The Effect of Market Risk on Financial Performance of Commercial Banks in Kenya

Jane Gathigia Muriithi

doi:10.11648/j.jfa.20160404.18

Abstract

Despite the growth in the Kenyan banking sector, market risk still remains a major challenge. The objective of study was to assess the effect of market risk on financial performance of commercial banks in Kenya. The study covered the period between year 2005 and 2014. Market risk was measured by degree of financial leverage, interest rate risk and foreign exchange exposure while financial performance was measured by return on equity. The study used the balance sheets components and financial ratios for 43 registered commercial banks in Kenya. Panel data techniques of random effects, fixed effects estimation and generalized method of moments (GMM) were used to purge time–invariant unobserved firm specific effects and to mitigate potential endogeneity problems. The pairwise correlations between the variables were carried out. F- test was used to determine the significance of the regression while the coefficient of determination, within and between R<sup>2</sup>, were used to determine how much variation in dependent variable is explained by independent variables. From the results financial leverage, interest rate and foreign exchange exposure have negative and significant relationship with bank profitability. Based on the study findings, it is recommended that commercial banks especially locally owned are required to consider finding ways of mitigating the market risks by use of financial instruments such as financial derivatives and be active in derivatives markets. These may reduce their interest rate risk and foreign currency risk exposure. The commercial banks are also required to monitor the financial leverage so as to reduce the financial risk.

Highlights

The banking sector is the backbone of the Kenyan economy and it is a critical vehicle that links the Kenyan economy to the rest of the world
The research study employed Time Series Cross Sectional (TSCS) research design that was used to show the effect of the financial risks on the financial performance of commercial banks in Kenya. (TSCS) research design is a quasiexperimental research design that reference [14] explained that TSCS designs have long been considered as one of the best designs for the study of causation, next to a purely random experiment
The study presents the findings as follows; (1) each long run model is presented separately and its post-estimation diagnostics discussed to establish the reliability of the findings (2) the study discriminates between the long run models using Hausman test (3) the study presents the naïve OLS and fixed effects estimates of the short run specification to establish the range where the coefficient of lagged return on equity should lie in the generalized method of moments (GMM) specification (4) the study estimates and presents the GMM specification while presenting the instruments used and discussing the postestimation diagnostics of the GMM model

Summary

Introduction

The banking sector is the backbone of the Kenyan economy and it is a critical vehicle that links the Kenyan economy to the rest of the world. In the process of providing financial services, banks may be affected by various kinds of financial risks among them being market risk. Market risk refers to the risk to an institution resulting from movements in market prices, in particular, changes in interest rates, foreign exchange rates, and equity and commodity prices. Form of market risk arises where banks accept financial instruments exposed to market price volatility as collateral for loans [14]. A 1995 survey of major financial firms in Unites States of America (USA) revealed that at least 90% are using some form of financial engineering to manage market risks which are interest rates, foreign exchange or commodity price risks [2]. Insurance firms, savings and loans firms are active in derivatives markets. There is substantial commonality in the underlying rationale for the use of derivatives and the financial engineering techniques that are employed the types

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Conclusion