CHAPTER ONEINTRODUCTION1.1BACKGROUND TO THE STUDYInterest rates play important role in controlling major macroeconomic variables.The primary role of interest rate is to help in the mobilization of financialresources and to ensure efficient utilization of resources for the promotion ofeconomic growth and development (CBN 1970).However, they are various states of interest rates in the financial system. Theyare generally classified into two categories: Deposit and lending rates. Depositsrate are paid to savings and time deposits of different maturities, while lendingrates are interest rates charged on loans to customers and they vary according tocost of loanable funds and lending margins.A number of factors influence the behaviour of interest rates in aneconomy. Prominent among these are the volume of savings, inflation,investment, government spending, monetary policy and taxation constitute themajor source (supply) of credit while investment represents the major demandfor credit. Therefore, the level of savings partly determines the level of interestrates. For instance, a decrease in the accumulation of loanable funds (savings) isbound to exert an upward pressure on interest rates, just as the reverse situationwould tend to have a moderating effect. Usually, when the structures of interestrate are changed, the resulting relative rates of return will induce shift in theassets portfolio of both banks and the non-banks public institutions. Hence, thedirection and magnitude of changes in the market interest rates are of primaryimportance to economic agents and the policy makers.Consequently, the Nigerian Economy has been highly prone to interest ratevolatility and fragility (CBN, 2000). Interest rates of all instruments haveexperienced very volatile movements. Inconsistencies have been the order ofthe day (Adewunmi, 1997).Prior to the structural adjustments programme (SAP), the level and structure ofthe interest rates were administratively determined by the Central Bank ofNigeria (CBN). Both deposits and lending rates were fixed by the bank, basedon policy decision (CBN, 1962). At that time, the major reasons foradministering interest rates were the desire to obtain social optimum resourceallocation, promote orderly growth of the financial market and combat inflationin implementing the credit policy. During this time, the minimum rediscountrate which was very low, averaging about 7.25 percent between 1975 and 1985.Also, preferred sectors could not access funds because financial institutionswere unable to raise sufficient funds form the money market at the favouredconcessionary rates (Staley and Morse, 1966). Within the general framework ofderegulating the economy in 1986, in order to enhance competition and efficientallocation of resources, the CBN introduced a market based interest rate policyin August 1987 (CBN, 1987).The policy decision was not without controversy,and later,it was generally agreed that low interest rates did not encouragesavings. It was feared that high interest rate which was likely to accommodatethe deregulation of interest rates allowed banks to determine their lending anddeposit rates according to market conditions through negotiations with theircustomers (CBN, 1987).However, the minimum rediscount rate (MRR) which influenced interest ratescontinued to be determined by the CBN in line with changes in overalleconomic conditions. The MRR which was 15 percent in August 1987 wasreduced to 12.5 percent in December 1987 with the objective of stimulatinginvestment and growth in the economy (CBN, august 9, 2006). During the sameperiod, the prime lending rates of commercial banks and merchant banks wereon the average 18.0and 20.5 percents respectively. But following the need formoderate monetary expansion in 1989, the MRR was raised to 13.5 percent. Itwas also observed that there were wide disparities in the interest rates structureof the various banks.As it were, the ceiling on interest rates were removed in January 1992 andretained in 1993. Interest rate in 1993 was volatile and rose to unprecedentedlevel. On the basis of the foregoing developments, some measures ofregulations were introduced in 1994. The developments in interest rates withinthis period were generally within the prescribed limits but the rates on the otherhand were negative in real terms since inflation was estimated to be over 50percent.All the same, the banks still maintained the interest rate regime in 1995 withsome modifications just to make it flexible. Nevertheless, it should be noted thatthe change in interest rates were significantly different from what prevailedduring the era of regulation. Over the past three decades, high macro-economicinstability has become a key determinant and the consequence of poor economicmanagement. Nigeria, a country blessed with abundant natural resources is seenas one the countries that have the most volatile macroeconomic aggregates. Thisis in order with National Economic Empowerment and Development strategy(NEEDS, 2004) which says that “between 1975 and 2000, Nigeria’s broadmacroeconomic aggregates growth, the terms of trade, the real exchange rate,government revenue and spending were among the most unstable in thedeveloping world”.It is these developments which have fuelled the need to embark upon this study.It could be possible that the macroeconomic instability is deep rooted in erraticmovements of interest rates.