the total number of reporting finance companies stood at 48 while the total assets/liabilities was N2, 445.9 milliom (Annex 6). However, by 1996, the number of operating fmance companies increased to 125 and the total assets/liabilities expanded

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to N8, 940.1 million. The total assets of the 28 reported Finance companies in 2001 was N 12,903.5 million. However, the figure declined to N 11,684.9 million in 2002

(Annex 6).

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2.5.4 Discount Houses

Discount houses were established to serve as financial intermediaries between the CBN ' Iicensed banks and other financial institutions. They mobilize funds for investment in securities by providing discount/rediscounting facilities in government short-term debt instruments. They are therefore the indirect windows through which government short term securities are traded. There are five operating discount houses in Nigeria. The total assets and liabilities of the operating discount houses amounted to W57 .3 billion at the end of2002.

2.5.5 Bureaux de Change

In arder to broaden the foreign exchange market and improve access to foreign exchange, especially for small users, Bureaux de change was Iicensed to operate since 1989. The number of such institutions operating in 1989 stood at 240. Their activities are supervised bythe CBN.

2.5.6 Primary Mortgage Institutions (PMIS)

Primary mortgage institutions operate within the ftamework of Decree No. 53 of 1989.

Essentially, PMis mobilize savings for the development of the housing sector. Their total assets/liabilities rose to W 2,790.3 million in 1997 (Annex 5). In reaction to distress in the sector and to restore confidence among customers, the Federal Mortgage Bank of Nigeria issued a "clean bill of health" to 116 mortgage institutions. The capital requirement for new primary mortgage institutions have been raised to W20 million.

2.5. 7 Insu rance Companies

Prior to 1992, The Federal Ministry of Finance (FMF) licensed and supervised insurance companies in Nigeria. In 1997, the National Insurance Commission was established and repl'}ced the Nigerian Insurance Supervisory Board (NISB) as the regulatory organ in the

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industry. The insurance companies consist of life and non-life as well as those which engage in both activities, and reinsurance firms. They mobilize relatively long-term funds and act as financial intermediaries. Their investments are mainly in government securities and mortgage industry. The Nigerian insurance industry has grown tremendous1y over the years. There were 187 insurance companies operating in the country in 1996. The total assets/liabilities of insurance companies at the end of 1996 amounted to W17,144.8 million while it increased to W54,734.0 in 2002 (Annex 6). Their funds were sourced main1y through reduction in outgoings and other assets which accounted for 80.8 percent oftotal funds.

2.5.8 Nigerian Social lnsurance Trust Fund (NSITF)

The NSITF was established by Decree No. 73 of 1993 to replace the defunct National Provident Fund (NPF) which was established in 1961 as a compulsory pension scheme for non-pensionable public servants and employees in the private sector.

The main objective of the NSITF was to adopt a more comprehensive social security scheme for Nigerian employees. The scheme is expected to improve the benefits payable to contributors. Nigerian private sector was expected to contribute 2.5 percent of their respective gross monthly incomes to the NSITF as against the flat rate of W4.00 monthly under the old NPF scheme. In addition, each employer in the private sector was expected to contribute 5 percent ofthe gross monthly emoluments as supplement to the employees' contributions.

2.6 CAPITAL MARKET DEVELOPMENT

The capital market is saddled with the responsibility of mobilizing medium to long term funds for development purposes. This involves the issuance and marketing of shares, bonds, and debentures, using the services of brokers, dealers and underwriters. The market has two segments: The primary and secondary markets. The primary market is the market for new issues of securities while the secondary market deals with the existing

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securities. The Nigerian stock exchange plays a prominent role in this market. The stock market capitalization rose by 20.0 percent from N662.6 billion in 2001 to N763.9 billion in 2002.

2.7 DEVELOPMENT FINANCE INSTITUTIONS (DFis)

Specialized banks or development finance institutions (DFis) were established to contribute to development of specifie sectors of the economy. They consist of the Nigeria Industrial Development Bank (NIDB), Nigeria Bank for Commerce and Industry (NBCI), Nigeria Agricultural and Co-operative Bank (NACB), Nigeria Export-Import Bank and Urban Development Bank (UDB).

2.7.1 The Nigerian Industrial Development Bank (NIDB)

The NIDB was established in 1964 following the restructuring of the Investment Company of Nigeria (ICON). The bank was specifically established to provide credit and other facilities to industries, particularly medium and large-scale enterprises. The NIDB sources funds from banks, the CBN, the Federal Government and the Finance Corporation. The total assets of the NIDB amounted to N6.9 billion at the end of 1995 (Annex 5). The total assets increased to N 7.1 billion in 1996. The bank is currently being restructured for better performances.

2.7.2 The Nigerian Bank for Commerce and Industry (NBCI)

The Federal government in the wake ofits indigenization policy in 1972 set up the NBCI to develop national enterprises in small and medium scale. Sources of funds for NBCI are subventions from the Federal govemrnent and the CBN through penalties imposed on commercial and merchant banks for credit short- falls on loans to small and medium- scale enterprises. The bank also engages in share underwriting, project identification and

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feasibility studies. The total assets of this bank stood at W374.5 million in 1986 and increased to W 2,529.7 million in 1995 (Annex 5 ).

2. 7.3 The Nigerian Agricultural and Co- operative Bank (NACB)

The NACB was established mainly to finance agricultural development projects and allied industries. It sources its funds from government subventions, credit short-falls on agricultural loans by commercial and merchant banks through CBN, and loans from international finance institutions such as the International Bank for Reconstruction and Development (IBRD), African Development Bank (ADB), European Investment Bank (EIB) and the International Fund for Agricultural Development (IFAD), The bank:'s total assets rose from N 497.7 million in 1986 to W6,347.5 million in 1996 (Annex 5).

2.7.4 The Nigerian Export-Import Bank (NEXIM)

The Nigerian Export- Import Bank was established by Decree 38 of 1991 to provide finance, risk rnitigating facilities and trade information as well as advisory services to the Nigerian export community. The bank commenced operation on January 2nd, 1991 with facilities in the following areas: trade finance, project finance, treasury operations, export advisory service, and market information. Under trade finance, the Rediscounting and Refinancing Facility (RRF) was introduced to assist banks provide pre- and post shiprnent finance in local currency in support of non oil exporters. Under the project finance, the Foreign Input Facility (FIF) was introduced to provide the export sector with immediate foreign exchange requirement for the importation of raw materials and equiprnent needed to produce goods locally for export.

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2.8 THE FINANCIAL SECTOR REFORMS 2.8.1 Pre- Financial Sector Reform

The Nigerian financial system of the pre-reform period essentially catered for the needs of planned development in a mixed-economy framework where the government sector had a predominant role in economie activity. As part of planned development, the economie environment that guided monetary policy before 1986 was characterized by the dominance of the oil sector, the expanding role of the public sector in the economy and over-dependence on the extemal sector. In order to maintain priee stability and a healthy balance of payments position, monetary management depended on the use of direct monetary instruments such as credit ceilings, selective credit controls, administered interest and exchange rates, as well as the prescription of cash reserve requirements and special deposits. The use of market-based instruments was not feasible at that point because of the underdeveloped nature of the financial markets and the deliberate restraint on interest rates.

The most popular instrument of the monetary polie y was the issuance of credit rationing guidelines, which primarily set the rates of change for the components and aggregate commercial bank loans and advances to the private sector. The sectoral allocation ofbank credit in CBN guidelines was to stimulate the productive sectors and thereby curtail inflationary pressures. The fixing of interest rates at relatively low levels was done mainly to promote investment and growth. Occasionally, special deposits were imposed to reduce the amount offree reserves and credit-creating capacity of the banks. Minimum cash ratios were stipulated for the banks in the mid-1970s on the basis of their total deposit liabilities, but since such a cash ratio were usually lower than those voluntarily maintained by the banks, they proved less effective as a policy restraint on their credit operations.

From the mid-1970s, it became increasingly difficult to ac hi eve the aims of the monetary policy. Generally, monetary aggregates, government fiscal deficit, GDP growth rate, inflation rate and the balance of payments position moved in undesirable directions.

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Compliance by banks with credit guidelines was less than satisfactory. The major source of problem in monetary management was the nature of the monetary control framework, the interest rate regime and the non harmonization of fiscal and monetary policies. The monetary control framework which relied heavily on credit ceiling and selective credit controls incidentally failed to achieve the set monetary targets as their implementation became less effective with time. The rigidly controlled interest rate regime, especially the low levels of the various rates, encouraged monetary expansion without promoting the rapid growth of the money and capital markets.

The low interest rates on govemment debt instruments did not sufficiently attract private sector savers and since the CBN was required by law to absorb the unsubscribed portion of government debt instruments, large amount of high-powered money were usually injected into the economy. During the oil boom era, the rapid monetization of foreign exchange earnings resulted in large increases in government expenditure which substantially contributed to monetary instability. In the early 1980s, oil receipts were not adequate to meet increasing levels of demands and since expenditures were not rationalized, government resorted to borrowing from the Central Bank to finance huge deficits.

2.8.2 Financial Sector Reform

The Structural Adjustment Programme (SAP) was adopted in July, 1986 against the glut in the international oil market and the resultant deteriorating economie conditions in the country. It was designed to achieve fiscal balance and balance of payments viability by altering and restructuring the production and consumption patterns of the economy, eliminating priee distortions, reducing the heavy dependence on crude oil exports and consumer goods imports, enhancing the non-oil export base and achieving sustainable growth. Other aims were to rationalize the role of the public sector and accelerate the growth potential of the private sector. The main strategies of the programme were the deregulation of external trade and payments arrangements, adoption of a market-

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determined exchange rate for the Naira, substantial reduction in complex pnce and administrative controls and more reliance on market forces as a major determinant of economie activity.

The full financialliberalization process in the Nigerian economy started in 1986 with the introduction of a more dynamic interest rate policy. In that year banks were obliged to negotiate with their customers acceptable interest rates on savings and time deposits;

CBN minimum which was fixed at (8.5 %) per annum. Also ali lending rates were adjusted upwards by 2 percentage points, subject to a maximum of 15 percent.

Consequently, lending rates generally rose and yields on deposits became more attractive.

These were followed by licensing of new banks into the system. The main instrument of the market-based framework was the open market operations (OMO). This was complemented by reserve requirements and discount window operations. The adoption of a market-based framework such as OMO in an economy that had been under direct control for a long period, required substantial improvement in the macroeconomie, legal and regulatory environment.

In order to improve macroeconomie stability, efforts were directed at the management of

ex cess liquidity, th us a number of measures were introduced to reduce liquidity overhang in the system. These included the reduction in the maximum ceiling on credit growth allowed for banks; the recall of the special deposits requirement against outstanding external payment arrears to CBN from banks, abolition of the use of foreign guarantee/external currency deposits as collaterals for Naira loans and the withdrawal of public sector deposits from banks to the CBN. Also effective from August, 1990 the use of stabilization securities for the purpose of reducing the bulging size of ex cess liquidity in banks was re-introduced. Commercial banks' reserve requirements were increased in 1989, 1990, 1992, 1999, and 2002.

The rising level of fiscal deficits was id~ntified as a major source of macroeconomie instability. Consequently, Government agreed not only to reduce the size of its deficits