EFFECTS OF FOREIGN EXCHANGE ON FINANCIAL PROFITABILITY OF FINANCIAL INSTITUTIONS
A CASE STUDY OF CENTENARY BANK, NAJJANANKUMBI BRANCH
CHAPTER ONE: INTRODUCTION
1.1 Background to the Study
Foreign exchange is an integral part in every institutions decision about foreign currency exposure (Allayannis, Ihrig, and Weston, 2001). Currency risk hedging 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). Selecting the appropriate hedging 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. 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, 2001).
Foreign exchange practices include both internal and external hedging strategies. Internal hedging (also called operational hedging) refers to the use of internal organizational strategies to manage currency exposure and includes all those techniques that do not require external parties. The basic goal of hedging is to eliminate exposure. The most obvious way to reduce the exposure is not to have an exposure. Operational hedging involves activities such as matching of cash inflows and outflows, intercompany netting of receipts and payments, leading and lagging, transfer pricing agreements, pricing policies and asset-liability management (Nathan, 2000). Papaioannou (2006) argues that since currency hedging is often costly, a firm may first consider such ―natural‖ hedges before hedging externally as it would be cheaper do so. External hedging (or financial hedging) involves use of financial derivatives like futures and forward contracts, options, derivatives as well as money market transactions. Papaioannou (2006), notes that hedging instruments are currently available with different varieties and complexity, and that they include both over-the-counter and exchange-traded products. Over-the-counter currency hedging instruments include currency forwards and cross-currency swaps, while exchange-traded products include currency options and currency futures.
Like any other institution that has a cross-border obligation denominated in hard currency, financial institutions also can be affected by convertibility and transfer risks. In both cases, the MFI may have the financial capacity to make its hard currency payments, but cannot do so because of national government restrictions or prohibitions on making foreign currency available for sale or transferring hard currency outside the country. These risks are known respectively as convertibility risk and as transfer (or remittance) risk. Organizations exposed to foreign exchange risk have three options. First, they can choose to do nothing about their exposure and accept the consequences of variations in currency values or the possibility that their government may impose restrictions on the availability or transfer of foreign currency. This is not a recommended path. Second, they can “hedge” against their exposure. For example, they can purchase a financial instrument that will protect the organization against the consequences of those adverse movements in foreign exchange rates. Finally, they can partially hedge against the risks, or limit their hard currency exposure to set levels (Nathan, 2000).
Financial profitability is a measure of financial health over time, across industries or sectors in aggregate and can be used to gauge an organization‘s effectiveness. Firm performance is a multidimensional construct that consists of four elements (Alam et al. 2011). Customer-focused performance, including customer satisfaction, and product or service performance; financial and market performance, including revenue, profits, market position, cash-to-cash cycle time, and earnings per share; human resource performance, including employee satisfaction; and organizational effectiveness, including time to market, level of innovation, and production and supply chain flexibility. Despite the success of many financial institutions, millions of low-income individuals in developing countries still do not have access to financial services. High operating costs and capital constraints within the MFI industry have prevented financial institutions from meeting the enormous demand. Additionally, Dehejia et al (2005) show that the demand for credit by the poor is not inelastic. The high interest rates charged may be limiting the ability of financial institutions to serve poorer potential clients. Thus, the researcher seeks to examine the effect of foreign exchange on the financial profitability of financial institutions.
1.2 Statement of the Problem
Financial institutions undertake to cover risks that may be denominated in currencies other than their home currency. An unfavourable change in exchange rates might therefore pose challenges on them delivering on the promised performance.The rapid increase in private sector, international investment in microfinance, plus a dose of common sense, makes foreign currency risk management an important topic for microfinance lenders and borrowers. Seventy percent of cross-border, fixed-income investments are denominated in foreign currencies (meaning currencies other than the currencies in which the Financial institutions are operating), leaving financial institutions with significant foreign exchange exposure. During the most recent global financial crisis, some financial institutions that depend on foreign currency have suffered heavy foreign exchange losses that threaten their overall viability (Littlefield and Kneiding 2009). Previous studies have focused on the practices adopted by financial institutions in managing foreign exchange risk without relating these management practices to profitability. With increased foreign donor funding to financial institutions, the fluctuations in exchange rates tend to pose significant foreign exchange risk hence the management of the foreign exchange ultimately affects the profitability. Therefore, the there is need to assess the effect of foreign exchange on profitability of financial institutions.
1.3 General objective of the study
The study will assess the effects of foreign exchange on profitability of financial institutions.
1.4 Specific objectives
The study will be guided by the following objectives;
- To identify various foreign exchange practices used in financial institutions.
- To investigate the challenges of foreign exchange in financial institutions and suggest best practices to minimize them.
- To assess how foreign exchange practices affect profitability of financial institutions.
1.5 Research questions
- What various foreign exchange practices are used in financial institutions?
- What are the challenges of foreign exchange in financial institutions and how can they be minimized?
- How do foreign exchange practices affect profitability of financial institutions?
1.6 Scope of the study
The study will aim at examining the effects of foreign exchange on profitability of financial institutions. It will be carried out at centenary bank which is located in Najjanankumbi branch – Wakiso district, the bank is located approximately 5km (3.1mi) by road, south of the central district of Kampala. The study will be carried out for a period of three months from February to April, 2017.
1.7 Significance of the study
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 profitability of financial institutions. Financial institutions are the most reliable savings and credit facilities available in Uganda.
Policy makers will use the recommendations of this study finding to explore avenues to enhance capacities within financial institutions for managing foreign exchange risk.
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.
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
This chapter reviews literature related on foreign exchange risk, foreign exchange practices, determinants of financial profitability and effect on financial profitability.
2.2 Foreign exchange Practices
Dawson et al., (1994), define a swap as an exchange of liabilities denominated in a different currency involving two parties who agree to exchange specific amounts of two different currencies at the outset in their home currency. The two parties make periodic payments over time in accordance to predetermined rule to reflect differences in interest rates between the two currencies involved. A cross-currency swap is generally used at the start of a loan period. Cross currency swaps allow two counterparties to exchange specific amounts of two different currencies at the outset and to make repayments over time. In a currency swap, interest payments in two currencies are exchanged over the life of the contract, and the principal amounts are repaid either at maturity or according to a predetermined amortization schedule.
Marshal, (1997), examined the extent of derivatives and the reasons for their use by carrying out surveys in 250 large UK companies. They found a wide spread use of both forwards and options (96% and 59% respectively). They pointed out that comparing to the primary reason for the use of forwards were company policy, commercial reasons and risk aversions, a good understating of instrument, and price were prominent. While the primary reason to use options was company management.
Bodnar and Richard, (1998), indicate that the most frequently used method is forward exchange contract. With forwards, the firm can be fully hedged. However, some risks including settlement risk that exchange rate moves in the opposite direction as either forecast, and counter party risk which the other party is unable to perform on the contract, the high cost of forward contracts will sometimes prevent firms to exercise this tool to fully hedge their exposures.
According to Fatemi and Glaum, (2000), foreign exchange forward is an agreement to purchase or sell a set amount of a foreign currency at a specified price for settlement at a predetermined future date, or within a predetermined window of time. Foreign exchange forwards help investors manage the risk inherent in currency markets by predetermining the rate and date on which they will purchase or sell a given amount of foreign exchange. The portfolio is thus protected against a possible negative currency move and there are no additional price complications in execution from doing a spot trade. Deliverable forwards are contracts that are settled with the physical delivery of the foreign currency. Non-deliverable forwards are cash-settled for the gain or loss on the value of the contract.
Fatemi and Glaum, (2000), found out that most of the use derivative instruments for hedging purposes and that translation exposure were the foreign exchange exposure that most firms were greatly concerned with. Bradley and Moles, (2002), argued that there is a significant relationship between firm’s exchange rate sensitivity and the degree to which it sells sources and funds itself internationally.
According to Moles, (2002), foreign Exchange risk arises from the mismatch between the assets held by an MFI (denominated in the local currency of the MFI’s country of operation) and the loans that fund its balance sheet (often denominated in USD or a stronger currency). 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 MFI (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 MFI. Financial institutions are particularly vulnerable to foreign exchange rate risk, since they operate in developing countries where the risk of currency depreciation is high. Furthermore, extreme currency depreciation tends to be highly correlated with a general deterioration of local economic conditions, which can cause higher loan delinquencies and a reduction in profitability of financial activities. Several studies have attempted to provide insight into the practices of foreign exchange.
Moles, (2002), like any other institution that has a cross-border obligation denominated in hard currency, Financial institutions also can be affected by convertibility and transfer risks. In both cases, the MFI may have the financial capacity to make its hard currency payments, but cannot do so because of national government restrictions or prohibitions on making foreign currency available for sale or transferring hard currency outside the country. These risks are known respectively as convertibility risk and as transfer (or remittance) risk. Organizations exposed to foreign exchange risk have three options. First, they can choose to do nothing about their exposure and accept the consequences of variations in currency values or the possibility that their government may impose restrictions on the availability or transfer of foreign currency. This is not a recommended path. Second, they can “hedge” against their exposure. For example, they can purchase a financial instrument that will protect the organization against the consequences of those adverse movements in foreign exchange rates. Finally, they can partially hedge against the risks, or limit their hard currency exposure to set levels.
According to Abor, (2005), leading and lagging involves delaying the original payment but within a company’s divisions or subsidiaries. If the currency of a subsidiary is sought to appreciate, it may accelerate its payment (leading) and realize the payment before the currency appreciates. The reverse is true if a currency is expected to depreciate, then the company will delay its payment (lagging). However, the first should only take into account the gain or loss from the currency but also the cost for increasing or decreasing the liquidity. Further, a lead strategy, involves attempting to collect foreign currency receivables only when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. On the other hand a lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate.
Lel and Nianian, (2007), outline that as a relative new financial derivative used to hedge foreign exchange exposure, currency swaps have a rapid development. Since its introduction on a global scale in early 1980’s currency swap market has become one of the largest financial derivative markets in the world.
Lel and Nianian, (2007), an option is a unique financial instrument or contract that confers upon the holder or the buyer thereof the right, but not an obligation, to buy or sell an underlying asset, at a specified price, on or up to a specified date. In short, the option buyer can simply let the right lapse by not exercising it. On the other hand, if the option buyer chooses to exercise the right, the seller of the option has an obligation to perform the contract according to the agreed terms. The asset underlying a currency option can be a spot currency or a futures contract on a currency. An option on a spot currency gives the option buyer the right to buy or sell the said currency against another currency, while an option on a currency futures contract gives the option buyer the right to establish a long or short position in the relevant currency futures contract. Options on spot currencies are commonly available in the interbank over-the-counter markets, while those on currency futures are traded on exchanges.
According to CFTC,(2009), netting is the reduction in the number of transactions that a firm needs to make in order to cover an exposure. It requires the firm to have a centralized organization of its cash management. The centralization means that the companies collect foreign currency cash flows between subsidiaries and groups them together as inflows and outflows in the same currency. The objective of netting is to save transaction costs by netting off intercompany balances before arranging payment. This is where multinational groups engage in intergroup trading i.e. related companies located in different countries trade with one another. The advantages are: reduction in foreign exchange purchase costs, commission, selling and buying rates, and less loss in interest from having money in transit. Loss due to netting positions by swap dealers can be as little as10% for agricultural commodities and quite large for energy and metals.
Sekmen, (2011),priceadjustments involves changing prices in different manners. When the local currency of a subsidiary is devaluating, the subsidiary can increase the price, so as to cancel the effect of devaluation. This technique is particularly used in countries where devaluation is high and where derivative markets are efficient. However, as a disadvantage of this method, prices cannot be raised without any consideration about competitors because if prices increase too much the client will choose an equivalent cheaper product/service from a competitor. Flexibility may be exhibited in the ability to pass through changes in the price of inputs or in the general level of prices to consumers through frequent price adjustments.
2.3 Determinants of Financial profitability
Studies have shown that bank specific and macroeconomic factors affect the performance of commercial banks (Flamini et al., 2009). According to Al-Tamimi, (2010), the determinants of bank performances can be classified into bank specific (internal) and macroeconomic (external) factors. These are stochastic variables that determine the output. Internal factors are individual bank characteristics which affect the banks performance. These factors are basically influenced by internal decisions of management and the board. The external factors are sector-wide or country-wide factors which are beyond the control of the company and affect the profitability of banks. The overall Financial profitability of banks in Kenya in the last two decade has been improving. However, this doesn’t mean that all banks are profitable, there are banks declaring losses (Oloo, 2010). In this regard, the study of Olweny and Shipho, (2011), in Kenya focused on sector-specific factors that affect the performance of commercial banks. Yet, the effect of macroeconomic variables was not included.
2.3.1 Bank Specific Factors/Internal Factors
According to Dang, (2011), the internal factors are bank specific variables which influence the profitability of specific bank. These factors are within the scope of the bank to manipulate them and that they differ from bank to bank. These include capital size, size of deposit liabilities, size and composition of credit portfolio, interest rate policy, labour productivity, and state of information technology, risk level, management quality, bank size, ownership and the like. CAMEL framework often used by scholars to proxy the bank specific factors. CAMEL stands for Capital Adequacy, Asset Quality, Management Efficiency, Earnings Ability and Liquidity. Each of these indicators are further discussed below.
2.3.1.1 Capital Adequacy
Banks capital creates liquidity for the bank due to the fact that deposits are most fragile and prone to bank runs. Moreover, greater bank capital reduces the chance of distress (Diamond, 2000). According to Athanasoglouet al., (2005), capital is one of the bank specific factors that influence the level of bank profitability. Capital is the amount of own fund available to support the bank’s business and act as a buffer in case of adverse situation. However, it is not without drawbacks that it induce weak demand for liability, the cheapest sources of fund Capital adequacy is the level of capital required by the banks to enable them withstand the risks such as credit, market and operational risks they are exposed to in order to absorb the potential loses and protect the bank’s debtors. Capital adequacy ratio shows the internal strength of the bank to withstand losses during crisis. Capital adequacy ratio is directly proportional to the resilience of the bank to crisis situations. It has also a direct effect on the profitability of banks by determining its expansion to risky but profitable ventures or areas (Sangmi and Nazir, 2010). According to Dang (2011), the adequacy of capital is judged on the basis of capital adequacy ratio (CAR).
2.3.1.2 Asset Quality
According to Athanasoglouet al., (2005), the bank’s asset is another bank specific variable that affects the profitability of a bank. The bank asset includes among others current asset, credit portfolio, fixed asset, and other investments. Often a growing asset (size) related to the age of the bank. More often than not the loan of a bank is the major asset that generates the major share of the banks income. Loan is the major asset of commercial banks from which they generate income. Different types of financial ratios used to study the performances of banks by different scholars. It is the major concern of all commercial banks to keep the amount of nonperforming loans to low level. This is so because high nonperforming loan affects the profitability of the bank. Thus, low nonperforming loans to total loans shows that the good health of the portfolio a bank. The lower the ratio the better the bank performing (Sangmi and Nazir, 2010). The quality of loan portfolio determines the profitability of banks. The loan portfolio quality has a direct bearing on bank profitability. The highest risk facing a bank is the losses derived from delinquent loans (Dang, 2011). Thus, nonperforming loan ratios are the best proxies for asset quality.
2.3.1.3 Management Efficiency
Athanasoglou et al., (2005), the higher the operating profits to total income (revenue) the more the efficient management is in terms of operational efficiency and income generation. The other important ratio is that proxy management quality is expense to asset ratio. The ratio of operating expenses to total asset is expected to be negatively associated with profitability. Management quality in this regard, determines the level of operating expenses and in turn affects profitability. Sangmi and Nazir, (2010), management Efficiency is one of the key internal factors that determine the bank profitability. It is represented by different financial ratios like total asset growth, loan growth rate and earnings growth rate. Yet, it is one of the complexes subject to capture with financial ratios. Moreover, operational efficiency in managing the operating expenses is another dimension for management quality. The performance of management is often expressed qualitatively through subjective evaluation of management systems, organizational discipline, control systems, quality of staff, and others. Yet, some financial ratios of the financial statements act as a proxy for management efficiency. The capability of the management to deploy its resources efficiently, income maximization, reducing operating costs can be measured by financial ratios. One of this ratios used to measure management quality is operating profit to income ratio (Sangmi and Nazir, 2010).
2.3.1.4 Liquidity Management
Ilhomovich, (2009), used cash to deposit ratio to measure the liquidity level of banks in Malaysia. According to Dang, (2011), liquidity is another factor that determines the level of bank performance. Liquidity refers to the ability of the bank to fulfill its obligations, mainly of depositors. According to Dang, (2011), adequate level of liquidity is positively related with bank profitability. The most common financial ratios that reflect the liquidity position of a bank according to the above author are customer deposit to total asset and total loan to customer deposits. Other scholars use different financial ratio to measure liquidity. However, the study conducted in China and Malaysia found that liquidity level of banks has no relationship with the performances of banks (Said and Tumin, 2011).
2.3.2 External Factors/ Macroeconomic Factors
During the declining GDP growth the demand for credit falls which in turn negatively affect the profitability of banks. On the contrary, in a growing economy as expressed by positive GDP growth, the demand for credit is high due to the nature of business cycle. During boom the demand for credit is high compared to recession (Athanasoglou et al., 2005). The same authors state in relation to the Greek situation that the relationship between inflation level and banks profitability is remained to be debatable. The direction of the relationship is not clear (Vong and Chan, 2009). Sangmi and Nazir, (2010),the macroeconomic policy stability, Gross Domestic Product, Inflation, Interest Rate and Political instability are also other macroeconomic variables that affect the performances of banks. For instance, the trend of GDP affects the demand for banks asset.
2.4 How foreign exchange practices affect financial profitability of financial institutions
Evan et al., (1985), defines foreign exchange as a program of assessment (identification and quantification) and counterstrategies to mitigate exchange rate risk and saves firm`s economic value. Evan further adds foreign exchange risk is a financial risk to manage value creation and loss prevention in a firm by internal and external financial tools. Taggert and McDermott, (2000), assert that forex related firms are subject to foreign exchange risk on the payables and receipts in foreign currencies.
According to Moles, (2002), foreign Exchange risk comes about as a disparity between the assets held by a bank 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. Banks are particularly vulnerable to foreign exchange rate risk, since they operate in developing countries where the risk of currency depreciation is high.
According to Carter et al., (2003),use of foreign exchange management strategies results in reduced foreign exchange exposure hence minimal losses. According to Carter et al., (2003), changes in exchange rate can influence a firms current and future expected cash flows and ultimately, stock prices. The direction and magnitude of changes in exchange rate on firms value are a function of a firm’s corporate hedging policy which indicates whether the firm utilizes operational hedges and financial hedges to manage currency exposure and the structure of its foreign currency cash flows.
Operational exposure occurs where the market position of a firm changes as a result of the effect of exchange rate changes on competition, prices and demand. Translation risk is also related to assets or income derived from offshore enterprise. Translation exposure occurs through currency mismatch and it is related to assets or income derived from offshore enterprise (Madura, 2003).Dufey, (2005), contend that risk management departments without well trained personnel to man the departments are less effective and the company will many a time be prone to such currency risks.
El-Masry, (2006), translation risk occurs where the value of the existing obligations are worsened by movements in the foreign exchange rates. Transactional exposure arises from future cash flows such as trade contracts and also occurs where the value of existing obligations are affected by changes in foreign exchange rates. Economic risk relates to adverse impact on entity /income for both domestic and foreign operations because of sharp, unexpected change in exchange rate.
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. Firms are exposed to foreign exchange risk if the results of their projects depend on future exchange rates and if exchange rate changes cannot be fully anticipated. Generally, companies are exposed to, Transaction exposure, Economic exposure and Translation exposure (El-Masry, 2006; Salifu et al, 2007).
Stacy and Williamson, (2010), examine risk management and performance in a sample of firms in 14 companies listed on the Johannesburg stock exchange. They find that better risk management is associated with better performance in the form of Tobin’s q and ROA.
Lee, (2010), shown that firms that have robust currency risk management frameworks have higher firm performance. The main characteristics of good risk management identified in these studies include; leadership of the risk team, adequate compensation of the risk team and compliance with laws & best practice. There is a view that companies with risk management departments are better corporate performers. In recent times on the contrary, emphasis has geared towards general employee training in currency risk management. Piet and Raman, (2012), say spot rate changes are offset by changes inflation though small firms may depend on unstable currency rates for profits.
2.5 Conclusion
Financial institutions need additional funding to meet demand, and debt capital is the most likely source for this funding. Foreign exchange rate risk is significant, and though it is only one factor in a decision to lend to a bank, it is a strong deterrent. Finally, the existing foreign exchange practices are prohibitively expensive, either to the client or the institution. Most of these studies have focused on foreign exchange practices in developed nations whose financial position is different from that of Uganda. The ones done in Uganda have focused on different industries other than the Microfinance institutions. Thus there is no literature focusing on various foreign exchange practices by microfinance institutions in Uganda. This study therefore seeks to add literature on the effect of foreign exchange on financial profitability of financial institutions in Uganda.
