CHAPTER
ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
Bank like other private enterprises establish
polices aimed at achieving their primary objectives. 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 lending 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 include 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 response, 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 depends on
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.
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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