CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

A large body of research has examined the link between financial development and economic growth, and between financial development and poverty reduction through growth, from both micro and macro perspectives (Levine, 1997; Beck, Demirgüç-Kunt & Levine, 2007). This study departs from the finance–growth nexus but keeps the macro angle. It asks whether there is a direct relationship between financial deepening and aggregate welfare, and it looks at how welfare is linked to the deepening of the financial sector and at the transmission mechanisms involved.

Few would doubt that income growth made possible by access to financial services improves people’s lives. Higher income lets people raise their living standards and escape extreme poverty. Without a developed financial sector, domestic savers and foreign investors hesitate to part with their money even for sound investments, which lowers output as measured by GDP and reduces household welfare. A well-developed financial system, by contrast, enables firms to expand production and gives households the ability to obtain essential assets such as a house, to insure against income shocks, to start a business, to receive cheaper remittances and to enjoy a pension in retirement. In this sense the financial sector is an engine of both growth and household welfare. The evidence on this point is increasingly specific. Beck et al. (2007) found that financial development disproportionately raises the incomes of the poorest fifth of the population and reduces income inequality, with about 40% of the long-run effect on the poor coming through lower inequality and about 60% through faster aggregate growth.

Financial intermediation supports growth, and this leads to financial deepening, which refers to the greater mobilisation of financial resources in the formal financial sector, the easing of the liquidity constraints of banks, and the enlargement of the funds available to finance projects. Directly measuring how well the financial sector performs each of its functions is difficult. It is not possible to observe directly the quality and quantity of the monitoring a bank does when it extends a loan, especially in a large country such as Nigeria, so researchers rely on proxies. Commonly used indicators of financial deepening are the ratio of broad money (M2) to GDP, the ratio of private credit extended by commercial banks to GDP, and other financial assets.

Ndebbio (2004) argued that a shallow financial system, one with a narrow range of financial assets, helps to explain why output stagnates in many sub-Saharan African countries. He defined financial deepening simply as an increase in the supply of financial assets in the economy, so that the widest range of assets, including broad money, liabilities of non-bank financial intermediaries, treasury bills, shares and money market funds, would ideally be included in its measurement. He used broad money because data on the other assets were lacking for most African countries. This study follows the same definition. Where the supply of financial assets is small, deepening is likely to be shallow, and where it is large, deepening is likely to be high. Developed economies are characterised by high financial deepening, which reflects significant growth and improvement of the financial sector and which has in turn supported the growth of the whole economy. Because data on a wider set of financial assets are lacking, this study uses the ratio of private sector credit to GDP, along with the ratio of broad money to GDP, as its measures of financial deepening.

Nigeria’s financial sector has been repeatedly reformed in an effort to deepen it. It has been argued that the financial liberalisation of the 1980s, which included interest rate deregulation and the entry of new banks, widened financial openness without producing corresponding financial depth. In 2004 the Central Bank of Nigeria (CBN) required the 89 deposit money banks then in operation to raise their minimum capital to N25 billion each through fresh capital or mergers and acquisitions. By the close of the first phase of the programme on 31 December 2005, 25 banks had met the requirement, and the licences of 14 banks that failed to do so were revoked (Soludo, 2006). Kanu (2015) notes that in May 2005 the 89 banks had only 3,382 branches between them, which reflected the many small banks with limited reach. Banking reforms are part of broader financial sector reforms, which are driven by the need to deepen the financial sector, to strengthen it for growth, to integrate it into the global financial system and to mobilise savings in line with international best practice. Consolidation became the main reform instrument, and it was followed by other measures, including the rescue of eight deposit money banks with large non-performing loans in 2009.

The indicators of financial depth have fluctuated, but they rose after the reforms. Based on the researcher’s computation from the CBN statistical bulletin, the ratio of M2 to GDP stood at 43.4% at the end of 2009 and 38.9% in 2010, private sector credit to GDP at 33.2% in 2010 against 41.1% in 2009, and the ratio of deposit money bank assets to GDP fell from 69.6% in 2009 to 58.8% in 2010. The indicators of financial deepening (M2 to GDP and private sector credit to GDP) increased between 2005 and 2006, which suggests that the reforms influenced the level of financial deepening. In Nigeria the banking system clearly dominates the flow of funds, so that bank-led reform has an important effect on the level of economic development.

Welfare concerns in Nigeria have been closely tied to the country’s general lack of development and to the economic hardship of the 1980s and 1990s. Given steady population growth and declining incomes since 1980, it is difficult to avoid the conclusion that most people at lower income levels suffered a large loss in aggregate welfare. Household per capita expenditure can provide insight into the economic welfare and living conditions of the population, so it is used in this study as the measure of aggregate welfare. The assessment of aggregate welfare becomes necessary as the financial sector deepens, because households are important players in that sector, both as savers and as borrowers. Financial deepening ought to improve aggregate welfare directly by increasing the returns on savings and reducing their risk, particularly for low-income earners, since savings enable poor households to smooth their consumption. More consumption raises the demand for goods and services, which stimulates agricultural and industrial production, leading to more jobs and higher economic growth.

Reducing the high level of poverty remains a major developmental challenge, and it features prominently in the global development agenda, which includes ending poverty in all its forms by 2030. The poor need to be empowered, and for many Nigerians access to even a small amount of credit can make a considerable difference to their ability to earn a self-reliant income. As finance deepens, it is therefore necessary to establish whether the CBN and other regulators have struck a good balance between regulating the sector effectively and providing an environment that promotes widely accessible financial services with fewer systemic crises.

Financial deepening can affect welfare through several channels. In theory, it can affect vulnerability, investment and the smoothing of consumption. Whether it reduces or increases vulnerability is not obvious, because a larger volume of credit also raises the risk of borrowers falling into hardship. Against this, the most important channel through which deepening improves welfare directly is increased access to financial services, since access to savings services, for example, helps households and firms cope with economic shocks. A well-functioning financial system also creates strong incentives for investment, fosters trade and business linkages, provides broad access to assets and markets, and allows remittances and transfers to reach the poor more cheaply and securely. It allows the poor to save in a safe place, to borrow to start micro-enterprises and to insure against shocks, and wider access generates employment, raising incomes and welfare. The transmission mechanism works through the expansion of bank branches, especially in rural areas, which can also provide support services such as training and capacity building.

There are, however, sceptical views about whether financial deepening broadens access and delivers welfare gains. Greenwood and Jovanovic (1990) showed that, as a nation moves from a primitive, slow-growing economy to a developed, fast-growing one, it passes through a stage in which the distribution of wealth between rich and poor widens, which implies an inverted-U relationship between financial deepening and inequality. The empirical evidence for Nigeria is mixed and depends on the indicator. Saidu and Marafa (2020), using data for 1980 to 2018, found a long-run relationship between financial sector development and poverty reduction, and they point out that about 64.1% of Nigerian adults lacked access to formal financial services in 2012 and that private sector credit was then only 20.2% of GDP. Kazeem (2022) found, for 1999 to 2019, that broad money had a significant positive effect on per capita income and household consumption expenditure, whereas domestic credit to the private sector had a significant negative effect on per capita income and no significant effect on consumption. Dabwor and Abimiku (2016), for 1990 to 2013, found that the ratio of broad money to GDP reduced poverty, while the ratio of private sector credit to GDP showed the opposite effect.

On this basis the study restricts its analysis of the link between financial deepening and aggregate welfare to financial accessibility indicators such as bank branch expansion, the savings rate and the cost of acquiring credit, and it is designed to answer the following question: are there proportionate aggregate welfare benefits for all income levels from financial reforms that strengthen the economy as a whole?

1.2 Statement of the Problem

Many studies have established that financial deepening promotes faster average growth and that this has welfare implications (Levine, 1997; Beck et al., 2007). What has not been established is whether the aggregate welfare gains from financial deepening benefit the whole population equally or favour the rich or the poor. If deepening intensifies income inequality, that distributional effect will weaken its benefits for the poor, so theory yields conflicting predictions about its welfare implications (Greenwood & Jovanovic, 1990; Beck et al., 2007). Where financial reforms are not accompanied by an adequate regulatory framework and by fiscal and macroeconomic stability, deepening may have large effects on the distribution of wealth and adverse effects on welfare. Regulators in developing countries have to strike a balance between regulating the sector effectively and creating a good environment for deepening, and the indicators of deepening that work in some countries may not work in others.

In Nigeria, work on recent deepening has concentrated on its effect on economic growth (Ndebbio, 2004), on the assumption that growth will benefit the whole economy. Growth is necessary for welfare improvement, but it is not all that matters, and access to financial services is crucial. The recent consolidation of banks improved the speed and quality of bank services to customers, but these benefits have not reached people in rural areas. Bank branches are concentrated in urban areas with good infrastructure that can yield good returns, and a significant share of credit transactions still takes place in informal markets, despite government efforts to channel credit to the productive sector through deposit money banks. Saidu and Marafa (2020) report that about 64.1% of adults lacked access to formal financial services in 2012, which forces many of the poor to rely on narrow, risky and expensive informal services that limit their ability to participate fully in markets.

There have also been concerns about the cost and availability of credit. High interest rates and anomalies in lending for agricultural production, a sector expected to catalyse welfare improvement, persist, and banks have been setting minimum balances for savings accounts and curtailing lending in favour of risk minimisation. These developments may continue to reduce the financial accessibility of low-income earners and confine them to low-return activities. Private consumption expenditure in Nigeria has fluctuated considerably, which implies that private per capita consumption expenditure, a measure of aggregate welfare, will follow the same pattern. There is therefore a concern that the recent reform-led financial deepening will have an effect similar to that of the earlier liberalisation period, which left commercial bank accounts inaccessible to most Nigerians and produced severe welfare implications that appear indirectly through macroeconomic policy. It is thus unclear whether the recent deepening processes in Nigeria will improve aggregate welfare or broaden access to financial services.

In view of this, there is a need to investigate empirically the level of deepening that has occurred in Nigeria and the nature of its effect on aggregate welfare. The research questions below follow from this need.

1.3 Research Questions

i. What is the level of financial deepening that has occurred in Nigeria from 2005 to 2010?

ii. What are the determinants of financial deepening in Nigeria?

iii. Does financial deepening lead to aggregate welfare improvement in Nigeria?

1.4 Objectives of the Study

The main objective of the study is to answer one critical question: are there aggregate welfare benefits from financial reform policies that strengthen the economy? More specifically, the study intends to:

a) investigate the structural changes in the pre-consolidation and post-consolidation periods in Nigeria;

b) analyse the factors that determine the level of financial deepening in Nigeria; and

c) determine the nature of the effect that financial deepening has on aggregate welfare in Nigeria.

1.5 Hypotheses of the Study

H₀a: There are no structural changes in the level of financial deepening in the country after 2005.

H₀b: Macroeconomic variables do not determine the level of financial deepening in Nigeria.

H₀c: Financial deepening has no direct effect on aggregate welfare in Nigeria.

1.6 Policy Relevance

The call for financial sector reform should be examined critically, especially its effect at every level of the economy. This study is important at a stage of economic development when efforts are being made to reposition the financial sector so that it can play a key role in development at all income levels. It will help policy makers and government to understand the structural changes that have taken place under the reform policies in Nigeria, and it will provide information useful in designing a more targeted financial reform policy that benefits the poor. It will also add to the literature on the link between finance and aggregate welfare.

1.7 Scope of the Study

This country-specific study covers the period 1975 to 2010. The period was chosen on the basis of data availability and to provide enough observations for time-series analysis.

1.8 Source of Data and Econometric Software

The data will be obtained from the Central Bank of Nigeria Statistical Bulletin, and the econometric software to be used is Stata 10 and EViews 8.

References

Beck, T., Demirgüç-Kunt, A., & Levine, R. (2007). Finance, inequality and the poor. Journal of Economic Growth, 12(1), 27–49. https://doi.org/10.1007/s10887-007-9010-6

Central Bank of Nigeria. (2006, January). The outcome of the banking sector recapitalization and the way forward (Press conference by Professor Charles C. Soludo, Governor). Abuja: Central Bank of Nigeria. https://www.cbn.gov.ng/OUT/SPEECHES/2006/Govadd%2016-1-06.pdf

Dabwor, D. T., & Abimiku, C. A. (2016). Poverty incidence in Nigeria: Does financial deepening matter? Journal of Economics and International Finance, 8(6), 56–65.

Greenwood, J., & Jovanovic, B. (1990). Financial development, growth, and the distribution of income. Journal of Political Economy, 98(5, Pt. 1), 1076–1107. https://doi.org/10.1086/261720

Kanu, C. (2015). Nigeria’s 2005 bank recapitalization: An evaluation of effects and social consequences. Research Journal of Finance and Accounting, 6(17).

Kazeem, B. (2022). Impact of financial development on inclusive growth in Nigeria. Journal of Economic Research & Business Administration, 139(1), 73–82. https://doi.org/10.26577/be.2022.v139.i1.07

Levine, R. (1997). Financial development and economic growth: Views and agenda. Journal of Economic Literature, 35(2), 688–726.

Ndebbio, J. E. U. (2004). Financial deepening, economic growth and development: Evidence from selected sub-Saharan African countries (AERC Research Paper No. 142). African Economic Research Consortium.

Saidu, I., & Marafa, A. A. (2020). The effect of financial sector development on poverty reduction in Nigeria: An empirical investigation. International Journal of Economics and Financial Issues, 10(4), 9–17.