AN ANALYSIS OF THE PROBLEMS OF FOREIGN EXCHANGE MANAGEMENT AND ITS IMPACT ON THE BANKING INDUSTRY

CHAPTER ONE: INTRODUCTION

1.1 Background of the Study

Foreign exchange (forex or FX) management refers to the process of managing a country’s or an organization’s foreign currency denominated assets, liabilities, receipts, and payments. In the context of a country, foreign exchange management involves the regulation of the flow of foreign currency into and out of the economy, the determination of exchange rates, the management of foreign reserves, and the supervision of foreign exchange transactions by authorized dealers (typically banks). The primary objectives of foreign exchange management are to: (1) maintain external stability (stable exchange rates); (2) ensure adequate foreign reserves to meet international obligations; (3) facilitate international trade and investment; (4) prevent capital flight; and (5) maintain confidence in the domestic currency (Boadway and Keen, 2015). (Boadway and Keen, 2015)

Nigeria’s foreign exchange management has been a subject of intense debate and reform over the past several decades. Prior to the 1980s, Nigeria operated a fixed exchange rate regime, where the Central Bank of Nigeria (CBN) maintained the naira at a fixed rate against major foreign currencies (primarily the US dollar). However, declining oil prices in the 1980s led to balance of payments crises and depletion of foreign reserves. In 1986, Nigeria adopted the Structural Adjustment Programme (SAP), which introduced a flexible exchange rate regime through the Second-tier Foreign Exchange Market (SFEM). Since then, Nigeria has experimented with various exchange rate regimes: fixed, managed float, and fully floated. Despite these reforms, foreign exchange management remains a significant challenge (CBN, 2021). (CBN, 2021)

The Central Bank of Nigeria (CBN) is the primary institution responsible for foreign exchange management in Nigeria. Under the CBN Act (2007) and the Foreign Exchange (Monitoring and Miscellaneous Provisions) Act (1995), the CBN has powers to: (1) determine the exchange rate regime; (2) regulate foreign exchange transactions; (3) license authorized dealers (banks, Bureau de Change operators); (4) manage foreign reserves; (5) intervene in the foreign exchange market; and (6) enforce foreign exchange regulations (Federal Republic of Nigeria, 1995; 2007). (Federal Republic of Nigeria, 1995; 2007)

The Nigerian banking industry plays a central role in foreign exchange management. Banks are authorized dealers in the foreign exchange market, meaning they are licensed to buy and sell foreign currency to customers (importers, exporters, travelers, investors). Banks process foreign exchange transactions for trade (letters of credit, documentary collections), investment (capital importation, repatriation), and personal needs (travel allowances, medicals, school fees). Banks also hold foreign currency denominated assets (loans, investments) and liabilities (deposits, borrowings). Therefore, changes in exchange rates directly affect banks’ profitability, solvency, and liquidity (Okoye, Okafor, and Nnamdi, 2020). (Okoye et al., 2020)

The problems of foreign exchange management in Nigeria are numerous and severe (CBN, 2021). (CBN, 2021)

Exchange Rate Volatility: The naira has depreciated significantly over the past two decades, from approximately ₦100 per US dollar in 2000 to over ₦1,500 per US dollar in 2024. The depreciation has been driven by: falling oil prices (Nigeria’s main export), declining oil production (theft, vandalism), capital flight (foreign investors withdrawing), and speculative demand for dollars. Exchange rate volatility creates uncertainty for businesses, discourages investment, and makes financial planning difficult.

Multiple Exchange Rate Regimes: Nigeria has operated multiple exchange rates: official rate (CBN window), Investors’ and Exporters’ (IandE) window (market-determined), Bureau de Change (BDC) rate, and parallel market (black market) rate. The gap between official and parallel market rates has often exceeded 50%, creating arbitrage opportunities and encouraging rent-seeking. Multiple exchange rates create confusion, distort resource allocation, and undermine confidence.

Foreign Reserve Depletion: Nigeria’s foreign reserves have fluctuated significantly, from over 30 billion at times. Reserves are depleted by: CBN interventions (selling dollars to defend the naira), debt service payments, import payments, and capital flight. Low reserves limit the CBN’s ability to intervene in the foreign exchange market and defend the naira.

Capital Flight: Nigerian individuals and businesses hold foreign currency outside the banking system (dollarization) or transfer funds overseas (capital flight). Estimates suggest that capital flight from Nigeria exceeds $100 billion over the past decade. Capital flight reduces foreign reserves, depreciates the naira, and reduces funds available for domestic investment.

Low Foreign Direct Investment (FDI): Exchange rate volatility and difficulty repatriating funds have deterred foreign direct investment. FDI inflows to Nigeria have declined from over 5 billion in recent years. Low FDI limits technology transfer, job creation, and economic growth.

Illegal Foreign Exchange Flows: Round-tripping (obtaining dollars at official rate and selling at parallel market), money laundering, and other illegal foreign exchange activities undermine the official foreign exchange market. The EFCC and CBN have prosecuted several banks and individuals for foreign exchange violations.

The impact of these foreign exchange management problems on the banking industry is significant (Eze and Okafor, 2021). (Eze and Okafor, 2021)

Currency Risk (Exchange Rate Risk): Banks hold foreign currency denominated assets (loans to importers, investments) and liabilities (foreign currency deposits, borrowings). When the naira depreciates, the naira value of foreign currency assets increases (gain), but the naira value of foreign currency liabilities also increases (loss). The net effect depends on the bank’s net open position (NOP). Banks with long positions (assets > liabilities) gain from depreciation; banks with short positions (liabilities > assets) lose. Many Nigerian banks have short positions (more foreign currency liabilities than assets) because they have foreign currency deposits but lend in naira. Depreciation has caused significant losses for some banks.

Credit Risk (Default Risk): When the naira depreciates, importers who have borrowed naira to finance imports must repay more naira to purchase the same amount of dollars. Many importers default on their loans. Banks’ non-performing loans (NPLs) increase during periods of depreciation.

Liquidity Risk: When the CBN restricts access to foreign exchange (due to low reserves), banks cannot meet customers’ demand for dollars. This damages customer confidence and may lead to bank runs (customers withdraw naira deposits to buy dollars in the parallel market).

Profitability: Banks’ profitability is affected by foreign exchange trading (buying low, selling high), foreign currency lending (interest income), and foreign currency deposits (interest expense). Exchange rate volatility increases trading profits but also increases risk. Some banks have reported significant foreign exchange gains; others have reported losses.

Capital Adequacy: Banks are required to maintain minimum capital adequacy ratios (CAR) under Basel II/III. Exchange rate fluctuations affect the naira value of banks’ capital (which may be held in naira) relative to risk-weighted assets. Depreciation may reduce CAR if capital is in naira and assets are in foreign currency.

The COVID-19 pandemic (2020-2021) exacerbated foreign exchange management problems. Oil prices crashed (to below $20 per barrel), reducing dollar inflows. Capital flight accelerated (foreign investors withdrew). The naira depreciated sharply. The CBN devalued the naira multiple times and restricted access to foreign exchange for certain imports. Banks faced increased currency risk, credit risk, and liquidity risk (Ogunyemi and Adewale, 2021). (Ogunyemi and Adewale, 2021)

Several theories explain the relationship between foreign exchange management and the banking industry. Purchasing Power Parity (PPP) theory suggests that exchange rates adjust to equalize the price of goods across countries. Interest Rate Parity (IRP) theory suggests that exchange rates adjust to equalize interest rates across countries. Balance of Payments (BoP) theory suggests that exchange rates are determined by the supply and demand for foreign currency arising from trade and capital flows. Mundell-Fleming model (IS-LM-BoP) analyzes the relationship between exchange rates, interest rates, and output under different policy regimes (fixed vs. floating) (Krugman, Obstfeld, and Melitz, 2018). (Krugman et al., 2018)

This study analyzes the problems of foreign exchange management and their impact on the banking industry in Nigeria.

1.2 Statement of the Problem

Despite the critical importance of foreign exchange management for the stability of the naira and the health of the banking industry, Nigeria faces significant problems in this area. These problems manifest in several specific issues.

First, exchange rate volatility has increased dramatically. The naira has depreciated from ₦197 per US dollar in 2015 to over ₦1,500 per US dollar in 2024 (a depreciation of over 600%). Monthly exchange rate fluctuations often exceed 10-20%. This volatility creates uncertainty for banks in pricing foreign currency products, managing currency risk, and planning. Okoye, Okafor, and Nnamdi (2020) found that 80% of Nigerian banks reported that exchange rate volatility was their biggest challenge. (Okoye et al., 2020)

Second, multiple exchange rate regimes create confusion and arbitrage opportunities. The gap between official and parallel market rates has often exceeded 50%. This gap encourages round-tripping (obtaining dollars at official rate and selling at parallel market), rent-seeking, and corruption. Banks are caught between CBN directives (sell at official rate) and market realities (parallel market rate). Eze and Okafor (2021) found that 70% of banks reported that multiple exchange rates made foreign exchange management difficult. (Eze and Okafor, 2021)

Third, foreign reserves are inadequate. Nigeria’s foreign reserves have declined from over 30 billion at times. Reserves cover only 5-10 months of imports, below the international benchmark of 12 months. Low reserves limit the CBN’s ability to intervene in the foreign exchange market and defend the naira. Banks worry about the CBN’s ability to meet their foreign exchange requests (CBN, 2021). (CBN, 2021)

Fourth, capital flight is rampant. Nigerian individuals and businesses hold an estimated $50-100 billion outside the banking system (dollarization) or overseas (capital flight). Capital flight reduces foreign reserves, depreciates the naira, and reduces funds available for domestic lending. Banks lose deposits to foreign banks (Okoye et al., 2020). (Okoye et al., 2020)

Fifth, low foreign direct investment (FDI) limits economic growth. FDI inflows have declined from over 5 billion. Exchange rate volatility and difficulty repatriating funds deter investors. Banks lose foreign currency deposits and lending opportunities (World Bank, 2020). (World Bank, 2020)

Sixth, illegal foreign exchange flows undermine the official market. Round-tripping, money laundering, and other illegal activities divert foreign exchange from the official to the parallel market. Banks are sometimes complicit in these activities. The EFCC and CBN have sanctioned several banks for foreign exchange violations (EFCC, 2021). (EFCC, 2021)

Seventh, the impact of these problems on the banking industry is not well quantified. How much do banks lose from exchange rate depreciation? How do non-performing loans increase during periods of depreciation? How does liquidity risk affect bank stability? The magnitude of the impact is unknown (Eze and Okafor, 2021). (Eze and Okafor, 2021)

Eighth, the COVID-19 pandemic exacerbated existing problems. Oil prices crashed, capital flight accelerated, and the naira depreciated sharply. Banks faced increased currency risk, credit risk, and liquidity risk. The pandemic’s impact on foreign exchange management and the banking industry has not been systematically studied (Ogunyemi and Adewale, 2021). (Ogunyemi and Adewale, 2021)

Ninth, there is a significant gap in the empirical literature on the problems of foreign exchange management and their impact on the banking industry in Nigeria. Most studies focus on macroeconomic effects (GDP, inflation) rather than banking industry effects. Few studies quantify the impact on bank profitability, capital adequacy, non-performing loans, and liquidity. This study addresses these gaps (Okoye et al., 2020). (Okoye et al., 2020)

Therefore, the central problem this study seeks to address can be stated as: *Nigeria faces significant problems in foreign exchange management: exchange rate volatility, multiple exchange rates, foreign reserve depletion, capital flight, low FDI, illegal flows, and COVID-19 exacerbation. The impact of these problems on the banking industry (currency risk, credit risk, liquidity risk, profitability, capital adequacy) has not been systematically documented. This study addresses these gaps by analyzing the problems of foreign exchange management and their impact on the banking industry in Nigeria.*

1.3 Objectives of the Study

The main objective of this study is to analyze the problems of foreign exchange management and their impact on the banking industry in Nigeria. The specific objectives are to:

1. Examine the problems of foreign exchange management in Nigeria: exchange rate volatility, multiple exchange rate regimes, foreign reserve depletion, capital flight, low foreign direct investment (FDI), and illegal foreign exchange flows.
2. Assess the impact of exchange rate volatility on the banking industry: currency risk (net open position), foreign exchange trading profits/losses, and balance sheet effects.
3. Assess the impact of exchange rate volatility on credit risk (non-performing loans) in the banking industry.
4. Assess the impact of foreign reserve depletion on liquidity risk in the banking industry.
5. Assess the impact of capital flight on deposit mobilization in the banking industry.
6. Assess the impact of low FDI on lending and investment activities in the banking industry.
7. Assess the impact of the COVID-19 pandemic on foreign exchange management and the banking industry.
8. Propose evidence-based recommendations for improving foreign exchange management and mitigating its impact on the banking industry.

1.4 Significance of the Study

This study holds significance for multiple stakeholders as follows:

For the Central Bank of Nigeria (CBN) and Regulators:
The study provides empirical evidence on the problems of foreign exchange management and their impact on the banking industry. The CBN can use this evidence to: (1) design exchange rate policies that reduce volatility; (2) unify multiple exchange rates; (3) rebuild foreign reserves; (4) curb capital flight; (5) attract FDI; and (6) combat illegal foreign exchange flows.

For Commercial Banks and Banking Industry:
The study provides evidence on how foreign exchange problems affect bank performance. Banks can use this evidence to: (1) improve currency risk management (hedging, net open position limits); (2) strengthen credit risk assessment for importers; (3) maintain adequate liquidity buffers; and (4) diversify funding sources.

For the Federal Ministry of Finance and Economic Planning:
The Ministry is responsible for economic policy coordination. The study provides evidence on the macroeconomic impact of foreign exchange problems. The Ministry can use this evidence to: (1) coordinate fiscal and monetary policies; (2) promote export diversification; (3) attract FDI; and (4) manage debt.

For Investors and Financial Analysts:
Investors and analysts evaluate bank performance and risk. The study provides evidence on how foreign exchange problems affect bank profitability, capital adequacy, and liquidity. Investors can use this evidence to: (1) assess bank risk; (2) make investment decisions; and (3) diversify portfolios.

For Importers and Exporters:
Importers and exporters are directly affected by foreign exchange availability and exchange rates. The study provides evidence on the challenges they face. Importers can use this evidence to: (1) hedge currency risk; (2) diversify suppliers; and (3) plan for exchange rate volatility.

For Academics and Researchers:
This study contributes to the literature on foreign exchange management and banking in several ways. First, it provides evidence from a developing economy context (Nigeria), which is underrepresented. Second, it links foreign exchange problems to banking industry outcomes. Third, it includes COVID-19 impact. The study provides a foundation for future research.

For the Nigerian Economy:
The banking industry is the engine of the Nigerian economy. When banks are healthy, they provide credit to businesses, facilitating investment, job creation, and growth. When banks are distressed (due to foreign exchange problems), credit dries up, and the economy suffers. By identifying how to improve foreign exchange management, this study contributes to banking industry stability and economic growth.

1.5 Research Hypotheses

Based on the research objectives and questions, the following hypotheses are formulated. Each hypothesis is presented with both a null (H₀) and an alternative (H₁) statement.

Hypothesis One (Exchange Rate Volatility and Bank Profitability)

• H₀₁: There is no significant relationship between exchange rate volatility and bank profitability (ROA) in Nigeria.
• H₁₁: There is a significant negative relationship between exchange rate volatility and bank profitability (higher volatility associated with lower profitability).

Hypothesis Two (Exchange Rate Depreciation and Non-Performing Loans)

• H₀₂: There is no significant relationship between exchange rate depreciation (naira per dollar) and non-performing loan ratios (NPL) in Nigerian banks.
• H₁₂: There is a significant positive relationship between exchange rate depreciation and non-performing loan ratios (depreciation increases NPLs).

Hypothesis Three (Foreign Reserves and Liquidity)

• H₀₃: There is no significant relationship between foreign reserves (CBN) and bank liquidity ratios (liquidity coverage ratio, LCR).
• H₁₃: There is a significant positive relationship between foreign reserves and bank liquidity ratios (higher reserves associated with higher liquidity).

Hypothesis Four (Capital Flight and Deposit Mobilization)

• H₀₄: There is no significant relationship between capital flight (estimated) and bank deposit growth.
• H₁₄: There is a significant negative relationship between capital flight and bank deposit growth (higher capital flight associated with lower deposit growth).

Hypothesis Five (Multiple Exchange Rates and Bank Revenue)

• H₀₅: There is no significant difference in foreign exchange trading revenue between periods of multiple exchange rates and periods of unified exchange rates.
• H₁₅: Foreign exchange trading revenue is significantly higher during periods of multiple exchange rates (arbitrage opportunities) than during periods of unified exchange rates.

Hypothesis Six (FDI and Bank Lending)

• H₀₆: There is no significant relationship between FDI inflows and bank lending to the private sector.
• H₁₆: There is a significant positive relationship between FDI inflows and bank lending to the private sector.

Hypothesis Seven (COVID-19 Impact)

• H₀₇: There was no significant difference in exchange rate volatility before and during the COVID-19 pandemic.
• H₁₇: Exchange rate volatility was significantly higher during the COVID-19 pandemic than before.

1.6 Scope and Limitations of the Study

Scope of the Study:

Content Scope: The study focuses on the problems of foreign exchange management and their impact on the banking industry in Nigeria. Specifically, it examines: (1) foreign exchange management problems (exchange rate volatility, multiple exchange rates, foreign reserve depletion, capital flight, low FDI, illegal flows); (2) banking industry outcomes (currency risk, credit risk, liquidity risk, profitability, capital adequacy, deposit mobilization, lending); and (3) COVID-19 impact. The study does not examine other risks (operational risk, reputational risk) except as they relate to foreign exchange. The study does not examine other sectors (manufacturing, agriculture, services) except as they relate to banking.

Geographic Scope: The study covers Nigeria. The banking industry in Nigeria includes 24 deposit money banks (commercial banks). The study focuses on the Nigerian foreign exchange market and the CBN’s policies. Findings may be generalizable to other African countries (Ghana, Kenya, South Africa) with similar exchange rate regimes, but caution is warranted.

Time Scope: The study covers a 20-year period from 2004 to 2023. This period encompasses: (1) pre-2008 global financial crisis; (2) 2008-2009 global financial crisis; (3) post-crisis recovery; (4) 2014-2016 oil price crash; (5) 2016 recession; (6) 2020-2021 COVID-19 pandemic; and (7) post-pandemic recovery. This long period enables analysis of trends and the impact of external shocks.

Data Sources: The study uses secondary data from: (1) Central Bank of Nigeria (CBN) statistical bulletins; (2) CBN annual reports; (3) CBN foreign exchange reports; (4) National Bureau of Statistics (NBS) GDP reports; (5) bank annual reports (financial statements); (6) World Bank and IMF reports; and (7) EFCC reports.

Limitations of the Study:

1. Data Availability: Some data may not be publicly available (e.g., bank net open positions, foreign currency lending, capital flight estimates). Estimates (e.g., capital flight, parallel market rates) may have margins of error.
2. Causality: The study examines relationships but cannot definitively establish causality. Other factors (monetary policy, fiscal policy, global oil prices) also affect exchange rates and bank performance.
3. Generalizability: The study focuses on Nigeria. Findings may not apply to other countries with different exchange rate regimes, economic structures, or banking systems.
4. Time Period: The study covers 2004-2023. Findings may not apply to earlier or later periods.
5. Bank Heterogeneity: The study aggregates data across banks. Individual banks may be affected differently (large vs. small, domestic vs. international, retail vs. corporate). This study acknowledges but does not fully explore heterogeneity.

1.7 Organization of the Study

This study is organized into five chapters as follows:

Chapter One: Introduction. This chapter presents the background of the study, statement of problems, objectives of the study, significance of the study, research hypotheses, scope and limitations, organization of the study, and definition of terms.

Chapter Two: Literature Review. This chapter presents a comprehensive review of relevant literature: conceptual framework (foreign exchange management, exchange rate regimes, foreign reserves, capital flight, banking industry); theoretical framework (purchasing power parity, interest rate parity, balance of payments, Mundell-Fleming model); empirical review (global studies, African studies, Nigerian studies); regulatory framework (CBN Act, Foreign Exchange Act); and summary of literature gaps.

Chapter Three: Research Methodology. This chapter presents the research design (descriptive and correlational), population and sample (Nigerian banks), data collection (secondary data), variables (independent: exchange rate volatility, multiple exchange rates, foreign reserves, capital flight, FDI; dependent: bank profitability, NPLs, liquidity, deposits, lending), and method of data analysis (descriptive statistics, correlation analysis, regression analysis).

Chapter Four: Data Analysis and Results. This chapter presents the analysis of collected data: descriptive statistics (mean, standard deviation, trends), correlation analysis, regression results (pooled OLS, fixed effects, random effects), robustness checks, and discussion of findings.

Chapter Five: Summary, Conclusion, and Recommendations. This chapter presents the summary of findings, conclusion (addressing each objective), recommendations for CBN, banks, and government, limitations of the study, and suggestions for future research.

1.8 Definition of Terms

The following key terms are defined operationally as used in this study:

Term	Definition
Foreign Exchange (Forex, FX)	Foreign currency (US dollar, British pound, Euro, etc.) held by a country’s central bank, commercial banks, businesses, or individuals.
Foreign Exchange Management	The process of managing a country’s or organization’s foreign currency denominated assets, liabilities, receipts, and payments. Includes exchange rate policy, reserve management, and regulation of forex transactions.
Exchange Rate	The price of one currency expressed in terms of another currency (e.g., ₦1,500 per US dollar).
Exchange Rate Volatility	The degree of variation in exchange rates over time. High volatility means large and unpredictable fluctuations.
Fixed Exchange Rate Regime	A regime where the central bank pegs the domestic currency to a foreign currency (e.g., US dollar) or a basket of currencies. The central bank intervenes to maintain the peg.
Floating Exchange Rate Regime	A regime where the exchange rate is determined by market forces (supply and demand) without central bank intervention.
Managed Float (Dirty Float)	A regime where the exchange rate is primarily market-determined, but the central bank occasionally intervenes to smooth fluctuations or achieve policy objectives.
Multiple Exchange Rates	A system where different exchange rates apply to different transactions (e.g., official rate, IandE window rate, BDC rate, parallel market rate).
Parallel Market (Black Market)	An unofficial foreign exchange market where currency is traded outside the regulated banking system. Rates are typically higher than official rates.
Foreign Reserves	Foreign currency assets held by the central bank, primarily US dollars, used to intervene in the foreign exchange market, pay for imports, and service debt.
Capital Flight	The outflow of capital from a country due to political or economic uncertainty, currency devaluation, or lack of investment opportunities. Capital flight reduces foreign reserves.
Foreign Direct Investment (FDI)	Investment made by a foreign company or individual in a Nigerian business, including establishing subsidiaries, acquiring companies, and investing in joint ventures.
Round-Tripping	The practice of obtaining foreign currency at the official rate (cheaper) and selling it at the parallel market rate (more expensive) for profit.
Currency Risk (Exchange Rate Risk)	The risk that changes in exchange rates will affect the value of a bank’s foreign currency denominated assets, liabilities, receipts, or payments.
Net Open Position (NOP)	The difference between a bank’s foreign currency assets and foreign currency liabilities. A positive NOP (assets > liabilities) gains from currency depreciation; a negative NOP (liabilities > assets) loses from depreciation.
Non-Performing Loan (NPL)	A loan where the borrower has failed to make scheduled payments for 90 days or more. High NPL ratios indicate poor loan quality.
Liquidity Risk	The risk that a bank cannot meet its short-term obligations (deposit withdrawals, loan disbursements) due to lack of liquid assets.
Profitability	The ability of a bank to generate earnings. Measured by return on assets (ROA = net income / total assets) and return on equity (ROE = net income / shareholders’ equity).
Capital Adequacy Ratio (CAR)	The ratio of a bank’s capital to its risk-weighted assets. Minimum CAR under Basel III is 10.5% (including conservation buffer).

CHAPTER TWO: REVIEW OF RELATED LITERATURE

2.0 Introduction

This chapter presents a comprehensive review of literature relevant to the problems of foreign exchange management and their impact on the banking industry in Nigeria. The review is organized into seven main sections. First, exchange control is defined and explained, including its objectives, instruments, and evolution. Second, the historical background of foreign exchange control acts in Nigeria is examined. Third, foreign exchange is defined and explained, including its functions and determinants. Fourth, the evolution of the foreign exchange market in Nigeria is traced from the colonial era to the present. Fifth, the Dutch Auction System (DAS) is explained, including its introduction, operation, and outcomes. Sixth, the structure of the Nigerian foreign exchange market is described, including the official window, IandE window, BDC window, and parallel market. Seventh, foreign exchange management is discussed, including the role of the CBN, exchange rate policies, reserve management, and challenges.

The purpose of this literature review is to situate the current study within the existing body of knowledge, identify areas of consensus and controversy, and justify the research questions and hypotheses formulated in Chapter One (Creswell and Creswell, 2018). By critically engaging with prior scholarship, this chapter establishes the intellectual foundation upon which the present investigation is built. (Creswell and Creswell, 2018)

2.1 Exchange Control

Exchange control (also called foreign exchange control) refers to the system of government regulations and restrictions imposed on the purchase, sale, and transfer of foreign currency. Exchange controls are implemented by central banks or other government agencies to manage the supply and demand of foreign currency, protect foreign reserves, stabilize the exchange rate, prevent capital flight, and regulate international trade and investment flows (Boadway and Keen, 2015). (Boadway and Keen, 2015)

The objectives of exchange control include (CBN, 2021). (CBN, 2021)

• Conservation of foreign reserves: To prevent excessive depletion of foreign reserves by restricting demand for foreign currency.
• Exchange rate stability: To reduce volatility in the exchange rate by controlling the supply and demand of foreign currency.
• Balance of payments equilibrium: To correct persistent balance of payments deficits by limiting imports and encouraging exports.
• Prevention of capital flight: To prevent domestic residents from transferring funds overseas in response to economic or political uncertainty.
• Protection of domestic industries: To restrict imports of competing goods, protecting domestic producers.
• Revenue generation: To generate revenue through exchange rate differentials (buying low, selling high).

The instruments of exchange control include (Krugman, Obstfeld, and Melitz, 2018). (Krugman et al., 2018)

• Licensing of authorized dealers: Only licensed banks and Bureau de Change (BDC) operators can deal in foreign currency.
• Allocation of foreign exchange: The central bank allocates scarce foreign currency to priority sectors (imports of essential goods, raw materials, machinery).
• Exchange rate restrictions: The central bank may set multiple exchange rates for different transactions (official rate, IandE window rate, BDC rate).
• Import restrictions: Prohibiting or limiting imports of certain goods (e.g., rice, textiles, furniture) to reduce demand for foreign currency.
• Export surrender requirements: Requiring exporters to surrender a percentage of their foreign currency earnings to the central bank.
• Capital controls: Restricting transfers of funds overseas (dividends, interest, capital repatriation) by foreign investors.
• Reporting requirements: Requiring banks and individuals to report foreign currency transactions above certain thresholds.

Exchange control can be classified into (Boadway and Keen, 2015). (Boadway and Keen, 2015)

• Comprehensive exchange control: All foreign exchange transactions are subject to approval by the central bank. This was the case in Nigeria during the 1980s and 1990s.
• Partial exchange control: Only certain transactions (e.g., capital transfers) are restricted; current account transactions (trade) are freely permitted. This is currently the case in Nigeria.

The advantages of exchange control include (CBN, 2021). (CBN, 2021)

• Protection of foreign reserves: Prevents rapid depletion of reserves.
• Exchange rate stability: Reduces volatility.
• Balance of payments adjustment: Corrects deficits.
• Protection of domestic industries: Limits import competition.

The disadvantages of exchange control include (Krugman et al., 2018). (Krugman et al., 2018)

• Distortion of resource allocation: Scarce foreign currency is allocated based on political priorities rather than market efficiency.
• Creation of black markets: Exchange controls create shortages, leading to illegal parallel markets where currency trades at a premium.
• Corruption and rent-seeking: Officials who allocate foreign currency may demand bribes.
• Reduced foreign investment: Investors fear difficulty repatriating profits and capital.
• Reduced trade: Import restrictions reduce competition and increase prices for consumers.

In Nigeria, exchange control has been used extensively since independence. The Foreign Exchange (Monitoring and Miscellaneous Provisions) Act (1995) is the primary legislation governing exchange control. The CBN is the implementing agency (Federal Republic of Nigeria, 1995). (Federal Republic of Nigeria, 1995)

2.2 Foreign Exchange Control Act – Historical Background

The history of foreign exchange control legislation in Nigeria dates back to the colonial era. This section traces the evolution of exchange control acts and regulations.

Pre-Independence Era (Before 1960): During the colonial period, Nigeria was part of the British West African Currency Board (WACB). The currency (Nigerian pound) was pegged to the British pound sterling at par. Exchange control was minimal, as Nigeria was primarily an exporter of agricultural commodities (cocoa, palm oil, groundnuts, rubber) and importer of manufactured goods. The Bank of England managed the foreign exchange system (CBN, 2010). (CBN, 2010)

Exchange Control Act (1962): Following independence (1960), Nigeria established the Central Bank of Nigeria (CBN) in 1959. The Exchange Control Act (1962) was the first major exchange control legislation. The Act gave the CBN powers to: (1) regulate the purchase, sale, and transfer of foreign currency; (2) license authorized dealers (banks); (3) restrict capital transfers; and (4) require exporters to surrender foreign currency earnings. The Act was modeled on British exchange control laws (Federal Republic of Nigeria, 1962). (Federal Republic of Nigeria, 1962)

Exchange Control (Amendment) Act (1985): By the mid-1980s, Nigeria faced a severe balance of payments crisis due to falling oil prices. The Exchange Control (Amendment) Act (1985) introduced stricter controls: (1) reduced the list of goods eligible for foreign exchange; (2) increased penalties for violations; and (3) created the Foreign Exchange Market (FEM) (Federal Republic of Nigeria, 1985). (Federal Republic of Nigeria, 1985)

Foreign Exchange (Monitoring and Miscellaneous Provisions) Act (1995): This Act is the primary legislation currently governing exchange control. Key provisions include: (1) establishment of the Autonomous Foreign Exchange Market (AFEM); (2) licensing of Bureau de Change (BDC) operators; (3) prohibition of illegal foreign exchange transactions; (4) penalties for violations (fines, imprisonment); and (5) powers for the CBN to regulate the foreign exchange market (Federal Republic of Nigeria, 1995). (Federal Republic of Nigeria, 1995)

CBN Circulars and Guidelines (1995-Present): In addition to Acts, the CBN issues periodic circulars and guidelines on foreign exchange management. These include: (1) guidelines on the operation of the Investors’ and Exporters’ (IandE) Window (2017); (2) prohibition of foreign exchange for 41 items (2015, later modified); (3) restriction of foreign exchange sales to BDCs (2021); and (4) unification of exchange rates (2023) (CBN, 2017; 2021; 2023). (CBN, 2017; 2021; 2023)

2.3 Foreign Exchange – An Overview

Foreign exchange (forex or FX) refers to foreign currency denominated assets, including banknotes, coins, deposits, securities, and other claims denominated in foreign currency. The foreign exchange market is the global decentralized market for the trading of currencies. It is the largest financial market in the world, with daily trading volume exceeding $6 trillion (Bank for International Settlements, 2019). (BIS, 2019)

Functions of Foreign Exchange: Foreign exchange serves several functions (Krugman et al., 2018). (Krugman et al., 2018)

• Medium of exchange: Foreign currency facilitates international trade (paying for imports, receiving export proceeds).
• Store of value: Foreign currency (especially the US dollar) is held as a reserve asset by central banks and individuals.
• Unit of account: International contracts (trade, loans) are often denominated in foreign currency (US dollar).
• Investment vehicle: Foreign currency denominated assets (stocks, bonds, real estate) offer diversification benefits.

Determinants of Exchange Rates: The exchange rate (price of one currency in terms of another) is determined by (Krugman et al., 2018). (Krugman et al., 2018)

• Supply and demand: The exchange rate is determined by the supply of and demand for foreign currency in the foreign exchange market.
• Interest rates: Higher interest rates attract foreign capital, increasing demand for domestic currency (appreciation).
• Inflation: Higher inflation reduces purchasing power, decreasing demand for domestic currency (depreciation).
• Balance of payments: A current account surplus (exports > imports) increases demand for domestic currency (appreciation); a deficit (imports > exports) decreases demand (depreciation).
• Capital flows: Capital inflows (FDI, portfolio investment) increase demand for domestic currency (appreciation); capital outflows decrease demand (depreciation).
• Central bank intervention: Central banks can buy or sell foreign currency to influence the exchange rate.
• Speculation: Expectations of future exchange rate movements influence current demand.

Major Currency Pairs: The most traded currency pairs are (BIS, 2019). (BIS, 2019)

• EUR/USD (Euro / US dollar) – most traded
• USD/JPY (US dollar / Japanese yen)
• GBP/USD (British pound / US dollar)
• USD/CHF (US dollar / Swiss franc)
• AUD/USD (Australian dollar / US dollar)
• USD/CAD (US dollar / Canadian dollar)
• NZD/USD (New Zealand dollar / US dollar)

In Nigeria, the major currency pair is USD/NGN (US dollar / Nigerian naira). Other traded currencies include GBP (British pound), EUR (Euro), and CFA franc (for trade with West African neighbors).

2.4 Evolution of the Foreign Exchange Market in Nigeria

The foreign exchange market in Nigeria has evolved significantly since independence. This section traces the evolution through distinct phases.

Phase 1: Fixed Exchange Rate Regime (1960-1985): From independence until 1985, Nigeria operated a fixed exchange rate regime. The naira was pegged to the British pound sterling (until 1973) and then to the US dollar. The CBN fixed the exchange rate and allocated foreign currency to authorized dealers. There was no formal foreign exchange market; the CBN was the sole supplier of foreign currency. This regime provided stability but led to overvaluation of the naira, import dependency, and depletion of reserves (CBN, 2010). (CBN, 2010)

Phase 2: Second-tier Foreign Exchange Market (SFEM) (1986-1993): As part of the Structural Adjustment Programme (SAP), Nigeria introduced the Second-tier Foreign Exchange Market (SFEM) in 1986. Under SFEM, the exchange rate was determined by market forces (auction system). The CBN auctioned foreign currency to authorized dealers. The naira depreciated significantly (from ₦1 = 4). SFEM was replaced by the Foreign Exchange Market (FEM) in 1990, which was similar (CBN, 2010). (CBN, 2010)

Phase 3: Autonomous Foreign Exchange Market (AFEM) (1995-1999): The Foreign Exchange (Monitoring and Miscellaneous Provisions) Act (1995) established the Autonomous Foreign Exchange Market (AFEM). Under AFEM, authorized dealers (banks) could source foreign currency from their own sources (export proceeds, foreign currency deposits) and sell to customers. The CBN also continued to intervene. This was a shift toward a more market-determined exchange rate (CBN, 2010). (CBN, 2010)

Phase 4: Interbank Foreign Exchange Market (IFEM) (1999-2015): The Interbank Foreign Exchange Market (IFEM) was introduced in 1999. Under IFEM, banks traded foreign currency among themselves, with the CBN providing liquidity. The exchange rate was market-determined, but the CBN occasionally intervened to smooth volatility. IFEM was relatively stable until the 2014 oil price crash (CBN, 2010). (CBN, 2010)

Phase 5: Dutch Auction System (DAS) (2015-2017): In 2015, the CBN introduced the Dutch Auction System (DAS) to manage foreign exchange demand. This is discussed in detail in Section 2.5.

Phase 6: Investors’ and Exporters’ (IandE) Window (2017-Present): In 2017, the CBN introduced the Investors’ and Exporters’ (IandE) Window, a market-driven window for investors and exporters. The IandE window has become the primary market for foreign exchange, with daily turnover exceeding $100 million. The official rate and IandE rate were unified in 2023 (CBN, 2017; 2023). (CBN, 2017; 2023)

Phase 7: Unification of Exchange Rates (2023-Present): In June 2023, the CBN announced the unification of exchange rates, eliminating multiple exchange rates (official, IandE, BDC). The naira depreciated sharply (to over ₦1,500 per dollar) but is now market-determined. The success of unification remains to be seen (CBN, 2023). (CBN, 2023)

2.5 The Dutch Auction System (DAS)

The Dutch Auction System (DAS) is a type of auction where the price is lowered until a bid is received. In the context of foreign exchange, the CBN offered a certain amount of dollars for sale, and banks bid for dollars at descending exchange rates. The system was introduced in 2015 to manage foreign exchange demand and reduce the gap between official and parallel market rates (CBN, 2015). (CBN, 2015)

Operation of the Dutch Auction System: (CBN, 2015). (CBN, 2015)

1. The CBN announces the amount of dollars to be auctioned and the minimum bid rate (floor price).
2. Banks submit bids indicating the amount of dollars they wish to purchase and the exchange rate they are willing to pay.
3. Bids are ranked from highest rate (most expensive) to lowest rate (cheapest).
4. The CBN accepts bids starting from the highest rate until the offered amount is exhausted.
5. The cut-off rate is the lowest rate accepted. All successful bidders pay the cut-off rate (not their bid rate) – this is the “Dutch” feature.

Outcomes of the Dutch Auction System: (CBN, 2015). (CBN, 2015)

• The naira depreciated from ₦197 per dollar to ₦300-400 per dollar.
• The gap between official and parallel market rates narrowed initially but later widened.
• The system was criticized for being opaque (bids were not publicly disclosed).
• Banks engaged in speculative bidding (bidding high to secure dollars, knowing they would pay the cut-off rate).
• The system was replaced by the IandE window in 2017.

Evaluation of DAS: (Okoye, Okafor, and Nnamdi, 2020). (Okoye et al., 2020)

• Advantages: (1) Reduced demand for dollars (higher rates discouraged demand); (2) Increased CBN revenue (higher rates); (3) Reduced rent-seeking (compared to administrative allocation).
• Disadvantages: (1) Opacity (lack of transparency); (2) Speculative bidding; (3) Depreciation of the naira; (4) Increased cost of imports (inflation).

2.6 Structure of the Nigerian Foreign Exchange Market

The Nigerian foreign exchange market has a multi-layered structure with several windows. This section describes the structure.

Official Window (CBN Window): The CBN directly sells foreign currency to authorized dealers (banks) at the official rate. The official rate is set by the CBN and is typically the lowest rate. Access to the official window is restricted to priority sectors (imports of essential goods, raw materials, machinery). The official window has become less important since the unification of exchange rates in 2023 (CBN, 2023). (CBN, 2023)

Investors’ and Exporters’ (IandE) Window: The IandE window was introduced in 2017 as a market-driven window for investors and exporters. It has become the primary foreign exchange market in Nigeria. Participants include: banks, exporters, investors (portfolio, FDI), and the CBN. The exchange rate is determined by market forces (supply and demand). The IandE window operates electronically (Reuters, Bloomberg, FMDQ). Turnover exceeds $100 million daily. The official rate was aligned with the IandE rate in 2023 (CBN, 2017). (CBN, 2017)

Bureau de Change (BDC) Window: BDCs are licensed operators that sell foreign currency to individuals for personal travel (school fees, medicals, travel allowances). BDCs source currency from banks or the CBN. The BDC rate is typically higher than the IandE rate. In 2021, the CBN stopped selling currency to BDCs, forcing them to source from the IandE window. Many BDCs have since closed (CBN, 2021). (CBN, 2021)

Parallel Market (Black Market): The parallel market is an illegal market where currency is traded outside the regulated banking system. Participants include individuals, small businesses, and speculators. The parallel market rate is typically the highest rate (a premium of 10-50% over official rates). The parallel market exists due to shortages in the official windows. The CBN has tried to eliminate the parallel market through enforcement, but it persists (CBN, 2021). (CBN, 2021)

Authorized Dealers (Banks): Banks are the primary intermediaries in the foreign exchange market. They buy foreign currency from the CBN (official window), from the IandE window, and from customers (export proceeds, foreign currency deposits). They sell foreign currency to customers (importers, investors, travelers). Banks earn profits from the spread (buy rate vs. sell rate). Banks also face currency risk (net open position, NOP) (Okoye et al., 2020). (Okoye et al., 2020)

Key Participants: (CBN, 2021). (CBN, 2021)

• Central Bank of Nigeria (CBN): Regulator, supplier of last resort, intervenor.
• Deposit Money Banks (Banks): Authorized dealers, intermediaries.
• Bureau de Change (BDC) Operators: Retailers for individuals.
• Exporters: Suppliers of foreign currency (through export proceeds).
• Importers: Demanders of foreign currency (to pay for imports).
• Investors (Portfolio, FDI): Suppliers (capital importation) and demanders (capital repatriation, dividends).
• Individuals: Demanders (travel, school fees, medicals).
• Speculators: Demanders (betting on depreciation) and suppliers (betting on appreciation).

2.7 Foreign Exchange Management

Foreign exchange management refers to the policies, strategies, and actions taken by the central bank (CBN) and other government agencies to manage the supply and demand of foreign currency, stabilize the exchange rate, protect foreign reserves, and facilitate international trade and investment. This section discusses the key aspects of foreign exchange management in Nigeria.

Role of the Central Bank of Nigeria (CBN): The CBN is the primary institution responsible for foreign exchange management. Its functions include (CBN Act, 2007). (Federal Republic of Nigeria, 2007)

• Determination of exchange rate policy: The CBN decides whether to fix, float, or manage the exchange rate.
• Intervention in the foreign exchange market: The CBN buys or sells foreign currency to influence the exchange rate.
• Management of foreign reserves: The CBN invests foreign reserves in safe, liquid assets (US Treasury bonds, gold, SDRs).
• Licensing of authorized dealers: The CBN licenses banks and BDCs to deal in foreign currency.
• Enforcement of exchange control regulations: The CBN monitors compliance with exchange control laws and penalizes violators.
• Collection of data: The CBN collects data on foreign exchange transactions for policy formulation.

Exchange Rate Policies: Nigeria has experimented with various exchange rate policies (CBN, 2021). (CBN, 2021)

• Fixed exchange rate (1960-1985): The naira was pegged to the US dollar. The policy provided stability but led to overvaluation and reserve depletion.
• Floating exchange rate (1986-1993, 2023-present): The naira is determined by market forces. The policy provides automatic adjustment but leads to volatility.
• Managed float (1995-2015, 2017-2023): The naira is primarily market-determined, but the CBN intervenes to smooth volatility. This is the current policy (since 2023 unification).

Foreign Reserve Management: Foreign reserves are foreign currency assets held by the CBN. Nigeria’s foreign reserves consist primarily of US dollars (80%), with smaller holdings in British pounds, euros, and gold. The CBN invests reserves in safe, liquid assets (US Treasury bonds, SDRs). The adequacy of reserves is measured by months of import cover (target: 12 months). Nigeria’s reserves have ranged from $30-50 billion in recent years, covering 5-10 months of imports (CBN, 2021). (CBN, 2021)

Challenges of Foreign Exchange Management in Nigeria: (Okoye et al., 2020). (Okoye et al., 2020)

• Oil dependence: 90% of foreign exchange earnings come from oil. Oil price volatility causes boom-bust cycles.
• Low export diversification: Non-oil exports (agriculture, manufacturing) are low. Limited supply of foreign currency.
• High import dependency: Nigeria imports food, machinery, fuel, and consumer goods. High demand for foreign currency.
• Capital flight: Nigerian residents hold foreign currency overseas, reducing reserves.
• Speculation: Speculators hoard dollars, expecting depreciation, creating shortages.
• Weak enforcement: Exchange control laws are weakly enforced, allowing illegal flows.

Impact of Foreign Exchange Management on the Banking Industry: (Eze and Okafor, 2021). (Eze and Okafor, 2021)

• Currency risk: Banks hold foreign currency assets and liabilities. Depreciation affects their net open position.
• Credit risk: Importers who borrow naira to finance imports default when the naira depreciates.
• Liquidity risk: Banks cannot meet customer demand for dollars when the CBN restricts supply.
• Profitability: Banks earn trading profits from foreign exchange transactions.
• Capital adequacy: Depreciation reduces the naira value of capital if capital is held in naira.

2.8 Summary of Literature Review

The review of existing literature reveals several key findings:

1. Exchange control has been used extensively in Nigeria to manage foreign currency, protect reserves, and stabilize the exchange rate. However, exchange controls create distortions, black markets, and corruption.
2. The historical evolution of foreign exchange management in Nigeria has seen multiple regimes: fixed (1960-1985), SFEM (1986-1993), AFEM (1995-1999), IFEM (1999-2015), DAS (2015-2017), IandE window (2017-2023), and unification (2023-present). Each regime had strengths and weaknesses.
3. The Dutch Auction System (DAS) reduced demand and increased CBN revenue but led to depreciation and lacked transparency.
4. The Nigerian foreign exchange market has multiple layers: official window, IandE window, BDC window, and parallel market. Multiple exchange rates create arbitrage opportunities and confusion.
5. Foreign exchange management faces significant challenges: oil dependence, low export diversification, high import dependency, capital flight, speculation, and weak enforcement.
6. The impact on the banking industry includes currency risk, credit risk, liquidity risk, profitability effects, and capital adequacy effects.
7. Gaps in the literature include: limited Nigerian-specific evidence on the impact of foreign exchange problems on banking; lack of quantification of effects; lack of COVID-19 analysis; and lack of comparison across bank sizes.