DETERMINANTS OF FINANCIAL STABILITY AMONG

COMMERCIAL BANKS IN KENYA

BY

ELIZABETH GITHINJI

UNITED STATES INTERNATIONAL UNIVERSITY - AFRICA

FALL 2016

ii

DETERMINANTS OF FINANCIAL STABILITY AMONG

COMMERCIAL BANKS IN KENYA

BY

ELIZABETH GITHINJI

A Research Project Submitted to the Chandaria School of

Business in Partial Fulfillment of the Requirement for the Degree

of Master of Business Administration (MBA)

UNITED STATES INTERNATIONAL UNIVERSITY AFRICA

FALL 2016

iii

DECLARATION

I, the undersigned, declare that this is my original work and has not been submitted to any other

college, institution or university other than the United States International University in

Nairobi for academic credit.

Signed: ________________________ Date: ____________________________

Elizabeth Githinji (639648)

This project has been presented for examination with my approval as the appointed supervisor.

Signed: ________________________ Date: ____________________________

Prof. Amos Njuguna

Signed: _______________________ Date: ____________________________

Dean, Chandaria School of Business

iv

COPYRIGHT

© Copyright by Elizabeth Githinji, 2016

All rights reserved. No part of this project may be produced or transmitted in any form or by

any means, electronic, mechanical, including photocopying, recording or any information

storage without prior written permission from the author.

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ABSTRACT

The purpose of this study was to establish the internal and external factors that influence

financial stability of commercial banks in Kenya. The study also aimed to determine the

financial strategies used to enhance financial stability of commercial banks in Kenya. This

study adopted a descriptive research design. This approach was used to describe variables

rather than to test a predicted relationship between variables. The population of this study

included 43 commercial banks in Kenya as at June 2016. The study adopted census survey on

all the commercial banks in Kenya. The study administered the questionnaires to two top

managers from each bank. The two top managers were derived from different branches of the

same bank.

The study further used random sampling to select the respondents among the top managers of

commercial banks. The study administered the questionnaires to two top managers from each

bank which made a total sample size of 82 respondents. The researcher used drop and pick

method in administering the questionnaire. Descriptive statistics was employed in data

analysis. Descriptive statistics included the means and frequencies were used to analyze

quantitative data and capture the characteristics of the variables under study. The study further

used inferential statistics such as regression and correlation to ascertain the relationship

between independent and dependent variables.

The finding showed that commercial banks operating costs, the size of the bank, board size,

capital size, Sound Interest Rate Policy and productive employees influenced commercial bank

financial stability. The results of the model summary indicated that bank internal factors

combined accounted for 26.3% of the variation in financial stability. The finding showed that

interest rates, inflation rates, interest rate spread, exchange rates and GDP growth influenced

commercial bank financial stability. The external factor accounted for 29.1% of the variation

in financial stability of commercial banks in Kenya. The findings revealed that commercial

banks in Kenya used supervision, bank policy, financial reconciliation, income diversification

and financial innovations in enhancing financial stability of commercial banks.

This study concluded that for internal factors of the commercial banks which include operating

costs, the size of the bank, board size, capital size, Sound Interest Rate Policy and productive

employees affects financial stability of commercial banks. The study also concluded that

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commercial banks benefit from the increased business activities and thus improved

profitability. The study further concluded that commercial banks must take measures is to

diversify the financial sector in terms of both number of domestic competitors and types of

saving and lending instruments available. The study finally, concluded that many banks

through their financial stability reports must attempt to assess the risks to financial stability by

focusing on a small number of key indicators. The study recommended that internal factors are

within the scope of the bank to manipulate them. Therefore, commercial banks in Kenya should

adjust their internal factors in order to boost their financial stability. The study also

recommended that government through the central bank should formulate sound policies to

regulated interest rates; inflation rates interest rates spread and the rate of economic growth.

This will assist in ensuring financial stability of the commercial banks.

ACKNOWLEDGEMENT

I would like to acknowledge my supervisor for the guidance and wise counsel during the

development of this thesis. I would also like to acknowledge my friends and family for their

support.

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DEDICATION

I dedicate this project to my family.

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TABLE OF CONTENTS

DECLARATION.............................................................................................................. iii

COPYRIGHT ................................................................................................................... iv

ABSTRACT ....................................................................................................................... v

ACKNOWLEDGEMENT ............................................................................................... vi

DEDICATION................................................................................................................. vii

TABLE OF CONTENTS .............................................................................................. viii

LIST OF FIGURES ......................................................................................................... xi

LIST OF TABLES .......................................................................................................... xii

CHAPTER ONE ............................................................................................................... 1

1.0 INTRODUCTION....................................................................................................... 1

1.1 Background to the Study .......................................................................................... 1

1.2 Statement of the Problem ......................................................................................... 5

1.3 Purpose of the Study ................................................................................................ 6

1.4 Research Questions .................................................................................................. 6

1.5 Significance of the Study ......................................................................................... 6

1.6 Scope of the Study ................................................................................................... 7

1.7 Definition of Terms.................................................................................................. 8

1.9 Chapter Summary .................................................................................................... 9

CHAPTER TWO ............................................................................................................ 10

2.0 LITERATURE REVIEW ................................................................................... 10

2.1 Introduction ............................................................................................................ 10

2.2 Effect of Internal Factors on Financial Stability .................................................... 10

2.3 Effect of External Factors on Financial Stability ................................................... 17

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2.4 Financial Strategies Used to Enhance Financial Stability ..................................... 22

2.5 Chapter Summary .................................................................................................. 28

CHAPTER THREE ........................................................................................................ 28

3.0 RESEARCH METHODOLOGY ....................................................................... 28

3.1 Introduction ............................................................................................................ 28

3.2 Research Design..................................................................................................... 28

3.3 Population and Sampling Design ........................................................................... 29

3.4 Data Collection Methods ....................................................................................... 30

3.5 Research Procedures .............................................................................................. 30

3.6 Data Analysis Methods .......................................................................................... 31

3.7 Chapter Summary .................................................................................................. 33

CHAPTER FOUR ........................................................................................................... 33

4.0 RESULTS AND FINDINGS ............................................................................... 33

4.1 Introduction ............................................................................................................ 33

4.2 Demographic Characteristics of the Respondents ................................................. 34

4.3 Financial Stability of Commercial Banks in Kenya .............................................. 38

4.4 Effect of Internal Factors on Financial Stability .................................................... 39

4.5 Effect of External Factors on Financial Stability ................................................... 46

4.5 Financial Strategies Used to Enhance Financial Stability ..................................... 51

4.6 Chapter Summary .................................................................................................. 55

CHAPTER FIVE ............................................................................................................ 55

5.0 DISCUSSION, CONCLUSION AND RECOMMENDATION ....................... 55

5.1 Introduction ............................................................................................................ 55

5.2 Summary ................................................................................................................ 55

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5.3 Discussions ............................................................................................................ 57

5.4 Conclusions ............................................................................................................ 61

5.5 Recommendations .................................................................................................. 62

REFERENCES ................................................................................................................ 64

APPENDICES ................................................................................................................. 72

Appendix I: Letter of Introduction .................................................................................... 72

Appendix II: Questionnaire............................................................................................... 73

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LIST OF FIGURES

Figure 4.1 Department of the Respondents ........................................................................ 35

Figure 4.2 Working Experience of the Respondents .......................................................... 35

Figure 4.3 Current Position of the Respondents................................................................. 36

Figure 4.4 Education Level of the Respondents ................................................................. 37

Figure 4.5 Marital Status of the Respondents .................................................................... 37

Figure 4.6 Age Group of the Respondents ......................................................................... 38

Figure 4.7 Trend in Non-Performing Loan of Commercial Banks in Kenya..................... 39

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LIST OF TABLES

Table 2.1 Data Analysis and Variables Operationalization .............................................. 32

Table 4.1: Response Rate ................................................................................................... 34

Table 4.2: Influence of Operating Cost and Financial Stability ......................................... 39

Table 4.3: Bank Size and Financial Stability ..................................................................... 40

Table 4.4: Board Size and Financial Stability .................................................................... 41

Table 4.5: Capital Size and Financial Stability .................................................................. 41

Table 4.6: Sound Interest Rate Policy and Financial Stability ........................................... 42

Table 4.7: Productive Employees and Financial Stability ................................................. 42

Table 4.8: Correlation Analysis for Internal factors and financial stability ....................... 43

Table 4.9: Model Summary................................................................................................ 44

Table 4.10: ANOVA Results ............................................................................................ 45

Table 4.11: Regression Coefficients Results .................................................................... 45

Table 4.12: Interest Rates and Financial Stability ............................................................ 46

Table 4.13: Inflation Rates and Financial Stability .......................................................... 47

Table 4.14: Interest Rate spread and Financial Stability .................................................. 47

Table 4.15: Exchange Rates and Financial Stability ........................................................ 48

Table 4.16: GDP Growth and Financial Stability ............................................................ 48

Table 4.17: Correlation Analysis for External factors and financial stability .................. 49

Table 4.18: Model Summary ............................................................................................ 50

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Table 4.19: ANOVA Results ............................................................................................ 50

Table 4.20: Regression Coefficients Results .................................................................... 51

Table 4.21: Productive Employees and Financial Stability.............................................. 52

Table 4.22: Bank Policy and Financial Stability .............................................................. 52

Table 4.23: Financial Reconciliation and Financial Stability .......................................... 53

Table 4.24: Income Diversification and Financial Stability ............................................. 54

Table 4.25: Financial Innovations and Financial Stability ............................................... 54

1

CHAPTER ONE

1.0 INTRODUCTION

1.1 Background to the Study

Stability of the financial system in an economy is an important catalyst for economic growth

due to its function in facilitating exchange of value (Swamy, 2014). Through their functions,

they facilitate the flow of funds from surplus households to deficit households in a more

efficient manner thereby promoting economic growth and development (Ratnovski, 2013).

Commercial banks need to proactively study the operating environment and develop relevant

strategies that would reduce the severity of their exposure to situations that are likely to affect

their financial stability. According to Huang and Ratnovski (2011), an adequate regulatory

mechanism beyond the traditional reserve requirements needs to be enforced to address and

mitigate the systemic component of funding liquidity risk among commercial banks. The

reserve ratios made by each bank may not be adequate for the liquidity exposure they face as

they are subjectively determined. Ratnovski (2013) argues that some commercial banks set

their liquidity levels through mimicking behavior in liquidity choices which may also arise

from learning motives.

According to Azam and Siddiqoui (2012), commercial banks have to learn, adopt and re-orient

themselves to the changing environment if they are to be competitive and perform their

intermediation function effectively. Like other organizations, the banking industry is faced

with turbulence arising from increased globalization, internationalization, advancements in

information, communication and technology and trade liberalization. Commercial banks

therefore, ought to proactively engage themselves in strategies that will enable them to respond

to the environmental challenges in order to gain competitive advantage (Khrawish, 2011).

Financial stability describes the condition where the financial intermediation process functions

smoothly thereby building confidence among users (Merga, 2013). It refers to the smooth

operation of the system of financial intermediation processes between households, firms and

the government through a range of financial institutions supported by a myriad of financial

infrastructure (Khan, 2011).

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Financial stability may be hampered by both internal processes and strong shocks leading to

the emergence of weak spots. Such shocks may arise from the external environment, domestic

macroeconomic developments, main debtors and creditors of financial institutions, economic

policies or changes in the institutional environment (Azam & Siddiqoui, 2012). Any interaction

between weak spots and shocks can result in the collapse of major financial institutions and

disruption of the functions of the financial system as regards financial intermediation

processes. In the extreme case, it may even lead to a financial crisis with adverse implications

for the economy (Vento & Ganga, 2010).

The performance of commercial banks can be affected by internal and external factors. These

factors can be classified into bank specific (internal) and macroeconomic variables. The

internal factors are individual bank characteristics which affect the bank's performance. These

factors are basically influenced by the internal decisions of management and board (Almazari,

2014). The external factors are sector wide or country wide factors which are beyond the

control of the company and affect the profitability of banks (Azam & Siddiqoui, 2012). Bank

stability is mostly measured in a negative way by considering individual or systemic distress

broadly defined as periods where the banking system is not capable of fulfilling its

intermediation function for the economy effectively anymore. Koch, and MacDonald, (2014)

define banking distress as systemic if non-performing assets reach at least 10% of total assets

at the peak of the crisis; the fiscal cost of the rescue operations. Many central banks through

their financial stability reports (FSRs) attempt to assess the risks to financial stability by

focusing on a small number of key indicators (Gadanecz & Jayaram, 2008).

Fluctuations in the global financial system are a constant concern and due to this many

countries are prioritizing financial stability over financial growth, as growth maybe

unsustainable over long periods of time (Schneider, 2008). To achieve financial stability, many

countries are by strengthening financial regulation. Without sound and effective regulation,

financial systems can become unstable, triggering crises that can devastate the real economy

as evidenced by the recent global financial crisis that began in 2007 (Spratt 2013). Finances

are meant to facilitate productive economic activity; the aim of regulation is to maintain

financial stability and to promote economic growth.

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The Central Bank of Kenya was established in 1966 through an Act of Parliament (The Central

Bank of Kenya Act of 1966), this was as a result of the desire among the three East African

countries to have independent monetary and financial policies. The Act determined the

objectives, functions and autonomy of the Central Bank. The Act was restructured in April

1997 to conform to ongoing economic reforms. Further amendments have been done in

October of 2015 to the CBK Act so as to conform to changes in the global financial sector

(Njagi, 2009).

Prudential guidelines issued by CBK are to reduce the level of risk to which bank creditors are

exposed and Bank supervision entails enforcement of rule and regulation and judgment

concerning the soundness of bank asset, its capital adequacy and management (Ochieng, 2014).

This regulatory structure creates transparency between institutions in the banking sector as

well as the individuals and corporations with whom they conduct business with. The financial

regulations for banks are being rewritten in response to the global financial crisis, but their

implementation requires complex steps depending on each country’s policies and procedures

they could have very different effects on financial stability of the banks (Njeule, 2013). The

reform programme is also expected to engender a diversified, strong and reliable banking

sector in the country. Studies have shown that the objectives of financial sector reforms are

broadly the same in most countries of Sub-Saharan Africa (Balogun, 2007).

In 1988, the Basel committee issued Basel I Accord; Basel II Accord was issued in 2004 and

In December 2010, the Committee announced proposals dubbed Basel III. The CBK regulates

banks using the Basel Accord as a standard to measure the implementation of the regulations

by banks and financial institutions in the country and currently they are using Basel I but are

in the process of formulating a policy position on implementation of Basel II (KPMG, 2012).

The new guidelines that came into force in January 2013 contain some features of Basel II and

Basel III on capital adequacy requirements (Oloo, 2013). In general, Kenya seeks to implement

the Basel Accords for ensuring financial stability of the country’s financial sector. The Kenyan

banking system has continued to record compliance with the minimum capital and liquidity

prudential requirements. The prudential and financial stability indicators have shown that the

financial sector is sound (Omondi, 2014).

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The banking industry in Kenya is very sensitive and important to the economy in term of

stability and growth. Regulations and supervisions have become imperative in the enforcement

of rule and regulation and also in the judgment concerning the soundness of bank asset, bank

management and capital adequacy (Ochieng, 2014). The regulations creates an air of

transparency in the operations of the banking activities; interaction among banking institutions,

corporations and customers. Ndungu (2010) observed that the goal of regulatory guidelines is

to help banks and other financial institutions become stronger players and in a manner that will

ensure longevity and hence higher returns to the shareholders over time as well as greater

impacts on the Kenyan economy.

A strong financial system plays a critical role in enabling growth and reducing vulnerability to

crises among commercial banks. This mitigates the likelihood of disruptions in the financial

intermediation process that are severe enough to significantly impair the allocation of savings

to profitable investment opportunities (Stein, 2011). Financial stability is an essential

requirement not only for monetary stability, but also for healthy development of the economy.

Financial stability refers to a condition in which the financial system which comprises financial

institutions, financial markets and market infrastructures is capable of facilitating real

economic activities smoothly and unraveling financial imbalances arising from shocks (Alfi,

2014). Financial instability entails heavy costs for an economy since the volatility of price

variables in the financial markets increases economic risks and financial institutions or

corporations may even go bankrupt (Vlahović, 2014).

The instrument best suited to maintain financial stability is macro prudential regulation. It may

be a straightforward instrument to wield when the central bank is also the main regulatory

and supervisory authority for the financial system (Corbo, 2010). But for the many instances

in which that is not the case, macro prudential policy will have to be jointly implemented by

the central bank and several other agencies. It will be crucial, then, to have explicit

collaboration between all the relevant regulatory authorities and the central bank. Special

attention must be paid to the institutional framework to ensure that they will have the incentives

to do so (Padoa-Schioppa, 2003).

Macro prudential regulation should have a dual purpose: reduce the incentives for financial

institutions to increase leverage during a boom, and make the financial system more robust

5

during a bust (Corbo, 2010). It includes the use of pro-cyclical capital requirements and loan

provisions to moderate lending during a credit boom, placing larger requirements on systemic

institutions to account for the incentive to become too big to fail, and increasing the risk

weights attached to riskier lending during a boom (Borio, 2011).

1.2 Statement of the Problem

A safe and sound banking system ensures the optimal allocation of capital resources, and

regulators therefore aim to prevent costly banking system crises and their associated adverse

feedback effects on the real economy (Jahn & Kick, 2012). A dysfunctional financial industry

puts pressures on businesses and households thereby adversely affecting the real economy as

capital may be prevented from flowing to worthy investments and may lead to credit crunches.

In order to ensure that the financial industry remains sound to perform its financial

intermediation role effectively, it is important that individual financial institutions in the

industry implement relevant strategies that would ensure their financial stability (Jahn & Kick,

2012).

A number of studies have been conducted on financial stability and financial sector responses

across the world. For instance, Diaconua and Oanea (2014) examined the main determinants

of bank’s stability using the evidence from Romanian Banking Sector. The findings showed

that GDP growth and interbank offering rate for three months were two significant factors with

positive impact on financial stability for a commercial bank. This study was undertaken in

Romanian Banking sector while the current study was done in Kenya with different economic

conditions.

In another study, Acharya (2009) examined a theory of systemic risk and design of prudential

bank regulation. The findings show that regulatory mechanisms such as bank closure policy

and capital adequacy requirements commonly based only on a bank’s own risk fail to mitigate

aggregate risk-shifting incentives, and can accentuate systemic risk. Further, prudential

regulation was shown to operate at a collective level, regulating each bank as a function of

both its joint (correlated) risk with other banks as well as its individual (bank-specific) risk.

In Kenya, Opala (2014) examined the effect of financial stability on the performance of deposit

taking SACCOs in Nairobi County. The findings show that there were factors that positively

influenced the financial performance of Deposit taking Saccos in Nairobi County, including

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liquidity, capital adequacy, size of the SACCO and management quality. This study did not

review the strategies adopted by commercial banks to ensure financial stability. The SACCO

sector though very important, it operates on a different model from that used by commercial

banks. From the above review, it is evident that the existing studies have concentrated on other

aspects of financial stability including determinants and effects whereas none of the studies

has concentrated on strategies adopted to enhance financial stability among commercial banks

in Kenya. This study therefore seeks to fill this research gap. This study seeks to evaluate the

effectiveness of strategies adopted by commercial banks to enhance financial stability.

1.3 Purpose of the Study

The purpose of the study was to establish the determinants of financial stability among

commercial banks in Kenya.

1.4 Research Questions

The research questions of this study were:

1.4.1 What are the effects of internal factors on the financial stability of commercial banks in

Kenya?

1.4.2 How do external factors affect financial stability of commercial banks in Kenya?

1.4.3 What financial strategies are used to enhance financial stability by commercial banks in

Kenya?

1.5 Significance of the Study

1.5.1 Policy Makers and Regulatory Authorities

The study will inform policy makers in the Government of Kenya through Central Bank of

Kenya (CBK) and other regulatory institutions like Capital Markets Authority (CMA) on the

financial performance and financial stability of commercial banks in Kenya. The findings from

this study may help the relevant regulatory institutions to formulate relevant policies, rules and

guidelines that would guide the commercial banks operations and maintain stability in the

banking industry in Kenya

1.5.2 Commercial Banks in Kenya

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It is further hoped that through the findings of this study, commercial banks in Kenya may

learn of the policies and regulations and how they affect stability of the banking industry. This

may inform the management of these institutions to ensure that the operations of the various

banks conform to the regulations so as to maintain stability in the industry. The study

established that internal factors and macro-economic indicators affect financial stability,

therefore commercial banks should considers internal factors and macro-economic indicators

when addressing financial stability crisis.

1.5.3 The Public

The general public may wish to read the study to further their knowledge on the effects of

CBK’s regulations on the financial stability of the banking industry in Kenya. The acquired

knowledge from this study may help in adopting right decisions on where to do banking basing

it on the financial stability of the bank. The public that is keen on financial stability of

commercial banks can assessed the internal bank factors and economic conditions since this

study established the relationship between these variables and financial stability.

1.5.4 Researchers and Academicians

The study builds on the existing body of knowledge and points out area for further research

work on the effect of CBK’s regulations on financial stability of the banking industry in Kenya.

This study may increase the knowledge on the effect of Central Bank of Kenya’s regulations

on financial stability of the banking industry in Kenya and give empirical findings on the

relationship between effect of the CBK regulations and the financial stability of the banking

industry in Kenya. Future researchers can use the findings of these study to justify the

relationship between internal bank factors economic conditions and financial stability of

commercial banks.

1.6 Scope of the Study

This study focused on the Central bank of Kenya management and staff in the legal department

and 42 commercial banks operating in Kenya as at 31st December 2016. The study targeted

management and staff in the legal department and managers in each of the commercial bank.

The respondents in this study both at the Central bank and at the commercial banks are busy

people and getting appointments proved to be difficult. The researcher distributed

8

questionnaires and gave them time to fill then collect them later. And some got the

questionnaires via email. Telephone conversations with the respondents were done to remind

them to answer the questionnaire. Banking is a sensitive area as there is a lot of competition in

the sector; therefore information about the operations and financial performance may not be

willingly offered. The researcher will assure the participants that the information is only for

academic purposes and confidentiality will be maintained.

1.7 Definition of Terms

1.7.1 Central bank of Kenya Regulations

Prudential guidelines are to reduce the level of risk to which bank creditors are exposed to and

enforcement of rule and regulation and judgment concerning the soundness of bank asset, its

capital adequacy and management (Central Bank of Kenya Act, 2014).

1.7.2 Financial Stability

Financial stability is an absence of instability, a situation in which economic performance is

potentially impaired by fluctuations in the price of financial assets or by an inability of financial

institutions to meet their contractual obligations Chant (2003).

1.7.3 Internal Factors

The internal factors are individual bank characteristics which affect the bank's financial

stability. These factors are basically influenced by the internal decisions of management and

board (Al-Tamimi and Hussein, 2010).

1.7.4 Macro-Economic Indicators

Macroeconomic indicators are key statistics that indicate the direction of an economy.

Economic indicators can be anything the investor chooses, but specific pieces of data released

by government and non-profit organizations have become widely followed (Kane, Bodie &

Marcus, 2005).

1.7.5 Financial Strategies

Financial strategies are a practice a firm adopts to pursue its financial objectives Akhtar, Ding

& Ge, 2008).

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1.7.6 Financial Innovation

Frame and white (2014) define financial innovation as including something that is new in the

market, reduces costs of financial intermediation, reduces risks in financial intermediation,

provides an improved product features that meets customer demands.

1.9 Chapter Summary

This chapter provided background information of the study; it also presents the statement of

the problem, purpose of the study, research questions, and significance of the study, scope and

definition of terms. The next chapter was literature review. Literature review looked at the

empirical studies and other literature relevant to the subject of Determinants of financial

stability of commercial banks in Kenya.

Chapter two explored the literature that related to the study variables. It also entailed

operational framework and theoretical framework. The empirical review addresses the various

studies that have been done on the area. Chapter three entailed the identification of the research

design, the target population, the sample design, the data collection instrument, pilot testing

and methods of data analysis. Chapter four presented the study findings and chapter five

contains conclusion and recommendations.

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CHAPTER TWO

2.0 LITERATURE REVIEW

2.1 Introduction

This chapter presents a review of previous research done on studies related to the determinants

of financial stability among commercial banks in Kenya. It specifically presents literature on

institutional factors that affect financial stability; macro-economic factors and financial

stability; and measures taken to enhance financial stability of commercial banks. These were

discussed in details below.

2.2 Effect of Internal Factors on Financial Stability

2.2.1 Financial Stability

The turmoil on the financial markets during 2007-2008, invalidated a number of paradigms,

due to the fact that many large credit institutions with international activities, although they

were assigned by rating agencies with lower levels of risk categories faced bankruptcy or last-

minute intervention of the state so that they can continue their activity (Hodachnik, 2009).

Thus arose some controversy about the effectiveness of financial ratings as surveillance tools

and on the level of trust that was given to this instrument for monitoring and evaluation of the

stability of commercial banks in order to avoid an excessive level risk due to asymmetry

information. Taking into account the fact that banks must have an appropriate tool to assess

their strengths and their vulnerabilities in order to consolidate their capacity to trigger a

systemic risk (Lavrushin & Mamonova, 2011).

Stability of the banks is provided by high profitability of their activities, and also

sufficient liquidity which indicates that banks has a balanced structure of assets and liabilities

(Klaas & Vagizova, 2014). Financial stability of the banks in medium term can be reduced

because of insufficient quality of capital, assets and liabilities, associated with aggression of

their credit policy that increases credit risk, and as a result, probability of losses. Poor quality

of credit portfolio indicating that unqualified management approaches of a credit portfolio are

used with insufficient capitalization of some of banks. But the size of capital defines ability of

bank to maintain stability during the crisis periods, dependence on interbank credit market and

significant share of demand liabilities in structure of bank liabilities (Klaas & Vagizova, 2014).

11

The considerable share or active growth of such mobile, difficult to predict resources is

dangerous, because recall of these funds or their spending can lead to bank insolvency and as

a result to loss of bank stability (Klaas & Vagizova, 2014).

Financial stability of banks is maintained by sufficient capitalization which is characterized by

the security level of risk assets and acted as the guarantor of bank reliability and liquidity, and

also high profitability demonstrates effectiveness of credit organizations resources use

(Hodachnik, 2009). Vagizova, Klaas and Batorshina, (2013) posited that problem areas of lack

of financial stability by commercial banks are the poor quality of assets and liabilities due to a

considerable share of the overdue credits and demand liabilities, dependence on interbank

credits that on the one hand characterizes unstable position of bank, but on the other hand

shows trust in bank from other banks, the aggressive credit policy, and also poor quality of

credit portfolio.

According to Gómez (2015) some banks in financial instability are characterized by sufficient

level of liquidity and qualitative resource base which is important because the raised funds take

vital share in structure of bank resources and they provide to meet needs of the enterprises, the

organizations and the population, including credit resources requirements. Relative instability

banks were connected with undercapitalization, a considerable share of the interbank credits

in structure of liabilities and overdue credits, poor quality of credit portfolio, and in some cases

with aggressive credit policy and insufficiently stable resource base (Gómez, 2015).

2.2.2 Internal Factors

According to Athanasoglou et al. (2008) internal factors are within the scope of the bank to

manipulate them and that they differ from bank to bank. The internal factors include bank size,

board size, capital, operating cost, risk management capacity, size of deposit liabilities and

ownership among others. One of the important internal factors that can be picked from income

statement that affects bank financial stability is the amount of expenses incurred during the

bank operations within a certain period of time. This is what is referred to us cost efficiency

from the efficiency theory. Efficient management of bank resources has implications on its

performance. It is expected that high bank expenses will lead to lower bank profits. Such

negative relationship has been supported by various studies such as Obamuyi (2013) who

suggested that profitable banks operate at lower costs. This findings support the efficiency

12

wage theory, which states that the productivity of employees increase with the wage rate. Large

banks operate at lower costs because of economies of scale and can raise capital at lower costs.

A few researchers have found that internal factors of the bank have no significant role in

determining its financial stability (Micco, Panizza & Yanez, 2007 and Athanasoglou, et al.

2008).

2.2.2.1 Operating Cost

The level of operating expenses is normally looked at as a way of measuring the efficiency of

a firm’s management (Onuonga, 2014). Memmel and Raupach (2010) in their study of several

European countries conclude that operating costs have a negative effect on profit measures

despite their positive effect on net interest margins. Efficiency in cost management is normally

measured as a ratio (operating costs to assets). This is due to the fact that only operating

expenses can be directly associated to the outcome of bank management (Athanasoglou, et al.

2008). This has resulted in a negative relationship due to the fact that improved management

of bank expenses lead to improved efficiency and thus improved profitability ratios.

Commercial banks that are interested in achieving high profitability need to develop ways of

ensuring that their costs of operations are maintained at an acceptable level. Firms that are able

to minimize their costs of operations are considered to be more efficient and it is also expected

that they post higher profits margins than their counterparts that have higher costs of operations

(Athanasoglou, et al., 2008).

Hoffmann (2011) suggested that high cost of operations lead to lower profit margins since it

means that the organization is spending more in order to get output. It is important to note that

due to competition and market regulations, a bank that is faced by high cost of operations

cannot pass the whole burden to the customers through increasing the bank fees and charges

and therefore this means that the bank has to shoulder it (Andrés & Arce, 2012). Increased

costs affect the left side of the profit and loss statement and this means that the profits realized

will be lower than in a case where the costs of operations are lower (Andrés & Arce, 2012).

The operating costs of a bank are normally expressed as a percentage of the profits and they

are normally expected to influence the financial performance of the bank in a negative manner

(Swarnapali, 2014).

13

Onuonga (2014) conducted a study on the analysis of financial stability of Kenya’s top six

commercial banks. This study aimed at investigating the impact of the internal determinants of

financial stability of Kenya`s top six commercial banks over the period 2008-2013, This study

used generalized least squares method to estimate the impact of bank assets, capital, loans,

deposits and assets quality on banks financial stability. This paper used return on assets (ROA)

as a measure of profitability. The findings revealed that bank size, capital strength, ownership,

operations expenses, diversification do significantly influence financial stability of the top six

commercial banks.

2.2.2.2 Bank Size

According to Shapiro (2008) large firms have more negotiating powers leading to lower

financing costs on average which in turn improves on their overall stability in the market. In

essence, large firms are able to hedge and diversify risks more in comparison to smaller firms.

This in turn influences the company’s ability to exploit varied methods of diversifying that in

turn influences long term survival.

Bowa (2015) examined the effect of bank capitalization on liquidity of commercial banks in

Kenya. The regression results showed that size of bank and asset quality have an influence on

banks liquidity ratio. However, it was identified that bank size had the highest influence on

banks liquidity ratio. This therefore shows that the current held assets by banks that is both

fixed and current assets determines the overall stability of banks to a great extent. The results

suggested that larger banks essentially enjoy economies of scale which in turn positively

influences their profitability. The study further asserts that holding assets in highly liquid form

tends actually increases income levels. On the contrary, banks with poor asset quality often

suffer from high credit risks leading to less profitability. Banks size therefore determines the

banks` ability to remain profitable and sustainable for the foreseeable future. In essence, if a

bank cannot be able to utilize its held assets to generate revenues, then it cannot be able to

remain stable in the long run as liabilities and other obligations will have to be met as and when

they mature (Bowa, 2015).

14

Vijayakumar and Tamizhselvan (2010) found a positive relationship between firm size and

profitability. In their study, which was based on a simple semi-logarithmic specification of the

model, the authors used different measures of size (sales and total assets) and profitability

(profit margin and profit on total assets) while applying model on a sample of 15 companies

operating in South India.

The size of the commercial bank or any other business entity in terms of the assets is a very

significant determinant of profitability due to various issues. Commercial banks that have a

large asset size are able to expand their operations geographically to regions where competition

is not very high or to regions where the market is largely untapped. Such a move would increase

the customer base of the bank in a significant manner and this would also lead to increased

customer deposits (Goddard, Molyneux & Wilson, 2004). Most of the profits of commercial

banks come from the reinvestment of the customer deposits as well as through lending to

borrowers. Increased customer deposits mean that the bank has a higher lending capacity. Such

a high lending capacity will result in the bank making more money from the loans and thus

recording higher profit margins than those commercial banks that have a smaller asset size

(Ongore & Kusa, 2013). It is therefore clear that there is a relationship between the size of the

bank and its level of financial profitability (Ongore & Kusa, 2013).

Amato and Burson (2007) tested size-profit relationship for firms operating in the financial

services sector. The authors examined both linear and cubic form of the relationship. With the

linear specification in firm size, the authors revealed negative influence of firm size on its

profitability. However, this influence wasn’t statistically significant. On the other hand, the

authors found evidence of a cubic relationship between ROA and firm size. Hoffmann (2011)

conducted a study on the determinants of stability of the banks operating in US for the period

of 1995- 2007. The study undertook the internal and external factors affecting the financial

stability of banks in US economy. The study found that there is a negative relationship between

the size of the bank and financial stability which affirmed the belief that banks are working

most carefully and dismissing potentially profitable trading chances. The cost advantages due

to the bank size do not impact on the profitability of the banking industry of US.

2.2.2.3 Board Size

15

The board of directors has an important function in the stability of commercial banks and in

particular the relationship between the chairperson and the chief executive officer is key

(Donaldson and Davis, 1991). Konadu (2009) was centered on the impact flow of bigger board

size on financial performance of firms in Nigeria. The study was to find out the relationship

between bigger board and financial performance by adopting the use of secondary data from

the Nigerian Stock Exchange fact book drawn from various industries during the period 2001

– 2010 via the regression statistical technique. The findings of the study revealed that bigger

board size affects the financial performance of a firm in a negative manner. Based on the

findings of the study, firms are enjoined to place a remarkable degree of emphasis on the area

of corporate governance and to some extent embark on eliminating CEO duality.

Yermack (1996) examined the relation between board size and firm performance, concluding

that the smaller the board sizes the better the performance, and proposing an optimal board

size of ten or fewer. Yermack findings have important implications, not least because they may

call for the need to depend on forces outside the market system in order to determine the size

of the board. The role of the CEO and the chairman is important in improving the value of a

firm. A single person holding both roles (CEO duality) has an important bearing on the value

of a firm and there are two schools of thought in this regard.

Maina and Ondongo (2013) supported agency theory and suggested that a single person

holding the positions of CEO and chairman cannot monitor the organization well. In addition,

a person being head of the board and operations is not a healthy sign keeping in mind the

principles of corporate governance. They further suggest the agency problem increases when

a single person holds both these important roles. The shareholders also bear higher monitoring

costs in the absence of the chairman in a firm. The dual leadership firm may lack proper

direction affecting the shareholders wealth in a negative manner.

Bennedsen et al (2004) studied the relationship between board size and performance of 500

Danish firms. Their study also supported a negative relationship between the two. However,

authors also observed that board size below six has no effect on bank financial stability. It’s

viable for only large size board more than seven. Diwedi & Jain (2002), conducted a study on

340 large, listed Indian firms for the period 1997- 2001. This study found a weak positive

relation between board size and performance of the firm. Adams & Mehran (2005) accessed

16

the relationship between banking firm’s performance and board size and found a non-negative

relationship between board size and Tobin’s Q. They further argued that features of the bank

holding company organizational form might make a larger board more desirable for these

firms. They further explained that the board size is significantly related to characteristics of the

sample firms’ structures. However, literature that link board size to bank financial stability is

very scanty, therefore bank financial performance is a proxy to financial stability.

2.2.2.4 Capital Size

Capital is one of the bank specific factors that influence the level of bank financial stability.

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. 2008). Banks capital creates liquidity for the

bank due to the fact that deposits are most fragile and prone to bank runs. Moreover, greater

bank capital reduces the chance of distress (Diamond, 2000). However, it is not without

drawbacks that it induce weak demand for liability, the cheapest sources of fund 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.

According to Dang (2011), the adequacy of capital is judged on the basis of capital adequacy

ratio (CAR). Capital adequacy ratio shows the internal strength of the bank to withstand losses

during crisis. Capital adequacy ratio is directly proportional to the resilience of the bank to

crisis situations. It has also a direct effect on the profitability of banks by determining its

expansion to risky but profitable ventures or areas (Sangmi and Nazir, 2010). Dang (2011) and

Sangmi and Nazir, 2010 argument therefore confirms that capital size has a positive and

significant relationship with bank financial stability.

Capital is also found to be another important internal determinant of bank financial stability.

Altunbas, Carbo, Gardener and Molyneux, (2007) showed that there was a positive relationship

between bank capitalization and financial stability. Said and Tumin (2011) suggested that

capital is better modeled as an internal determinant of bank profitability, as higher profits may

lead to an increase in capital and it also implies that well-capitalized banks face lower risks of

going bankrupt, which reduces their costs of funding.

17

2.3 Effect of External Factors on Financial Stability

2.3.1 External Factors

The macroeconomic policy stability, Gross Domestic Product, Inflation, Interest Rate and

exchange rates are also other macroeconomic variables that affect the financial stability of

commercial 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. this section contain analysis of literature on the effect of interest rates,

inflation rates, exchanges rates and GDP growth on the financial stability of commercial banks

in Kenya.

2.3.1.1 Interest Rates

Githae (2012) examined the effects of interest rates spread on the financial performance of

commercial banks in Kenya. Study results showed that a strong relationship exists between

commercial banks financial performance and interest rate spread, inflation and default risks.

The study recommended that the government ought to regulate prevailing inflation and interest

rates as it would aid commercial banks to operate in a more stable environment. Jamal and

Khalil (2011) concluded that the more banks are involved in international trade especially

foreign transactions, the more they faced with more financial risks due to fluctuating inflation

and interest rates which affects exchange rates. This in turn affects the attainable revenue from

foreign exchange dealings and contracts.

Kimani (2013) posited that the central bank rate, cash reserve ratio, open market operation and

uncertainty are caused by possible outcomes due to changes in monetary policies aimed at

controlling inflation and interest rates. This in turn affects banks’ lending behavior by

commercial banks. The more they give out loans they more they face credit risks which have

the potential to sink commercial banks all together.

Podder (2012) evaluated the relationship between interest rates and financial stability of

commercial banks and found that the relationship is particularly apparent for smaller banks

than large. They further noted that a reduction in the interest rates during a recession period

results in a slower growth in bank loans while at the same time increasing the amount of

18

nonperforming loans and thus increased loan losses. This therefore means that commercial

banks, particularly the smaller ones may have a lot of difficulties in maintaining their financial

performance when the market rates are on a decreasing trend (Podder, 2012).

Interest rates affect both the commercial banks and their customers in two major ways. When

the interest rates rise, customers are unable to service their existing loans which leads to losses

to the commercial banks since if the situation continues that way, they are forced to write off

their debts (Makkar & Singh, 2013). This eats into the profits of the company since it means

that the commercial bank is not able to recover both the principal amounts loaned as well as

the expected interest from the customers (Makkar & Singh, 2013). When the interest rates are

too low, the interest earned from the loaned out amounts is negligible and thus contributes little

to the profitability of the commercial bank. There is therefore need for a balance in the interest

rates in order to ensure the banks benefit (Lipunga, 2014).

Onyango (2016) explored the relationship between loan duration and interest rates for

commercial banks in Kenya. The research results revealed that an increment in lending risks

results to increments in average loan duration of commercial banks. This increment in lending

risks enables banks to control their overall risk exposure by limiting amounts lend to

borrowers. This therefore enables them to protect their loan assets hence ensuring that they

remain liquid and stable for the long run. The increments in loan durations as result of

increments in interest rates enables banks to potentially recover issued loans in rough economic

times experienced in the economy. This is a counter-measure to recover more loans by issuing

longer repayments period. This enables optimal recovery of loans thus influencing banks’

ability to remain in operation despite prevailing adverse interest rates.

Ekweny (2014) examined interest rates volatility on nonperforming loans portfolio of listed

commercial banks in Kenya. Research results showed that interest rate volatility negatively

affect the performance of non-performing loans portfolio. The study recommended that the

country ought to handle its macroeconomic variables in an appropriate manner as changes in

variables like inflation and interest rates bring about currency devaluation which affects

commercial banks performance. In addition, proper macroeconomic policies need to be put in

place in order to attain stability in Kenyan commercial banks performance. In essence, banks

operations are affected to a great extent by prevailing level of inflation and interest rates as it

19

affects possible returns. The aligning of operations so as to ensure that estimated changes in

these rates are incorporated will reduce potential negative outcomes hence ensure that

profitability and survival are attained.

2. 3.1.2 Inflation Rates

Kavinya (2013) examined the effects of macroeconomic factors on internet banking by

commercial banks in Kenya. The study concluded that a macroeconomic factor that is inflation

rates as well as economic growth is determinants of the adoption of internet banking in Kenya.

The study however recommended that CBK needs to enhance macroeconomic stability via

maintaining a low inflation rate in the country. The study sensitized the need for commercial

banks to ensure compliance in regards to all requirements to in regards to borrowing. This

would help to avoid bad debts that not only reduce banks profitability but also negatively affect

liquidity position which is an indicator of financial stability.

High inflation rates lead to high interest rates on loans and thus lead to higher income to

commercial banks. Swarnapali (2014) asserts that the effect of inflation on banking

performance depends on whether inflation is anticipated or unanticipated. In an event where

an increase in the inflation rates is fully anticipated and an adjustment is made to the interest

rates accordingly, then this leads to a positive influence on the financial performance of

commercial banks. When an increase in the inflation rates is not anticipated, it results in a

situation where the local borrowers are faced with cash flow difficulties and this can result in

the termination of bank loan agreements in a premature fashion thus causing loan losses for

the issuing commercial bank. The general observation is that when commercial banks take a

lot of time to adjust their interest rates after changes in the inflation rates, it leads to a situation

where the bank’s operating costs may rise faster than the revenues of the bank. High and

variable inflation may cause difficulties in planning and in negotiation of loans.

High inflation rates also lead to a situation where consumers find themselves at a position of

low purchasing power and they therefore tend to use most of their money for consumption.

This means that the money that would have been used for investments or savings in commercial

banks is redirected to consumption. Such a situation therefore reduces the amount of money

20

being deposited in commercial banks as savings by the consumers and this in turn reduces their

cash reserves as well as their ability to issue loans to borrowers (Rasiah, 2010).

Sufian and Chong (2008) argued that consumers will also tend to withdraw their savings from

commercial banks at such times since there is not enough money to spend due to the low

purchasing power. Banks therefore find themselves in a situation where they have fewer funds

available to them to offer as loans to borrowers. The fact that most of the profits of commercial

banks are derived from interest earned on loans means that a bank that cannot offer loans to its

customers makes less money. This will then affect its profitability in a negative manner. It is

therefore clear that inflation rates as well as other macro-economic indicators influence the

profitability of commercial banks.

As inflation rises, the marginal impact of inflation on banking lending activity and stock market

development diminishes rapidly. For economies with inflation rates exceeding 15 percent,

there is a discrete drop in financial sector performance. Finally, while the data indicate that

more inflation is not matched by greater nominal equity returns in low-inflation countries,

nominal stock returns move essentially one-for-one with marginal increases in inflation in

high-inflation economies (Boyd, Levine & Smith, 2001). Inflation can be argued to negatively

affect the financial stability of commercial banks. Since these market frictions lead to the

rationing of credit, credit rationing becomes more severe as inflation rises. As a result, the

financial sector makes fewer loans, resource allocation is less efficient, and intermediary

activity diminishes with adverse implications for capital investment (Boyd, Levine & Smith,

2001). The reduction in capital formation negatively influences both long-run economic

performance and equity market activity, where claims to capital ownership are traded

(Rousseau & Wachtel, 2002). Higher inflation rates will lead to losses especially where banks

do not adopt sound hedging strategies to militate against forex risk. This in turn affects overall

stability of the bank when it makes hefty losses as a result of forex trading (Borio, English &

Filardo, 2003).

2. 3.1.3 Exchange Rates

Understanding the role of exchange rate depreciation on individual banks is important to

anticipate banking sector stability or potential fragility due to the exchange rate depreciation.

21

Most of the literature on the choice of exchange rates pays little attention to implications for

financial stability in commercial banks (Eichengreen & Hausmann, 1999). Regardless of the

reasons for choosing currency denomination of assets and liabilities, banks are exposed to

exchange rate risks when they hold assets and incur liabilities denominated in foreign currency.

In developing countries, generally, banks do not incur the cost of hedging instruments in

protecting risk due to the exchange rate changes. This could be due to the lack of such

instruments in developing countries, or for other reasons such as the high cost of hedging

(Sahminan, 2007).

Gachua (2011) examined the effect of foreign exchange exposure on firm’s financial

performance. The research found that unrealized foreign exchange gains/losses have an effect

on the Net Income of listed companies as it was posted to either income statement or owners’

equity. The level of foreign exchange gains or losses is determined by a large extent by

prevailing inflation rates in the country. Pitia and Lado (2015) sought to test of relationship

between exchange rate and inflation in South Africa. The study found that an increase in

interest rates should lead to an increase in the financial performance of commercial banks since

this leads to an increase in the spread between the interest rates for savings and the interest

rates for borrowing.

As a financial intermediary, commercial banks are more exposed to the effect of exchange rate.

Exchange rate can affect bank performance both directly and indirectly. The direct effect is

easy to identify and can be easily managed. However, the indirect effect of exchange rate on

the profitability of commercial banks is very subtle. Basically, it emanates from the impact of

exchange rate on the business of bank clients and the economy in general. According to

Tadesse (2015) findings, exchange rate has statistically significant negative impact on the

profitability of commercial banks. The result showed that exchange rate has statistically

significant positive impact on the loan growth of banks.

2. 3.1.4 GDP Growth

The relationship between financial development and economic growth has received

considerable attention in both developed and developing economies. This concern about

banks’ financial stability and economic growth finds its justification in the policy implications

22

that the relationship can bring about, as improved living standards for their citizens as well as

increased economic growth rates are the goals sought by many governments. Moreover, recent

research findings have indicated that countries with better developed financial systems tend to

have a faster rate of economic growth.

According to the study by Bakang (2012) on financial deepening and economic growth has

mostly dealt with the causality issue between the two concepts with two main hypothesis: the

first one, the supply-leading hypothesis argues that financial stability drives economic growth

through the presence of efficient markets while the second, the demand-leading hypothesis

posits that economic growth is a response to the expansion of financial markets and progress.

In various empirical studies, cross-countries studies suggest a positive association between

financial stability and economic growth indicating also that the initial level of financial

development is a good predictor of the subsequent rates of economic growth (Levine and King,

1993) whereas other studies present evidence of negative effects of financial deepening on

growth (De Gregorio & Guidotti, 1995). However, cross-countries studies fail to address

countries specific macroeconomic environment leading to biased policy implications.

Nguena and Abimbola (2013) investigated the implication of financial stability dynamics for

financial policy coordination in the West African Economic and Monetary Union sub-region

(WAEMU). They adopted a hypothetical-deductive theoretical approach and an empirical

investigation in both static and dynamic panel data econometrics. The study recommended the

implementation of a financial policy directed at increasing the level of savings rate, GDP per

capita growth rate and density. It also recommended the reduction of the level of reserves in

the sub-region.

2.4 Financial Strategies Used to Enhance Financial Stability

2.4.1 Financial Strategies

Several studies have recommended various measures in ensuring financial stability in different

economies. Veron (2015) examined on how financial stability could be enhance in Asia. One

of the key measures is to diversify the financial sector in terms of both number of domestic

competitors and types of saving and lending instruments available. Many central banks through

23

their financial stability reports (FSRs) attempt to assess the risks to financial stability by

focusing on a small number of key indicators. In Kenya, some banks have expanded their

branch networks in the region. By December 2012, Kenyan banks had established 282

branches in neighboring countries (Uganda 125, Tanzania 70, Rwanda 51, Burundi 5, and

South Sudan 31). Such banks pose an increasing challenge for regulators across Africa (Beck

2013). Financial integration implies that the negative externality costs of bank failure go

beyond national borders that are not taken into account by national regulators and supervisors.

2.4.1.1 Supervision

Monetary, fiscal, and prudential supervisory policies can be significant contributors to creating

a systemically risky or stable financial environment (Garicano & Lastra, 2010). Supervisors

charged with implementing policy, whether through a new macro-prudential supervisor or as

part of an existing institution, must inform and be informed by monetary, fiscal, prudential,

competition, and other government policies (Garicano & Lastra, 2010). In all cases, however,

there must be due regard for the sole or primary responsibility of these other supervisors in

their areas of authority. If the macro-prudential supervisor is not the central bank, for example,

it should not be given the authority to set or unduly influence interest rates, though it may be

appropriate to allow it to comment at times when excessively low or high interest rates over a

long period of time pose a macro-prudential threat (Ferguson, 2010).

The special relationship between monetary policy and macro-prudential policy implies a

pivotal role for the central bank even if macro-prudential authority is not vested in the central

bank. In addition, while a close relationship with governmental authorities charged with fiscal

policy is necessary, the macro-prudential supervisor should not be so closely linked to the

fiscal authorities that its political independence is, or appears to be, compromised (Padoa-

Schioppa, 2003).

2.4.1.2 Bank Policy

In almost all cases, this policy should aim at fostering market mechanisms in the functioning

of the banking system, especially the setting of interest rates for saving and borrowing and

24

competition among banks (Čihák, Demirgüç-Kunt, Feyen and Levine, 2012). It is natural for

governments everywhere to be tempted to distort the functioning of the financial system to

facilitate the financing of their own operations or of specific economic activities or agents that

they favour, a stance that the economic jargon loosely refers to as financial repression.

But this temptation of financial repression should be resisted in most circumstances, except

during wars or other acute and temporary national emergencies. Specifically, the compression

of interest rates offered to savers through a combination of capital controls and constraints on

domestic banks a common form of financial repression is typically destabilising, because it

encourages savers to find their way around the interest rate caps with harmful unintended

consequences (Lardy, 2014).

In the absence of a generally accepted framework for financial stability, policymakers in

developing countries need to exercise judgment while determining which choices are best

suited to their specific situation (Posen & Véron, 2015). The most important point is that there

is no simple linear relationship between financial repression and stability postponing or

avoiding financial liberalisation not only has costs but so doing can itself undermine systemic

stability in developing economies (François & Sud, 2006). That fact holds, even though it is

undeniable that Anglo-American light-touch financial regulation and supervision were

destabilising and warn us to avoid extreme deregulation (Lindgren, Garcia & Saal, 1996).

Posen and Véron (2015) offer the following guidelines for policymakers pursuing financial

stability in commercial banks in developing countries: Bank-based or bank-centric financial

systems are not inherently safer than systems that include meaningful roles for securities and

capital markets. Domestic financial systems should be steadily diversified in terms of both

number of domestic competitors and types of saving and lending instruments available (and

thus probably types of institutions).

Posen and Véron (2015) further argued that financial repression should be focused on

regulating the activities of financial intermediaries and investment managers/funds, not on

compressing interest rates and returns for domestic savers. Cross-border lending from regional

financial centers in foreign currency should be in limited quantities only for top companies,

but creation of multinational banks’ subsidiaries in the local economy and local currency

lending and bond issuance should be encouraged. Macro-prudential tools can be useful and, if

25

anything, are more effective in less open or less financially deep economies than in more

advanced financial entrepots, but they must be used aggressively when needed and are

particularly suited for dealing with real estate booms/busts.

2.4.1.3 Financial Reconciliation

According to Njonde and Kimanzi (2014) a comprehensive record keeping system makes it

possible for entrepreneurs to develop accurate and timely financial reports that show the

progress and current condition of the business. Better reports on cash reconciliation will enable

the commercial banks to keep track of any loopholes that may arise for cash frauds. In a bid to

identify a number of antecedents associated with fraudulent financial reporting, Bell and

Carcello (2000) conducted a study which found out that such items as rapid growth, weak or

ineffective internal controls, managerial preoccupation with meeting earnings projections, and

aggressive managerial attitudes coupled with weak control environments increase cash

mismanagement in financial institutions.

Cheptumo (2010) studied response strategies to fraud related challenges by Barclays Bank of

Kenya. Among other findings, the study reported that Proactive fraud detection procedures

such as data analysis, continuous auditing techniques, and other technology tools can be used

effectively to detect financial instability involving cash reconciliation failures by identifying

anomalies, trends, and risk indicators within large populations of transactions.

A study by Abdul (2014) showed that there is need for the owners and managers of the

commercial banks to embrace proper accounting records keeping in order achieve financial

performance. More efforts need to be channeled on accounting record keeping for effective

performance of business units because accounting record keeping strongly affects performance

of small scale business units.

2.4.1.4 Income Diversification

Several studies have recommended various measures in ensuring financial stability in different

economies. Veron (2015) examined on how financial stability could be enhance in Asia. One

of the key measures is to diversify the financial sector in terms of both number of domestic

26

competitors and types of saving and lending instruments available. Many central banks through

their financial stability reports (FSRs) attempt to assess the risks to financial stability by

focusing on a small number of key indicators. In Kenya, some banks have expanded their

branch networks in the region. By December 2012, Kenyan banks had established 282

branches in neighboring countries (Uganda 125, Tanzania 70, Rwanda 51, Burundi 5, and

South Sudan 31). Such banks pose an increasing challenge for regulators across Africa (Beck

2013).

According to DeYoung and Rice (2004), banks are increasingly exploiting nontraditional

avenues of generating income, to the extent that in recent times, almost half of banks’ incomes

in the US are obtained from nontraditional activities and this reflects not only a diversification

of banks into nontraditional activities, but also a shift in the way banks earn money. As margins

and fees tended to tighten in many domestic banking markets during the 1980s and 1990s,

many banks responded by implementing strategies of product diversification, merger and

overseas expansion in an attempt to defend their profitability.

Diversification of banking activities also includes venturing into off-balance sheet activities.

Such activities, though not entirely new from a historical perspective, have expanded

considerably in range and scope in recent years. According to Nachane and Gosh (2007), a

popular reason for the dramatic growth of bank off-balance sheet activities has been that banks

may have used them as a means of augmenting earnings to offset reduced spreads on traditional

on-balance sheet lending business. While the basic functions of banks and other financial

service

companies have remained relatively constant over time, the specific products and services

through which these functions are provided have changed.

The theoretical case for income diversification seems to be supported by Markowitz portfolio

theory and the conventional wisdom of seeking not to put all ones eggs in the same basket. It

has also been argued that combining different types of income earning activities non-interest

and interest earning assets results in rebalancing of income away from interest income and may

increase return and diversify risks which affect financial stability (Gamra and Plihon, 2011).

Nonetheless, the evidence that benefits of revenue diversification exist is quite mixed. For

example, Wolfe and Sanya (2010) in their study of 226 listed banks in 11 emerging economies

27

highlight the fact that revenue diversification by banks can create value. However, they warn

that there are adverse effects in over-relying on non-interest income.

2.4.1.5 Financial Innovations

Beyani and Kasonde (2005) studied financial innovation and its importance on modern risk

management systems. The researchers concluded that it is imperative for firms to readily adopt

modern risk management systems in order to mitigate against business risks hence ensure

survival for the long run. It was further established that banks ought to have a futuristic view

when formulating risk measurement systems bearing in mind that rapid technological changes

and rapid markets growth are readily changing. This will ensure that they remain relatively

stable despite prevailing industry situations. The study also revealed that institutional, process

and product innovations will always present heightened risk levels especially due to

unfamiliarity levels at first. Therefore, banks need to adopt innovations that promise high

returns but at reasonable risk levels so as not to compromise on stability.

According to Gallegati and Tedeschi (2009) innovation and its consequences have created new

concern about the functioning and management of international and domestic financial

systems. Access to safe, easy and affordable credit and other financial services by the poor and

vulnerable groups, disadvantaged areas and lagging sectors is recognized as a precondition for

accelerating growth and reducing income disparities and poverty (Kohn, 2004). Wang, Gui

and Ma (2009) researched on risks of Chinese commercial banks as a result of independent

innovation. Research findings showed that financial innovations essentially increase the

circulation of capital which in turn leads to safety of assets through higher profitability and

liquidity. This in turn positively improves banks stability as they are able to handle and counter

existing negative market forces with ease.

Despite the recognized importance of financial innovation and an extensive descriptive

literature, there have been surprisingly few empirical studies. This situation has denied the

banks the much needed information regarding this important area of financial innovations

sometimes leading to reverse causality in the innovation-financial performance relationship.

Otoo (2013) study found that some banks in Kenya had adopted some financial innovations

28

such as credit cards, mobile, internet and agency banking. The financial innovations had great

impact on the financial performance of the banks which has led to increased financial stability.

2.5 Chapter Summary

This chapter provides review of previous literature related to this study. This chapter analyses

the previous studies conducted on the influence of bank internal factors on financial stability.

The internal factor that the study assessed include, operating cost, bank size, board size and

capital size of the bank. The study also reviewed literature on the influence of external factors

such as inflation rates, interest rates, exchange rates and GDP growth on the financial stability

of commercial banks. The chapter also provides some of the financial strategies used to

enhance financial stability of commercial bank. Chapter three entailed the identification of the

research design, the target population, the sample design, the data collection instrument, pilot

testing and methods of data analysis.

CHAPTER THREE

3.0 RESEARCH METHODOLOGY

3.1 Introduction

The purpose of this study was to establish the determinants of financial stability among

commercial banks in Kenya. This chapter presented a review of the research methodology that

was adopted in this study. Specifically, the chapter discussed the methods and procedures that

were used in the research. These include, research design, the population of the study, the

sample size, the sample design, data collection instruments, research procedure, ethics and the

data analysis approach that were taken.

3.2 Research Design

This study adopted a descriptive research design. Descriptive research refers to research design

that focuses on the accurate portrayal of the characteristics of persons, situations or groups

(Polit and Hungler 2004). This approach was used to describe variables rather than to test a

predicted relationship between variables. Descriptive survey makes standardized measurement

more precise by enforcing uniform definitions upon the respondents (Streubert, Speziale and

29

Carpenter 2011). Standardization ensured that similar data was collected from groups then

interpreted comparatively. Descriptive survey was appropriate for this study because it entailed

collecting data from samples that can be compared in terms of demographic factors and also it

focuses on complex analysis to bring out the correlation of variables. The researcher opted to

use this kind of research considering the desire of the researcher to obtain first hand data from

the commercial banks so as to formulate rational and sound conclusions and recommendations

for the study.

3.3 Population and Sampling Design

3.3.1 Study Population

A research population is a well-defined collection of individuals or objects known to have

similar characteristics and usually have a common, binding characteristic or trait (Connaway

and Powell, 2010). There were 41 commercial banks in Kenya as at June 2016 (CBK, 2016).

The study administered the questionnaires to two top managers from each bank. The two top

managers were derived from different branches of the same bank.

3.3.2 Sampling Design

A sample design is the architecture or the strategy used to select study participants or

respondents (Kothari, 2004). The study adopted census survey on all the commercial banks in

Kenya.

3.3.2.1 Sampling Frame

A sampling frame is a list of population from which a sample is drawn (Leary, 2001). It is the

source material or device from which list of all elements within a population that can be

sampled is drawn and may include individuals, households or institutions. The sampling frame

for this study included all the top level managers in employees list in all commercial banks in

Kenya as at the period of the study.

3.3.2.2 Sampling Technique

Sampling refers to the systematic selection of a limited number of elements out of a

theoretically specified population of elements (Kothari, 2004). The study further used random

sampling to select the respondents among the top managers of commercial banks. Random

30

sampling was appropriate to ensure that no bias in selecting the branches where the respondents

was derived and also to reduce the bias in selecting the managers to participate in the study.

Random sampling was used because the study population was large. Random sampling enabled

the study to select a sample that represents the whole population (Blumberg, Cooper and

Schindler, 2005).

3.3.2.3 Sample Size

The sample size of this study included all the commercial banks in Kenya. The study

administered the questionnaires to two top managers from each bank which made a total

sample size of 82 respondents.

3.4 Data Collection Methods

Data collection is the precise, systematic gathering of information relevant to the research sub-

problems, using methods such as interviews, participant observations, focus group discussion,

narratives and case histories (Burns and Grove, 2005). This study used primary. Primary data

was collected on the three research objectives. Primary data was collected by the use of the

questionnaire. The questionnaire had 5 sections consisting of both open and closed ended

questions. The first section contained questions on the demographic characteristics of the

respondents while the remaining sections were based on the research questions. The questions

were constructed using both likert and binary. The researcher used drop and pick method in

administering the questionnaire.

3.5 Research Procedures

After constructing the data collection instrument the researcher conducted a pilot study in order

to minimize the possible instrumentation error and hence increase the reliability and validity

of the data collected, pilot study was conducted to measure the research instruments reliability

and validity (Mathiyazhagan and Nandan, 2010). A pilot study was undertaken on 10% of the

sample that was not included in the final sample. Questionnaires were delivered to the

respondents to fill by the researcher in person. The questionnaires were emailed to those

respondents that were inaccessible.

31

3.6 Data Analysis Methods

Data Analysis is the processing of data collected to make meaningful information out of them

(Saunders, Lewis and Thornhill, 2009). Data collected from questionnaires was coded and

keyed into a computer. Quantitative data was analyzed using the Statistical Package for Social

Sciences (SPSS version 20). The study used both descriptive and inferential statistics for data

analysis. Descriptive statistics including the means and standard deviations was used to analyze

quantitative data and capture the characteristics of the variables under study. Simple linear

regression analysis and Pearson’s Product Moment Coefficient (r) were computed to test

research questions and to determine the nature and the strength of the relationship among the

variables, with r ranging from -1 to +1. Multiple regression analysis and ANOVA tests was

also used to test research questions. A linear multivariate regression model was used to

measure the relationship between the independent variables and the dependent variable which

are explained in the model. The regression model helped to explain the magnitude and direction

of relationship between the variables of the study through the use of coefficients like the

correlation, coefficient of determination and the level of significance.

Y= a + β1X1+ β2X2+ β3X3+ β4X4+

Where:

Y = Financial Stability

X1 = Operating Costs

X2 = Bank Size

X3= Board Size

X4= Capital Size

X5 = Interest rates

X6 = Exchange rates

X7= GDP growth

X8= Inflation rates

= Error term

32

a= constant

In the model a is the constant term while the coefficient β1 to β4are used to measure the

sensitivity of the dependent variable (Y) to unit change in the explanatory variable (X1….8).

is the error term which captures the unexplained variations in the model. The analyzed data

will be presented in form of tables, charts and graphs.

3.6.1 Operational Frameworks

Table 2.1 Data Analysis and Variables Operationalization

Variables Type of variable Measurement Tests

Financial Stability Dependent Variable Non-Performing

loans

Trend analysis

Internal Factors Independent

Variable Operating Costs

Bank Size

Board Size

Capital Size

Descriptive

statistics,

Correlation &

regression analysis

Macro-economic

Indicators

Independent

Variable

Interest rates

Inflation rates

Exchange rates

GDP growth

Descriptive

statistics,

Correlation &

regression analysis

33

Financial Strategies Independent

Variable Supervision

Bank policy

Reconciliation

Descriptive

statistics,

Source: Researcher (2015)

3.7 Chapter Summary

Chapter three entailed the identification of the research design, the target population, the

sample design, the data collection instrument, pilot testing and methods of data analysis.

Chapter four presented the study findings and chapter five contained conclusion and

recommendations.

CHAPTER FOUR

4.0 RESULTS AND FINDINGS

4.1 Introduction

The general objective of this study was to establish the determinants of financial stability

among commercial banks in Kenya. This chapter contained details of presentation of data

analysis, results and findings. Results presentation was organized based on the specific

objectives of the study. Descriptive analysis was employed; which included; mean frequencies

and percentages. The organized data was interpreted on account of concurrence to objectives

using assistance of computer packages especially Statistical Package for Social Sciences

(SPSS) to communicate the research findings. The analysed data was presented in frequency

and percentage tables; this enhanced easier interpretation and understanding of the research

findings. The data for the study was collected via structured questionnaires that were

34

administered in person. Based on our target sample size of 72, a total of 62 complete responses

were received, representing 86.1% response rate. According to Mugenda and Mugenda (2003)

a response rate of over 50% is adequate for a descriptive study; hence we were able to carry

out an effective analysis of the results and findings.

Table 4.1: Response Rate

Category Frequency Percentage

Returned questionnaires 62 86.1%

Unreturned questionnaires 10 13.9%

Total 72 100%

4.2 Demographic Characteristics of the Respondents

The demographic data sort from the respondents included gender, academic level, job level,

and work experience and income levels of the respondents. The results in the subsection below

were obtained from the respondents on their demographic information.

4.2.1 Department of the Respondents

The findings of the stage indicate that 48.4% of the respondents who participated in this study

were from R&D department. Those from the finance department were 30.6% while those from

human resource department and marketing department were 11.3% and 9.7% respectively. The

findings were favourable for the study since the respondents were well placed to respond to

the questions in the questionnaire.

35

Figure 4.1 Department of the Respondents

4.2.2 Working Experience of the Respondents

The study was also interested in the working experience of the respondents. The study assumed

that employees with more years of experience were also better placed to respond to the

questionnaire. The findings revealed that 33% of the respondents had between 6 and 9 years

of experience. The respondents with over 10 years of experience were 31% of the respondents

while 25% had 3 to 5 years of experience. Those with less than 2 years of experience were the

least at 11%. These findings imply that the respondents had enough experience to respond to

the questions in the questionnaire.

Figure 4.2 Working Experience of the Respondents

9.7 11.3

30.6

48.4

0

10

20

30

40

50

60

Marketing Department Human ResourceDepartment

Finance Department R&D Department

less than 2 year11%

3 to 5 years25%

6 to 9 years33%

Over 10 years31%

36

4.2.3 Current Position of the Respondents

The study was interested in how long the respondents had served in their current position. The

study showed that 38.7% of the respondents had served in their position for between 1 and 2

years. The findings further indicated that 32.3% of the respondents had stayed for between 2

and 3 years. Those who indicated to have stayed in their current position for between 3 and 4

years were 21% and finally those who had stayed for less than 1 year were the least at 8.1%.

Figure 4.3 Current Position of the Respondents

4.2.5 Education Level of the Respondents

Education level of the respondents was a key factor the study was interested in. it is assumed

that respondents who are well educated provide credible information compared to those with

low level of education. The findings of this study indicated that 40.3% of the respondents had

master degrees level of education, 27.4% had bachelor’s degree, another 21% had professional

degree, 6.5% had doctorate degree while only 4.8% had 1 or more years of college, no degree.

The findings imply that the information provided by the respondents were credible.

8.1

38.7

32.3

21

0

5

10

15

20

25

30

35

40

45

less than 1 year 1 to 2 years 2 to 3 years 3 to 4 years

37

Figure 4.4 Education Level of the Respondents

4.2.6 Marital Status of the Respondents

The results on marital status indicated that majority of the respondents were either married or

single. The widowed, separated and divorced were the least at in that order.

Figure 4.5 Marital Status of the Respondents

4.8

27.4

40.3

21

6.5

0

5

10

15

20

25

30

35

40

45

1 or more years ofcollege, no degree

Bachelors’ degree Masters’ degree Professional degree Doctorate degree

40.3

9.7 9.78.1

32.3

0

5

10

15

20

25

30

35

40

45

Married Widowed Separated Divorced Single

38

4.2.6 Age Group of the Respondents

The finding showed that 38% of the respondents were of age group of between 46 and 60 years

while 37% were between 31 and 45 years. Those above 60 and over were 13% and finally

those between 26 and 30 years were 12%. The findings imply that the respondents had worked

long enough in the banking industry to understand determinants of financial stability.

Figure 4.6 Age Group of the Respondents

4.3 Financial Stability of Commercial Banks in Kenya

The study used non-performing loans as a measurement of financial stability in commercial

banks in Kenya. The study analysed the trend of non-performing loans in commercial banks in

Kenya from a period of 2007 to 2015. The results indicated that there was an increase in non-

performing loans which indicated that financial stability of commercial banks in Kenya had

decreased within the period of the study.

26 to 3012%

31 to 4537%

46 to 6038%

61 and over13%

39

Figure 4.7 Trend in Non-Performing Loan of Commercial Banks in Kenya

4.4 Effect of Internal Factors on Financial Stability

The first objective of this study was to establish the effects commercial banks internal factors

on the financial stability of commercial banks. The specific internal factor that the study

focused on included, commercial banks operating costs, the size of the bank, board size, capital

size, Sound Interest Rate Policy and productive employees. The study employed descriptive

statistics mainly percentages and frequencies on establishing the effects of internal factor on

financial stability.

4.4.1 Operating Cost and Financial Stability

The study sought to find out to what extent operating cost affected financial stability. The

respondents were required to indicate the level of influence of operating cost on financial

stability. The results showed that 48.4% of the respondents indicated that operation cost had

very large effect on financial stability while 37.1% of the respondents indicated that operating

cost had extremely large influence on financial stability. Those who indicate operating cost did

not affect financial stability were 8.1%.

Table 4.2: Influence of Operating Cost and Financial Stability

Frequency Percent

R² = 0.784

0

500

1000

1500

2000

2500

3000

3500

4000

2007 2008 2009 2010 2011 2012 2013 2014 2015

NPL (millions)

40

Not at all 5 8.1

slight 1 1.6

Moderate 3 4.8

Very Large 30 48.4

Extremely Large 23 37.1

Total 62 100

Mean 4.05

Std. Deviation 1.108

4.4.2 Bank Size and Financial Stability

The study was also interested in the influence of bank size on the financial stability on

commercial banks in Kenya. Similarly, the respondents were required to indicate to what extent

Bank Size affected financial stability of commercial banks. The results indicated that 40.3%

of the respondents’ rate bank size to have very large effect on financial stability on commercial

banks. Those who indicated that bank size had extremely large effects were 35.5%. On the

other hand, 12.9% of the respondents indicated bank size had no effects on financial stability.

Table 4.3: Bank Size and Financial Stability

Frequency Percent

Not at all 8 12.9

slight 6 9.7

Moderate 1 1.6

Very Large 25 40.3

Extremely Large 22 35.5

Total 62 100

Mean 3.76

Std. Deviation 1.375

4.4.3 Board size and Financial Stability

The study further sought to establish the influence on Board size on the financial stability on

commercial banks in Kenya. The results revealed that 59.7% of the respondents felt that board

size had extremely large effect on financial stability of commercial banks in Kenya while 21%

indicated that board size had very large effect. A small proportion (3.2%) of the respondents

felt that board size had no influence on financial stability of commercial banks of Kenya.

41

Table 4.4: Board Size and Financial Stability

Frequency Percent

Not at all 2 3.2

slight 4 6.5

Moderate 6 9.7

Very Large 13 21

Extremely Large 37 59.7

Total 62 100

Mean 4.27

Std. Deviation 1.089

4.4.4 Capital Size and Financial Stability

The study further aimed to find out the influence bank’s capital size on the financial stability

of commercial bank in Kenya. The findings of this study showed that combined 79.0% of the

respondents indicated that capital size of the commercial banks had very large effect on

financial stability of commercial banks. The results implied that commercial banks with large

capital size are likely to be more financial stable compared to banks with small capital size.

Table 4.5: Capital Size and Financial Stability

Frequency Percent

Not at all 6 9.7

slight 1 1.6

Moderate 6 9.7

Very Large 23 37.1

Extremely Large 26 41.9

Total 62 100

Mean 4

Std. Deviation 1.215

42

4.4.5 Sound Interest Rate Policy and Financial Stability

Among the factors that destabilize commercial banks financial are non-performing loans. Non-

performing arise due to poor interest rate policy. Therefore, the study was interested to find

out the influence sound interest rate policy on the financial stability of commercial banks in

Kenya. The result indicated that over 77.4% of the respondents indicated that sound interest

rate policy greatly influenced the financial stability of commercial banks. Out of the remaining

respondents only 9.7% indicated that sound interest rate policy had no influence on financial

stability of financial banks in Kenya.

Table 4.6: Sound Interest Rate Policy and Financial Stability

Frequency Percent

Not at all 6 9.7

slight 2 3.2

Moderate 6 9.7

Very Large 23 37.1

Extremely Large 25 40.3

Total 62 100

Mean 3.95

Std. Deviation 1.234

4.4.6 Productive Employees and Financial Stability

The study also aimed to establish the influence of productive employees on the financial

stability. The result revealed that 46.8% of the respondents indicated that productive

employees had very large influence on financial stability of commercial banks in Kenya.

Another 30.6% of the respondents indicated that productive employees had extremely large

influence on commercial banks financial stability. Only 11.3% of the respondents were of the

opinion that productive employees had no any relationship with commercial banks financial

stability.

Table 4.7: Productive Employees and Financial Stability

Frequency Percent

Not at all 7 11.3

slight 3 4.8

Moderate 4 6.5

43

Very Large 29 46.8

Extremely Large 19 30.6

Total 62 100

Mean 3.81

Std. Deviation 1.252

4.4.7 Correlation Analysis for Internal factors and financial stability

The study conducted a correlation analysis to test the association between internal factor and

financial stability measured by non-performing loans. The results indicated that operating cost

had positive and significant association with non-performing loans. Bank Size, Board size,

Capital Size, Sound interest rate policy and productive employees were found to negatively

impact on Non-performing loans. Increase in these factors would lead to reduction in the

amount of Non-performing loans in commercial banks in Kenya consequently leading to

financial stability.

Table 4.8: Correlation Analysis for Internal factors and financial stability

Operating

Cost

Bank

Size

Board

size

Capital

Size

Sound

interes

t rate

policy

Productive

employees

Operating

Cost

Pearson

Correlation 1

Sig. (2-tailed)

N 62

Bank Size

Pearson

Correlation .384**

Sig. (2-tailed) 0.002

N 62 62

44

Board size

Pearson

Correlation .410** .516**

Sig. (2-tailed) 0.001 0

N 62 62 62

Capital Size

Pearson

Correlation .329** .550** .335**

Sig. (2-tailed) 0.009 0 0.008

N 62 62 62 62

Sound

interest rate

policy

Pearson

Correlation .314* .660** .364** .459**

Sig. (2-tailed) 0.013 0 0.004 0

N 62 62 62 62 62

Productive

employees

Pearson

Correlation .444** .591** .556** .410** .439**

Sig. (2-tailed) 0 0 0 0.001 0

N 62 62 62 62 62 62

Financial

Stability

NPL

Pearson

Correlation 0.231 -0.244 -0.246 -.365** -0.223 -0.221

Sig. (2-tailed) 0.071 0.056 0.054 0.004 0.081 0.084

N 62 62 62 62 62 62

** Correlation is significant at the 0.01 level (2-tailed).

* Correlation is significant at the 0.05 level (2-tailed).

4.4.8 Regression Analysis for Internal factors and financial stability

The study further adopted the use of regression model to ascertain the relationship between

internal factors and financial stability of commercial banks in Kenya. The results of the model

summary indicated that bank internal factors combined accounted for 26.3% of the variation

in financial stability this was indicated by an R-Square of 0.263.

Table 4.9: Model Summary

Model R R Square Adjusted R Square Std. Error of the

Estimate

1 .403a .263 .255 31613.81166

a. Predictors: (Constant), Productive employees, Operating Cost , Capital Size , Board size, Sound

interest rate policy, Bank Size

45

The results of ANOVA test show that the F value was 9.218 with a significance of p value =

0.004 which was less than 0.05, meaning that internal factors were significant predictors of

commercial banks financial stability.

Table 4.10: ANOVA Results

Model Sum of Squares df Mean Square F Sig.

1

Regression 12616622010.228 6 2102770335.038 9.218 .004b

Residual 64963150686.647 65 999433087.487

Total 77579772696.875 71

a. Dependent Variable: Financial Stability (NPL)

b. Predictors: (Constant), Productive employees, Operating Cost , Capital Size , Board size, Sound

interest rate policy, Bank Size

The results of regression coefficients indicated that productive employees, capital size, board

size, sound interest rate policy, bank size all had negative relationship with non-performing

loans but only capital size was found to have a significant negative relationship with non-

performing loans. Operating cost on the other hand was found to have a positive relationship

with non-performing loans therefore; an increase in operating cost would result to an increase

in non-performing loans but an increase in productive employees, capital size, board size,

sound interest rate policy, bank size would result to a reduction in non-performing loans hence

financial stability.

Table 4.11: Regression Coefficients Results

B Std. Error Beta t Sig.

(Constant) 5730.957 1414.765 4.051 0.000

Operating Cost 620.519 337.262 0.231 1.84 0.071

Bank Size -527.556 270.787 -0.244 -1.948 0.056

Board size -670.727 341.826 -0.246 -1.962 0.054

Capital Size -893.631 294.334 -0.365 -3.036 0.004

Sound interest rate policy -6206.031 4341.523 -0.219 -1.429 0.158

Productive employees -2373.01 4185.696 -0.086 -0.567 0.573

a Dependent Variable: Financial Stability (NPL)

46

4.5 Effect of External Factors on Financial Stability

The second objective of their study was to establish the influence of macro-economic factors

on commercial banks stability. The study focused interest rates, inflation rates, interest rate

spread, exchange rates and GDP growth on financial stability of commercial banks.

4.5.1 Interest Rates and Financial Stability

Previous studies have examined the effects of interest rates on the financial performance of

commercial banks in Kenya. This study focused on the finding out the influence of interest

rates on financial stability. The findings of this study revealed that 41.9% and 24.2% of the

respondents indicated that interest rates had very large and extremely large influence on

financial stability of commercial banks. On the other hand, the respondents who indicated that

interest rates had no influence on commercial stability were 6.5%. These findings imply that

increase in interest rates negatively influenced commercial banks financial stability.

Table 4.12: Interest Rates and Financial Stability

Frequency Percent

Not at all 4 6.5

slight 4 6.5

Moderate 13 21

Very Large 15 24.2

Extremely Large 26 41.9

Total 62 100

Mean 3.89

Std. Deviation 1.216

4.5.2 Inflation Rates and Financial Stability

From the analysis of literature, it was established that high inflation rates lead to high interest

rates on loans and thus lead to higher income to commercial banks. In an event where an

increase in the inflation rates is fully anticipated and an adjustment is made to the interest rates

accordingly, then this leads to a positive influence on the financial performance of commercial

banks. This study sought to establish how inflation rates affected financial stability of

commercial banks in Kenya. The result showed that a combined 74.2% of the respondents

revealed that inflation had large influence on financial stability of commercial banks. The

47

respondents who felt otherwise were 4.8%. The findings imply high inflation rates could

possibly influence financial stability of commercial banks.

Table 4.13: Inflation Rates and Financial Stability

Frequency Percent

Not at all 3 4.8

slight 5 8.1

Moderate 8 12.9

Very Large 21 33.9

Extremely Large 25 40.3

Total 62 100

Mean 3.97

Std. Deviation 1.145

4.5.3 Interest Rate spread and Financial Stability

The results further showed that 41.9% of the respondents revealed that interest rate spread had

a great impact on financial stability of commercial banks. The result further revealed that 29%

of the respondents revealed that interest rate spread had very large impacts on financial

stability. On the other hand 4.8% of the respondents felt that interest rate spread had slight

influence while another 4.8% indicated that interest rate spread have no influence on

commercial banks financial stability. The findings imply that the higher the interest rate spread

the less financially stable the banks could be.

Table 4.14: Interest Rate spread and Financial Stability

Frequency Percent

Not at all 3 4.8

slight 3 4.8

Moderate 12 19.4

Very Large 18 29

Extremely Large 26 41.9

Total 62 100

Mean 3.98

Std. Deviation 1.123

48

4.5.4 Exchange Rates and Financial Stability

Understanding the role of exchange rate depreciation on individual banks is important to

anticipate banking sector stability or potential fragility due to the exchange rate depreciation.

Therefore this study focused on the establishing the influence of exchange rate on commercial

banks financial stability. The finding showed that a combined 75.8% of the respondents

indicated that exchange rate had a very large and extremely large effect on financial stability

of commercial banks in Kenya. Only 6.5% of the respondents indicated that exchange rate had

no influence on financial stability of commercial.

Table 4.15: Exchange Rates and Financial Stability

Frequency Percent

Not at all 4 6.5

slight 2 3.2

Moderate 9 14.5

Very Large 24 38.7

Extremely Large 23 37.1

Total 62 100

Mean 3.97

Std. Deviation 1.116

4.5.5 GDP Growth and Financial Stability

The relationship between financial development and economic growth has received

considerable attention in both developed and developing economies. This concern about

banks’ financial stability and economic growth finds its justification in the policy implications

that the relationship can bring about. The study sought to establish the influence of GDP growth

on financial stability of commercial banks. The findings showed that exactly 50% of the

respondents indicated that GDP growth had extremely large influence on financial stability of

commercial banks in Kenya. Another 24.2% of the respondents indicated that GDP growth had

very large effects on financial stability of commercial banks in Kenya.

Table 4.16: GDP Growth and Financial Stability

Frequency Percent

Not at all 3 4.8

49

Slight 2 3.2

Moderate 11 17.7

Very Large 15 24.2

Extremely Large 31 50

Total 62 100

Mean 4.11

Std. Deviation 1.118

4.5.6 Correlation Analysis for External factors and financial stability

The second objective of this study was to establish the effect of external factors on the financial

stability of commercial banks in Kenya. The conducted a correlation tests to ascertain the

association between external factors and financial stability of commercial banks in Kenya. The

results indicated that interest rates were found to have significant negative correlation (r=-.270,

p=0.034) with financial stability. The findings implied that increase in interest rates negatively

impact financial stability of the commercial banks in Kenya. Inflation rates and interest rates

spread were also found to be negatively related to financial stability of commercial banks. On

the other hand exchange rates and GDP growth were found to have a positive correlation with

financial stability of commercial. Increase in both exchange rate and GDP growth would

positively impact on financial stability of commercial banks in Kenya.

Table 4.17: Correlation Analysis for External factors and financial stability

Interest

Rates

Inflation

Rates

Interest Rate

spread

Exchange

Rates

GDP

Growth

Interest Rates

Pearson

Correlation 1

Sig. (2-tailed)

N 62

Inflation Rates

Pearson

Correlation .665**

Sig. (2-tailed) 0

N 62 62

Interest Rate

spread

Pearson

Correlation .557** .503**

Sig. (2-tailed) 0 0

N 62 62 62

Exchange Rates

Pearson

Correlation .542** .559** .583**

Sig. (2-tailed) 0 0 0

50

N 62 62 62 62

GDP Growth

Pearson

Correlation .658** .745** .415** .730**

Sig. (2-tailed) 0 0 0.001 0

N 62 62 62 62 62

Financial

Stability NPL

Pearson

Correlation -.270* -0.215 -0.129 0.15 .261*

Sig. (2-tailed) 0.034 0.093 0.317 0.246 0.04

N 62 62 62 62 62

** Correlation is significant at the 0.01 level (2-tailed).

* Correlation is significant at the 0.05 level (2-tailed).

4.4.8 Regression Analysis for External factors and financial stability

The study further used regression analysis to test the relationship between external factors and

financial stability of commercial banks in Kenya. The results showed that relationship R=0.502

and r-square =.291. The findings revealed that external factor accounted for 29.1% of the

variation in financial stability of commercial banks in Kenya.

Table 4.18: Model Summary

Model R R Square Adjusted R Square Std. Error of the

Estimate

1 .502a .291 .280 2959.00598

a. Predictors: (Constant), GDP Growth, Interest Rate spread , Interest Rates, Inflation Rates,

Exchange Rates

The results of ANOVA test show that the F value was 4.404 with a significance of p value =

0.040 which was less than 0.05, meaning that external factors were significant predictors of

commercial banks financial stability.

Table 4.19: ANOVA Results

Model Sum of Squares df Mean Square F Sig.

1

Regression 49367561.691 5 9873512.338 4.404 .040b

Residual 490320116.983 56 8755716.375

Total 539687678.674 61

a. Dependent Variable: Financial Stability NPL

51

b. Predictors: (Constant), GDP Growth, Interest Rate spread , Interest Rates, Inflation Rates,

Exchange Rates

The regression coefficient results revealed that interest rates had a negative and significant

relationship (B=-612.572, p=0.034) with financial stability of commercial banks in Kenya while

GDP growth was found to have a positive and significant relationship (B=562.004, p=0.04) with

financial stability of commercial banks in Kenya. The effect of inflation rates (B=-61.506,

p=0.895) and interest rates spread (B=-11.82, p=0.977) was found to be negative but statistically

insignificant. Exchange rates on the other hand were found to have positive relationship with

financial stability and the relationship was also statistically insignificant.

Table 4.20: Regression Coefficients Results

B Std. Error Beta t Sig.

(Constant) 906.889 1125.854 0.806 0.424

Interest Rates -612.572 282.033 -0.27 -2.172 0.034

Inflation Rates -61.506 464.114 -0.028 -0.133 0.895

Interest Rate spread -11.82 416.553 -0.005 -0.028 0.977

Exchange Rates 253.08 459.278 0.116 0.551 0.584

GDP Growth 562.004 267.807 0.261 2.099 0.04

a Dependent Variable: Financial Stability NPL

4.5 Financial Strategies Used to Enhance Financial Stability

The final objective of this study aimed to establish various financial strategies used to enhance

financial stability of commercial banks in Kenya. The study sought to find out whether

commercial banks used supervision, bank policy, financial reconciliation, income

diversification and financial innovations in their quest to enhance their financial stability.

52

4.5.1 Supervision

Monetary, fiscal, and prudential supervisory policies can be significant contributors to creating

a systemically risky or stable financial environment. The study also sought to find out to what

extent the commercial banks in Kenya used supervision in enhancing financial stability. The

findings showed that 33.9% of the respondents indicated that commercial banks used

supervision in enhancing financial stability. Whereas, 24.2% of the respondents indicated that

supervision was used to extremely large extent in enhancing financial stability.

Table 4.21: Productive Employees and Financial Stability

Frequency Percent

Not at all 6 9.7

slight 9 14.5

Moderate 11 17.7

Very Large 21 33.9

Extremely Large 15 24.2

Total 62 100

Mean 3.48

Std. Deviation 1.277

4.5.2 Bank Policy

Bank policy should aim at fostering market mechanisms in the functioning of the banking

system, especially the setting of interest rates for saving and borrowing and competition among

banks. This study sought to find out from the commercial banks the extent to which commercial

banks employed the use of bank policy in enhancing financial stability of the banks. The study

required the respondents to indicate the extent to which they used bank policy in enhancing

financial stability. The findings showed that 48.4% of the respondents indicated that bank

policy was used large by commercial banks in enhancing financial stability while 16.1%

indicated that bank policy was not used to enhance financial stability of commercial banks.

The result implied that commercial banks with comprehensive policy are likely to more

financially stable compared to banks without proper policy.

Table 4.22: Bank Policy and Financial Stability

Frequency Percent

53

Not at all 10 16.1

slight 12 19.4

Moderate 10 16.1

Very Large 18 29

Extremely Large 12 19.4

Total 62 100

Mean 3.16

Std. Deviation 1.381

4.5.3 Financial Reconciliation

The study further sought to find out if the commercial banks used financial reconciliation in

enhancing financial stability. Financial reconciliation include a comprehensive record keeping

system that makes it possible for entrepreneurs to develop accurate and timely financial reports

that show the progress and current condition of the business. This could be one of the financial

innovations that commercial banks adopt in enhancing financial stability. The findings of this

study showed that commercial banks in Kenya used financial reconciliation in enhancing

financial stability.

Table 4.23: Financial Reconciliation and Financial Stability

Frequency Percent

Not at all 7 11.3

slight 12 19.4

Moderate 7 11.3

Very Large 13 21

Extremely Large 23 37.1

Total 62 100

Mean 3.53

Std. Deviation 1.445

4.5.4 Income Diversification

One of the key measures to enhance financial stability is to diversify the financial sector in

terms of both number of domestic competitors and types of saving and lending instruments

available. The study intended to establish to what extent the commercial banks in Kenya used

income diversification in enhancing financial stability. The findings of this study showed that

54

56.5% of the respondents agreed that income diversification was large used by commercial

banks to enhance financial stability.

Table 4.24: Income Diversification and Financial Stability

Frequency Percent

Not at all 8 12.9

slight 11 17.7

Moderate 8 12.9

Very Large 15 24.2

Extremely Large 20 32.3

Total 62 100

Mean 3.45

Std. Deviation 1.434

4.5.5 Financial Innovations

Finally the study sought to find out the extent to which commercial banks used financial

innovations such as modern risk management systems and process and product innovations

among others. The finding showed that 25.8% and 19.4% of the commercial banks in Kenya

indicated to use financial innovations to extremely large and very large extent respectively. On

the other hand 24.2% of the commercial banks indicated not to use financial innovations in

enhancing their financial stability. The findings imply that financial innovations are not used

by all the banks in enhancing their financial stability.

Table 4.25: Financial Innovations and Financial Stability

Frequency Percent

Not at all 15 24.2

slight 5 8.1

Moderate 14 22.6

Very Large 12 19.4

Extremely Large 16 25.8

Total 62 100

Mean 3.15

Std. Deviation 1.513

55

4.6 Chapter Summary

This chapter provides presentation of the results and findings. The results and findings are

presented in form of tables and charts. The results of the demographics characteristics of the

respondents are provided in the introduction. The findings are presented based on the research

questions. Both descriptive and inferential statistics were used to ascertain the relationship

between independent variables and dependent variable. The findings showed that both internal

and external factors affect financial stability of commercial banks in Kenya.

CHAPTER FIVE

5.0 DISCUSSION, CONCLUSION AND RECOMMENDATION

5.1 Introduction

This chapter addressed the discussion, conclusions and recommendations. This was done in

line with the objectives of the study. This chapter summarized the findings of the study and

made conclusions upon which recommendations are drawn. Suggestion for further study was

also captured as a way of filling the gaps identified in the study. The study pursued three

objectives upon which conclusions are aligned to.

5.2 Summary

The purpose of this study was to establish the effect of internal factors and external factors on

the financial stability of commercial banks in Kenya. The study also aimed to determine the

financial strategies used to enhance financial stability of commercial banks in Kenya. This

56

study adopted a descriptive research design. This approach was used to describe variables

rather than to test a predicted relationship between variables. The population of this study

included 41 commercial banks in Kenya as at June 2016 (CBK, 2016). The study adopted

census survey on all the commercial banks in Kenya. The study administered the

questionnaires to two top managers from each bank. The two top managers were derived from

different branches of the same bank.

The study further used random sampling to select the respondents among the top managers of

commercial banks. Random sampling was appropriate and ensured no bias in selecting the

branches where the respondents were derived and also reduced the bias in selecting the

managers that participated in the study. Random sampling was used because the study

population was large. The study administered the questionnaires to two top managers from

each bank which made a total sample size of 82 respondents. This study mainly used primary.

Primary data collected on the three research objectives. The researcher used drop and pick

method in administering the questionnaire. Descriptive statistics was employed in data

analysis. Descriptive statistics included the means and frequencies were used to analyze

quantitative data and capture the characteristics of the variables under study.

The first objective of this study was to establish the effects of internal factors on the financial

stability of commercial banks in Kenya. The study employed descriptive statistics mainly

percentages and frequencies on establishing the effects of internal factor on financial stability.

The finding showed that commercial banks operating costs, the size of the bank, board size,

capital size, Sound Interest Rate Policy and productive employees influenced commercial bank

financial stability. The results of the model summary indicated that bank internal factors

combined accounted for 26.3% of the variation in financial stability this was indicated by an

R-Square of 0.263.

The study further sought to establish the effects of macroeconomics factors on the financial

stability of commercial banks in Kenya. Similarly, the study employed descriptive statistics

mainly percentages and frequencies on establishing the effects of internal factor on financial

stability. The finding showed that interest rates, inflation rates, interest rate spread, exchange

rates and GDP growth influenced commercial bank financial stability. The results showed that

57

relationship R=0.502 and r-square =.291. The findings revealed that external factor accounted

for 29.1% of the variation in financial stability of commercial banks in Kenya.

The study finally intended to find out some of the financial innovation adopted by financial

banks to enhance their financial stability. The study employed the use of descriptive statistic

where the respondents were required to indicate the extent to which they used financial

strategies such as supervision, bank policy, financial reconciliation, income diversification and

financial innovations in their quest to enhance their financial stability. The findings revealed

that commercial banks in Kenya used supervision, bank policy, financial reconciliation,

income diversification and financial innovations in enhancing financial stability of commercial

banks. The findings showed that 33.9% of the respondents indicated that commercial banks

used supervision in enhancing financial stability. The findings also showed that 48.4% of the

respondents indicated that bank policy was used large by commercial banks in enhancing

financial stability while 16.1% indicated that bank policy was not used to enhance financial

stability of commercial banks. The study further found out that 56.5% of the respondents

agreed that income diversification was large used by commercial banks to enhance financial

stability. Finally, the findings revealed that 25.8% and 19.4% of the commercial banks in

Kenya indicated to use financial innovations to extremely large and very large extent

respectively. On the other hand 24.2% of the commercial banks indicated not to use financial

innovations in enhancing their financial stability.

5.3 Discussions

5.3.1 Effect of Internal Factors on Financial Stability

The first objective of this study was to establish the effects of internal factors on the financial

stability of commercial banks in Kenya. The study employed descriptive statistics mainly

percentages and frequencies on establishing the effects of internal factor on financial stability.

The finding showed that commercial banks operating costs, the size of the bank, board size,

capital size, Sound Interest Rate Policy and productive employees influenced commercial bank

financial stability.

58

The findings of this study concurs with Athanasoglou et al., (2005) who argued that the internal

factors include bank size, board size, capital, operating cost and risk management capacity.

The same scholars also contend that the major external factors that influence bank performance

are macroeconomic variables such as interest rate, inflation, economic growth and other factors

like ownership

The findings also agreed with Memmel and Raupach (2010) who studied several European

countries and concluded that operating costs have a negative effect on profit measures despite

their positive effect on net interest margins. Efficiency in cost management is normally

measured as a ratio (operating costs to assets). The findings was also supported by Hoffmann

(2011) who suggested that high cost of operations led to lower profit margins since it means

that the organization is spending more in order to get output. It is important to note that due to

competition and market regulations, a bank that is faced by high cost of operations cannot pass

the whole burden to the customers through increasing the bank fees and charges and therefore

this means that the bank has to shoulder it. Increased costs affect the left side of the profit and

loss statement and this means that the profits realized will be lower than in a case where the

costs of operations are lower

On his part Bowa (2015) examined the effect of bank capitalization on liquidity of commercial

banks in Kenya. The regression results showed that size of bank and asset quality have an

influence on banks liquidity ratio. However, it was identified that bank size had the highest

influence on banks liquidity ratio. The results suggested that larger banks essentially enjoy

economies of scale which in turn positively influences their profitability. Similarly, Amato and

Burson (2007) tested size-profit relationship for firms operating in the financial services sector.

The authors examined both linear and cubic form of the relationship. With the linear

specification in firm size, the authors revealed negative influence of firm size on its

profitability. However, this influence wasn’t statistically significant.

5.3.2 Effect of External Factors on Financial Stability

The study further sought to establish the effects of macroeconomics factors on the financial

stability of commercial banks in Kenya. Similarly, the study employed descriptive statistics

mainly percentages and frequencies on establishing the effects of internal factor on financial

59

stability. The finding showed that interest rates, inflation rates, interest rate spread, exchange

rates and GDP growth influenced commercial bank financial stability.

The findings of this study supported the findings of various authors who conducted similar

studies. For instances Githae (2012) examined the effects of interest rates spread on the

financial performance of commercial banks in Kenya. Study results showed that a strong

relationship exists between commercial banks financial performance and interest rate spread,

inflation and default risks. Jamal and Khalil (2011) on the other hand concluded that the more

banks are involved in international trade especially foreign transactions, the more they faced

with more financial risks due to fluctuating inflation and interest rates which affects exchange

rates. This in turn affects the attainable revenue from foreign exchange dealings and contracts.

Similarly, Onyango (2016) explored the relationship between loan duration and interest rates

for commercial banks in Kenya. The research results revealed that an increment in lending

risks results to increments in average loan duration of commercial banks. This increment in

lending risks enables banks to control their overall risk exposure by limiting amounts lend to

borrowers. The findings were further supported by Ekweny (2014) who examined interest rates

volatility on nonperforming loans portfolio of listed commercial banks in Kenya. Research

results showed that interest rate volatility negatively affect the performance of non-performing

loans portfolio. The study recommended that the country ought to handle its macroeconomic

variables in an appropriate manner as changes in variables like inflation and interest rates bring

about currency devaluation which affects commercial banks performance.

Sufian & Chong, (2008) argues that consumers will also tend to withdraw their savings from

commercial banks at such times since there is not enough money to spend due to the low

purchasing power. Banks therefore find themselves in a situation where they have fewer funds

available to them to offer as loans to borrowers.

Whereas, Gachua (2011) research found that unrealized foreign exchange gains/losses have an

effect on the Net Income of listed companies as it was posted to either income statement or

owners’ equity. The level of foreign exchange gains or losses is determined by a large extent

by prevailing inflation rates in the country. Similar views were shared by Bakang (2012) who

argued that financial stability drives economic growth through the presence of efficient

60

markets while the second; the demand-leading hypothesis posits that economic growth is a

response to the expansion of financial markets and progress.

5.3.3 Financial Innovations Used to Enhance Financial Stability

The study finally intended to find out some of the financial innovation adopted by financial

banks to enhance their financial stability. The study employed the use of descriptive statistic

where the respondents were required to indicate the extent to which they used financial

strategies such as supervision, bank policy, financial reconciliation, income diversification and

financial innovations in their quest to enhance their financial stability. The findings revealed

that commercial banks in Kenya used supervision, bank policy, financial reconciliation,

income diversification and financial innovations in enhancing financial stability of commercial

banks.

According to Padoa-Schioppa, (2003) the special relationship between monetary policy and

macro-prudential policy implies a pivotal role for the central bank even if macro-prudential

authority is not vested in the central bank. In addition, while a close relationship with

governmental authorities charged with fiscal policy is necessary, the macro-prudential

supervisor should not be so closely linked to the fiscal authorities that its political

independence is, or appears to be, compromised

Posen and Véron (2015) on the other hand suggested that Bank-based or bank-centric financial

systems are not inherently safer than systems that include meaningful roles for securities and

capital markets. Domestic financial systems should be steadily diversified in terms of both

number of domestic competitors and types of saving and lending instruments available (and

thus probably types of institutions). Posen and Véron (2015) further argued that financial

repression should be focused on regulating the activities of financial intermediaries and

investment managers/funds, not on compressing interest rates and returns for domestic savers.

On his part, Cheptumo (2010) studied response strategies to fraud related challenges by

Barclays Bank of Kenya. Among other findings, the study reported that Proactive fraud

detection procedures such as data analysis, continuous auditing techniques, and other

technology tools can be used effectively to detect financial instability involving cash

61

reconciliation failures by identifying anomalies, trends, and risk indicators within large

populations of transactions.

A study by Abdul (2014) showed that there is need for the owners and managers of the

commercial banks to embrace proper accounting records keeping in order achieve financial

performance. More efforts need to be channeled on accounting record keeping for effective

performance of business units because accounting record keeping strongly affects performance

of small scale business units. Similarly, Beyani and Kasonde (2005) concluded that it was

imperative for firms to readily adopt modern risk management systems in order to mitigate

against business risks hence ensure survival for the long run. It was further established that

banks ought to have a futuristic view when formulating risk measurement systems bearing in

mind that rapid technological changes and rapid markets growth are readily changing. Whereas

according to Gallegati and Tedeschi (2009) access to safe, easy and affordable credit and other

financial services by the poor and vulnerable groups, disadvantaged areas and lagging sectors

is recognized as a precondition for accelerating growth and reducing income disparities and

poverty (Kohn, 2004). Wang, Gui and Ma (2009) findings showed that financial innovations

essentially increase the circulation of capital which in turn leads to safety of assets through

higher profitability and liquidity. This in turn positively improves banks stability as they are

able to handle and counter existing negative market forces with ease.

5.4 Conclusions

5.4.1 Effect of Internal Factors on Financial Stability

Banks are the backbone of the financial system in most developing countries and will remain

so for the foreseeable future. Thus, banking sector will remain fundamental to shaping the

financial system and ensuring financial stability. This study concluded that for internal factors

of the commercial banks which include operating costs, the size of the bank, board size, capital

size, Sound Interest Rate Policy and productive employees affects financial stability of

commercial banks. In Kenya the commercial banks dominate the financial sector. In a country

where the financial sector is dominated by commercial banks, any failure in the sector has an

immense implication on the economic growth of the country.

62

5.4.2 Effect of External Factors on Financial Stability

This study further concluded that an economy with favorable macro-economic conditions gives

room for businesses to thrive. The study also concluded that commercial banks benefit from

the increased business activities and thus improved profitability. 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. The macroeconomic policy

stability, Gross Domestic Product, Inflation, Interest Rate and exchange rates are also other

macroeconomic variables that affect the financial stability of commercial banks.

5.4.3 Financial Strategies Used to Enhance Financial Stability

The study concluded that commercial banks must take measures is to diversify the financial

sector in terms of both number of domestic competitors and types of saving and lending

instruments available. The study concluded that many banks through their financial stability

reports must attempt to assess the risks to financial stability by focusing on a small number of

key indicators. Commercial banks in Kenya must focus on supervision, bank policy, financial

reconciliation, income diversification and financial innovations to enhance financial stability.

5.5 Recommendations

Based on the findings of this study the following recommendations were made;

5.5.1 Recommendation for Improvement

5.5.1.1 Effect of Internal Factors on Financial Stability

The study recommended that internal factors are within the scope of the bank to manipulate

them. Therefore, commercial banks in Kenya should adjust their internal factors in order to

boost their financial stability.

5.5.1.2 Effect of External Factors on Financial Stability

The study also recommended that government through the central bank should formulate sound

policies to regulated interest rates; inflation rates interest rates spread and the rate of economic

growth. This will assist in ensuring financial stability of the commercial banks.

5.5.1.3 Financial Innovations Used to Enhance Financial Stability

63

The study further recommended that commercial banks should adopt financial innovations in

enhancing their financial stability. Some of the financial innovations recommended that

commercial banks should adopt included modern methods of financial reconciliations, modern

risk assessment method. The commercial banks should also diversify their earning to enhance

their financial stability.

5.5.2 Recommendations for Future Research

The study recommended that future studies should focus on establishing the level of adoption

of hedging tools by commercial banks in Kenya and the influence on commercial banks

financial stability.

64

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APPENDICES

Appendix I: Letter of Introduction

Date…………………..

To The Management,

Dear Respondent,

RE: ACADEMIC RESEARCH PROJECT

I am a student from the United States International University, pursuing a Master in Business

Administration (MBA). I am carrying out research on ‘‘determinants of financial stability

among commercial banks in Kenya’’. This is in partial fulfilment of the requirement for the

degree of Masters at the United States International University

Kindly take a few minutes of your time to fill in this questionnaire to the best of your

knowledge. The data collected in this study will be used for academic purposes only.

Your co-operation will be highly appreciated.

Kind Regards,

73

Appendix II: Questionnaire

Kindly take few minutes to complete the questionnaire as guided. Your responses will be

handled confidentially and ethically.

Thank you for agreeing to participate in this academic study.

SECTION A: GENERAL /DEMOGRAPHIC DATA

Kindly tick () on the option that best applies to you

1. Which department do you work in within the bank?

a. Marketing Department

b. Human Resource Department

c. Finance Department

d. R&D Department

2. How long have you been working in the banking Industry?

a. less than 2 year

b. 3 to 5 years

c. 6 to 9 years

d. Over 10 years

3. How long have you been in your current position?

a. less than 1 year

b. 1 to 2 years

c. 2 to 3 years

d. 3 to 4 years

4. Does your bank have several branches?

a. Yes

b. No

5. What is the highest degree or level of school you have completed? If currently enrolled,

mark the previous degree grade or highest degree achieved.

a. 1 or more years of college, no degree

b. Bachelors’ degree

74

c. Masters’ degree

d. Professional degree

e. Doctorate degree

6. What is your marital status?

a. Married

b. Widowed

c. Separated

d. Divorced

e. Single

7. What is your age group?

a. 26 to 30

b. 31 to 45

c. 46 to 60

d. 61 and over

SECTION B: Effect of Internal Factors on Financial Stability

To what extent does the following internal factors affect financial stability of commercial

banks in Kenya? 1= extremely large, 2=very large, 3=Moderate, 4=slight, 5=Not at all

No Statements 1 2 3 4 5

1. 1 Operating Cost

2. 2 Bank Size

3. 3 Board size

4 Capital Size

5 Sound interest rate policy

6 Productive employees

75

Kindly state any other internal factors that you think do affect financial stability of commercial

banks in Kenya.

…………………………………………………………………………………………………

…………………………………………………………………………………………………

……...

SECTION C: Effect of External Factors on Financial Stability

To what extent does the following external factors affect financial stability of commercial

banks in Kenya? 1= extremely large, 2=very large, 3=Moderate, 4=slight, 5=Not at all

No Statement 1 2 3 4 5

4. 1 Interest Rates

5. 2 Inflation Rates

6. 3 Interest Rate spread

7. 4 Exchange Rates

8. 5 GDP Growth

Kindly state any other external factors that you think do affect financial stability of commercial

banks in Kenya.

…………………………………………………………………………………………………

…………………………………………………………………………………………………

……........

SECTION D: Financial Strategies Used to Enhance Financial Stability

To what extent do commercial banks in Kenya use the following Financial Strategies to

Enhance Financial Stability? 1= extremely large, 2=very large, 3=Moderate, 4=slight, 5=Not

at all

Financial Strategies 1 2 3 4 5

1 Supervision

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2 Bank Policy

3 Financial Reconciliation

4 Income Diversification

5 Financial Innovations

THANK YOU FOR YOUR PARTICIPATION IN THIS SURVEY