FINANCIAL LIBERALISATION POLICY AND THE PERFORMANCE OF THE FINANCIAL SECTOR IN NIGERIA

Abstract

The study focuses on investigating the impact of financial liberalisation policy on the performance of the financial sector in Nigeria by utilising Analysis of  Covariance (structural break with mix dummy coded and continuous variables) and applying the Ordinary Least Square (OLS) technique which corrected for arbitrary levels of serial correlation. Utilising the dataset that covers the period of 1970Q1-2013Q4, the study employs domestic and external macroeconomic  variables. The econometrics results show that real per capita income is positively linked to banks’ ability to lend to the private  sector  while  trade  openness  may  stimulate  higher  banks  deposits  and investment  in  the  capital  market  if  institutional  qualities  as  well  as  a  sound macroeconomic environment are put in place. Further, lending rate, deposit rate and inflation have a higher dampening impact on the financial sector performance in the period  of  financial  liberalisation  policy.  However,  the  study  finds  thatfinancial liberalisation policy adopted in 1987 has a significant impact on the performance of the banking sector but has no significant impact on the performance of the capital market. The study therefore provides supports for the sceptical empirical view of the policy  in  Nigeria  that  it  might  be  associated   to  non-interest  rate  and  other macroeconomic factors. Policy-wise the study suggests that since the macroeconomic variables are important factors influencing the performance of the financial sector, it is vital for government to createconducive environment that will attract foreign and boost domestic investors. At the same time so much interest on consumption should be checked in  order to encourage attraction of savings in banks and investment in the capital market. Also, non-interest rate factors should be strengthened to enhance the financial sector performance  and further financial liberalisation  policy along  with fiscal  and  monetary  policy  discipline  should  be  carried  out  to  achieve  positive significant performance of the capital market.

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

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

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

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).

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.

Following the banking crisis of 2009, the Asset Management  Company of  Nigeria (AMCON) was established in 2010, to purchase banks’ nonperforming loans (NPLs) in exchange for zero coupon bonds and inject funds to bring capital to zero. With this, regulations and supervision were strengthened and enhanced corporate governance. In

the same year, universal banking was dropped and banks were instructed to establish holding companies or divest their nonbank activities.

From the above background  it is obvious that the financial liberalization policy  in Nigeria acts to strengthen the market mechanisms and uphold ethical standards. It is therefore basically directed towards the freeing of interest rate controls, free entry of foreigners  to  domestic  financial  markets,  abolishing   direct  controls  on  credit, administering  competition,  removing  limit  on the  scope  of banking  activities  and developing the capital market. Hence  considering the aim of this policy in Nigeria, there  is  need  for  proper  understanding  of  its  impact  on  the  performance  of  the financial sector.

1.2      Statement of the Problem

During the early 1980s, the Nigerian economy stifled and the financial sector  was characterised  by financial repression which slowed down the efficient  allocation of resources and increased financial markets segmentation. As the situation got worst off even after the adoption of stringent measures, in 1982, there was need for financial liberalization policy (Okpara, 2010).

As part of the programme under SAP, in 1987, financial liberalization was choicely employed to free up financial sector by removing the vestiges of financial repression. This is in order to improve the institutional  low rate of  mobilisation,  efficiency in resource allocation for growth of the private sector as well as influence and stabilise the behaviour of the entire economy. While the programme gave financial institutions ability to come up with several new products, services and competitive exercises, the proliferation of these  innovations  in the face of the macroeconomic  situation could largely be responsible for either promoting or hampering the financial intermediation, capital mobilization and economic growth. However, the policy could not on its own have  efficiently stimulated  financial  sector and economic  performance  consistently overtime.  For  instance  Owolabi  (2014)  shows  that  between  1971-2012,  the  pre- liberalization policy had more effect in stabilizing three  banks’ (First bank, Union bank and United Bank for Africa) performance  (profits) than the post-liberalization period. Onwumere, Okore, and Ibe (2012) show that as a result of deposit and lending rate owing to the liberalization  policy,  the aftermath was counterproductive  to the

Nigerian  economy.  On the contrary,  the  policy was  seen to  have favoured  banks (Dabo, 2012; Omowumi, 2012) and capital market performance (Idowu&Babatunde, n.d). It is worthy of note that these studies did not consider  the period prior to the policy implementation.The  inability to investigate the  events in this period poses a problem when considering only the post liberalisation policy era hence carrying out the pre and post liberalisation policy comparative analysis that will guide future policy framework.

In addition to this, research so far on the impact of the policy on financial  sector’s performance in terms of intermediation (the ability to attract more savings, allocate credit  efficiently  and  development  of  the  capital  market  size)  is  minimal  when compared  to  either  the  impact  of  financial   liberalisation  policy  or  impact  of intermediation  on economic growth,  industrial and agricultural sector performance. The implication of this is that these studies do not provide answers on issues related to how macroeconomic variables such as interest rate, inflation, GDP, and terms of trade affect financial intermediation as well as market size/investment during the period of financial  repression  and  liberalisation  implementation.  Considering  these  is  vital because  repression  and liberalisation  can have positive  or negative  impact  on  the financial sector depending on the nature of the macroeconomic environment in place.

It is proper therefore, to identify how this policy may have stimulated the  financial sector performance indicators before and after the policy implementation.In  view of the above, the following relevant questions deserve to be addressed to guide this study

1.3      Research Questions

Based  on the stated  problems  above,  the research questions  below  will guide  the study.

1. To what extent has financial liberalization policy made impact on the performance of the banking sector in Nigeria?

2.To what extent has financial liberalization policy made impacton the performance of the capital marketinNigeria?

1.4      Objectives of the Study

The broad objective of this study is to ascertain the impact of financial liberalization on the performance of the financial sector in Nigeria. Specifically, the objectives of this study include:

1. To examine impact of financial liberalization policy on performance of the banking sector in Nigeria.

2.  To  investigate  impact  of  financial  liberalization  policy on  performance  of  the

capital market inNigeria.

1.5      Research Hypotheses

With regard to stated objectives, the hypotheses below will guide our study.

HO1: Financial liberalization policyhas no significant  impact on performance of  the banking sector in Nigeria.

HO2: Financial liberalization policy has no significant impact on performance of the capital market in Nigeria.

1.6      Significance of the Study

There is no doubt that a well-functioning financial sector influences growth through increased   capital  accumulation  and  efficiency  of  capital  allocation.   The  study contributes to the literature by giving insight to how the efficient intermediation role, capital mobilisation and the sizes of the various subsectors of the Nigerian financial sector fared before and after liberalization policy. This is to point out the need for more recommendation for further liberalization policy. This study will therefore be of interest to academics by adding to the body of knowledge on the Nigerian financial sector in which the capital market is relatively small in size compared to the banking, dominant subsector. Also, this will be of interest to the academics through bridging the present existing gap in  the literature.   Finally,  not only has the study provided beneficial policy instruments that policy makers will design and adopt, it will also be of  help  to   market  participants  especially  domestic  investors  with  little  or  no knowledge of the capital market response to economic policy. To the  government,

itprovides  necessary  information  on  how  to  provide  necessary  macroeconomic environment that will improve the financial sector and invariably support the growth of  the  private  sector  as  well  as  domestic  and  foreign  investors  thus  leading  to economic growth.

1.7      Scope of the study

This  research  is a country-specific  study concentrating  on the  financial  sector  in Nigeria. The financial sector in this context comprises of the Deposit Money Banks and capital market. The study uses quarterly data spanning the period of 1970Q1 to

2013Q4. In order to present more robust results, the econometric estimate is broken into two sections with regard to structural breaks and policy change during the period under  review.   Thus,  the  estimates  is  categorised   into  pre  and   post  financial liberalization periods respectively. Although there are many instruments of financial liberalization policy, banking sector and capital market performance that have been employed in empirical research but for the purpose of this study, the banking sector is captured   by  two  performance   indicators   and   the  capital  market   by  a  single performance indicator. For the banking sector performance, commercial banks’ credit to  the  private  sector  and  total  deposit  serve  as  proxies  while  the  capital  market isproxied by ratio of market capitalization to GDP. The independent variables include real  GDP  per  capital  (rpgdp),  deposit  rate  (depr)  and  lending  rate  (lendr),  trade openness (tot) and inflation (inf). The primary variable,financial liberalization policy is captured by a dummy.

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