Vanguard (Lagos)

18 February 2004

Nigeria: The Role of the Central Bank in the Nigerian Financial System

The Central Bank is pivotal in the management of the national economy. Its role is not only to regulate and monitor the financial system, but also to ensure its development, prevent financial distress which could undermine confidence in the system as well as facilitate sustained growth.

The pervasive role of the Central Bank is, infact, appreciated in the light of its continuous monitoring of the domestic and international economies. Its knowledge of the economic environment is the major source of information for economic planning, while the trends in the economy are rightly or wrongly attributed to the actions of the Central Bank.

My presentation shall be in five parts. Part I presents an overview of the Nigerian financial system; while the functions of the Central Bank of Nigeria (CBN) and the enabling environment are articulated in Part II. Part Ill examines the Bank's monetary management, surveillance and promotional roles. In Part IV, the challenges for the CBN are highlighted, while Part V offers the concluding remarks.

PART II: THE FINANCIAL SYSTEM: ROLE AND COMPOSITION

Role The financial system is described as the gamut of financial institutions, financial instruments and financial markets. The role of the financial system in the economy is appreciated in the light of the important functions which it performs, namely financial intermediation and capital formation, management of the payments system, and facilitating the effectiveness of monetary policy.

The most important function of the financial system is financial intermediation which facilitates the mobilization of resources from those who have (surplus units) and their transfer to those who do not have (deficit units), thus influencing savings and investment and facilitating the achievement of the growth objective of economic policy. Banks constitute the payments system, which consists of rules, Institutions and technical mechanisms for the transfer of money for the settlement of personal and business transactions. The payments system represents an important nerve centre of the economy, providing the link between the real and financial sectors. The more efficient the payments system, the greater the confidence of the public and the faster the pace of economic activities. Payments instruments include currency or cash; paper-based instruments, such as cheques, bank drafts; paperless instruments, namely automated teller machines (ATMs), automated clearing houses (ACHs), internet payments and wire transfers; and other instruments such as postal and money orders, vouchers and prepaid cards. The safe and efficient operation of the system is, therefore, of concern to both market participants and public officials, especially central bankers.

The financial system also provides the institutional framework through which monetary policy is conducted. In other words, the system constitutes the channel through which monetary policy actions are transmitted to the real sector to achieve price stability, facilitate output growth and enhance employment opportunities. Monetary policy is one of the instruments of economic management, employed by the monetary authorities, especially the Central Bank, to keep the growth of money supply at a level that is consistent with the absorptive capacity of the economy.

Composition and Structure The Nigerian financial system has, over the years, undergone some changes in terms of ownership, structure, depth and breath, number of institutions for the implementation of government's capital projects, and for the economic environment, and the regulatory framework within which establishment, expansion and modernization of businesses.

PART II: THE FUNCTIONS OF THE CENTRAL BANK OF NIGERIA (CBN)

The principal functions of the CBN, as spelt out in the CBN Act, 1958 and amendments, 1991 and 1998, include: Issuance of legal tender currency (notes and coin) in Nigeria;

* Maintenance of Nigeria's external reserves in order to safeguard the international value of the national currency (-involves the management of the country's debt and foreign exchange);

* Promotion of monetary stability and a sound and efficient financial system in Nigeria;

* Acting as banker and financial adviser to the Federal Government; and

* Acting as lender of last resort to the banks.

THE ROLE OF THE CENTRAL BANK IN THE NIGERIAN FINANCIAL SYSTEM

In line with these broad objectives is the mandate to formulate and implement monetary and financial policies aimed at ensuring price stability and financial sector soundness towards promoting sustainable economic growth and development. It is instructive to note that the objectives of price and financial sector stability reinforce each other. Macroeconomic stability is a necessary condition for sustaining stability of the financial system, while a stable and sound financial system is a pre-requisite for the effective conduct of monetary policy. Thus, the CBN Act, as amended, considerably strengthened the powers of the Bank as an agency of government with responsibility for maintaining monetary stability and a sound financial system in the country, while the Banks and Other Financial Institutions Act (BOFIA), as amended, enhanced the Bank's powers over the financial system with the aim of ensuring high standards of financial practice and sustained financial stability. As part of its responsibility to promote a sound financial structure, efficient payments and settlement system, the CBN has supervisory and surveillance responsibilities over the deposit money banks and other financial institutions. The Bank also maintains current account for deposit money banks, provides clearing facilities through which instruments from the banks are processed, as well as provide temporary accommodation to banks in the performance of its function as lender of last resort.

Apart from its traditional functions, the CBN, like its counterpart in developing countries with under-developed financial markets, has acted as a catalyst for economic development through the establishment of an institutional framework for facilitating the intermediation of financial resources for productive investment, as well as the promotion of specialized financial institutions.

The monetary and financial policies pursued in recent years have been designed to support the attainment of the basic objectives of the economic reforms programme adopted in July 1986. Within the context of financial sector reform, the CBN has moved from an era of direct control and regulation to deregulation and liberalization which place emphasis on indirect tools of monetary policy. The driving force for the shift in approach has been the desire to achieve enhanced efficiency in the mobilization and utilization of resources, as well as developing an efficient framework for monetary management.

Further amendments to the CBN Act in 1998 conferred operational autonomy on the CBN. The need to grant the Bank operational autonomy was informed by the political interference which hindered the effective performance of the Bank and thus, its inability to exercise professionalism in the management of monetary policy and pre-empting the financial sector distress which occurred in the 1990s. Infact, the argument for Central Bank independence, the world-over, centres on the ground that monetary and financial sector management is very important and delicate and should, therefore, be left in the hands of professionals and skilled experts rather than to politicians.

PART Ill: MONETARY MANAGEMENT. SURVEILLANCE AND DEVELOPMENTAL ROLES OF THE CBN

Monetary Policy The monetary management role of the CBN is appreciated in the light of the need to maintain macroeconomic stability which is a necessary condition for the achievement of sustainable growth. This is borne out of a strong empirical evidence of the inverse relationship between money supply, inflation and long-term growth. Although there are other factors that are associated with the rise in the general price level, however, inflation is basically considered as a monetary phenomenon in the sense that it cannot last without an accommodating monetary policy. Lessons of experience have shown that an appropriate rate of monetary growth over a period will lead to low and positive interest rate which will foster exchange rate stability, enhance savings, investment and output.

The CBN has responsibility for formulating and implementing monetary policy, aimed at maintaining money supply growth at a level that is consistent with the absorptive capacity of the economy. The term "monetary policy" refers to actions taken by the CBN to affect monetary and other financial conditions in pursuit of the policy Objectives of price stability, sustainable output growth and a healthy balance of payments. The discretionary control of the money stock involves the expansion or contraction of money and influencing interest rates (cost of credit) to make money cheaper or more expensive, depending on the prevailing economic conditions and thrust of policy. Since most of the factors that influence money supply (e.g. inflow of foreign assets and government borrowing/expenditure) are not amenable to control by the monetary authorities, attempts are made to influence banks' credit operations.

The rationale for this stems from the fact that banks create money through their excess reserves. Thus, increases in reserves enhance banks' credit-creating capacity. In order to minimize the impact of credit generation on the money stock and hence restrain inflation as well as stabilize the exchange rate, the CBN influences bank reserves in the desired direction through various techniques/policy instruments.

Following the adoption of market-based or indirect approach to monetary control, Open Market Operations (OMO) has, since 1993, become the dominant instrument of liquidity management, with discount rate and reserve requirements as the main adjustment instruments.

The Bank also implemented a policy framework for the development and promotion of a deregulated, competitive and sound money market. This involved the deregulation of interest rates and the strengthening of the legal and institutional framework for the conduct of monetary policy. The Bank, however, determines its Minimum Rediscount Rate (MRR) to indicate the direction of interest rate changes, given the responsiveness of other rates of interest to the MRR. Under the OMO framework, bank reserves constitute the operating target. With OMO, reserves are supplied or drained from the market to keep the inter-bank rate within the desired range.

The market thus determines interest rates and allocates credit. OMO had been conducted weekly up to October 2003. Effective November 2003, the CBN introduced the daily OMO to enhance liquidity management. The use of indirect instruments promotes greater use of financial system's resources, encourages competition, and tends to price capital according to its scarcity. Indirect techniques, however, function better in an interest-sensitive financial market.

Furthermore, the instrument autonomy granted to the CBN conferred on the Bank the power to introduce its own monetary policy instrument. To this end, the Bank introduced the CBN certificate and uses it in times of need. Meanwhile, at the instance of the Bank, the Federal Government has approved the National Savings Certificate (NSC), a savings instrument which would complement CBN's efforts in promoting growth in domestic savings and address the problem of excess liquidity in the banking system on a sustainable basis.

In recognition of the fact that monetary policy impacts on the ultimate objectives with a substantial lag, the CBN, in 2002, adopted a medium term framework for the conduct of monetary policy. The shift from the annual to a two-year programme was designed to free monetary policy implementation from the problem of time inconsistency and over reaction, owing to temporary shocks.

Reform of the Payments System The CBN, as the manager of the payments system, established a number of clearing houses in the country to facilitate the clearing of cheques among the clearing banks. The Bank introduced the Magnetic Ink Character Recognition (MICR) in order to modernize the processing of cheques and other payment instruments, while the Nigeria Inter-bank Settlement System (NIBSS) was established in 1994 by the Bankers Committee (with CBN as Chairman) to accept and effect inter-bank transfers instantly.

NIBSS also provides a courier system for the speedy movement of financial instruments, and complements CBN's clearing and settlement systems. The ultimate objective is to minimize bottlenecks and settlement delays, as well as provide same day clearing and settlement of high value inter-bank transfers and payments.

The installation of the Real Time Gross Settlement System (RIGS) is expected to be completed in the first quarter of 2004 and will facilitate large value transfers. Furthermore, the Enhanced Transfer Module for large value transfers from CBN's branches to the head office of banks in Lagos went live in 2003 and is meant to replace the use of telex messages as well as minimize the incidence of large floats. Currently, the clearing period for local, inter-city and up country cheques has been reduced from 5,12 and 21 days, respectively, to 4, 9 and 12 days. With the introduction of two clearing sessions daily in Lagos area, the local clearing cycle has been reduced from 4 to 3 days. Modern forms of payment instruments have also evolved, including electronic money, while the CBN has issued guidelines on electronic banking to market operators.

The currency structure has been restructured over time to include higher denominations. This has helped in reducing the cost of intermediation for banks.

Meanwhile the settlement system is undergoing further reform which will foster a safe, stable and smooth-functioning banking system, devoid of collateral shocks and disruptions, as well as ensure settlement finality at the CBN. Banks that meet specified criteria would be designated as Settlement Banks, while the unsuccessful ones would do their clearing through the former under agency arrangement.

Developmental Role

The CBN has been involved in the promotion of the growth of the financial markets, namely money, capital and foreign exchange markets. The Bank nurtured the money market through the introduction of money market instruments, such as treasury bills, treasury certificates and eligible development stocks. To deepen the market, the CBN granted licenses to discount houses and some stockbrokers to participate in trading in government securities.

The Bank also fostered the growth of the capital market through the issuance of Federal Government Development Stocks to stimulate the market for enhanced patronage and accommodation of government's longer-term financial requirements.

The CBN is a major player in the foreign exchange market, and has carried out various reforms in the management of the market and the exchange. rate in a deregulated financial environment.

As a matter of deliberate policy, the CBN was instrumental to the establishment of some specialized financial institutions and special schemes and funds, aimed at channeling long-term financial resources to specific sectors of the economy, in support of the growth objective of government. Examples of such institutions are the erstwhile Nigerian Agricultural and Cooperative Bank (NACB, 1973) and the Agricultural Credit Guarantee Scheme (ACGS, 1977) for. agriculture;

Nigerian Industrial Development Bank (NIDB, 1964) and Nigerian Bank for Commerce and Industry (NBCI, 1973) for industry; Federal Mortgage Bank of Nigeria (FMBN, 1977) for residential housing construction; Urban Development Bank (UDB, 1992) for the development of urban dwelling, mass transportation and public utilities; and Nigerian Export-Import Bank (NEXIM) for exports. Some of these institutions have been restructured in order to make them more effective in the delivery of financial resources and advisory services to enterprises and thereby make them relevant to the developmental aspirations of the Nigerian economy. The other schemes include:

(i) Agricultural Credit Guarantee Scheme (ACGS)

This scheme has been used specifically to finance agricultural activities through the banks. The CBN guarantees 75 per cent of bank loans to this sector in order to encourage agricultural productipn, given the fact that the Nigerian economy remains predominantly agricultural. In pursuit of its developmental function and increased effort to ensure the flow of credit to the agricultural sector, the authorized share capital of the ACGS was reviewed upward from N100 million to N3.0billion, while the loan limits under the scheme were also raised. A credit guarantee scheme, similar to the ACGS, is being designed for the industrial sector.

(ii) Financing the Development of SMEs

The Bankers Committee, decided that 10 per cent of profit before tax of every bank would be set aside and channelled to equity investment in small and medium-scale industries, under the Small and Medium. Industries Equity Investment Scheme (SMIEIS) which was lunched in August 2001. The activities targeted under the scheme include agroallied information technology, telecommunications, manufacturing, educational establishments, services, tourism and leisure, solid minerals and construction To ensure the effectiveness of the programme, banks are expected to identify, guide and nurture enterprises to be financed under the scheme.

The CBN has embarked on various projects to facilitate a speedy utilization of resources set aside by banks under the scheme. For example, the Bank commissioned 7 Universities to undertake baseline studies on resource endowments and potentials for the establishment of small and medium scale industries in the 6 geo-political zones of Nigeria and Lagos. When completed, a compendium of investment potentials in such industries will be available to all states of the Federation and posted on CBN website for easy access. This would provide the necessary database for potential investors in the SMIEIS.

(iii) Rediscounting and Refinancing Facility (RRF)

In a continued effort to encourage medium to long-term lending to the productive sectors of the economy by banks, aimed at expanding and diversifying the economy's production base, the CBN, with effect from 2002, adopted a refinancing facility at concessionary interest rate. This facility is designed to support long-term financing of agricultural production, semi-manufacturing, solid minerals and information technology. A similar scheme had earlier been put in place to encourage NEXIM to finance exports.

Financial Sector Surveillance

Adequate regulation and supervision of the financial system~ are crucial elements for financial stability. Prudential regulation refers to the set of laws, rules and standards that is designed to minimize the risks banks assume and to ensure the safety and soundness of both individual institutions and the system as a whole, which is a pre-requisite for the efficiency of the payments system, the

successful implementation of monetary policy, and enhancement of savings and

- investment.

There are provisions in the CBN Act and BOFIA, as amended, as well as the CBN's Monetary Policy Guidelines, which govern the operations of financial institutions in Nigeria. The provisions cover licensing, and scope of operations to ensure that their operations conform with the socio-economic aspirations of the country; determination of fitness and properness of the promoters to ensure sound management; limit of loans to insiders; guidelines to check money laundering and advance fee fraud; minimum capital requirements; and prudential guidelines, encompassing capital adequacy and liquidity ratios, as well as mandatory uniform accounting standards. Others include returns to be submitted to the CBN by financial institutions; power of the CBN to conduct routine and special examinations; management and control of ailing financial institutions and power of the CBN to revoke a financial institution's operating licence.

The Bank also exercises supervisory control over financial institutions to ensure compliance with the guidelines and prescribed standards. This it does through periodic on-site examination and off-site supervision to ensure sound banking practices. The On-Site function is carried out by the Bank Examination Department, while Off-Site surveillance is performed by the Banking Supervision Department. These functions, however, overlap, and are complementary. The Other Financial Institutions Department was established in 2001 to oversee the surveillance of financial institutions other than deposit money banks. A regime of sanctions is imposed on the financial institutions for non-compliance and on individual bank staff and directors for financial misconduct.

Furthermore, the Credit Risk Management System (CRMS) was introduced to enable the CBN obtain returns from deposit money banks on all credit of NI .0 million and above for compilation and dissemination to any interested party Also, the CBN and NDIC, in July 2003, put in place a

framework on Contingency Planning for Bank Systemic Crisis for the banking system. The framework consists of policies, actions and measures necessary for the prevention, management and containment of banking crisis. Suffice to say that this framework provides early warning signals on the health of the banking system and steps to be taken by individual banks and the regulatory authorities to deal with identified problems. The CBN also initiated a private sector funded lifeboat facility in 2002 which was accessed by banks with temporary liquidity problems.

The CBN collaborates with the operators in the banking industry, under the platform of the Bankers Committee, to discuss and resolve issues of concern including the need for banks to observe the prudential and monetary policy guidelines, in order to minimize the risks which banks assume as well as facilitate the implementation of monetary policy. To this end, the Bankers Committee, in 2001, set up a sub-committee on Ethics and Professionalism.

The CBN encourages self-regulatory organizations (SROs) in the industry to complement regulatory intervention. Such SROs include the: Chartered Institute of Bankers of Nigeria (CIBN), Money Market Association of Nigeria (MMAN), Institute of Chartered Accountants of Nigeria (ICAN), etc.

These professional bodies have established codes of conduct which their members are committed to uphold, while disciplinary action is taken against any member found to have engaged in unprofessional conduct. At the individual bank level, the CBN monitors banks' compliance with the maintenance of robust internal control systems. Internal control procedures ensure that transactions are conducted according to laid-down criteria. Suffice to say that a strong system of accounting and administrative controls is necessary to safeguard assets, check the accuracy and reliability of accounting data, provide operational efficiency, and encourage adherence to established policies.

The regulatory authorities have, over the years, adopted various types of distress resolution measures to sanitise the banking industry. These were holding actions, including the take-over of problem banks, and outright liquidation of the operating licenses of 33 banks between 1994 and 2003. Currently, the authorities are exploring the option of mergers and acquisition as a restructuring mechanism in the banking industry. The merit of this option is that healthy and resilient banks are encouraged to purchase the assets and assume the liabilities of weak banks, thereby assuring continuity in the provision of banking services and sustaining public confidence.

PART IV: CHALLENGES FOR THE REGULATORY AUTHORITIES

The policy issues raised by experience,represent the challenges for the monetary/regulatory authorities. The challenges are discussed as follows:

o Government Fiscal Operations: The success of the monetary authorities in regulating the money supply over the years has depended largely on the behaviour of Government spending and fiscal deficit. Government's fiscal operations resulted in persistent deficits for most of the period since independence, while the monetary financing of such deficits by CBN, against its informed judgement, induced monetary growth that was substantially out of line with targets, with adverse implications for domestic prices and the exchange rate. (see Table I). However, there are indications that the Government is committed to strengthening the co-ordination of fiscal policy with monetary policy. The recent floatat ion of the Federal Government Bond, the first since 1988, which was not underwritten by the CBN, is a case in point.

o Bolstering the Technical Ability of the CBN: The effectiveness of liquidity management also depends largely on the accuracy and timeliness of

information available to the CBN. Reliance on indirect instruments, such as

OMO, requires the generation of data on both the balance sheet of the Bank and that of the banking system, as well as the projection of the demand for and supply of reserves and their effect on broader credit and monetary aggregates. Besides, monetary management requires some of the vital data generated outside the financial sector. Two of such critical inputs necessary

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