CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND
OF THE STUDY
Bank
like other private enterprises establish polices aimed at achieving their
primary objectives
Profitability:
Interest
rate is the cost on borrowing and also the payment to a borrower of funds to
the lenders of the use of money borrowed. The interest rate policy is one of
the major tools employed by the monetary authorities to regulate the value,
supply and cost of money in an economy. In other words, the economic activity
in any economy to a large extent is influenced by interest rate.
Interest
rate as a component of cost of fund, has contributed both positively and
negatively on the economy, and has gained considerable attention from
economist, lender and borrowers alike. It effect the demand for and allocation
of available laonable funds, it also effect the level of consumption on one
hand, and the level and patter of investment on the other hand, as higher
interest rates discourage borrowing and encourage savings and will also tend to
slow the economy. Lower interest rate encourage borrowing and economic growth
i.e the lower the interest rate, he higher the profit expectation as business
are expected to pay certain percentage of the money borrowed (little) as
interest for fund borrowed. Conversely, the higher the rate of interest the
less the profit expectations
There
was a time when the charging of interest on loans was sinful. It was using
one’s financial power for the save of extorting money after the banking debacle
of 2007 to 2008, questions on the morality and usefulness of interest rate have
arisen yet again. Until 1970’s the main line of argument was that because
interest rate represent the cost capital, low interest rate will encourage
people to borrow and promote economic growth. Thus, during the era, the policy
of low interest rate was adopted by many countries including the developing
countries of Africa (of which Nigeria is among). This position was, however
challenged by what is now known as the orthodox approach to financial
liberalization mckinnon kapur and the broader mckinnon- shaw hypothesis
suggested that high positive real interest- rate will encourage saving. This
will lead, in turn to move investment and economic growth, on the classical
assumption that prior savings is necessary for investment.
However,
high rate of interest to the borrowers on lending has contributed to the bank
failure in higher-risk segments of the credit market. This involved elements of
moral hazard on the part of both the banks and their borrower’s and the adverse
selection of the borrower’s. it was in part motivated by the high cost of
mobilizing funds. Because they wore perceived by depositors as being less safe
than the established bands, as commercial banks has to offer depositors higher
deposit rates. They also had difficulty
in attracting non-interest bearing current account because they could offer few
advantages to current account holders which could not also obtained from the
established banks. Some of the commercial banks relied heavily on high-cost
interbank borrowing from other banks and financial institutions on which real
interest rates of over 20 percent where not uncommon.
The
high cost of funds meant that the commercial bank had to generate high earnings
from their assets, for example, by charging high lendi ng rates with
consequences for the quality of their loan portfolios. The commercial banks
almost inevitably suffered from the adverse selection of their borrowers, many
of who had been rejected by the foreign banks (or would have been, had they
applied for a loan). Because they did not meet the strict creditworthiness
criteria demanded of them. As they had to charge higher lending rates to
compensate for local banks to compete with the foreign banks for the “prime”
borrowers (ie the most creditworthy borrower). As a result, the credit markets
were segmented, with many of the banks operating in the risky segment, saving
borrowers prepared to pay high lending rates because they could access no
alternative sources of credit. High risk borrowers includes other banks and
NBFIs which were short of liquidity and prepared to above market interest rate
for inter-banks deposits and loans. In Nigeria some of the commercial banks
were heavily exposed to finance houses which collapsed in large number in 1993,
as well as to other local Banus (Augustto and Co., 1995, pg. 40). Consequently,
bank distress had domino effects because of the extent to which commercial
banks lent to each other. Arguably a change in interest rate for loans is not
likely to effect decision to interest on long term equipment and other such
assets but will affect total spending in the economy.
1.2 STATEMENT
OF THE PROBLEM
the
financial system of most developing nations of which Nigeria is among, have
come under stress as a result of the economic shocks in recent time.
Additionally, financial repression, which has largely manifested through
discriminate distortions financial prices including interest rates has tended
to reduce the real rate of growth and the real size of the financial system relative
to non-financial magnitudes.
Consequently,
most countries both developed and developing have taken major steps to
liberalize their interest rates as part o the reform of the entire financial
system. Such liberalization represents a policy responses, encompassing a
package of measures to remove all undesirable state imposed constraints on the
free working of the removal of interest rate ceiling and loosening of deposit
and credit control (Killick and Marhn:1990).
According
to the Keynesians, interest rate increases investment while a rise in the rate
of interest dempen’s investment. Anyawu (1993) reported that as soon as the
central bank of Nigeria announced deregulation of interest rate in 1987, bank
over reacted by purchasing interest rate tools high reaching 30-40 percent.
Such rise helped in rendering borrowers
insolvent while is nothing but boomerage.
Interest
rate has contributed both positively and negatively on the economy (how people
lend and borrow money as it effect the demand for and allocation of available
loanable funds. Hence, the need for this research work, to determine if the
interest rates have helped in increasing the level of investment or how people
responds to lending and borrowing when
interest is high or low among banks in Nigeria.
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