CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

The impact of the 2008 global financial crisis on many economies re-affirmed the need to protect the financial system from shocks, both endogenous and exogenous. Consequently, policymakers and regulators in many countries implemented various drastic regulatory measures to rescue their financial systems from meltdowns, and to avert deep economic downturns (Dermiguc-Kunt & Kane, 2003; Cobbinah & Okpalaobieri, 2009; Massa & Willem te Velde, 2008; Berkmen et al, 2009). Measures adopted include government takeover of banks or capital injections, interest rate cuts, subsidies to ailing sectors, and bank deposit guarantees. Among all these, the deposit insurance scheme has generated much interest among scholars and policy makers (Campbell et al, 2009; Mbarek & Dorra, 2011; Chu, 2011).

In every economy, the financial sector occupies a strategic position because of the important function it plays in the flow of funds. Economists have long recognised that financial markets in general, and banks in particular, play a vital role in the efficient functioning and development of any economy (Guzman, 2000).Finance is relevant for growth and development because efficient financial systems resolve agency problems better, thus enabling firms to borrow at cheaper rates and invest more. In addition, finance also plays a major role in the structural transformation of less developed economies characterised by moderate industrialisation, and where small-tomedium scale enterprises dominate (Chakraborty & Ray, 2006). 

As a rule, economic activities increase when savings-surplus units are able to channel funds to the savings-deficit units. This intermediation role of the financial sector actually provides the basis for capital formation and other activities necessary for economic growth. Literature is replete with studies carried out in the finance-growth nexus. Levine (1997) suggests that finance promotes growth principally by the efficiency of capital allocation, and not necessarily by increasing investment. Chandrasekhar (2002) emphasises this by pointing out that financial structures and financial institutions have been acknowledged in literature as having assisted disadvantaged economies to leverage on existing productive capacities. The consensus view of academics is that properly functioning financial intermediaries improve the efficiency of capital allocation, encourage savings, and lead to more capital formation (Wachtel, 2003; Santomero, 1997; Frolov, 2004; Aziakpono, 2005). 

Most of these studies have been focused on whether a market- or bank-based financial structure is more important for growth (Levine, 2002; Demirguc-Kunt & Levine, 1999; Dolar & Meh, 2002; Cuadro-Saez & Garcia-Herrero, 2007).  Findings indicate that in the main, market-based systems are preferable for economies that are developed, and have the necessary institutional infrastructure to reap the resultant benefits. On the other hand, bank-based system may be more effective at mobilizing savings, allocating capital and exerting corporate control in less developed countries (Levine, 2000; Demirguic-Kunt & Levine, 2004). Factors such as a weak legal environment, resulting in inability to enforce creditors’ rights, as well as shallow and under-developed capital markets all contribute to the predilection for a bank-dominated financial structure. Thus, the banking system plays a pivotal role as most of the capital flows to the real sector come from it. Given the importance of the real sector to the performance of a country, it is hardly surprising that many policies of the governments of such countries focus on ensuring that the banking sector experiences minimal disruptions. 

Over time, governments have developed innovative measures to maintain the stability of the banking system. Carletti & Hartmann (2002) assert that the special status accorded banks is justified because less wealthy individuals may hold a substantial portion of their wealth in various forms of bank deposits; consequently, the possibility of bank failures and the resultant adverse macroeconomic repercussions have motivated much of the public policies toward banks (Calomiris, 2007). The financial safety net simply means a set of measures that governments have established to forestall, avert, or resolve any threats to the financial system. Preferred instruments that have been utilised include prudential regulation and supervision to enhance bank soundness thereby reducing the risk of bank failure, the function of the central bank as the lender-of-last resort , government guarantees in crisis situations, prompt corrective actions, resolution procedures and a deposit insurance scheme (White, 2004; Ogunleye, 2009).

Depositors typically do not have in-depth information about the operations of their banks. As such, when there is signalling, either by rumours or other mechanisms, they will either move their funds to a bank that is perceived as being safer or into alternative investments. Corroborating this, Diamond and Dyvbig (1983) assert that during a bank run, depositors rush to withdraw their deposits because they expect the bank to fail. This action may however turn into a self-fulfilling prophecy as such sudden withdrawals can force the bank to liquidate many of its assets at a loss and consequently, fail. Therefore, to protect depositors and by so doing, prevent them from moving their funds to other jurisdictions to the detriment of the productive capacity of the economy, governments establish a deposit insurance scheme. It has been argued that government provision of deposit insurance is justified on the grounds that deposit insurance creates a safe savings vehicle for small, unsophisticated individuals, as well as providing financial and monetary stability. Furthermore, explicit deposit insurance provides a faster, smoother and more consistent administrative process for extending protection to depositors and for protection against bank runs (Pennacchi, 2009; Ogunleye, 2009).

The United States of America was the first to introduce a national system of deposit insurance in 1934 after the Great Depression when bank runs were the order of the day, and the country faced massive bank failures (McCarthy, 1980). Over 9,000 banks failed within the 1930 – 1933 period because concerns about the future of the dollar had led to massive deposit withdrawals in order to facilitate speculative holdings of foreign currencies, gold and gold certificates.  Despite many actions taken, such as suspensions, and injection of funds from the Treasury, the economy sank deeper in the throes of an acute banking crisis that left the citizenry suffering untold hardships. The introduction of federal deposit insurance proved to be an immediate success in restoring public confidence and stability to the banking system as only nine banks failed in 1934 (Federal Deposit Insurance Corporation, 1998). 

Typically, some form of legislation, such as the central bank law, banking law, or the constitution, establishes a guarantee scheme for deposits (Ngalawa et al, 2011; Safakli & Guryay, 2007). An explicit deposit insurance scheme therefore exists where a dedicated institution is established to manage the affairs of the fund; for example, the Nigeria Deposit Insurance Scheme (NDIC). On the other hand, implicit deposit insurance exists to the extent that the political incentives that shape a government’s reaction to crisis make a taxpayer bailout of insolvent banks seem inevitable (Demirguc-Kunt & Kane, 2003). 

Structurally, the Nigerian economy has been dominated by two sectors namely, agriculture and crude petroleum sectors. In terms of revenue generation, however, the economy is mono-cultural. In the 1960s and early 1970s, the major revenue earner was agriculture however, since the late 1970s, the oil sector has dominated in revenue generation (Ezirim et al, 2010). Nigeria’s economic aspirations have remained that of altering the structure of production and consumption patterns, diversifying the economic base and reducing dependence on oil, with the aim of putting the economy on the path of sustainable, all-inclusive and non-inflationary growth. The implication of this is that while rapid growth in output, as measured by the real gross domestic product (GDP), is important, the transformation of the various sectors of the economy is even more critical. This is consistent with the growth aspirations of most developing countries, as the structure of the economy is expected to change as growth progresses (Sanusi, 2010). 

Accordingly, Soyibo & Adekanye (1992) assert that the role of an efficient banking system in economic growth and development lies in savings mobilization and intermediation. Thus, improved financial intermediation, especially through banking institutions, would not only help bridge the gap between domestic saving and investment in Nigeria, but more importantly facilitate trade and capital formation. Furthermore, Fadare (2011) argues that the banking sector plays a very important role in the Nigerian economy as a supplier of credit to the many different sectors which require funds for growth. Banks intermediate by first generating deposits which they subsequently lend to these sectors, thereby taking different risks including that of nonrepayment of such loans. Deposit insurance is therefore required to protect the providers of these loanable funds from such risks of non-repayment. 

The Nigerian deposit insurance scheme is regulated by the Nigeria Deposit Insurance Corporation (NDIC) Decree No. 22 of 1988 (replaced by the NDIC Act 16 of 2006), which established the Corporation to insure deposit liabilities of all licensed deposit-taking financial institutions in Nigeria. The Deposit Insurance Scheme (DIS) was introduced following the deregulation of the financial system under the Structural Adjustment Programme (SAP) in 1986, to provide a further layer of protection for depositors, promote financial stability by complementing the supervisory activities of the Central Bank of Nigeria (CBN) in ensuring a safe and sound banking system (Nigeria Deposit Insurance Corporation (NDIC), 2011).

1.2 STATEMENT OF THE PROBLEM

Researchers have argued that explicit deposit insurance schemes encourage excessive risk-taking or financial recklessness on the part of financial institutions, which could ultimately lead to instability in the banking industry despite the huge deposits mobilised by such banks (Brock, 2003; Garcia, 2000; Demirgüç-Kunt and Kane, 2003; Dowd, 1993; Ketcha, 1999). 

According to Ngalawa et al (2011), protecting economic agents (in this instance, depository institutions) from the negative consequences of their behaviour increases their appetite for risk. The belief of bank managers that their depositors’ funds are protected may encourage them to make sub-optimal lending decisions. In effect, such managers may seek to achieve higher returns by taking on increasingly risky investments without performing proper due diligence on such loans, and monitoring them effectively. 

An explicit deposit insurance scheme (hereafter DIS) makes it very clear that it is a safety net for the depositors, thus, if a  depository institution becomes insolvent, the government absorbs all (or nearly all) of the depositors’ losses. This could weaken market discipline – the monitoring of bank activities by depositors and other bank stakeholders, and in a lax regulatory environment, may lead to systemic instability as more banks become distressed, and either have to be bailed out or liquidated (Cull et al, 2004). 

Literature abounds with studies conducted on the implications of DIS for different economies.

However, most of these works have been concentrated on the developed world, such as the US,

Eurozone, Latin America and Asian economies (Eisenbeis & Kaufman, 2007; Kuritzkes et al, 2002). A review of existing literature reveals the paucity of empirical works on countries in the sub-saharan region of Africa (Anyanwu, 1997; Cheng & Ellyne, 2011). This is particularly alarming when one considers that some countries in Africa have established explicit DIS, often as part of the policy recommendations of international financial experts (Demirgüç-Kunt & Kane, 2002; ). This study therefore evaluated the effect of DIS on bank intermediation in the Nigerian banking industry. 

1.3 OBJECTIVES OF THE STUDY

The major objective of the study is to establish empirically the effect of deposit insurance scheme on banking industry intermediation in Nigeria. 

However, the specific objectives of the study are:

1.      To determine whether the presence of an insurance scheme improves the quality of bank deposits in Nigeria.

2.      To assess if the presence of an insurance scheme has any significant impact on the quality of bank assets in Nigeria. 

3.      To examine if the presence of an insurance scheme exacerbates systemic risk in the Nigerian banking industry.

1.4 RESEARCH QUESTIONS

The following research questions were formulated for the study:

1.      How far can the presence of an insurance scheme affect the quality of bank deposits in Nigeria?

2.      What impact has the existence of an insurance scheme on the quality of bank assets in Nigeria?  

3.      To what extent has the presence of an insurance scheme exacerbated systemic risk in the Nigerian banking industry?

1.5 RESEARCH HYPOTHESES

The following null hypotheses were formulated for the study:

1.      The presence of an insurance scheme does not have a positive and significant impact on the quality of bank deposits in Nigeria.

2.      The existence of an insurance scheme has no positive and significant impact on the quality of bank assets in Nigeria.

3.      The presence of an insurance scheme has no positive and significant impact on systemic risk in the Nigerian banking industry.

1.6 SCOPE OF THE STUDY

The study was carried out for the period 1990 to 2012. This period is significant because while an explicit deposit insurance scheme was established in 1988 in Nigeria with the enactment of the Nigeria Deposit Insurance Corporation (NDIC) Act No. 2 of 1988 (now repealed and reenacted as NDIC Act No.16 of 2006), the NDIC actually commenced operations in 1989. Furthermore, the Bank and Other Financial Institutions (BOFIA) Act of 1991 was enacted within the period to ensure further stability in the financial sector. Finally, the NDIC was first able to successfully carry out liquidation activities in 1994 following the enactment of the Failed Banks (Recovery of Debts and Other Financial Malpractices in Banks) Act No. 18 of 1994. 

1.7 SIGNIFICANCE OF THE STUDY

The study will be of immense benefit to the following:

Policy Makers

The most compelling reason given for the establishment of deposit insurance schemes has been to protect the banking industry from destabilising bank runs which could cripple the economy. However, the experience of the 2008 global financial crisis revealed the inadequacy of such schemes to perform their basic functions. Thus, many governments had to adopt additional measures to retain confidence in the banking sector. Findings from this study will provide policy makers with needed information (supported by empirical evidence) on the efficacy of their deposit insurance scheme. 

Banks and other Financial Intermediaries

This study will enable banks and other financial intermediaries to understand the rationale behind the establishment of explicit deposit insurance schemes. In doing this, they will better appreciate the consequences of their intermediating activities on the stability of the financial system

General Public

Findings from the study are expected to educate the public on the objective of deposit insurance. Furthermore, it is expected that more awareness will be created on the important role of providing market discipline via monitoring to inhibit the tendencies of the depository institutions towards excessive financial recklessness.

Academics

It is intended that the study will further enrich the literature on the relationship between deposit insurance schemes and bank intermediation, and provide a basis for future studies in this very important area.

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