CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Risk is inherent in every business, but organizations that embed the right risk management strategies into business planning and performance management are more likely to achieve their strategic and operational objectives. Taking risk is core to the Bank’s business, and risks are an inevitable consequence of being in business. The bank’s aim is therefore to achieve an appropriate balance between risk and return and minimize potential adverse effects on its performance. Pyle (1997) mentioned that risk management among banks has been inadequate and stressed the importance for a uniform procedure to monitor and regulate risks. Risk management is an issue that needs to be stressed and investigated, especially in the banking industry, where the need for a good risk management structure is extremely important. Dynamic business practices and demanding regulatory requirements mean that organizations require a broader and clearer perspective on enterprise-wide risk than ever before.

1.1.1 Financial Risk Management

Financial risk management is the quality control of finance. It is a broad term used for different senses for different businesses or things but basically it involves identification, analyzing, and taking measures to reduce or eliminate the exposures to loss by an organization or individual. Various authors including Stulz (1984), Smith et al (1990) and Froot et al (1993) have offered reasons why managers should concern themselves with the active management of risks in their organizations. The main aim of management of banks is to maximise expected profits taking into account its variability/volatility (financial risk). Financial risk management is pursued because banks want to avoid low profits which force

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them to seek external investment opportunities. When this happens, it results in suboptimal investments and hence lower shareholders’ value since the cost of such external finance is higher than the internal funds due to capital market imperfections. There are five main types of financial risks classified in the following categories:

Credit Risk; the analysis of the financial soundness of borrowers has been at the core of banking activity since its inception. This analysis refers to what nowadays is known as credit risk, that is, the risk that counterparty fails to perform an obligation owed to its creditor. It isstill a major concern for banks, but the scope of credit risk has been immensely enlarged with the growth of derivatives markets. Another definition considers credit risk as the cost of replacing cash flow when the counterpart defaults. Greuning and Bratanovic (2009) define credit risk as the chance that a debtor or issuer of a financial instrument whether an individual, a company, or a country will not repay principal and other investment-related cash flows according to the terms specified in a credit agreement. Inherent to banking, credit risk means that payments may be delayed or not made at all, which can cause cash flow problems and affect a bank‘s liquidity.

Interest Rate Risk; Interest rate risk is founded on variations on interest rates and can be perceived in different forms. The first methods refer to variation in interest rates in joining with variable loans and short-term financing. An increase in the interest rate leads to higher interest payments for the variable rate loan and more expensive follow-up funding. This decreases the company’s earnings and can in worst case lead to financial distress. Second, the vice versa case refers to cash positions of the company with a variable interest rate. A fall in

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this rate leads to a loss in earnings. Thirdly, also fixed rate debt contracts can be a risk for the company. In times of decrease interest rates those contracts because higher payments then a variable loan wanted do and are disadvantageous for the company. It can be summarized that the more corporate debt and especially short-term and variable rate debt a company has, the more vulnerable it is to changes in the interest rate (Dhanini, 2007).

Foreign Exchange Risk; Exchange risk occurs when a company is involved in international business and the cash in or outflows are in a foreign exchange rate. As this rate is not fixed and cannot be fully anticipated a possible change in a foreign exchange rate leads to the risk of changes in the amount of a payable / receivable and by that a change in the amount of money the company has to pay / will receive. This risk is measured by the concept of transaction exposure (Glaum, 2000).

Capital Management Risk; Capital requirement is of great importance under the Basel Accords and these set the guide lines for the financial institutions. It is internationally accepted that a financial institutions should have capital that could cover the difference between expected losses over some time horizon and worst case losses over the same time horizon. Here the worst case loss is the loss that should not be expected to exceed with the some high degree of confidence. This higher degree of confidence might be 99% or 99.9%.The reason behind this idea is that expected losses are normally covered by the way a financial institution prices its products. For instance, the interest charged by a bank is designed to recover expected loan losses. The firm wants to be flexible and at the same time lower the costs for financing .The period of loans is significant in joining with the assets,

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which are funded with the loan. Here, often a disparity between the durations can be detected. Long-term assets are then funded with short-term and regulating rate loans, leading to a shortfall in cash flows in times of rising interest rates. This element again can lead to an inferior ranking of the company and inferior conditions to get future problems regarding follow-up financing over the rest of the lifetime of the asset can occur. Vice versa long-term financing of short-term assets might lead to access financing when the asset is no longer existing. This causes of needless interest payments for the company (Vickery, 2006).

Liquidity Risk; According to Greuning and Bratanovic (2009), a bank faces liquidity risk when it does not have the ability to efficiently accommodate the redemption of deposits and other liabilities and to cover funding increases in the loan and investment portfolio. These authors go further to propose that a bank has adequate liquidity potential when it can obtain needed funds (by increasing liabilities, securitising, or selling assets) promptly and at a reasonable cost. The Basel Committee on Bank Supervision consultative paper (June 2008) asserts that the fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole, (Greuning and Bratanovic, 2009).

1.1.2 Financial Performance

Financial performance consists of many different methods to assess how well an organization is using its assets to generate income (Richard, 2009). Common examples of financial performance comprise of operating income, earnings before interest and taxes, and net asset value. It is of great importance to note that no single measure of financial performance

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should be considered on its own. Rather, a thorough evaluation of a company's performance should take into account many different measures of its performance. Companies must evaluate and monitor their profitability levels periodically so as to measure their financial performance through use of the profitability measures computed from the measures explained above. The two most popular measures of profitability are ROE and ROA. ROE measures accounting earnings for a period per dollar of shareholders’ equity while ROA measures return of each dollar invested in assets.

1.1.3 Relationship between Financial Risk Management and Financial Performance of

Commercial Banks

Company motives for managing financial risks are the same as those for employing a risk management, as financial risks are a subgroup of the company’s risks. One of the main motives is to reduce the instability of earnings or cashflow due to financial risk exposure (Dhanini, 2007). The reduction enables the firm to perform better forecasts (Drogt & Goldberg, 2008). This will help to guarantee that sufficient funds are available for the company for investment and dividends (Ammon, 1998).

Another reason for management of financial risks is to avoid financial distress and the costs connected with it (Triantis, 2000; Drogt & Goldberg, 2008). Lastly also management own-interest of stabilizing earnings or the objective to keep a constant tax level can be motives for financial risk management (Dhanini, 2007). Depending on which of the arguments is in the focus of the company, the risk management can be structured. The focus is either on minimizing volatility or avoiding large losses (Ammon, 1998).

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Reduced instability in cash flows or earnings and prevention of losses allow better planning of liquidity needs. This can avoid shortcuts of available funds and consumption of equity (Eichhorn, 2004). In order to maintain financially liquidity and avoid end of period losses, it needs to be analysed which the maximum tolerated loss is. The attention of the risk management should therefore be in correspondence with the actual financial situation of the company. This study seeks to determine the relationship between financial risk management and financial performance of commercial banks in Kenya.

1.1.4 Commercial Banks in Kenya

Commercial banks in Kenya are governed by the Companies Act (Cap, 486) the Banking Act,(Cap, 488) the Central Bank of Kenya Act (Cap, 491) and the various prudential regulations issued by the Central Bank of Kenya (CBK). The Kenyan banking sector was liberalized in 1995 and exchange controls lifted. The Central Banks of Kenya, which falls under the Treasury docket, is responsible for formulating and implementing monetary policy and fostering the liquidity, solvency and proper operations of the commercial banks in Kenya. This policy formulation and implementation also includes financial risk management and the financial performance of commercial banks in Kenya. The financial performance and financial risk management is also monitored by the CBK.

As at 31 December, 2013, the banking sector comprised 43 commercial banks, 1 mortgage finance company, 9 microfinance banks, 7 representative offices of foreign banks, 102 foreign exchange bureaus, 3 money remittance providers and 2 credit reference bureaus. According to the Central bank of Kenya report on banking sector performance for the quarter ended 31 December, 2013, there are a total of 43 licensed commercial banks in the country

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and one mortgage finance company. Out of the 43 commercial banks, 29 are locally owned and 14 are foreign owned.

The locally owned commercial banks comprise 3 banks with significant shareholding by government and state corporations and 26 local commercial banks being privately owned. However out of all the banks only 10 of them are listed in the Nairobi Securities Exchange having met the conditions of listing and applied for the same. As at 31 December 2013 the financial performance aspects of commercial banks as well as financial risks management was guided by the CBK prudential guidelines issued in January 2013. Commercial banks in Kenya are required by CBK to submit audited annual reports which include their financial performance and in addition disclose various financial risks in the reports including credit risk, interest rate risk, foreign exchange risk, liquidity risk as well as capital management risk on a yearly basis by 31 March of every year. The Kenyan banking sector registered improved performance in 2013 by registering a 15.9 percent growth in total net assets from Ksh. 2.33 trillion in December 2012 to Ksh. 2.70 trillion in December 2013. (Source: Central Bank of Kenya).

1.2 Research Problem

Financial risk is inherent in every commercial bank, but commercial banks that embed the right financial risk management strategies into business planning and financial performance management are more likely to achieve their strategic and operational objectives. Taking financial risk management is core to the Bank’s financial performance. The bank’s aim is

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therefore to achieve an appropriate balance between risk and return and minimize potential adverse effects on its financial performance.

This requires more dynamic and sound Financial Risk Management methods to perform well in an ever dynamic and highly competitive banking industry, which will translate into having a competitive advantage and thus generate growth in profits. Some aspects of risks present opportunities through which firms can have a competitive edge over others and contribute to improvement of financial performance (Stulz, 1996). Literature on financial risk management suggests that firms with better financial risk management strategies tend to have better financial performance. By relating financial risk management to financial performance, commercial banks can have an insight into the value of financial risk management.

The recent financial crisis and the failure of banking system even in the developed countries like the USA have forced the policy makers and researchers to look into the details of these failures and in doing so, financial risk has come out as one factor that need to be addressed by banks to guarantee their sustenance. Therefore a bank must determine what its level of financial risk is and then implement a financial risk management requirement that would cover that risk (Ferguson, 2008).

A study by consultancy firm Ernst & Young and the Institute of International Finance (2013) asserts that banks, having moved to enhance the structure of risk management post-crisis, are still working to fully operationalize those policies with most banks still finding it difficult to embed risk appetite. Banks are reviewing their cultures across legal entities and business

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units following several high-profiles conduct scandals. There is a much greater focus beyond financial risk to operational risk and reputational risk, including the issue of risk appetite. Risk transparency in banks is driving further enhancement of stress testing and sizable further investment in IT and data. The study further notes that banking business models are being rethought in light of the regulatory changes, leading to exiting from activities, businesses, markets and geographies. Almost universally, risk governance is more central to the management of banks and has much more senior management and board attention placed on it than was the case pre-crisis.

The Kenyan Financial Sector is considered as one of the key segments of the economy. According to the CBK, the banking sector employs more than 60,000 employees and the volume of transactions in terms of monetary value has been growing at an average of 10.5% pa since 2005. The Kenyan vision 2030 blue print identifies financial sector stability as of the attainment of the objectives of the strategy and point out that the sector should grow by 8% over the next 20 years to help the country achieve its objective. This can only be achieved if there is growth in and stability in the financial sector and cases of the institutions insolvency or financial crisis happening should be prevented at all cost. Financial risk management helps lessen the chances that a bank may become insolvent if sudden shocks occur.

The Central Bank of Kenya (CBK) reported that more than 90% of banks in the country were reporting reduced losses as a result of increased risk management and that almost all claimed risk awareness had increased at their institutions. In a survey of banks and mortgage institutions in Kenya, the CBK contacted 43 significant institutions to “assess the adequacy

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and impact of risk management guidelines” the central bank had issued in 2005. The development of risk management as an autonomous function in particular has been rapid, with 95% of institutions surveyed saying they had created “independent and well-funded risk management functions”.

Empirical studies done in Kenya have focused in credit risk management and among them are credit risk management by coffee coops in Embu district (Njiru, 2003), survey of credit risk management practices by pharmaceutical manufacturing firms in Kenya (Nduku, 2007) and assessment of credit risk management techniques adopted by microfinance institutions in Kenya (Mwirigi, 2006). To the researchers best knowledge there is limited empirical evidence on the relationship between financial risk management and performance of commercial banks in Kenya. This study seek to fill the existing research gap by answering the following research question, does there exist a relationship between financial risk management and financial performance of commercial banks in Kenya?

1.3 Research Objective

To determine the relationship between financial risk management and financial performance of commercial banks in Kenya

1.4 Value of the Study

The study provides useful information to policy makers and regulators to design targeted policies and programs that will actively stimulate the growth and sustainability of the

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