IMPACT OF THE STRUCTURE OF NIGERIAN FINANCIAL SYSTEM ON ECONOMIC GROWTH

ABSTRACT

This study examines specifically the impact of the structure of the Nigerian financial system on economic growth. The study used time series data for 17 year period: 1992-2008, to fill this important research gap. The study used the Time Serial General Method of Movement regression approach to estimate the formulated models in line with financial structure theories. The growth rate of the gross domestic product was adopted as the dependent variable, while the independent variables include; conglomerate index of bank-based financial structure; conglomerate index of market-based financial structure, conglomerate index of financial service-based financial structure; and the conglomerate index of the  legal-based financial structure. The regression results showed that the coefficient of bank-based theory was positive in promoting economic growth. The market-based theory was also positive in promoting economic growth. The coefficient of the financial service view was found to be positive in exerting influence on long- run growth. However, the legal-based theory coefficient was negative in promoting economic growth. On the overall, the structure of the Nigerian financial system is most consistent with the financial service view, which hypothesizes that the bank-based structure, market-based structure and legal-based structure are all important to the development of the financial system since they play  different  roles  in  ameliorating  risk  and  promoting  investment  at  different  stages  of economic development. Based on these findings, the study recommends that policy makers should focus their attention on legal, regulatory, and other policy reforms that encourages the proper functioning of both markets and banks, rather than concern themselves with the degree to which Nigerian financial system is bank-base or market-based.

1.1      Background of the Study

CHAPTER ONE

INTRODUCTION

The taxonomy established by Gerschenken (1962), which divided financial system into two categories; ‘bank-based and market-based’ financial structure has generated serious controversy among scholars. The argument has been polarized along the following lines; (1) the standard parameters or measurement for classifying a country’s financial system either as bank-based or market-based; (2) which of these classifications exert more influence on economic growth; and (3) the determinants of a country’s financial structure.

Financial structure has to do with the institutions, financial technology, and rules of the game that  specify how  financial activity is  organized at  a point  in time (Stulz, 2001). Financial structure provides (1) a payment system, (2) a mechanism for pooling funds, (3) a way of transmitting resources across space and time, (4) a way to manage uncertainty and control risk, (5) price information to allow the economy to implement a decentralized allocation, and (6) a way to deal with the asymmetric information problems that arise when one party to a financial transaction has an information that the other party does not have (Merton, 1995).

According to Stulz (2001), financial structure is to the financial system what foundation is to the house. Many different houses can be built on the same foundation. However, a foundation makes it impossible to build some type of houses. Thus, the function of a financial system can be performed by different institutions or according to different rules. The difference in the characteristics of a country’s financial system and level of economic growth has led to the classification of the financial system into ‘bank-based and market based’ financial structure (Gerschenken, 1962).

The link between financial structure and long-run growth can be examined on the basis of competing theories of financial structure. These are: the bank-based theory, the market-based theory, the financial services theory and the legal based theory (Gerschenken, 1962; Levine,

2002; Beck and Levine, 2002 and La Porta et al; 1997). The bank-based theory lays much emphasis on the positive role of banks in  development and growth, and also,  stresses the shortcomings of market-based financial systems. It argues that banks can finance development

more effectively than markets in developing economies, and, in the case of state-owned banks, market  failures can be overcome and allocation of savings can be  undertaken strategically (Gerschenkron, 1962). Those banks that are unhampered by regulatory restrictions, can exploit economies of scale and scope in information gathering and processing (for more details on these aspects of bank-based systems, see Levine, 2002, and Beck and Levine, 2002).

The bank-based theory emphasises the importance of banks in identifying good projects, mobilising resources, monitoring managers and managing risk, while stressing the deficiency of market-based economies. For example, it has been argued that banks are effective at financing projects that are characterised by substantial asymmetric information (e.g, adverse selection and moral hazard), because banks have developed expertise for distinguishing between “bad and good” borrowers. According to the bank-based theory, bank-based financial systems, especially in countries at an early stage of economic development, are more effective at fostering growth than market-based financial system.

Indeed, bank-based financial systems are in a much better position than market-based systems to address agency problems and short-termism (Stiglitz, 1985; Singh, 1997). The bank-based theory also stresses the shortcomings of market-based systems. The latter reveal information publicly, thereby reducing incentives for investors to seek and acquire information. Information asymmetries are thus accentuated, more so in market-based rather than in bank-based financial systems (Boyd and Prescott, 1986). Banks can ease distortions emanating from asymmetric information through forming long-run relationships with firms, and, through monitoring, contain moral hazard. As a result, bank-based arrangements can produce better improvement in resource allocation and corporate governance than market-based institutions (Stiglitz, 1985; Bhide, 1993).

In particular, advocates of the bank based view argue that well functioning markets instantly reveal information in public markets, which provides individual investors with less incentive to acquire information. This argument is primarily based on the well known free-rider problem. If information is going to be revealed by the market, no one has incentive to collect it. As a result, competitive financial markets may be characterised by underinvestment in information. Consequently, well developed financial markets have a negative impact on the identification of innovative projects and thereby impede efficient resource allocation (Stiglitz, 1985 and Booth,

Greenbaum, and Thakor, 1993). Banks may have better incentives to gather information and monitor firms, and can efficiently internalize the fixed cost of doing so (Diamond, 1991).

Proponents of the bank-based theory also underscore the fact that liquid markets can create an environment in which individual investors behave as if they were myopic (Bhide, 1993). Specifically, because individual investors are able to readily sell their shares in liquid markets, they have fewer incentives to monitor managers thoroughly. This implies that greater market development may hinder corporate and economic performance (Levine, 1997, 2000). Another argument that financial markets are not well suited for corporate control is that insiders have better information about the firms than outsiders do. This information asymmetry moderates the potential effectiveness of takeovers, given that it is more likely that well informed insiders will outbid less informed outsiders (Arestis, Demetriades and Luintel, 2001).

Moreover, the bank-based theory argues that while markets can potentially provide the best- customised products for diversifying risk, they are unable to diversify aggregate shocks because, for a number of reasons, markets are incomplete. Another strand of argument relates to informational asymmetries and related problems (e.g., adverse selection and moral hazards). Contracts for the delivery of the financial services can be contingent only on states whose occurrence can be verified to the satisfaction of all counterparties (Rajan and Zingales, 1999). Another class of reasons stems from transaction costs: the time and money spent in carrying out financial transactions are major impediments in the development of markets (Allen and Gale,

1997). Yet, another class of reasons comes from enforceability constraints: a promise to deliver one unit of financial service is worthless if delivery cannot be enforced. This incompleteness of market-based structure gives rise to the development of institutions such as banks that can take the place of “missing markets”,

Therefore,  in  some  cases,  particularly  those  involving  intertemporal  risk-sharing,  “which averages aggregate risks over time through the accumulation of reserves in safe assets”, bank- based systems may offer better risk ameliorating services than market-oriented system (Allen and Gale, 1997). More precisely, even in countries with weak legal and accounting systems, powerful banks can  still  make  firms reveal  information and  pay  back their  debts,  thereby

facilitating expansion and long-run growth (Rajan and Zingale, 1999). In sum, the bank-based theory predicts that bank-based systems are more growth promoting than market-based systems.

However, the market-based theory highlights the advantages of well-functioning markets, and stresses the problems of bank-based financial systems. Big, liquid and well-functioning markets foster   growth  and   profit   incentives,   enhance   corporate  governance   and   facilitate   risk management (Levine, 2002, and Beck and Levine, 2002). The inherent inefficiencies of powerful banks are also stressed, for they “can stymie innovation by extracting informational rents and protecting firms with close bank-firm ties from competition ….. may collude with firm managers against other creditors and impede efficient corporate governance” (Levine, 2002, p. 3). Market- based financial systems reduce the inherent inefficiencies associated with banks and are, thus, better in enhancing economic development and growth.

A related argument is that developed by Boyd and Smith (1998), who demonstrate through a model that allows for financial structure changes as countries go through different stages of development. Their findings show that countries become more market-based as development proceeds. An issue of concern, identified by a recent World Bank (2001) study in the case of market-based financial systems  in  developing countries,  is  that  of asymmetric  information. Scholars have argued that the complexity of modern economic and business activity has greatly increased the variety of ways in which insiders can try to conceal firm performance. Although progress in technology, accounting, and legal practice has also improved the tools of detection, on balance the asymmetry of information between users and providers of funds has not been reduced as much in developing countries as it has in advanced economies – and indeed may have deteriorated.

The market-based theory essentially counter-attacks the bank-based theory by concentrating on problems generated by powerful banks. First, in the process of financing firms, banks get access to information that is not available to other lenders. Banks can use such inside information to extract rents from firms. More concretely, at the time of new investments or debt renegotiations, banks can have bargaining power over a firm’s expected future profits. Powerful banks can obtain disproportionately large share of the profits, so that firms will have fewer incentives to undertake high risk and profitable projects (Rajan, 1992).

Second, when banks enter into a debt contract with firms, they have a natural bias towards low risk projects that have a high probability of success. The drawback of this behaviour, however, is that low risk projects are generally low-return investments. Therefore, bank-based financial systems can curtail technological innovation and long-run economic growth. Weinstein and Yafeh (1998) have found evidence in Japan that supports these two points. They show that, while close relationship between banks and firms increase the availability of capital to borrowing firms, they do not necessarily lead to profitability or growth. In fact, the cost of capital for firms with close bank ties is higher than that of their peers, which suggests that most of the benefits from these relationships are appropriated by banks. The slow growth rate of bank clients also indicates that banks discourage firms from investing in risky but profitable projects.

Third, powerful banks can collude with managers against outsiders, which in turn impedes competition, corporate controls, the creation of new firms, and thus long-run economic growth (Hellwig, 1998). Wenger and Kaserer (1998) provide evidence from Germany where banks misrepresent balance sheet of firms to the public and encourage firm managers to misbehave.

Fourth, Allen and Gale (1999) argue that, although intermediaries can be effective at eliminating duplication of information gathering and processing, they can have less success dealing with uncertainty, innovation, and new ideas. For example, the assessment of new technologies is hard either because little information is available about their potential returns because the information itself is difficult to  judge without some expertise or sound knowledge. The wide range of possibilities and the lack of hard data mean that there is often substantial diversity of opinion (Chemmanur and Fulghieri, 1994; Levine, 2000). Bank financing requires delegation of the decision regarding the financing of a project to a relatively small number of decision makers. When there is no disagreement, this kind of delegation is very effective and can imply substantial cost savings. A problem, however, exists when diversity of opinion persists. Although managers do everything they possibly can to choose project they believe are worthwhile ( i.e., abstracting from the principal-agent problem), diversity of opinions suggests that some of the providers of fund disagree with those decisions. If the likelihood of disagreement is high enough, investors may have fewer incentives to supply funds (Chemmanur and Fulghieri, 1994).

Consequently, bank-based financial systems imply the underfunding of new technologies. Because market-based systems allow individuals to agree and disagree, and therefore allow coalitions of people with similar views to join together to finance projects, markets are very effective at financing industries that are new, or where relatively no relevant data is created; that is, industries in which little information is available and a diversity of opinion perseveres (Allen and Gale, 2001).

The financial services theory (Merton and Bodie, 1995; Levine, 1997), is actually consistent with both the bank-based and the market-based theory. Although it embraces both, it minimizes their importance in the sense that the distinction between bank-based and market-based financial systems matters less than was previously thought; it is financial services themselves that are by far more important, than the form of their delivery (World Bank, 2001). In the financial services theory, the issue is not the source of finance. It is rather the creation of an environment where financial services are soundly and efficiently provided. The emphasis is on the creation of better functioning banks and markets rather than on the type of financial structure.

Simply put, this theory suggests that it is neither banks nor markets that matter; it is both banks and markets. They are different components of the financial system; they do not compete, and as such ameliorate different costs, transaction and information, in the system (Boyd and Smith,

1998; Levine, 1997; Demirguc-Kunt and Levine, 2001). Under these circumstances, financial arrangements emerge to ameliorate market imperfections and provide financial services that are well placed to facilitate savings mobilisation and risk management, assess potential investment opportunities, exert corporate control, and enhance liquidity. Consequently, as Levine (2002:3) argues, “the  financial services view places the  analytical spotlight on how to  create better functioning banks and markets, and relegates the bank-based versus market-based debate to the shadows”

The legal-based theory of financial structure –espoused by Laporta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998, 1999a,1999b) – extends the financial services view and unconditionally rejects the bank-based versus market-based debate. The legal-based theory argues that finance is a set of contracts. These contracts are defined – and made more or less effective – by legal rights and enforcement mechanisms. From this perspective, a well functioning legal system facilitates

the operation of both markets and intermediaries. It is the overall level and quality of financial services – as determined by the legal system – that improves the efficient allocation of resources and economic growth. According to the legal-based theory, the century long debate concerning bank-based versus market-based financial systems is analytically vacuous.

Empirically, a number of studies have concentrated on comparisons that view Germany and Japan as bank-based systems, while the US and UK as market-based systems. These studies have employed rigorous country-specific measures of financial structure. Studies on Germany and Japan use measures of whether banks own shares or whether a company has a ‘main bank’ respectively (Hoshi et al., 1991; Mork and Nakkamura, 1999; Weinstein and Yafeh, 1998). These studies provide evidence that confirm the distinction between bank-based and market- based financial systems in the case of the countries considered. However, reassessment of the evidence on the  benefits of the  Japanese  financial system in  view of the  economy’s poor performance in the 1990s has concluded against the beneficial effects of the bank-based nature of this system. Bank dependence can lead to a higher cost of funds for firms, since banks extract rent from their corporate customers (Weinstein and Yafeh, 1998).

Studies on the US and the UK concentrate on the role of market takeovers as corporate control devices (Wenger and Kaserer, 1998; Levine, 1997), and conclude in favour of market-based financial systems. Goldsmith (1969: 407), however, argues that such comparison in the case of Germany and the UK for the period 1864-1914 does not contribute to the debate since “One cannot well claim that a superiority in the German financial structure was responsible for, or even contributed to, a more rapid growth of the German economy as a whole compared to the British  economy  in  the  half-century  before  World  War  I,  since  there  was  no  significant difference in the rate of growth of the two economies”.

Levine (2002:4) in reinforcing Goldsmith’s (1969) argument concludes that “financial structure did not matter much since the four countries have very similar long-run growth rates”. Levine (2002) addresses this problem by using a broad cross-country approach that allows treatment of financial system structure across many countries with different growth rates. The findings of this study support neither the bank-based nor the market-based theory; they are, instead, supportive

of the  financial  services theory,  that  better-developed financial system  is  what  matters for economic growth.

An earlier study by Demirguc-Kunt and Levine (1996), using data for forty-four industrial and developing countries for the period 1986 to 1993, conclude that countries with well-developed market-based institutions also have well-developed bank-based institutions; and countries with weak market-based institutions also have weak bank-based institutions, thereby supporting the view that  the  distinction between bank-based and  market-based financial systems  is  of no consequence.  Also,  Levine  and  Zevros  (1998),  employing  cross-country regressions  for  a number of countries covering the period 1976 to 1993, conclude that market-based systems provide different services from bank-based systems. In particular, market-based systems enhance growth through the provision of liquidity, which enables investment to be less risky, so that companies can have access to capital through liquid equity issues (Atje and Jovanovic, 1993, and Harris, 1997). The World Bank (2001:48) provides a comprehensive summary of the available evidence, which also reaches similar conclusions. It argues strongly that the evidence should be interpreted as clearly suggesting that “both development of banking and of market finance help economic growth: each can complement the other”.

To provide greater information on both the importance and determinants of financial structure, economists have broadened the debate to include a wider array of national experiences However empirical studies yield to  controversies, which are also  based on conceptual and statistical descriptions. The arguments are still on, with improved statistical and econometric tools of analysis. Country-specific studies have also been undertaken, yielding to more controversies and revelations on the  subject  matter. At  individual country level,  empirical study on Nigerian financial structure based on the researcher’s knowledge is scant, yet the structure of Nigerian financial system is expanding both in size and complexities. It is this knowledge gap that this study wants to fill.

1.2      STATEMENT OF RESEARCH PROBLEM

The decision of developed and developing economies to move conveniently away from free market fundamentals to a regulated economy regime with the government taking up major stakes in the financial markets through the injection of funds into the institutions as a measure of

curbing  the  global  financial  crisis  has  raised  important  issue  of  controversy  in  policy formulation. Some countries injected liquidity in the form of preference shares, while others injected liquidity in the form of tier-two capital. Analysts believed that these decisions were informed by the countries preference for a particular financial structure and also, evidences based on studies undertaken in those countries. In developed economies, policy makers show strong preference to a particular financial structure that exerts more influence on economic growth.

In Nigeria, the government via the Central Bank of Nigeria (CBN) injected N620b in form of tier-two capital. This important bail-out decision has the capacity of promoting based-based financial structure over market-based financial structure. However, the government did not in any way attempt a bail-out the capital market, when one considers the fact that the stock market was not spared either by the global financial crisis. For example, the Nigerian Stock Exchange that witnessed unprecedented growth in total market capitalization and value of share traded for

2004 to early 2008, experienced a serious downturn in its activities during the global credit crunch. According to Udeme (2009) the market capitalization of the 303 listed equities.., which had opened on January 1st, 2008, at N10.18tn and later appreciated to N12.395tn as at March

2008, suffered its highest fall in the 48-year history of the Nigerian Stock Exchange, depreciating by N3.223tn or 32 per cent to N6.957tn by the year end. Similarly, the NSE All Share Index depreciated by the same margin from 63,016.60 at which it opened in January, to 31,450.78 at the last trading day at 2008 (Udeme, 2009).

The decision to bail-out banks in the form of tier-two capital raises important questions such as; what  is  the  structure of Nigerian  financial  system?; which  of these  structures exert  more influence  on  economic  growth?  Research  that  clarifies  our  understanding  of  the  financial structure that promotes economic growth in Nigeria will have policy implication and shape future policy oriented research. Also, information from such study will influence the priority policy makers and advisor attach to reforming the financial system. A very good understanding of the country’s financial structure will in no measure be invaluable for such an important decision.  Relying  on  existing  studies  of  financial  structure  in  other  jurisdiction  can  be misleading.

The major shortcomings with existing studies are; they focus on a narrow set of countries with similar levels of GDP per capita, such that countries have similar long-run growth. The debate has  primarily  focused  on  four  countries,  Germany,  Japan,  United  States  of  America,  and England.  United  States  of  America  and  England  are  generally  classified  as  market-based financial  system;  while  Germany  and  Japan  are  classified  as  bank-based  financial  system (Arestis and Demetriades, 1993; King and Levine, 1993).

Other concerns have been raised on these cross-country studies. For instance, Levine and Zervos (1996) state that panel regressions mask important cross-country differences and suffer from “measurement, statistical, and conceptual” problems. Quah, 1993 and also Caseli et al., (1996), demonstrate the difficulties associated with the lack of balanced growth paths across countries when pooling data. Pesaran and Smith (1995) point out the heterogeneity of coefficients across countries.  Luintel and  Khan (2002)  show that  panel  estimates often do  not  correspond to country-specific estimates. Consequently, generalizations based on panel results may proffer incorrect inferences for several countries in the panel. In short, according to Arestis and Luintel (2004), panel estimates may be misleading at country level; consequently their policy relevance may be seriously impaired. Arising from conflicting results of cross-country studies on financial structure, the need to carry out a country-specific study which is the pre-occupation of this work is justified.

1.3      OBJECTIVES OF THE STUDY

The overall objective of this study is to investigate empirically how financial structure can predict growth using data from Nigeria. To achieve this, the study shall strive to accomplish the following specific objectives;

(I)       Investigate whether the Nigerian financial structure is bank based or market based.

(II)      Determine the impact of bank-based (bank-based theory) financial structure on long- run economic growth in Nigeria.

(III)     Ascertain the impact of market-based (market-based theory) financial structure on long-run economic growth in Nigeria.

(IV)    Establish  the  relationship  between  overall  financial  deepening  (financial  service theory) and long-run growth in Nigeria.

(V)      Investigate  the  relationship  between the  financial  structure  defined  by  the  legal system (legal-based theory) and long-run growth in Nigeria.

(VI)    Establish the determinants of Nigerian financial structure.

1.4      RESEARCH QUESTIONS

This study will try to provide answers to the following questions;

I.   Is the Nigerian financial structure bank-based or market-based?

II.  What is the impact of bank-based financial structure on economic growth in Nigeria? III. What is the impact of market-based financial structure on long-run growth in Nigeria?

IV. Is there any relationship between the financial services available in the Nigerian financial system and long-run growth in Nigeria?

V.  Does the financial system defined by the legal system exert any impact on long-run growth in Nigeria?

VI. What is(are) the determinant(s) of financial structure in Nigeria?

1.5 RESEARCH HYPOTHESES

Based on these objectives, the following a priori assumptions will be made; (I)       The structure of Nigerian financial system is not bank-based.

(II)      Bank-based financial structure does not exerts positive influence on long-run growth in Nigeria.

(III)     Market-based financial structure does not impact positively on long-run economic growth in Nigeria.

(IV)    The overall financial deepening is not the major determinant of long-run economic growth in Nigeria.

(V)      There is no positive and significant relationship between the financial system defined by the legal system and long-run growth in Nigeria.

(VI)    Nigerian  Legal  origin  is  not  the  major  determinant  of  the  country’s  financial structure.

1.6      SCOPE OF THE STUDY

This study will cover the period: 1986-2008. Borrowing extensively from other works along this line,  the  study  will  focus  mainly  on  financial  structure  variable  such  as:  total  market

capitalization,  value  of shares traded,  banking  credit  to  private  sector,  monetary aggregate (defined as currency, demand deposits, travelers’ cheque, other chequable deposits, savings deposits, small time deposits, money market deposits accounts, money market mutual fund not owned by institutions, overnight repurchase agreement and overnight Eurodollar), and other dummies that will be used to proxy the legal system.

The data will be collated from the Nigerian Stock Exchange fact books, the Nigerian Stock Exchange annual report and statements of account (various), Central Bank of Nigeria statistical bulletin, Central Bank of Nigeria annual statements of accounts (various).

1.7      SIGNIFICANCE OF THE STUDY

a.  To Policy Makers

Besides resolving theoretical debates, providing empirical evidence on financial structure will help in formulating growth-enhancing public policies. If the evidence supports either the bank- based or market-based theorys of financial structure and growth, then policy makers can focus on formulating  and  implementing policies  to  encourage and/or  enhance the  development  of a particular financial structure. Towards this end,  Demirguc-Kunt and Levine (1999) provide evidence on the legal, tax, and policy determinants of financial structure.

If the evidence rejects the bank-based and market-based approaches and supports the financial services approach to financial structure, then policy makers should focus more on improving the functioning of both banks and markets. More specifically, evidence supporting the legal-based theory of financial structure and growth would highlight the importance of strengthening the rights of investors and improving the efficiency of contract enforcement. Thus, empirically distinguishing the merits of the competing views of financial structure and growth has critical policy implications for Nigeria.

b.  The Body of Academic

This study will contribute immensely in resolving the ranging debate on the relationship between financial structure and long-run growth. The study will contribute to existing literature, and will be of great value to further studies in Nigeria on financial structure and long-run growth.

c.   Financial Institutions

This study considers the role of banks and stock market in promoting long-run growth in Nigeria. This study, partly will review the channels through which bank and stock market activities promotes economic growth. This considerably is very important information for banks in their credit  policy formulation, and  for the Nigerian Stock Exchange in regulating stock market activities.

1.7      Operational Definition of Terms

Financial Structure

Financial structure consists of the institutions, financial technology and the rules of the game that define how financial activity is organized at a point in time. Thus, financial structure is the polarization of a country’s financial system based on how firms mobilize funds. This polarization is majorly bank-based (financing firms through banking activities) or market-based (financing firms  through  the  capital  market).  Merton  (1991)  argues  that  a  financial  system  provides payment system; a mechanism for pooling funds; a way to manage uncertainty and control risk; and a way to deal with asymmetric-information problems that arise when one party to a financial transaction has information that other party does not have. These functions can be performed in different ways in different economies.

Focusing narrowly on how firms raise and manage funds, large corporations primarily raise funds through banks in bank centered economies and through public markets in market centered economies. The same function of a financial system can be performed by different institutions or according to different rules. There is a direct relationship between a country’s economic growth and financial structure. For example, Japan and United States of America had quite different financial structures at the same level of economic growth. Hence, no case can be made that the financial structure is completely endogenously determined (Levine, 2005).

Implicit in the financial structure argument is the notion of a tradeoff. Two familiar disciplines, corporate finance and development finance, can each be used to provide the analytical basis for this tradeoff view. Many development economists argue that investment is the key to growth and readily note that much more corporate finance is raised from banks than from equity sales even in the most developed markets. In traditional corporate finance, financial structure is seen as the

total financing mix of a firm or the sources of funding available to a firm. While in development finance, financial structure which is the core of this study is a slight departure since it looks at corporate source of funding from a macroeconomic perspective. The financial structure under this study is an assessment of overall financial development-the overall quantity and quality of financial instruments, markets and banks on economic growth. Since financial structure deals with the dichotomy of the financial system into the role of banks and markets in promoting economic growth, it is important to show the relationship between financial development and financial structure (Stulz, 2001).

Indicators of financial development that have been used in the literature consists of measures like turnover of stock market, stock trading relative  to  GDP, liquid  liabilities relative to  GDP, proportion of funds raised externally by firms,  and  so  on. All these  measures of financial development can be dramatically used for financial structure. However, there is no one to one relationship between financial development and financial structure (Levine, 2000). For instance, reliance on external funding might be the same in a economy where the capital market plays an important role and in an economy where banks play an important role. Financial structure can hinder  or  promote  financial  development.  Policies  can  have  a  direct  impact  on  financial structure, but they can only have an indirect impact on financial development. Policy makers cannot legislate changes in the degree of financial development but they can legislate changes in financial structure. This makes it  especially important to understand how financial structure affects economic growth in Nigeria

Bank-Based Theory

We will use this theory to investigate the role of banks in promoting economic growth in Nigeria. In line with the bank-based theory, this study made use of bank indicators like bank structure activity, structure efficiency and structure size. The bank-based theory emphasises the positive role  of banks  in development and growth, and, also,  stresses the  shortcomings of market-based financial systems. It argues that banks can finance development more effectively than markets in developing economies, and, in the case of state-owned banks, market failures can be overcome and allocation of savings can be undertaken strategically (Gerschenkron, 1962).

Those banks that are unhampered by regulatory restrictions, can exploit economies of scale and scope in information gathering and processing (for more details on these aspects of bank-based systems, see Levine, 2002, and Beck and Levine, 2002). Indeed, bank-based financial systems are in a much better position than market-based systems to address agency problems and short- termism (Stiglitz, 1985; Singh, 1997).

The bank-based theory emphasizes the importance of banks in identifying good projects, mobilizing resources, monitoring managers, and managing risk while stressing the deficiency of market-based economies. For example, it has been argued that banks are effective at financing projects that are characterized by substantial asymmetric information (e.g., adverse selection and moral hazards), because banks have developed expertise in distinguishing between “bad” and “good” borrowers. According to the bank-based theory, banks, especially in countries at an early state  of economic  development,  are  more  effective  at  fostering  growth than  market-based financial structure.

The bank-based theory also stresses the shortcomings of market-based systems. The latter reveal information publicly, thereby reducing incentives for investors to seek and acquire information. Information asymmetries are thus accentuated, more so in market-based rather than in bank- based financial systems (Boyd and Prescott, 1986). Banks can ease distortions emanating from asymmetric information through forming long-run relationships with firms, and, through monitoring, contain moral hazard. As a result, bank-based arrangements can produce better improvement in resource allocation and corporate governance than market-based institutions (Stiglitz, 1985; Bhide, 1993)

Market-Based Theory

In investigating the market-based theory, this study will use data from the Nigerian stock market. Thus,  the  market-based  theory  is  an  empirical  investigation  of  how  the  market  promotes economic growth. Market-based financial system tends to have a larger proportion of equity titles. It is characterised by firms being controlled by outsiders at arm’s length with an important role for asset prices determined on financial markets as disciplining devices for the management of  the  firm.  The  emergence  of  a  market-based  or  a  bank-based  financial  structure  has implications for the incentives of households and entrepreneurs to take risk and will thus affect

their saving and investment behaviour. Moreover, the different forms of financial relations have an impact on the commitments of debtor and creditor for instance in long-term projects and on the feasibility of adjusting investment plans according to changes in the economic environment.

The market-based theory highlights the positive role of markets in promoting economic success (Beck and Levine 2000a). In particular, markets facilitate diversification and the customization of risk management devices. Furthermore, proponents of the market-based theory stress deficiencies in bank-based systems. First, by acquiring expensive information about enterprises, banks can extract large rents from firms. This reduces the incentives for firms to undertake high- risk, high-return projects because firms will lose an excessively large proportion of the potential profits to banks (Rajan 1992).

Second, since banks make loans, they have an inherent bias toward low-risk, and therefore, low- return projects. Thus, bank-based systems may retard innovation and growth (Morck and Nakamura 1999; Weinstein and Yafeh 1998). Furthermore, powerful banks may collude with firm managers against other investors, which stymies competition, effective corporate control, the emergence of new firms, and economic growth (Hellwig 1998).

Thus, proponents of the market-based theory stress that markets will reduce the inherent inefficiencies associated with banks and thereby enhance new firms formation, the ease with which  firms  and  industry attract  capital to  expand,  and  overall economic  growth.  Finally, proponents of market-based financial systems claim that markets provide a richer set of risk management tools that permit greater customization of risk ameliorating instruments. While bank-based systems may provide inexpensive, basic risk management services for standardized situations, market-based systems provide greater flexibility to tailor make products. Thus, as economies mature and need a richer set of risk management tools and vehicles for raising capital, they may concomitantly benefit  from a  legal and regulatory environment that  supports the evolution of market-based activities, or overall growth may be retarded.

Financial service theory

The financial service theory looks at the overall function of the financial system. This theory posits that it is the overall deepening of the financial system measured by the total financial instruments available in a financial system that promotes economic growth. In line with this

view, the study will use a conglomerate index of bank and market indicators to investigate the impact of financial instruments on economic growth.

This theory argues that it is neither banks nor markets that matter; it is both banks and markets since  they  both  play  different  roles  in  promoting  economic  growth.  They  are  different components of the financial system; they do not compete, and as such ameliorate different costs, transaction and information, in the system (Boyd and Smith, 1998; Levine, 1997; Demirguc- Kunt  and  Levine,  2001).  Under  these  circumstances,  financial  arrangements  emerge  to ameliorate market imperfections and provide financial services that are well placed to facilitate savings  mobilisation and  risk  management,  assess  potential  investment  opportunities,  exert corporate control, and enhance liquidity. Consequently, as Levine (2002:3) argues, “the financial services view places the analytical spotlight on how to create better functioning banks and markets, and relegates the bank-based versus market-based debate to the shadows”

The financial services view (Merton and Bodie, 1995; Levine, 1997), is actually consistent with both the bank-based and the market-based theorys. Although it embraces both, it minimises their importance in the sense that the distinction between bank-based and market-based financial systems matters less than was previously thought; it is financial services themselves that are by far more important, than the form of their delivery (World Bank, 2001). In the financial services view, the issue is not the source of finance. It is rather the creation of an environment where financial services are soundly and efficiently provided. The emphasis is on the creation of better functioning banks and markets rather than on the type of financial structure.

Legal-based theory

Legal scholars Merryman and Clark (1978) argue that a legal tradition is more than a set of rights and regulations: A legal tradition, as the term implies, is not a set of rules of law about contracts, corporations and crimes, although such rules will almost always be in some sense a reflection of the tradition. Rather, it is a set of deeply rooted, historically conditioned attitudes about the nature  of  the  law,  about  the  role  of  law  in  the  society  and  the  polity,  about  the  proper organization and operation of a legal system, and about the way the law is or should be made, applied, studied, perfected and taught. The legal tradition relates the legal system to the culture of which it is a particular expression.

The legal-based theory is an extension of the financial service theory. It  is put forward by LaPorta et al. (1997,1998,1999).  They reject the debate centered on bank-based versus market- based interpretation.  Levine (2000), building on LaPorta et al. (1997,1998,1999) argues “that creating strong legal systems that support the right of outside investors (both equity and debt investors) and then efficiently enforcing those codes is crucial for providing growth enhancing financial services” Intuitively, this is a simple idea, since a promise to deliver one unit of financial service tomorrow is worthless if delivery cannot be enforced. Thus, this theory argues that the structure of a country’s financial system is irrelevant in promoting growth. Thus, it is the legal system that determines economic growth and whether a country is bank or market based is immaterial.

The legal based theory further asks why common-law countries are market-dominated and civil- law countries are bank-dominated. This theory provides an explanation by linking it to legal traditions. Civil-law courts have been less effective in resolving conflicts than common-law courts because civil-law judges traditionally refrain from interpreting the codes and creating new rules. In a civil-law environment, where potential conflicts between borrowers and individual lenders inhibit the development of markets because the courts are unable to penalize defrauding borrowers, it shows that banks can induce borrowers to honor their obligations by threatening to withhold services that only banks can provide. In other words, banks emerge as the primary contract enforcers in economies where courts are imperfect.

On the argument between civil and common law countries, ne explanation stems from the countries’ regulatory environment. In the U.S. for example, Depression-era restrictions on the banking industry may have led to the small size of the banking industry relative to capital markets. This argument, however, does not explain two facts: First, it shows that the importance of banks as a financing source has not declined as a result of the change in the regulatory environment. The change in the size of all bank loans relative to the stock market capitalization before the Great Depression and after the WWII is insignificant.

Second, U.K. and U.S. have developed market-oriented systems although there were no regulatory restrictions on British banks comparable to those in U.S. A second explanation comes from Allen and Gale (1999, 2000). They argue that markets are needed in situations of rapidly

advancing technologies because they can aggregate information from a wide range of disparate sources. Banks, however, are needed when technologies are clearly understandable and investments just need monitoring. Although this argument holds in Western Europe and North America, it does not explain whether markets are more important than banks in Nigeria.

A third argument might be based on the findings of LaPorta et al. (1997, 1998) and Levine (1998, 1999). LaPorta et al. (1997,1998) find that markets develop better in countries where shareholder rights are well-protected. Because high shareholder rights are found in common-law countries, they conclude that it is no wonder that markets are larger in common-law countries relative to civil law countries. Levine (1998, 1999) finds that banks develop better in countries where creditor rights are well-protected and that civil-law countries have well-developed banks.

Two questions Levine (1998, 1999) leaves unanswered are that if banks develop better when creditors  are  well-protected,  why  is  the  banking  system of the  common-law countries  not significantly larger (in terms of their total share in the economy) than the banking system of French/Scandinavian-civil-law countries even though creditors are better-protected in common- law  countries? Similarly,  given  that  the  differences  in  the  level  of creditor  protection are insignificant between German-civil-law and common-law countries, why is the German banking system significantly larger than the common-law banking system?

Likewise, Rajan and Zingales (2000) object to the connection LaPorta (1998) make between market friendliness and legal tradition. Rajan and Zingales (2000) find that France’s stock market was much bigger as a fraction of its GDP than markets in the U.S. in 1913 (0.78 vs. 0.41). In

1980, roles had reversed (0.09 vs. 0.46) and in 1999, the difference between the two countries is no longer astonishing (1.17 vs. 1.52). Also, in the beginning of the 20th century, equity issues were more common in Germany than they were in United Kingdom. In the light of these facts, Rajan and Zingales assert that the relative market friendliness of common-law countries uncovered by LaPorta et al. (1997, 1998) seems a fluctuating phenomenon, and is unlikely to be explained by something as permanent as the origin of the legal system”.

This conclusion, however, may be too strong in that it goes so far as to claim that a permanent legal tradition precludes fluctuations in the structure of the financial system. Rajan and Zingales (2000) do not clarify why this must be so. The mere observation that investors were better-

protected in civil-law countries at  the turn of the 20th century is  not enough to reject the connection between legal traditions and financial system structure. It is possible that the level of investor protection in an economy, reflected in shareholder and creditor rights, does not capture the important differences between the legal traditions, and therefore, using this variable would not reveal the connection between the origin of a legal system and the structure of a financial system. In this study, we will examine the impact of legal based theory on economic growth using three indicators of the rights of outside investors and the degree to which these rights are enforced.

Economic Growth

Economic growth is a term used to indicate the increase of per capita gross domestic product (GDP) or other measure of aggregate income (Samuelson, 1985). It is often measured as the rate of change in GDP. Economic growth refers only to the quantity of goods and services produced and economic growth can be either positive or negative. Negative growth can be referred to by saying that the economy is shrinking. Negative growth is associated with economic recession and economic depression. In order to compare per capita income across multiple countries, the statistics may be quoted in a single currency, based on either prevailing exchange rates or purchasing  power  parity.  To  compensate  for  changes  in  the  value  of  money  (inflation or deflation) the GDP or GNP is usually given in “real” or inflation adjusted, terms rather than the actual money figure compiled in a given year, which is called the nominal or current figure.

According to Lipsey (1982), economists draw a distinction between short-term economic stabilization  and  long-term economic  growth.  The  topic  of  economic  growth  is  primarily concerned with the long run. The short-run variation of economic growth is termed the business cycle. The long-run path of economic growth is one of the central questions of economics; despite some problems of measurement, an increase in GDP of a country is generally taken as an increase in the standard of living of its inhabitants. Over long periods of time, even small rates of annual growth can have large effects through compounding.

The notion of growth as increased stocks of capital goods (means of production) was codified as the Solow (1956) Growth Model, which involved a  series of equations which showed the relationship between labour-time, capital goods, output, and investment. According to this view,

the role of technological change became crucial, even more important than the accumulation of capital. This model, developed by Solow (1956) and Trevor Swan (1956) in the 1950s, was the first attempt to model long-run growth analytically. This model assumes that countries use their resources efficiently and that there are diminishing returns to capital and labour increases. From these two premises, the neoclassical model makes three important predictions.

First, increasing capital relative to labour creates economic growth, since people can be more productive given more capital. Second, poor countries with less capital per person will grow faster because each investment in capital will produce a higher return than rich countries with ample capital. Third, because of diminishing returns to capital, economies will eventually reach a point at which no new increase in capital will create economic growth. This point is called a “steady state”. In this study, we model economic growth as the growth rate of real income per capita.

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