Basel II Operational Risk Management and Financial Performance of Commercial Banks in Kenya

Abstract

Today’s banking business is faced with many operational risks. This makes their management to adopt various modalities among them Basel II Accord to minimise them. The purpose of this study was to establish the effects of Basel II operational risk management on financial performance of commercial banks in Kenya. This was achieved through testing the effect of five variables on financial performance; financial fraud, regulatory non-compliance penalties, business disruption & utility outage, operational risk legal liability cost and employment practices & workplace safety non-compliance costs. The population of the study comprised of all the 42 commercial banks in Kenya as at 31st June 2017. A sample of 38 commercial banks was obtained through stratified random sampling to ensure that all the differential features of tier I, tier II and tier III commercial banks were captured in this survey. The study utilized both primary and secondary data, where primary data was obtained through self-administered questionnaires which were completed by either banks’ security officers in charge of fraud investigations, or internal auditors or operations managers depending on the tier of the bank. Secondary data was obtained from Central Bank of Kenya annual reports. The study adopted descriptive research design while data was analysed using Statistical Package for Social Sciences (SPSS) version 22 and STATA version 15 to obtain statistics like averages, percentages, standard deviation, correlation coefficients and significance among others. The study adopted profits before tax, return on assets and return on equity to measure financial performance. The findings from the study were presented using frequency distribution tables and line graphs to give visual impression. Paired t-test analysis was performed to examine the weight of each operational risk variable against the financial performance variable before and after Basel II implementation while Pearson correlation analysis was performed to establish the relationship between the independent variables and dependent variables. The hypothesis testing was conducted at 5% level of significance. The correlation results indicated that out of the five variables only financial fraud cost had a significant (p value = 0.041) negative (r = - 0.168) on financial performance of commercial banks. The negative correlation among all the five variables and financial performance means that a significant increase in any of these variables would result to decrease in financial performance and vice versa. The paired t-test findings indicated that the average profit before tax increased by KES 457M but could not entirely be attributed to Basel II implementation as explained by the p value of 0.791 > 0.05. While decrease in return on assets by 0.96% and return on equity by 5.02% could be attributed to Basel II implementation (p value of 0.000 and 0.013 respectively). This study recommends that commercial banks’ management invests in enhanced ICT related fraud controls which should be entrenched in the commercial banks’ ICT processes relating to mobile banking and internet banking in order to reduce system hacking frauds by external computer fraudsters as this was the major cause of fraud which consequently reduces profitability of a bank.