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

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. Ftest was used to determine the significance of the regression while the coefficient of determination, within and between R2, 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.