EFFECT OF MACROECONOMIC VARIABLES ON PROFITABILITY OF .

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International Journal of Economics, Commerce and ManagementUnited KingdomVol. III, Issue 4, April 2015http://ijecm.co.uk/ISSN 2348 0386EFFECT OF MACROECONOMIC VARIABLES ONPROFITABILITY OF COMMERCIAL BANKS LISTED IN THENAIROBI SECURITIES EXCHANGEChristine Nanjala SimiyuSchool of Business and Public Management, KCA University, Nairobi, Kenyakitisw@gmail.comLessah NgileMachakos University College, Nairobi, KenyaAbstractBased on vital contribution of the commercial banks to economic progression Kenya, this studyendeavors to investigate the effect of macroeconomic variables on financial profitability of listedcommercial banks in the Nairobi Securities Exchange (NSE) for years 2001 to 2012. Panel dataanalysis using Fixed Effects model was applied on the data to examine the effects of threemajor macroeconomic variables which included: Gross Domestic Product (GDP), Exchangerates, and interest rates on profitability of the listed commercial banks. The study findingsindicated that real GDP growth rate had positive but insignificant effect to profitability ofcommercial banks as measured through Return On Assets (ROA). Further, real interest rateshad a significant negative influence on profitability of listed commercial banks in Kenya. Whilethe exchange rate had a positive significant effect on the profitability of listed commercial bankson Nairobi Securities Exchange.Keywords: Return on Assets, Panel Data, Fixed Effects, Profitability, NSE, KenyaINTRODUCTIONOne driving force of any economy is the interaction of the individual companies within it, bothwith each other and with financial institutions. Basic to this interaction must be well-foundedknowledge as to the relative financial health of these companies. Logic suggests that a majorfactor affecting company failure rate would be the overall economic circumstances within whichLicensed under Creative CommonPage 1

Christine & Lessahcompanies are operating. An effective and efficient functioning of the financial sector requiressound and favorable macroeconomic environment in the country. However, in this era ofglobalization it is imperative for the financial sector to be strongly integrated with the globaleconomy. Increased integration and growing macroeconomic fluctuations require more attentionto be paid to the link between the ”noise” that these fluctuations represent and the company’sown development.In Kenya, although financial markets have been liberalized and are operating oncompetitive basis, they still have a long way to go to achieve the required level of development.One may conclude that the process of liberalization created a mushroom growth of both theNon-Banking Financial Institutions (NBFIs) and banks, giving rise to profit, competition and alsotheir existence (Otuori, 2013). In fact, during the past few years, a major chunk of the financialsector was shifted from the public sector toward private ownership in the country.Macroeconomic Variables Affecting Profitability of BanksThe subject of macroeconomic factors and their effect on profitability of companies have beenstudied extensively but results lack consensus. Scott and Arias (2011) studied profitability of fivelargest banks in United States. They proved that GDP growth did not directly affect the profitlevel of U.S banking sector. Hoffmann (2011) used GMM and pooled OLS estimation approachto study US banks. The final result of both regression models indicates no considerablerelationship. Sufian (2011) analyzed 11-29 Korean commercial banks during year 1992-2003.Linear regression results revealed negative impact of Gross Domestic Product (GDP) on Returnon Assets (ROA), but positive impact of inflation. An empirical study by Damena (2011), on theprofitability determinants of Ethiopian commercial banks used 10 years balance sheet data of 7leading banks confirming positive effect of GDP, inflation and interest rate. Likewise, Davydenko(2011) used fixed effects estimation technique and proved that both GDP and Inflation have apositive relationship with ROA of Ukrainian banks. Saksonova and Solovjova (2011) performedcomparative analysis of five largest Latvian commercial banks during period of economic crises.GDP growth had positive contribution to profits, and inflation negatively affected ROA.The following are the macro economic variables that affect financial profitability of listedcommercial banks that are discussed in this research. The real interest rate is the rate ofinterest an investor expects to receive after allowing for inflation. It can be described moreformally by the Fisher equation, which states that the real interest rate is approximately thenominal interest rate minus the inflation rate. A consumer price index (CPI) measures changesin the price level of a market basket of consumer goods and services purchased by households.The CPI in the United States is defined by the Bureau of Labor Statistics as "a measure of theLicensed under Creative CommonPage 2

International Journal of Economics, Commerce and Management, United Kingdomaverage change over time in the prices paid by urban consumers for a market basket ofconsumer goods and services."GDP is an inflation-adjusted measure that reflects the value of all goods and servicesproduced in a given year, expressed in base-year prices, often referred to as "constant-price.Inflation is a sustained increase in the general price level of goods and services in an economyover a period of time due to the devaluation of the fiat currency being usedExchange rate (also known as a foreign-exchange rate, forex rate, between twocurrencies is the rate at which one currency will be exchanged for another. However the macroeconomic variables that were considered in this study were real Gross Domestic Product(GDP), real interest rates and exchange rate.Financial Profitability of Commercial BanksFinancial profitability of commercial banks is measured through the following variables;ROE is a financial ratio that refers to how much profit a company earned compared to the totalamount of shareholder equity invested or found on the balance sheet. ROE is what theshareholders look in return for their investment. A business that has a high return on equity ismore likely to be one that of generating cash internally. Thus, the higher the ROE the better thecompany is in terms of profit generation. It is further explained by Khrawish (2011) that ROE isthe ratio of Net Income after taxes divided by Total Equity Capital. It represents the rate ofreturn earned on the funds invested in bank by its stockholders. ROE reflects how effectively abank management is using shareholders funds. Thus, it can be deduced from the abovestatement that the better the ROE the more effective the management in utilizing theshareholders capital.ROA is also another major ratio that indicates the profitability of a bank. It is a ratio ofIncome to its total asset (Khrawish, 2011). It measures the ability of the bank management togenerate income by utilizing company assets at their disposal. In other words, it shows howefficiently the resources of the company are used to generate the income. It further indicates theefficiency of the management of a company in generating net income from all the resources ofthe institution (Khrawish, 2011). Wen (2010), state that a higher ROA shows that the companyis more efficient in using its resources.Net Interest Margin (NIM) is a measure of the difference between the interest incomegenerated by banks and the amount of interest paid out to their lenders (for example, deposits),relative to the amount of their (interest earning) assets. It is usually expressed as a percentageof what the financial institution earns on loans a specific time period and other assets minus theinterest paid on borrowed funds divided by the average amount of the assets on which it earnedLicensed under Creative CommonPage 3

Christine & Lessahincome in that time period (the average earning assets). The NIM variable is defined as the netinterest income divided by total earnings assets (Gul et al., 2011). Net interest margin measuresthe gap between the interest income the bank receives on loans and securities and interest costof its borrowed funds. It reflects the cost of bank intermediation services and the efficiency ofthe bank. The higher the net interest margin, the higher the bank's profit and the more stable thebank is. Thus, it is one of the key measures of bank profitability.PAST STUDIESVarious studies show that commercial banks play a vital role in the economic resourceallocation of countries. They contribute to economic growth of the country by making fundsavailable for investors to borrow as well as financial deepening in the country (Otuori, 2013).Commercial banks appear very profitable in Sub-Saharan Africa (SSA) where average returnson assets were about 2 percent over the last 10 years, significantly higher than bank returns inother parts of the world (Flamini et al, 2009).The profitability of commercial banks can be affected by internal and external factorswhich can be classified into bank specific (internal) and macroeconomic variables (Flamini et al,2009). The internal factors are individual bank characteristics which affect the bank'sprofitability, these factors are basically influenced by the internal decisions of management andboard. The external factors are sector wide or country wide factors which are beyond the controlof the company and affect the profitability of banks.The major reasons behind high return in the region as outlined by Ongore (2013) were;investment in risky ventures and the existence of huge gap between the demand for bankservice and the supply thereof. That means, in SSA the number of banks are few compared tothe demand for the services; as a result there is less competition and banks charge high interestrates. This is especially true in East Africa where the few government owned banks take thelion's share of the market (Ongore, 2013).The macroeconomic condition, which determines the level of credit worthiness of theborrowers, asset quality, increase and decrease in the value of collateral and other relatedfactors, is the main source of macroeconomic shocks to the bank’s portfolio. Furthermore,regulatory environment of an economy, level of financial development and level of concentrationof the financial sector also explain its profitability. The instruments of monetary policy likeinflation, real exchange rate, and short-term interest rate act as important determinants ofprofitability of companies in a country. According to Asimakopoulos, Samitas and Papadogonas(2009), financial sector institutions can capture a range of factors that impose risks on thefinancial system and devise ways to manage such factors. So, for long-term sustainability of theLicensed under Creative CommonPage 4

International Journal of Economics, Commerce and Management, United Kingdomfinancial sector, banks should be capable of operating in a competitive environment whilemitigating the risk factor.All companies strive to be successful and sustainable. To achieve this goal, it isimportant that company profitability continues to grow. In this regard, a fundamental researchquestion is "what are the main variables that drive continual profitability?" as Kenya isdominated by Commercial Banks, it is of vital concern to associate their profitability withcountry’s progress, and hence, a study to identify the cumulative impact of macroeconomicvariables on the profitability of commercial banks would add to the strategies devised in interestof the institutions’ development. Purpose of this research was to study the relationship betweenmacroeconomic variables and profitability of commercial banks in Kenya.PROBLEM STATEMENTIn order to survive in the long run, it is important for a bank to identify factors affecting itsprofitability so that it can take initiatives to increase its profitability by managing the dominantdeterminants (Podder, 2012). Bank profitability is also vitally important for all stakeholders, suchas the owners, the investors, the debtors, the creditors, the depositors, the managers of banks,the regulators and the government. The profitability of banks gives directions to the stakeholders in their decision making. As outlined by Podder (2012), it gives direction to the debtorsand the investors to make decision whether they should invest money in bank or investsomewhere else, It also flashes direction to bank managers whether to improve its finance andRegulatory agencies and government are also interested in financial profitability for theregulation purposes.Globally, banking is a rapidly growing industry. Every bank is trying to enhance overallprofitability plus profits to occupy a better position in the financial system. This study will identifythe key macroeconomic elements that have impact on the profitability of banks. This is justifiedon the grounds that there are few studies on the effect of macroeconomic variables on bankprofitability in Kenya. Available studies lack consensus on the effect of macroeconomic factorson bank profitability. For instance, Ongore and Kusa (2013) established that macroeconomicvariables insignificantly affect bank profitability. They used regression analysis and found thatrise in inflation rates affected profitability of commercial banks negatively. However, therelationship was not significant at 5% level. A study by Kanwal and Nadeem (2013) in Pakistanestablished that there was a strong positive relationship of real interest rate on ROA. The studyfurther established that GDP had a significant positive relationship with ROA. However,Athanasoglou et al (2006) on the other hand found that exchange rates and GDP positivelyinfluenced profitability while interest rates had a negative influence on profitability. Alper andLicensed under Creative CommonPage 5

Christine & LessahAnbar (2011) observed the returns of Turkish banks and inferred that GDP grow

Exchange rate (also known as a foreign-exchange rate, forex rate, between two currencies is the rate at which one currency will be exchanged for another. However the macro economic variables that were considered in this study were real Gross Domestic Product (GDP), real interest rates and exchange rate. Financial Profitability of Commercial Banks Financial profitability of commercial banks is .