Financial Intermediation and Economic Development in Nigeria Assignment

Financial Intermediation and Economic Development in Nigeria Assignment Words: 4972

Abstract Financial intermediation is an important activity In the economy because It allows funds to be channeled from people who might otherwise not put them to productive use to people who will ultimately put the funds to productive uses.

In line with the assumption that banking sector plays an Important role In financing the Investment projects, successive governments In Nigeria have carried out reforms and Institutional Innovations In the banking sector. The overall Intention of these reforms has been to ensure financial stability so as to Influence the growth of the economy ND also enhance banks to play a critical role of financial Intermediation In Nigeria.

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However, despite the fact that Nigerian banks have undergone series of restructuring/reforms aimed at strengthening the banks’ ability to efficient service delivery and fund the real sector, problems such as; Inefficiency In allocating funds to the real sector, lack of long-dated funding, neglect of the core private sector in terms of credit extension, weak capacity of the banks to fund the real sector, low-level activities of banks, and liquidity still lingers.

This study therefore, examines empirically the impact of financial intermediation on the development of the Nigerian economy with the aim of determining the importance of financial intermediaries and its influence. This study found out that the financial intermediaries (banks) in Nigeria exhibit inefficiency and weak capacity in the allocation of funds to finance the some sectors. On the overall therefore, the study found that the economy Nigeria rely heavily on the banking sector to finance its activities even though the desired expectation is not met by the banks.

The study therefore, concluded that financial intermediaries (banks) are important in attaining financial development. The study therefore recommend that banks should ensure greater domestic savings manipulation for investment and growth, using market-determined interest rates, and government should ensure that the Asset Management Company of Nigeria (AMOCO) established by the CB to take over toxic loans of banks. Financial intermediaries for the purpose of this study refers to financial institutions especially banks (deposit money banks, [DMS]) that mobile savings for investment purposes.

They act as Intermediaries between ultimate savers and ultimate borrowers. The Justification for using banks as our financial intermediaries Is based on the fact that banking system plays a crucial role in economic growth. For example, In Nigeria, banks represent 87. 4% of the financial system assets and 63. 6% of the total credit extended to the private sector (King, 2003). Furthermore, banks are the oldest, biggest, and fastest growing financial Intermediaries In Nigeria.

The process of financial intermediation involves the manipulation and allocation of financial resources through the financial (money and capital) markets by financial institutions (banks and non-banks) and by the use of financial instruments (savings, securities and loans). The efficiency and effectiveness of financial intermediation in any economy depend critically on the level of development of the country’s financial system. In effect, the underdeveloped nature of the financial system in most developing countries accounts largely for the relative inefficiency of financial intermediation in those economies.

In these countries the financial system is dominated by banks, which are typically oligopolies in structure and tend to concentrate on short-term lending as against investments with long-term gestation period. The alternative/complementary source for financing development projects is he development of debt or equity markets which at best, is at the rudimentary stage of development. It is in this regard that specialized financial institutions, including government owned development banks have been established in Nigeria to bridge the gap.

The principal function of deposit money banks is the manipulation of savings for investment. The importance of banks in generating growth within an economy has been widely acknowledged, for example Schumacher (1932) cited in Blue, Federal, Fink, and Hashish (2002) identified banks role in facilitating technological innovation through their intermediary role. Schumacher believed that efficient allocation of savings through identification and funding of entrepreneurs with the best chances of successfully implementing innovative products and production processes are tools to achieve real growth.

The process that facilitates the transferring of the savings of some economic units to others for consumption or investment at a price is generally referred to as financial intermediation (Blue, et al. , 2002). For financial intermediation to take place there must be instruments and financial institutions operating together with the objective of bringing about economic development of the country. Financial institutions include banks and non- banks loan suppliers such as finance companies, mortgage lenders, and development finance institutions (Doffs).

Financial intermediation is an important activity in the economy because it allows funds be channeled from people who might otherwise not put them to productive use to people who will ultimately put the funds to productive uses, for as maintained by Age(2004), financial intermediation helps promote a more efficient and dynamic economy. Moreover, Levine (2002) asserts that corporate control by creditors (iii) provision of risk-reducing arrangement (iv) pooling f capital, and (v) ease of making transactions.

Beside, one of the activities of financial intermediaries involves intermediating between the surplus and the deficit sector of the economy. The availability of credit function positively allows the fruition of this role and is also important for the growth of the economy. Many studies identify a theoretical relationship between financial intermediation and the development of an economy, and hypotheses put forward by these studies have been examined empirically.

Several researchers (for example, Goldsmith, 1969; Mimicking, 1973; Shaw, 1973; Fry, 1988; and King and Levine, 1993) have identified the significance of banks to the growth of the economy. In assessing the relationship, a large number of recent empirical studies (for example, Age, 2004; Levine, 2005; and Dyad, Adequate, and Dyad, 2008) have relied on measures of size of financial intermediaries to provide evidence of a link between financial system development and economic growth.

They used macro level data such as size of financial intermediaries relative to Gross Domestic Product (GAP), to determine the impact of financial development on economic growth. In particular, Dyad, et al. , (2008) found no consistent relationship between financial development and economic growth in Nigeria for the period 1986-2005. Also, there are many studies that investigate the relationship between financial intermediation and economic development in Nigeria [notable among them include; Age(2004); Underbid (2004); Dyad, et al. (2008); Gag and Chukka (2008); Abdullah(2009); and Amazon and Cherokee (2009)] but the results of these studies are divergent. The divergence seems to emanate from the different estimation procedures and data employed for analysis. The financial intermediaries in an economy are saddled with the primary responsibilities financial resource manipulation and intermediation. They redirect funds from surplus spending units to deficit spending units.

Financial intermediaries provides funds used as a capital input by producers in other sectors of the economy as well as by final consumers. The impact of the delivery of these financial services in the form of capital to the producers is felt both in the short-run and in the long-run. Thus, the financial sector, especially the banking system, is important in the smooth functioning of the economy. Similarly, the real sector of the economy forms the main driving force of the economy. It is the engine of economic growth and development.

Essentially, the real sector relies on the banking sector for the provision of required funds for investment purposes. To this end therefore, it is assumed that an increases in the bank lending to the real sector will increase the activity of the real sector, and vice versa (Blue, et al. , 2002). Therefore, in line with the assumption that banking sector plays an important role in financing avariciousness, successive governments in Nigeria have reared out reforms and institutional innovations in the banking sector.

The overall intention of these reforms has been to ensure financial stability so as to influence the growth of the economy and also enhance banks to play a critical role of financial intermediation in Nigeria. In particular, the bank consolidation exercise has drastically shaped and positioned the sector to play the important role of financing the real sector to bring about growth in Nigerian economy. Moreover, the credit view hypothesis asserts that the banking sector affects aggregate economic performance. Increase their loan volume; hence, investment would increase, and gross domestic product (GAP) would rise accordingly.

The International Economic Development Council defines economic development as an “activity that seeks to improve the economic well-being and quality of life for a community, by creating and/or retaining jobs… “Development can also be referred to as the quantitative and qualitative changes in the economy. Such actions can involve multiple areas including development of human capital, critical infrastructure, regional competitiveness, environmental sustainability, social inclusion, health, safety, literacy, and other initiatives. Economic development differs from economic growth.

Whereas economic development is a policy intervention endeavor with aims of economic and social well- being of people, economic growth is a phenomenon of market productivity and rise in GAP. Economic development can also be referred to as the qualitative and quantitative changes in an existing economy. Economic development involves development of human capital, increasing the literacy ratio, improve important infrastructure, improvement of health and safety and other areas that aim at increasing the general welfare of the citizens. . LITERATURE REVIEW AND THEORETICAL FRAMEWORK Financial intermediaries offer a broader range of services to its customers, both lenders and borrowers. They also, play a role in enhancing and influencing the pattern of economic growth of an economy. Financial intermediaries that play these roles include deposit money banks and insurance companies. To extent that the size of the intermediating sector reflects the volume of these services and increases in the efficiency of their delivery, it should related to real sector growth.

Both traditional and recent literatures offer insights for understanding the potential role of financial intermediaries in real sector growth. This section reviews some of the literatures on the subject matter as well as provides the theoretical framework for this study. Financial intermediation is used to refer to the process that facilitates the transferring of savings of some economic unit to others for investment at a price, while the real sector of an economy is the main driving force that moves the economy forward.

The relationship between financial intermediation and economic development has received considerable attention in the growth literature of the sass and sass. While many important contributions (for example; Goldsmith, 1969; Mimicking, 1973; Shaw, 1973) offered detailed arguments and evidence for a role of finance in promoting long-run growth, these studies did not establish the direction, timing, and relative strength of causal links.

King and Levine (AAA) address the issue of direction in a cross sectional study that relates broad proxies for the intensity of financial intermediation to measures of real sector performance using postwar international data, yet causal inference is restricted to the observation that economies with greater financial depth at a given point in time appear to grow faster in subsequent decades than those with lower initial levels of financial activity.

Time series studies of individual countries (for example, Jung, 1986) find bi-directional causality between financial and real variables in postwar data, and seem to offer little hope for disentangling direct effects from feedback. However, the pioneering relationship between financial development and economic growth has remained an important issue of debate in developing economies. Most of the literature has mainly soused on the role of macroeconomic stability, inequality, income and wealth, institutional development, ethnic and religious diversity and financial market imperfections.

Among these factors the role of financial markets in the growth process has received considerable attention. In this framework, financial development is considered by many economists to be of paramount importance for output growth. Particularly, government restrictions on the banking system such as, interest rate ceiling, high reserve requirements and directed credit programmer hinder financial development and reduce output growth [(Mimicking (1973) and Shaw 1973)].

The early contributions due to Mimicking (1973) and Shaw (1973) postulate that the government intervention in the pricing and allocation of alienable funds impedes financial development and depress real interest rates. Mimicking (1973) emphasizes that the order and appropriate sequencing of financial reforms in the financial sector would be much more effective once price stabilization has taken place.

The endogenous growth literature stresses the influence of financial markets on economic growth (Benignant, Smith & Starr, 1995; Greenwood & Smith, 1997). Similarly, Bengali and Spiegel (2000) argue that a positive relationship is expected between financial development and total factor productivity, growth and investment. Meanwhile, a set of recent literatures offer key insights for understanding the potential role of financial intermediaries in economic performance.

Broadly, defining financial intermediaries as individuals or institutions that solicit alienable funds from surplus spending units and allocate theses funds among deficit units whose direct debt they absorb, Benignant and Smith (1991), for example formalize the “debt accumulation” channel with an overlapping generation oodles in which the disposition of savings shifts from unproductive liquid assets to the assets of emerging intermediaries that can exploit investment synergies and encourage output growth through the capital stock.

In another attempt, Greenwood and Jovanovich (1990) demonstrate in a dynamic general equilibrium setting that as savers become able to avoid idiosyncratic risks and gain confidence in the ability of intermediaries to make profitable allocation decision, they place an increasing portion of their surpluses with intermediaries. Here, increases in the efficiency of the uncial sector lead to output growth, which in turn generates additional demand for deposits and financial services.

Similarly, King and Levine (Bibb) construct an endogenous growth model in which intermediaries reduce inefficiencies by acquiring information about the quality of individuals projects that is unavailable to private investors and public markets. The informational advantage encourages the funding of less-established firms that are likely to develop innovative intermediate and final products. A reduction in the cost of productivity enhancement is then shown to accelerate economic growth rates. Another class of models focuses on the role of intermediaries in monitoring loan recipients.

Susann (1993), for example, show that better monitoring of loan recipients in a unapologetically competitive banking sector reduces markups, encourages entry, and reduces the banking sector’s share in Gross National Product (GNP). However, Rousseau (1998) shows that a search for temporary asymmetries can lead to more efficient monitoring, narrower loan-deposit rate spreads, applicants of generally higher quality, and increases in deposits. Furthermore, Beck, Levine, and Lazy (2000) find that financial development has a rage and positive impact on total factor productivity, which feeds through to overall Gross Domestic Product (GAP) growth.

The problem with the previous studies is that a positive relationship between financial intermediaries and real sector growth can exist for different reasons. As output increases the demand for financial services increases too, this in turn has a positive effect on financial development. Accordingly, therefore, owing to the differing opinions regarding the relationship between finance and economic growth, many empirical studies have investigated the relationship teens financial depth defined as ratio of total bank deposit liabilities to nominal GAP and economic growth.

But the results are ambiguous. Other studies based on the cross section and panel data positive effects of financial development on output growth even after accounting for other determinants of growth as well as for potential biases induced by simultaneity, omitted variables and unobserved country specific effect on the finance – growth nexus, also produced mixed results. On the other hand, the studies based on the time series data give contradictory results.

For example, Adam (1998) examines how efficient the financial intermediation process has been in Insignia’s growth performance. The empirical results show that financial intermediation process is sub-optimal and caused by high lending rate, high inflation rate, low per capita income, and poor branch networking. However, Lintel and Khan (1999) used a sample of ten less developed countries and concluded that the causality between financial development and output growth is bi-directional for all countries.

In another attempt, Age (2004) examines the empirical relationship between financial intermediaries and growth in Nigeria. The study employed data on aggregate deposit money banks’ credit over time and GAP to establish that a moderate relationship exists between financial deepening and growth in Nigeria. He concludes that the development of financial intermediary institutions in Nigeria is fundamental for overall economic growth.

Similarly, Underbid (2004) investigates financial deepening, economic growth and development for Sub-Sahara African countries. The study used two financial deepening variables namely the degree of financial intermediation measured by MM as ratio to GAP, and the growth rate of per capita real money balances. The study finds that a developed financial sector spurs overall high but sustainable growth of an economy. Again, Diamond (2004) in Gag and Chukka (2008) investigates the role of financial development on economic growth in South Africa.

The study uses three proxies of financial development namely the ratio of MM to GAP; the ratio of currency to narrow money, and the ratio of bank claims on the private sector to GAP against economic growth provide by real GAP per capita. He employed the Johannes-Julius congregation approach and vector error correction model to empirically reveal overwhelming demand following response teens financial development and economic growth. In another study, Waded (2005) examines the long run causal relation between financial development and economic growth for South Asian countries namely India, Pakistan and Bangladesh.

He disaggregated financial system into “bank-based” and “capital market based” assess the long run relationship between financial development and economic growth. The empirical findings of the study suggest that the result of error correction model indicate causality between financial development and economic growth but running from financial development to economic growth. In a similar analogy, Radar and Dammar (2006) analyzes the effect of financial sector deepening on economic growth in Turkey.

The study conclude that financial development may not always contribute to growth, and the conditions under which such a contribution takes place should be investigated further. Mohammed and Assiduously (2006) investigate the effect of financial development on economic performance in Sudan from 1970 to 2004. The study estimated the short run and long run relationship between financial development and economic growth and other conditioning variables on economic Roth using the autoregressive distributed lag (RADAR) model to congregation analysis by Pesaro and Shin (1999).

Their empirical results indicate a weak relationship between financial development and economic growth in Sudan due to the inefficient allocation of resources by banks, the absence of appropriate investment climate required to foster significant private investment in order to promote growth in the long run, and poor quality of bank credit allocation. Furthermore, Gag and Chukka (2008) examine the direction of causality between “banked” financial deepening variables and economic growth in Nigeria between 970 and 2005.

The study employed the augmented Granger causality test approach developed by Today and Hampton (1995) to ascertain the direction of causality between “bank-based” financial deepening and economic growth in Nigeria between 1970 and 2005. The congregation test results suggest that financial deepening and economic growth are positively congregated and that there is only one concentrating vector indicating a stable and sustainable long-run equilibrium relationship in the Full Information Maximum Likelihood (FEM..) Multivariate Johannes and Julius (1988, 1992) and Julius (1990) framework.

In the Today-Hampton sense, the study finds that the Nigerian evidence supports the demand-following hypothesis for “bank- based” financial deepening variables like private sector credit and broad money; while it supports the supply-leading hypothesis for the “bank-based” financial deepening variables like loan/deposit ratio and bank deposit liabilities. Thus, the empirical findings suggest that the choice of bank based financial deepening variable influences the causality outcome. However, Dyad, et al. (2008) empirically examines the relationship between structural adjustment, financial sector development, and economic prosperity in Nigeria. The study employed time series data and using Superman (RYO) correlation coefficient technique to show that there is no consistent relationship between financial development and economic growth in Nigeria for the period 1986-2005. Additionally, Amazon and Cherokee (2009) examined financial deepening and economic development in Nigeria between 1986 and 2007.

The study concluded that the financial system has not sustained an effective financial intermediation, especially credit allocation and a high level of modernization of the economy. Consequently, Boot, Greenberg and Thacker (1993) suggest that well- developed markets could have a negative impact on the identification of innovative projects and thereby impede efficient resource allocation. Financial intermediaries internalize the fixed cost of doing so.

The free-rider problem is less severe in intermediary-based systems, since banks can make investments without revealing their actions instantaneously in public markets. Shaw (1973) proposes a debt intermediation hypothesis, whereby financial intermediation between savers and investors resulting from financial liberalizing (higher real interest rates) and velveteen increase the incentive to save and invest, stimulates investments due to an increased supply of credit, and raises the average efficiency of investment..

Financial intermediation theory was first formalized in the works of Goldsmith (1969), Mimicking (1973) and Shaw (1973) who see financial markets as playing a pivotal role in economic development, attributing the differences in economic growth across countries to the quantity and quality of services provided by financial institutions. Lastly, Abdullah (2009) studied the impact of banking sector consolidation on the real sector of the Nigerian economy, using Raw Score Computational Method of Correlation Coefficient; the study established that there is a strong positive relationship between size of Bank Capitalization and Bank Lending.

The study also established a strong positive relationship between size of Bank Lending and growth in Nigeria. Financial intermediation theory was first formalized in the works of Goldsmith (1969), markets are essentially handmaidens to domestic industry, and respond passively to other factors that produce cross-country differences in growth. 3. 0 IMPACT OF FINANCIAL INTERMEDIATION ON ECONOMIC DEVELOPMENT Financial Intermediation involves institutions that raise their funds by borrowing, for on- lending.

These include insurance companies, credit and cooperative societies, investment companies and the Nigeria Social Insurance Trust Fund (INSIST). Generally, money as a medium of exchange (or exchange equivalent) has substitutes; instruments in which non-bank financial intermediaries deal. Institutions that deal in these money substitutes/instruments do so for three main reasons. First, they are crucial channels of credit in their own right such that their efficient operations would facilitate the workings of the financial system.

Secondly, many of these intermediaries issue and deal in liabilities that are almost indistinguishable from money. Thirdly, even when these assets are not money substitutes, they sufficiently resemble money to enable their exchange for money if the yields on them are attractive. Therefore, one can refer to these institutions as creators of money. The distinguishing characteristic of financial intermediaries is that their assets consist almost exclusively of financial instruments primarily for non-financial borrowers, such as business enterprises, households and Governments.

The contributions of financial intermediation and finance to the nation’s GAP has ranged between 8 and 10 per cent in recent years. Banks are the linchpin of the economy of any country. They occupy central position in the country’s financial system and are essential agents in the development process. By intermediating between the surplus and deficit savings’ units within an economy, banks mobile and facilitate efficient allocation of national savings, thereby increasing the quantum of investments and hence national output (Folia, 2004).

Through financial intermediation, banks facilitate capital formation (investment) and promote economic growth. As pointed out earlier, financial intermediaries facilitate the manipulation of savings, acquire and disseminate costly the efficient allocation of capital to firms, thereby encouraging long-run economic growth. The ability of intermediaries to promote economic development stems from their capacity to gather information on lenders and monitor their activities. In well- functioning markets, information is instantly revealed to the public, providing less incentive for free riders and other individual investors to acquire information.

Similarly, Allen and Gale (1997) stress that the incompleteness of markets gives rise o the development of institutions such as financial intermediaries that fill in the blanks of “missing markets. ” While, Raja and Singles (1999) further argue that intermediaries have advantages over financial markets in most institutional environments, noting that even in countries with weak legal and accounting systems, powerful intermediaries can still make firms reveal information and pay back their debts, thereby facilitating expansion and long-run growth.

Thus, Dollar and Me (2002) also suggest that, over time, financial intermediaries are better at providing sis-improving services than market-oriented systems, particularly in cases involving inter-temporal risk sharing, where intermediaries accumulate reserves in safeties and are able to average out aggregate risks over time.. Another view is that financial markets are not able to provide corporate control because insiders have better information about the firms than outsiders.

This informational asymmetry has the tendency to moderate the potential effectiveness of takeovers, given that well- informed insiders will more likely outbid less-informed outsiders. Proponents of the intermediary-based view argue that although markets can potentially provide products for diversifying risk, they are unable to diversify aggregate shocks because they are incomplete. Due to problems of adverse selection and moral hazard, contracts for the delivery of financial services are contingent only on states whose occurrence can be verified to the satisfaction of all counterparts.

Consequently, Boot, Greenberg and efficient resource allocation. Financial intermediaries have better incentives to gather information and monitor firms and can efficiently their actions instantaneously in public markets. . Management of Liquidity Risk Hence, financial markets and institutions reduce liquidity risk through banking intermediation and the trading of equities. As the costs of transactions in the stock market fall, there is more investment in illiquid, high-return projects and consequently higher growth.

In the same vein, financial intermediaries enhance liquidity and reduce liquidity risk by offering liquid deposits to savers and undertaking a mix of liquid, low-return investments and illiquid, high-return investments to satisfy demand. By receiving deposits from savers and investing in a ix of liquid and illiquid assets, banks provide insurance to savers against liquidity risk while facilitating long-run investments in high-return projects. Thus, by eliminating liquidity risk, banks foster investments in high-return, illiquid projects and by so doing accelerate growth. I Information Acquisition and Resource Allocation Without financial intermediaries, savers are not prepared to commit their savings to investors who are engaging in long-term risky projects, because it is difficult and costly to monitor and evaluate such projects. In addition, savers may not have the enterprises, managers and economic conditions. Savers therefore withhold their savings and do not invest in projects for which they have very little or reliable information. Financial systems therefore emerge to minimize the costs of acquiring information on projects and to monitor and evaluate their performance (Diamond 1984).

Levine (1997) demonstrates the role of the banks in acquiring information with this example. Consider a situation where there is a fixed cost to acquire information about a production technology. In the absence of intermediaries, each investor must pay the fixed cost. This information cost structure creates an avenue for a group of individuals to form (or Join or use) financial intermediaries to economize on the costs of acquiring and processing information about investments.

The emergence of the intermediaries therefore minimizes of the cost of acquiring information about risky investment projects and improves the allocation of resources. The capacity of financial intermediaries to gather and process information has significant growth implications. As argued by Greenwood and Jovanovich (1990), many firms and entrepreneurs are searching for capital to support their investment projects. Hence, financial intermediaries that are better at screening viable firms and managers will induce a more efficient allocation of scarce financial capital and resources and consequently faster growth.

Financial intermediaries ameliorate the economic consequences of informational asymmetries, with beneficial implications for resources allocation and economic activity. Iii. Monitoring of Investment Projects Another role of financial markets and institutions is to reduce the cost of acquiring information and monitoring investment projects. In general, business owners design uncial contracts to ensure that their firms are managed in their best interests.

At the same time, creditors such as banks, equity and bond holders create financial arrangements to force owners and managers to run firms in accordance with the interests of the creditors. Financial intermediaries are very important because they ensure that the flow of embroiled savings (or capital) to profitable investments is not impeded. They also ensure that markets and institutions improve monitoring and corporate control of investment projects, the accumulation of capital and the efficient allocation of resources to ensure long-run growth.

To understand the linkage between monitoring of projects and growth, let us consider an investment environment where it is costly for outside investors in a project to verify its returns. This creates the need for the development of financial intermediaries, because the inside owners have incentives to misrepresent project returns to the outsiders, and the cost of verification prevents the outside owner from monitoring the project. Under this condition, outsiders would not be prepared to invest in the project, since they cannot ascertain the true return on the project due the cost of verification.

Hence, verification costs impede investment decisions and reduce economic efficiency. They also imply that outsiders constrain firms from borrowing to expand investment because higher leverage means greater risk of default and higher verification expenditures by lenders. A financial institution would lend to the inside owners of the project if they post a collateral and allow for the monitoring of the project. Financial intermediaries reduce information costs even further because they can mobile the savings of many individuals and lend these resources to project

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