The effect of Financial Risk on Profitability of Tier Three Commercial Banks in Kenya

Abstract

The general objective of this study was to determine the effect of financial risk on profitability of tier three commercial banks in Kenya. This study is anchored to the existing literature review by theories and empirical studies that were reviewed. This study employed descriptive research design, collected data from elopements of audited financial statements of all the 22 tier three commercial banks in Kenya submitted to CBK for 5 years (2015-2-19) and analyzed them with descriptive and inferential statistics. Diagnostics tests were conducted on the data to ensure that regression assumptions underpinning multiple regression through ordinary least squares were met and misspecification did was checked in this study. Through, Hausman test, this study elected panel fixed effect regression model for its analysis. The findings of panel fixed effects regression model showed that credit risk (non-performing loans ratio) has statistically significant negative effect on profitability (return on capital employed) of commercial banks in Kenya (β= -0.084037, p-value= 0.0388) at significance level of 0.05. Liquidity risk (acid test ratio) was found with statistically insignificant negative effect on profitability (re-turn on capital employed) of tier three commercial banks in Kenya (β= -0.029777, p-value=0.2844) at significance level of 0.05. Operational risk (operating expenses ratio) was found with statistically significant negative effect on profitability of tier three commercial banks in Kenya (β= -0.041991, p-value = 0.0009) at significance level of 0.05. Therefore, this study recommended that management of tier three commercial banks and financial regulators led by CBK in Kenya should ensure that risk management measures in tier three commercial banks including proper credit appraisal, proper loan contracts management, good control of expenses are effective to minimize credit risk and operational risk in tier three commercial banks. This study also recommended that the effect of liquidity risk on profitability of commercial banks should be studied further since it was found to be statistically insignificant although it was negative.

Keywords: Tier Three Banks, Financial Risk, Liquidity Risk, Operational Risk, Panel Data