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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