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Project Topic:

THE RELATIONSHIP BETWEEN STOCK PRICES AND COMMERCIAL BANKS LENDING RATES IN NIGERIA

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 Format: MS WORD ::   Chapters: 1 - 5 ::   Pages: 55 ::   Attributes: Questionnaire, Data Analysis, Abstract  ::   243 people found this useful

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ECONOMICS UNDERGRADUATE PROJECT TOPICS, RESEARCH WORKS AND MATERIALS

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THE RELATIONSHIP BETWEEN STOCK PRICES AND COMMERCIAL BANKS LENDING RATES IN NIGERIA

 

1.0 REVIEW OF RELATED LITERATURE

In Nigeria, two broad monetary policy regimes could be distinguished since the establishment of the Central Bank in 1959. The first regime was characterized by direct administrative controls on credit and interest rates, while the other dwells on the era where credit to the private sector was competitively distributed. In the first period (until 1986) banks were assigned mandatory guidelines on how much credit to make to preferred sectors of the economy. More so, minimum cash ratios were stipulated and special deposits were used to control free reserves with banks. Thus, banks made most loans essentially in order to meet government regulations and not necessarily based on the expected returns. The wisdom of this era was to stimulate growth of the domestic economy by delivering credit at low interest rates, while pegging and defending the naira from wanton depreciation, mainly motivated by the need to avoid foreign inflation in imported intermediate and capital goods. According to Nnanna (2001) historically, the Central Bank of Nigeria via its monetary policy circulars had directly controlled the volume and cost of credit in the economy, until the era of financial sector liberalization in the mid-80s. He also found in the same study that distortions in the pricing of loans caused by the administrative intervention in the market rendered financial intermediation by the deposit money banks ineffective. In the era of liberalized interest rates beginning from 1993, deposit money banks engaged in diligent credit packaging and risk analysis before making loans in order to reduce carrying non-performing assets in their books. Consequently, loans were advanced based on the computed returns to investment and the relative risk in the borrowing sector. The major consequences of liberalization have been increases in the volatility of interest rates and increased sensitivity of the exchange rate to domestic economic developments and external shocks, which eventually affected prices and consequently, increased the sensitivity of exchange rate to the interest rate as stable exchange rate helped lock-in inflation. From 1970 to 1985 (Figure 1), which marked the period of strict administrative controls, the standard deviation of the prime lending rate was 1.8 and rose to 6.8 in the period between 1986 and 1992. During this period the economy had become liberalized to a large extent, but interest rate liberalization only came in 1993. However, the extent of dispersion of interest rate slowed to 5.3% in the years since 1993. The wide dispersion in the years after direct controls is indicative of the effects of market interactions and administrative frictions in the policy break point, while the relative convergence after 1993 could be explained by the numerous entries in the banking industry and improved efficiency of the intermediation process. Nnanna and Dogo (1998) have shown that financial liberalization has led to increased credit to the private sector of the economy. However, evaluating the sectoral distribution of loans by the deposit money banks in Nigeria, it could be observed that the real sectors of the economy have not benefited proportionately. This situation could be attributed to the relative high risk and the long period of pay back associated with the sector. Foreign exchange movements have been pivotal in the supply of money in the Nigerian economy, particularly, since the commercial exploration of crude oil. Foreign exchange policies have essentially sought to ensure a healthy balance of payments and the attainment of a stable exchange rate. Before deregulation of the economy external sector policies depended on foreign exchange allocations and administered exchange rates. In the circumstance, the levels of money supply flowing from net foreign earnings were fairly stable and predictable

Traditional literature links the extent of bank lending to the level of economic activity and interest rate. Growth in the Gross Domestic product calls forth greater investment and greater demand for bank loans. While low interest rates encourage consumption and grow loans. Greene and Villanueve (1991) show strong negative correlation between real interest rates and private investments. Following are other factors that influence the lending behaviour of banks. By regulation, the single obligor limits for lending connects the size of a bank’s balance sheet to the volume of loans it can make to an enterprise. Literature on capital adequacy and other prudential guidelines are extensive and their links to the lending pattern of banks have been well documented in the literature including (Kashyap and Stein, 2000; Benanke and Gertler, 1987) Both studies infer that in situations of credit constraints, the level of capital will determine the extent of bank lending. However, it has been argued that though it might appear apparent that the level of banks’ capital does matter for the volume of lending, what is less clear is whether the trends in bank loans are caused by variations in capital or by cheer changes in the level of demand for bank loans (Sharpe, 1995). Financial liberalization, particularly external finance liberalization and stock price movements also influence bank lending. Financial liberalization unleashes mixed impact for economic agents in the loans market. For companies, while the international sources of capital are opened including share offers and the relative price of foreign capital tends to decline. For banks, competition heightens and the interest rate spread diminishes. Financial liberalization also improves the ability of domestic banks in developing markets to improve on credit packaging and risk assessment. Overall, the loan base for banks is enlarged. Olaf et al. (2007) summarizes the arguments for financial liberalization in Thailand by stating that the good news is that liberalization makes borrowing cheaper and easier as it decreases interest rate spreads and reduces collateral requirements. Moreover, it modernizes the financial system by enlarging the power of market forces at the cost of traditional institutions, here reflected in a declining importance of collateral based and relationship lending. However, one of the downsides of financial liberalization is the fact that more risky ventures could be financed by banks and in the face of reduced collateral requirements. Banking becomes more risky by greater interest rate and exchange rate changes (Stiglitz, 2004). Equity price fluctuations may affect the lending behaviour of banks, especially where banking regulations do not impose explicit ceilings on lending. In such operating environments, loans flow freely to sectors where return on investment is higher and risk is well understood and could be managed. The connection between equity price fluctuations and lending behaviour of banks could be traced in diverse dimensions. In jurisdictions that banks hold equities in their portfolio of investments, an increase in share values will boost the size of banks’ balance sheets and encourage increased lending. The reverse will play out when equity prices dip, other factors held steady. There might be a twist in this line of linkage especially for lending in developing countries. Banks in these countries have very shallow avenues for investment such that the stock market acts as an active competitor for investments vis-à-vis loans and advances. In this circumstance, expectation might be that an increase in stock prices will attract funds away from loans in favour of incremental outlay on stock investments. Declining stock prices also weakens borrowers’ collaterals held in equities, thus shrinking the demand for loans. Kim and Ramon (1994) evaluated stock prices and bank lending behaviour in Japan and found that changes in stock prices positively correlated with loans advanced, particularly, in the period after the loans market had been deregulated. Mansor (2006) applied the VAR technique to discern the effects which stock market fluctuations could have on the volume of loans and whether bank loans propagate financial shocks to the real economy in Malaysia. The variables included were bank loans, stock prices, consumer price index, Gross Domestic Product, Interest rate and exchange rate. The result indicated a positive response of bank loans to innovations on stock prices. However, there was no evidence of feed back from bank loans to stock prices. The latter finding led to the conclusion that bank health may depend crucially on the stock market, but that the attempt to invigorate the stock market through increased lending is futile. The other ancillary finding is that despite much hype on the currency mismatching of bank assets and liabilities, there seems to be no effect of exchange rate on bank loans. The exchange rate may only affect bank loans indirectly through its effect on stock prices and real output – which are dampened by currency depreciation. To identify the under currents in the fluctuation of loan supplies, an alternate approach has emerged which links loan supply to macroeconomic shocks. Potential sources of macroeconomic shocks are exchange rate changes, interest rate fluctuations, changing monetary policy stance, financial market volatilities and fiscal actions of governments. Degirmen (2007) applied the vector autoregression (VAR) to determine that public borrowing in Turkey crowded out private loans. From a policy perspective, the lending view of monetary policy transmission is anchored on the hypothesis that reduction in bank reserves squeezes their loan making capabilities. Mbutor (2007) has documented that monetary tightening, signaled by an increase in the monetary policy rate, reduces bank lending in Nigeria. The outcome is explained by many factors including the divestment from loans and advances to investment in government securities and other short term inter bank outlets. Azis and Thorbecke (2002) show that positive interest rate and exchange rate shocks decrease both capital and loan growth in domestic banks relative to foreign banks in Indonesia. Generally, the nature of the macroeconomic environment influences the lending behaviour of banks. A booming economy provokes expectations that future flow of income streams are assured, thus, encouraging demand and supply for loans. As asserted by Talavera et al. (2006), banks make out more loans during periods of boom and reduced level of macroeconomic uncertainty and curtail lending when the economy is in recession. Studies focused on the effects which macroeconomic stability might have on the lending behaviour of banks in Nigeria have received limited attention. However, Somoye and Ilo (2009) in a recent study have indicated measures of macroeconomic stability- including changes in money supply, exchange rate and inflation- impact on bank loans only in the long run perspective: while in the short run, the total deposit and capital base of banks play very important roles in influencing the ability of banks to make loans. The mixed nature of outcomes of studies regarding the impact the stock prices and exchange rate dynamics might have on the lending pattern of banks lends necessity to this study of how bank lending in Nigeria reacts to exchange rate and equity price fluctuations. Asset prices, broadly defined, would have been more reflective of portfolio adjustments, but data are mainly available in high frequencies only on the equity front.

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