Role Of Banks Financial Institutions In Economic Growth Economics Essay

Achieving high and sustainable rates of economic growth has long been the goal of economic development in all countries. In an effort to promote growth several policies have been initiated by governments to raise the living standards of their population so as to rid poverty.

However, the promotion of development needs a sufficient amount of capital stock and profitable investment that guarantees a sustainable growth in the economy. In recent years, policies to improve savings mobilization has increasingly been suggested as appropriate since savings rate can affect economic growth through financing productive investment. Therefore, the mobilization of savings is a necessary condition for achieving high and sustainable rates of economic growth.

However, the argument regarding the necessity of savings for success is linked with another argument regarding the effectiveness of savings in financing capital accumulation and therefore increasing investments (Pagano, 1993 and Beck et al, 2000). This leads to the question of the importance and role of financial sector in the complex relationship between savings, investment and development. The interplay between financial sector development and macro-economic working on the one hand and savings on the other, has been addressed in the economic development and development literature (Levine, 1997, Westley, 2001 and Beck et al, 2005).

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The debate on this issue remains relevant and controversial. The discussions occur in different dimensions, one of these being the relationship between savings and growth. The second dimension of the debate is the effect of financial sector development in savings, which leads to the important question of whether the interest rate has any effect on saving. A third aspect of the debate is the relationship between the banking sector and development, leading to the question: does the banking sector development cause economic growth or does growth cause or encourage banking sector development?

In recognition that banks play crucial roles in economic development of countries, this study seeks to address the above issues. Firstly it examines the literature on banking sector development, assessing the impact of stock liquidity, interest rates, lending, and savings on the GDP and the stimulation of economic growth. Secondly, it evaluates the importance of financial sector development by examining its impact on economic growth and investment, which is the main source of growth.

Thirdly, it will examine the Nigerian banks and the economy, analysing its contribution to the growth of the Nigerian economy and how the different banking sector reforms have impacted on its power and conversely to the economic development of Nigeria.

Research Aim

The research aims to examine the role of banking sector development and economic growth in Nigeria, analysing its liquidity base, lending policies and various reforms of the sector, with a view to finding an explanation for the country’s precarious, slow and chaotic growth. In order to achieve this aim, this paper considers different arguments and propositions in the literature and employs statistical and econometric tools to evaluate the trends that have on its own prevailed in key aspects of the banking sector.

Objectives

The following specific research objectives were established in order to achieve the objective of the research:

• To assess the position and structure of the Nigerian banking sector.

• To determine the type and the nature of adopted reforms and liberalisation policies and objectives associated with them.

• To assess the impact of banking sector development on savings, lending and investment and thus economic development of Nigeria.

CHAPTER TWO

LITERATURE REVIEW

2.1 Introduction

The financial sector plays a vital role in the economic development of any country. It links savings and investments and therefore, promotes economic growth, which is enhanced because a more efficient and well-structured financial sector helps to mobilise more savings and increase productive investment that leads to economic growth.

Finance also plays a crucial role in any economy as companies must take invested funds to support the following production of goods and services. Also governments often borrow to finance short-term and long-term shortfalls between expenditures and revenues. Households equally borrow from the financial sector to fund large purchases that exceed their existing incomes.

While self-finance through savings is an option for companies and families, however, the services provided by these financial sector firms through the provision of vehicles and instruments for these savings, investment, lending and borrowing actions are generally superior to self-finance through accumulated savings.

In developing countries, the roles of capital and the financial sector is even more crucial. This is because the citizenry and government hope that their economies will grow rapidly, so as to generate significantly higher per capita incomes and standards of conduct. King and Levine, (1993) notes that an efficient financial sector i.e. one that encourages savings, marshals those savings effectively, and allocates them to the investments that will produce larges increases in future products and services can be an pivotal part of strategy to achieve rapid economic growth.

To underscore the importance of the financial sector development the economy and partly address perceived shortcomings of the sector in providing financial services, governments has internationally intervened extensively in the operations of the financial services sector (World Bank, 1989).

Such interventions have included: government ownership of banks, insurance companies and other financial intermediaries; government limitations on the applicant by domestic and foreign enterprises into the financial services sector; government designation of sectors to which banks should lend; government regulation of interest rates; government strictures as to the forms and types of financial instruments that can be offered and government taxation of different instruments, transactions and income flows related to financial services.

The financial sector of an wealth encompasses firms such as banks, insurance companies, pension funds, stock brokerage firms that provide these and other financial services for the rest of the economy. However, this paper is exclusively concerned with the banking sector.

2.2 The role of the financial sector

An effective and efficient financial sector can improve the allocation of resources within an economy by improving the mobilization of resources from financial units with surplus funds and facilitating the transfer of those resources from actual savers to those economic units with an investment or use demands that are in excess of their own savings thus, creating wealth in the economy. The importance of this process can not be underestimated because through this process, the resources of an economy are better utilized, leading to a higher level of real income. As noted by Zahid (1995) the effective functioning of the financial sector leads to a higher average returns on investment resulting in higher savings rate, yielding more liquidity to the financial sector which they can contribute to profitable investments, which ultimately will increase the success rate of the economy.

Ideally, the banking sector develops to serve as an efficient intermediary between depositors and investors, generating market-clearing prices and interests rates. Such a situation has practical implications for saving and growth. According to Bencivenga and Smith (1991) the beneficial activities of banks are accepting deposits, lending thus eliminating the need for self financing.

Bank activities include two significant implications for savings and investment providing liquidity; banks allow risk-averse savers to hold bank deposits rather than pure (but unproductive) assets. Of particular importance is that banks can economise on liquid reserve holdings that do not contribute to capital accumulation. Also by eliminating self-financed capital investment, banks prevent the unnecessary liquidation of such investment by entrepreneurs who think that they need liquidity.

2.3 Banking sector development and economic growth

There is a considerable theoretical and empirical study that establishes a link between banking sector development and economic growth. This is because the nature of the banking system is infinite and widely spread where there are recent changes in banking regulations, services and instruments. The impact of these changes spread over the borders of one small regional economy to international and global economy.

In reality, many developing countries have not developed their financial systems and these have not been a priority and therefore not placed at the top of their development and growth agendas, unlike in developed economies it is recognised to be of significant importance to their economies and as such regards the financial system as the heart of the system because it harmonises economic activities and the efficient allocation of resources.

A wide range of empirical evidence supports the view that banking development can directly affect economic development and growth and lower income inequality (Jallian and Kirkpatrick, 2001; Westley, 2001). This is in agreement with the observation of the World Bank (2001) that there is a possibility of a casual relationship between an effectively- functioning banking system, macro-economic stability, poverty reduction and economic growth.

Comparative research on the link between the banking system and economic growth shows that firms located in economies with well-developed banking sector and stock markets, have grown faster than those in economies with similar systems but which are less developed (Demirguc-Kunt and Maksimovic, 1996; Levine and Zervous, 1996 and Rajan and Zingales, 1996).

It can be said that financial development has a dual impact on economic growth. On the one hand, the development of domestic financial markets may improve the effectiveness of capital accumulation and on the other hand, financial intermediation can contribute to rise in the savings rates investment. This approach was emphasized by Goldsmith (1969), who also finds some positive correlation between financial development and the level of real per capital GNP. He attributes this relationship to the positive impact that financial development has in encouraging more efficient use of the capital stock.

This was further corroborated by Greenwood and Jovanovic (1990) who showed that there is a positive two-way causal relationship between economic growth and financial development, pointing out that the process of growth stimulates higher participation in financial markets thereby facilitating the creation and expansion of financial institutions. While on the other hand financial institutions, by collecting and analyzing data from various potential investors, allow investment projects to be undertaken more efficiently hence stimulates investment and growth.

Banking sector development can also be measured by the margin between lending and deposit interest rates and by the percentage of non-performing loans in the economy. This is because both are significantly and negatively related to economic growth as non-performing loans describe the quantity and quality of information that the banking sector has collected and analysed which in turn affects its lending to investors.

Financial sector development may be an essential prerequisite for economic growth, since well-functioning markets and financial institutions may reduce the transaction costs and asymmetric information problems. At the same time, financial institutions play an increasingly pivotal role in identifying investment opportunities, selecting the most profitable projects, mobilizing savings, facilitating trading and the diversification of risk, as well as improving corporate governance mechanisms.

Also Becsi and Wang (1997), found that the underdevelopment of the banking sector negatively impacts upon population and growth, whereas efficient banking sectors positively affect economic growth through the efficient allocation of resources to the most productive users. In addition they revealed that restricting the deposit rate and increasing reserve requirements, reduce growth rates. Similarly, Levine (1997) supports the argument of a positive association between financial sector development and economic growth, arguing that the development of financial institutions and markets is an essential part of the growth process and not “an inconsequential side show responding passively to economic growth and industrialisation (p.689).

The World Bank (2001) cited empirical studies, which strongly suggested that improvements in financial arrangements precede and contribute to economic performance. For example, King and Levine (1993a) showed that the level of financial development in 1960 was a significant determinant of economic growth. Other recent studies have tried to determine whether financial development leads to improved economic growth and performance. For example, Beck et al, (2000) evaluated the long-term impact of the exogenous component of financial intermediary development on the sources of economic growth by using cross-country sample with data averaged over a period 1960-1995. They found that financial intermediaries have a large, positive effect on total factor productivity growth and that the log-term links between financial development and both physical investment growth and private saving rates are weak.

Equally, Nidkumana (2001) investigated the links between financial development and economic development, finding that empirical research on the relationship between financial development and economic growth in Africa remains limited. However, the existing evidence suggests that financial development is positively related to the growth rate of real income and further indicates that financial systems are still relatively under-developed in the majority of African countries.

Neimke (2003) used a theoretical and empirical approach to explain the dynamic link between financial development and economic growth in the transition countries. He found that both the theoretical explanations and the empirical results, point to financial institutions having significant effects for investment and the development of factor productivity as the foundation for long-term positive growth. This is particularly true of Central and Eastern Europe as well as for the former Soviet Union economies that have inherited widely obsolete capital stock and are thus suffering from sharp declines in their growth rates.

Beck et al (2005) found that financial development boots the growth of industries that are naturally composed of small firms, more than large-firm industries. Their work contributes to the literature on the mechanism through which the financial development boosts aggregate economic growth. Besides confirming that financial development facilitates economic growth by boosting the growth of firms that rely on external finance, they show that financial development fosters economic growth by relieving constraints on small firm growth.

Fase and Abma (2003) examined the empirical relationship between financial development and economic growth in nine emerging economies in South-East Asia finding that financial development matters for economic growth. The results indicate that improvement of the banking system in developing countries may benefit economic development and also that the financial infrastructure is of immense importance for economic welfare.

Analysing the relationship between banking sector development and growth in the short and long term, Fisman and Love (2004) found that over the long run, banking sector development supports and promotes economic growth through a deepening of markets and services that channel savings to productive investment; these positive aspects of banking development lead to higher economic growth in the long-term.

Regarding the role of banking sector development in both oil and non-oil exporting countries, Nili and Rastad (2007) reported a lower level of financial development for the oil economies when compared with the rest of the world. The study also shows that the weakness of financial institutions contributes to the poor performances of economic growth in oil economies and that this weakness might be associated with the dominant role of government in total investment and under-developed private sector.

For a rapidly developing economy like China, the development of the financial sector has significantly induced growth in the real economy. According to Liang and Teng (2005) who investigated the relationship between financial development and economic growth over the period 1952-2001, found that financial development, physical capital stock, international trade and real interest rate are all economically and significantly related to economic growth. They also suggested that in developing countries it is critical to establish well-developed financial systems, particularly with sound financial intermediation and liberalised interest rates, all of which are essential for the efficient allocation of credit, which in turn can help maintain sustainable high economic growth.

Calderon and Liu (2003) examined the direction of causality between banking sector development and economic growth on data from 109 developing countries and industrial countries from 1960 to 1994. They found that the banking sector development generally leads to economic growth and that there is a positive interaction between financial and economic growth. They also reported that financial deepening contributes more to the casual relationship in the developing countries. Financial deepening propels economic growth through both a more rapid capital accumulation and productivity growth.

However, not all economists agree that the banking sector development plays any remarkable role in economic growth. For example, the Miller-Modigliani theorem (1961) argued that “real economic decisions are independent of the methods of financing, thus leaving only a passive role for the financial sector” (cited in Wang, 1997:47). Also Chandavarker (1992) concluded that “none of the pioneers of development economics even list finance as a factor in development, thus finance is viewed as handmaiden to enterprise by responding to the demand for the particular types of financial services generated by economic development” (p.134).

Furthermore, Ram (1999) argues that the impact of bank development on economic growth is theoretically ambiguous stating that there is a lack of significant positive association between financial development and economic growth.

Shan, et al (2001) take a different view regarding the link between financial sector development and economic growth arguing that recent experiences are comparatively inconsistent with the widely held view. They noted that the rapid growth of many Asian economies in the 70s and 80s has been accomplished with domestic financial sectors that could not be regarded as developed. Furthermore, they argued that many OECD countries embarked on financial reforms in the 1980s, yet savings, investment and growth in them have not accelerated. Even where savings has risen following financial deregulation, there is yet little empirical evidence concerning a linkage between savings and domestic environment (Bodman, 1995).

It could be argued that the roles of banks in economic growth of countries are limited especially in developing economies where imperfect information exists. The paradigm of asymmetric information between borrowers and lenders offers valuable insights into the forms that finance is likely to take; as it will determine who will be able to obtain finance, from whom and under what terms and conditions. This process will severely limit access to funds for those who need it and thus slow the rate of economic activities. Thus, banks engage in credit rationing to compensate for this risk by imposing higher prices on borrowers which discourages borrowers with worthwhile investments from seeking loans, thereby worsens the rate economic activities in the country. In effect the role of banks in economic growth is severely limited as credit rationing discourages a pool of borrowers which undermines the markets (Bhattacharya and Thakor, 1993).

Though, De Gregorio (1993) suggests that the relationship between borrowing constraints and growth will ultimately depend on the importance of the effect of borrowing constraints on the marginal productivity of capital relative to their effect on the volume of savings. Guidotti and De Gregorio (1995) shows that a relaxation of borrowing constraints increases the incentives for human capital accumulation which is likely to increase the marginal product of capital hence may lead to higher growth despite the reduction in savings.