Banks and Economic Development: A Review

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Economic development is about enhancing the productive capacity of an economy by using available resources to reduce risks, remove impediments which otherwise could lower costs and hinder investment. The banking system plays the important role of promoting economic growth and development through the process of financial intermediation. Many economists have acknowledged that the financial system, with banks as its major component, provide linkages for the different sectors of the economy and encourage high level of specialization, expertise, economies of scale and a conducive environment for the implementation of various economic policies of government intended to achieve non-inflationary growth, exchange rate stability, balance of payments equilibrium and high levels of employment.

The role of finance in economic development is widely acknowledged in the literature. In particular, Schumpeter (1911) put the role of financial intermediation at the center of economic development. He argued that financial intermediation through the banking system played a pivotal role in economic development by affecting the allocation of savings, thereby improving productivity, technical change and the rate of economic growth. He believed that efficient allocation of savings through identification and funding of entrepreneurs with the best chances of successfully implementing innovative products and production processes are tools to achieve this objective.

The endogenous growth literature also supports the argument that financial development has a positive impact on growth. Well functioning financial systems are able to mobilize household savings, allocate resources efficiently, diversify risk, and enhance the flow of liquidity, reduce information asymmetry and transaction cost and provide an alternative to raising funds through individual savings and retained earnings. These functions suggest that financial development has a positive impact on growth.

I may be stating the obvious, by highlighting the central role that banks play in the development of every economy by mobilizing resources for productive investments and being the conduit for the implementation of monetary policy. Yet, I have given this the emphasis it requires. Due to the critical nature of these roles, and the fact that the ability of banks to effectively impact on economic development hinges largely on their soundness and efficiency, governments across the world continue to take variety of measures to safeguard the banking sector through reforms.

Such reforms often focus on increased risk management procedures and enhanced corporate governance in order to strengthen and reposition the banking industry to enable it contribute effectively to the development of the real sector through its intermediation process. In addition, such reforms may involve a comprehensive process of substantially improving the regulatory and surveillance framework; fostering healthy competition in banking operations, ensuring an efficient framework for monetary management, expansion of savings mobilization base, enforcement of capital adequacy, and the promotion of investment and growth through market-based interest rates. The need for reforms on an on-going basis has become more imperative with the increasing sophistication of the global financial products. The recent experience from the global financial crisis has further underscored the imperatives for countries to embark on banking reforms on a regular basis.

The process of reforming a financial sector usually involves the movement from an initial situation of controlled interest rates, poorly developed money and securities market and under-developed banking system, towards a situation of flexible interest rates, an expanded role for market forces in resource allocation, increased autonomy for the central bank and a deepening of the money and capital markets. It would indeed be difficult to define the components of ‘good’ banking sector reform in absolute terms.

Generally speaking, good reforms would engender clear market entry and exit conditions; ensure the ability of banks to function according to market principles without state intervention in their decision-making; guarantee central bank independence and establish independent banking oversight. This means that reform in the domestic financial system will comprise of three key policy actions.

The first is removal of price restrictions; that is, the removal of ceilings on deposit interest rates and restrictions on lending interest rates. The second component is removal of quantity restrictions; that is, the removal of direct credit allocation mechanisms, relaxation of reserve requirements, and removal of restrictions on foreign currency deposits. The third policy action consists of removal of entry barriers in the financial system. In countries with a heavy government presence in the financial sector, reform would usually involve privatization of public financial institutions and relaxation of restrictions on the creation of private financial institutions. Liberalization would also include opening up of the financial system to foreign players. All these actions aim at promoting strong competition in the financial system, which improves the efficiency of intermediation through the dismantling of monopolies in the financial system.

Thus, a well repositioned bank is therefore expected to perform its role more efficiently and contribute to the development and growth of the economy. Banking sector reform leads to improved financial services which lead to cost reduction by the industrial concerns. More people will have access to funds from the banking system and this will increase aggregate demand for goods and services. Increased aggregate demand will impact positively on output and employment generation thereby reducing poverty – the ultimate goal of economic management.

In the final analysis, bank reforms aim at ensuring financial deepening which implies the ability of financial institutions to effectively mobilize savings for investment purposes. The growth of domestic savings provides the real structure for the creation of diversified financial claims. It also presupposes active participation of financial institutions in financial markets, which in turn entail the supply of quality (financial) instruments and financial services.

By Sanusi Lamido Sanusi, CON
Governor, Central Bank of Nigeria

Excerpted from a Keynote Address at the Seminar on “Becoming An Economic Driver While Applying Banking Regulations.”