EFFECT OF FINANCIAL RISK MANAGEMENT ON FINANCIAL

PERFORMANCE OF ISLAMIC BANKS IN KENYA

A RESEARCH PROJECT PROPOSAL PRESENTED IN PARTIAL

FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF THE
DEGREE OF MASTER OF BUSINESS ADMINISTRATION SCHOOL OF
BUSINESS, UNIVERSITY OF NAIROBI

SEPTEMBER 2016
 DECLARATION

This research project proposal is my original work and has not been submitted to any
other university for award of a degree.

Signature………………………………………….Date………………………………….

This research project proposal has been submitted for examination with my authority as
the university supervisor

Signature………………………………………….Date………………………………….

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 TABLE OF CONTENTS

DECLARATION................................................................................................................ i
ABBREVIATIONS AND ACRONYMS ........................................................................ iii
CHAPTER ONE: INTRODUCTION ............................................................................. 1
1.1 Background of the Study .............................................................................................. 1
1.1.1 Financial Risk Management............................................................................... 2
1.1.2 Financial Performance of Banks........................................................................ 3
1.1.3 Risk Management and Financial Performance.................................................. 4
1.1.4 Islamic Banking in Kenya.................................................................................. 4
1.2 Research Problem ......................................................................................................... 5
1.3 Research Objective ....................................................................................................... 7
1.4 Value of the Study ........................................................................................................ 7

CHAPTER TWO: LITERATURE REVIEW ................................................................ 8

2.1 Introduction ................................................................................................................... 8
2.2 Theoretical Review ....................................................................................................... 8
2.3 Determinants of Financial performance in Commercial Banks .................................. 12
2.4 Empirical Review........................................................................................................ 14
2.5 Summary of Literature Review ................................................................................... 16

CHAPTER THREE: RESEARCH METHODOLOGY ............................................. 18

3.1 Introduction ................................................................................................................. 18
3.2 Research Design.......................................................................................................... 18
3.3 Population of Study..................................................................................................... 18
3.4 Data Collection ........................................................................................................... 18
3.5 Data Analysis .............................................................................................................. 19

REFERENCES ................................................................................................................ 21
APPENDICES ................................................................................................................. 26
Appendix 1: List of Commercial banks offering Islamic banking services...................... 26

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 ABBREVIATIONS AND ACRONYMS
APT Arbitrage pricing theory
CAPM Capital asset pricing model
CAR Capital adequacy ratio
CBK Central bank of Kenya
COSO Committee of Sponsoring Organizations
ERM Enterprise Risk Management
IMF International monetary fund
NIM Net interest margin
ROA Return on Assets
ROE Return on Equity
US United States

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 CHAPTER ONE: INTRODUCTION

1.1 Background of the Study

Financial risk management is the practice of creating economic value in a firm by using financial
instruments to manage exposure to risk, particularly credit risk and market risk. Other types
include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to
general risk management, financial risk management requires identifying its sources, measuring
it, and plans to address them. Financial risk management can be qualitative and quantitative. As
a specialization of risk management, financial risk management focuses on when and how to
hedge using financial instruments to manage costly exposures to risk (Tapiero, 2004).

The concept of financial risk management is anchored on enterprise risk management theory,
modern portfolio theory, capital asset pricing theory and arbitrage pricing theory. Enterprise Risk
Management (ERM) is a framework that focuses on adopting a systematic and consistent
approach to managing all of the risks confronting an organization. Modern portfolio theory
(MPT) is a theory of investment which attempts to maximize portfolio expected return for a
given amount of portfolio risk, or equivalently minimize risk for a given level of expected return,
by carefully choosing the proportions of various assets (Mignola & Ugoccioni, 2006). The
capital asset pricing model (CAPM) helps us to calculate investment risk and what return on
investment we should expect while the arbitrage pricing theory predicts a relationship between
the returns of a portfolio and the returns of a single asset through a linear combination of many
independent macro-economic variables.

For many years, Islamic banks have witnessed double digit growth rates, surpassing their
conventional peers. According to Kearney (2014), at first it seemed all well for Islamic banking
industry. There was ample room for growth as Islamic banking rarely exceeds a third of total
market share. Several potential markets with large muslim population remain largely untapped.
Such include India and the common wealth of independent state countries, made up of former
soviet republics. In addition, overall banking penetration in many of country’s core markets is
still low, with low banking penetration levels in many core industry markets.

1
1.1.1 Financial Risk Management
Financial risks are only one category of a broad field of risks. Furthermore financial risks can be
classified into three subclasses credit risk, liquidity risk, and market risk. Market risk can be
classified into four broad classes, foreign currency, interest rate, commodity, and equity risk. For
financial risk management there are many different kinds of definitions. Some researchers define
it whether very broadly or narrowly which leads that there is no globally accepted definition of
financial risk management (Yakup & Asli, 2010). However financial risk is such a complex and
extensive concept that financial risk-management practitioners need often specialize themselves
only to certain part of financial risk management as for instance foreign exchange risk.

However Ekwall (2010) has relatively narrow view to risk management, he finds risk
management as the risk handling process. Panos et al (2009) define risk management as the
process whereby decisions are made to accept a known or anticipated risk and/or the
implementation of actions to reduce the effects or likelihoods of those risks. Furthermore in
Jansson and Norrman’s (2004) view risk management leads to avoiding, reducing, transferring,
sharing or taking the risk. Also it is good to notice that risk management is a very broad term due
to the wide range of risks and thus there are several categories of risk management as financial
risk management operational risk management, supply chain risk management (Mishkin, 2007).
Boston Consulting Group (2001) defines financial risk management as a sequence of four
processes which include identification of events into one or more broad categories such as
market, credit, operational and other risks into specific sub-categories assessment of risks using
data and risk mode, monitoring and reporting of the risk assessments on a timely basis and
control of these risks by senior management. Jansson and Norrman (2004) define risk
management process as focusing on understanding the risks, and minimizing their impact.
Kuusela and Ollikainen (1998) describe the risk management process as Risk identification,
measurement and analyzing, controlling and finance, evaluation and cost calculations.

Financial risk management has become a booming industry starting ’90 as a result of the
increasing volatility of financial markets, financial innovations (financial derivatives), the
growing role played by the financial products in the process of financial intermediation, and
important financial losses suffered by the companies without risk management systems (for
example, Enron and WorldCom), (Gheorghe & Gabriel, 2008). Shafiq and Nasr (2010) also

2
notes that Risk Management as commonly perceived does not mean to minimize risk; in fact, its
goal is to optimize the risk-reward trade off. And, the role of risk management is to assure that
an institution does not have any need to engage in a business that unnecessarily imposes risk
upon it.Talel (2010) notes that risk management is still evolving in Kenya and therefore many
institutions lack adequate information on effective risk management methodologies

1.1.2 Financial Performance of Banks

The financial performance of commercial banks is of great importance on its future operating
activities. The financial performance of any institution cannot be found without analyzing its
financial statements. Performance is gauged by net income and cash from operations. The
financial performance of banks and other institutions has been measured using a combination of
ratio analysis, benchmarking, measuring performance against budget or a mix of these
methodologies (Avkiran, 1995).

Profitability ratios are often used as indicators of credit analysis in banks, since profitability is
associated with result management performance. ROE and ROA are the most commonly used
ratios. Foong (2008) indicated that efficiency in banks can be measured using ROE which
illustrates to what extent banks use reinvested income to generate future profits. Joetta (2007)
presented the purpose of ROE as a measurement of amount of profit generated by the equity in
the firm. He also mentions that ROE is an indicator of the efficiency to generate profits from
equity. This capability is connected to how well the assets are utilized to produce profits as well.
The firm’s credit policies have an integral influence on the level debtors, measuring the
manager’s position to invest optimally in its debtors and be able to trade profitably with
increased revenue (Van Horne, 1998).

According to Khrawish (2011), profit is the ultimate goal of commercial banks. All the strategies
designed and activities performed thereof are meant to realize this grand objective. However, this
does not mean that commercial banks have no other goals. Commercial banks could also have
additional social and economic goals. However, the intention of this study is related to the
financial performance aspect of Islamic banks in Kenya. To measure the financial performance of
commercial banks there are variety of ratios used, of which, Return on Asset (ROA) and Return on
Equity (ROE) are the major ones. ROE is a financial ratio that refers to how much profit a company

3
earned compared to the total amount of shareholder equity invested or found on the balance sheet.
ROE is the ratio of Net Income after Taxes divided by Total Equity Capital. ROA is also another
major ratio that indicates the profitability of a bank. It is a ratio of income to its total asset. It
measures the ability of the bank management to generate income by utilizing company assets at their
disposal (Khrawish, 2011).

1.1.3 Risk Management and Financial Performance

Commercial banks like other businesses are well advised to use sound risk management practices
when planning for the future so as not to deplete the resources of the company. Harker and
Satvros, (1998) argued that commercial banks could not survive with increased losses and
expense ratios. Preventing losses by taking precautionary measures is a key driver of profitability
and a key element in reducing risks. Kersnar (2009) asserted that financial institutions have a
direct financial interest in reducing losses through preventing accidents and other adverse
activities and ensuring that if one occurs, its effects on the organization’s wellbeing are
minimized.

Given the importance of risk management in the functioning of financial institutions, the
efficiency of a bank’s risk management is expected to significantly influence its financial
performance. An extensive body of banking literature (Santomero & Babbel, 1997) argues that
risk management is paramount to the financial performance of banks. According to Pagano
(2001), risk management is an important function of banking institutions in creating value for
shareholders and customers. The corporate finance literature has linked the importance of risk
management with the shareholder value maximization hypothesis. This suggests that a firm will
engage in risk management policies if it enhances shareholder value (Ali & Luft, 2002).

1.1.4 Islamic Banking in Kenya

In Kenya, Islamic banks are not separately defined in the Banking Act. All banks including those
operating pursuant to Islamic Banking principles are subject to the requirements of the Banking
Act. Indicators in the first year of operations of the two fully-fledged Islamic banks pointed to
potential for Islamic banking in Kenya. There is still room to grow this market niche given
tremendous expansion of Kenya’s banking sector for instance, the number of bank accounts
tripled from 2.6 million in 2005 to 7.5 million in 2009 (Gulf African Bank, 2014). Currently
there are 2 fully fledged Islamic Banks and five commercial banks offering Islamic bank product

4
and services in Kenya (CBK, 2015). Islamic Banking prohibits interest but allows profit sharing.
Therefore Sharia compliant financing products have element of “trading” and “holding of fixed
assets” as the bank has to buy and sell financed assets. However, Section 12 of the Banking Act
restricts trading and holding of fixed assets and thus the Banking Act was amended in 2006 to
enable exemption of innovative products such as Sharia compliant banking financing products
from trading and holding of fixed assets restrictions.

Barclays' La Riba account was the first-ever Shari'ah-compliant account in Kenya. The account
was set up in December 2005. However, Kenya’s first Islamic bank, First Community Bank
(FCB) was granted a banking license in May 2007. The bank started operations in May 2008.
Apart from FCB, Gulf African Bank is the other bank in Kenya with a license to operate as a
fully-fledged Islamic bank. Other banks in Kenya such as Kenya Commercial Banks, Barclays
Bank, Standard Chartered Bank, Chase Bank and National Bank have Islamic windows. The
study is focusing on Islamic Banking because much of the research that has been done on the
effect of risk management on financial performance has been on conventional banks. Therefore,
there exists knowledge on how risk management in Islamic Banks affects their financial
performance as they employ different banking approaches from conventional banks (CBK,
2015).

1.2 Research Problem

Financial risk management is an integral part of a bank’s operations. It involves integrating risk
management practices into the processes, systems and culture of the institution. Financial
institutions face increasing pressure from various stakeholder groups to effectively manage their
operational risks and to report their performance transparently across such risk management
initiatives (Basel Committee on Banking Supervision, 2014). By linking operational risks,
management and performance, banks can effectively and efficiently appreciate the value of
implementing risk-based management framework. Such appreciation is critical for an
organization to consistently invest resources in improving and evolving its operational risk
management framework in order to drive strategy, resource allocation and other decisions
necessary for it to achieve its organizational objectives (Payle, 1997).

5
Financial institutions have faced numerous difficulties over the years for a multitude of reasons.
The major causes of serious banking problems continue to be directly related to poor risk
management practices, lax credit standards for borrowers and counterparties or lack of attention
to changes in economic or other circumstances that lead to deterioration in the credit standing of
a bank’s counterparties (Gil-Diaz, 2008). Despite these facts, over the years there has been an
increase in the number of significant bank problems in both, matured as well as emerging
economies (Basel Committee on Banking Supervision, 2014). Banks should now have a keen
awareness of the need to identify, measure, monitor and control various risks for survival as well
as their progress (Oloo, 2009).

Some of the global studies on risk management and financial performance include BNM (2008)
who established that the sturdiness of the financial institutions is of vital significance as observed
during the most modern US financial crisis of 2008. The IMF (2008) anticipated total losses to
reach $945 billion globally by April 2008. World's largest banks announced write-downs of $274
billion in total on the first anniversary of the credit crunch. While US subprime mortgages and
leveraged loans may reach $1 trillion according to some estimates of July 2008 (Kollewe, 2008).
A new rulebook by the name of Basel III was formulated as a repercussion of the 2007-2009
financial crises so as to take in a number of measures in order to reinforce the resilience of the
banking sector (BCBS, 2009). The review of the local studies shows that there have been several
studies on risk management in Kenya. Kabiru (2002) did a study on the relationship between
credit risk assessment practices and the level of non-performing loans of Kenyan banks. Ongechi
(2009) analyzed the risk management strategies used by Fina Bank Limited in lending to SMEs.
Kithinji (2010) analysed credit risk management and profitability of commercial banks in Kenya.
Muasya (2009) analyzed the impact of non- performing loans on the performance of the banking
sector in Kenya in the time of global financial crises while Wanjira (2010) studied the
relationship between non- performing loans management practices and financial performance of
commercial banks in Kenya. These studies have primarily focused on the practices used by
commercial banks in dealing with credit risk management aspects with no reference to Islamic
Banks. Yet there are unique risks associated with Islamic Banks such as shariah non-compliance
risk, displaced commercial risk, equity investment risk and rate of return risk. None of the
studies have dealt with the comprehensive risk management practices that address all the aspects
of business risks including operational, financial, compliance and governance risks and their
effect on the financial performance of the Islamic banks in Kenya. This study therefore seeks to
6
fill this gap by establishing the effect of financial risk management on the financial performance
of Islamic banks in Kenya. The study therefore seeks to answer the following research question:
What is the effect of financial risk management on the financial performance of Islamic banks in
Kenya?

1.3 Research Objective

The objective of this study will be to assess the effect of financial risk management on the financial
performance of Islamic banks in Kenya.

1.4 Value of the Study

The study will offer valuable contributions from both a theoretical and practical standpoint.
From a theoretical standpoint, it contributes to the general understanding of risk management
and its effect on the financial performance of Islamic banks and by extension other conventional
banks in Kenya.

The study may enable Islamic Banks management in Kenya to improve their risk management
process and to adopt efficient strategies to improve firm financial performance through the risk
management processes. This may enable the Islamic Banks to perform better and to grow their
businesses and maintain a competitive advantage.

The regulator (Central Bank of Kenya) may use this study to design and improve on the current
risk management framework for all commercial banks in Kenya. The study may also add to the
existing body of knowledge on risk management. This may benefit academicians and other
researchers by providing materials that form the basis for further research on risk management in
the banking sector.

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 CHAPTER TWO: LITERATURE REVIEW
2.1 Introduction
This chapter focuses on review of theoretical, conceptual, and empirical literature along the
study’s conceptualization. First, the chapter presents literature on theoretical underpinnings of
the study followed by conceptual and empirical literature on financial risk management and
financial performance of commercial banks. The chapter closes with a summary and knowledge
gap for this study.

2.2 Theoretical Review

This study is anchored on four theories which are reviewed in this section. These theories
include the enterprise risk management theory, modern portfolio theory, capital asset pricing
theory and arbitrage pricing theory.

2.2.1 Enterprise Risk Management Theory

A corporation that chooses to manage risks can do so in two fundamentally different ways: it can
manage one risk at a time, or it can manage all of its risks holistically. The latter approach is
often called enterprise risk management (ERM). According to Tseng (2007), Enterprise Risk
Management (ERM) is a framework that focuses on adopting a systematic and consistent
approach to managing all of the risks confronting an organization. Gordon et al. (2009) on the
other hand defines ERM as the overall process of managing an organization’s exposure to
uncertainty with particular emphasis on identifying and managing the events that could
potentially prevent the organization from achieving its objective. ERM is an organizational
concept that applies to all levels of the organization. According to Committee of Sponsoring
Organizations (COSO) (2004), Enterprise risk management is a process, effected by an entity’s
board of directors, management and other personnel, applied in strategy setting and across the
enterprise, designed to identify potential events that may affect the entity, and manage risk to be
within its risk appetite, to provide reasonable assurance regarding the achievement of entity
objectives.

In conducting ERM, the following are listed as some of the areas or aspects of the organization
that a risk manager needs to look into namely: the people, intellectual assets, brand values,
business expertise and skills, principle source of profit stream and the regulatory environment
8
(Searle, 2008). This will help organization to balance the two most significant business
pressures; the responsibility to deliver succeed to stakeholders and the risks associated with and
generated by the business itself in a commercially achievable way. By doing so, the risk manager
is constantly aware of the risks it faces and therefore constantly monitors its exposure and be
positioned to change strategy or direction to ensure the level of risks it takes is acceptable.

2.2.2 Modern Portfolio Theory

Modern portfolio theory (MPT) is a theory of investment which attempts to maximize portfolio
expected return for a given amount of portfolio risk, or equivalently minimize risk for a given
level of expected return, by carefully choosing the proportions of various assets (Mignola &
Ugoccioni, 2006). Since the 1980s, companies have successfully applied modern portfolio theory
to manage market risk. Many companies are now using value at risk models to manage their
interest rate and market risk exposures. Unfortunately, however, even though credit risk remains
the largest risk facing most companies, the practice of applying modern portfolio theory to risk
has lagged (Linbo, 2004).

Companies recognize how credit concentrations can adversely impact financial performance. As
a result, a number of institutions are actively pursuing quantitative approaches to credit risk
measurement. The banking industry is also making significant progress toward developing tools
that measure credit risk in a portfolio context. They are also using credit derivatives to transfer
risk efficiently while preserving customer relationships. Portfolio quality ratios and productivity
indicators have been adapted (Chopra & Sodhi, 2004). The combination of these developments
has precipitated vastly accelerated progress in managing credit risk in a portfolio context.
Traditionally, organizations have taken an asset-by-asset approach to risk management. While
each company’s method varies, in general this approach involves periodically evaluating the
quality of service exposures, applying a service risk rating, and aggregating the results of this
analysis to identify a portfolio’s expected losses. The foundation of the asset-by-asset approach
is a sound risk review and internal risk rating system (Mignola & Ugoccioni, 2006).

2.2.3 Capital Asset Pricing Theory

William Sharpe (1964) published the capital asset pricing theory (CAPM). Parallel work was
also performed by Treynor (1961) and Lintner (1965). CAPM extended Harry Markowitz's
portfolio theory to introduce the notions of systematic and specific risk. CAPM decomposes a
9
portfolio's risk into systematic and specific risk. Systematic risk is the risk of holding the market
portfolio. As the market moves, each individual asset is more or less affected. To the extent that
any asset participates in such general market moves, that asset entails systematic risk.

Specific risk is the risk which is unique to an individual asset. It represents the component of an
asset's return which is uncorrelated with general market moves (Lintner, 1965). “No matter how
much we diversify our investments, it's impossible to get rid of all the risk. As investors, we
deserve a rate of return that compensates us for taking on risk. The capital asset pricing model
(CAPM) helps us to calculate investment risk and what return on investment we should expect.”
It took nearly a decade after the introduction of CAPM for investment professionals to begin to
view it as an important tool in helping investors understands risk. The key element of the model
is that it separates the risk affecting an asset's return into two categories. The first type is called
unsystematic, or companies-specific, risk. The long-term average returns for this kind of risk
should be zero. The second kind of risk, called systematic risk, is due to general economic
uncertainty. CAPM states that the return on assets should, on average, equal the yield on a risk-
free bond held over that time plus a premium proportional to the amount of systematic risk the
stock possesses (Markowitz, 1952).

The treatment of risk in the CAPM refines the notions of systematic and unsystematic risk
developed by Harry M. Markowitz in the (1950s). Unsystematic risk is the risk to an asset's
value caused by factors that are specific to an organization, such as changes in senior
management or product lines. For example, specific senior employees may make good or bad
decisions or the same type of manufacturing equipment utilized may have different reliabilities at
two different sites. In general, unsystematic risk is present due to the fact that every company is
endowed with a unique collection of assets, ideas and personnel whose aggregate productivity
may vary (Markowitz, 1952).

2.2.4 Arbitrage pricing theory

The Arbitrage Pricing Theory (APT) is described in investopedia as an asset pricing model based
on the idea that an asset's returns can be predicted using the relationship between that same asset
and many common risk factors. It was created in 1976 by Stephen Ross; this theory predicts a
relationship between the returns of a portfolio and the returns of a single asset through a linear
combination of many independent macro-economic variables. It is a one-period model in which
10
every investor believes that the stochastic properties of returns of capital assets are consistent
with a factor structure. It is often viewed as an alternative to the capital asset pricing model
(CAPM), since the APT has more flexible assumption requirements. Whereas the CAPM
formula requires the market's expected return.

APT uses the risky asset's expected return and the risk premium of a number of macro-economic
factors. The theory describes the price where a mispriced asset is expected to be. Arbitrageurs
use the APT model to profit by taking advantage of mispriced securities. A mispriced security
will have a price that differs from the theoretical price predicted by the model. By going short an
overpriced security, while concurrently going long the portfolio the APT calculations were based
on, the arbitrageur is in a position to make a theoretically risk-free profit (Ross, 1976). The basis
of arbitrage pricing theory is the idea that the price of a security is driven by a number of factors.
These can be divided into two groups: macro factors and company’s specific factors. Ross'
formal proof shows that the linear pricing relation is a necessary condition for equilibrium in a
market where agents maximize certain types of utility. The subsequent work, which is surveyed
below, derives either from the assumption of the preclusion of arbitrage or the equilibrium of
utility-maximization. A linear relation between the expected returns and the betas is tantamount
to an identification of the stochastic discount factor. The APT is a substitute for the Capital Asset
Pricing Model (CAPM) in that both assert a linear relation between assets’ expected returns and
their covariance with other random variables (Ross, 1976).

Arbitrage pricing theory does not rely on measuring the performance of the market. Instead, APT
directly relates the price of the security to the fundamental factors driving it. The problem with
this is that the theory in itself provides no indication of what these factors are, so they need to be
empirically determined. Obvious factors include economic growth and interest rates. For
companies in some sectors other factors are obviously relevant as well - such as consumer
spending for retailers. The potentially large number of factors means more betas to be calculated.
There is also no guarantee that all the relevant factors have been identified. This added
complexity is the reason arbitrage pricing theory is far less widely used than CAPM (Sharpe,
2012).

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2.3 Determinants of Financial performance in Commercial Banks

Lyman and Charles (2008) defined financial performance as the operational strength of a firm in
relation to its revenue and expenditure as revealed by its financial statements. The financial
performance of banks is expressed in terms of profitability. Profitability is a company’s ability to
earn a reasonable profit on the owner’s investment.

2.3.1 Capital Adequacy

Capital is the amount of own fund available to support the bank's business and act as a buffer in
case of adverse situation (Athanasoglou et al., 2005). Banks capital creates liquidity for the bank
due to the fact that deposits are most fragile and prone to bank runs. Capital adequacy is the level
of capital required by the banks to enable them withstand the risks such as credit, market and
operational risks they are exposed to in order to absorb the potential loses and protect the bank's
debtors. It has also a direct effect on the profitability of banks by determining its expansion to
risky but profitable ventures or areas (Sangmi & Nazir, 2010).

2.3.2 Bank Size

Demnirguc-Kuntand Huizinga (2000) report that larger banks tend to have higher margins which
lend support to those findings. Short (1979) argues that large banks are generally able to raise
less expensive capital which positively affects profitability. Staikouras and Wood (2004) and
Kosmidou et al (2005) suggest that large banks are likely to enjoy higher economics of scale and
hence be able to produce services at a lower cost and more cheaply and efficiently than can small
banks which would have a positive influence on profitability.

Flamini et al, (2009) argue that large banks with greater domestic market share operating in a
non-competitive environment may enjoy higher profits as they pay lower deposit rates to
depositors who demand lower deposits rates because they perceive big banks to be safer.
Furthermore, Goddard et al (2004) mentions that large banks in highly concentrated market may
obtain abnormal profits if they are able to exert market power in the wholesale or capital
markets.

12
2.3.3 Bank Liquidity
Liquidity implies how quickly a bank can convert its assets into cash at face value to satisfy its
maturing liabilities (those of depositors and borrowers) as they fall due even under adverse
conditions. Banks with sufficient investments in liquid assets have a greater ability to weather
short-term liquidity crisis. Additionally, without adequate cash resources to meet short-term
liquidity requirements, a bank will find it impossible to continue its operation even if its capital
or solvency remains acceptable (Rahman et al, 2009).

However, there remains the question of what is the optimal balance of liquid assets given the
risk-return trade-off of holding a relatively high proportion of liquid assets. Generally, higher
level of liquidity makes banks less vulnerable to failure but is also usually associated with lower
rates of return and may result in lost profitable investment opportunities, which would influence
bank profitability negatively. Martinez Peria and Mody (2013) explain that high liquidity ratios,
either self-imposed for prudential reasons or as a result of regulation (i.e. reserve or liquidity
requirements) inflict a cost on banks since it implies that banks have to give up holding higher
yielding assets.

2.3.4 Management Efficiency

Management Efficiency is one of the key internal factors that determine the bank profitability. It
is represented by different financial ratios like total asset growth, loan growth rate and earnings
growth rate. The performance of management is often expressed qualitatively through subjective
evaluation of management systems, organizational discipline, control systems, quality of staff,
and others. The capability of the management to deploy its resources efficiently, income
maximization, reducing operating costs can be measured by financial ratios. One of this ratios
used to measure management quality is operating profit to income ratio (Sangmi & Nazir, 2010).

The higher the operating profits to total income (revenue) the more the efficient management is
in terms of operational efficiency and income generation. The other important ratio is that proxy
management quality is expense to asset ratio. The ratio of operating expenses to total asset is
expected to be negatively associated with profitability. Management quality in this regard,
determines the level of operating expenses and in turn affects profitability (Athanasoglou et al,
2005).

13
2.3.5 Credit Risk
Credit risk is broadly defined as the risk of financial loss arising from borrowers' failure to honor
their contractual obligations. For banks, credit risk arises principally from lending activities but
also may arise from various other activities where banks are exposed to the risk of counter party
default, such as trading and capital market debt-based securities. The importance of the quality
of bank loans portfolio stems from the fact that poor loans quality may affect bank performance.

Miller and Noulas (1997) suggest that the higher the exposure to high-risk loans, the higher the
accumulation of unpaid loans and the lower the profitability. Duca and McLaughlin (1990),
using a sample of U and S banks conclude that variations in bank profitability are largely
attributable to variations in loan loss provisions as they find little difference between the net
income of the sample banks after netting out loan loss provision Poor asset quality is perceived
to cause capital erosion and increase credit and capital risks.

2.3.6 Microeconomic Factors

The macroeconomic policy stability, Gross Domestic Product, Inflation, Interest Rate and
Political instability are also other macroeconomic variables that affect the performances of
banks. For instance, the trend of GDP affects the demand for banks asset. During the declining
GDP growth the demand for credit falls which in turn negatively affect the profitability of banks.
On the contrary, in a growing economy as expressed by positive GDP growth, the demand for
credit is high due to the nature of business cycle. During boom the demand for credit is high
compared to recession (Athanasoglou et al., 2005).

2.4 Empirical Review

Hakim and Neamie (2001) examined the relationship between credit risk and bank’s
performance of Egypt and Lebanon bank in 1990s. Using data for banks from the two countries
over the period 1993-1999, the study estimated a fixed effects model of bank return with varying
intercepts and coefficients. The findings showed that credit variable is positively related to
performance, while liquidity variable is insignificant across all banks and have no impact on
performance. The study also found a strong link between capital adequacy and commercial bank
return with high capitalization being the hindrance to return. The study concluded that capital is
a sunk cost with large banks realizing high profits in absolute but not in percentage terms. As a
policy implication, the study provides important input for the policymakers in the MENA region

14
to set better performance targets, and enable bank managers to allocate capital more efficiently
across their business units. The study also contributed in terms of how commercial banks can
better employ their current capital and evaluate their future performance.

The study by Drzik (2005) showed that following the 1991 recession, financial institutions
invested heavily in risk management capabilities. These investments targeted financial (credit,
interest rate, and market) risk management. It also showed that these investments helped reduce
earnings and loss volatility during the 2001 recession, particularly by reducing name and
industry-level credit concentrations. He also suggests that the industry faced major risk
challenges (better treatment of operational, strategic, and reputational risks and better integration
of risk in planning, human capital management, and external reporting) that were not addressed
by recent investments and that would require development of significant new risk disciplines.

Ariffin and Kassim (2009) analyzed the relationship between risk management practices and
financial performance in the Islamic banks in Malaysia. In achieving this objective, the study
assessed the current risk management practices of the Islamic banks and linked them with the
banks’ financial performance. The study used both the primary (survey questionnaires) and
secondary data (annual reports). The results of the study shed some light on the current risk
management practices of the Islamic banks in Malaysia. By assessing their current risk
management practices and linking them with financial performance, the study hoped to
contribute in terms of recommending strategies to strengthen the risk management practices of
the Islamic banks so as to increase the overall competitiveness in the Islamic banking industry.

Al-Smadi (2010) applied risk index to measure exposure to risk of several Jordanian banks,
using data over 1995 to 2008. His findings indicated that three major macroeconomic variables
were statistically significant. They were GDP, inflation rate and market interest rate. He
provided evidence that internal variables had effects on credit risk more than external variables.
He found that the relationship between GDP and credit risk was significantly negative, while it
was positive on inflation and also positive on interest rate. There were five bank-specific
variables: NPL, loan concentration in risky sectors, loan growth, bank size and net interest
margin in their study. These five variables had significant relationship with credit risk. Loan
growth and loan concentration in risky sectors had positive effects as well. Bank size had a
negative effect on credit risk.
15
By testing the influence of risk factors in determining banks’ performance, the study by Angbazo
(1997) found that default risk is a determinant of banks’ net interest margin (NIM) and the NIM
of super- regional banks and regional banks are sensitive to interest rate risk as well as default
risk. By investigating the determinants of NIM for 614 banks of 6 European countries and US
from 1988 to 1995, the study finds that interest rate volatility has a positive significant impact on
the banks performance (Angbazo, 1997).

Kithinji (2010) analysed credit risk management and profitability of commercial banks in Kenya
and concluded that the bulk of the profits of commercial banks was not influenced by the amount
of credit and non-performing loans suggesting that other variables other than credit and non-
performing loans had an impact on profits. Muasya (2009) analyzed the impact of non-
performing loans on the performance of the banking sector in Kenya in the time of global
financial crises. The findings confirmed that non- performing loans do affect commercial banks
in Kenya.

Wanjira (2010) studied the relationship between non- performing loans management practices
and financial performance of commercial banks in Kenya. The study concluded that there was a
need for commercial banks to adopt non-performing loans management practices. Kimutai,
(2006) investigated risk management in the Kenya Oil industry. The study established that the
Working Capital (WC) requirement had gone up because of rising crude prices and upfront taxes
payments and secondly unit margins had shrunk overtime. As a survival strategy the industry
was forced to diversify to other means and ways to stay afloat. From the foregoing, oil sector due
to its nature had to engage in credit for market share and sales volume. The multiplier effect was
credit risk coupled with high liquidity needs.

2.5 Summary of Literature Review

From this chapter the financial risk management in the banking sector cannot be understated.
Risk management is nowadays considered as a key activity for all companies. Many of the
disastrous losses through the bank crisis would have been avoided if good risk management
practices have been in place. All the previous studies established that banks should have proper
risk management function and better risk management techniques so as to lead to better financial
performance. The concept of financial risk management involves studying the various ways by
which businesses and individuals raise money, as well as how money is allocated to projects
16
while considering the risk factors associated with them. Since, most of the previous studies are
theoretical; the current study aims to fill the gap in the literature by focusing on the effect of
financial risk management on the financial performance Islamic banks in Kenya.

17
 CHAPTER THREE: RESEARCH METHODOLOGY

3.1 Introduction
This chapter deals with how the research will be conducted in order to achieve the stated
objective. It presents the research design and methodology that will be used to carry out the
research. The chapter also discusses the study population, data collection methods and data
analysis techniques.

3.2 Research Design

For the purpose of this study, the research design that will be used is descriptive survey research
design. Mugenda and Mugenda, (2008) stated that the descriptive research design is a method
which enables the researcher to summarize and organize data in an effective and meaningful
way. The design is appropriate for this study as it helps to describe the state of affairs as they
exist without manipulation of variables which is the aim of this study (Kothari, 2004). A
descriptive study determines the frequency with which something occurs and investigates the
relationship between two or more variables, and in this case, the study will investigate the effect
of financial risk management on the financial performance of Islamic banks in Kenya.

3.3 Population of Study

The population of this study will be the all the seven (7) commercial banks that have Islamic
banking services. Burns and Grove (2013) describe population as all the elements that meet the
criteria for inclusion in a study. The population of this study will be all commercial banks
offering Islamic banking products in Kenya. They comprise of two fully fledged Islamic banks
(Gulf African Bank and First Community Bank) and five conventional banks that has Islamic
windows; Barclay’s banks, National Bank, Chase Bank, Kenya Commercial Bank and Standard
Chartered Bank. The period of study will be five years from 2011 up to 2015.

3.4 Data Collection

For the purpose of this study, the researcher will use only secondary data. The secondary data
will include: return on assets, liquidity ratio, ratio of interest sensitive assets, value of interest
sensitive liabilities, regulatory capital, total risk weighted assets, and total bank assets. The
secondary data will be obtained from the published annual reports spanning five years (2011 -

18
2015) for the Islamic banks and conventional banks with Islamic windows in Kenya. The study
will adopt panel data model in data collection and analysis.

3.5 Data Analysis

Data collected will be edited, coded and classified into different components to facilitate a better
and efficient analysis. In analysing the quantitative data, the study will use descriptive statistics
using Statistical Package for Social Sciences (SPSS). Measures of central tendency (mean),
measures of dispersion (standard deviation), frequencies and percentage will be applied for
quantitative variables (Kothari, 2004). Tables and other graphs will be used as appropriate to
present the data findings. Qualitative data will be analysed using multi-variate regression
analysis with financial performance as the dependent variable.
3.5.1 Regression Model
The regression model to be tested will be:

Y = β0 + β1 X1 + β2 X2 + β3 X3 + β4 X4 + β5 X5 + β6 X6 + ε

Where:
Y = Financial performance (as measured by ROA)

β0 = constant: It defines the level of credit rating without inclusion of predictor variables

β1 – β5 = regression coefficients

X1 = Credit risk
X2 = Insolvency risk
X3 = Interest sensitivity ratio
X4 = Capital adequacy
X5 = Operating efficiency
X6 = Control variables

ε = Unexplained Variables i.e. error term, it represents all the factors that affect the dependent
variable but are not included in the model either because they are not known or difficult to measure.

19
3.5.2 Operationalization of Study Variables
Variable Measure
Y Financial performance ROA (Return on Assets) = [net income / total assets]
X1 Credit risk [NPLs / Financing Book]
X2 Insolvency risk liquidity ratio= [liquid assets / total deposits]
X3 Interest sensitivity ratio [ratio of interest sensitive assets/ interest sensitive liabilities]
X4 Capital adequacy [core capital / total risk weighted assets]
X5 Operating efficiency operating expenses/ net operating income
X6 Control variables size of the bank

3.6.3 Test of Significance

Significance of Islamic banking variables as predictors of financial inclusion will be tested using
the t-test. The significance of the overall model in explaining financial inclusion through the
independent variables will be measured through the F-test.

20
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25
 APPENDICES
Appendix 1: List of Commercial banks offering Islamic banking services

1. First Community Bank Limited

2. Gulf African Bank
3. Kenya Commercial Bank
4. Barclays Bank of Kenya
5. Standard Chartered Bank
6. Chase Bank
7. National Bank

26