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1.1    Background to the Study

The function of deposit money banks is the mobilization of savings for investment. The importance of banks in influencing economic growth within an economy is widely acknowledged. Schumpeter (1932) as cited in Blum, Federmair, Fink and Haiss (2002) identified bank’s role in facilitating technological innovation through their intermediary roles. He believes 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 a real growth.

According to Blum, etal (2002), financial intermediation is the process of transferring the savings of some economic units to others for  consumption or investment at a price. For financial intermediation to take place there must be instruments and financial institutions operating together with the objective of bringing about economic growth of the country. Black (2002) defines financial intermediaries as firms whose main function is to borrow money from one set of people and lend it to another. Financial Intermediary institutions consist of banks and non-bank loan suppliers such as Finance companies, mortgage lenders and development finance institutions.

Many researchers have identified a theoretical relationship between financial intermediation and the real sector (the output and services sector of the economy), for instance, Smith (1976) cited in Blum, et al (2002) express the view that the high density of banks in the Scotland of his times was a crucial factor for the rapid development of Scottish economy. Schumpeter (1932) cited in Blum, et al, (2002) argued that the creation of credit through the banking system was an essential source of entrepreneur’s capability to drive real sector growth by funding and employing new combinations of factor use.

Many researchers (for example, Goldsmith, 1969; McKinnon, 1973; Shaw, 1973; Fry, 1988; and King and Levine 1993) have pointed out the significance of banks to the growth of the economy. In examining the relationship, a number of recent empirical studies (for example, Azege, 2004; Levine, 2005; and Ayadi, Adegbite, 2008) have relied on measures of size of financial intermediaries to provide evidence of a link between financial system development and economic growth. This used macro level data such as size of financial intermediaries relative to Gross Domestic Product (GDP) to determine the impact of financial development on economic growth. In particular, Ayadi, and Adegbeti (2008) established a positive relationship between financial development and economic growth in Nigeria for the period of 1986 – 2005.

Also there are many other studies that investigate the relationship between financial intermediation and real sector growth in Nigeria. Notable among them are; Azege (2004); Ndebbio (2004); Ayadi, et al, (2008); Agu and Chukwu (2008); Adbullahi (2009); and Nzotta and Okereke (2009), but the results of these studies are divergent. The divergence seems to emanate from the different estimation procedures and the data used for analysis. These results are deficient in that they did not attempt to evaluate the causality between financial intermediation and real sector growth in Nigeria. They merely examine the correlation between financial intermediation and real sector. Another observed weakness of these previous studies is that they did not discuss the implications of the relationship that exist between finance and real sector growth. These studies also did not give the specific implication of each variable of financial intermediation on the real sector activities in Nigeria. This means there is a gap in the literature which needs to be covered by research.

This study is an attempt to cover the gap that exists in this area of study by examining empirically, the impact of financial intermediation by banks on the real sector growth of the Nigerian economy.

1.2    Statement of the Problem

The financial intermediaries of the Nigerian economy are expected to be responsible for financial resource mobilization and intermediation between the various sectors of the economy. They are to redirect funds from the surplus sectors to the deficit sectors of the economy. The financial intermediaries are supposed to provide the funds used as capital inputs by producers in other sectors of the economy as well as the final consumers. The impact of the delivery of these financial services in the form of capital to the producers and individuals is felt both in the short-run and in the long-run. Therefore, the financial sector, especially the banking sector is very important in effective functioning of the real sector of the economy.

The real sector of the economy forms the main driving force of the economy. It is the engine of economic growth and development. Largely, the real sector depends on the banking sector for the provision of the required funds for investment purposes. Thus, it means that an increase in the bank lending to the real sector will increase the activities of the real sector and vice versa (Blum, etal, 2002). Based on the assumption that the banking sector plays an important role in financing the real sector, successive government in Nigeria have carried out reforms and institutional innovations in the banking sector with the aim of ensuring financial stability of the sector so as to influence the growth of the economy and also to ensure that banks plays the critical roles of financial intermediation in Nigeria. In particular, the bank consolidation exercise in 1986 has drastically shaped and positioned the banking sector to the important role of financing the real sector to bring about the growth of the economy.

However, despite the series of reforms and restructuring aimed at strengthening the bank’s ability to efficient service delivery and branch networking and fund the real sector, problems still persists such as; decline in domestic credit by the banking sector to the private sector, there is also a considerable liquid mismatch in the Nigerian economy (CBN, 2007).

Another problem is that of high concentration of loans to few sectors of the Nigerian economy to the detriment of other sector. According to CBN, (2007), there is a high concentration of loans to oil and gas and communication sectors with credit exposures within the banking sector remaining predominantly short-dated (at less than 12 months) highlighting the bank relative lack of long dated funding. Similarly, there is a significant mismatch (Hashim, 2011) between where credit is supplied (by sector) and the main contributors to the GDP (by sector). For example, although agriculture is the largest contributor to the Nigerian’s GDP (42% of total GDP in 2007), only 3% of bank credit exposure is to the agricultural sector in 2007. When compared to the communication sector which contributed only 2.38% of total real GDP in 2007 was  supplied with 24% of total credit to the private sector in 2007 (CBN, 2007). Therefore, the problem remains that the real sector is yet to be effectively linked to the financial intermediaries in the country.