EXCHANGE RATE RISK OF COMMERCIAL BANKS: A STUDY OF DIAMOND BANK OF NIGERIA PLC
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CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Banks earn returns to shareholders by accepting and managing risk, including the risk that borrowers may default or that changes in interest rates may narrow the interest spread between assets and liabilities. Historically, borrower defaults have created the greatest losses to commercial banks, whereas interest margins have remained relatively stable, even in times of high rate volatility. Although credit risk is likely to remain the dominant risk to banks, technological advances and the emergence of new financial products have provided them with dramatically more efficient ways of increasing or decreasing interest rate and other market risks. On the whole, these changes, when considered in the context of the growing competition in financial services have led to the perception among some industry observers that interest rate risk in commercial banking has significantly increased (Kritzman, 1993).
Exchange rate risk is simply the risk to which investors are exposed because changes in exchange rates may have an effect on investments that they have made. A fairly traditional view of banks is that they borrow short and lend long. That is, banks engage in financial intermediation activities such that the maturity structure of their assets may exceed the maturity structure of their liabilities. If so, then bank earnings and net worth could be negatively affected by unanticipated increases in interest rates. The exposure of bank profitability and net worth to unanticipated changes in interest rates is what is meant by the term interest-rate risk (Robinson, 1995).
Recent research has emphasized that the incentives for risk-taking in banking are significantly affected by the regulatory environment and banking competition Papaioannou, (2001). The open economy aspects of bank risk taking, however, remain as an relatively uncharted area.
Another important source of interest rate risk (also referred to as ‘‘basis risk’’), arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar re-pricing characteristics. When interest rates change, these differences can give rise to unexpected changes in the cash flows and earnings spread among assets, liabilities, and off-balance-sheet instruments of similar maturities or re-pricing frequencies (Brewer, Elijah, William and James, 2001).
1.2 Statement of the Problem
The conventional wisdom that interest rate risk does not pose a significant threat to the commercial banking system is criticized by broad indicators.
Competitive pressure is of the challenges affecting banking practices and the industry’s management of exchange rate risk. Specifically, competition may be reducing the banking industry’s ability to manage interest rate risk through discretionary pricing of rates on loans and deposits.
Moreso, to meet the recent rise in loan demand, banks have made up the funding shortfall with overnight borrowings of federal funds, securities repurchase agreements, and other borrowings. These funding changes may have effectively shortened the overall liability structure of the industry and, along with other pressures facing the industry, must be adequately considered in managing interest rate risk (Bianchi, 1988).
Furthermore, collateralized mortgage obligations (CMOs) and so-called structured notes are other instruments with option features. They may also contain substantial leverage that compounds their underlying level of interest rate risk.
1.3 Aim and Objectives of the Study
The aim of this research work is to study the analysis of exchange rate risk of commercial banks and the objectives of this study include:
- To examine how exchange rate risk affect commercial bank operation.
- To examine the causes of exchange rate risk in the banking sector.
iii. To review the strategic steps taken by financial institution in resolving the problem of exchange rate risk.
- To examine the effect of exchange rate risk on Nigeria Economy.
1.4 Relevant Research Questions
The research questions are tailored to suit the aim and objective of the study. The study is guided by the following research questions:
- What are the effects of exchange rate risk on Commercial Banks operation?
- What are the causes of exchange rate risk in the banking sector?
- What are the strategic steps taken by financial institution in resolving the problem of exchange rate risk?
- What effect does exchange rate risk have on Nigeria Economy?
1.5 Relevant Research Hypotheses
The following hypothetical statements were developed for the study. It will be either accepted or rejected after the analyses of the respondents view have been done. They are buttressed below:
Hypothesis One
Ho: There is no significant relationship between exchange rate risk and commercial bank operation.
H1: There is significant relationship between exchange rate risk and commercial banks operation.
Hypothesis Two
Ho: There is no significant relationship between exchange rate risk and the economy of Nigeria
H1: There is significant relationship between exchange rate risk and the economy of Nigeria
1.6 Significance of the Study
The findings of the study will inform banks in developing mechanisms for hedging such exposure by developing interest rate risk mitigation guidelines. It will help to prepare financial analysts against exchange rate risk serving as precautionary guide in their financial dealings.
Being the regulator of the operations of commercial banks, the study will inform the bank in formulating policies geared towards regulation of interest rates within the banking sector. It will also serve as an eye-opener to banks in preparing them against high risk of exchange rate that can be detrimental to customers’ savings.
Finally, the study forms a basis for future researchers and academicians who may be conducting research on risk exposure on related financial sector indicators or instruments.
1.7 Scope and Limitation of the Study
The examines exchange rate risk of commercial banks with a view to explore the data of Diamond Bank of Nigeria Plc.
Some perceived constraints may be encounter by the researcher in the course of carrying out the research work. The limitations are as follows:
- Inadequate material: Inadequate material constituted one of the limitations of the research work. The non-availability of materials like journals, textbooks etc the research study.
- Finance: The researcher also may encounter some financial constraints which will contribute in limiting the work in the sense that fund available was not enough to carry out the research to a logical conclusion.
- Time: Time is also another factor or limitation that may affect the research work. The limited time may not give the researcher enough opportunity to do more rigorous work.
1.8 Definition of Terms
Risk: A probability or threat of damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive action
Risk-Free Rate Of Return: The theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time (Kritzman, 1993)
Volatility : This is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices. An implied volatility is derived from the market price of a market traded derivative (Bianchi, 1988).
Asset: In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset. Simply stated, assets represent value of ownership that can be converted into cash (Ahmad, 2007).
Borrow: Any type of borrowing from persons or banks for improving a business or personal income that is payable during short or long time.
Commercial Bank: An institution which accepts deposits, makes business loans, and offers related services. Commercial banks also allow for a variety of deposit accounts, such as checking, savings, and time deposit (Ariff, 2007).
Economy: The wealth and resources of a country or region, esp. in terms of the production and consumption of goods and services.
Exchange Rate: Current market Price for which the currency of a country can be exchanged for another country’s currency.
Interest Rate: An interest rate is the rate at which interest is paid by borrowers for the use of money that they borrow from a lender.
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