ABSTRACT

This study investigates the impact of financial liberalisation policy on the performance of the financial sector in Nigeria. It applies Analysis of Covariance (a structural break specification mixing dummy-coded and continuous variables) estimated by ordinary least squares (OLS) with corrections for arbitrary levels of serial correlation. The data are quarterly and cover 1970Q1 to 2013Q4, and the study uses domestic and external macroeconomic variables. The results show that real per capita income is positively linked to the ability of banks to lend to the private sector, and that trade openness may stimulate higher bank deposits and investment in the capital market if institutional quality and a sound macroeconomic environment are in place. The lending rate, the deposit rate and inflation have a larger dampening effect on financial sector performance during the period of financial liberalisation. The study also finds that the financial liberalisation policy adopted in 1987 has a significant impact on the performance of the banking sector but no significant impact on the performance of the capital market. This supports the sceptical empirical view of the policy in Nigeria, namely that its effects may be associated with non-interest-rate and other macroeconomic factors. In terms of policy, because macroeconomic variables are important determinants of financial sector performance, government should create an environment that attracts foreign investors and boosts domestic ones. Excessive consumption should be restrained in order to encourage savings in banks and investment in the capital market. Non-interest-rate factors should also be strengthened, and further liberalisation, together with fiscal and monetary discipline, should be pursued in order to achieve a positive and significant performance of the capital market.

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

National policy decisions such as financial liberalisation have long been used to improve the financial sector in many countries. The argument in their favour is that liberalisation promotes risk diversification across countries, specialisation, efficiency in the allocation of capital and growth. The contrary view is that liberalisation can harm growth in the presence of distortions, trigger financial instability and misallocate capital, to the detriment of macroeconomic performance. Recent cross-country evidence leans toward the favourable view but with qualifications. Mukherjee et al. (2021), using panel data for nine emerging economies, find that liberalisation raises financial depth and that capital account openness does not destabilise the financial sector, while Farhat (2023) finds that economic growth, trade openness and financial liberalisation all contribute positively to banking sector development in developing and emerging economies. Evidence from Sub-Saharan Africa has been more cautious, linking liberalisation to financial fragility where supervision and macroeconomic conditions are weak (Misati & Nyamongo, 2012).

Policymakers worldwide have used liberalisation as a unifying theme for establishing policy regimes that are free from financial repression and crises. The driving force of the policy is to transform developing economies by building a more efficient, robust and deeper financial system that can support private sector enterprises and the rapid maturation of capital markets. A growing consensus among researchers is that liberalisation brings several benefits, but that the improvement in financial performance may not come without cost. Its supporters argue that it promotes transparency and accountability, reduces adverse selection and moral hazard, eases liquidity problems in financial markets, makes capital markets in emerging countries more efficient and attracts foreign direct investment, and that it brings market integration and an investment boom through a lower cost of capital. Its critics hold that it is a key factor behind financial fragility and banking crises, lower banking profitability and bank failures. It follows that the financial sector may experience substantial gains, or substantial losses and crisis, as it moves from a controlled to a free system. In many countries, the widening of banking and capital market activity has accompanied liberalisation, although at one time it was noted that the policy favoured the growth of the money market over the capital market, probably because indirect finance through the money market is regarded as more important than direct finance through the capital market in developing countries. With the growing interest in the role of national policy in financial markets, attention is gradually shifting to capital market indicators as well.

In the Nigerian financial system, the two subsectors of the formal sector are the bank financial institutions (such as deposit money banks) and the non-bank financial institutions (such as the capital market). Their primary task is intermediation, that is, channelling funds from surplus units to deficit units in order to enhance economic activity. Banks take deposits and operate in the short term, which limits their capacity to supply long-term capital given the nature of their assets, whereas the capital market operates in the medium and long term. The financial sector is an important sector of the economy that can contribute strongly to sustained economic growth. It raises the availability of funding by mobilising idle savings, facilitating transactions and attracting foreign investment, and these benefits are more likely to be achieved if liberalisation is adopted. For example, liberalisation frees the financial sector to ease the availability of credit to the private sector. For financial services to be provided efficiently and effectively, however, the sector must adjust to financial policies, and any further liberalisation imposed on it will extend to its performance and so affect other parts of the economy.

The Nigerian financial system was highly regulated before 1987. Government regulated interest rates, imposed credit ceilings, owned financial institutions and framed regulations in order to acquire financial resources cheaply. Because of this heavy control and the interest rate distortions that followed, the financial system may not have mobilised and supplied funds at the desired level, which stifled economic growth. To correct this, financial liberalisation was introduced with the support of the World Bank and the International Monetary Fund (Ikhide & Alawode, 2001). In the decade before independence, the Nigerian banking sector was already subject to heavy government regulation. After independence, extensive regulation by the Central Bank of Nigeria (CBN) and direct participation by federal and state governments brought in a series of interventionist policies. These policies amounted to financial repression, in that resources were channelled away from areas where private rates of return would have been highest. The banking sector was controlled through the Banking Ordinance of 1952 (in terms of the quantity, cost and direction of resource allocation) and through monetary policy instruments, namely aggregate ceilings on bank credit expansion, sectoral credit guidelines, interest rate controls and the indigenisation policy. The capital market depended on government policies such as borrowing through development stocks and indigenisation. The indigenisation policy, first introduced in 1972 and revised in 1977, was the first policy to regulate financial operations. It required the transfer of equity in foreign-owned enterprises to Nigerians and was intended to encourage Nigerian entrepreneurs to enter business alongside foreign financial institutions, which were dominated by foreign investors. To achieve this, government limited the scope of foreign investment and capped foreign participation at 40 percent equity in a listed security. The policy was amended in 1989 to accommodate a larger foreign presence in the capital market.

By the early 1980s, the weaknesses of indigenisation, the collapse of world oil prices, a large portfolio of non-performing loans, uncompetitive financial institutions, economic recession and financial repression led government to adopt an economic recovery programme, the Structural Adjustment Programme (SAP). The SAP of 1986, backed by the World Bank and the IMF, was designed to restructure and revitalise the fiscal sector and to liberalise regulation of the financial sector through new institutions and structures. Its key measures were the liberalisation of external trade and exchange controls and the adoption of methods to encourage domestic production and expand the supply base of the economy. It also created financial measures that affected both the banking sector and the capital market, namely interest rate deregulation, the Second-Tier Foreign Exchange Market (SFEM), privatisation and debt conversion (debt-to-equity swaps). In 1987 financial liberalisation was introduced as part of the SAP economic blueprint. Its main reforms were the liberalisation of interest rates, the replacement of credit ceilings with Open Market Operations (OMO), the decontrol of exchange rates, the development of the capital market and the promotion of competition and efficiency by relaxing bank licensing and entry barriers. The number of banks rose from 34 in 1987 to 90 in 2003 and then fell to 20 by 2012. These reforms were implemented gradually, as the following account shows.

A market-based interest rate policy was introduced in 1987, so that banks could charge market-based rates, mobilise more savings, supply enough funds to investors and allocate resources more freely. It was also meant to discourage debt financing by firms and encourage equity financing. With high interest rates in the money market, firms turned to the capital market for equity, which put pressure on the Nigerian capital market and opened greater opportunities for private investors to borrow from it. In January 1994, because of wide variations and unnecessarily high rates, government reversed the policy and reintroduced interest rate regulation. The cap was retained in 1995 with minor changes to allow some flexibility and was removed in 1996, after which deposit and lending rates were determined by market forces. Recent work on the transmission of policy rates to bank rates covers both regimes: Jibrilla and Balami (2022) compare the pre-liberalisation period (1962 to 1987) with the post-liberalisation period (1987 to 2020), finding that the pass-through of the policy rate to retail rates is larger before liberalisation and that banking crises raise lending rates, and Nadani et al. (2026) find that the lending rate responds more strongly to policy rate changes after liberalisation, although asymmetry persists in both periods.

On 15 June 1988 the Nigeria Deposit Insurance Corporation (NDIC) was set up by Decree No. 22 of 1988 to provide deposit insurance and related services and so promote confidence in the banking industry. Its importance became clear during the widespread distress of the 1990s and the bank consolidation exercise of 2004 and 2005. In June 1989, privatisation, a tenet of the programme, was enacted to improve the management, efficiency and performance of the enterprises affected, reduce government debt, raise funds for infrastructure, enhance growth and instil market discipline. It was expected to develop the capital market by raising the quality and quantity of financial instruments traded and to achieve widespread shareholding. In the same year Bureaux de Change were licensed to widen access to foreign exchange for small users and to enlarge the foreign exchange market. In 1990 Prudential Guidelines were introduced to control depositor risk exposure and protect the financial system as a whole, and steps were taken to strengthen the capital base of banks. Revised Prudential Guidelines followed in 2010, covering risk management, corporate governance, Know Your Customer (KYC) rules, anti-money laundering and counter-financing of terrorism, and loan provisioning.

In 1991, the federal government deregulated the pricing of securities and disengaged the Securities and Exchange Commission (SEC) from the pricing of new stocks, leaving the market in the hands of stockbrokers and issuing houses. Further efforts improved settlement, brokerage services and clearing and reduced the risk of capital investment, and the Central Securities and Clearing System (CSCS) came into being in 1997. Together with the Automated Trading System (ATS), it improved market performance. In September 1992 bank licensing barriers and credit ceilings were deregulated, and bank loans and advances began to rise in the immediate aftermath, with a noticeable increase in credit to both the private and public sectors. The capital market and capital flows were liberalised in 1995. In that year government promulgated the Nigerian Investment Promotion Commission Decree No. 16, which was meant to liberalise the investment climate. It replaced the Nigerian Enterprises Promotion Decree and the Exchange Control Act of 1962, effectively internationalised the Nigerian capital market and made it a channel for foreign capital inflow, which in turn led to the institutionalisation of foreign currency deposits in 2000. Recent evidence suggests that liberalisation has indeed benefited the market: Akande et al. (2025) find, for 1986 to 2022, that financial liberalisation significantly enhances stock market returns in Nigeria. In 1999 the Investments and Securities Act (ISA) No. 45 aided the reconstitution of the SEC and introduced measures to improve listing disclosure and curb insider trading.

Because of the deep financial distress between 1993 and 1998, a further policy change was needed. In 2001 the Universal Banking Policy was introduced, which freed banks to operate banking, securities and insurance businesses so that all financial services could be delivered efficiently at lower cost and bank risk-return profiles could be improved through diversification. In 2004 bank consolidation was introduced to strengthen the banking sector, with the minimum capital requirement raised from N2 billion to N25 billion, to be met by the end of 2005. Consolidation sharply reduced the number of banks, from 89 to 20 by 2012, and the capital market served as an instrument for banks in meeting the N25 billion requirement. Consolidation created fewer and stronger banks, but its effect on competition was ambiguous, and its effect on performance was mixed: Okoye et al. (2020), comparing banks before and after the 2004–2005 reform, find that profitability is significantly lower in large banks after the reform and higher in smaller ones. In 2007 the SEC approved a new minimum capital base for all capital market operators in order to strengthen the market to face global competition.

After the banking crisis of 2009, the Asset Management Corporation of Nigeria (AMCON) was established in 2010 to purchase banks’ non-performing loans (NPLs) in exchange for zero-coupon bonds and to inject capital into insolvent banks (Ungersboeck & Runkel, 2021). Regulation and supervision were strengthened, and corporate governance was enhanced. In the same year the universal banking model was dropped, and banks were instructed to establish holding companies or divest their non-bank activities.

From this background it is clear that financial liberalisation in Nigeria was meant to strengthen market mechanisms and uphold ethical standards. It was directed at freeing interest rates from control, allowing foreigners to enter domestic financial markets freely, abolishing direct controls on credit, administering competition, removing limits on the scope of banking activities and developing the capital market. Given these aims, there is a need for a proper understanding of the impact of the policy on the performance of the financial sector.

1.2 Statement of the Problem

During the early 1980s the Nigerian economy stagnated, and the financial sector was characterised by financial repression, which slowed the efficient allocation of resources and increased the segmentation of financial markets. The situation worsened even after stringent measures were adopted, and the need for financial liberalisation was recognised from about 1982.

As part of the SAP, financial liberalisation was deliberately employed in 1987 to free the financial sector by removing the remnants of financial repression. The aim was to improve the low rate of resource mobilisation, raise the efficiency of resource allocation for private sector growth and stabilise the behaviour of the whole economy. The programme enabled financial institutions to introduce new products and services and to compete, but given the macroeconomic situation, the spread of these innovations could either promote or hamper financial intermediation, capital mobilisation and economic growth. The policy could not by itself stimulate financial sector and economic performance consistently over time. The evidence is mixed. Some studies find that the pre-liberalisation period stabilised bank profits better than the post-liberalisation period, and that the effects of liberalised deposit and lending rates were counterproductive for the economy. Others find that the policy favoured banks and capital market performance, as the evidence on stock market returns suggests (Akande et al., 2025). A common weakness is that many of these studies did not consider the period before the policy was implemented. This limitation poses a problem, because considering only the post-liberalisation era makes it impossible to carry out the pre- and post-liberalisation comparison needed to guide future policy. Recent work on interest rate pass-through has begun to compare the two regimes (Jibrilla & Balami, 2022; Nadani et al., 2026), but comparable studies of banking and capital market performance together remain few.

In addition, research on the impact of the policy on financial sector performance in terms of intermediation, that is, the ability to attract more savings, allocate credit efficiently and develop the size of the capital market, is minimal compared with research on the impact of liberalisation on growth or on industrial and agricultural performance. As a result, these studies do not answer how macroeconomic variables such as interest rates, inflation, GDP and terms of trade affect financial intermediation and market size and investment during the periods of financial repression and liberalisation. This matters, because repression and liberalisation can have a positive or negative effect on the financial sector depending on the macroeconomic environment in place. It is therefore appropriate to identify how the policy may have stimulated financial sector performance indicators before and after implementation. In view of the above, the following questions deserve to be addressed to guide the study.

1.3 Research Questions

Based on the problems stated above, the following research questions guide the study:

1. To what extent has financial liberalisation policy made impact on the performance of the banking sector in Nigeria?
2. To what extent has financial liberalisation policy made impact on the performance of the capital market in Nigeria?

1.4 Objectives of the Study

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

1. Examine the impact of financial liberalisation policy on the performance of the banking sector in Nigeria.
2. Investigate the impact of financial liberalisation policy on the performance of the capital market in Nigeria.

1.5 Research Hypotheses

In line with the stated objectives, the following hypotheses guide the study:

• H₀₁: Financial liberalisation policy has no significant impact on performance of the banking sector in Nigeria.
• H₀₂: Financial liberalisation policy has no significant impact on performance of the capital market in Nigeria.

1.6 Significance of the Study

A well-functioning financial sector influences growth through greater capital accumulation and more efficient allocation of capital. This study contributes to the literature by showing how the efficiency of intermediation, capital mobilisation and the size of the various subsectors of the Nigerian financial sector fared before and after liberalisation, and thereby points to the need for further recommendations on liberalisation policy. It will interest academics by adding to the body of knowledge on the Nigerian financial sector, in which the capital market is small relative to the dominant banking subsector, and by bridging an existing gap in the literature. It will also provide useful policy inputs for policymakers and will help market participants, especially domestic investors with little or no knowledge of how the capital market responds to economic policy. For government, it provides the information needed to create the macroeconomic environment that will improve the financial sector and support the growth of the private sector and of domestic and foreign investors, and thereby economic growth.

1.7 Scope of the Study

This is a country-specific study that concentrates on the financial sector in Nigeria. In this study the financial sector comprises the deposit money banks and the capital market. The study uses quarterly data for 1970Q1 to 2013Q4. To obtain more robust results, the econometric estimation is divided into two sections that reflect the structural break and the policy change during the period, so that estimates are reported for the pre- and post-liberalisation periods. Although many instruments of financial liberalisation, and many indicators of banking and capital market performance, have been used in empirical research, this study captures banking sector performance with two indicators and capital market performance with one. Commercial banks’ credit to the private sector and total deposits serve as proxies for banking sector performance, and the ratio of market capitalisation to GDP serves as the proxy for the capital market. The independent variables are real GDP per capita (rpgdp), the deposit rate (depr), the lending rate (lendr), trade openness (tot) and inflation (inf). The primary variable, financial liberalisation policy, is captured by a dummy variable.

REFERENCES

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