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CHAPTER ONE

INTRODUCTION

1.1  BACKGROUND OF THE STUDY:

In recent years, many studies have examined the link between financial deepening and economic development as well as the link between financial development and poverty reduction via economic growth from both micro and macro perspectives, example, Levine (2004), Fitzgerald (2008), Nzotta and Okereke (2009), etc. In this study we depart from the finance-growth nexus, but still from the macro angle to see if there is a direct relationship between financial deepening and aggregate welfare. We will look at how welfare is linked to financial sector deepening and the existing transmission mechanisms. Few will doubt that income growth through access to financial services leads to improvement in people’s lives. Increased income allows people to enhance their living standards and escape from extreme poverty. From the works of Claessen and Feijen (2006), without a developed financial sector, for example, domestic savers and foreign investors would be more hesitant to part with their money to otherwise sound investments, resulting in lower economic output as measured by GDP and household welfare. They sressed that a well-developed financial system enables firms to expand production and provides households with the ability to obtain essential assets like a house, insure against income shocks, start a company, receive cheaper remittances, and enjoy a pension when they retire.

As such, the financial sector is an engine of economic growth and household welfare. Most literature confirmed that financial market plays a vital role in the process of economic growth and development by facilitating savings and channeling funds from savers to investors, Nzotta and Okereke (2009). Financial intermediation of growth leads to financial deepening, which refers to the greater financial resource mobilization in the formal financial sector and the ease in liquidity constraints of banks and enlargement of funds available to finance projects, Fisher (1933).

Direct measurement of how well the financial sector performs each of its functions is difficult. As Ndebbio (2004) observed, it is not possible to observe directly the quality and quantity of the monitoring services performed by a bank when it extends a loan, at least not for a large country like Nigeria. Hence, researchers use proxies to measure financial deepening. Typically used indicators of financial deepening are ratio of MS2

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(money) to GDP, ratio of private credit extended by commercial banks to GDP, and other financial assets.

As Ndebbio (2004) observed, only countries with high per capita incomes can experience rapid growth in financial assets. Such countries are none other than the developed countries. But what is crucial here is what constitutes the financial assets that wealth-holders must have as a result of high per capita income. Only when we can identify those financial assets will we be able to approximate financial deepening adequately. In short, and for our purpose, we borrow a lift from Ndebbio (2004) in asserting that financial deepening simply means an increase in the supply of financial assets in the economy. Therefore, the sum of all the measures of financial assets gives us the approximate size of financial deepening. That means that the widest range of such assets as broad money, liabilities of non-bank financial intermediaries, treasury bills, value of shares in the stock market, money market funds, etc., will have to be included in the measure of financial deepening. To simply pick the ratio of private sector credit to gross domestic product (GDP), as done in this study, is because of lack of data on other measures of financial assets likely to adequately approximate financial deepening in most Sub-Saharan African countries.

In his study, Ndebbio (2004) noted that if the increase in the supply of financial assets is small, it means that financial deepening in the economy is most likely to be shallow; but if the ratio is big, it means that financial deepening is likely to be high. He further went on to stressed that developed economies are characterized by high financial deepening, meaning that the financial sector in such countries has had significant growth and improvement, which has, in turn, led to the growth and development of the entire economy.

One common problem affecting the growth of development economies is the issue of “financial shallowness” which is seen by many economists as an outcome of the adoption of inappropriate financial policy. In the 1980’s, Nigeria alongside other African countries experienced widespread financial liberalization, interest rate deregulation, the entry of new banks and the likes, with the intention to deepen the financial sector but ended up producing financial openness without much financial depth, Collier and Gunning (1999). They further stressed that the legacy of financial liberalization in these countries was the establishment of weak banking organizations that were unable to open up the

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opportunities created by liberalization. Reflecting this in Nigeria saw the country being relegated to having less financial depth than other developing areas. As a result, banks were vulnerable to systemic crisis and the systemic risks in the country high. Thus, the Nigerian banking system was evidently limited in its resources mobilization with an adverse effect on the economy which hit more on the poor since they are the most vulnerable and hence financial deepening

This prompted the Central Bank of Nigeria (CBN) to come up with new banking reform policies in 2005 in a bid to strengthen and increase the financial assets of banks. Banking reforms are part of financial sector reforms, and financial sector reforms are propelled by the need to deepen the financial sector and reposition it for growth to become integrated into the global financial architecture and evolve a banking sector that is consistent with regional integration requirement, savings mobilization and international best practices, Nnanna et al (2004).The recent banking sector reforms which experienced consolidation of banking institutions affected the level of financial deepening in the country.

Consolidation of banks has been the major reform policy instrument being adopted recently in correcting deficiencies in the financial sector. It ushered in other reform policies that followed including the bail-out of eight deposit money banks with huge non-performing loans in 2009.

A review of the financial deepening indicators show that, the depth of the financial sector as measured by the ratio of MS2 to GDP even though has been fluctuating but has increased more than previous years. For the period of the study the ratio at the end of 2009 stood at 43.4 per cent and 38.9 per cent for 2010. Bank financing of the economy measured by the ratio of private sector credit to GDP stood at 33.2 per cent though lower than that 41.1 per cent of 2009. The intermediation efficiency indicator as measured by the ratio of currency outside banks to broad money supply was 9.4 per cent compared with 8.6 per cent at end of December, 2009. The size of the banking system relative to the size of the economy indicated by the ratio of deposit money banks assets to GDP, declined from 69.6 per cent at end of December 2009 to 58.8 per cent in 2010, (CBN 2010 annual report). Below is a chart showing the ratio of deposit banks assets to GDP and a graph showing the ratio of broad money (MS2) to GDP, private sector credit to GDP.

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