CHAPTER ONE
INTRODUCTION
1.1 Background of the
study
The financial systems
of most developing nations have come under stress as a result of the economic
shocks of the 1980s. The economic shocks largely manifested through
indiscriminate distortions of financial prices which includes interest rates,
it tend to reduce the real rate of growth and the real size of the financial
system relative to non-financial magnitudes (Davidson and Gabriel, 2009). The
preferential interest rates were based on the assumption that the market rate,
if universally applied, would exclude some of the priority sectors.
Interest rates were, therefore, adjusted periodically with ‘visible
hands’ to promote increase in the level of investment in the different sectors
of the economy. For example agriculture and manufacturing sectors were accorded
priority, and the commercial banks were directed by the Central Bank to charge
a preferential interest rates (vary from year to year) on all loans and
advances to
small-scale industries. Since 1986, the
inception of interest rates deregulation, the government of Nigeria has been
pursuing a market determined interest rates regime, which does not permit a
direct state intervention in the general direct of the economy (Adebiyi and
Obasa, 2004).
Lending which may be on short, medium or long-term basis is one of the
services that deposit money banks do render to their customers. In other words,
banks do grant loans and advances to individuals, business organizations as
well as government in order to enable them embark on investment and development
activities as a means of aiding their growth in particular or contributing
toward the economic development of a country in general (Felicia, 2011). Deposit money banks are the most important
savings, mobilization and financial resource allocation institutions. Consequently,
these roles make them an important phenomenon in economic growth and
development. In performing this role, it must be realized that banks have the
potential, scope and prospects for mobilizing financial resources and
allocating them to productive investments and in return promote their
performance. Therefore, no matter the sources of the generation of income or
the economic policies of the country, deposit money banks would be interested
in giving out loans and advances to their numerous customers bearing in mind,
the three principles guiding their operations which are, profitability,
liquidity and solvency (Adolphus, 2011).
However, banks decisions to lend out loans are influenced by a lot of
factors such as the prevailing interest rate, the volume of deposits, the level
of their domestic and foreign investment, banks liquidity ratio, prestige and
public recognition to mention just but a few. Lending practices in the world
could be traced to the period of industrial revolution which increase the pace
of commercial and production activities thereby bringing about the need for
large capital outlays for projects. Many captains of industry at this period
were unable to meet up with the sudden upturn in the financial requirements and
therefore turn to the banks for assistance (Ezirim, 2005).
Again, the emergence of banks in Nigeria in
1872 with the
establishment of
the African Banks Corporation (ABC) and later appearance of other banks in the
scene during the colonial era witnessed the beginning of banks’ lending
practice in Nigeria. Though, the lending practices of the then colonial banks
were biased and discriminatory and could not be said to be a good lending
practice as only the expatriates were given loans and advances. This among
other reasons led to the establishment of indigenous banks in Nigeria. Prior to
the advent of Structural Adjustment Programme (SAP) in the country in 1986, the
lending practices of banks were strictly regulated under the close surveillance
of the bank’s supervisory bodies. The SAP period brought about some relaxation
of the stringent rules guiding banking practices. The Bank and Other Financial
Act Amendment (BOFIA) 1998, requires banks to report large borrowing to the
CBN. The CBN also require that their total value of a loan credit facility or
any other liability in respect of a borrower, at any time, should not exceed
20% of the shareholders’ funds unimpaired by losses in the case of commercial
banks (Felicia, 2011).
This study becomes imperative because
banks in Nigeria need to understand how to manage these huge assets in terms of
their loans and advances. For the banks to balance their main objectives of
liquidity, profitability and solvency, lending must be handled effectively and
the banks must behave in a way that there potential customers are attracted and
retained.
Interest rate is
the cost of 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 loanable
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(2005) 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 affect 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. Consequently, most countries both
developed and developing have taken major steps to liberalize their interest
rates as part of the reform of the entire financial system.
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