The Impact Of Financial Liberalization On The Performance Of Deposit Money Banks (DMBs) In Nigeria, 1975-2013

Project and Seminar Material for Economics

Project and Seminar Material for Economics


Abstract


This study examines the overall impact of Financial Liberalization on the Performance of Deposit Money Banks (DMBs) in Nigeria. The study is specifically directed towards analyzing the rationale of executing a financial liberalization policy; preparing an account of the evolution, process and sequencing of the financial liberalization; and evaluating the impact of the various liberalization measures on key performance variables of DMBs. Most of the previous studies focused on the economic growth aspect of financial liberalization and yet, very little is known empirically about its impact on profitability, credit to the private sector and deposit growth of DMBs. To bridge this gap, a financial liberalization index has been developed to evaluate all of the three dimensions of DMBs in Nigeria. Time series annual data from the period 1975-2013 are employed.

The time series annual property of the data is analysed using the Ordinary Least Squares (OLS) technique. The research utilizes an autoregressive distributed lag to co-integration approach (ARDL-ECM) to evaluate the impact. The result of the analysis of the study reveals that financial liberalization in Nigeria has brought a mixed impact. Financial liberalization does not lower profitability of DMBs in Nigeria due to high reserve ratio and heavy investment in stabilization securities.

It is also found that deregulation fails to increase credit availability to the private sector as a result of increasing dosage of stabilization securities, high lending rates and the paucity of loan supply. Furthermore, accelerated deposit growth experienced by DMBs during the deregulation is occasioned by changes in the overall liberalization package, rising per capita income, government deficit spending and per capita bank branch. These results suggest that the government should fine tune the various policies in the liberalization package in order to enhance the performance of deposit money banks in Nigeria.


Chapter One


Introduction

1.1 Background to the Study

In a number of developing countries of the world the financial system is highly regulated. This is because of the pivotal position the financial industry occupies in these economies. An efficient system, it is widely accepted, is a sine qua non for economic growth and efficient functioning of a nation’s economy. Thus, for the industry to be efficient, it must be regulated in view of the failure of the market system to recognize social rationality and the tendency for market participants to take undue risks which could impair the stability and solvency of their institutions.

However, the highly controlled state of the financial system in developing countries pulled the private sector back from playing an active role in the economy. The government controlled the interest rates and credit ceilings, owned banks and other financial institutions, and framed regulations with a view to making it easy for the government to acquire financial resources at a low cost. Since the nominal interest rate was controlled and the real interest rate mostly remained negative, savings could not be encouraged. As a result, investment could not increase to the desired level. This ultimately slowed economic growth.

In 1973, McKinnon (1973) and Shaw (1973) identified this problem of financial repression in developing countries and argued for a liberalization of the financial system. The standard economic theory suggests that liberalization strengthens financial development, leads to a more efficient allocation of resources, higher level of investment and higher long-run economic growth of the economy (Levine, 2001; Bonfiglioli and Meadicino, 2004). On the other hand, financial repression forces financial institutions to pay low and often negative real interest rates, reduces private financial savings thereby reducing the resources available to finance capital accumulation.

The World Bank and the International Monetary Fund (IMF), since the mid-1980s, started to prescribe financial liberalization as a basic framework for member developing countries to foster their economic growth (The World Bank Group, 2005). With this, the era of financial liberalization started in the developing countries with the technical and financial assistance of the World Bank and the IMF. The initial liberalization measures taken by some developing countries in the early 1980s showed very impressive result. This type of result became the motivating factor for other developing countries to liberalize their financial sector.

Based on these expectations, in the past three decades, many African countries have implemented financial liberalization as a component of the Structural Adjustment Programme (SAP) under varying financial structures and different macro-economic conditions. To this end, such countries eased or lifted bank interest rate ceilings, lowered compulsory reserve requirements and entry barriers, reduced government interference in credit allocation decisions and privatized banks and insurance companies. Some countries even actively promoted the development of local stock markets and encouraged entry of foreign financial intermediaries.

For more than two decades after independence, the Nigerian financial system was repressed, as evidenced by ceilings on interest rates and credit expansion, selective credit policies, high reserve requirements, and restriction on entry into the banking industry. This situation inhibited the functioning of the financial system and especially constrained its ability to mobilize savings and facilitate productive investment.

In 1986, the authorities commenced an extensive reform of the financial system as part of the SAP. The major financial sector reform policies implemented were deregulation of interest rates, exchange rate and entry into the banking business. Other measures implemented include: establishment of Nigeria Deposit Insurance Corporation (NDIC), strengthening the regulatory and supervisory institutions, upward review of capital adequacy standards, capital market deregulation and introduction of indirect monetary policy instruments.

Obviously, the sector that is most affected by financial liberalization is the commercial banking sector. The banking sector reform package is anchored on a 13-point programme, some of which include: increase in the minimum capital base requirement of the banks from N2 billion to N25 billion by the end of 2005, of which banks failing to meet the new requirements were expected to merge or else have their licenses revoked (Soludo, 2004).

Implementation of the consolidation exercise triggered various mergers in the banking sector and reduced the number of deposit banks in Nigeria from 89 to 25 by the end of 2005.

In view of these structural changes, the question that arises is: What have these reforms impacted on the banking industry? Therefore, this study focuses on the impact of financial liberalization on the performance of commercial banks (now deposit money banks) in Nigeria.


1.2 Statement of the Problem

In 1986, consequent upon the down turn of the economy and in response to IMF and World Bank economic adjustment programme, the Nigerian government initiated a series of reform measures ,among which is the liberalization of the financial system. Paramount among the financial sector reform were: removal of restrictions on interest rates, relaxation of constraints on licensing of new banks to increase competition, easing of economic restrictions on foreign exchange, greater autonomy in bank management, increased capital adequacy requirements, abolition of credit rationing, among others.

A peculiar feature of the reform programme in Nigeria is that the deregulation of controls has been partial and inconsistent. Before 1986, the sale of foreign exchange was rigidly controlled through the use of import licences and the exchange rate was fixed by fiat. To restore appropriate exchange rates and correct the over-valuation of the domestic currency, the authorities began the auction sales of foreign exchange to licensed dealers.

The liberalization of exchange rates was followed in 1987 by the full deregulation of both deposit and loan rates. In January 1987, a partial deregulation was attempted but by August, all rates had become market determined. A similar pattern of policy reversals applies to the reform of interest rates. Interest rates were decontrolled in 1987, but the Central Bank of Nigeria (CBN) has stipulated a maximum spread between deposit and lending rates since 1989 and ceilings on bank lending rates were imposed during 1991, removed in the following year and then re-imposed at the beginning of 1994.

Simultaneously, with the interest rate deregulation, conditions for licensing new banks were relaxed. In response, the number of deposit money banks (DMBs) rose dramatically from 40 in 1986 to 119 by the end of 1991. But by the end of 2005, the number had fallen to 25 following the consolidation exercise (Okonjo-Iweala, 2007). Some of the issues highlighted above pointed to the disorderly manner in which the reform had been implemented in Nigeria. In effect, the reform had not been a one-shot smooth process. This therefore complicated the task of assessing its outcome on the performance of deposit money banks in Nigeria.

Furthermore, the aim of the domestic financial liberalization is to improve economic performance through increased competitive efficiency within financial markets thereby indirectly benefiting non-financial sectors of the economy. Yet, after the prescribed financial liberalization the domestic economy has failed to experience impressive performance and 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 shallow and the apparent diversity of the financial system is deceptive.

And although a wide variety of financial institutions and markets exist, deposit money banks overwhelmingly dominate the financial system and traditional bank deposits represent the major form of financial saving (World Bank, 2000). 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, total liabilities and total credit in the banking system.

Thus, it is not clear whether the adoption of financial liberalization policies has any direct impact on the banking sector. In view of this, it stands to reason that there is the need to empirically investigate the actual impacts of financial liberalization on deposit money banks in Nigeria since they dominate the financial market.


1.3 Research Questions

This study is guided by the following questions:

  1. What is the evolution and process of financial liberalization in Nigeria?
  2. How has the financial liberalization impacted on DMBs in Nigeria in terms of profitability, credit to the private sector, and deposit growth?

1.4 Objectives of the Study

The broad objective of this study is to investigate empirically the impact of different aspects of financial liberalization on the performance of financial institutions in Nigeria using DMBs as a case study. The specific objectives are to:

  1. Examine the financial liberalization process in Nigeria.
  2. Evaluate the impact of financial liberalization on DMBs in Nigeria, in terms of profitability, credit to the private sector, and deposit growth.

1.5 Hypotheses of the Study

To achieve the specific objectives (ii), the study is guided by the following hypotheses:

  • H1: Financial liberalization does not lower the profitability of DMBs in Nigeria.
  • H2: Financial liberalization does not enhance the total credit of DMBs to the private sector in Nigeria.
  • H3: Financial liberalization does not accelerate the deposit growth of DMBs in Nigeria.

1.6 Scope of the Study

This study assesses the impact of financial liberalization on the performance of DMBs in Nigeria using time series annual data from the period 1975-2013. Such ‘before and after’ liberalization approaches together with the Error Correction Model (ECM) are employed to control for other factors or developments that may have helped shape the performance outcome.


1.7 Significance of the Study

The study is relevant because the policy of financial liberalization has been an integral preoccupation of various governments of Nigeria since the IMF Structural Adjustment Programme of 1986. Besides, the study adds valuable knowledge to the existing literature on DMBs in Nigeria. Data on financial liberalization Index in Nigeria has been prepared. The study is also significant in that it utilizes a new methodology in evaluating the impact of financial liberalization on DMBs in Nigeria. To this end, an autoregressive distributed approach to co-integration has been employed to analyze the impact of financial liberalization on key performance variables, namely, profitability, credit to the private sector and deposit growth of DMBs in Nigeria.

Furthermore, the outcome of this research will be of immense benefit to the government on how to fine tune the various policies in the liberation package in order to promote the growth of DMBs in Nigeria. Also, the study is significant in that it will bring to the fore the linkage existing between financial liberalization and profitability, credit to the private sector and deposit growth of DMBs. Finally, the study will increase our understanding of the response of DMBs to the liberalization policies.


1.8 Organization of the Study

This research work comprises six chapters in all. The first is the introductory chapter and it dwells on the historical background and the nature of the problem of the study. The study also set out the objectives, scope and significance of the study. Besides, three hypotheses are generated for empirical investigation. In chapter two, a survey of the literature on financial liberalization which forms the theoretical basis of this study is carried out. The implementation of financial liberalization in Nigeria and the sequencing are examined in chapter three. Chapter four focuses on the methodology of the study. The empirical results of this work are presented and discussed in the fifth chapter. The chapter concludes with the discussion of major findings. Finally, in chapter six, the study draws conclusions, and makes relevant recommendations.

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