Effect of financial risk on financial performance of commercial banks in Kenya

Abstract

Banking sector in Kenya is exposed to various risks which originate from both the internal and external environment. Banks financial viability and long-term sustainability are threatened by financial risk. Market risk, credit, liquidity and operational risks possess a major challenge despite growth in the sector. This study sought to explore the effect of financial risk on financial performance of commercial banks in Kenya. The quantitative research design was adopted in the study. The target population of this study was the 43 commercial banks licensed by CBK by December 2014. Time Series Cross Sectional unbalanced secondary panel data was anlysed. The data was obtained from published financial statements of accounts of all 43 commercial banks in Kenya, CBK, and the Banking survey publications for ten years from 2005 to 2014. The study used financial ratio analysis and panel data techniques of random effects, fixed effects estimation and generalized method of moments, GMM to purge time–invariant unobserved firm specific effects and to mitigate potential endogeneity problems. The pairwise correlations between the variables were carried out. Wald and F- tests were used to determine the significance of the regression while the coefficient of determination, overall, within and between R2, were used to determine how much variation in dependent variable is explained by independent variables. Chow and Breusch and Pagan Lagrange multiplier (LM) tests were used to test whether the fixed effects model is better than pooled OLS model and the appropriateness of the random-effects model relative to the pooled OLS model respectively. The findings of the study indicated that credit, market, liquidity and operational risks have significant negative effect on return on equity. The component of financial risk that had the most impact on financial performance was cost to income ratio. The conclusion of the study was that there exist inverse relationship between financial risk and financial performance of Kenyan commercial banks. Hence the commercial banks together with the bank supervisors should make a trade-off between financial risk and financial performance.