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IMPACT OF FINANCIAL INTERMEDIATION ON ECONOMIC GROWTH IN NIGERIA 1994 – 2013

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CHAPTER ONE

INTRODUCTION

  • BACKGROUND OF THE STUDY

One of the activities of financial institutions (banks) involves intermediating between the surplus and deficit sectors of the economy.  According to Bencivenga and Smith (1991), the basic activities of banks are acceptance of deposits and lending  to a large number of agents, holding of liquid reserves against predictable withdrawal demand, issuing of liabilities that are more liquid than their primary assets and eliminating or reducing the need for self financing of investments.  In particular, by providing liquidity, banks permit risk averse savers to hold bank deposits rather than liquid (but unproductive) assets.  The funds obtained are then made available for investment in productive capital.

 

Moreover, by exploiting the fact that banks have large number of depositors and hence predictable withdrawal demand, they can economize on liquid reserves holdings that do not contribute to capital accumulation.  Again, Bencivenga and Smith (1991), further argued that by eliminating self-financed capital investment, banks also prevent the unnecessary liquidation of such investment by entrepreneurs who find that they need liquidity.  In short, an intermediation industry permits an economy to reduce the fraction of savings held in the form of unproductive liquid assets, and to prevent misallocation of invested capital due to liquidity needs (Bencivenga and Smith, 1991).  Schumpeter in Kings and Levine (1991), argued that the services provided by financial intermediaries–mobilizing savings, evaluating projects, managing risks, monitoring managers and facilitating transactions, are essential for technological innovation and economic growth and development.

 

Levine et al (2000), posits that financial intermediaries emerge to lower the costs of reaching potential investments, exerting corporation, controls, managing risks, mobilizing savings and conducting exchanges. Financial intermediaries by providing these services to the economy, influence savings and allocation decisions in ways that may alter long-run growth rates. Banks play an effective role in the economic growth and development of a country. This role they perform excellently by helping to mobilize idle savings of the Surplus Unit (SUs) for onward lending to the Deficit Units (DUs), thus helping in the capital formation of a nation (Ujah and Amaechi, 2005). It is in realization of the importance of bank’s role in financial intermediation that successive governments in Nigeria have been allocating deliberate roles to them in various National Development Plans.

 

Afolabi (1998), states that with financial intermediation, the transfer of funds from the surplus sector to the deficit sector becomes very simple. The intermediary will act as a pool, collecting deposits of millions of savers and can create forums, e.g. interest-yielding accounts. The intermediary matches the deposit requirements of the saver with the investment requirements of the borrower.  He acts as a pool, collecting savings of different sizes from different categories of savers and meeting the investment needs of the various types of investors.  The surplus sector therefore gains by placing his money with the intermediary since the income to be earned does not depend on whether or not the intermediary has in fact lent the money out or whether or not the money was profitably lent.  The overall economic effect according to Afolabi (1988) is that financial intermediation leads to a better aggregation of savings and therefore helps in capital formation and investment in the economy.

 

The banks are mainly involved in financial intermediation, which involves channeling funds from the surplus units to the deficit units of the economy, thus transforming bank deposits into loans or credits. The role of credit on economic growth has been recognized as credits are obtained by various economic agents to enable them meet operating expenses (Bencivenga and Smith, 1991). For instance, business firms obtain credit to buy machinery equipment. Farmers obtain credit to purchase seeds, fertilizers, erect various kinds of farm buildings. According to Nwanyanwu (2010), the provision of credit with sufficient consideration for the sector’s volume and price system is a way to generate self-employment opportunities. This is because credit helps to create and maintain a reasonable business size as it is used to establish and/or expand the business to take advantage of economies of scale. It can also be used to improve informal activity and increase its efficiency. This is achievable through resource substitution, which is facilitated by the availability of credit, while highlighting the role of credit. Nwanyanwu (2010), further explained that credit can be used to prevent an economic activity from total collapse in the event of natural disaster, such as flood, drought, disease or fire. Credit can be generated to revive such an economic activity that suffered the set back.

 

The banking sector helps to make these credits available by mobilizing funds from savers who have no immediate needs of such funds and thus channel such funds in form of credits to investors who have brilliant ideas on how to create additional wealth in the economy but lack the necessary capital to execute the ideas. It is instructive to note that the banking sector has stood out in the financial sector as of prime importance, because in many developing countries of the world, the sector is virtually the only financial means of attracting private savings in a large scale to enhance economic growth (Afolabi, 1998).

 

Banks all over the world as we have earlier noted, provide a wide range of services including financial intermediation to suit the needs of their customers, be they individuals, corporate or government customers.  In developing nations as ours, the majority of the people are poor, capital for investments are in short supply, means of transport are underdeveloped as well as basic infrastructures.  Banks through their intermediation role and other services, aim at overcoming these obstacles and thus, promote economic growth of the nation. Economic growth is often measured in terms of the level of production within the economy, the Gross Domestic Product (GDP) as well as the rate of physical capital accumulation among other possible measures (Zakaria, 2008). Majority of scholars accept economic growth as an increase in the level of national income and output in a country. According to Nnanna (2004), it implies an increase in the net national product in a given period of time. He explained that economic growth is generally referred to as a quantitative change in economic variables, normally persisting over successive periods. He added that the determinants of economic growth are availability of natural resources, rate of capital formation, capital output ratio, technological progress, dynamic entrepreneurship and other factors.

 

Oluitan (2010) sees economic growth as a steady process by which the productive capacity of the economy is increased over time to bring about rising levels of national output and income. Jhingan (2006) viewed economic growth as an increase in output. He explained further that it is related to a quantitative sustained increase in the country’s per capita income or output accompanied by expansion in its labour force, consumption, capital and volume of trade. The major characteristics of economic growth are high rate of productivity, high rate of structural transformation, international flows of labour, goods and capital. From the synthesizing insights of these definitions, economic growth in this work is defined as a sustained increase in national income or output of a nation. Thus, an economy is said to be growing if there is a sustained increase in the actual output of goods and services per head.

 

According to Greenwood and Jovanovich (1990), the dependence on domestic sources of capital, therefore, requires a wide range of independent well-organized and adapted financial institution, which has to mobilize internal resources for the purpose of capital formation and allow the capital to be invested conveniently and freely into desired developmental ventures.

Deposit Money Banks, the basic component of financial institutions should be thus the major relevant and important institutions, which encourage and mobilize savings and channel them into productive investments because of their network of offices, their generally numerous clientele and the relative ease with which people transact business with them. Thus, they are the dominant institutions of financial intermediation. It is therefore expected that effective financial intermediation will exert a positive impact on economy.

 

The importance of banks in generating growth within an economy has been widely discussed by various scholars.  Many economists believe that financial intermediaries play important roles in economic growth.  Studies by Beck, Levine and Loayza (2000a) and Levine, Loayza and Beck (2000) confirm that well-functioning banks accelerate economic growth.  Furthermore, a seminal study conducted by King and Levine (1993) on seventy seven countries made up of developed and developing economies showed that finance not only follow growth; finance seems important to lead economic growth.  Greenwood and Jovanovich (1990) also observed that financial institutions produce better information, improve resource allocation and thereby induce growth.  These studies further buttress the assertion that financial intermediation stimulate economic growth.  Despite the above views, some scholars believe that finance is a relatively unimportant factor in economic growth.  They postulate that economic growth is a causal factor for financial development. Gurley and Shaw (1967) as cited in Oluitan (2010) argue that as the real sector grows, the increasing demand for financial services stimulate the financial sector.  Lucas (1988) in Kings and Levine (1993) believed that economists have badly over-stressed the role of financial factors in economic growth.  Robbinson (1952) as cited in King and Levine (1993) contends that financial development simply follows economic growth and that the engine of growth must be sought elsewhere.

 

Nigeria is the most populous African country with a population of over 160 million people.  It is also one of the world’s top producers of crude oil and despite this, the country is among the poor economies in the world.  Banks dominate the financial sector in Nigeria and therefore, given the mixed results of empirical finding as shown above, it is important to examine whether such postulations hold for the Nigerian economy.  Again, there is detailed information about Nigerian banking history, but little information is available on the activities of the financial industry and how they affect the economy where they operate.  Similarly, factors which motivate or drive growth within the economy relative to the industry are largely under researched.  All these stimulate and motivate the researcher towards carrying out this study to fill this gap.

It is therefore against this background and given the intermediary role of deposit money banks in economic growth and development that this study aims at exploring in the light of past trends, the extent to which financial intermediation impacts on the economic growth of Nigeria.

 

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