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FINANCIAL RISK AND FINANCIAL PERFORMANCE OF COMMERCIAL BANKS INRWANDA

A case of Equity Bank Rwan a

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C!AP"ER ONE

IN"ROD#C"ION "O "!E S"#D$

%&% Back'(oun of t)e Stu y

According to Athanasoglou et al, (2005) the role of commercial banks remains central in

financing economic activity and its effectiveness exert positive impact on overall economy as a

sound and profitable banking sector is better able to withstand negativeshocks and contribute to

the performance of the financial system !he author (Athanasoglou et al 2005) further notes that

bank risk taking has some effects on bank profits ("erformance) as indicated by total assets, total

deposit, net interest, margin and net income #obakovia (200$) asserts that the profitability of a

bank depends on its ability to foresee, monitor and avoid risks, and possibility of provisions to

cover losses brought about by risks that arise

%isk simply implies a possibility of unexpected outcome &t creates the notion that future events

may have some degree of uncertainty, thereby exposing an institution to adversity ('mmett

*) As it is the ma+or goal of a firm to maximi e benefits from cash flows and market status,

managers usually achieve their ob+ective through series of activities ranging from product sales,

deposit acceptance, provision of funds to clients, etc -ence risk is inevitable for financialinstitutions !he difference in taking reasonable risk is key to financial firms. profitability and

asset growth /inancial risk is an umbrella term for multiple types of risk associated with

financing, including financial transactions that include company loans in risk of default

( asserley, )

%isk in financial institutions cannot be fully eliminated but what is critical is how efficient a

bank can manage its risk exposures %isk management is the analysis of risk coupled with the

implementation of 1uality risk controls turk (200*) defines risk management as the process by which managers satisfy their risk taking needs by identifying key risks, obtaining consistent,

understandable, operational risk measures, choosing which risks to reduce, which to increase

and by what means, and establishing procedures to monitor the resulting risk position &n other

words, risk management is the process of assessing operational dangers of a particular position,

measuring its magnitude, and mitigating such exposures in order not to deter the institutional

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goals of the banking firm !he changing dynamics of banking activities, the sub+ected

environments within which banks operate, and the volatility of the world economy imply that

risk management must also ad+ust with time (#ikker 3 4et makers, 2005)

!he ob+ective of financial risk management is not to prohibit or prevent risk taking activity, butto ensure that the risks are consciously taken with full knowledge, clear purpose and

understanding so that it can be measured and mitigated &t also prevents an institution from

suffering unacceptable loss causing it to fail or materially damage its competitive position

/unctions of risk management should actually be bank specific dictated by the si e and 1uality of

balance sheet, complexity of functions, technical professional manpower and the status of 4&6

in place in that bank (#uttimer, 200 )

!he application of sound financial risk management practices related to the ade1uacy of provisions and reserves in accordance with #asel standards which re1uire banks to have a capital

ade1uacy ratio of 78 !he maintenance of capital ade1uacy is like aiming at a moving target as

the composition of risk9weighted assets gets changed every minute on account of fluctuation in

the risk profile of a bank apital ade1uacy is known as the core capital providing permanent

and readily available support to the bank to meet the unexpected losses Aggregate risk exposure

is estimated through %isk Ad+usted %eturn on apital (%A% ) and 'arnings at %isk ('a%)

method are used by bank to estimate the cost of 'conomic apital 3 expected losses that may

prevail in the worst 9case scenario and then e1uates the capital cushion to be provided for the

potential loss %A% is the first step towards examining the institution.s entire balance sheet

on a mark to market basis, if only to understand the risk return trade off that have been made &n

order to enhance the supervisory mechanism, some banks have put in place, a system of %isk

based supervision :nder risk based supervision, supervisors are expected to concentrate their

efforts on ensuring that financial institutions use the process necessarily to identifymeasure and

control risk exposure !he %#6 is expected to focus supervisory attention in accordance with the

risk profile of the bank (4edhat, 200;)

#anks have also been involved in a process of upgrading their risk management capabilities to

include both, loan reviews and portfolio analysis

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loan syndications, loan trading, credit derivatives, and creating securities, backed by pools of

assets (securiti ation), the banks have become more active in management of risk -edging and

greater diversification of banking portfolio is being done in order to narrow the dispersion of

possible portfolio outcomes and ensure that the combinations of selected assets offset the

movements of each other(#uttimer, 200 )

!he ultimate ob+ective of risk management implementation is to maintain financial performance

in the banking sector as aspects of financial risk management promote early warning system of

monitoring relevant indicators= as well as stimulating and making provisions for possible realistic

strains on the system by conducting stress testing !he above, helps regulators to monitor the

system and prepare for ways to avert potential or discovered stress on the system hence

establishing financial performance (#ikker 3 4et makers, 2005)

!he financial performance of commercial banks can be measured by the %eturn on Assets

(% A) which is a ratio that measures company earnings before interest 3 taxes ('#&!) against

its total net assets !he ratio is considered an indicator of how efficient a company is using its

assets to generate before contractual obligation must be paid &t is calculated as> % A?

'#&! !otal Assets %eturn n Assets gives an indication of the capital intensity of the banking

industry, which will depend on the industry= banks that re1uire large initial investment will

generally have lower return o n assets (Apps, ;)

@efault %ate (@%) is the term for a practice in the financial services industry for a particular

lender to change the terms of a loan from the normal terms to the default terms that is, the terms

and rates given to those who have missed payments on loan (Apps ;) @% ratio can be

calculated as @r %atio ? on "erforming Boans !otal Boan #ad @ebt ost is created when a

bank agrees to lend a sum of assets to a debtor and granted with expected repayment= in many

cases, however the debtor is unable to repay the debt at the fixed period of time by a certain date

&n addition, changes in the valuation of debt currency change the effective si e of the debt due toinflation or deflation, even though the borrower and the lender are using the same currency

onse1uently, this can lead to bad debt cost #ad debt cost includes lawyer.s fees, consultancy

fees 3 commissions to auctioneers (Apps, ;) #ad debt costs ratio can be calculated as> #@

%atio? #ad debt cost !otal cost

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/inancial risks have resulted in failure of a number of financial inst itutions in both developed

and developing world /or instance #ank of America lost a total of C2*D million, itigroup C2D2

million and :#6 ED20 million n @ecember 2, 200 , 'nron orporation, the largest :6 energy

trader, filed for hapter bankruptcy protection, creating the largest bankruptcy case in history

6tandard 3 "oor.s estimates that 'nron and its consolidated entities had C $ billion of on9

balance9sheet debt and as of 6eptember $0, 200 , the company had more thanC billion of

liabilities on derivatives contracts, including energy, power, and other commodities 9related

forwards, swaps, and options held by a wide variety of institutions 6imultaneously, many

business counterparties experienced large e1uity price declines owing to credit risk concerns

&n igeria, wo+ori, Akintoye, and Adidu (20 ) notes that at the height of the distress in 5,

;0 out of the 5 operating banks were distressed= the ratio of the distressed banks arising from

non9performing loans and leases to their total loans and leases was ;*8 !he ratio deteriorated to

* 8 in ;= to 728 in *= and by @ecember 2002, the licences of $5 of these distressed

banks had been revoked &n Fenya, the nonperforming loans as a proportion of total loans which

is another proxy for credit risk averaged 5 078 in 2007, $ 58 in 200*, stood at D $8 in 200;

and further averaged ; 0*8 in 2005 and ;D8 in 200D otably, the level of nonperforming

loans given by nonperforming loans to total loans decreased during the period 200D to 2007

( #F, 20 0)

At the close of 20 2, %wanda.s banking sector was composed of nine commercial banks and five

specialised institutions (that included three micro9finance banks, one development bank, and one

co9operative bank) ommercial banks. total assets returned a G $8 y9o9y growth to stand at

:6@ ;bn, making it the second smallest banking sector in the larger 'ast African ommunity

('A ) region, after #urundi -owever, banking sector penetration still remains low, with the

ratio of total banking sector assets to H@" standing at 278 in local currency terms, and

representing a massive growth opportunity !he #ank of Figali (#F) continued its dominance as

the country.s largest bank, with total assets worth :6@D ;mn at the close of 20 2 /rom a

profitability perspective, the %wandan banking sector.s $8 return on e1uity (% ') places

it at the bottom of the profitability rankings of the 'A region -owever, on a micro9level,

#an1ue ommerciale du %wanda (# %) was the country.s most profitable bank

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determining the influence of financial risk practices on the financial performance on

commercial banks in %wanda

%&. O,/ecti0es of t)e Stu y

%&.&% 1ene(a- O,/ecti0e

!he general ob+ective of this study will be to determine the influence of financial risk on the

financial performance of commercial banks in %wanda

%&.&* S2ecific O,/ecti0es

!he study will be guided by the following specific ob+ectives=

i !o examine the influence of risk aggregation and capital allocation practices on financial performance of '1uity #ank %wanda

ii !o investigate the influence of supervision and regulation on the financial performance of

'1uity #ank %wanda

iii !o evaluate the influence of disclosures on the financial performance of '1uity #ank

%wanda

iv !o determine the influence of funded and unfunded credit protection on financial performance of '1uity #ank %wanda

%&3 Resea(c) 4uestions

i

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%&5 Si'nificance of t)e Stu y

!he study will be significant to financial institutions because they will be able to understand

credit management and risk management practices and how they influence the financial

performance of the banks and how the same can be leveraged to achieve high financial

performance !he study will also be important to the bank operational staff and management

who will be able to understand the risk management practices that contribute to financial

performance of commercial banks and ensure that they undertake acceptable banking practices

and procedures !he study will also facilitate bank customers to understand and appreciate risk

management practices instituted by banks so as to adhere to prudential banking practices

!he study will provide insight in the most successful strategies banks use to handle credit risk

!he findings of the study will assist ational #ank of %wanda in formulating guidelines that willenhance %isk 4anagement in the banking sector Academicians will benefit from the

information of the study as the study will contribute to existing body of knowledge !he study

will further provide the background information to research organi ations and scholars and

identify gaps in the current research for further research

%&6 Li+itations of t)e Stu y

!ime factor will be a ma+or limitation for this study owing to combination of academic work and

office duties as well as family responsibilities &n addition, the limitation of validity cannot betotally eliminated

%&7 Sco2e of t)e Stu y

!his research study could not include all commercial banks in %wanda= it will only look at

'1uity #ank %wanda as a case study !he researcher will consider the performance of the bank

from 20 2 up to 20 $