EFFECT OF BANK SIZE AND FINANCIAL RISK EXPOSURE ON FINANCIAL PERFORMANCE OF COMMERCIAL BANKS IN KENYA NELLY M. KONYA, MBA, B.COM, CPA (K) A THESIS SUBMITTED TO THE SCHOOL OF BUSINESS IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE AWARD OF THE DEGREE OF DOCTOR OF PHILOSOPHY IN BUSINESS (FINANCE OPTION) OF KENYATTA UNIVERSITY. MARCH, 2018 i DECLARATION I declare that this thesis is my original work and has not been presented in any other university or institution of higher learning for award of any diploma or degree. Signed: ……………………………..…….Date: ………………………….………. Nelly M. Konya D86/CTY/PT/25221/2011 We confirm that the work in this thesis was done by the candidate under our supervision. Signed: ……………………………..……. Date: ………………………….………. Dr. Ambrose Jagongo Department of Accounting and Finance, School of Business, Kenyatta University. Signed: ……………………………..……. Date: ………………………….………. Dr. George Kosimbei Department of Economic Theory, School of Economics, Kenyatta University. ii ACKNOWLEDGEMENTS I greatly thank the Almighty God for without Him I could not have made it this far. I also extend my gratitude to my family members, relatives and friends for their continuous support and encouragement to aim higher. I sincerely appreciate my lecturers for their enlightment during coursework that got me interested in this subject. I thank and acknowledge the support given by my supervisors, (Dr. Ambrose Jagongo and Dr. George Kosimbei) for their patience, guidance and constructive assistance throughout this study. Further dedication is to Mr. David Muriithi and Mr. Josea Kiplangat for their guidance and assistance. Lastly, I thank all the people who in their special ways made this thesis a success. iii ABBREVIATIONS AND ACRONYMS ALM Assets and Liability Management BCBS Basel Committee on Banking Supervision BLUE Best Linear Unbiased Efficient CAMEL Capital adequacy, Asset quality, Management efficiency, Earnings performance, and Liquidity CBK Central Bank of Kenya CPI Consumer Price Index CR Concentration Ratio DMUs Decision Making Units EIU Economic Intelligence Unit FE Fixed Effects GDP Gross Domestic Product GLS Generalised Least Square HHI Hirschman- Herfindall Index IAS International Accounting Standard IASB International Accounting Standard Board IFRS International Financial Reporting Standard IMF International Monetary Fund IPI Industrial Production Index KBA Kenya Bankers Association MP Market Power NIM Net Interest Margin iv PG Prudential Guidelines PMS Performance Management System POP Persistence of Profit PWC Pricewaterhousecoopers RE Random Effects RMPH Relative Market Power Hypothesis ROA Return on Assets SCP Structure-Conduct-Performance SSA Sub-Saharan Africa VIF Variance Inflation Factor v OPERATIONAL DEFINITION OF TERMS Bank size: refers to the classification of banks by CBK according to weighted composite index comprising of assets, deposits, bank shareholding, number of deposit accounts and loan accounts to tiers one, two and three. Bank characteristics: these are the internal factors that affect the performance of commercial banks. Basel III: refers to a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. Commercial Bank – refers to a company which carries on, or proposes to carry on, banking business by providing financial services in Kenya and is licensed and regulated by the Central Bank of Kenya as mandated under the Banking Act. Financial Performance: refers to the accomplishment of a bank’s targets or goals over a specified period of time, expressed in terms of overall profits and losses during that time. Financial risk exposure: refers to the risk that involves financial loss to firms. Financial risk generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more e.g. market risk, liquidity risk, and credit risk. Hirschman- Herfindall Index: is the sum of the squared market shares of all banks in the market/or sample. vi Interest rate spread: is the interest rate charged by banks on loans to private sector customers minus the interest rate paid by commercial or similar banks for demand, time, or savings deposits. Macroeconomic variables: these are variables that affect the banking industry and are unchanged over a certain period of time e.g. Kenya Gross Domestic Product Growth Rate. Prudential Guidelines – are regulations to be adhered to by financial institutions in order to maintain a stable and efficient banking and financial system in Kenya. Weighted Composite Index – measures the variation in the value of a composite number defined as the aggregate of assets, deposits, bank shareholding, and number of deposit accounts and loan accounts to classify banks into three peer groups by CBK. vii TABLE OF CONTENTS DECLARATION .............................................................................................................. ii ACKNOWLEDGEMENTS ............................................................................................ iii ABBREVIATIONS AND ACRONYMS ........................................................................ iv OPERATIONAL DEFINITION OF TERMS ............................................................... vi LIST OF FIGURES ......................................................................................................... xi ABSTRACT ..................................................................................................................... xii CHAPTER ONE ............................................................................................................... 1 INTRODUCTION ............................................................................................................ 1 1.1 Background to the study ........................................................................................... 1 1.2 Statement of the Problem ....................................................................................... 14 1.3 General Objective ................................................................................................... 16 1.4. Research Hypotheses ............................................................................................ 16 1.5 Significance of the Study ....................................................................................... 17 1.6 Scope of the study .................................................................................................. 18 1.7 Organisation of the study ....................................................................................... 18 CHAPTER TWO ............................................................................................................ 20 LITERATURE REVIEW .............................................................................................. 20 2.1 Introduction ............................................................................................................ 20 2.2 Theoretical Review ................................................................................................ 20 2.3 Empirical Literature Review .................................................................................. 25 2.4 Summary and Gaps of Literature Review .............................................................. 39 CHAPTER THREE ........................................................................................................ 44 RESEARCH METHODOLOGY .................................................................................. 44 3.1 Introduction ............................................................................................................ 44 3.2 Research Philosophy .............................................................................................. 44 3.3 Research Design ..................................................................................................... 44 3.4 Empirical model ..................................................................................................... 46 3.5 Target Population ................................................................................................... 48 3.6 Sampling Techniques ............................................................................................. 48 3.7 Data Sources ........................................................................................................... 49 3.8 Data Collection Instruments ................................................................................... 49 3.9 Diagnostic Tests ..................................................................................................... 50 3.10 Data Analysis and Presentation ............................................................................ 54 3.11 Ethical Considerations ......................................................................................... 55 CHAPTER FOUR ........................................................................................................... 56 EMPIRICAL RESULTS, INTERPRETATION AND DISCUSSIONS .................... 56 4.1 Introduction ............................................................................................................ 56 4.2 Data Analysis and Interpretation ............................................................................ 56 4.3 Unit root / stationarity ............................................................................................ 63 4.4 Test