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).

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