EFFECT OF FOREIGN EXCHANGE RISK MANAGEMENT ON THE PROFITABILITY OF COMMERCIAL BANKS IN NIGERIA (A CASE STUDY OF SELECTED COMMERCIAL BANKS IN CROSS RIVER STATE)

CHAPTER ONE

INTRODUCTION

BACKGROUND OF THE STUDY

Foreign exchange rate risk management is an integral part in every banks decision about foreign currency exposure (Allayannis, Ihrig, and Weston, 2008). Currency risk or hedging strategies entails eliminating or reducing the risk, and it requires 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, 2011). Selecting the suitable hedging strategy is usually a frightening task because of the complexities concerned in activity accurately current risk exposure and picking the suitable degree of risk exposure that ought to be covered. The need for currency 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 (Papaioannou, 2008). The issue of currency risk management for financial firms is independent from their core business and is usually dealt by their corporate treasuries. Most multinational firms have also risk committees to oversee the treasury’s strategy in managing the exchange rate (and interest rate) risk (Lam, 2014). This shows the importance that firms put on risk management issues and techniques. Conversely, international investors usually, but not always, manage their foreign exchange rate risk independently from the underlying assets and/or liabilities. Since their currency exposure is related to translation risks on assets and liabilities denominated in foreign currencies, they tend to consider currencies as a separate asset class requiring a currency overlay mandate (Allen, 2014). Exchange rate volatility creates a risky business environment in which there are uncertainties about future profits and payments. 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 Kenya (World Bank & MTTI, 2016). Commercial banks play a critical role in economic development of countries. They channel funds from depositors to investors through their financial intermediation role. Beyond the intermediation function, the financial performance of banks has critical implications for economic growth of countries. Good financial performance rewards the shareholders for their investment. This, in turn, encourages additional investment and brings about economic growth. In order to provide a sustainable intermediation services in the economy and reasonable reward for the shareholders, banks need to be profitable (Pan and Pan, 2014). 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 and Kusa, 2013). According to different studies, the profitability of bank can be influenced by different factors. The performance of commercial banks can be affected by internal and external factors which can be classified into bank specific (internal) and macroeconomic variables (Ongore and Kusa, 2013). The internal factors are the individual bank characteristics that affect the profitability of banks and these factors are basically influenced by the decision of management and board. The external factors are a 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 (Kanwal and Nadeem, 2013). 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 and Mauer, 2014).When 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 (Rao and Lakew, 2012). If the amount of foreign currency assets and liabilities are the same, there is no direct effect of the exchange rate variation on the bank’s balance sheet and income statement. The direct effect occurs when the banks do not hold the same amount of foreign currency assets and foreign currency liabilities. The indirect effects of the exchange rate on the banks performance can be channelled through its effect on the demand for loans, the extent of competition, and other aspects of banking conditions (Chamberlain etal., 2014).Exchange rate variation might affect the price of domestic products, import, export, and FDI etc. This in turn might influence banks portfolio and operation in different ways. Some studies (Rao and Lakew (2012), Kanwal and Nadeem (2013), Pan and Pan (2014), Ongore and Kusa (2013), kiganda (2014)) have examined the effect of these internal and external factors on the banks profitability. However, very few of these studies have assessed the impact of exchange rate (one of the macroeconomic factors) on banks profitability. For example, Kiganda (2014) on his study of the effects of macroeconomic factors on commercial banks profitability in Kenya found that exchange rate has negative insignificant effect on the banks profitability as expressed by ROA.

1.2 STATEMENT OF THE PROBLEM

Exchange rate fluctuations affect operating cash flows and firm value through translation, transaction, and economic effects of exchange rate risk exposure. Income based on fair values reflects income volatility more than historical cost-based income. In the banking industry, international transactions have increased tremendously (Giddy and Dufey, 2007). These transactions are affected by the change in exchange rates of currencies involved. Similarly, banks recognize losses and gain on asset and liability denominated by foreign currency as home currency appreciates in value. Unlike the direct effect, the indirect effect of exchange rate risk management variation on the banks profitability, which basically emanate from the influence of exchange variation on the businesses in general and import and export trade in particular is very subtle and cannot be easily determined. However, it is crucial to know how exchange rate variation aggregately affects the profitability of commercial banks and focusing on the direct effect of exchange rate variation alone may lead banks to wrong operational and strategic decisions. As already noted, Nigerian currency has been continuously depreciating against major hard currencies and how this depreciating trend aggregately affects the Nigerian commercial banks performance (profitability) is not clearly known. There is therefore need to understand how various foreign exchange risk management techniques influence the performance of commercial banks. There is also need to understand the outcome of using each of these techniques and which one has a greater impact on the financial performance of these institutions.

AIMS OF THE STUDY

The major purpose of this study is to examine effect of foreign exchange risk management on the profitability of commercial banks in Nigeria. Other general objectives of the study are:

1. To examine the level of foreign exchange risk management in Nigeria.

2. To examine the extent to which the applicability of the practice of foreign exchange risk management is being practiced in Nigeria.

3. To examine the effect of foreign exchange risk management on profitability of commercial banks in Nigeria.

4. To examine the problems with the management of foreign exchange risk in the Nigerian economy.

5. To examine the relationship between foreign exchange risk management and profitability of commercial banks in Nigeria.

6. To recommend ways of ensuring adequate management of foreign exchange risks in the banking sector.

1.4 RESEARCH QUESTIONS    

1. What is the level of foreign exchange risk management in Nigeria?

2. To what extent is the applicability of the practice of foreign exchange risk management being practiced in Nigeria?

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

4. What are the problems with the management of foreign exchange risk in the Nigerian economy?

5. What is the relationship between foreign exchange risk management and profitability of commercial banks in Nigeria?

6. What are the recommended ways of ensuring adequate management of foreign exchange risks in the banking sector?

1.5 RESEARCH HYPOTHESES

Hypothesis 1

1. Foreign Exchange risk management does not have effect on the profitability of commercial banks in Nigeria.
2. : Foreign Exchange risk management has a significant effect on the profitability of commercial banks in Nigeria

Hypothesis 2

1. There is no significant relationship between Foreign exchange risk management and profitability of commercial banks in Nigeria.
2. : There is a significant relationship between Foreign exchange risk management and profitability of commercial banks in Nigeria

SIGNIFICANCE OF THE STUDY

The study will enrich Treasury/Risk managers with knowledge on risk management especially techniques associated with foreign exchange risk management within the Kenyan banking industry. Most Treasury Managers of banks, insurance companies and other financial institutions will use the findings in the enforcement of such foreign exchange risk management policies in such organizations. The literature, study findings and recommendations will supplement the existing body of knowledge on bank foreign exchange risk management. This study is important to various stakeholders in the financial sector because it will provide an insight into the effects of financial risk management on financial performance of banks. Banks are the most reliable savings and credit facilities available in Kenya. The study will be valuable to investors because it will provide information on the foreign exchange risks which will help them make sound decisions. The study will be useful to academicians as it will provide information that can be used as a basis for further research. The study will also propose areas for further research which will be very important to researchers who will easily get to know what needs to be done in the area of study. Finally, the study is of immense benefit to policy makers, investors, financial manager’s lecturers and the general public.

1.7    SCOPE OF THE STUDY 

The study is based on the study on effect of foreign exchange risk management on the profitability of commercial banks in Nigeria, case study of selected commercial banks, Cross River State.

1.8 LIMITATION OF STUDY

Financial constraint- Insufficient fund tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature or information and in the process of data collection (internet, questionnaire and interview).

Time constraint- The researcher will simultaneously engage in this study with other academic work. This consequently will cut down on the time devoted for the research work.

DEFINITION OF TERMS

Foreign Exchange: Foreign exchange is the exchange of one currency for another or the conversion of one currency into another currency. Foreign exchange also refers to the global market where currencies are traded virtually around the clock.

Foreign Exchange Risk Management:  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. Foreign exchange risk can be defined as the potential transaction, translation gains and losses when foreign investments are valued in terms of the investor’s home currency.

Risk: Risk of an asset is the potential change of future returns due to its assets (Weston & et al, 2008). Investors always face the risk that their rates of return asset June be lower than value of expected. So the "risk" is likely to be different the real rate of return with investor's desired rate. The risk of a financial asset is a function of one or more factors that cause changes securities prices in market.

Management: - This is defined as the process of directing, co-ordination and influencing the operations of an organization so as to obtain desired result and enhance a total performance.

Commercial Banks- These are financial institutions, which accept deposit and other loans to the customers.