The relationship between interest rate risk management and profitability of commercial banks in Kenya

Abstract

Despite the rising importance of fee-based income as a proportion of total income for many banks, Net interest income remains one of the principal elements of bank net cash flows and after tax earnings. As a result, despite earnings diversification, variations in net interest income remain a key determinant of changes in profitability for commercial banks in Kenya. Currently the return on investments from treasury bills is low and banks are looking for alternatives to invest their excess money. This has led to cheap financing as a result. of too much liquidity in the economy which continues to drive down the interest rates. The progressive lowering of the signaling rate has led banks to reduce the interest rates on lending. Managing the profit margins in an environment where the central Bank of Kenya is pursuing a low interest rate regime is a hurdle to the commercial banks.

This study set out to determine the relationship between interest rate risk management and profitability of commercial banks in Kenya.Net interest income forms the biggest proportion of the banks overall income and this was observed for the 5-year period under study which was subsequently regressed against interest rate risk in each year. Interest rate risk was measured as the interest rate sensitivity gap between assets and liabilities maturing/repricing in time bands of less than three months, between three and.twelve months and maturities in periods above one year. These three cl\tegories formed the independent variables for use in this study.

The study found out there is a strong direct relationship between interest rate risk and the net interest income hence the earnings of commercial banks. Interest rate sensitivity gap movements accounted for 50.8% of variations in net interest income. This shows that proper interest risk management not only reduces a bank's exposure to the risk but it also provides an opportunity to stabilize and improve on their earnings resulting to higher profits. Overall, net interest income is increased by maintaining high positive long term sensitivity gaps in an increasing interest rate environment and low negative long term sensitivity gaps in a declining interest rate environment.