CHAPTER ONE

INTRODUCTION

1.1          Background to the Study

According to Cecchetti, Kohler and Upper (2009), banking crises have plagued the world for centuries, touching virtually all regions and generations. To Laeven (2011), the occurrences of banking crises, “have been a common phenomenon throughout history” (p.4.2). Therefore, it could be stated that banking crisis is as old as the history of banking and this is experienced in developed and developing countries alike; it still occurs till date. In the United States of America (USA), for example, the first banking panic occurred in 1792 (Sylla, Wright & Cowen, 2009; Calomiris, 2009a). Thereafter, banking crisis became a persistent feature of the USA banking landscape till present day, except between 1945 and 1970s, considered relatively bank crisis free (Reinhart & Rogoff, 2008a; Calomiris, 2009a).

In Nigeria, the establishment of African Banking Corporation in 1892 ushered in modern banking (Familoni, 1995; Unugbro, 2010), but, according to Ndekwu (1994), it was also the first bank to face failure in Nigeria. From 1930 to 1959, the Nigerian banking system experienced failures and out of the 26 banks established during the colonial period, only four survived (Owualah, 1999). To Alashi (2002), the pre-1950s distress-syndrome was again experienced in the late 1980s, such that 60 out of 115 banks as at December 1995 were distressed and most were closed by Central Bank of Nigeria (CBN). Meanwhile, Nigeria Deposit Insurance Corporation (NDIC) (1994-2003) put the number of banks closed between 1994 and 2003 at 34. Soludo (2004) revealed that as at March 2004, out of 89 banks in existence, 14 were marginal and 11 were unsound.

According to Sanusi (2010), the mass distress experienced in the banking system laid the foundations for the 2004 banking sector consolidation in Nigeria. By December, 2005 the deadline for the banking sector consolidation exercise, the number of banks reduced from 89 to 25 (NDIC, 2009). Besides, the 2007 USA global financial crisis also impacted on the banking system of Nigeria. The takeover of eight banks by Central Bank of Nigeria (CBN) in 2009 was an indication that the Nigerian banking system was still troubled. In the words of Ogunleye (2010) “contrary to expectation that the bank consolidation programme initiated in 2004, would ensure the emergence of stronger banks and a more resilient banking system, distress syndrome still pervades the banking system”(p.15). However, Cook (2011) remarked

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that the Nigerian banking reform of 2005 only enhanced safety and soundness by different measures but bank distress was not reported or under reported after 2005. Moreover, Obinagwan (2014) and Nnodim (2014) reported evidences of crisis in Nigeria banking system in 2013 and 2014.

The episodes of crises in the Nigerian banking system over the years had been attributed to two broad categories of causes, internal and external (Enendu, Nwaoba, Kama, Salisu, Yakubu & Nwosu, 2010). According to Enendu, et al. (2010), the internal causes are factors such as weak management, inadequate capital base and poor management of assets as well as liabilities within the control of the operators, while the external causes which are not limited to macroeconomic instability and inadequate legal framework arose from the social-political and economic environment in which the banks operate. Further, Bordo andMeissner (2015) argued that international factor accounts for crisis as evident in Nigeria by the virtue of the 2007 global financial crisis.

Apparently, a crisis ridden banking system may be unable to discharge its roles efficiently and effectively. The roles as stated by West African Institute for Financial and Economic Management (1998), Kama (2010) and Adeyemi (2010) include financial intermediation, provision of an efficient payment system and a vehicle for implementation of monetary policies. In addition, other effects of bank crisis in Nigeria captured theoretically are deposit run, massive portfolio shift to safer assets, reduction of the quality of bank credits, unemployment, demonetisation, instability in money demand, distortion in money supply and retardation of rate of capital formation, low output as well as pace of economic growth and development (Ebhodaghe, 1995 and Ebhodaghe, 1996a).

Also, during banking crisis era in Nigeria, M1 and M2 components of monetary aggregates as could be discerned from Appendix 1 changed. For example, M1 and M2 whose growth rates were at lowest ebb of -3.8% and 6.6%, respectively in 1987 trended smoothly upwards to achieve a growth rate of 40.9% and 38.4%, respectively in 1988. From 1989 to 2003, the growth rate of M1 oscillated between 18.4% and 52.8% while that of M2 was between 16.8% and 46.4%. However, M1 and M2 growth rate that were 29.4% and 23.7%, respectively in 2003 fell to 5.3% and 10.3%, respectively in 2004 and started rising but not smoothly until 2008 when M1 had a growth rate of 58.3% while M2 had 59.7%. These M1 and M2 movements suggest a likely distortion of money demand and supply during the banking crisis. On the other hand, it could be seen also from Appendix 1 that the inflationary episodes of 1989 to 1990 and 1992 to1995 in Nigeria occurred during banking crisis period. It is

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observable that inflation reached a height of 70.5% in 1990, fell to 12.7% in 1991 and rose to 72.8% in 1995.Therefore, it can be stated, that banking crisis in Nigeria was associated with inflation. Gbosi (2009) contended that banking crisis fuels inflationary pressure in Nigeria. Apart from the above, it suffices to add that the effect of banking crisis in Nigeria have been theoretically documented in literature such as Ologun (1994) and Ogubunka (2003).It is the contention of this study that the effects of banking crises are always presented as if it is homogenous. In essence, consideration has not been given to optimal threshold level of banking crisis beyond which banking crisis becomes detrimental to the economy.

The effects of banking crisis could be classified into non-monetary and monetary. The non-monetary effects include output and human capital while the monetary effects consist of and not confined to money demand and inflation. Although, studying of demand for money has become a common practice, there is acute shortage of attention empirically as to its underlying assumptions and properties with respect to banking crisis, especially in Nigeria. Moreover, when the invaluable roles of money demand and price level were considered in the implementation of monetary policy among other things, it becomes imperative to establish the status of money demand and inflation empirically during banking crisis. Bayo (2011) averred that “the search for a reliable inflation function continues to be an intensive activity” (p.267). Further, Bayo posited that very little is still known about the contemporary relationship between inflation and its determining variables in Nigeria. Therefore, establishing the behaviour of inflation within the context of banking crisis is a worthwhile venture. Hence, the concern of this study is to estimate the monetary effects of banking crisis with focus on money demand and inflation in Nigeria.

1.2          Statement of the Problem

The history of banking around the world has been interrupted at relatively frequent intervals by episodes of crises which affect every facet of the economy such as the banking system, money demand, inflation, output, human capital and stock market. Banking crisis makes the attainment of potential beneficial effects of having an efficient banking system difficult. It creates liquidity squeeze, reduces lending, increases interest rate and reduces output which in turn destabilises money demand and puts pressure on inflation. This poses challenge to monetary policy, the payment system, financial intermediation, investment, economic activities and price stability.

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Banking crisis often creates currency flight and surge in demand for cash which made the ratio of cash to narrow money increase (Central Bank of Nigeria/Nigeria Deposit Insurance Corporation (CBN/NDIC), 1995). This distorts money demand and makes implementation of monetary policy difficult. The cash intensity in the Nigerian economy as measured by currency outside the bank (COB) to narrow money (M1) and broad money (M2), respectively in percentage is as shown in Appendix 2. The COB/M1 and COB/M2 have the same trend save for COB/M1 recording higher values than COB/M2 for each year from 1970 to 2008. For example, in 1989, 1994 and 2008 COB/M1 values were 39.7%, 64.4%, and 19.5%, respectively while COB/M2 values were 20.7%, 38.3% and 10.4%, respectively. The deteriorating trends of COB/M1 and COB/M2 were indicative of the fact that cash intensity was in a worsening state during the banking crisis. The cash intensity situation stems from the view of bank customers that deposits with the banks will be lost because of the crisis. This leads to drawing down on deposits and in turn leads to cash intensity and make much money to be outside the banking system. With this situation, it is observed that liquidity squeeze, reduction in bank credit and increase in interest rate, among other things disrupt the demand for money. As this occurs, it affects the payment system. It also assists to compromise the overall stance of monetary policy and inflation objectives as money outside the banking system is usually difficult to control by monetary authorities.

There is also the view that during financial crisis the simple money demand function will not completely capture the behaviour of the real money and that the stable relationship observed during the normal period breaks down (Miyagawa & Morita, 2009). The implication, therefore, is that, the traditional money demand function estimation tends to produce misleading results and money becomes an unsuitable indicator of monetary policy. In essence, it leads to ineffective implementation of monetary policy.

Banking crisis reduces output and affects inflation and the level of economic activities is reduced. It is also held that banking crisis which destabilises the relation between prices and the variables that explain its behaviour breeds ineffective implementation of monetary policy (Garcia-Herrero, 1997; Lindgren, Garcia & Saal, 1996). In addition, Garcia-Herrero (1997) held that the capability to attain inflation objectives is weakened by banking crisis. At the end, there is decline in economic activities. It is common knowledge that inflation drives real interest rate. It could be seen from Appendix 2 that real interest rate trend in Nigeria indicates a worsening trend during the banking crisis of 1989 to 2008 when compared to the non-banking crisis era of 1970 to1988. In the volatility, real interest rate declined from -31.2% in

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1984 to -41.5% in 1988. By 1990, it had degenerated to -51.7% and as at 1995 it had further deteriorated to -60.19%. Since real interest rate that determines realisation of efficient financial intermediation has been shown to be in a bad state because of banking crisis that adversely affects inflation, it stands to reason that it constitutes hindrance to financial intermediation. This makes it difficult for the bank to play its traditional roles of providing resources for long-term investment and growth of the economy. Put differently, the financial intermediation difficulty leads to low investment, which translates to decline in economic activity. This further puts stress on inflation, incapacitates the attainment of inflation objectives and renders realisation of monetary policy stance meaningless.

It is the observation of this study that the movements of M1 and M2 growth rate and inflation as depicted in Appendix 1 could be ascribed to banking crisis but are not convincing reference point about its impact on money demand and inflation. Therefore, the movements could not be seen to be proper proven behaviour of money demand and inflation during banking crisis in Nigeria. Nonetheles, it would likely pose challenge to effectiveness of monetary policies.

From the foregoing and following Kerlinger (1964), Poincare (1952) as cited in Sunmola (2009) “there is no one “right” way to state a research problem but a problem stated in question form is the best way”(p.52). Therefore, this study’s problem was summarily put thus: How has banking crisis influenced the behaviour of money demand and inflation in Nigeria?

1.3          Research Questions

To guide this study, it became imperative to specifically provide answers to the following questions:

i. What is the possibility of constructing a banking crisis index for Nigeria?