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Full Project – EFFECT OF EXCHANGE RATE POLICIES ON THE PERFORMANCE OF DEPOSIT MONEY BANKS

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CHAPTER ONE

INTRODUCTION

1.1 Background to the study

Deposit money banks play a critical role in economic development of countries as they channel funds from depositors to investors through financial intermediation. Beyond the intermediation function, the financial performance of banks has critical implications on economic growth of countries. Good financial performance rewards the shareholders for their investment. This in turn encourages additional investment and brings about economic growth (Kiganda, 2014). In order to provide sustainable intermediation services in the economy and reasonable rewards for the shareholders, banks need to be profitable. They can do so, if they generate necessary income to cover their operational cost. On the other hand, poor banking performance can lead to banking failure and crisis which have negative repercussions on the economic growth (Ongore&Kusa, 2013).

Globalization is said to have enhanced the trading relationship between countries, particularly, with the introduction of the electronic payment system. The foreign exchange market portends to be the largest financial market in the world; more so, large banks are the greatest players in this market. The greatest volume of currency is traded in the interbank market. This is where banks of all sizes trade currency with each other and through electronic networks. Large banks, account for a larger percentage of total currency traded in the international financial markets (Lambe, 2015). Banks facilitate foreign exchange transactions for clients and conduct speculative trades from their own trading desks. When banks act as dealers for clients, the bid-ask spread represents the bank’s profit. Speculative currency trades are executed to profit on currency fluctuations. The current global trend of large banks establishing corporate branches outside their country of domain has further heightened their degree of exposure to exchange rate risk management. The profitability of such large banks might be significantly affected by fluctuations in exchange rate (Amenawo, Hodo & Emmanuel 2016).

According to different studies in banking literature (Rao&Lakew, 2012; Kanwal&Nadeem 2013; Pan & Pan 2014; Ongore&Kusa 2013; Kiganda 2014) the performance of a bank can be influenced by different factors. The performance of deposit money banks can be affected by internal and external factors which can be classified into bank specific (internal) and macroeconomic variables. The internal factors are the individual bank characteristics that affect the performance of banks and these factors are basically influenced by the decision of the management and board. The external factors are sector wide or country wide factors, which are beyond the control of the company.

Generally, the bank specific factors may relate to a bank’s overall managerial practices on different operational aspects of the bank while the external factors are related to the industry and macroeconomic variables; within which the bank operates. Exchange rate is one of the macroeconomic variables that could influence banks profitability; it may affect individual banks directly and/or indirectly. It directly affects the banks through the structure of assets and liabilities denominated in foreign currency, off- balance sheet exposure, and non-asset based services (Martin &Mauer, 2003).When two assets and liabilities are invoiced in foreign currency, exchange rate variations directly affect the values of the assets and the liabilities in terms of domestic currency, through recognition of gain or loss. This research work therefore seeks to examine the effect of exchange rate policies on the performance of deposit money banks, most especially when making a sectorial analysis and given that bank sizes are usually measured by total asset or total deposit (which becomes a critical factor).

1.2 Statement of the Problem

Studies on foreign exchange policies and fluctuations have gained so much attention in the literature recently because we operate an open economy as a result of natural endowment. Activities in foreign exchange market determine the attractiveness of a nation’s currency and the level of development of that economy. All transactions done there will form a very vital aspect of the activities of financial sectors and the effect of deposit money banks cannot be over emphasized in the allocation of economic resources (Ongore&Kusa, 2013). Banks’ performance contributes immensely to the economic growth of a country by making funds available for investors to borrow and enhance financial deepening. This is as a result of the market not only being a vehicle of settling international transactions but functions also as a medium of interaction between sellers and buyers of foreign exchange in a bid to negotiate a mutually acceptable price for the promotion and furtherance of international transactions.

Ngerebo (2012) opines that foreign exchange markets represent a global means of communication among the large commercial banks that serve as financial intermediaries for such exchange since commercial banks use international lending as their primary form of international investing. The market operations in turn influence the commercial banks by facilitating exchange, payments, international transactions and playing important role in the foreign exchange market. Ongore and Kusa (2013) further explain that the internal factors are peculiar to each banks, an example of such internal factors is size of the firm. External factors on the other hand are macro-economic variable such as exchange ratepolicices, GDP, inflation rate, interest rate etc. Although Ani, Ugwunta and Okanya (2013) opine that because of the central role of banks in the financial intermediation, banks are hugely affected by the foreign exchange market.

The operations in the foreign exchange market which is a veritable component of banking operations has significant implications for banks credit to the domestic economy, internal reserves and their general intermediation operations (Ngerebo, 2012). As such in today’s global economy, any company trading in international markets is affected by foreign exchange rate policies and fluctuations which are as a result of uncertainty in international transactions both in goods and financial assets. Most of the research reviewed focused on exchange rate volatility and other macro-economic variables such as GDP and Inflation and few on the effect of exchange rate policies and fluctuation on banks performance specifically in Nigeria.

According to Mbabazize, Daniel and Ekise (2014), movements in exchange rates can work in the company’s favour and enhance performance and on the other hand have the opposite effect and seriously erode profit margins or lead to loss. The Naira (Nigerian currency ₦) has witnessed a continuous depreciation in the exchange market. The exchange rate of US Dollar to naira from 1997- 2000 rate was fixed at ₦21.8861 and then increased to ₦ 92.6934 in 2001. The rate further moved to ₦133.504 in 2006 but reduced in 2008 to 121.21. In 2009, the exchange rate increased to ₦127.7880 but reduced to ₦118.5669 in 2011 while in 2012 and 2013 it increased to ₦148.9017 and ₦150.2980 respectively (CBN, 2013). Currently, the exchange rate is ₦357 (CBN, 2018).

Generally, it would be expected that the banks would be able to boost their performance through their large volume of foreign exchange (Lambe, 2015) but this area remains a grey area in research. Hence, this study evaluates the effect of exchange rate policies for the period of 2005 to 2017 by providing empirical evidence on the effect of exchange rate policies on the profitability, liquidity, efficiency and solvency of Nigerian deposit money banks. This is with the motive to draw the attention of policy makers and banks management to the need to establish strategies and policies with the sole aim of appreciating the naira value and mitigating against foreign exchange risk.

1.3 Research Questions

The following research questions are formulated for the study based on the research problems:

To what extent do exchange rate policies affect deposit money banks’ efficiency in Nigeria?
How do exchange rate policies affect solvency of deposit money banks in Nigeria?
To what extent do exchange rate policies affect liquidity of deposit money banks in Nigeria?
How do exchange rate policies affect financial market performance of deposit money banks in Nigeria?

1.4 Research Objectives

Therefore, the main objective of this study is to empirically examine the overall effect of exchange rate policies on the performance of money deposit banks in Nigeria. However, the specific objectives of this study are to:

examinethe effect of exchange rate policies on deposit money banks’ efficiency.
evaluate how exchange rate policies affect solvency of deposit money banks in Nigeria.
investigate how exchange rate policies affect liquidity of deposit money banks in Nigeria.
examine how exchange rate policies affect financial market performance of deposit money banks in Nigeria.

1.5 Research Hypotheses

H_O1:Exchange rate policies have no significant effect on deposit money banks’ efficiency

H_O2: Exchange rate policies have no significant impact on deposit money banks’

solvency

H_O3: Exchange rate policies have no significant impact on deposit money banks’ liquidity

H_O4: Exchange rate policies have no significant impact on deposit banks’ financial

market performance.

1.6 Justification of the Study

Despite different exchange rate regimes in Nigeria, the exchange rate of the naira has remained unstable since the deregulation period due to the policies adopted. The need to investigate the effect of these exchange rate policies on the performance of the banking industry is important for the economy. For a country that is import dependent, the stability of its exchange rate is important for credit allocation (Adebiyi, 2006). It is therefore important to examine how the policies of exchange rate affect the performance of the industry.

Banks can easily identify the direct effect of exchange rate policies on their profitability through accounting adjustment (recognizing gain or loss) on foreign currency denominated assets and liabilities. However, it is not easy to determine the direction and magnitude of its indirect effect on bank’s performance resulted by changes in macroeconomic factors that are caused by exchange rate variations. It is believed that the empirical findings of this study will potentially help bank directors, managers & workers to clearly understand how the exchange rate policies aggregately affect banks profitability and devise appropriate policies, procedures and mechanisms to reduce the exchange rate risk exposure of their banks.

The study result may also be a useful input for bank regulators and supervisors to induce commercial banks to have proactive exchange rate risk management strategies that encompass both the direct & indirect impact of exchange rate policies on banks performance. Lastly, this study will contribute its share to the scanty available literature on the Nigerian banking sector.

1.7 Scope of the Study

This study examines the effect of exchange rate policies on the performance of deposit money banks in Nigeria. This study focuses on the banks’ efficiency, banks solvency, banks liquidity and financial market performance of banks in Nigeria. This study thus examines the effect of exchange rate policies on the performance of banks in Nigeria from the period of 2005-2017. This provides a clear pointer to the effect in recapitalization and post consolidation era of Nigeria banking industry.

1.8 Organization of the study

This study is organized into five chapters. Chapter one is introduction and it embodies the background to the study, statement of the problem, research questions, objectives of the study, research hypotheses, justification for the study, scope of the study and organization of the study. Chapter two provides literature review and it is divided into conceptual review, theoretical review, empirical review and identified gaps in the literature.

Chapter three focuses on the methodology made up of model specification, research design, population of the study, sample size and sampling technique, sources of data collection, method of data analysis and variable measurement. Chapter four comprises results and discussion of findings. The concluding chapter which is chapter five summarizes, concludes and recommends based on the findings of the study.

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