CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Roles that banks undertake in the financial system create important question in understanding issues arising in finance. The coherence of the chain of activities where surplus finances are moved into fruitful ventures is paramount for development. Financial institutions facilitate ease of this chain of events (Franklin and Elena,2008). Commercial banks play a crucial role of regulating and mobilizing finances from surplus financial units (holders) to insufficient financial entities (borrowers). They undertake the intercessor function that has uninterrupted consequence on the productivity and financial wellbeing of a country. (Wainaina 2013)

To enable banks, carry out their roles in an economy Allayannis et al (2001) argued that management of risk is a central part in every banks decision involving foreign exchange rate and currency exposure. Determination of balance of trade is based on the variation of shilling rate, where shilling rates as any goods are built on the fair market drivers of demand and supply of foreign money. Local currency supply fluctuates due to a country’s fiscal and monetary strategies (Berger & Bouwman, 2010). The request for currency is brought forth by various causes namely: inflation, interests rates, government regulations to mention but a few. Macroeconomic and industry related factors also potentially influence the return on stocks of companies. Increases in the intercountry sale of goods and wealth changes has forced exchange rates a major determinant of business profitability and equity prices (Bradley and moles, 2002). Changes in exchange rates creates an unsafe environment since existence of reservations about potential profits and outflows. This is particularly manifested in those nations with no financial tools to protect from exchange exposure. This is as evident in Kenya which is a developing country (world bank & MTTI,2006). 

1.1.1 Exchange Rate Volatility Risk

Direct or simple nominal exchange rate can be termed to be the cost of a single unit of foreign money in units of the home money (Nydahl, 1999). Foreign exchange risk is referred by Butler (2008) as the peril associated with unanticipated fluctuations in conversion rates. He goes further to mention that exchange exposure is the degree to which unpredicted variations in exchange rates affect the worth of a company’s properties and obligations.

Private investment is considerably and adversely affected by improbability and macroeconomic unpredictability as indicated by econometric evidence of investment behavior and conventional factors such as real interest rates, historical advance of economic undertakings and private segment credit (Savedi, 2013). On the same note, (Gilchris, 2013) says that FX changes impacts on the performance of banks whose role in an economy is to allocate economic resources from depositors to investors. However, banks can only undertake this important role if the operational costs they incur during operation is covered through generation of necessary income. There is an association that ensues between rates instability and poor profitability of banks.

Inflation and inflationary expectations can press interest rate upward which affects landing terms resulting to reduced credit demand and lending ability of commercial banks (Keynes, 2006). Exchange rates affect interest rates and have an indirect impact on profitability through cost of loanable funds. There is an increase of value in commercial banks arising from the sale of foreign currency at a high exchange rate that results to increased profitability. This said, it may explain the contribution of changes and volatile exchange to the debt profile of banks and reduction of profit level of borrowers (Owoeye & Ogunmakin, 2013). Where the cost of the current obligations depreciates, transaction risk occurs. On the other hand, transactional exposure occurs due to future receipts and is experienced when the price of the prevailing commitment is impacted by changes in exchange rates. Where there are unexpected changes in exchange rate, economic risk is experienced characterized by adverse impacts on income of both domestic and foreign operations. Changes in the marketplace situation of a firm owing to impacts of FX changes on charges, call and rivalry is known as operational exposure (El-Masry,2006).

Translation risk refers to risk associated with assets from multinational enterprises while translation exposure is experience due to mismatch of currency and is also related to income from offshore enterprises (Madura, 2003). Foreign exchange risk is brought forth by the disparity on securities owned by a bank and its capital. A negative change in the local currency against the USD results to an upsurge in the interest rates. This leads to the bank being deemed as un-creditworthy and cause loss of revenue (moles ,2012).

In conclusion, the main function of commercial banks is resource allocation, that is creating a conduit of funds from lenders to borrowers. This is done to produce enough income to protection for operating costs incurred during operation. This basically means that banks have to make profits. Going further, their performance is critical and vital to the development of countries.  Due to profitability shareholders get rewarded and increase their finances from outside bringing about growth in the economy, consequently, bad or poor performance will result to a banking crisis which will lead to falling economic growth (Panayiotis et al, 2006).

1.1.2 Financial Performance

It’s an evaluation of a company’s reports done for given period where there is comparison of firms across the same industry. According to Murthy and Sree (2003), financial performance refers to the ability to leverage operational and investment decisions and strategies to achieve a business’ financial stability. It’s used as a bar to measure the achievements of a bank’s financial goals guided by its financial objectives and benchmarks. The paramount objective of any firm is to make profits. There are a number of ratios for measuring profitability such as; Net Interest Margin, ROA and ROE.

The ROA ratio evaluates the easiness and efficiency of a company’s asset management capabilities and how they in turn use this to make profits. It measures the profit earned against investments on total assets. Calculation for this is: Net Income /Total Assets (Brealey et al, 2008). External and internal factors are also crucial to the performance of commercial banks (Al-Tamimi 2010; Aburime, 2005). Internal factors are basically bank precise factors or the bank characteristics that generally touch on the internal decisions made by the management board. External factors on the other hand are sector or industry wide factors beyond a firm’s control. The banking sector is the single sector highly affected by the key macroeconomic variables which include interest rates, inflation and economic growth measured by GDP and therefore their financial performance will mostly depend on macroeconomic stability. Macroeconomic steadiness is the backbone of prosperous efforts to lead to an increased development and economic growth in the private sector. Research across board has shown that investment growth and profitability positively affect macroeconomic stability (Easterly, Islam & Stiglitz, 1999). 

1.1.3 Exchange Rate Volatility Management and Financial Performance

Changes in currency exchange rates can generate significant gains or losses and they could end up in the income statement resulting to a distorted impression of what is happening to the financial institution concerned (Watkins, 2014). There are three ways in which exchange rate fluctuations affect the domestic prices: first and foremost is by import prices, which directly impacts on the local prices, secondly, is by the intermediate imports prices which impacts the local production costs. Finally, is via the prices local commodes in a foreign currency (Gatobu, 2013).

More so unrealized foreign exchange gains/losses according to Gatobu (2013) have impact on incomes of transnational companies in reserves. Foreign exchange variations involve the companies’ import of inputs, creditors, international sales and debtors which affects its income hence affecting reserves. Carter et al (2003) argued that alterations in

FX rate can determine a company’s present and impending anticipated cash flows and eventually, share prices. The course and extent of modifications in FX rate on firm’s worth are a role of a company’s company hedging strategies which illustrates if the company applies operational hedges and financial hedges.

1.1.4 Commercial Banks in Kenya

Commercial banks have been doing very well in Kenya in terms of profitability. Most banks have been having a good performance but a few have been realizing losses.  Failures in this industry in the developed countries have therefore led Kenyan authorities to take precautionary and mitigating measures in a bid to understand how the performance of banks and the macroeconomic factors influences bank profits in accordance to the CBK (2011) Supervision Report, 30 banks out of 43 are locally held while the others are owned by foreigners. 35% of bank assets are owned by the foreign owned banks.

In 2010 the Kenyan shilling exceedingly depreciated losing value against the major world currencies, for example against the USD it averaged 101.270 in Oct 2011 from 81.029 in Jan 2011. Commercial banks took a course of action by diversifying their revenue streams in order to increase their profitability (Macharia, 2013). Recently, many developing countries have embarked on reforming their financial systems, changing their institutions into efficient intermediaries as well as providing viable financial services to sections of the population on a sustainable basis (Seibel, 2011).

1.2 Research Problem 

Jamal and Khalil (2011) exchange rate fluctuations are a paramount foundation of risk for banking institutions where huge exchange losses result to banks failure besides causing huge burdens on banks’ profitability, foreign rates volatility has negatively affect bank performance posing a challenge to commercial banks’ managers in their core function of credit management and profitability (Baum, Mustafa, and Neslihan, 2009).

The rate fluctuations in Kenya over the years varies resulting to the sudden devaluing of KES against other world currencies which has in turn adversely affected the Kenyan economy. This has seen the exchange rate against the USD get to as high as Ks 106 making it difficult for the banks to predict the future rate with precision. This has greatly affected the performance of commercial banks as they seek to provide adequate currency to promote international business by hedging their transactions against foreign exchange losses (Majok, 2015).

Many researches touching on impacts of FX fluctuation based on the performance financially in other nations have been done. For example, Elhiraika and Ismail (2006) based their research on the monetary division policy and poverty decrease in Sudan. They looked at how poverty alleviation has been per the investment in Sudan. Restructurings in the financial area should be heightened in order to develop a pro-poor financial structure which in this case involves both Islamic and conventional microfinance programs. Adam (2012) also examined exchange rate options for South Sudan.

Locally. Maina (2010) did a study on the electric power sector in Kenya and the impact exchange rate variability has on it. His findings show that investments were high in the power subsector when the exchange rates were stable as compared to times of high fluctuations. Njenga (2014) analyzed real FX volatility on Kenya’s economic growth where he established that GDP is positively influenced by exchange rate volatility but is not significant in affecting GDP growth rate. Ramos (2013) studied Kenya’s impact due to FX changes on retail prices. 

Oduori (2012) conducted a study touching on the methods used by banks to combat arising operational, strategic and credit risks while Mutua (2013) studied FX risk management strategies and how they impacted Kenya’s foreign owned bank performance. Cherop (2010) conducted an analysis on FX instabilities on earnings resulting from tea export among small scale tea processing industries in Kenya were she established that the exchange rate fluctuations greatly affected the earnings of smallholders at tea factories. During the time of depreciating local currency, the export earnings were higher even with low export quantities while export earnings reduced when the currency was appreciating.

From the analysis of previous studies above, the existing studies looked at FX fluctuations and company performance targeting different sectors. With an increase in transaction of goods and services using foreign currency there is a substantive increase in foreign exchange risk, therefore FX risk management eventually influences the monetary performance of the bank. However, their findings may not be applicable for the banking sector due to macro-economic variables. Hence this study sought to solve the research questions, namely: what are the effects of the exchange rate volatility and foreign exchange risk on commercial banks performance in Kenya?

1.3 Research Objective

 The objectives of this research were as indicated below:

1.3.1 General Objective

This study had the general objective establishing the effects of the exchange rate volatility (appreciation, stability and depression) on financial performance of commercial banks in Kenya.

1.3.2 Specific Objectives

(a)            the specific objective of the project was to determine the effects of exchange rate volatility on banks performance in Kenya.

(b)           It also sought to investigate whether bank characteristics such as bank size and inflation have any intervening effect in the relationship in (a) above.

1.4 Value of the Study 

With the recent collapse of several commercial banks in Kenya, this study will be of benefit to several key people: for commercial bank managers, it will shed more light on the outcomes of the recent fluctuation of the KES currency against the other currencies in the world for instance the US dollar and the pound. It will also provide more insight on exchange rate loss mitigation policies and strategies.

For the Government of Kenya, the findings of this study would inform the formulation of policies and regulations for a strong and resilient banking industry. It will further provide insight on ways of curbing the depreciation of the Kenyan shilling against the major world currencies.

This study is important to various stakeholders in the financial sector because it will provide an insight into the implications of risk management strategies on banks. This will assist them to better advice the financial institutions on the best hedging practices to undertake to limit their exchange risk exposure.

Finally, the study will be useful to scholars as it will provide information that can be used as a basis of other researches. It also proposes further research areas which will be very important to researchers who will easily get to know what needs to be done in this particular area of scholarly.

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