THE FINANCIAL SYSTEM AND ECONOMIC GROWTH IN NIGERIA

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CHAPTER ONE

INTRODUCTION

1.1       Background of the Study

A financial system is a set of rules, regulations and the aggregation of financial arrangement, institutions and agents that interact with each other and the rest of the world to foster economic growth and development of a nation (Nzotta and Okereke, 2009). According to Nwude (2004), financial systems consist of financial markets, financial intermediaries, financial instruments, rules, conventions and norms that facilitate and regulate the flow of funds through the macro-economy. A good financial system, according to Rousseau and Sylla (2001), is one that has these five key components: (i) Sound public finances and public debt management, (ii) Stable monetary arrangement, (iii) A variety of banks some with domestic and others with international orientations and perhaps some with both orientation, (iv) Well functioning securities market, and (v) A central bank to stabilize domestic finances and manage international financial relations.

Economists argue about the relationship between the financial system and economic growth. Economic growth can be defined as the expansion of the economy through a simple widening process. It involves enhancing the productive capacity of an economy by employing available resources to reduce risks, remove impediments which otherwise could lower costs and hinder investment (Sanusi, 2011). Economic growth also refers to a sustained increase in the output of an economy (Hogendorn, 1992).

The role of the financial system in promoting economic growth generated so much controversy among scholars and practitioners. Economists hold four different views on the relationship between finance and growth: supply leading view, demand following view, bi-directional relationship and no relationship between finance and growth (Apergis, et. al., 2007). The supply leading view asserts that finance impact positively on economic growth (King and Levine, 1993; Neusser and Kugler, 1998; Levine, et. al., 2000). This theoretical stand-point is traced to the work of Schumpeter (1911), cited in Arestis and Dematriades, (1993) who argues that production requires credit to materialize, and that one can become an entrepreneur by previously becoming a debtor…what the entrepreneur first wants is purchasing power before he requires any goods. Specifically, he sees financial intermediaries as agents of growth. Demirguc-Kunt (2008) stresses that financial systems help mobilize and pool savings, provide payments services that facilitate the exchange of goods and services, produce and process information about investors and investment projects to enable efficient allocation of funds, monitor investments and exert corporate governance after these funds are allocated, and help diversify, transform and manage risk. The financial system, as opined by Miller (1998), plays a very crucial role in alleviating money frictions and, hence, influencing savings rate, investment decisions, technological innovations and long-run growth rate.

Contrary to the view of Schumpeter and other scholars on the importance of finance to economic growth is Robinson’s (1952), cited in Levine (2004) who stresses that finance simply follows growth and that where enterprise leads, finance follows. She argues that although growth may be constrained by credit creation in less developed financial systems, in more sophisticated systems, finance is viewed as endogenous responding to demand requirements. 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 (Jung, 1986).

The third view supports the bi-directional relationship between financial system and economic growth (Demetriades and Hussein, 1996; Greenwood and Smith, 1997). Finally, proponents of the last view reject the existence of a finance-growth relationship (Lucas, 1988).

The debate revolves around the role of bank and capital market in promoting economic growth. Among scholars who support the view on the importance of financial system to economic growth came a different line of argument. This centered on the categorization of the financial system into bank-based and market-based and the comparative importance of both systems to economic growth. Attempts were made to find out whether one type of financial system better promotes economic growth than the other (Arestis, et. al., 2005). Using data from UK and US as market-based versus Japan and Germany as bank-based, studies have shown the relevance of financial structure, that is the degree to which a financial system is bank-based or market-based to economic growth (Hoshi, et. al., 1991; Mork and Nakkrumura, 1999; Weinstein and Yafeh, 1998; and Arestis, et. al., 2001). However, this relevance has been criticized since these countries in the past have shared similar growth. This has widened the debate along four competing theories of financial structure; bank-based view, market-based view, financial services-based view and 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 deficiency of market-based economies. It points out the short-coming of the market-based financial system as revealing information publicly, thereby reducing incentives for investors to seek and acquire information. Information asymmetries are thus accentuated, more so in market-based rather than in bank-based financial systems (Arestis, et. al., 2005). The bank-based view therefore, stresses the importance of financial intermediation in ameliorating information asymmetries and inter-temporal cost. Information asymmetries may introduce inefficiency in the system and reduce the level of activity, increase sensitivity to disturbances such as changes in the riskless interest rate and or in productivity (Gertley, 1988). 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 (2004) posits that financial intermediaries improve   (i) acquisition of information on firms,   (ii) intensity with which creditors exert corporate control, (iii) provision of risk reducing arrangements, (iv) pooling of capital, and (v) ease of making transaction.

The bank based financial system is seen to be in a better position to address agency problems and short-termism than the market-based (Stiglitz, 1985; Singh, 1997). Furthermore, banks may be more effective in providing external resources to new firms that require stage financing because banks can more plausibly commit to making additional funding available as the project develops than markets that may have more difficult time in making credible, long term commitment.

Arestis and Demetriades (1993) assert that the basic features of a bank-based financial system are; 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 and not so much on equity with banks exercising important monitoring roles.

The market-based view on the other hand highlights the positive role of market and stresses the problem with the bank-based view. Powerful banks can stymie innovation by extracting informational rents and protecting established firms with close bank-firm ties from competition (Hellwig, 1991; Rajan, 1992). 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 (Hellwig, 1991; Wenger and Kaserer, 1998). According to the market-based view, markets reduce the inherent inefficiencies associated with banks and enhance economic growth (Levine, 2002). Stock market influences information acquisition, corporate control, risk management and savings mobilization (Levine, 2000). It contributes to economic growth by enhancing liquidity of capital investments (Levine, 1997). A liquid equity market allows savers to sell their shares easily if they so desire thereby making shares relatively more attractive investments. According to Osinibu (1998), the stock market is an economic institution, which promotes efficiency in capital formation and allocation. It enables governments and industry to raise long-term capital for financing new projects, and expanding and modernizing 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 become more market-based than bank-based (Boyd and Smith, 1998).

Arestis and Demetriades (1993) assert that 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 in encouraging mergers and takeovers. This market provides substantial amounts of financing to industries.

The financial service view supports neither the bank-based nor the market based financial structure but sees the importance of both systems in promoting economic growth. These financial systems do not compete but exist to ameliorate different cost (Levine, 2000).  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.

The Legal based view is an extension of the financial services based view and it posits that it is the overall level and quality of financial system as determined by the legal system that helps improve the efficient allocation of resources and economic growth. It argues that a well functioning legal system facilitates the operations of both banks and markets (Laporta, et. al., 1997, 1998, 1999).

Earlier works along this line used cross-country data. Researchers were encouraged to broaden the argument along individual country, particularly developing countries in order to capture individual country peculiarities. In Nigeria case studies, some works examine financial system and growth along 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 (Olofin and Afangindeh, 2008; Sabiu, et. al., 2009; Ujunwa, et. al., 2012). It remains inconclusive as to which components of the financial system better promotes economic growth. This study therefore sought to assess bank-based and market-based financial systems in order to ascertain their impact on economic growth in Nigeria.

 

 

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