1.1       Background to the Study

In a number of developing countries of the world the financial system is highly regulated. This is because of the pivotal position the financial industry occupies in these economies. An efficient system, it is widely accepted, is a sine qua non for economic growth and efficient functioning of a nation’s economy.  Thus, for the industry to be efficient, it must be regulated in view of the failure of the market system to recognize social rationality and the tendency for market participants to take undue risks which could impair the stability and solvency of their institutions.

However, the highly controlled state of the financial system in developing countries pulled the private sector back from playing an active role in the economy. The government controlled the interest rates and credit ceilings, owned banks and other financial institutions, and framed regulations with a view to making it easy for the government to acquire financial resources at a low cost. Since the nominal interest rate was controlled and the real interest rate mostly remained negative, savings could not be encouraged. As a result, investment could not increase to the desired level. This ultimately slowed economic growth.

In 1973, McKinnon (1973) and Shaw (1973) identified this problem of financial repression in developing countries and argued for a liberalization of the financial system. The standard economic theory suggests that liberalization strengthens financial development, leads to a more efficient allocation of resources, higher level of investment and higher long-run economic growth of the economy (Levine, 2001; Bonfiglioli and Meadicino, 2004). On the other hand, financial repression forces financial institutions to pay low and often negative real interest rates, reduces private financial savings thereby reducing the resources available to finance capital accumulation.

The World Bank and the International Monetary Fund (IMF), since the mid-1980s, started to prescribe financial liberalization as a basic framework for member developing countries to foster their economic growth (The World Bank Group, 2005).  With this, the era of financial liberalization started in the developing countries with the technical and financial assistance of the World Bank and the IMF. The initial liberalization measures taken by some   developing countries in the early 1980s showed very impressive result. This type of result became the motivating factor for other developing countries to liberalize their financial sector.

Based on these expectations, in the past three decades, many African countries have implemented financial liberalization as a component of the Structural Adjustment Programme (SAP) under varying financial structures and different macro-economic conditions.  To this end, such countries eased or lifted bank interest rate ceilings, lowered compulsory reserve requirements and entry barriers, reduced government interference in credit allocation decisions and privatized banks and insurance companies. Some countries even actively promoted the development of local stock markets and encouraged entry of foreign financial intermediaries.

For more than two decades after independence, the Nigerian financial system was repressed, as evidenced by ceilings on interest rates and credit expansion, selective credit policies, high reserve requirements, and restriction on entry into the banking industry. This situation inhibited the functioning of the financial system and especially constrained its ability to mobilize savings and facilitate productive investment.

In 1986, the authorities commenced an extensive reform of the financial system as part of the SAP. The major financial sector reform policies implemented were deregulation of interest rates, exchange rate and entry into the banking business.  Other measures implemented include: establishment of Nigeria Deposit Insurance Corporation (NDIC), strengthening the regulatory and supervisory institutions, upward review of capital adequacy standards, capital market deregulation and introduction of indirect monetary policy instruments.

Obviously, the sector that is most affected by financial liberalization is the commercial banking sector. The banking sector reform package is anchored on a 13-point programme, some of which include: increase in the minimum capital base requirement of the banks from N2 billion to N25 billion by the end of 2005, of which banks failing to meet the new requirements were expected to merge or else have their licenses revoked (Soludo, 2004).  Implementation of the consolidation exercise triggered various mergers in the banking sector and reduced the number of deposit banks in Nigeria from 89 to 25 by the end of 2005.

In view of these structural changes, the question that arises is: What have these reforms impacted on the banking industry? Therefore, this study focuses on the impact of financial liberalization on the performance of commercial banks (now deposit money banks) in Nigeria.


1.2    Statement of the Problem