Financial Performance of Omani Banks: A Literary Analysis Essay

Introduction

The banking sector forms the backbone of the economy of any nation. Banks take up some critical roles such as pushing for stable costs, employment opportunities and economic development. Omani's banking system has been seeing remarkable progress as of late, chiefly because of supported increment in oil costs, actions to expand the economy and efforts put forward to increase industrial, land and other infrastructures as well as the privatization of major projects. There have been major acquisitions in the banking system of Oman dated back to the 1990s where new banks have emerged, and to date, there are eighteen business banks. Some of the banks are National Bank of Oman (NBO), Bank Muscat (BM), Oman International Bank (OIB), Bank Dhofar (BD), Oman Arab Bank (OAB), Al Ahli Bank (AB) and Bank Sohar (BS). Factors including currency derivatives, exposure risks, purchase power parity, and inflation has impacts on the profitability and the general financial performance of banks. Banks are very significant institutions to any economy as they are vital to many businesses. A primary drive to the research and studies on financial performances of the banks is the fact that an increase in financial performance results in improved effectiveness and activities of the companies and organizations. Financial performance is the process where a financial statement is used to measure the efficiency, profits and other economic traits of a firm. Therefore, analysis and evaluation of financial performance are instrumental to any organization as it improves its competitiveness in the marketplace.

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

Order now

Currency Derivatives

Currency derivatives are financial tools whose values derive from other assets like foreign exchange, bonds, equities, commodities, and interest rates. The derivatives instruments commonly used include swaps, forwards, futures and options. These instruments are utilized by users to ensure maximum security against risks that can be caused by future changes in price. In the case of uncertainties in exchange rates and interests, equity and commodity prices and creditworthiness, a user will be safeguarded. Derivative instruments are widely spread to all the firms both financial and non-financial ones (Nystedt,2004). The study further highlights that one of the ground-breaking activities in the modern-day financial markets is the banks participating in derivatives activities. Due to the increase in competitiveness in the markets and a decrease in profits, banks have been forced to make use of derivative tools. Advancement in the earnings of the banks that charge no interest was a product of employing derivative instruments (Hasan & Ebrahim,2004). Apart from derivatives, banks can get their revenues through guarantees and commitments. However, the only way banks can evade tax and thus getting more earnings is by utilizing derivative tools. Nevertheless, such activity can increase credit, draw market and cause operational risks which in turn alter the solvency and liquidity of the banks.

Conversely, a remarkable increase in derivative activities of the Omani's banks may be due to escalating "credit, interest and foreign exchange rate risk exposures," as they operate in both domestic and international markets. Banks tend to use these financial derivatives to curb the risks without affecting their financial positions. The use of financial derivatives does not cost banks as they manage risks and thus they can substitute other expensive capitals. However, derivatives put investors to more threats. Opening capital to derivatives is less, and the future returns are high because of the significant influence it has on the contracts of the fluctuating assets. It is, therefore, necessary to appropriately hedge derivatives because if poorly managed can cause losses to the banks.

Banks that use derivative cannot experience uncertainties in their interest rates and therefore lend more money which in turn gives them higher returns (Deshmukh & Greenbaum,1983). Banks using derivatives to curb the risks that may arise in interest rates would be greater compared to those that do not. Research also suggest that a firm may count losses they trade derivatives for profit as it is a risky activity (Stern & Linan,1994). Exposure to financial risk is managed by using derivatives as it enables investors to relocate and distribute the financial risk (Tsetsekos &Varangis, 1997).

Inflation

Inflation is the degree at which the overall price levels for goods and services rises and thus, the purchasing power of the exchange is declining. There are significant measures of the price inflation which includes the inflation rate and annualized percentage variation in the overall price index. Generally, the economists agree that extreme growth of the money supply is due to high rates of inflation and hyperinflation. Fixed rate of inflation is preferred by most of the economists today (Robert ,1997). Keeping low rates of inflation is the responsibility of the financial authorities which are the central banks of the countries. Central banks control the supply of money by establishing interest rates and by creating banking requirements.

Return On Equity (ROE)

Return on Equity is defined as, the volume of net earnings returned as a percentage of trader's value. Return on value actions by an organization reveals the profit that the organization has made from the money invested by traders. Without a considerable return on the investment, banks may suffer a big blow in earnings and therefore unable to gather for expenses of administration and other standard costs. The money earned by a conventional bank through its investments is a feature to the earnings obtained by a lender. The return on value in banking institutions is an interest of most of the investors. The control of investment by a standard bank has, and the urge to reduce the costly value has given rise to Return on Equity. Economizing cost works in the condition that debts are sponsored with bailout conditions and down payment insurance (Admati et al.,2011). Moreover, traders obtain a competitive advantage through the return on value for banking institutions, for instance, individuals and businesses target those conventional banks with a huge investment. Banks announce their arrival on amount through the use of annual reports and other economic tools, and thus the stakeholders get to learn about an organization and decide upon investment. The profits obtain used for greater commitments in investment by an institution. As per many pieces of research, it is evident that return on equity is connected to investment. It is very complicated to evaluate the actual nature of the standard banks as it needs to unravel the efficiency aspect caused by a significant creation of value of an element which is an outcome of better threats (Rajan, 2005).

Banks Performance

Profitability, return on equity, return on assets and liquidity are the critical factors used to measure the performance of the banking sectors. Modern theories emphasize the importance of the regulation of information in the credit market, and they define the negative impacts of inflation on banks and equity markets (Huybens & Smith,1999). As a result of an increase in the rate of inflation, the actual price of returns reduces and thus investment and return on equity declines causing a downfall in the financial performance of a bank. Consequently, when inflation rises, credit rationing is affected and therefore, banks offer fewer loans, reduces capital investment and lessens resource allocation. Research shows that the reduction in capital formation influence the overall economic performance and decline in the activity of the equity market. (Moore, 1986; Choi, Smith, et al., 1996; Azariadis and Smith, 1996). Inflation has the following impacts on financial performance. First, variations in stock returns and interest margin are linked to higher inflation rates. Secondly, an increase in inflation rates paralyzes economic activities in that it lessens lending and capital investment. Finally, the study points out that, if inflation reaches a critical point, then further increase in the rate of inflation will have no impact on the activities of the banking system.

Purchasing Power Parity

Purchasing power parity examines the relationship existing between exchange rates and the relative prices. In the event of a floating exchange, fluctuation of the purchasing power parity for any two currencies calculated as the ratio of price for the goods traded would then be estimated by a variation in the equilibrium rate for the exchange of the two currencies (Shapiro & Rutenberg, 1976). Interest rate theory for the expected exchange rates explains the relationship between foreign exchange rates and relative interest rates. The difference in the nominal interest rates between two states depicts fluctuations in the exchange rates. This is referred to as international Fisher effect a phenomenon which was defined by Fisher (1896). Research further suggests that an increase in the price level causes the deflation of the foreign exchange rate as compared to other nations and therefore, making sure that the relative value of similar goods is the same across different countries.

The purchasing power parity theory further proposes that relative prices stabilized the fluctuations in the foreign exchange rate as "one price law" would suggest. One price law indicates that in a competitive market, similar goods are traded for the same amount given that one currency is used to rate them.

Exposure Risk

Financial risk includes liquidity risk, market risk and credit risk which together cause uncertainties in the financial performance of any economic sector (Tafri et al., 2009; Dimitropoulos et al., 2010). Credit risk is the main risk in the financial industry that affects the performances of banks, especially for the local banks. Credit risk is the risk resulting from the varying net worth of assets owing to the failure of the party with a contractual debt to meet obligations (Pyle,1999).

Interest rate risk as the risk of fluctuation of deposit interest rate and lending (Dimitropoulos,2010). A bank may face an interest rate risk when the lending interest rate becomes less than the deposit interest rate and higher than the market rate. Exchange rate risk connected to the fall in the value of the local currency, an increase in prices and output decrease. The study seconds further that a bank may face exchange rate loss if it fails to put a reasonable price on the currency as it buys and sells foreign currency or when the value of the foreign currency continuously depreciates. Credit risk has a significant impact on the financial performance of the Islamic banks (Tafri et al.,2009). The research evaluated the relationship between Return on Equity and interest rate risk and found out that the two aspects are insignificant in the Islamic banks. Also, the impact of liquidity risk is irrelevant to the Islamic banks. The studies carried out show the factors that affect financial performance and profitability of banks. The research reveals vital information to both the administrators and the users on the profitability of banks. The information is helpful to the management in that it helps them make sound decisions to improve the performance of the banks. In Oman, banks show different financial performance as they differ in profit-making due to inflation, purchasing power parity, exposure risk, and currency derivatives. To obtain a general economic performance, banks should reduce costs without altering the quality of their services by increasing profitability and efficiency. Moreover, local banks should increase their investment with foreign banks to obtain the profit. Above all...