Background to the Study
The theoretical argument that supports the link between financial development and growth is that a well developed financial system performs several critical functions to enhance the efficiency of intermediation by reducing information, transaction, and monitoring costs. A well developed financial system enhances investment by identifying and funding good business opportunities, mobilizes savings, enables trading, hedges and diversification of risks, and facilitates the exchange of goods and services. These functions result in a more efficient allocation of resources, rapid accumulation of physical and human capital, and faster technological progress, which in turn results to economic growth.
An efficient financial system is one of the foundations for building sustained economic growth and an open, vibrant economic system. In the early neoclassical growth literature, financial services played a passive role of merely channeling household savings to investors. Nevertheless, Demetrides and Andrianova (2004) as structured in the works of Goldsmith (1969) and Mickinnon (1973) were among authors who offered a contrary view. They proposed a more role for financial services in promoting growth. Ever since, substantial volume of theoretical and empirical literature has emerged, analyzing the role of finance in growth and development. The success of the financial
System throughout the world has been predicted on the initiation of financial sector reforms.
The Nigerian financial system can be broadly divided into two categories namely: the formal financial system and the informal financial system. The formal financial system can be further subdivided into capital and money market institutions and these comprise the banks and non-bank financial institutions. The informal sector comprises the local money lenders, the thrifts and savings associations etc. Prior to 1986 the activities of these institutions were regulated by the Federal Ministry of Finance (FMF), Central Bank of Nigeria (CBN), Nigerian Deposit Insurance Corporation (NDIC), Securities and Exchange Commission (SEC), National Insurance Commission (NIC), Federal Mortgage Bank of Nigeria (FMBN), and the National Board For Community Banks. But following the collapse of the world oil market in the late 1970s, there was a drastic reduction in earnings from crude oil as a result of which the country began to experience a severe economic downturn. In 1981, Nigerian government adopted various austerity measures such as price control and demand management policies. However, by December 1985, it became evident that austerity measures without a proper structural adjustment were inadequate response to the fundamental economic problems confronting the economy. Consequent upon the foregoing, the Nigerian government initiated a series of reform measures aimed at bringing about economic growth and stability in 1986. Paramount among these policies was the financial sector liberalization. The aim of initiating these reforms is to create a more efficient and stable system, which will facilitate optimum performance in the economy. This means providing a foundation for implementing effective stabilization policies and successfully mobilizing capital and putting it to effective use, which leads to achieving higher rates of economic growth (Johnston and Sundararajan, 1999). Many countries have experienced successful financial sector reforms which have been accompanied by improvements in economic growth and efficiency of the financial system, while other countries have faced financial crises and disruptions to economic growth.
The essence of emphasis on the development of the Nigerian financial sector is in the theory of financial repression which posits that efficient utilization of resources via a highly organized, developed and liberal financial system enhances economic growth. This thesis, more or less, confirmed the conclusions of earlier works on the importance of the financial system which could be traced back to the works of Schumpeter (1912) as put forward by Masten (2008) and Arcandi (2012). Further enhancements to this hypothesis were explored in the works of Galbis (2011).This school of thought is classified as supply-led theory of finance-growth nexus. While there is a near consensus that a well-functioning financial sector is a precondition for the efficient allocation of resources and the exploitation of an economy’s growth potential, the economic literature is less consensual on how and to what extent finance affects economic growth.