FOREIGN EXCHANGE RISK MANAGEMENT AND COMMERCIAL BANKS PERFORMANCE IN NIGERIA


Content

 

 

ABSTRACT

 

The focus of this research was on foreign exchange risk management and commercial banks performance in Nigeria. The objective of this research was to determine the effect of foreign exchange risk management on the profitability of commercial banks in Nigeria, to determine the effect of foreign exchange risk management on the shareholders’ fund of commercial banks in Nigeria, identify risks associated with foreign exchange in the Nigerian banking industry and determine the foreign exchange risk management techniques mostly used by commercial banks in Nigeria.  A detailed presentation and analysis of data used use in obtaining the result that explains Foreign Exchange Risk Management and Commercial Banks Performance in Nigeria and this consists Statement of accounts of First Bank of Nigeria, UBA Bank, Access Bank, Diamond Bank and Standard Chartered Bank for the period, 2011-2015. The data used for this study included; Returns on Equity (ROE), Returns on Asset (ROA), Prime Lending Rate (PLR), Non-Performing Loans (NPL), Exchange Rate (EXCH) and Bank Size (BNKSZ) measured by Total Asset. ROE, ROA, PLR, NPL and BNKSZ were available from 2011 to 2015. Findings of the study show that there is a negative impact of exchange rate on bank’s profitability as measured by returns on equity. The result shows that a unit increase in exchange rate which is devaluation causes bank’s profitability to drop by 1.08%. This result is so simply because exchange rate devaluation increases the cost of banking operations and hence imported banks automation and other activities are grossly managed. Hence the null hypothesis is rejected and alternative is accepted and we conclude that there is a significant relationship between the effects of foreign exchange risk management on the profitability of commercial banks in Nigeria. As part of recommendation, the issues related to foreign exchange trading should always be taken into account in efforts to improve banks’ foreign exchange transactions and financial performance. Also, the Government should put in place more measures to increase the country’s exports as this will go a long way in improving the performance of commercial banks in Nigeria.

 

 

 

 


TABLE OF CONTENT

                                                                                                                                      Pages

Title Page                                                                                                                                i

Certification                                                                                                                            ii

Dedication                                                                                                                              iii

Acknowledgement                                                                                                                  iv

Abstract                                                                                                                                  v

Table of Content                                                                                                                     vi

 

CHAPTER ONE: INTRODUCTION                                                                       

1.1      Background to the Study                                                                                            1

1.2      Statement of the Problem                                                                                            3

1.3      Aims and Objectives                                                                                                    4

1.4       Research Question                                                                                                      4

1.5      Research Hypotheses                                                                                                   5

1.6      Significance of the study                                                                                             5

1.7      Scope of study                                                                                                             6

1.6      Definition of Terms                                                                                                     6

           References                                                                                                                   7

CHAPTER TWO: LITERATURE REVIEW                                                         

2.0        Preamble                                                                                                                    8

2.1        Conceptual Framework                                                                                              8

2.2        The Concept of Policies for Currency Risk Management                                         10

2.2.1     The Concept of Market Risk Management                                                                11

2.2.2     Foreign Exchange Risk Management                                                                         12

2.3         Theoretical Framework                                                                                              13

2.3.1     Foreign Exchange Exposure Theory                                                                          13

2.3.2     Interest Rate Parity Theory                                                                                        14

2.3.3      Arbitrage Pricing Theory                                                                                          14

2.4.1       Effect of Foreign Exchange Risk Management and                                               15

              Commercial Banks performance                                          

2.4.1       Risk Management Process                                                                                       16

2.4.2       The Concept of Risk Exposure Limits                                                                     16            

2.4.3       Currency Position Limits                                                                                         18

2.4.4       The Concept of Settlement Risk                                                                              19

2.4.5       The Concept of Counterpart Risk                                                                            20

2.4.6       The Concept of Revaluation Risk                                                                            20

2.4.7       The Concept of Liquidity Risk                                                                                21

2.4.7.1     Forward Contract                                                                                                   22

2.4.7.2    Cross-currency Swaps                                                                                              22

2.4.7.3    Leading and Lagging                                                                                               22

2.5           Review of Empirical Studies                                                                                   25

2.5.1       Empirical Study of the origin and components Currency risk                                 27

2.5.2       Empirical Study of Operational Risk Management in a Bank Treasury                  27

               Environment  

2 .6         Related Party Financing                                                                                          28

2.6.1        Management policies to reduce loan risk                                                                29

2.6.2       Lending Authority                                                                                                   29

2.6.3       Type of Loans and Distribution by Category                                                          30

2.6.4        Appraisal Process                                                                                                    30

2.6.5       Loan Pricing                                                                                                            30

2.6.6       The needs for liquidity                                                                                             31

2.6.7       A Model of Total Growth of a Bank’s Assets and Capital                                     33

   References                                                                                                               35

CHAPTER THREE: RESEARCH METHODOLOGY                                         

3.0         Preamble                                                                                                                   38

3.1         Research Design                                                                                                       38

3.2         Population of the Study                                                                                           39

3.3         Sample size and Sample Technique                                                                          39

3.4         Model Specification                                                                                                 39

3.5         Sources and Measurement of Data                                                                          41

3.6         Criteria for Decision Making under the Regression Analyses                                  41

              References                                                                                                                44

CHAPTER FOUR: PRESENTATION AND ANALYSIS OF DATA                  

4.0         Presentation and Analysis of Data                                                                            45

4.1         Descriptive Statistics                                                                                                45

4.1.1      Econometric Analyses                                                                                                45

4.1.2.1   Unit Root Test                                                                                                          45

4.1.2.2   Co-integration Test                                                                                                    47

4.1.2.3   Testing Hypothesis One                                                                                            48

4.1.2.4   Discussion of Results                                                                                                48

4.1.2.5   Testing Hypothesis Two                                                                                            49
4.1.2.6   Discussion of Results                                                                                               50

 

CHAPTER FIVE: SUMMARY, CONCLUSION AND RECOMMENDATIONS

5.0.        Introduction                                                                                                              51

5.1.        Summary of Finding                                                                                                 51

5.2         Conclusion                                                                                                                 53

5.3         Recommendations                                                                                                    54

5.4         Limitation of Study                                                                                                  54

5.5         Suggestions for further studies                                                                                 55

  Bibliography                                                                                                            56

               Appendix                                                                                                                60

 


CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Foreign Exchange rate plays an increasingly significant role in any economy as it directly affects domestic price level, profitability of traded goods and services, allocation of resources and investment decision. The foreign exchange rate in Nigeria today has gone from bad to worse  rising from N197 to $1 about a  year ago to N  318- $1 dollar (5/08/2016) according to exchangerate.org.uk and this is an increase of 167% just within the space of one year. The problems of foreign exchange risk management on performance of banks in Nigeria are independent from banks core business and therefore, it is usually handled by the banks corporate treasuries. Lee (2010) added that most multinational banks have also risk committees to oversee the treasury’s strategy in managing exchange rate issues and it is important that firms create risk management issues and techniques.

The liberalisation of the exchange rate regime in 1986 has led to introduction of various techniques with the view of finding the most appropriate method for achieving acceptable exchange rate. Foreign exchange rate risk management is an integral part of every bank decision about foreign currency exposure (Allayannis, Ihrig, and Weston, 2001). Evan et al (1985) defined foreign exchange risk management as a program concerned with the identification and quantification of counterstrategies to deal with foreign exchange rate risk and to ensure profitability of most banks. Kirt (2004) further added that foreign exchange risk is a financial risk which is used to manage value creation and loss prevention in a firm by internal and external financial tools.

Piet and Raman (2012) noted that spot rate changes are offset by changes in inflation though small firms may depend on unstable currency rates for profits. Taggert and McDermott (2000) asserted that forex related firms are subject to foreign exchange risk on the payables and receipts in foreign currencies. Papaioannou (2001) referred to foreign exchange risk as the risk related with the unexpected changes in exchange rates and foreign exchange exposure as the extent to which unexpected changes in exchange rates affect the value of a firm’s assets or liabilities.  According to Featherson, Littlefield and Mwangi (2006), foreign exchange risk arises when fluctuation in the relative values of currencies affects the competitive position or viability of an organization and this exposes banks to foreign exchange risk if the results of their projects depend on future exchange rates and if exchange rate changes cannot be fully anticipated. El-Masry (2006) further added that this exposes banks to, Transaction exposure, Economic expouijmsure and Translation exposure.

Some of the major types of foreign exchange rates include Fixed Exchange Rate System (or Pegged Exchange Rate System); Flexible Exchange Rate System (or Floating Exchange Rate System). Managed Floating Rate System and managed exchange rate (Salifu et al, 2007). (Nwankwo, 1980) noted that Nigeria has moved to various types of floating regimes of exchange rate from the fixed/pegged regimes between 1960s and the mid-1980s Since the adoption of the Structural Adjustment Programme (SAP) in 1986. Floating exchange rate has been shown to be preferable to the fixed arrangement because of the responsiveness of the rates to the foreign exchange market (Nwankwo, 1980).

Foreign exchange risk management strategies entail eliminating or reducing this risk, and require understanding of both the ways that the exchange rate risk could affect the operations of economic agents and techniques to deal with the consequent risk implications (Barton, Shenkir, and Walker, 2002).

According to Papaioannou (2001), selecting the appropriate risk management strategy is often a daunting task due to the complexities involved in measuring accurately current risk exposure and deciding on the appropriate degree of risk exposure that ought to be covered. Papaioannou (2001) also added that the need for foreign risk management started to arise after the break down of the Bretton Woods system and the end of the U.S. dollar peg to gold in 1973. Exchange rate volatility creates a risky business environment in which there are uncertainties about future profits and payments. World Bank & MTTI (2006) report stated that these are especially exacerbated in countries where financial instruments for hedging against foreign exchange risk are not developed, which is the case in many developing countries including Nigeria. Therefore, the central focus of this research is to examine foreign exchange risk management and commercial Banks performance in Nigeria.

1.2        Statement of the Problem

Foreign Exchange risk comes about as a disparity between the assets held by banks and the loans that fund its balance sheet. An unexpected depreciation of the local currency against the USD can dramatically increase the cost of servicing debt relative to revenues. It can also negatively affect the creditworthiness of the bank (hence the ability to raise new funds) and even generate a negative net income, with serious consequences for the long-term financial stability of the bank (Moles, 2002).  According to Moles (2002), Banks and

Insurance companies are particularly vulnerable to foreign exchange rate risk, since they operate in developing countries where the risk of currency depreciation is high.

The banking industry in Nigeria is characterized by numerous teething problems and these resulted from their types of customers and the seemingly liberal and/or informal system of operations. The rapid increase in private sector, international investment in microfinance, plus a dose of common sense, makes foreign exchange risk management an important topic for Insurance especially as it regards performance. Also, today in Nigeria, the foreign exchange rate to the Nigeria currency (Naira) is disheartening and this has caused lots of businesses in the country to liquidate or go bankrupt. Also, the Nigeria banks are blamed by most organisations and business men for being responsible for the high exchange rate of foreign currency to the Naira and this issue is beginning to grossly affect banks as most banks are beginning to secretly and silently lay off workers.  Therefore this research intends to examine foreign exchange risk management and commercial Banks performance in Nigeria.

1.3       Aim and Objectives of the Study

The aim of this study is to determine the effects of foreign exchange risk management on the performance of commercial banks in Nigeria. The specific objectives are:

i.                 To determine the effect of foreign exchange risk management on the profitability of commercial banks in Nigeria

ii.               To determine the effect of foreign exchange risk management on the shareholders’ fund of commercial banks in Nigeria.

iii.             To determine the foreign exchange risk management techniques mostly used by commercial banks in Nigeria to manage risk exposures

iv.             To identify risks associated with foreign exchange in the Nigerian banking industry.

1.4       Research Questions

  i.                  What are the effects of foreign exchange risk management on the profitability of commercial banks in Nigeria?

ii.                  What are the effects of foreign exchange risk management on the shareholders’ fund of commercial banks in Nigeria?

 iii.               What are the risk management techniques mostly used by commercial banks in Nigeria to manage foreign risk exposures?

 iv.               What are the risks associated with foreign exchange in the Nigerian banking industry?

 

 

 

1.5       Research Hypotheses

Hypothesis One

H0:       There is no significant relationship between the effects of foreign exchange risk management on the profitability of commercial banks in Nigeria.

H1:       There is significant relationship between the effects of foreign exchange risk management on the profitability of commercial banks in Nigeria.

 

Hypothesis Two

H0:       There is no significant relationship between the effects of foreign exchange risk management on the shareholders’ fund of commercial banks in Nigeria.

H1:       There is significant relationship between the effects of foreign exchange risk management on the shareholders’ fund of commercial banks in Nigeria.

1.6       Significance of the Study

This study will provide a basis for closer scrutiny of the formulations and applications of the different relevant aspects of foreign exchange risk management in existence and in use especially in the Nigeria banking industry. The study will also provide answers regarding contemporary applications of risk management, its relative importance with respect to corporate goals and its degree of applicability in specific business concerns and also, its effects on banks in Nigeria.

This study will be of more relevance to top level managers with whom foreign risk management programmes are being entrusted with and also to the banking industry in general. The government would benefit from this study as they would look at areas in which they can  improve by further implementing policies that can assist the banks in minimizing foreign exchange risk so as to safeguard the investment of bank customers and bank asset. Researchers would benefit from this study as they can delve into the work and seek out ways to further improve on it, seeing as the need to continually improve on knowledge is unquenchable.

1.7       Scope of the Study

The basic premise of the study is to evaluate foreign exchange risk management and commercial banks performance in Nigeria. Selected Banks in Nigeria will serve as the organization of study for this research work. Effort will be made to identify foreign exchange risks associated with the activities of selected commercial banks in Nigeria as well as its effect on the performance of the selected banks.

 

1.8       Definition of Terms

Banks: A business that keeps money for individual people or companies, exchanges currencies, makes loans, and offers other financial services.

Compliance: The state or act of conforming with or agreeing to do something

Foreign exchange risk: is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company.

Transaction risk: The risk of an exchange rate changing between the transaction date and the subsequent settlement date, i.e. it is the gain or loss arising on conversion.

Economic risk: A change in the present value of the future after tax cash flows due to changes in exchange rates.

Uncertainty: The quality or state of being uncertain, that is, something that nobody can predict. Uncertainty is a potential, unpredictable, immeasurable and uncontrollable outcome


Risk: The intentional interaction with uncertainty. Risk is a consequence of action taken in spite of uncertainty

Risk impact: The impacts (financial, reputational, regulatory, etc.) that will happen should the risk event occur.

Risk event: An actual instance of a risk that happened in the past.

Risk cause: The preceding activity that triggers a risk event (e.g. fire was caused by faulty electrical equipment sparking).

Risk Management: The procession or technique of determining, minimizing, and preventing accidental loss in a business

 

 

 

 

 

 

 

 

 

 

 

                                                   


References

Allayannis, G. & Ofek, E. (2001). Exchange Rate Exposure, Hedging, and the Use of Foreign Currency Derivatives. Journal of International Money and Finance, 20 (2), 273-296.

Barton, T. L., Shenkir, W. G. & Walker, P. L. (2002). Making enterprise risk management pay off. FT Press.

El-Masry, A A. (2006). Derivatives use and risk management practices by UK nonfinancial companies. Managerial Finance volume 32 number 2.137-159

Featherson, S., Littlefield, E. & Mwangi, P. (2006).Foriegn Exchange Management Microfinance: What is it and how can it be managed? Retrieved from http://www.cgap.org/sites/default/files/CGAP-Focus-Note-Foreign-Exchange-Rate-Risk-in-Microfinance

Lee, C. (2010). Corporate diversification and firm performance. Journal of political economy, 102, 1248-1280.

Littlefield, E. & Kneiding, C. (2009). The global financial crisis and its impact on microfinance. Washington, DC, CGAP Focus Note, (52).

Moles, P. (2002). Managing strategic exchange risks exposures. Managing Finance, 28, 29-39.

Nwankwo, (1980). Corruption in the banking sector, and economic growth: A cross-country study. Journal of international money and Finance, 13 (1).

Papaioannou M.I. (2001). Prospects and Challenges of Banking in Nigeria in the 21st Century, New Nigeria Newspaper,

Piet C.H and Raman. L.D (2012). Determinants of Financial Performance of Commercial Banks in Kenya. International Journal of Economics & Financial . 3 (1).

Salifu, Z., Osei, K A. & Adjasi, K. D. C. (2007). Foreign exchange risk exposure of listed companies in Ghana. The Journal of Risk finance,8(4), 380-393

 

 

 

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