THE FINANCIAL SYSTEM AND ECONOMIC GROWTH IN NIGERIA

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

A financial system is a network of institutions, markets, instruments, rules, and regulations that collectively facilitate the flow of funds, the mobilization of savings, and the efficient allocation of resources within an economy to foster economic growth and development (Megnigang, 2024). Financial systems consist of financial markets, financial intermediaries, financial instruments, and the regulatory and governance frameworks that facilitate and regulate the flow of funds through the macro-economy (Oyadeyi, 2025). A good financial system, according to Levine (1997), is one that performs five key functions: (i) pooling and mobilizing savings, (ii) producing and processing information about investments, (iii) monitoring investments and exerting corporate governance, (iv) facilitating the trading, diversification, and management of risk, and (v) facilitating the exchange of goods and services.

Economists argue about the relationship between the financial system and economic growth. Economic growth can be defined as the sustained expansion of an economy’s productive capacity, enabling it to generate higher levels of output, employment, and income over time (Olayemi and Eze, 2023). Economic growth also refers to a sustained increase in real gross domestic product (GDP) resulting from the efficient deployment of productive resources within an economy (Okonkwo, Salisu, and Omotor, 2023).

The role of the financial system in promoting economic growth has generated considerable controversy among scholars and practitioners. Economists hold four different views on the relationship between finance and growth: the supply-leading view, the demand-following view, a bi-directional relationship, and no relationship between finance and growth (Jima and Makoni, 2023; Liu et al., 2022). The supply-leading view asserts that financial development positively impacts economic growth. This theoretical standpoint traces its origins to Schumpeter’s seminal argument that financial intermediaries serve as engines of growth by mobilizing savings, evaluating investment projects, managing risk, monitoring managers, and facilitating transactions – functions that stimulate technological innovation and long-run economic development (King and Levine, 1993). Specifically, Schumpeter contended that production requires credit to materialize and that financial intermediaries are agents of growth. Demirguc-Kunt and Levine (2022) stress that financial systems help mobilize and pool savings, produce and process information about investors and investment projects to enable efficient allocation of funds, monitor investments and exert corporate governance after funds are allocated, and help diversify, transform and manage risk. The financial system plays a crucial role in alleviating market frictions and influencing savings rates, investment decisions, technological innovations, and long-run growth rates (Adedokun and Aga, 2023).

Contrary to the supply-leading view is the demand-following hypothesis, which holds that finance simply responds to changes in the real sector, suggesting that economic growth itself creates a demand for financial institutions and services (Jima and Makoni, 2023). The demand-following view states that finance actually responds to changes in the real sector, and that economic growth creates a demand for developed financial institutions and services. According to this view, where enterprise leads, finance follows, with financial development seen as an endogenous response to demand requirements emerging from a growing economy (Afolabi, 2022).

A third strand supports a bi-directional or feedback relationship between the financial system and economic growth. Recent evidence from a time-frequency analysis of 20 developing countries using monthly data from 2000 to 2023 found that while short-run tests revealed no causality in 40% of cases (consistent with the neutrality hypothesis), in the long run 60% of cases displayed strong bidirectional causality, supporting the feedback hypothesis (Studies in Economics and Finance, 2026). Finally, a fourth view rejects the existence of a finance-growth nexus altogether, suggesting that the financial sector is merely epiphenomenal to real economic activity (Ezzahid and Elouaourti, 2022).

The debate revolves around the relative roles of banks and capital markets in promoting economic growth. Among scholars who support the importance of the financial system to economic growth, a different line of argument emerged, centred on the categorization of the financial system into bank-based and market-based systems and the comparative importance of both to economic growth. Attempts were made to find out whether one type of financial system better promotes economic growth than the other (Say, Zhao, Wang, and Agbenyegah, 2023). Studies have examined the relevance of financial structure – that is, the degree to which a financial system is bank-based or market-based – to economic growth. Recent evidence suggests that neither system is unequivocally better for growth; rather, the outcome crucially depends on the efficiency of financial and legal institutions (Fouejieu, Sahay, and Cihak, 2022). This has widened the debate along four competing theories of financial structure: the bank-based view, the market-based view, the financial services-based view, and the legal-based view.

The bank-based view emphasizes the importance of banks in identifying good projects, mobilizing resources, monitoring managers, and managing risk, while stressing the deficiencies of market-based economies. It points out the shortcoming of market-based financial systems in publicly revealing information, thereby reducing incentives for investors to seek and acquire private information, which accentuates information asymmetries (Asante et al., 2023). Financial intermediation reduces informational asymmetries and agency problems and supports financial system stability and economic growth (Gambacorta, Yang, and Tsatsaronis, 2024). According to the bank-based view, bank-based financial systems, especially in countries at an early stage of economic development, are more effective at fostering growth than market-based financial systems. Levine (2005), as cited in Jima and Makoni (2023), posits that financial intermediaries improve: (i) acquisition of information on firms, (ii) intensity with which creditors exert corporate governance, (iii) provision of risk-reducing arrangements, (iv) pooling of capital, and (v) ease of making transactions.

The bank-based financial system is seen to be in a better position to address agency problems and short-termism than the market-based system. Furthermore, banks may be more effective in providing external resources to new and growing firms because banks can more plausibly commit to additional funding as projects develop than capital markets, which may have difficulty making credible long-term commitments (Fouejieu, Sahay, and Cihak, 2022). The basic features of a bank-based financial system include the close involvement of banks with industrial firms, companies having committed and knowledgeable shareholders with strong bank presence on management boards, and companies relying on bank loans rather than equity, with banks exercising important monitoring roles (Obadire, Moyo, and Munzhelele, 2022).

The market-based view highlights the positive role of markets and stresses the problems with the bank-based view. Powerful banks can stymie innovation by extracting informational rents and protecting established firms from competition. It further stresses that powerful banks with few regulatory restrictions on their activities may collude with firm managers against other creditors and impede efficient corporate governance (Weli, Okereke, and Nnamdi, 2022). According to the market-based view, well-functioning markets reduce the inherent inefficiencies associated with concentrated bank power and enhance economic growth (Say, Zhao, Wang, and Agbenyegah, 2023). Stock markets influence information acquisition, corporate control, risk management, and savings mobilization, and contribute to economic growth by enhancing the liquidity of capital investments. A liquid equity market allows savers to sell their shares easily, making them relatively more attractive investments. According to Adamu (2024), the stock market is an economic institution which promotes efficiency in capital formation and allocation, enabling governments and industry to raise long-term capital for financing new projects and expanding industrial or commercial concerns. If capital resources are not provided to those economic areas, especially industries where demand is growing and which are capable of increasing production and productivity, the rate of expansion of the economy often suffers. As countries pass through stages of development, they tend to become more market-based than bank-based (Megnigang, 2024).

The basic feature of a market-based financial system is having highly developed markets. Most external long-term funds are raised from the capital market, which is an open and active market that encourages mergers and takeovers and provides substantial financing to industries (Eniekezimene and Opuofoni, 2024).

The financial services view supports neither the bank-based nor the market-based financial structure exclusively, but sees the importance of both systems in promoting economic growth. Rather than competing, these financial systems exist to ameliorate different costs (Gambacorta, Yang, and Tsatsaronis, 2024). According to the financial services view, both financial systems should be seen as complementing each other rather than substituting. This view stresses the importance of creating an enabling environment where these financial systems can provide sound financial services rather than distinguishing between the two. Recent empirical evidence confirms that stock markets and banks may play a complementary role in enhancing economic growth, with the different contributions of various financial actors producing synergistic benefits (Adedokun and Aga, 2023).

The legal-based view is an extension of the financial services-based view and posits that it is the overall level and quality of the financial system, as determined by the legal system, that improves the efficient allocation of resources and promotes economic growth. It argues that a well-functioning legal system facilitates the operations of both banks and markets, and that cross-country differences in legal and accounting systems help account for differences in financial development (Levine, Loayza, and Beck, 2000, as cited in Gambacorta, Yang, and Tsatsaronis, 2024).

Earlier works along this line used cross-country data, but researchers were subsequently encouraged to broaden the argument to individual countries, particularly developing countries, in order to capture country-specific peculiarities. In Nigeria, some works have examined the financial system and growth along the four theories of financial structure – bank-based, market-based, financial services, and legal-based – in order to ascertain which theory is most consistent with the Nigerian financial system (Orekoya, Afolabi, and Akintunde, 2021; Weli, Okereke, and Nnamdi, 2022; Abosede and Oseni, 2022). It remains inconclusive as to which component of the financial system better promotes economic growth. This study therefore seeks to assess bank-based and market-based financial systems in order to ascertain their impact on economic growth in Nigeria.

1.2 Statement of Problem

One of the problems militating against the rapid growth of developing economies is the inadequate provision of investible funds. The Nigerian financial system, like those of other developing countries particularly in Sub-Saharan Africa, has over time remained relatively underdeveloped and a cause for concern to policy makers (Oyadeyi, 2025). Nigeria’s credit to the private sector as a percentage of GDP was only 14.1% in 2022, far below the 90.7% average for BRICS countries, illustrating the significant financing gap that constrains productive investment and economic growth (World Bank, 2023, as cited in CBN Recapitalization Policy Review, 2024). Policy makers in addressing this issue have come up with several financial reforms which have focused heavily on the banking sector without paying adequate attention to the capital market. For instance, the Banking Sector Recapitalization Programme announced in March 2024, requiring commercial banks with international authorisation to raise their minimum capital from N50 billion to N500 billion, and national commercial banks from N25 billion to N200 billion, demonstrates a continuing emphasis on banking sector reform (Central Bank of Nigeria, 2024). Meanwhile, the capital market, which is also an important segment of the financial system, appears to have received relatively less policy attention.

The capital market has played a crucial role in Nigeria’s financial system, particularly during earlier bank recapitalization exercises, when banks raised significant sums through equity offerings on the Nigerian Exchange (NGX). Since then, many banks have continued to access the capital market to raise additional capital for expansion and operational efficiency. This emphasis on the banking sector, which portrays Nigeria as predominantly bank-based, raises an important research question: Does one segment of the financial system better promote economic growth than the other?

Some studies in Nigeria have examined the structure of the Nigerian financial system based on the bank-based and market-based financial system views. Empirical evidence from studies using ARDL, VECM, and FMOLS methodologies shows that financial sector development – particularly credits to the private sector – has a positive and statistically significant impact on economic growth in Nigeria (Yusuf et al., 2023; Okafor and Lilian, 2022). However, findings on the relative contributions of bank-based versus market-based variables remain mixed and inconclusive. An investigation into stock market development and economic growth in Nigeria covering 1990 to 2023 found a long-run relationship, though the direction and magnitude of effects varied across different market indicators (Adamu, 2024).

It therefore becomes imperative to investigate bank-based and market-based financial systems in Nigeria with a view to ascertaining their adequacy as stimulators of economic growth.

1.3 Objectives of the Study

The objective of this study is to assess the impact of the financial system on economic growth in Nigeria based on bank-based and market-based financial system views. To achieve this, the study sought to fulfil the following specific objectives:

a. To investigate the impact of bank credit to private sectors on economic growth in Nigeria.

b. To assess the impact of bank assets on economic growth in Nigeria.

c. To investigate the impact of total value of shares traded on economic growth in Nigeria.

d. To assess the impact of market capitalization on economic growth in Nigeria.

1.4 Research Questions

This study sought to provide answers to the following research questions:

a. To what extent does bank credit to private sectors impact on economic growth in Nigeria?

b. To what degree do bank assets impact on economic growth in Nigeria?

c. To what extent does total value of shares traded impact on economic growth in Nigeria?

d. How does market capitalization impact on economic growth in Nigeria?

1.5 Research Hypotheses

To achieve the above objectives, the following hypotheses were formulated and tested:

a. Banks’ credit to private sector does not have a positive and significant impact on economic growth in Nigeria.

b. Bank assets do not have a positive and significant impact on economic growth in Nigeria.

c. Total value of shares traded does not have a positive and significant impact on economic growth in Nigeria.

d. Market capitalization does not have a positive and significant impact on economic growth in Nigeria.

1.6 Scope of the Study

This study examined the Nigerian financial system and economic growth based on bank-based and market-based financial system views. The aggregate data were collected from the Central Bank of Nigeria Statistical Bulletin, the Nigerian Exchange Group (NGX) annual reports and statements of account, and the Central Bank of Nigeria Annual Reports. The specific data include banks’ credit to the private sector, bank total assets, total value of shares traded, total market capitalization, and real gross domestic product.

The study covered the period 1991–2010. In 1991, following the spate of large-scale distress in the financial system, the Banks and Other Financial Institutions Decree 25 (BOFID) was promulgated to monitor the operations of the banking and financial sector and reduce the tide of distress. The Central Bank of Nigeria Decree of 1991 was also promulgated, expanding the functions of the Central Bank and granting it greater autonomy in monetary policy formulation. The Inter-ministerial Committee on the Nigerian Capital Market recommended the discontinuation of official pricing of securities and the establishment of additional stock exchanges in 1991, marking a landmark reform of the market-based segment of the Nigerian financial system.

1.7 Significance of the Study

Most works done along this line have been cross-country studies among developed countries, but this study focuses on Nigeria, which is still at its development stage. This study is therefore expected to be of immense benefit to the following:

Financial System Regulators: This study will assist regulators such as the Central Bank of Nigeria and the Securities and Exchange Commission in making policies geared towards developing the Nigerian financial system to enable it to compete with counterparts in other countries. With ongoing banking sector recapitalization and capital market deepening initiatives, evidence-based research of this nature can guide more effective regulatory decisions (Central Bank of Nigeria, 2024).

Government: This study will also be of benefit to the government in ensuring long-term macroeconomic stability and creating a conducive environment for both investors and savers, thereby fostering confidence in the Nigerian financial system and supporting the nation’s ambition of achieving a one-trillion-dollar economy (Oyadeyi, 2025).

Body of Academia: In the academic arena, this study will contribute to the enrichment of the literature on the financial system and economic growth in Nigeria, particularly in relation to the bank-based versus market-based debate. It will also serve as a body of knowledge to be referred to by researchers examining the finance-growth nexus in developing countries (Megnigang, 2024; Adamu, 2024).

1.8 Limitation of the Study

Due to unavailability of data, this study did not include other indicators of bank-based and market-based financial systems such as net interest margin, overhead costs, liquid liabilities, and turnover ratio. It also did not include other components of the Nigerian financial system such as insurance companies, finance houses, and mortgage banks, among others.

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