Project Abstract

<p> Financial risk is inherent in every commercial<br>bank, but commercial banks that embed the right financial risk management<br>strategies into business planning and financial performance management are more<br>likely to achieve their strategic and operational objectives. This study sought<br>to fill the existing research gap by answering the following research question,<br>does there exist a relationship between financial risk management and financial<br>performance of commercial banks in Kenya? The study adopted descriptive<br>research design<b>.</b>&nbsp;Secondary Data was<br>collected from the Central Bank of Kenya and Commercial Banks in Kenya and<br>multiple regression analysis used in the data analysis. The study had sought to<br>establish the relationship between financial risk management and financial<br>performance of commercial banks in Kenya. The study revealed that there was<br>there was a negative relationship between credit risk, interest rate risk, foreign<br>exchange risk, liquidity risk and financial performance of commercial banks in<br>Kenya. The study also revealed that there was a positive relationship between<br>capital management risk, bank deposits, bank size and financial performance of<br>commercial banks in Kenya. The study recommends there is need for the<br>management of commercial bank to control their credit risk, through<br>non-performing loan level as it was revealed that credit risk negatively<br>affects the financial performance of commercial banks in Kenya. There is need<br>for the management of commercial banks in Kenya to maintain the liquidity level<br>at safe level as it was found that liquidity risk negatively affect the<br>financial performance of commercial banks in Kenya. The management of<br>commercial banks in Kenya should hedge against foreign exchange risk and<br>interest rate risk as it was found that interest rate risk and foreign exchange<br>negatively affects the financial performance of commercial bank in Kenya. The<br>study recommends that there is need for commercial banks in Kenya to increase<br>their size, capital risk management and also their bank deposits. <br></p>

Project Overview

<p> </p><div><p><b>INTRODUCTION</b></p><p><b>1.1 Background of the Study</b></p><p>Risk is inherent in every business, but<br>organizations that embed the right risk management strategies into business<br>planning and performance management are more likely to achieve their strategic<br>and operational objectives. Taking risk is core to the Bank’s business, and<br>risks are an inevitable consequence of being in business. The bank’s aim is<br>therefore to achieve an appropriate balance between risk and return and<br>minimize potential adverse effects on its performance. Pyle (1997) mentioned<br>that risk management among banks has been inadequate and stressed the importance<br>for a uniform procedure to monitor and regulate risks. Risk management is an<br>issue that needs to be stressed and investigated, especially in the banking<br>industry, where the need for a good risk management structure is extremely<br>important. Dynamic business practices and demanding regulatory requirements<br>mean that organizations require a broader and clearer perspective on<br>enterprise-wide risk than ever before.</p><p><b>1.1.1 Financial Risk Management</b></p><p>Financial risk management is the quality control of<br>finance. It is a broad term used for different senses for different businesses<br>or things but basically it involves identification, analyzing, and taking<br>measures to reduce or eliminate the exposures to loss by an organization or<br>individual. Various authors including Stulz (1984), Smith et al (1990) and<br>Froot et al (1993) have offered reasons why managers should concern themselves<br>with the active management of risks in their organizations. The main aim of<br>management of banks is to maximise expected profits taking into account its<br>variability/volatility (financial risk). Financial risk management is pursued<br>because banks want to avoid low profits which force</p><p>1</p></div><div><p>them to seek external investment opportunities.<br>When this happens, it results in suboptimal investments and hence lower<br>shareholders’ value since the cost of such external finance is higher than the<br>internal funds due to capital market imperfections. There are five main types<br>of financial risks classified in the following categories:</p><p>Credit Risk; the analysis of the financial<br>soundness of borrowers has been at the core of banking activity since its<br>inception. This analysis refers to what nowadays is known as <i>credit</i>&nbsp;<i>risk</i>, that is, the risk that counterparty fails to perform an<br>obligation owed to its creditor. It isstill<br>a major concern for banks, but the scope of credit risk has been immensely<br>enlarged with the growth of derivatives markets. Another definition considers<br>credit risk as the cost of replacing cash flow when the counterpart defaults.<br>Greuning and Bratanovic (2009) define credit risk as the chance that a debtor<br>or issuer of a financial instrument whether an individual, a company, or a<br>country will not repay principal and other investment-related cash flows<br>according to the terms specified in a credit agreement. Inherent to banking,<br>credit risk means that payments may be delayed or not made at all, which can<br>cause cash flow problems and affect a bank‘s liquidity.</p><p>Interest Rate Risk; Interest rate risk is founded<br>on variations on interest rates and can be perceived in different forms. The<br>first methods refer to variation in interest rates in joining with variable<br>loans and short-term financing. An increase in the interest rate leads to<br>higher interest payments for the variable rate loan and more expensive<br>follow-up funding. This decreases the company’s earnings and can in worst case<br>lead to financial distress. Second, the vice versa case refers to cash<br>positions of the company with a variable interest rate. A fall in</p><p>2</p></div><div><p>this rate leads to a loss in earnings. Thirdly,<br>also fixed rate debt contracts can be a risk for the company. In times of<br>decrease interest rates those contracts because higher payments then a variable<br>loan wanted do and are disadvantageous for the company. It can be summarized<br>that the more corporate debt and especially short-term and variable rate debt a<br>company has, the more vulnerable it is to changes in the interest rate<br>(Dhanini, 2007).</p><p>Foreign Exchange Risk; Exchange risk occurs when a<br>company is involved in international business and the cash in or outflows are<br>in a foreign exchange rate. As this rate is not fixed and cannot be fully<br>anticipated a possible change in a foreign exchange rate leads to the risk of<br>changes in the amount of a payable / receivable and by that a change in the<br>amount of money the company has to pay / will receive. This risk is measured by<br>the concept of transaction exposure (Glaum, 2000).</p><p>Capital Management Risk; Capital requirement is of<br>great importance under the Basel Accords and these set the guide lines for the<br>financial institutions. It is internationally accepted that a financial<br>institutions should have capital that could cover the difference between<br>expected losses over some time horizon and worst case losses over the same time<br>horizon. Here the worst case loss is the loss that should not be expected to<br>exceed with the some high degree of confidence. This higher degree of<br>confidence might be 99% or 99.9%.The reason behind this idea is that expected<br>losses are normally covered by the way a financial institution prices its<br>products. For instance, the interest charged by a bank is designed to recover<br>expected loan losses. The firm wants to be flexible and at the same time lower<br>the costs for financing .The period of loans is significant in joining with the<br>assets,</p><p>3</p></div><div><p>which are funded with the loan. Here, often a<br>disparity between the durations can be detected. Long-term assets are then<br>funded with short-term and regulating rate loans, leading to a shortfall in<br>cash flows in times of rising interest rates. This element again can lead to an<br>inferior ranking of the company and inferior conditions to get future problems<br>regarding follow-up financing over the rest of the lifetime of the asset can<br>occur. Vice versa long-term financing of short-term assets might lead to access<br>financing when the asset is no longer existing. This causes of needless<br>interest payments for the company (Vickery, 2006).</p><p>Liquidity Risk<b>;</b><br>According to Greuning and Bratanovic (2009), a bank faces liquidity risk when<br>it does not have the ability to efficiently accommodate the redemption of<br>deposits and other liabilities and to cover funding increases in the loan and<br>investment portfolio. These authors go further to propose that a bank has<br>adequate liquidity potential when it can obtain needed funds (by increasing<br>liabilities, securitising, or selling assets) promptly and at a reasonable<br>cost. The Basel Committee on Bank Supervision consultative paper (June 2008)<br>asserts that the fundamental role of banks in the maturity transformation of<br>short-term deposits into long-term loans makes banks inherently vulnerable to<br>liquidity risk, both of an institution-specific nature and that which affects<br>markets as a whole, (Greuning and Bratanovic, 2009).</p><p><b>1.1.2 Financial Performance</b></p><p>Financial performance consists of many different<br>methods to assess how well an organization is using its assets to generate<br>income (Richard, 2009). Common examples of financial performance comprise of<br>operating income, earnings before interest and taxes, and net asset value. It<br>is of great importance to note that no single measure of financial performance</p><p>4</p></div><div><p>should be considered on its own. Rather, a thorough<br>evaluation of a company’s performance should take into account many different<br>measures of its performance. Companies must evaluate and monitor their<br>profitability levels periodically so as to measure their financial performance<br>through use of the profitability measures computed from the measures explained<br>above. The two most popular measures of profitability are ROE and ROA. ROE<br>measures accounting earnings for a period per dollar of shareholders’ equity<br>while ROA measures return of each dollar invested in assets.</p><p><b>1.1.3 Relationship between Financial Risk<br>Management and Financial Performance of</b></p><p><b>Commercial Banks</b></p><p>Company motives for managing financial risks are<br>the same as those for employing a risk management, as financial risks are a<br>subgroup of the company’s risks. One of the main motives is to reduce the<br>instability of earnings or cashflow due to financial risk exposure (Dhanini,<br>2007). The reduction enables the firm to perform better forecasts (Drogt &amp;<br>Goldberg, 2008). This will help to guarantee that sufficient funds are<br>available for the company for investment and dividends (Ammon, 1998).</p><p>Another reason for management of financial risks is<br>to avoid financial distress and the costs connected with it (Triantis, 2000;<br>Drogt &amp; Goldberg, 2008). Lastly also management own-interest of stabilizing<br>earnings or the objective to keep a constant tax level can be motives for<br>financial risk management (Dhanini, 2007). Depending on which of the arguments<br>is in the focus of the company, the risk management can be structured. The<br>focus is either on minimizing volatility or avoiding large losses (Ammon,<br>1998).</p><p>5</p></div><div><p>Reduced instability in cash flows or earnings and<br>prevention of losses allow better planning of liquidity needs. This can avoid<br>shortcuts of available funds and consumption of equity (Eichhorn, 2004). In<br>order to maintain financially liquidity and avoid end of period losses, it<br>needs to be analysed which the maximum tolerated loss is. The attention of the<br>risk management should therefore be in correspondence with the actual financial<br>situation of the company. This study seeks to determine the relationship<br>between financial risk management and financial performance of commercial banks<br>in Kenya.</p><p><b>1.1.4 Commercial Banks in Kenya</b></p><p>Commercial banks in Kenya are governed by the<br>Companies Act (Cap, 486) the Banking Act,(Cap, 488) the Central Bank of Kenya<br>Act (Cap, 491) and the various prudential regulations issued by the Central<br>Bank of Kenya (CBK). The Kenyan banking sector was liberalized in 1995 and<br>exchange controls lifted. The Central Banks of Kenya, which falls under the<br>Treasury docket, is responsible for formulating and implementing monetary<br>policy and fostering the liquidity, solvency and proper operations of the<br>commercial banks in Kenya. This policy formulation and implementation also<br>includes financial risk management and the financial performance of commercial banks<br>in Kenya. The financial performance and financial risk management is also<br>monitored by the CBK.</p><p>As at 31 December, 2013, the banking sector<br>comprised 43 commercial banks, 1 mortgage finance company, 9 microfinance<br>banks, 7 representative offices of foreign banks, 102 foreign exchange bureaus,<br>3 money remittance providers and 2 credit reference bureaus. According to the<br>Central bank of Kenya report on banking sector performance for the quarter<br>ended 31 December, 2013, there are a total of 43 licensed commercial banks in<br>the country</p><p>6</p></div><div><p>and one mortgage finance company. Out of the 43<br>commercial banks, 29 are locally owned and 14 are foreign owned.</p><p>The locally owned commercial banks comprise 3 banks<br>with significant shareholding by government and state corporations and 26 local<br>commercial banks being privately owned. However out of all the banks only 10 of<br>them are listed in the Nairobi Securities Exchange having met the conditions of<br>listing and applied for the same. As at 31 December 2013 the financial<br>performance aspects of commercial banks as well as financial risks management<br>was guided by the CBK prudential guidelines issued in January 2013. Commercial<br>banks in Kenya are required by CBK to submit audited annual reports which<br>include their financial performance and in addition disclose various financial<br>risks in the reports including credit risk, interest rate risk, foreign<br>exchange risk, liquidity risk as well as capital management risk on a yearly<br>basis by 31 March of every year. The Kenyan banking sector registered improved<br>performance in 2013 by registering a 15.9 percent growth in total net assets<br>from Ksh. 2.33 trillion in December 2012 to Ksh. 2.70 trillion in December<br>2013. (Source: Central Bank of Kenya).</p><p><b>1.2 Research Problem</b></p><p>Financial risk is inherent in every commercial<br>bank, but commercial banks that embed the right financial risk management<br>strategies into business planning and financial performance management are more<br>likely to achieve their strategic and operational objectives. Taking financial<br>risk management is core to the Bank’s financial performance. The bank’s aim is</p><p>7</p></div><div><p>therefore to achieve an appropriate balance between<br>risk and return and minimize potential adverse effects on its financial<br>performance.</p><p>This requires more dynamic and sound Financial Risk<br>Management methods to perform well in an ever dynamic and highly competitive<br>banking industry, which will translate into having a competitive advantage and<br>thus generate growth in profits. Some aspects of risks present opportunities<br>through which firms can have a competitive edge over others and contribute to<br>improvement of financial performance (Stulz, 1996). Literature on financial<br>risk management suggests that firms with better financial risk management<br>strategies tend to have better financial performance. By relating financial<br>risk management to financial performance, commercial banks can have an insight<br>into the value of financial risk management.</p><p>The recent financial crisis and the failure of<br>banking system even in the developed countries like the USA have forced the<br>policy makers and researchers to look into the details of these failures and in<br>doing so, financial risk has come out as one factor that need to be addressed<br>by banks to guarantee their sustenance. Therefore a bank must determine what<br>its level of financial risk is and then implement a financial risk management<br>requirement that would cover that risk (Ferguson, 2008).</p><p>A study by consultancy firm Ernst &amp; Young and<br>the Institute of International Finance (2013) asserts that banks, having moved<br>to enhance the structure of risk management post-crisis, are still working to<br>fully operationalize those policies with most banks still finding it difficult<br>to embed risk appetite. Banks are reviewing their cultures across legal<br>entities and business</p><p>8</p></div><div><p>units following several high-profiles conduct<br>scandals. There is a much greater focus beyond financial risk to operational<br>risk and reputational risk, including the issue of risk appetite. Risk<br>transparency in banks is driving further enhancement of stress testing and<br>sizable further investment in IT and data. The study further notes that banking<br>business models are being rethought in light of the regulatory changes, leading<br>to exiting from activities, businesses, markets and geographies. Almost<br>universally, risk governance is more central to the management of banks and has<br>much more senior management and board attention placed on it than was the case<br>pre-crisis.</p><p>The Kenyan Financial Sector is considered as one of<br>the key segments of the economy. According to the CBK, the banking sector<br>employs more than 60,000 employees and the volume of transactions in terms of<br>monetary value has been growing at an average of 10.5% pa since 2005. The<br>Kenyan vision 2030 blue print identifies financial sector stability as of the<br>attainment of the objectives of the strategy and point out that the sector<br>should grow by 8% over the next 20 years to help the country achieve its<br>objective. This can only be achieved if there is growth in and stability in the<br>financial sector and cases of the institutions insolvency or financial crisis<br>happening should be prevented at all cost. Financial risk management helps<br>lessen the chances that a bank may become insolvent if sudden shocks occur.</p><p>The Central Bank of Kenya (CBK) reported that more<br>than 90% of banks in the country were reporting reduced losses as a result of<br>increased risk management and that almost all claimed risk awareness had<br>increased at their institutions. In a survey of banks and mortgage institutions<br>in Kenya, the CBK contacted 43 significant institutions to “assess the adequacy</p><p>9</p></div><div><p>and impact of risk management guidelines” the<br>central bank had issued in 2005. The development of risk management as an<br>autonomous function in particular has been rapid, with 95% of institutions<br>surveyed saying they had created “independent and well-funded risk management<br>functions”.</p><p>Empirical studies done in Kenya have focused in<br>credit risk management and among them are credit risk management by coffee<br>coops in Embu district (Njiru, 2003), survey of credit risk management<br>practices by pharmaceutical manufacturing firms in Kenya (Nduku, 2007) and<br>assessment of credit risk management techniques adopted by microfinance<br>institutions in Kenya (Mwirigi, 2006). To the researchers best knowledge there<br>is limited empirical evidence on the relationship between financial risk<br>management and performance of commercial banks in Kenya. This study seek to<br>fill the existing research gap by answering the following research question,<br>does there exist a relationship between financial risk management and financial<br>performance of commercial banks in Kenya?</p><p><b>1.3 Research Objective</b></p><p>To determine the relationship between financial<br>risk management and financial performance of commercial banks in Kenya</p><p><b>1.4 Value of the Study</b></p><p>The study provides useful information to policy<br>makers and regulators to design targeted policies and programs that will<br>actively stimulate the growth and sustainability of the</p><p>10</p></div><p>commercial banks in the country. Regulatory bodies<br>such as the Central Bank of Kenya can use the study findings to improve on the<br>framework for risk management.</p><p>The study findings will benefit management and<br>staff of banks who will gain insight into the importance of financial risk<br>management adherence and its effect on risk mitigation in the operation of<br>banks.</p><p>The study is expected to add value to Researchers<br>and Scholars as it will contribute to the literature on the relationship<br>between financial risk management and performance of commercial banks in Kenya.<br>It is hoped that the findings will be of benefit to the academicians, who may<br>find useful research gaps that will stimulate interest in further research in<br>future. Recommendations have been be made on possible areas of future studies.<br>The study will also be of value to any investors interested in setting up<br>commercial banks or upgrading investment banks to commercial banks in the<br>country.</p> <br><p></p>