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Abstract

This research investigates the effect of open market operation on commercial banks.                                                                                                                                                                                                                                                                                                              This is performed by examining the causality and patterns of reactions of banking rates with respect to variation in open market rates. Based on vector auto regression analysis we show that there is one-way causation running from the open market rates to banking rates. Changes in open market rates significantly cause changes in the spread and deposit rates. However, no significant causation is identified for lending rates. The impulse response functions indicate that spread declines following positive innovation in open market rates and this is mainly due to the greater sensitivity of deposit rates to open market rates. The response of lending rates is shown to be low thus contributing to the decline in spread. Evidence of a dichotomy was also provided between banks asset and liability rates by failing to support causality between the two rates. These results suggest that for the commercial banking firms, increase in open market rates hindered their activities and could affect bank performance.

 

                                        CHAPTER ONE

INTRODUCTION

  • Background of the study

The existence of an effective banking sector is necessary for every economy because it creates the necessary environment of economic growth and development through its role in intermediating funds from surplus sector to deficit sector of the economic units. Banking sectors are financial intermediaries whose activities are for collection of savings and lending, thus standing in between the ultimate lender and the borrower and matching the investment requirement of the lender. This stimulates investment as well as international trade and balance of payments. In playing this important role of financial intermediation, the banking sector is seen as effective institution in the use of monetary policy, which relies on the control of money stock in order to influence financial and economic activities. The extent to which monetary policy influences financial and economic activities has been widely argued over the years, it is equally accepted that monetary policy affects economic and financial performance of any economy. There are diverse views on the extent of the effects and the channels through which these effects are achieved. This is particularly relevant in the Nigeria setting where the money and capital market are under-developed and Nigerian government has over the years adopted various instruments of monetary policy to regulate and control the cost, volume, availability and direction of money credit and also the performance of commercial banks. The central bank can either buy or sell government bonds in the open market (hence the name open market operation)  which is now mostly the preferred solution to enter into a rapor or secured lending transaction with a commercial banks: the central bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as collateral. A central bank uses open market operation as the primary means of implementing monetary policy. The usual aim of open market operations is aside from supplying commercial banks with liquidity and sometimes taking surplus liquidity from commercial banks to manipulate the short-term interest rate and the supply of base money in an economy and thus indirectly control the total money supply in effect expanding money or contracting the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities or other financial instruments. Monetary targets such as inflation, interest rates or exchange rates are used to guide this implementation.

The central bank also known as the banker’s bank maintains zero account for a group of commercial banks, which are the direct payment banks. A balance on such a zero account represents central bank money in the regarded currency. Since central bank money currently exists mainly in the form of electronic records rather than in the form of paper or coins (physical money), open market operations can be conducted by simply increasing or decreasing (crediting or editing) the amount of electronic money that a bank has in its reserve account at the central bank. This does not require the creation of new physical currency unless a direct payment bank demands to exchange a part of its electronic money against banknotes or coins.

In most developed countries, central banks are not allowed to give loans without requiring suitable assets as collateral. Therefore, most central banks describe which assets are eligible for open market transactions. Technically, the central bank makes the loan and synchronously takes an equivalent amount of an eligible asset supplied by the borrowing commercial bank.

Classical economic theory postulates a distinctive relationship between the supply of central bank money and short-term interest rates: like for a commodity, a higher demand for central bank money would increase its price, the interest rate. When there is an increased demand for base money, the central bank must act if it wishes to maintain the short-term interest rate. It does this by increasing the supply of base money: it goes to the open market to buy a financial asset such as government bonds. To pay for these assets, new central bank money is generated in the seller’s zero account, increasing the total amount of base money in the economy. Conversely, if the central bank sells these assets in the open market, the base money is reduced.

Technically, the process works because the central bank has the authority to bring money in and out of existence. It is the only point in the whole system with the unlimited ability to produce money. Another organization may be able to influence the open market for a period of time but the central bank will always be able to overpower their influence with an infinite supply of money.

 

Sales or purchases of government debt instruments (treasury bonds, treasury bills, treasury notes) on the open financial markets by a country’s central bank as part of it’s efforts to influence the size of the money supply and the levels of interest rates. Central bank decisions to buy up government debt instruments make for an expansionary monetary policy while sales of government debt instruments by the central bank represent a contractionary monetary policy.

  • Statement of the problem

Ever since the central bank of Nigeria invented the open market operation as a contractionary monetary policy to checked mate the liquidity or activities of the commercial banks, it has yield a lot of result in implementing the federal government policy, it is on this backdrop that the researcher intends to investigate the effect of the central bank monetary policy on the liquidity of the commercial banks.

  • Objective of the study

The main objective of the study is to ascertain the effect of open market operation on commercial banks operation with emphasis on first bank plc. However, for the successful completion of the study, the researcher intends to achieve the following sub-objective:

(1) To ascertain the effects of open market operation on commercial banks

(2) To ascertain the relationship between open market operation and the profitability of commercial banks

(3) To ascertain the relationship between the commercial bank and the central bank policy

(4) To evaluate the role of the open market operation in the development of the commercial banks

1.4 Research question

For the successful completion of the study, the following research question was formulated:

  • Are there any effects of open market operation on commercial banks?
  • Are there any relationship between open market operation and the profitability of commercial banks?
  • is there any relationship between the commercial bank and the central bank policy?
  • What is the role of the open market operation in the development of the commercial banks?

1.5 RESEARCH HYPOTHESES

For the successful completion of the study, the following research hypotheses was formulated by the researcher

H0open market operation has no impact on the activities of commercial banks

H1open market operation has a significant impact on the activities of the commercial banks

H02there is no significant relationship between open market operation and profitability of commercial banks

H2there is a significant relationship between open market operation and commercial banks profitability

 

 

  1. 6 Significance of the study

It is perceived that at the completion of the study, the findings will be of great importance to the management of banks as the study gives them an insight of what open market is all about, the study will also be of great importance to the regulators of the banking sector, the study will also be of great importance to researchers who intend to carry out a study on a similar topic and finally the study will be of great importance to academia’s, teachers, lecturers students and the general public as it will add to the pool of knowledge

1.7 SCOPE AND LIMITATION OF THE STUDY

The scope of the study covers the effect of open market operation on commercial banks operation. During the cause of the study, the researcher encounter some constrain which limited the scope of the study, below are some of the limitations of the study:

Finance: finance is a major limitation to the study as resources allocated to the study is limited

Time: time is a major constrain to the research as time allocated to the study is very limited

Research material: availability of research material is a major set back to the scope of the study

1.8 Definition of terms:

Open market operation

Open market operations refers to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system facilitated by the federal reserve. Purchases inject money into the banking system and stimulate growth, while sales of securities do the opposite and contract the economy. The federal’s goal in using this technique is to adjust and manipulate the federal funds rate which is the rate at which banks borrow reserves from one another.

 

Banks

A bank is a financial institution that accepts deposits from the public and creates credit. Lending activities can be performed either directly or indirectly through capital markets. Due to their importance in the financial stability of a country, banks are highly regulated in most countries. Most nations have institutionalized a system known as fractional reserve banking under which banks hold liquid assets equal to only a portion of their current liabilities. In addition to other regulations intended to ensure liquidity, banks are generally subject to minimum capital requirements based on an international set of capital standards known as the basel accords.

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