Abstract

This study arose from the need to address the challenges created by the distortion of money demand and the pressure on inflation that follow a banking crisis. These challenges include a liquidity squeeze and higher interest rates, which undermine the implementation of monetary policy, reduce investment and sharply contract economic activity. The study estimated the effects of banking crisis on money demand and inflation in Nigeria from 1970Q1 to 2014Q2. Its specific objectives were to construct a banking crisis index, to ascertain the optimal threshold level of banking crisis, to compare the behaviour of narrow and broad money demand, and to estimate the trend of inflation during banking crisis in Nigeria. Four research questions and three hypotheses were formulated. The banking crisis index was constructed using an approach adapted from Burnside and Dollar, and the threshold level was estimated with Hansen's threshold regression approach. A macro-econometric model was used to investigate money demand and inflation.

The banking crisis index showed a continuum of varying severity, ranging from -0.0513 to -0.5253. The optimal threshold level was put at 1 to 2 per cent, beyond which banking crisis was not conducive to the economy. In the in-sample simulation, broad and narrow money demand averaged 1.18 per cent and 1.36 per cent respectively, with a p-value of 0.932. For inflation, the values were 0.14 per cent when broad money was used in the specification and 0.34 per cent when narrow money was used. In the out-of-sample simulation, the increase (decrease) scenario gave 12.13 per cent (-10.62 per cent) for broad money demand and 16.33 per cent (-6.23 per cent) for narrow money demand, with a p-value of 0.271 (0.079). For inflation, the increase (decrease) scenario gave 13.88 per cent (-14.13 per cent) using broad money and 7.02 per cent (-2.9 per cent) using narrow money. The findings indicate that there was no difference between the behaviour of broad and narrow money demand during banking crisis, and that banking crisis adversely affected inflation. It is therefore recommended that, during a banking crisis, the monetary authority should seek to limit inflation by ensuring that the monetary policy rate is not increased.

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Banking crises have affected the world for centuries, touching virtually every region and generation. They are as old as banking itself and occur in developed and developing countries alike, and they still occur today. Laeven and Valencia (2020) document 151 systemic banking crises worldwide between 1970 and 2017, and a further update that extends the record to 2025 identifies 164 systemic banking crises, including borderline cases (Laeven & Valencia, 2026). In the United States, for example, the first banking panic occurred in 1792, and banking crises remained a persistent feature of the American banking landscape from then on, except for the period from 1945 to the 1970s, which was relatively free of bank crises.

In Nigeria, modern banking began with the establishment of the African Banking Corporation in 1892, which was also the first bank to fail in the country. Between 1930 and 1959 the Nigerian banking system experienced repeated failures, and of the 26 banks established in the colonial period, only four survived. The distress of the period before the 1950s was repeated in the late 1980s, so that by December 1995, 60 of the 115 banks then in existence were distressed, and most were closed by the Central Bank of Nigeria (CBN). The Nigeria Deposit Insurance Corporation (NDIC) put the number of banks closed between 1994 and 2003 at 34. As at March 2004, of 89 banks in existence, 14 were marginal and 11 were unsound, according to the CBN.

This mass distress laid the foundation for the banking sector consolidation of 2004. Amaegberi and Krokeyi (2023) note that the reform of 6 July 2004 required all deposit money banks to have at least N25 billion in paid-up capital by the end of 2005, and that the Asset Management Corporation of Nigeria (AMCON) Bill was passed into law in 2009. By December 2005, the deadline for the consolidation exercise, the number of banks had fallen from 89 to 25 (NDIC, 2009). The 2007 global financial crisis, which began in the United States, then also affected the Nigerian banking system, and the CBN's takeover of eight banks in 2009 showed that the system was still troubled. The picture of the reforms in the recent literature is nevertheless mixed. Alley, Hassan, Wali and Suleiman (2023) find that the 2004 and 2009 reforms enhanced the prudential performance of the banking industry and the stability of the financial system. Contrary to the expectation that consolidation would produce stronger banks and a more resilient system, however, distress continued to affect the banking system, and press reports pointed to signs of stress in 2013 and 2014.

The episodes of crisis in the Nigerian banking system have been attributed to two broad categories of cause, internal and external. The internal causes are weak management, inadequate capital and poor management of assets and liabilities, all of which are within the control of the operators. The external causes include macroeconomic instability and an inadequate legal framework, and they arise from the socio-political and economic environment in which banks operate. International factors also contribute to crisis, as the 2007 global financial crisis showed in Nigeria.

A banking system in crisis cannot discharge its roles efficiently and effectively. Those roles, as identified by the West African Institute for Financial and Economic Management and others, include financial intermediation, the provision of an efficient payment system and serving as a vehicle for implementing monetary policy. Other effects of banking crisis in Nigeria, as captured in the theoretical literature, include deposit runs, large portfolio shifts to safer assets, a fall in the quality of bank credit, unemployment, demonetisation, instability in money demand, distortion of money supply, a slower rate of capital formation, low output, and a slower pace of economic growth and development.

During the banking crisis era in Nigeria, the M1 and M2 monetary aggregates changed markedly, as Appendix 1 shows. The growth rates of M1 and M2 were at their lowest, at -3.8 per cent and 6.6 per cent respectively, in 1987, and rose smoothly to 40.9 per cent and 38.4 per cent in 1988. From 1989 to 2003 the growth rate of M1 oscillated between 18.4 and 52.8 per cent, and that of M2 between 16.8 and 46.4 per cent. The growth rates of M1 and M2, which were 29.4 per cent and 23.7 per cent respectively in 2003, fell to 5.3 per cent and 10.3 per cent in 2004, and then rose, though not smoothly, until 2008, when M1 grew by 58.3 per cent and M2 by 59.7 per cent. These movements suggest a likely distortion of money demand and money supply during the banking crisis. Appendix 1 also shows that the inflationary episodes of 1989 to 1990 and 1992 to 1995 occurred during the banking crisis period. Inflation reached 70.5 per cent in 1990, fell to 12.7 per cent in 1991 and rose to 72.8 per cent in 1995. It can therefore be said that banking crisis in Nigeria has been associated with inflation, and it has been argued that banking crisis fuels inflationary pressure in the country. The effects of banking crisis in Nigeria have also been documented in the theoretical literature.

This study contends that the effects of banking crises are always presented as if they were homogeneous. In other words, no consideration has been given to an optimal threshold level of banking crisis, beyond which the crisis becomes detrimental to the economy. The effects of banking crisis can be classified as non-monetary and monetary. The non-monetary effects include those on output and human capital, while the monetary effects include, but are not confined to, those on money demand and inflation. Although the study of money demand has become common, there is an acute shortage of empirical attention to its underlying assumptions and properties during banking crisis, especially in Nigeria. Recent work on Nigeria shows that the stability of money demand is still contested. Ujunwa, Onah, Ujunwa, Okoyeuzu and Kalu (2022) find stable money demand across narrow, broad and total money measures even after financial innovation is allowed for, whereas Oyadeyi (2025), using data for 1981Q1 to 2023Q4 and allowing for structural breaks, finds that the velocity of money functions were unstable. Because money demand and the price level matter so much for the implementation of monetary policy, it is imperative to establish empirically the status of money demand and inflation during banking crisis. The search for a reliable inflation function remains an intensive activity, and little is still known about the contemporary relationship between inflation and its determinants in Nigeria. Establishing the behaviour of inflation in the context of banking crisis is therefore a worthwhile undertaking. The concern of this study is to estimate the monetary effects of banking crisis in Nigeria, with focus on money demand and inflation.

1.2 Statement of the Problem

The history of banking around the world has been interrupted at fairly frequent intervals by episodes of crisis that affect every facet of the economy, including the banking system, money demand, inflation, output, human capital and the stock market. Banking crisis makes it difficult to achieve the potential benefits of an efficient banking system. It creates a liquidity squeeze, reduces lending, raises interest rates and reduces output, which in turn destabilizes money demand and puts pressure on inflation. This poses a challenge to monetary policy, the payment system, financial intermediation, investment, economic activity and price stability.

Banking crisis often causes currency flight and a surge in the demand for cash, which raises the ratio of cash to narrow money (CBN/NDIC, 1995). This distorts money demand and makes the implementation of monetary policy difficult. The cash intensity of the Nigerian economy, measured by currency outside banks (COB) as a percentage of narrow money (M1) and broad money (M2), is shown in Appendix 2. COB/M1 and COB/M2 follow the same trend, but COB/M1 was higher than COB/M2 in every year from 1970 to 2008. In 1989, 1994 and 2008, COB/M1 was 39.7 per cent, 64.4 per cent and 19.5 per cent respectively, while COB/M2 was 20.7 per cent, 38.3 per cent and 10.4 per cent. Cash intensity thus rose sharply during the crisis years, to a peak in 1994, before easing by 2008. It stems from the belief of bank customers that their deposits will be lost because of the crisis. This leads to the withdrawal of deposits and to cash intensity, so that a great deal of money ends up outside the banking system. In this situation, the liquidity squeeze, the reduction in bank credit and the rise in interest rates, among other things, disrupt the demand for money. This affects the payment system and compromises the overall stance of monetary policy and the inflation objective, because money outside the banking system is difficult for the monetary authorities to control.

It is also held that during a financial crisis the simple money demand function no longer captures the behaviour of real money, and that the stable relationship observed in normal periods breaks down. The implication is that the traditional money demand function tends to produce misleading results and that money becomes an unsuitable indicator of monetary policy, which leads to ineffective implementation of policy. Oyadeyi (2025) provides recent Nigerian evidence of such instability in the demand for money. Banking crisis reduces output and affects inflation, and the level of economic activity falls. It is also argued that a banking crisis that destabilizes the relation between prices and the variables that explain them leads to ineffective monetary policy, and that it weakens the ability to attain inflation objectives. The result is a decline in economic activity.

It is commonly known that inflation drives the real interest rate. Appendix 2 shows that the real interest rate in Nigeria worsened during the banking crisis of 1989 to 2008, compared with the non-crisis era of 1970 to 1988. The real interest rate fell from -31.2 per cent in 1984 to -41.5 per cent in 1988. By 1990 it had fallen to -51.7 per cent, and by 1995 to -60.19 per cent. The real interest rate determines the efficiency of financial intermediation, so its poor state, brought about by the adverse effect of banking crisis on inflation, hinders financial intermediation. It becomes difficult for banks to play their traditional role of providing resources for long-term investment and economic growth. Put differently, difficulty in financial intermediation leads to low investment, which reduces economic activity. This puts further stress on inflation, makes the inflation objectives unattainable and renders the stance of monetary policy meaningless.

This study observes that the movements of the M1 and M2 growth rates and of inflation shown in Appendix 1 can be linked to banking crisis, but that they are not convincing evidence of its effect on money demand and inflation. They cannot be regarded as proven behaviour of money demand and inflation during banking crisis in Nigeria. Nonetheless, they are likely to pose a challenge to the effectiveness of monetary policy. A research problem is often best stated in the form of a question, and the problem of this study is accordingly stated thus: How has banking crisis influenced the behaviour of money demand and inflation in Nigeria?

1.3 Research Questions

To guide the study, answers were sought to the following questions:

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

ii. What is the optimal threshold level of banking crisis for Nigeria?

iii. How does the behaviour of narrow money demand (M1) differ from that of broad money demand (M2) during banking crisis?

iv. What is the behaviour of inflation during banking crisis?

1.4 Research Objectives

The broad aim of this study is to estimate the effects of banking crisis on money demand and inflation in Nigeria. The specific aims are to:

1. Construct a banking crisis index;

2. Ascertain the optimal threshold level of banking crisis;

3. Compare the behaviour of narrow money demand and broad money demand during banking crisis; and

4. Estimate the behaviour of inflation during banking crisis in Nigeria.

1.5 Hypotheses

The following hypotheses were postulated and tested:

HO1: There is no optimal threshold level of banking crisis.

HO2: There is no statistically significant difference between the behaviour of narrow money demand and broad money demand during banking crisis.

HO3: Banking crisis does not change the behaviour of inflation.

1.6 Scope of the Study

This study focused on the estimation of the monetary effects of banking crisis in Nigeria and spanned 1970Q1 to 2014Q2. The variables used to construct the banking crisis index were real gross domestic product (RGDP), the ratio of capital equity to total assets and the ratio of non-performing loans to total loans. For the objective of the optimal threshold level of banking crisis, the variables were RGDP, the banking crisis index, investment, the ratio of broad money (M2) to gross domestic product (GDP), the consumer price index (CPI), the ratio of government expenditure to GDP, the parallel market exchange rate and the foreign exchange market rate. The two small-scale macro-econometric models used to achieve the money demand and inflation objectives consisted of a money demand equation, an inflation equation, an interest rate spread equation, an output equation and an identity equation. The variables used in these models were real money balances (M1 and M2), RGDP, the interest rate spread, the expected inflation rate, the inflation rate, parallel market exchange rate depreciation, the real interest rate differential, the monetary policy rate, the treasury bill rate, the CPI, the foreign exchange market rate, the banking crisis index, broad money supply, narrow money supply, real broad money supply, real narrow money supply, credit to the private sector, the output gap and investment. Shareholders' funds and capital formation were used as proxies for capital equity and investment respectively.

1.7 Significance of the Study

The study will be of great importance to stakeholders in the banking industry in several ways. First, the monetary authority could add the banking crisis composite index to its tools of monetary policy management. It is commonly known that during a boom it is not easy for the monetary authority to cut back monetary growth, because of resistance from fiscal authorities and investors, but that when the bubble bursts, the blame falls on the authority. An index that all stakeholders can observe would therefore be a better indicator.

Second, the result on the optimal threshold level of banking crisis will be important to policy makers, especially the central bank. It will guide the central bank in selecting an optimal target for banking crisis that is consistent with its long-term goal of sustainable growth. Emekaraonye, Dick and Agu (2024) show that the 2004 consolidation and the 2009 regulatory measures changed how monetary policy instruments transmit to prices and credit, which supports the need for crisis-sensitive policy guidance.

Third, understanding the status of money demand and inflation during banking crisis is indispensable to the banking system. It will help in designing intervention policy that can stabilize the banking system and enable it to carry out its traditional roles, such as financial intermediation, properly. The results could also be used to predict the monetary effects of banking crisis, which will give policy makers useful information for improved risk management. They will also help the CBN to fine-tune its strategies for achieving its inflation objective, especially price stability.

Fourth, the money demand function is a crucial variable in the formulation of many macroeconomic theories, so the results will give academics the knowledge of money demand during banking crisis that they need to formulate macroeconomic theories. Policy makers can draw on such theories to design policy that is as accurate as possible in achieving its targets, and so to enhance macroeconomic policy effectiveness during a crisis.

Finally, the new picture that the study gives will benefit banks and the personnel of financial regulatory institutions, since it will help in addressing banking crisis and the job losses associated with it.

References

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Amaegberi, M., & Krokeyi, W. S. (2023). Banking sector reforms and economic growth in Nigeria. Mediterranean Journal of Social Sciences, 14(6).

Emekaraonye, C. F., Dick, E. I., & Agu, C. (2024). An empirical analysis of the interaction between monetary policy and commercial bank lending in Nigeria. African Economic Research Consortium. https://publication.aercafricalibrary.org/handle/123456789/3790

Laeven, L., & Valencia, F. (2020). Systemic banking crises database II. IMF Economic Review, 68(2), 307–361. https://doi.org/10.1057/s41308-020-00107-3

Laeven, L., & Valencia, F. (2026). Systemic banking crises database: 1970–2025 (IMF Working Paper No. 2026/094). International Monetary Fund.

Oyadeyi, O. (2025). The velocity of money and lessons for monetary policy in Nigeria: An application of the quantile ARDL approach. Journal of the Knowledge Economy, 16(2), 8249–8285. https://doi.org/10.1007/s13132-024-02201-7

Ujunwa, A., Onah, E., Ujunwa, A. I., Okoyeuzu, C. R., & Kalu, E. U. (2022). Financial innovation and the stability of money demand in Nigeria. African Development Review, 34(2), 215–231.