FINANCIAL LIBERALISATION POLICY AND THEPERFORMANCE OF THE FINANCIAL SECTOR IN NIGERIA

FINANCIAL LIBERALISATION POLICY AND THEPERFORMANCE OF THE FINANCIAL SECTOR IN NIGERIA

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CHAPTER ONE: INTRODUCTION

1.1        Background to the Study

The use of national policy decisions such as financial liberalization policy to improve the financial sector in many countries of the world cannot be overemphasized. In their viewsAcemoglu and Zilibotti (1997) and Obstfeld (1994) as cited in Bakare (2011) discovered that by promoting cross-country risk diversification, financial liberalization fosters specialization, efficiency in capital allocation and growth. However, Eichengreen (2001) also cited inBakare(2011) posited that financial liberalization may be harmful for growth in the presence of distortions. It may trigger financial instability as well as misallocation of capital, which are detrimental to macroeconomic performance. Globally, policymakers employ financial liberalization policy as a unifying theme in order to establish policy regimes that are immune from financial repression and crises. Thus, the driving force of this policy is to transform developing economies by building a more efficient robust and deeper financial system which can support the private sector enterprises (Odhiambo, 2011) and a rapid maturation of capital markets (Ulici, 2012).

A growing consensus among researchers is that financial liberalization policy is often followed by several benefits and the extent to which it induces financial performance may not come without a cost. Thus, some researchers applaud its benefits on the basis that the policy promotes transparency and accountability, reduces adverse selection and moral hazard while alleviating liquidity problems in the financial markets (Stulz, 1999; Minshkin, 2001). It also leads to more efficient capital market in emerging countries (Kim &Singal, 2000) and foreign direct investment (Desai, Foley & Hines, 2006). Further, capital market liberalization leads to increased market integration and investment boom associated with a decrease in the cost of capital (Henry, 2003). On the contrary, it has been recognised also that the policy is a key factor responsible for financial fragility and banking crises (Demirguc-Kunt&Detragiache, 1998; Fawowe, 2010), decrease in banking profitability (Abdelaziz, Mouldi, &Helmi, 2011; Fisher &Chenard, 1997), and banks’ failure (Caprio&Klingebiel, 1996). From the above it can be deduced that, financial sector may experience substantial gain or the possibility


of substantial losses and crisis as the financial system transits from a controlled to a free system.

Widening the scope of the banks and capital markets performance in most countries has gone hand in hand with financial sector liberalization. Though, at one time, it was noted that the policy favoured the growth of the money market rather than the capital market (Ziorklui, 2001). This may be because in developing countries, indirect finance through the money market is seen as more important than direct finance through the capital markets. With the increasing interest on the role of national policies in the financial markets recently, emphasis is gradually shifting also to the capital market indicators.

In the Nigerian financial system, the two subsectors in the formal sector are the bank financial institutions (such as Deposit Money Banks) and non-bank financial institutions (such as capital market). These institutions’ primary task is to perform intermediation functions by channelling funds from surplus to deficit units to enhance economic activities. The bank financial institution is a deposit taking institution and operates in the short-term form which makes it incapable of providing a greater supply of long term capital due to its assets. On the other hand, the capital market operates in the medium and long term form. The financial sector is no doubt an important sector of the economy which can contribute robustly to sustain economic growth (Levine, Loayza&Thortern, 2000).Such sector increases the availability of funding by mobilising idle savings, facilitating transactions and attracting foreign investments. These may be attained highly if financial liberalisation policy is adopted in any country. For instance, the policy frees the financial sector to ease the availability of credit to the private sector.However, for an efficient and effective provision of financial services, the financial sector is required to adjust in response to financial policies and any further liberalisation policy imposed on the financial sector will entirely extend to its performance thereby, affecting the other parts of the economy.

Nigerian financial system was highly regulated prior to 1987. The government regulated the interest rates and imposed credit ceilings, owned financial institutions and framed regulations with a view to making it easy for the government to acquire financial resources at a cheaper rate. Due to the highly controlled state of the financial 2


sector and the concomitant interest rate distortions, financial system may not have mobilised and supplied funds to the desired level. This stifled economic growth in the country. To avert this state, financial liberalization policy was introduced with the support of World Bank and the International Monetary Fund.

During the decade prior to independence, the Nigerian banking sector faced undue government regulations. After independence, with the extensive regulations by the Central Bank of Nigeria (CBN) as well as direct participation by the government (federal and states) several financial policies known as interventionist policies were ushered in. The characteristic of these policies was that of financial repression such that resources were channelled away from areas where private rates of return would have been maximized (Brownbridge, 1996). The banking sector was controlled through the banking ordinance of 1952 (in terms of quantity, cost, and direction of resource allocation), monetary policy instruments: aggregate ceilings on the expansion of banks’ credit, sectorial credit guidelines, interest rate control, and indigenization policy. Meanwhile, the capital market level of activity also depended on government policies such as government borrowings through Development stocks and indigenization policy.

The Indigenization policy introduced in 1977 was the first policy to regulate financial operations. It ensured that privately controlled international corporations in Nigeria were converted into state owned corporations. This aimed at encouraging private Nigerian entrepreneurs to enter business with foreign financial institutions which were dominated by foreign investors. To achieve this, government restricted the scope of foreign investment and reduced the participation of foreigners to a maximum of 40% equity holding in a listed security. Later in 1989, the policy was re-amended to accommodate larger foreign presence in the capital market. By early eighties, with the downside of indigenization policy and the collapse of world oil prices accompanied by large portfolio of non-performing loans, uncompetitive financial institutions, economic recession and financial repression, the government decided to adopt an economic recovery program known as Structural Adjustment Program (SAP). The SAP of 1986, supported by World Bank and IMF, was designed to restructure and revitalize the fiscal sector as well as liberalize the regulations on financial sector by creating new institutions and structures. The key measures designed to achieve these

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were the liberalization of external trade, exchange controlsand implementationof methods that will encourage domestic production and expansion of the supply base of the economy. SAP, however, created some financial measures that affected both the banking sector and the capital market. These include interest rate deregulation, Second-Tier Foreign Exchange Market (SFEM), privatization, and debt conversion (debt to equity swaps) (Ikhide, 1997).

In 1987, the financial liberalization policy was introduced as part of economic blueprint under SAP. The key reforms that were implemented as part of the policy include; liberalization of interest rate, changing the concept of a credit ceiling with Open Market Operation (OMO), decontrolling exchange rates, developing the capital market, promoting competition and efficiency by liberalizing bank licensing/entry barriers which increased the number of banks from 34 in 1987 to 90 in 2003 and decreased to 20 in 2012. These key reforms however took a gradual process as explained below.

A market-based interest rate policy was introduced in 1987. The aim was to allow banks to charge market-based interest rates that will enhance their savings mobilization, supply of sufficient funds to investors and allocate resources more freely. It was also aimed to discourage debt financing by firms and encourage equity financing. With the high interest rate in the money market, business enterprises were motivated to patronize the capital market for equity and this mounted pressure on the Nigerian capital market and created greater opportunity for private investors to borrow from the capital market (Ikhide, 1997). However, in January 1994, as a result of wide variations and unnecessarily high rates, government reversed the policy and reintroduced measures of regulation on interest rate management. The cap was retained in 1995 with little change to allow for flexibility but was removed in 1996. The removal remained active, thus enabling the pursuit of a flexible interest rate regime in which bank deposit and lending rates were determined by the market forces. According to Omole and Falokun (1999), the trend portrays the bias of policy authorities towards a liberalized interest rate regime.

In June 15, 1988, the Nigeria Deposit Insurance Corporation (NDIC) was set up by decree No 22 of 1988 with outlined procedure on the provision of deposit insurance 4


and related services to banks in order to promote confidence in the banking industry. Its main importance was brought to focus in 1994 and 2006 when most of the Nigerian banks and other financial institutions were submerged in distress and bank consolidation exercise of 2004 and 2005 respectively (Iganiga, 2010).In June 1989, Privatization which is a tenet of the program was enacted to improve management, efficiency and performance of affected enterprises; reduce government’ debt, increase funds for infrastructure, enhance economic growth and development and instil market discipline (Ikhide, 1997). It was expected that this method will enhance capital market development by increasing the quality and quantity of financial instruments traded in the market and achieve a government objective of widespread shareholdings in the country. In the same year, Bureaux De Change was licensed to enhance access to foreign exchange to small users and to enlarge the foreign exchange market in Nigeria.

In 1990, Prudential Guidelines were introduced to control depository risk exposure and protectthe financial system as a whole. Under this, steps were taken to strengthen the capital base of banks. While in 2010 a revised Prudential Guidelines was designed to address various aspects of banks operations, such as risk management, corporate governance, Know Your Customer (KYC) and anti-money laundering/counter financing of terrorism and loan provisioning (IMF, 2013).

In 1991, the federal government deregulated the pricing of securities in the market and disengaged the Securities and Exchange Commission (SEC) from securities pricing of new stocks. The market was left in the hands of stock brokers and issuing houses. Further efforts were also taken to improve the settlement process, brokerage services, minimize clearing and the risk of capital investment. By 1997, the Central Securities and Clearing System (CSCS) came into being. This, in conjunction with Automated Trading System (ATS) improved the performance of the market (Babalola& Adegbite 2000). In September 1992, banks licensing barrier and credit ceiling on banks were deregulated. Banks’ loans and advances started experiencing increase in the immediate aftermath of the financial liberalisation. From the credit provided to the private and public sector there is a noticeable substantial increase (Fowowe, 2010).

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In a similar vein, the capital market and capital flow were liberalized in 1995. As a well-deserved development in 1995, the Nigerian government promulgated the Nigerian Investment Promotion Commission Decree No 16 whose thrust was to liberalize the investment climate in the country. It replaced the Nigerian Enterprise Promotion Decree of 1989 and the Exchange Control Act of 1962. This move effectively internationalized the Nigerian capital market, putting the market on the right track as a channel for foreign capital inflow into the economy(Ukah, 2010). Consequently, it led to institutionalization of foreign currency deposits in 2000. In 1999, the enactment of Investment and Security Act (ISA) 45 of 1999 aided the reconstitution of Securities and Exchange Commission and introduction of measures that improved listing disclosures and checking insider trading.

In order to further liberalize the financial sector due to deep financial distress between 1993 and 1998, there was need for another policy change to manage the distress. With this in 2001, Universal Banking Policy was introduced to empower the financial sector. This freed banks to operate both banking securities and insurance businesses in order to ensure efficient delivering of all financial services at reduced costs and also improve bank risk- return profile through diversification (Asogwa, 2005). In 2004 bank consolidation was introduced to strengthen the banking sector by drastically increasing the minimum capital requirement from N2 billion to N25 billion in 2002 and 2004 respectively. It however, became evident that consolidation of this sector led to a remarkable reduction in the number of banks from 89 to 20 in 2012. At this juncture, the Capital market served as an instrumentalist to the banks in order to meet the minimum capital requirement of the N25 billion. In as much as consolidation reduced the number of banks in the sector on the justification of creating few stronger firms, its effect on the level of competition was ambiguous (Ofoegbu&Iyewumi, 2013). In 2007, the Security and Exchange Commission approved a new minimum capital base for all capital market operators in the market. The aim was to strengthen and reposition the capital market to cope with the global competition.


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