FOREIGN EXCHANGE RISK MANAGEMENT AND IT IMPACT ON DEPOSIT MONEY BANKS IN NIGERIA
- BACKGROUND TO THE STUDY
Risk is an inevitable phenomenon which has lived with mankind since time immemorial.
In our domestic and especially in our business life, we find ourselves in situations where risk taking becomes the solution to our break through. Nevertheless, one should find a way to minimize or manage this risk in order not to affect the expected result from a given investment. In the financial sector, risk management is seen as one of the most essential internal itineraries upon which decisions are made by financial institutions.
The history of the Nigeria banking system connects with growth and burst cycles in the number of operating banks and their branches. Signs of growth are usually experienced when the policy environment presents questionable business opportunities within the banking sector. The Banking sector has a pivotal role in the development of an economy. It is the key driver of economic growth of the country and has a dynamic role to play in converting the idle capital resources for their optimum utilisation so as to attain maximum productivity (Sharma, 2003). In fact, the foundation of a sound economy depends on how sound the Banking sector is and vice versa. In Nigeria, the banking sector is considerably strong at present but at the same time, banking is considered to be a very risky business. Financial institutions must take risk, but they must do so consciously. However, it should be borne in mind that banks are very fragile institutions which are built on customers’ trust, brand reputation and above all dangerous leverage. In case something goes wrong, banks can collapse and failure of one bank is sufficient to send shock waves right through the economy. Therefore, bank management must take utmost care in identifying the type as well as the degree of its risk exposure and tackle those effectively. Moreover, bankers must see risk management as an ongoing and valued activity with the board setting the example.
In other words, there seems a sudden policy shift that makes it easy for ordinary business people to initiate processes that creates access to public funds in the name of bank deposits.
The banking industry as regulated by the Central Bank of Nigeria is made up of Deposit Money Banks usually referred to as Commercial Banks and other Financial Institutions which includes Micro-Finance Banks, Finance Companies, Bureau De Change, Discount Houses and Primary Mortgage Institutions.
Conventionally the banking system was focused on receipts of deposits from customers on demand. But today the banking system has transcended beyond that scope, the system now incorporates the performance of other auxiliary functions such as financial advisory services, foreign exchange transaction of both domestic and international payment systems.
Management of foreign exchange risk is one of the essence of the business of banking. The extent to which exchange risk management is being managed or controlled could either be said to be an art or science, Since the abolishment of the fixed exchange rate system and the replacement with a floating exchange rate system, exchange rate fluctuation has been a great concern to organizations, banks and even investors. In the recent past, we have seen the penetration of local banks in foreign markets as well as penetration of foreign banks in to the local markets. This exposes them to risks associated with dealing in foreign currency and the risks have to be managed. The study thus sorts to find out the effects of the foreign exchange risk management techniques on the financial performance of commercial banks in Nigeria.
Foreign exchange risk or currency risk exposure as some authors prefers to call risk associated with in fluctuations in currencies, has been defined severally by different authors. One thing that is glaring is the lack of consensus on what the term actually connotes.
According to Derosa (1991), 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”. Furthermore, Shapiro (1996) also gave an advanced and simplistic definition when be defined exchange risk as the variability in the value of the firm that is caused by uncertain exchange rate changes.
As long as there is flexible and market determined exchange rate, exchange rate risk will exist and become inevitable. Foreign Exchange Risk can be either Transactional or it can be Translational. When the exchange rate changes unfavorably it give rise to Transactional Risk, as the name implies because of transactions in Foreign Currencies, can be hedged using different techniques. Other one Translational Risk is an accounting risk arising because of the translation of the assets held in foreign currency or abroad. Foreign Exchange Risk in demand deposit banks.
Commercial banks, actively deal in foreign currencies holding assets and liabilities in foreign denominated currencies, are continuously exposed to Foreign Exchange Risk. Foreign Exchange Risk of a commercial bank comes from its very trade and non-trade services.
Egwuonwu (1995) stated that foreign exchange risk management is a new phenomenon in the study of risk exposure. This is because little was known about the subject and its practice and also foreign exchange management itself has been given little cognizant in the past and as a result, it was not considered as a possible tool for long term development in the nations economy.
The breakdown in the fixed foreign exchange rate to a market determines exchange rate was the fundamental factor responsible for the demand for foreign exchange risk management. Also, development in the fields of communication information technology, emergence of global investment called derivative securities (currency futures) options and currency sways) are other factors which contributed to the emergence of the subject.
In this light and in an effort to improve the effectiveness of the foreign exchange risk management in Nigeria the research study was undertaken. It is therefore in view of the foregoing that bankers actually tends to understand the very nature of foreign exchange risks, the methods of analyzing them and the various types of risks involved and ways of mitigating these exchange risks.
- STATEMENT OF PROBLEM
The statement of research problem in this study stems from the fact that banks appear very profitable in Nigeria, whether foreign exchange risk management assessed on country by country, income group or by individual banks. The Nigerian economy observed in the present dispensation has been characterized by worsening economic fortunes in terms of reduced growth, increased unemployment, galloping inflation, high incidence of poverty, worsening balance of payment conditions, high debt burden and increasing unsustainable fiscal deficit. There are management challenges confronting Nigeria banks since the advent of indigenous banks. Aside losses experienced by depositors, shareholders, employees and other stakeholders, the level of confidence in the financial system has been negatively affected.
The inability of most deposit money bank to survive and prosper in volatile market conditions, and to preserve themselves against all forms of foreign exchange risk such as unexpected changes in currency exchange rates, lost payments, delayed confirmation of payments and receivables, discrepancies between bank drafts received and the contract price, hedged currency risks in foreign exchange rates and other issues that may come up in their day-to-day transaction has continually tends to pose a greater danger and reduction in profitability ratio of some of these deposit money bank if not rather minimized.
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.
Finally, over the years, the transaction involving the use of foreign exchange has increase so also the increase in the risk involve in foreign exchange transaction. The problem is how to effectively manage these foreign exchange risks. Moreover, the inherent problems as experienced by the deposit money banks today can be linked to the partial or total neglect of the cannons of lending by the officers of the bank, attitude towards risk.
There is therefore need to understand how various foreign exchange risk management techniques influence the profitability of deposit money 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.
- OBJECTIVES OF THE STUDY
Bank profits as an important source for equity is imperative. If bank profits are reinvested, it is expected that it should lead to safer banks and consequently high level of profits. This could promote financial stability and economic development.
The major objective is to evaluate the impact of foreign exchange risk management on the profitability of demand deposit bank in Nigeria.
The study shall also seeks to delve into how the risk involved in foreign exchange can be effectively managed, by determining the following specific objectives:
- Determine the various exchange risks which the treasurer of the selected bank is exposed to in its foreign exchange transaction.
- Ascertain the constraint/problems with the management of foreign exchange risk in the Nigerian economy.
- Establish measures/steps could be taken to substantially improve foreign exchange risk management by deposit money banks in Nigeria.
- Determine to what extent applicability of the practice of foreign exchange risk management is practiced in the Nigerian economy
- Recommend possible modern techniques and how they can be employed in Nigerians economy.
- Investigate the effect of external foreign exchange risk management techniques on the financial performance of deposit money banks in Nigeria.
- Establish the effect of foreign currency swap on the profitability of deposit money banks in Nigeria.
1.4 Research Question
In the light of the above, some research questions become feasible and were used to guide the research study. They include:
- What is/are the problems with the management of foreign exchange risk in the Nigerian economy?
- What measures/steps could be taken to substantially improve foreign exchange risk management by deposit money banks in Nigeria?
- Determine to what extent applicability of the practice of foreign exchange risk management is practiced in the Nigerian economy
- Are there any possible Recommendation on modern techniques and how can they be employed in Nigerians economy?
- What are the effects of external foreign exchange risk management techniques on the financial performance of deposit money banks in Nigeria?
- What are the effects of foreign currency swap on the profitability of deposit money banks in Nigeria?
- What are the impacts or strategy for managing foreign exchange risk by deposit money banks in Nigeria?
1.5. SIGNIFICANCE OF THE STUDY
The research study is relevant because humans are prone to making mistakes for business concern; all facts of its existence are fraught with risk exposure. The business environment in which companies operates is becoming increasingly complex and uncertain due to the globalization of business and rapid introduction of new technologies.
The findings of this study will throw more light on the management of foreign exchange risk and why it is good for every organization.
It shall also seeks to recommend more sophisticated method of managing and controlling foreign exchange risk that would guarantee optimum level of profit profitability.
This study will also be of great importance to the government, business organizations, foreign elites, multinational companies, corporate individual, all forms financial and non-financial institution including small and medium scale enterprises since it will help to determine, and provide insight on the impact of foreign exchange risk on the economy if not tackled and managed effectively. It will also help to create responsibilities for all those in the financial sector to disclose relevant information relating to foreign exchange risk to their customers as the need arises.
It will also assist the investors and depositors to know the financial position of the deposit money banks they are investing in if it is going to be a profitable or not, and for all those in the regulated sector i.e. statutory auditors, a tax advisor, A forensic accountant, external auditor/accountant by providing them with fundamental information on how to manage foreign exchange risk in relation to their profit generation.
Finally it will be of great significance to schools and students, it will serve as a reference point for future researchers who will want to research more on the topic.
1.6. STATEMENT OF HYPOTHESIS
Research hypothesis is a testable statement regarding the relationship between two or more variables that comes from research problems. in fact, research problems cannot be properly address unless it is reduced to hypothesis.
The hypotheses are stated in the null form for testing:
Ho: Foreign exchange risk management do not have a significant influence on the profitability of Commercial Banks in Nigeria
Ho: the banks do not bother themselves with foreign exchange risk while transacting in foreign exchange currencies.
1.7. RESEARCH METHODOLOGY
Secondary data were purely and mainly used for this research study. Data generated in this study were references made to several write-ups, journals from relevant organizations such as the Central Bank of Nigeria. The method of data analysis in this study is the ordinary least squares. Using SPSS package software to analyse the hypothesis. This is used in determining the significance of foreign exchange risk management on the profitability of Commercial Banks in Nigeria.
1.8. SCOPE OF THE STUDY
Conceptually the study hovers around the implicit role of foreign exchange risk management on the profit generation of demand deposit banks in Nigeria.
Perceptively, this study is arranged to find out how losses or risk on fluctuation in exchange rate are mitigated, controlled, determined, transferred, reduced or minimized by the deposit money banks. Extensive investigation is conducted on the techniques or tools used and preference (if any) and why such.
However, the research was limited to deposit money banks operator in Ilorin metropolis due the schedule of the researcher.
This work is restricted to the deposit money banks under study. And no attempt was made to compare findings with what is obtained in banks from other country within the same banking sector.
1.9. LIMITATION OF THE STUDY
Financial constraint: in the course of the research study the researcher encountered some hitches and difficulties as a result of lack of adequate finance and capital to effectively carried out the research work and this factor slow down the completion of the project study.
Lack of relevant and uptodate research/reference materials: most of the libraries where the researcher visited to get information were not adequately equipped with enough/concrete information as related to foreign exchange risk management in deposit money banks, this limitation also pose a setback towards the completion of the project study.
Time Factor: due to the limited time available for the completion of the project, the researcher was unable to generate and carried out extensive research including the indepth knowledge on previous literature of the research topic. This factor also gives the challenges towards the completion of the project.