FINANCIAL STABILITY
FINANCIAL STABILITY1
Victor U. Oboh2
SECTION ONE
Introduction
Financial institutions, especially banks perform a peculiar function by providing
liquidity and facilitating payments, which are critical to the economic
development of any economy. By linking the real sector with the financial sector,
financial institutions, help to promote economic growth and development. The
core mandate of financial institutions is the facilitation of financial intermediation
by promoting savings and investments decisions, as well as carrying out a major
institutional role in the monetary policy transmission process.
Ensuring financial soundness and stability is crucial to achieving sustainable
growth and development in any economy, since the failure of financial
institutions, particularly banks, is capable of undermining public confidence in the
system, precipitate unanticipated contraction in money supply, reduce savings
and investments, and induce payment system collapse with adverse effects on
the real economy.
In most jurisdictions, monetary authorities are responsible for monitoring,
supervising and regulating financial institutions, towards preventing any incidence
of financial crisis. The objective is to build a robust financial system that is capable
of withstanding any shock, both from within and without and therefore, minimise
the probability of systemic distress.
This paper is aimed at promoting the understanding of the concept of financial
stability with a view to enhance financial literacy and elicit public support of
government policies and programmes towards building a strong and resilient
financial system.
1
This publication is not a product of vigorous empirical research. It is designed specifically
as an educational material for enlightenment on the monetary policy of the Bank.
Consequently, the Central Bank of Nigeria (CBN) does not take responsibility for the
accuracy of the contents of this publication as it does not represent the official views or
position of the Bank on the subject matter.
2
Victor U. Oboh is a Principal Manager in the Monetary Policy Department, Central Bank of
Nigeria.
1
FINANCIAL STABILITY
The organization of the rest of the paper is as follows: Chapter 2 introduced the
concept of financial stability; Chapter 3 discussed the rationale for pursuing
financial instability while the types, causes and consequences of financial
instability are discussed in chapter 4. Measures for preventing and managing
financial crisis are outlined in chapter 5; chapter 6 presented an overview of the
Nigerian financial system with chapter 7 concluding the paper.
2
FINANCIAL STABILITY
SECTION TWO
Concept of Financial Stability
2.1
Meaning of Financial Stability
Financial stability refers to the absence of systemic financial shocks or crises. It is
simply the avoidance of a financial crisis in an economy (Macfarlane, 1999). The
emphasis on systemic shocks or crises is important in this definition, as financial
instability does not only connote financial ill-health of a particular bank, firm or
household, but extended to cover the entire financial system in an economy.
According to Foot (2003), financial stability is attained if:
i.
Monetary stability is achieved
ii.
The employment level in an economy is close to its natural rate
iii.
The public reposes high confidence in the operations of key financial
institutions and markets and
iv.
There is relative stability in the price movements of both real and financial
assets.
By inference, financial stability cannot be achieved in an economy that is
characterized by rapid inflation or high rate of unemployment. Similarly, high
incidences of bank failures and inability of financial institutions to perform their
financial intermediary roles either for individuals or corporate customers are
symptoms of financial instability. This could lead to gradual erosion of public
confidence in the financial system. The implication is a slowdown in economic
growth due to the non-availability of credit, or high cost of financial
intermediation. Simply put, “financial stability is a state of affairs in which an
episode of financial crisis is unlikely to occur, so that fear of financial instability is
not a material factor in economic decisions taken by households or businesses”
(Allen and Wood, 2005).
It is important to emphasize that financial instability could be said to have
occurred, if the financial shock or stress is significant enough to cause substantial
damage to a large group of customers and counterparties. This implies that
occasional and minor stresses, leading to failures of smaller financial institutions
and losses of few large institutions, may not be regarded as financial instability,
but rather seen as parts and parcel of the normal developments in the financial
system (Crockett, 1997).
Though financial institutions encompasses both banks and non-banks, regulators
tend to focus more attention on banks, as instability in the banking system is
3
FINANCIAL STABILITY
capable of affecting the entire financial system more adversely due to its
contagion effects. In addition, the size of a financial institution is critical in central
banks‟ consideration as their failure could trigger system crisis. This is due to their
large volume of obligations to counterparties, which implies that any failure to
discharge these responsibilities could negatively affect the entire system (Central
Bank of Sri Lanka, 2005).
2.2
Relationship between Financial Stability and Monetary Stability
Monetary stability is the condition in which an economy achieves stable value of
money over time. Financial stability on the other hand, refers to a stable condition
of key financial institutions and markets that make up the entire financial system.
Monetary and financial stability policies play complementary roles in their
contributions to sustainable economic growth. For instance, if regulatory and
macro-prudential (financial stability) policies alone are insufficient to manage
excess liquidity during a financial cycle, appropriate changes in interest rate
(monetary policy) can be taken to stabilize the economy. Due to the close
linkage and the complementary relationship between monetary and financial
stability, they are often referred to as the two sides of the same public good
(Caruana, 2014). This is justified by the fact that both involve the management of
money and credit, and the instability of one affects the other.
But how does financial stability support monetary stability? A stable financial
system is fundamental to achieving an effective monetary policy. This could be
attributed to the critical chain of linkages that exist between monetary policy, the
banking system and the real economy. Financial instability can be described as a
lubricant that facilitates the smooth and effective operations of these linkages. In
other words, financial stability impairs the effectiveness and efficiency of
monetary policy. The implication is the malfunctioning and underperformance of
the intermediation role of financial systems resulting in non-availability of credit for
household and business. Dudley (2013) identified three major channels through
which financial instability can adversely affect monetary policy operations.
First is that financial instability can cause a major reduction in aggregate
demand, which could be difficult for a central bank to manage. For instance, it is
conventional for central banks to lower monetary policy rate during recessions to
stimulate aggregate demand, but there is a limit to which it can be lowered as it
cannot be easily pushed below zero. This condition can compel monetary
authorities to fall back on non-conventional instruments such as asset purchase
with dire consequences.
4
FINANCIAL STABILITY
Secondly, the linkage between monetary policy and financial conditions is
distorted during periods of financial instability. As banking system capital base
depletes or bank failure occurs, less credit is available to households and business
firms, hence hindering effective transmission of monetary policy.
The third is the likely disconnect between aggregate demand and financial
conditions during the period of financial instability. For instance, lowering of
interest rate may not be highly effective in stimulating aggregate demand during
a financial crisis if financial institutions accumulate huge debt.
5
FINANCIAL STABILITY
6
FINANCIAL STABILITY
SECTION THREE
Rationale for Financial Stability
3.1
Purpose of Financial Stability
The over-riding purpose of financial stability is to ensure an effective and efficient
functioning of the entire financial system. This involves the strengthening of the
entire financial institutions using both micro-prudential and macro-prudential
measures. The essence is to stabilize the operations of major financial institutions
whose collapse is capable of jeopardizing the health of the entire financial
system.
Essentially, financial system stability is critical to economic growth due to the
following four reasons:
(i) A stable financial system is a necessary condition for savers and depositors
to repose confidence and keep their funds with financial institutions for
investment purposes. As an important element of a conducive
macroeconomic environment, financial stability can attract both
local and foreign investment into an economy.
(ii) Monetary policy transmission is largely effective under a stable financial
system. Therefore, financial stability assists monetary authorities in
achieving their primary mandate of delivering price stability.
(iii) A stable financial system is fundamental to an efficient and wellfunctioning financial intermediation. A sound financial system is
fundamental to attracting investment and promoting economic
growth.
(iv) A stable financial system encourages markets to operate more
effectively, particularly in promoting efficient allocation and
distribution of economic resources.
3.2
Benefits of Financial Stability to the General Public
In addition to the critical roles of financial stability in ensuring rapid economic
growth, a stable financial system benefits the general public significantly in the
following ways:
(a) Its aids the day-to-day financial transactions: The services of financial
institutions are required on a daily basis by individuals and corporate
organizations for their transactions. Services such as payments of salaries,
7
FINANCIAL STABILITY
business transactions, utility bills, school fees, household purchases etc, are
largely facilitated by sound financial institutions.
(b) It encourages savings and deposit of funds: Savings and other investments
are usually kept with banks and similar financial institutions with promise to
pay the amount saved or invested with interest at stipulated time. In times
of need, depositors can withdraw their savings through the counter or
automated teller machines (ATMs). Similarly, financial institutions enable
the public to make payments to other parties through the use of credit
cards.
(c) Provision of loans: Sound financial institutions have the capacity to
mobilise and extend loans to those that need finances for purposes of
consumption and business operations. Availability of loans aid business
expansion and contribute to economic growth.
(d) Facilitation of foreign transactions: Transactions involving importation and
exportation of goods and services are largely undertaken through banks.
In addition, friends and relatives living abroad can send remittances
through banks. These transactions can only be successful if people are
confident of the safety of their funds with financial institutions.
8
FINANCIAL STABILITY
SECTION FOUR
Types, Causes and Consequences of Financial Instability
4.1
Types of Financial Instability
Two types of financial instability are common. These are institutional and market
instability:
(i) Institutional instability – this refers to a type of instability that is
characterized by bank failures arising from contagion effect. In other
words, the failure of one bank affects other banks adversely due to the
gradual erosion of depositor‟s confidence in the banking institution. It is
often referred to as a “convoy effect” and is capable of having
significant and immediate undesirable impacts, particularly in developing
economies. The worst affected in this situation is usually the real sector, as
it is deprived of loans due to the credit crunch. The situation could result in
increase in interest rate as banks‟ immediate priority is meeting their
liquidity needs, rather than lending to potential borrowers.
(ii) Market instability – This results from the volatility in asset prices and its
consequent pass-through effects on the real sector. A sharp change in
the price of assets, such as equity or estate, could flow through to other
sectors, particularly the real economy.
4.2
Causes of Financial Instability
Understanding the causes of financial instability is crucial to designing policies
that can prevent it from occurring. The following are some of the most common
factors that trigger financial instability:
(i)
Outflow of foreign capital: one of the major causes of financial instability
in recent time is the sudden and large outflow of foreign capital from
developing countries. Foreign capital outflow, particularly those that are
portfolio investments, usually result in shortages of funds in financial
institutions, which could lead to bank failures.
(ii) Economic recession: Economic downturns are known to trigger financial
crises. Economic crisis makes it difficult for borrowers to service their loans,
which in turn precipitate financial instability.
9
FINANCIAL STABILITY
(iii) Increase in interest rates: An increase in interest rate tends to trigger the
occurrence of financial instability. Increasing interest rate make it difficult
for lenders to ascertain borrowers with less risk investment projects. In other
words, a higher interest rate condition can lead to the problem of adverse
selection; that is, higher interest rate raises the probability of lending to
finance highly risk projects.
The complex process of identifying borrowers with riskier projects therefore
compels the lender to be more conservative in approving the number of
loans for prospective borrowers. This then leads to a reduction in the
quantum of loan supply, thereby resulting in a substantial reduction in the
volume of investment and aggregate economic activity.
(iv) Rise of uncertainty in the macroeconomic environment: A major shock
such as the failure of a prominent firm or non-financial institution, a period
of recession, political crisis or stock market crash could aggravate the
level of uncertainty in financial markets. This situation complicates the
lenders‟ task of separating low risk projects from those with high risks for
funding. The worsening problem of adverse selection causes lenders to be
reluctant in extending loans to potential investors. The consequence is
reduced volume of lending, leading to a decline in investment and a
slowdown in aggregate economic activities.
(v) Effect of asset market on balance sheet: A weak state of the balance
sheet is a possible precipitating factor for financial instability. A substantial
decline in balance sheets of both financial and non-financial institutions
can worsen the problems of adverse selection and moral hazard in
financial markets thereby triggering financial crisis. Lenders are more
willing to extend loans to firms with robust collateral security and high net
worth positions. Such borrowers are less likely to commit moral hazards
since they have much at stake to lose in case of default.
Stock market crashes usually result in a decline in company net worth and
this could make lenders also to be less willing to lend, as it increases the
risk of loss in the event of default. A major drop in lending could result in a
significant reduction in investment and economic activities thereby
causing financial instability.
Another factor that can affect the balance sheet, which is a potential
driver of financial instability in emerging economies, is the sudden and
unexpected depreciation or devaluation of exchange rate. If economic
agents such as banks and non-financial firms are uncertain of the future
10
FINANCIAL STABILITY
value of the domestic currency, they would prefer to issue debts
denominated in foreign currency. Sudden depreciation of the local
currency at a time when firms incur large debts tends to increase their
debt burden. A huge amount of debt, denominated in foreign currency,
was a major characteristic feature of the Chilean financial markets, prior
to its financial crisis in 1982 and in Mexico in 1994 (Mishkin, 1997).
(vi) Challenges in the banking sector: Banks play crucial roles in ensuring the
smooth functioning of financial markets. Therefore, any challenge that
constrains their ability to perform their traditional role of financial
intermediation and extension of loans to prospective borrowers, is
capable of causing a decline in investment and aggregate economic
activity.
A major factor that impairs on banks‟ intermediation role, is deterioration
in their capital base, which by implication reduces their lending capacity.
Deterioration in banks‟ balance sheet, was largely responsible for the
capital crunch that led to the headwinds, which slowed US economic
growth in the early 1990s.
4.3
Consequences of Financial Instability
Financial instability has adverse effects on households, private firms, government
and the economy at large. Crockett (1997) outlined five consequences of
financial instability as follows:
(i) Loss of depositors‟ funds: One of the outcomes of financial crisis is the loss
incurred by depositors and other creditors. As a result of bank failures,
funds deposited with banks usually suffer significant losses, thereby
affecting savers and depositors adversely.
(ii) Contagion effect: A collapse of one major financial institution is capable
of compromising the health of other financial institutions. This is caused by
the contagion effect or even by direct exposure.
(iii) Extra-budgetary cost: During periods of financial instability, government
usually implement intervention programmes through its monetary authority
to protect depositors‟ funds. Some of these measures are also intended to
rescue distressed financial institutions from total collapse. In the process,
government incurs extra-budgetary costs, particularly in trying to bail out
distressed banks. Funds originally intended for other development
programmes such as infrastructure and welfare services, could be
11
FINANCIAL STABILITY
diverted for the rescue operations of banks, thereby affecting the overall
delivery of welfare services to the public.
(iv) Erosion of public confidence in the financial system: Financial instability
erodes public confidence in the entire financial system, particularly due to
losses suffered by the public. As a result of losses incurred during financial
crises, restoring savers‟ confidence in the system becomes a difficult task,
even long after the crisis is over. The implication is low level of savings in
investment leading to a slowdown in growth.
(v) Poor macro-economic performance: Instability in the financial system is
capable of causing the entire macro-economy to malfunction. This is due
to the critical importance of the intermediation roles peculiar to financial
institutions and their contributions to economic growth.
12
FINANCIAL STABILITY
SECTION FIVE
Prevention and Management of Financial Instability
5.1
Measures for Preventing the Occurrence of Financial Instability
The multi-dimensional nature of the causes of financial instability calls for a suite of
strategies for preventing its occurrence. While ensuring financial stability remains
the primary responsibility of Central Banks, other critical stakeholders such as the
Fiscal authority or Finance ministry and financial institutions themselves have
important roles to play.
There are five key preventive measures usually adopted by government in
reducing the probability of the occurrence of financial instability in an economy.
These include:
(i) Establishment of statutory laws: Laws are necessary in every jurisdiction to
regulate the behaviours of economic agents. This is also applicable in the
financial sector, as managers of financial institutions are expected to
behave in accordance with the rules of the game. Government through
its monetary authority, has the mandate to design and enforce relevant
laws and regulations that would entrench financial discipline and prudent
behaviours by financial institutions. Financial institutions that fail to comply
with these laws are appropriately penalized to serve as deterrence to
others. These laws are subject to reviews as and when necessary, in line
with the dynamics and emerging challenges facing the economy.
(ii) Setting up of dedicated official agencies to regulate financial institutions:
Some countries establish dedicated agencies that are responsible for
regulating financial institutions. The purpose is to ensure a strong and
effective institution that is capable of absorbing any shock to the financial
system. In most countries, central banks are saddled with this responsibility
in addition to their primary mandate of achieving price stability. In other
jurisdictions, an official agency apart from the central bank is established
and dedicated to supervise and regulate the activities of financial
institutions. The establishment of such agencies is usually backed by laws
of parliament to ensure credibility.
(iii) Prudential supervision: As a way of preventing financial crisis, regulatory
authorities to set operational standards and rules, as well as enforce
compliance by commercial banks and other financial institutions. The
objective is to build a robust financial system that is capable of
13
FINANCIAL STABILITY
withstanding shocks. Prudent supervision helps to prevent bank failures
and customers‟ loss of confidence in the banking system.
To ensure effective supervision and mitigate any risk inherent in the
financial system, central banks adopt a variety of policy tools for
regulating financial institutions. Some of these measures include capital
adequacy requirements, bank reserve ratio and setting up of bank
margins.
The supervisory role of the central bank, specifically involves the provision
of oversight functions through off-site surveillance and on-site
examinations of financial institutions. During off-site surveillance, periodic
records such as monthly, quarterly, half-yearly and annual reports are
critically examined with a view to disclosing early warnings about
potential risk which can be remedied before it is too late.
The on-site examinations involves periodic visit by central bank officials to
financial institutions, to physically examine their books and records. The
essence is to assess the operations of the institutions and ensure that they
comply with all necessary prudential and regulatory requirements.
Through a robust feedback mechanism, findings and observations of
central bank examiners are communicated to the management of
affected financial institutions, to address the identified lapses.
(iv) Market conventions: These are agreements and consensus reached by
market practitioners and agents, in order to achieve a common
understanding and healthy practice, by all parties to a transaction. In that
manner, they help to prevent or checkmate unethical practices that may
undermine a stable financial system. Market conventions are not
necessarily public policies, but they complement government laws in
contributing to financial stability.
(v) Communicating relevant official information to stakeholders: The
disclosure of relevant information on latest macroeconomic
developments to stakeholders, by public authorities, is important in
promoting participation and eliciting support from other stakeholders in
the financial system. These include, periodic reports and policy statements
by government agencies, on current macro-economic conditions, fiscal
and monetary policy decisions and other financial reports. Making this
information available in public domain, promotes accountability and
helps to build the confidence of private actors in government.
14
FINANCIAL STABILITY
(vi) Designing effective physical infrastructure: Poorly designed physical
infrastructure, such as payment systems used by financial markets for
transactions, is capable of transmitting risks from one financial institution to
another and can therefore, affect financial stability negatively. For
instance, the emergence and widespread deployment of real-time gross
settlement (RTGS) as a replacement to deferred net settlement, has
strengthened the payment system, by eliminating the risk posed by an
insolvent bank on other participating banks. This is made possible by the
ability of RTGS to settle each payment in real time. The advantage is that
any bank that becomes insolvent during the working day, could easily be
identified and prevented from infecting other participating banks, through
payment system contagion.
5.2
Specific Tools Adopted by Monetary Authorities in Managing
Financial Instability
It is the mandate of the central bank or the designated monetary authority of the
country, to reduce the potential damage occasioned by a financial crisis and
minimise its impact on the economy. Several tools are available for central banks
to deploy in restoring financial stability in times of crisis. However, the suitability of
any tool depends largely on the structure and fundamentals of the economy, as
well as the nature of the financial crisis.
The first option is for central banks to provide liquidity support to banks through
collaterized lending arrangement. This is in fulfillment of central bank‟s role as the
lender of last resort.
Secondly, central banks may make use of the monetary policy rate (MPR) which
is one of their conventional monetary policy tools. During a period of financial
crisis, monetary authorities usually reduce the policy rate drastically in response to
the slowdown in aggregate demand. The objective is to encourage lending to
the real sector in order to stimulate production and demand. However, there is a
limit as to how low the MPR can be reduced.
The third tool, often referred to as the unconventional measure is considered if
the use of MPR failed to achieve meaningful financial stability. It is, therefore, a
complementary tool to the MPR. Examples of unconventional tools include
provision of unlimited but collaterized financing window to banks for an unusually
long maturity period, direct purchase of financial instruments to stimulate the
credit market, etc.
Fourthly, some central banks adopt flexibility approach as an additional tool
when appropriate. Some of these concessionary arrangements include relaxation
15
FINANCIAL STABILITY
of borrowing requirements by widening the scope of collateral instruments,
arrangements of cross-currency swaps with foreign banks so as to provide foreign
currency denominated liquidity, amongst others.
Finally, collaboration between the monetary authority and the fiscal agency can
be strengthened, particularly if the crisis requires government support in form of
provision of insurance or capital infusions.
16
FINANCIAL STABILITY
SECTION SIX
Financial Stability in Nigeria
6.1
The Structure of the Nigerian Financial System
The Nigerian financial system consists essentially of both formal and informal
sectors. The elements that constitute the formal sector include the regulatory
agencies; money, capital and foreign exchange markets; insurance companies
and brokerage firms; Deposit Money Banks; Development finance and other
financial institutions.
The informal financial sector is made up of organizations and groups, including
cooperative societies, savings and credit union, self-help groups etc.
6.2
Regulatory Authorities and the Nigerian Financial System Stability
The financial system of any economy performs a critical role in the mobilization
and rational allocation of funds for investment purposes. For effective
performance of this function, financial institutions are expected to be sound,
stable and reliable. Bank failure poses severe risks for the entire economy given
the intermediary role it plays, particularly as a holder of depositors‟ funds and
facilitator of payment systems.
Regulatory authorities are statutory institutions established to ensure that
stakeholders play and abide by the underlying rules in order to maintain financial
stability. The key agencies that regulate and supervise financial institutions in
Nigeria are outlined below:
The Central Bank of Nigeria (CBN) – The CBN provides regulatory oversight for
Deposit Money Banks, and other financial institutions that comprises comprising
primary mortgage institutions, Bureau De Change, Microfinance Banks, Finance
Companies, Discount Houses and Development Finance Institutions.
The Nigeria Deposit Insurance Corporations (NDIC): The mandate of NDIC include
the provision of insurance cover for depositors‟ funds in DMBs and other insured
financial institutions. The NDIC is responsible for liquidating distressed banks as well
as jointly responsible with the CBN in supervising DMBs and other insured
institutions.

The Securities and Exchange Commission (SEC): The SEC is charged with
the responsibility of regulating the Nigerian capital market.
17
FINANCIAL STABILITY

The Nigeria Stock Exchange (NSE): The NSE supervises the trading of
securities in the Nigeria stock market.

The Abuja Commodity and Securities Exchange: The ACSE takes charge
of commodity trading.
Self-regulatory organizations – these include professional associations that
prepare ethical codes and rules of practice by members. Some of these include
the Chartered Institute of Bankers of Nigeria (CIBN), Association of National
Accountants of Nigeria (ANAN), Institute of Chartered Accountants of Nigeria
(ICAN), Association of Issuing Houses of Nigeria, Chartered Institute of Stock
Brokers, Association of Capital Market Registrars, Financial market Dealers
Association of Nigeria, Association of Bureau De Change Operators of Nigeria,
and the Mortgage Banking Association of Nigeria.
6.3
Role of the Central Bank of Nigeria (CBN) in Ensuring Financial
System Stability
Promoting financial stability remains one of the core functions of the Central Bank
of Nigeria as outlined in Section 2 of the 2007 CBN Act. The CBN carries out this
vital function by undertaking financial sector surveillance with a view to
promoting the stability and soundness of the entire financial system. This would
engender public confidence in the Nigerian financial system. The absence of an
institution to carry out surveillance in the sector during the early stages of the
development of the Nigerian financial system, led to the failure of several banks
between 1892 and 1951 (CBN, 2010).
From the early stage of the Nigerian financial market, up to the mid-1980s, the
CBN adopted direct control of credit allocation and interest rate structure to
channel bank credit to prioritized sectors of the economy. During this period,
banks were mandatorily required to allocate a larger portion of their loanable
funds to the growth sectors such as agriculture and manufacturing at relatively
low interest rate. The low interest rate structure was designed to serve as an
incentive for private investors to access enough credit to increase output,
stimulate growth and provide jobs.
However, the direct control measures failed to deliver the expected results as
some banks preferred to face penalties rather than lending to some sectors,
which were often perceived as highly risky. Due to the high level of
disintermediation in the banking system, the direct control regime was abolished
giving way to the introduction of market-based approach in 1986.
18
FINANCIAL STABILITY
The adoption of market based model was the first comprehensive reform of the
financial system in Nigeria. It was predicated on the need to liberalize the interest
rate system, enhance efficiency and effectiveness of resource mobilization and
utilization and promote growth, particularly the real sector of the Nigerian
economy. To ensure a sound and stable banking system capable of delivering
effective intermediation role, the CBN formulated strategies through effective
surveillance and enforcement of prudential standards.
The primary goal of these reforms centered on increased liberalization of the
banking business, and the promotion of healthy competition and safety measures
amongst banks, towards engendering overall financial system stability. Some of
those key reforms embarked upon by the CBN are highlighted below:
(i) The 1986 deregulation of the financial sector as a component of the
Structural Adjustment Programme (SAP)
During this era, interest rate, exchange rate and laws on exit/entry into
banking business were liberalized. In addition, the NDIC was established to
strengthen regulatory and supervisory functions. Capital adequacy standards
were reviewed upward while direct monetary policy instruments were
introduced.
(ii) The 1990 introduction of prudential guidelines
Some prudential guidelines were introduced by the CBN in November, 1990
to strengthen the stability, safety and soundness of the Nigerian banking
system. The guidelines essentially focused on guiding banks towards the
adoption of a more cautious approach to classifying their credit portfolios
and disclosing their non-performing credit facilities. These guidelines were
meant to ensure the protection and safety of depositors‟ funds, and to
strengthen the banks to play their financial intermediary role more effectively.
(iii) The 1991 promulgation of the CBN Act No 24 and amendment acts of
1998.
The Acts and subsequent amendments, significantly increased the powers of
the CBN to ensure monetary stability and a sound financial system. It granted
autonomous powers to the CBN to formulate and implement monetary and
financial policies. The Banks and other Financial Institutions Act (BOFIA)
introduced regulatory reforms that contributed immensely to the stability of
the financial system in a deregulated economy. Consequently, the number of
commercial banks increased from 14 in 1970 to 29 in 1986 and 66 in 1993. It
then dropped to 54 in 1998 due to the incidence of bank failures, and
thereafter, rose to 89 in 2004.
19
FINANCIAL STABILITY
(iv) The 1992 licensing of more discount houses
More discount houses were granted licenses in 1992 in order to deepen the
primary and secondary markets where government debts are traded and
therefore boost intermediation of funds among financial institutions.
(v) 2001 Introduction of universal banking model
The introduction of the universal banking policy by the CBN in 2001, was
meant to abolish banks classification by nature of business. It was intended to
allow a level playing field for all banks, to engage in both retail and wholesale
business, thereby deepening their financial intermediation roles.
(vi) The 2004 banking consolidation reform
This was a major milestone in Nigerian banking sector reforms. According to
Soludo (2004), the key elements of the reform include:
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
The N25 billion minimum capitalization for banks with end-December
2005 as deadline.
Gradual withdrawal of public sector funds from DMBs.
Adoption of mergers and acquisition approach to consolidate the
banking institutions.
A regulatory framework that focuses on risk and strict compliance
with existing rules.
Zero tolerance for non-compliance, particularly in the submission of
data and information for regulatory purposes.
Complete automated process for rendition of returns and reports by
all financial institutions through the electronic Financial Analysis and
Surveillance System (e-FASS).
Establishment of a dedicated hotline, confidential internet address
for all Nigerians wishing to share any confidential information with
the Governor of the Central Bank on the operations of any bank or
the financial system.
Ensure that contingency planning framework for banking system
distress is strictly enforced;
Setting up of an Assets Management Company as part of financial
distress resolution strategy;
Strict enforcement of dormant laws, such as those pertaining to
issuance of dud cheques, and sharp malpractices by Board
members of banks.
Review and updating of relevant laws, and formulation of new ones
to strengthen banking system operations.
20
FINANCIAL STABILITY
l)
m)
Collaborate closely with the Economic and Financial Crimes
Commission (EFCC) to establish the Financial Intelligence Unit (FIU),
to tackle anti-money laundering and other economic crimes.
Overhaul of the management of the Nigerian Mint to effectively
meet the security printing needs of the country.
In summary, the 2005 banking consolidation programme of the CBN
mandated banks to raise their shareholders funds from N2 billion to N25
billion by December, 2005. The consolidation process was achieved
through the instrument of mergers and acquisition, culminating in the
emergence of 25 (later 24) new banks from the hitherto 89 banks. The
programme helped to strengthen the capital base, ensure safety of
depositors‟ funds and repositioned them towards enhanced financial
intermediation roles.
(Vii) The 2009 project alpha initiative for reforming the Nigerian financial
system
The reform was a follow up to the 2005 banking consolidation
programme. According to Sanusi (2012), the Project Alpha revolved
around 4 pillars, which include: „enhancing the quality of banks;
establishing financial stability; enabling healthy financial sector evolution
and ensuring that the financial sector contributes to the real economy‟.
In summary, the overarching goal of all the above mentioned reforms by
the CBN was to achieve the emergence of a strong financial system that
is capable of delivering effective and efficient intermediary functions of
transferring funds from surplus units to deficit areas of the Nigerian
economy.
21
FINANCIAL STABILITY
22
FINANCIAL STABILITY
SECTION SEVEN
Conclusions
Ensuring financial soundness and stability is central towards achieving sustainable
growth and development in any economy. The failure of financial institutions,
particularly banks is however, capable of undermining public confidence in the
system and shifting investment. This justifies why regulatory and supervisory
authorities spare no efforts in enforcing laws that ensure prudential practices
within the financial system.
In most jurisdictions, the Central Bank is the key regulator of the financial system
though other government agencies and the financial institutions themselves also
play complementary roles. In Nigeria, some of such other government agencies
include the Nigeria Deposit Insurance Corporations, the Securities and Exchange
Commission and the Nigeria Stock Exchange.
Some of the common causes of financial instability include capital outflow,
economic recession, increase in macroeconomic uncertainty and inflation as
well as persistent challenges in the banking sector. Financial instability poses
serious consequences on the health of the economy, including loss of depositors‟
funds, erosion of public confidence in the financial system, contagion effect and
extra-budgetary cost to government.
Most countries adopt preventive measures such as enactment of relevant laws,
establishment of strong regulatory agencies to carry out prudential supervision,
use of market conventions, deployment of a robust physical infrastructure and
dissemination of relevant information on macroeconomic development to the
public. Most central banks adopt both conventional and non-conventional
instruments in managing financial crisis.
In Nigeria, a number of financial system reforms have been introduced by the
CBN. These reforms include the 1986 Deregulation of the financial sector;
introduction of prudential guidelines in 1990; promulgation of the CBN Act No 24
of 1991 and Amendment Acts of 1998; licensing of more discount houses in 1992;
introduction of universal banking model in 2001; banking consolidation reform of
2004 and Project Alpha Initiative for reforming the Nigerian financial system of
2009. The overarching goal of these reforms was to ensure a robust financial
system that is capable of delivering effective and efficient intermediary functions
of transferring funds from surplus units to deficit economic areas.
23
FINANCIAL STABILITY
24
FINANCIAL STABILITY
Bibliography
Allen, W. A. and G. Wood (2005). Defining and Achieving Financial Stability. Cass
Business School, City University Special Paper No. 160.
Caruana, J. (2014). Redesigning the Central Bank for Financial Stability
responsibilities. Speech at the 135th Anniversary Conference of the
Bulgarian National Bank Sofia, June 6.
CBN (2010). Central Bank of Nigeria Financial Stability Report.
Central Bank of Sri Lanka (2005). Financial Systems Stability. Pamphlet Series No. 2.
Corbo, V. (2010). Financial Stability in a Crisis: What is the role of the Central
Banks? BIS working Paper N0.51
Crocket, A. (1997). Why is Financial Stability a Goal of Public policy? Paper
Presented at the Federal Reserve Bank of Kansas City 1997
Symposium: Maintaining Financial Stability in a Global Economy.
Jackson Hole, Wyoming, August 28-30.
Dudley, W. C. (2013). Why Financial Stability is a Necessary Prerequisite for an
Effective Monetary Policy. Bank for International Settlements 2013
Annual General Meeting, Basel, Switzerland.
Foot, M. (2003). What is Financial Stability and How do we get it? Speech
Delivered at the 2003 Roy Memorial Lecture.
Macfarlane, I. J. (1999). The Stability of the Financial System. 18 th Annual R. C. Mills
Memorial Lecture Delivered at the University of Sydney, July 29.
Mishkin, F. S. (1997). The Causes and Propagation of Financial Instability: Lessons
for Policymakers.
Ohuche, F. K. (2010). Lessons of the Global Financial and Economic Crisis for the
Nigerian Financial System. In Eboh, E. C. and O. Ogbu (eds.) The
Global Economic Crisis and Nigeria – Taking the Right Lessons,
Avoiding the Wrong Lessons.
Sanusi, S. L. (2012). Banking reform and its impact on the Nigerian economy
Lecture Delivered at the University of Warwick‟s Economic Summit, Warwick,
February 17.
Soludo, C. C. (2004). Consolidating the Nigerian Banking Industry to Meet the
Development Challenges of the 21st Century. Being an Address
Presented at the Special Meeting of the Bankers‟ Committee.
25
FINANCIAL STABILITY
26