CHAPTER ONE: INTRODUCTION

1.1 BACKGROUND OF THE STUDY This study seeks to analyze financial management practices and how it affects the performance of the banking firms basing the research on the National Bank of Kenya.

Financial management is that managerial activity which is concerned with the planning and controlling of the firms financial resources. It was a branch of economics till 1890, and as a separate discipline, it is of recent origin. Still it has no unique body of knowledge of its own and draws heavily on economics for its theoretical concepts even today. (IM Pandey 2008).

The subject of financial management is of immense interest to both academicians and practicing managers. To the academicians it is important because the subject is still developing and there are still certain areas where controversies exist for which no unanimous solutions have been reached as yet. Practicing managers are interested in this subject because among the most crucial decision of the firm are those which relate to finance and an understanding of the theory of financial management provide them with conceptual and analytical insights to make those decisions skillfully.

Some of the financial management practices that are there are: Investment decisions (long term asset mix) A firms investment decisions involve capital expenditures; hence they are referred to as capital budgeting decisions. A capital budget decision involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future.

Financing decision (capital mix) This function deals with the decision of when, where from and how to acquire funds to meet the firms investment needs. The central issue is to determine the appropriate proportion of equity and debt, the mix of debt to equity is called the firms capital structure.

Profit allocation (dividend decision) This is the decision of whether the firm should distribute all profits or retain them or distribute a portion and retain the balance. The proportion of profits distributed as dividends is called the dividend- payout ratio and the retained portion of profits is called the retention ratio.

Liquidity decision (short term asset mix) Investment in current assets affects the firms profitability and liquidity. Current assets management that affects the firms liquidity is an important finance function. Current assets should be managed efficiently for safeguarding the firm against the risk of illiquidity.

There are a total of forty six banks and non-bank financial institutions, fifteen microfinance institutions and forty eight foreign exchange bureaus in Kenya as indicated by price water house coopers website (www.pwc.com/extweb/industry.nsf). Thirty five of the banks, most of which are small to medium sized, are locally owned. The industry is dominated by a few large banks most of which are foreign owned, though some are partially locally owned. Six of the major banks are listed in the Nairobi Stock Exchange (NSE) with the latest being Equity bank. All banks have come together under Kenya Bankers Association (KBA) which serves as a lobby for the banks interest and also addresses issues affecting member institutions.

The Central Bank of Kenya website, (www.centralbank.go.ke) indicates that the period 19851995 is the most memorable as far as the Kenyas banking industry is concerned. Of the 29 commercial banks operating in Kenya in 1985, several folded during a banking crisis in 1986. In 1992, the number dropped to 15commercial banks and by 2009; there were 38 domestic and foreign commercial banks. Currently there are more than 40 commercial banks. In 2010, the total assets of Kenyas largest banks were 2.6 billion dollars representing half of the total assets of all commercial banks. It is alleged that the banking sector fragility in the late nineties resulted from poor management and worsening economic conditions (www.bankelele.com).

Despite all the closure of several banks within the industry during the last two decades, little has been done to analyze the effect of financial management practices on the performance of banks, and financial management function happens to be the backbone and very important function in the banking industry.

1.1.1 The National Bank of Kenya profile National Bank of Kenya Limited (NBK) was incorporated on 19th June 1968 and officially opened on Thursday November 14th 1968. In 1994, the Government reduced its shareholding by 32% (40 Million Shares) to members of the public. Again in May 1996, it further reduced its Shareholding by 40 million Shares to the public The current Shareholding now stands at: National Social Security Fund (NSSF) 48.06%, General Public - 29.44%, Kenya Government 22.5%.During the 34th AGM held on 25th April 2003 the bank increased its Share Capital by Ksh. 6 Billion i.e. from Ksh. 3 Billion to Ksh. 9 billion through the creation of 1,200,000,000 non-cumulative preference Shares of Ksh. 5 each. These Shares are at the disposal of the board who will offer them in accordance with the bank's articles, the CMA rules and the Companies Act. The bank provides banking, financial, and related services to the retail and corporate business segments in Kenya. Its deposit and other accounts include current, national saver, student, Pinnacle, Vision, foreign currency, Taifa, Al-mumin, Al-mumin Chequeing, wages, Uchuuzi SME transactional current, and Super Chama accounts, as well as call deposits and fixed deposits. The companys lending products portfolio comprises loans, overdrafts, personal loans to salaried customers, asset finance, mortgages, NBK study loans, and salary advances; and loans to tea farmers, sugar cane farmers, small and medium enterprises, and contractual seed farmers, as well as LPO financing. It also offers trade finance services in the areas of foreign and local remittance, bills collection, letters of credit, bankers guarantees and indemnities, and foreign currency transactions. In addition, the company provides safe custody, local and international Visa credit card, and Visa electron debit card services; treasury services, including money market operations, and buying and selling of treasury bills for customers; and standing instructions, bank cheques and drafts, bankers opinion, electronic payroll transfers, S.W.I.F.T. and cash connect money transfers, shares registry, custodial, collection VAT, ATM, telephone banking, customs duties collection, Internet banking, bank assurance, and trusteeship services. It operates 41 outlets. The company is headquartered in Nairobi, Kenya.

1.2 Statement of the problem For the banking industry to be able to perform well much need to be addressed as far as financial management is concerned. As managers make everyday decisions they will have to be more thorough in ensuring that the finances that commercial banks have are well managed. A firm secures whatever capital it needs and employs it in financing activities which generate returns on invested capital.

There are a number of gaps within commercial banks that demonstrate the need for enhancing financial management in these institutions such as inadequate financial policies and procedures particularly by the non-bank financial institutions. Furthermore not all institutions have functions and personnel dedicated for financial management and those who are there do not have enough training. There is therefore the need for the proper and effective management of financial institutions to attach considerable importance to improve the ability to identify measure, monitor and control the use of funds. The finance function of raising and using money although has a significance effect on other functions, yet it needs not necessarily limit or constraint the general running of the business.

Managers need to address the function with the seriousness it deserves, opportunities in the growth of the entire banking industry can become foreclosed due to the risks involved which can, in the long run, cause a decline in the performance of the banking industry.

1.3 Objectives of the study 1.3.1 General Objective The overall objective of the study is to establish the various financial management practices and their effects on the performance of the banking industry in Kenya.

1.3.2 Specific objectives 1. To examine how the performance of the bank in terms of assets and profits. 2. To analyse the management decisions in regards to the financial performance of the bank. 3. To identify the difficulties encountered by the bank in managing finances.

1.4 Research questions 1. How is the bank performing currently in terms of assets and profits? 2. What management decisions have been made in regards to the financial performance of the bank? 3. What are the difficulties encountered by the banks in managing finances?

1.5 Conceptual Framework Independent Variables Dependent Variable

Financial performance Financial Management Practices

Management decisions

Difficulties
Source (Author)

1.6 Significance of the study The findings of the study will not only be useful to the researcher but also to the National Bank of Kenya under study and to other researchers. To the researcher, it will give a better

understanding to the different management practices and their impacts on the banks. To the bank, it is hoped that the study will help the managers refine their management practices already in existence by highlighting the adequacy or otherwise of these practices. To the employees of the organization under study, it will give them a chance to air their concerns or appreciation about the existing financial management practices and also give their recommendations. To other researchers, the study will benefit them by being able to borrow ideas and apply them on their own researches. Other organizations will be able to use this research report to know how to better apply financial management practices on their own product and services.

1.7 Limitations of the study Limitations include any aspect of the study that might negatively affect the results of the study. Therefore, the challenges that might be encountered during the study include the challenges that might be encountered during the study include:-

i)

The study is limited to the extent that it focuses on one organization only, National Bank of Kenya. The findings may not be applicable to all the other banks and organizations. This can be overcome by future study on sample number of different banks and organizations in different geographical locations.

ii)

The use of questionnaires to gather information must be noted. The richness and depth of this research can be enhanced by use of interviews and observations. In addition, the research can benefit more by use of internal organizations documents like board minutes, policies and procedures which could provide more insights into the operations and strategic thinking of the management.

iii)

Confidentiality of information may limit the information availed by the respondents in aim to protect the banks corporate image. Competitors are always on the lookout and

because of this, the bank has to be secretive therefore limiting the kind of and amount of information they avail to researchers. The researcher will officially hand in a written letter to indicate the purpose of the research and guarantee to use the information only for educational purposes. 1.8 Scope of the study The study will confine itself to the National Bank of Kenya and will target its managers and employees. The study will seek to understand the of financial management practices applied at all the levels and come up with suggestions on how to make them more effective so as to improve performance. The study provides exploratory findings in the Kenyan context, and presents opportunities for further research.

CHAPTER TWO 2.0 LITERATURE REVIEW 2.1 Introduction This chapter looks, critically, at the financial management concept. It is divided into two main sections where the first one will look at the theoretical review of the study and the second section will look at work done by others.

2.2 Theoretical Review 2.2.1 The finance concept Financing decision is one of the most key functions to be performed by the finance manager in any organization, it constitutes the sources of funds where and how to acquire them to meet the firms financial needs. The central issue that presents itself to the finance manager is to determine the appropriate proportion of debt and equity. The mix of debt to equity is known as the firms capital structure. The financial manager must strive to obtain the best financing mix or the optimal capital structure for the firm. The firms capital structure is considered optimum when the market value of shares is maximized.

The scope of financial management can be clearly explained by exploring the roles and functions of a financial manager in a contemporary corporate set up. A financial manager has some traditional roles but there are various emerging roles due to changes in the environment. The traditional roles can be divided into two: 2.2.2.1 Managerial functions These functions require the technical skills, planning and expertise of a financial manager. They are: (a) financing decisions This involves looking for finances to acquire the assets of the firm. The finance may come from ordinary shares, long term debt, preference shares e.t.c, and the financial manager must identify the right source of funds which has the lowest cost. The principal objective of carrying out the financing roles is to ensure that: funds are made available at the right time funds are made available at the correct length of time

 funds are obtained at the lowest cost funds are used in the most efficient way

(b) long term investment decisions (capital budgeting decisions)

This involves the determination of where the acquired funds should be invested in order to generate revenue. The funds can be committed in the following investments taking into account the critical variables in each investment projects. The projects are evaluated in terms of risks and returns. Replacement of old and unproductive assets is also done here. Management must allocate limited resources between competing opportunities ("projects") in a process known as capital budgeting. Making this capital allocation decision requires estimating the value of each opportunity or project: a function of the size, timing and predictability of future cash flows.

(c) division of earnings decisions (dividend decision) Dividend decisions are very tricky because the value of the firm is sometimes determined by the amount of dividends that the firm has to pay. This decision is closely related to financing decision since most companies may wish to use retained profits as a source of finance. The company can only pay dividends out of profits made and thus reduces the amount of retained profits. If it finances its projects from retained earnings, then little or no dividend has to be paid and this has a direct effect on the value of the firm. The financial manager therefore has to decide the following: how much to pay ( dividend per share) when to pay (interim and final dividends) why pay dividends (does payment affect the value of the firm) how to pay (cash or bonus issue)

(d) liquidity decision Liquidity refers to the ability of the firm to meet its short maturing financial obligations as and when they become due for payment. It can also be referred to as working capital management. The management of investment in current assets is important because it affects the firms liquidity, profitability and risk. The more current assets a firm has the more liquid it is. This reduces the risk of becoming insolvent but it also reduces profitability because of too much capital tied up in current assets. The finance manager must however set an optimal level of each class of current assets since they are non income generating assets. He must ensure that neither insufficient nor unnecessary funds are invested in current assets.

2.2.2.2 Routine functions For effective execution of management functions have to be performed. They are short term in nature and require little technical expertise and skills for finance manager. They involve a lot of paper work and are mostly delegated to junior staff. They include: Supervision of receipts and payment Safeguarding of cash balances Records keeping and reporting Custody and safeguarding of important documents of the firm

2.3 Financial risks Financial risk in banking organization is the possibility that the outcome of an action or extent could bring up adverse effects on the financial institutions capital or earnings. (CBK Risk Management Guidelines, 2005)

Such outcomes could either results in direct loss of earnings or capital or may result in imposition of constrains or banks ability to meet its objectives. This research looks at the most commons risks in commercial banks namely strategic risks, credit risks, liquidity risks, interests risks, foreign

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exchange risks, price risks, operation risks, reputation risks and compliance / regulating risks. Greuning (2003) classifies this into: Pure risk Speculative risk

Pure risk: liquidity credit and solvency risks, Speculative risks: based on the financial arbitrage, can result in a profit if the arbitrage is correct or a loss if it is incorrect. Examples include interest rate risks, currency and market risks.

2.3.1 Credit risk It is defined as the current or prospective risk to earnings and capital arising from an obligors failure to meet the terms of any contract with the bank or if an obligor otherwise fails to perform as agreed. Largest source are loans. Greuning (2003) says that it is the chance that a debtor or financial instrument issuer will not be able to pay interest or repay the principal according to the terms specified in a credit agreement.

2.3.2 Strategic risk It could be defined as the current and prospective impact on earnings or capital arising from adverse business decisions improper implementation of decisions or lack of responsiveness to industry charges.

2.3.3 Interest rate risk Interest rate risk is the current or prospective risk to earnings and capital arising from adverse movement in interest rates. Excessive interest rate risk can pose a significant threat to financial institution earnings and capital base earnings.

2.3.4 Liquidity risk It is the current or prospective risk to earnings and capital arising from a banks inability to meet its liabilities when they fall due without incurring unacceptable losses. It arises when the cushion provided by the liquid assets are not sufficient to meet its obligations.

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2.3.5 Financial distress According to I.M. Pandey (2005) financial distress arises when a firm is not able to meet its obligations (payment of interest and principal) to debt-holders. The firms continuous failure to make payments to debt-holders can ultimately lead to the insolvency of the firm. For a given level of operating risk, financial distress exacerbates with higher debt. With higher business risk and higher debt, the probability of financial distress becomes much greater. The degree of business risk of a firm depends on the degree of operating leverage i.e. the proportion of fixed costs, general economic condition, demand and price variations, intensity of competition, extent of diversification and the maturity of the industry. Firms operating in turbulent business environment and in highly competitive markets are exposed to higher operating risk. The operating risk is further aggravated if the companies are highly capital intensive and have high proportion of fixed costs. Matured firms in relatively stable market conditions have lesser operating risk. Similarly, diversified companies with unrelated businesses are in better position to face fluctuating market conditions.

2.3.6 Costs of financial distress Financial distress may ultimately force a company to insolvency. Direct costs of financial distress include costs of din solvency. The proceedings of insolvency involve cumbersome process. The conflicting interests of creditors and other stakeholders can delay liquidation of the companys assets. The physical conditions of assets, which are not in use once the insolvency proceedings start, may deteriorate over time. They may be properly maintained. Their realizable value will decline. 2.3.7 How to manage financial risk Banks must quickly gain financial risk management capabilities in order to survive in a market oriented environment, withstand competition by foreign banks, and support private sector-led economic growth.

Since risk is inherent in banking and unavoidable, the task of financial management is to manage it in such a way that the different kinds of risks are kept at acceptable levels and profitability sustained. Doing so requires continual identification, quantification and monitoring of risk exposures, which in turn does sound policies, adequate organization, efficient processes, skilled analysts, and elaborate computerized financial system (Greuning, 2003).

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2.3.8 Active board and senior management oversight According to CBK (2005) boards of directors have ultimate responsibility for the level of risk taken by their institutions accordingly. They should approve the overall business strategy and significant policies of their organization and ensure that management is fully capable of managing the activities that their institutions conduct. The board is responsible for understanding nature of risk significant to their organization and also takes steps to develop an appropriate understanding of the risk their institutions face.

Seniors management is responsible for strategy implementation in a manner that limits risks associated with each strategy. They should have knowledge of all major business lines to ensure that appropriate policies, controls and risk monitoring systems are in place and that accountability and lines of authority are clearly delineated Senior management is also responsible for establishing and communicating a strong awareness of and need for effective internal controls and high ethical standards. 2.4 Liquidity and capital management for a bank To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with, notably, regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance: 1. Selling or redeeming other assets, or securitization of illiquid assets, 2. Restricting investment in new loans, 3. Borrowing funds (whether repayable on demand or at a fixed maturity), 4. Issuing additional capital instruments, or 5. Reducing dividends. Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as: 1. Demand deposits with other banks

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2. High quality marketable debt securities 3. Committed lines of credit with other banks As with reserves, other sources of liquidity are managed with targets. The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalization and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, a situation known as a run on the bank. Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2-3 months' etc. These residual contractual maturities may be adjusted to account for expected counter party behavior such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis. 2.5 Factors to consider when allowing credit 2.5.1 Collateral The Encyclopedia Britannica volume three defines collateral as a property pledged in case of a default. In theory, collateral is used as a security in the event of default by the clients and in turn reduce amount of loss to the lender. In practice it is used as a means of exerting pressure on the borrower to make maximum efforts to pay. Most financial institutions operate using collateral substitutes unlike major commercial banks and mortgage companies that emphasize on the use of collaterals such as land title deeds, vehicle logbooks and share certificates. The substitutes may include group guaranties; character based lending, risk of public embarrassment and risk of jail or legal action.

A study carried out by Benjamin and Ledgerwood (1998) revealed that the Association for the Development of Micro Enterprises (ADEMI) in the Dominican Republic uses a combination of

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collateral and guarantees to secure its loans. All borrowers are required to sign a legal contract stating their obligation to repay funds at specified terms. Alternative forms of collateral may include;

2.5.2 Compulsory Savings The Consultative Group to Assist the Poorest (CGAP) 1997 defines these as funds that must be contributed by a borrower as a condition of receiving a loan sometimes as a percentage of the loan, sometimes as a nominal amount. Waterfield and Duval (1996) categorically indicates the importance of compulsory savings as follows; it demonstrates the value of savings practices to the borrowers, it serves as additional guarantee mechanism to ensure repayment of loan, it can demonstrate the ability of clients to manage cash flow and periodic contributions and it helps to build up credit base of clients.

According to Marguerite (2000), a variation of compulsory savings required by Bank Rakyat of Indonesia is for borrowers to pay additional interest each month, which is returned to them at the end of the loan period, provided they have made full on time payments each month. The borrower receives a lump sum at the end of the loan term. This benefits the borrower and provides a concrete incentive to repay the loan on time thus benefiting the lender as well. 2.5.3 Assets Pledged at Less than the Value of the Loan Sometimes regardless the actual market value of assets owned by the borrower, the act of pledging the assets and the consequent realization that they can be lost causes the client to repay the loan.

2.5.4 Personal Guarantees Persons: friends or family members who in the event of the inability of the borrower to repay the guarantor, will be held responsible for repaying the loan.

2.5.5 Capacity to Pay According to Levitsky (1994), if the debt ratio is more than 5% of the recommended amount, then the client may have difficulty in repaying.

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2.5.6 Character of the Borrower Levitsky (1994) emphasizes on the importance of high levels of clients honesty and worthiness before credit is advanced to them.

2.5.7 The Prevailing Economic Conditions Noonan (1998) argues that a sales manager should evaluate the state of the economy to see whether it influences him to give credit.

2.6 Principles of financially viable lending Ledgerwood (1996) provided 4 principles of viable lending a follows:

2.6.1 Offer Services that Fit Preferences of Poor Entrepreneurs The loan terms should be favorable. ACCION international gives a period of 3 months whereas Grameen Bank gives a loan period of up to one year. Repeat loans-small loans appropriate for meeting the day-to-day financial requirements of businesses should also be provided and a customer friendly approach should be adopted. An example of repeat loans is the model adopted by Badan Credit Kecamalan in Indonesia which offers credit well under $100.

2.6.2 Streamline Operations to Reduce Unit Cost The lending process should be standardized and the application process made simple. The financial institution should decentralize loan approval and credit should be approved on the basis of easily verifiable criteria such as the existence of a going on enterprise.

2.6.3 Motivate Clients to Repay Loans This may include use of groups as guarantors, use of incentives such as offering larger or morel loans on repayment. Preferential pricing in exchange for prompt payment may also be adopted.

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2.6.4 Charge Full Cost Interest Rates and Fees The small loans sizes necessary to serve the poor may result in costs per loan requiring interest rates that are significantly higher than commercial bank rates. Poor entrepreneurs have shown willingness and an ability to pay such rates for services with attributes that fit their needs.

2.7 Methods of Credit Delivery 2.7.1 Individual Lending Largely depends on the assurance to repay and level of security. Formal financial institutions base lending decisions on business and client characteristics including cash flows, debt capacity, historical financial results, collateral and character. Informal sector base their lending on personal knowledge rather than on a sophisticated feasibility analysis and collateral.

Waterfield and Duval (1996) give the following characteristics of individual lending models; collaterals, screening and character checks of clients, tailoring of loan sizes and terms to business needs, frequent increase over time of loan sizes and terms, and developing of close relationships with the clients. They assert that loans to individuals are usually larger than to members of a group. Accordingly given equal number of loans, these loans to individuals provide large revenue base to cover the cost of delivery and maintaining the loans than group loans.

2.7.2 Group Based Lending Waterfield and Duval (1996) define group lending as advancing loans to groups-to individuals who are members of a group and guarantees each others loans or to groups that then sub loan to their members. It adopts the model of Rotating Savings and Credit Association (ROSCA) to provide additional flexibility in loan sizes and terms and generally to allow borrowers to access funds when needed rather than wait for their turn.

They go on to list the characteristics of group lending as follows; use of peer pressure as substitute for collateral, reduction of certain institutional costs through the use of group leaders to collect repayment. However several studies conducted in the past have linked group lending with certain disadvantages. A study carried out in Burkina Faso showed that the variable that had the most destabilizing effect on loan repayments was the domino effect. It demonstrated how group-lending

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institutions have better repayments rates than individual lending in good years but worse repayment rates in years with some type of crisis if several members of a group encounter repayment difficulties the entire group collapses leading to the domino effect.

2.8 Review of the Credit Structure It is necessary to mention that for the above credit delivery models to take place effectively, a review of the credit structure should be done. According to Wasilwa (2005) the larger the company the company the more complex the structure because of area expanse, divisions, subsidiaries, joint ventures and affiliations. Wasilwa (2005) goes on to indicate the sections that will exhibit higher levels of specialization which will in turn ease the work burden and bring better result

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2.9 Empirical Review

Government-owned Consolidated Banks pre-tax profit for the year ended December 2008 grew by more than three times to Sh84.9 million, up from Sh25.8 million in 2007.This represents a 229 per cent increase. However, the Treasury and State agencies which own the banks shares will not receive dividends as directors seek to comply with regulations that a company has to clear previous losses before rewarding its shareholders. Years of loss making prior to 2006 have lead to accumulated losses totaling Sh453.1 million at the end of 2008. This however is a reduction from the Sh576.9 million accumulated losses in 2007. These losses have to be cleared before the bank can legally pay out dividend. Most of the banks earnings in 2008 came from interest income, which rose from Sh369.5 million at the end of 2007 to Sh458.3 million according to figures the bank released. The bank from loans and advances to customers earned Sh419.9 million up from Sh317.3 million in 2007. Loans and advances to customers in 2008 rose 23 per cent to Sh2.7 billion from Sh2.2 billion in 2007. On the other hand customer deposits reached Sh3.2 billion up from Sh2.8 billion in 2007. The company had a history of poor performance largely due to its origin. It was established in 1990 from the ruins of a number of fallen institutions that included Rural and Urban Credit and Union Bank. In the 2006/7 Budget, the government factored in Sh22 billion intended for the revival of the National Bank of Kenya to the tune of Sh20 billion and Sh2 billion for the Consolidated Bank. NBK got its share in March 2007 although the funds were not released until late in the 2006/7 financial year. There has always been the intention by the government to plan the banks initial public offering (IPO). Currently, the bank has 10 branches and one agency located in various parts of the country.

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CREDIT RISK Lending has always been the primary function of banking, and accurately assessing borrower creditworthiness has always been the only method of lending successfully. Credit analysis supports marketing officers by evaluating companies before lending money to them. According to Ernst and Youngs research, it is noted that non-financial performance indicators drive at least 35% of investor decisions. Given the high risk economys environment managers should be capable of fulfilling their companys future growth potential.

Since the early seventies the domain of financial operations witnessed a significant transformation. The breakdown of the Bretton Woods Agreement, coupled with a liberalization of the financial markets and the inflation and oil crisis of the same time, led to increased volatility of interest rates. The environment of fixed income securities where private and corporate investors, insurance and pension fund managers would turn for secure investments became more volatile than the stock market.

Walmsley (1998) the continued deregulation of the banking market has increased volatility and the intensified competition in the financial industry; financial innovation with the engineering of new instruments has accelerated rapidly. Well known new products include standardized financial futures and options, floating rate instruments, caps and floors, interest rate and preferred stock.

Financial engineering is one more aspect of risk management, how the risk is managed determines the future of any business continuation. For instance when issuing collateralized mortgage obligations the collateral must sustain bond retirements, both in the very unlikely case of an immediate complete prepayment of all mortgages in the collateral and in the equally unlikely case of no prepayment Sykes(1987)

Bierwag (1987), Fabozzi and Pollack (1987), Granito (1984), and Platt (1986).the main reason why banks are going under is because they dont take time to understand the borrowers of loans i.e. they no longer do the bond portfolio immunization strategy which is used to match interest

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rate risk of an asset portfolio against a future stream of liabilities in order to achieve net zero market exposure.

INTEREST RATE RISK MANAGEMENT Interest is controlled by matching durations of assets and liabilities. When interest rate moves both sides of the balance sheet are affected in the same manner, leaving net present value virtually unaltered.

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CHAPTER 3
RESEARCH METHODOLOGY 3.1 Introduction This chapter consists of a description of secondary data, research design and target population, sampling design, size and data collection techniques. It finally looks at the data analysis techniques that will be applied.

The data for this study is to be obtained through interviews from manager of National bank through explaining what was needed to be done. Both the primary and secondary data are to be used in the analysis.

3.1.1 Secondary data Data is to be mainly sourced from related websites of commercial banks, CBK and various financial management books and guidelines. Data will also be collected from the annual reports of these banks.

3.1.2 Primary data Primary data is to be collected from the field by interviewing the managers of this bank.

3.2 Research design The design to be used will be a descriptive summary. The study is a case of National Bank within Mombasa town in Kenya. The study will elicit information from the manager of the bank. The specific information that the study seeks relates to the various financial management practices and the extent to which they affect the performance of the banking industry. A case of this bank will give a better understanding of the practices of financial management.

3.3 Target Population Population is defined as the total number of aggregate of all units possessing certain characteristics from which sample of study can be derived. It is a collection of all measurements of a particular type of interest to the decision maker. The success of any research depends on the extraction of the required information from the appropriate population. However in case of a

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research involving a large number of the population under study, then a sample needs to be drawn from the entire population that has sufficient characteristics representing the population to draw accurate inferences from it.

This study will be conducted in the National Bank of Kenya in Mombasa town and is targeting approximately 20 members of staff of the entire bank in different levels of management.

3.4 Sampling design and size A sample is any group of measurements selected from a population for analysis. An important decision that had to be taken in adopting a sampling technique is about the size of the sample. Size of the sample means the number of sampling units selected from the population for investigation. The following will be considered while deciding the sample size: the size of the population, the resources available, the degree of accuracy or precision desired and homogeneity of the population. In this study a sample size of ten staff will be used which is approximately 50% of the total population. The sampling design to be used is non probability sampling.

3.5 Data collection methods. The main method of data collection is the use of interviews. Interview schedules will be used to guide the researcher in the process of interviewing. Data will also be collected from secondary materials like the annual reports and financial reports.

3.5.1 Interview schedule This is a verbal method that allows the researcher to directly exchange ideas, opinions, or information between the interviewer and interviewee. It is also a fact- finding technique. They can be in the form of direct personal interviews or indirect oral interviews. The study will utilize direct personal interviews, under this method there is a face to face contact with the informants. The researcher will ask questions pertaining to the study and collect the desired information. This method leads to immediate response to queries and more data in great depth was up to date, further the researcher will be able to carefully sandwich questions which informants are likely to be sensitive to answer with others hence making information collected adequate, though the method may be time consuming.

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3.5.2 Secondary data 3.5.2.1 Document review Document review involves consultation of the companys printed documents on topics related to the topics under study. The documents to be reviewed include financial statements, balance sheets, companys pamphlets and others. Other materials with relevant information are textbooks, the internet and even architectural plans. This is to be done to fill the gap of information and facts not covered by the other data collection tools. The method is beneficial in outlining issues that respondents are not willing to give probably due to fear of victimization. It is an easier way of obtaining information about the internal control systems in place.

3.6 Data analysis techniques A qualitative approach will be used to analyze the data collected. This is because data will be collected through interviews, and it is the most suitable method of analyzing the data.

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CHAPTER FOUR

DATA PRESENTATAION AND ANALYSIS 4.1 Introduction

This chapter looks at the various factors that have led to a change(s) in the performance of the banking industry. Tables have been prepared to present data for analysis on the assets and profits of commercial banks. Data has also been presented on the risk management composition and the various classes of risks. Data presentation in this chapter has preceded its analysis under each class of role throughout the chapter. The earnings, as at the end of March 2008, rose to Sh403 million compared to Sh228 million over the same period last year. 4.2 Back to normal "Despite the unfortunate happenings of the first two months of the year, we are happy that the business environment is slowly getting back to normal," he said. National Bank's strengthening of its marketing team saw its customer deposits increase by 20 per cent, up from Sh30 billion to Sh36 billion. Aggressive marketing by banks has seen them use all manner of tactics in their bid to attract new clients especially through the direct marketing model. The increase in the number of customers also reflected on the bank's total non-interest income, which grew by 48 per cent to Sh414 million from Sh280 million over the same period last year. "The bank is always looking into ways that will widen access of the bank's products and services to customers. We are also studying the market to continuously offer customized products and services to suit the needs of our diverse customer base," said Mr. Marambii.

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4.3 Reduced expenses At the same time, the bank's total operating expenses reduced from Sh914 million to Sh754 million indicating continued operational efficiency and improvement in quality of assets. For the past 12 months, National Bank's shareholders' funds have increased from Sh3.4 billion to Sh5.2 billion.
Company: Sector: Market: Par value: Market value: Shares issued: Market cap (Mn): EPS: DPS: Dividend yield: P/E ratio: Trading status: National Bank of Kenya Ltd Finance and Investment Nairobi Stock Exchange (NSE) 5.00 29.75 200,000,000 5,950.00 3.89 0.00 0.00% 7.65 Normal

National Banks earnings increase to Sh1 billion - 8/11/2007 NBK pre-tax profit up by 35 p.c. - 20/7/2007 National Bank profit increases to Sh617m - 20/7/2007 NBK investors miss dividend - 22/6/2007 NBK taps into captive business for profit growth - 29/5/2007

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Performance over....

Past one month

High: 69.00

Past one year

Avg:

Past five years

47.28 Low:

Other...
25.00

High:

76.00

Avg:

37.27

Low:

14.40

High:

34.50

Low:

28.75

Avg:

27.00

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4.4 Lending Products

A) Overdrafts An overdraft facility can help meet your short term funding needs for payments such as salary, utility bills, rentals, inventory and other routine overhead expenses. Interest is only charged on the utilized debit balance, which can be reduced at any time at your discretion. You can only avoid maintaining too much surplus cash in the non-bearing Current Account.

A flexible running limit for financing is offered by the Bank to customers whereby they may borrow on a continuing basis to match their day to day requirement of funds. Whenever the customer has surplus cash, it can reduce the level of borrowings, thereby reducing interest costs as well.

However, the available limit for borrowing remains the same throughout the life of the facility.

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B) Asset Financing Steady Cash Flow is the lifeblood of any business and to make sure your Company enjoys smooth, uninterrupted cash flow, NBK has developed asset financing that offers you a cash advance for every sale you make. Through Asset Based Financing Solutions, you can take advantage of secured revolving lines of credit and associated term loans based on the current value of your Accounts Receivable, Inventory and Equipment. For your Business Asset Acquisition or Expansion Requirements, Financing options are available for all types of equipments. These options include Vehicle Financing, Transportation and Construction Equipment, Printing Presses, Material, Handling Equipments, Machine Tools, Textile Equipment, Manufacturing and Processing Plants, Telecommunication Systems, Computer Packages, Medical Equipment and many others.

C) Business Loans To assist you with your medium to long term financing needs, NBK provides business loans with exceptional flexibity. Enjoy a tailored repayment schedule based on your cash flow, long term goals and the useful life of the asset you are financing.

It is good commercial practice to match the term of the loan with the useful life of the asset as your future cash flow can be accurately calculated. TOTAL ASSETS IN THE BANKING INDUSTRY Total assets in the banking sector expanded by 33.8% from Kshs 853.7bn to Kshs 1,142.6bn for the 12 months to 31st July 2008. The major asset in the sectors balance sheet was loans and advances, which constituted 51.3% of total assets. During the same period, total loans and advances, net of provisions increased by 22% from Kshs 480bn to Kshs 585.8bn. The increase in total advances primarily reflects credit extended for purchase of shares in the Safaricom IPO. Total deposit liabilities increased by 25.2% to Kshs 868.2bn. While foreign currency deposits increased by 66.3% to Kshs185.3bn over the same period. The increase is attributable to external donor inflows, inflows from institutional investors for the purchase of Safaricom shares and remittances by Kenyans in the diasporas.

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The sectors profit before tax increased by 34.6% from Kshs 20.4bn in July 2007 to Kshs 27.4bn in 2008. Growth in profitability is attributable to increase in interest income on loans and advances, which rose by 32.7% from Kshs 30.6bn to Kshs 40.6 bn. Though total expenses increased by 31.2% to Kshs 55.9bn, loan loss provisions for the period declined from Kshs 2.9bn to Kshs 2.7 bn.

The level of capitalization, as measured by the ratio of total capital to total risk weighted assets ratio increased from 16.9% to 18.3% for the year to July 2008. Paid-up capital in the sector increased by 5.3% to Kshs 51.9 bn. Total shareholder funds increased by 36.7% to Kshs 146 bn. The increase in capital and reserves in the sector is attributable to profit retention and capital injection by some institutions. This should enhance the sectors capacity to absorb losses, expand operations and therefore broaden the scope of financial intermediation. Asset quality, as measured by the share of non-performing loans (NPLs) to gross loans in the year to July 2008, improved during the 12 months to July 2008. The level of NPLs declined from Kshs 70.7bn (14.7% of gross loans) to Kshs 56.3bn (9.0%). Subsequently, the ratio of net non-performing loans to gross advances improved from 4.7% to 3.4% over the period. The reduction was attributable to prudential risk management, write-offs and recoveries of non-performing loans by institutions.

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CHAPTER FIVE FINDINGS, CONCLUSION AND RECOMMENDATION

5.1 Introduction The study aimed at establishing the effect of financial management on the performance of the banking industry. Data was collected through interviewing managers of NBK. The research found out that the banking industry was generally performing well and that there was generally a positive growth. However such growth could not directly be associated with deliberate financial management practices of these banks. It was also established that these function is not commonly used effectively and as such much need to be addressed as much as far as the function is concerned. This chapter seeks to bring out the main findings of the research and offer recommendations based on the result of the study.

5.2 Findings: Government-owned Consolidated Banks pre-tax profit for the year ended December 2008 grew by more than three times to Sh84.9 million, up from Sh25.8 million in 2007.This represents a 229 per cent increase. However, the Treasury and State agencies which own the banks shares will not receive dividends as directors seek to comply with regulations that a company has to clear previous losses before rewarding its shareholders. Years of loss making prior to 2006 have lead to accumulated losses totaling Sh453.1 million at the end of 2008. This however is a reduction from the Sh576.9 million accumulated losses in 2007. These losses have to be cleared before the bank can legally pay out dividend. Most of the banks earnings in 2008 came from interest income, which rose from Sh369.5 million at the end of 2007 to Sh458.3 million according to figures the bank released on Tuesday. The bank from loans and advances to customers earned Sh419.9 million up from Sh317.3 million in 2007.

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Loans and advances to customers in 2008 rose 23 per cent to Sh2.7 billion from Sh2.2 billion in 2007. On the other hand customer deposits reached Sh3.2 billion up from Sh2.8 billion in 2007.The Company had a history of poor performance largely due to its origin. It was established in 1990 from the ruins of a number of fallen institutions that included Rural and Urban Credit and Union Bank. In the 2006/7 Budget, the government factored in Sh22 billion intended for the revival of the National Bank of Kenya to the tune of Sh20 billion and Sh2 billion for the Consolidated Bank. NBK got its share in March 2007 although the funds were not released until late in the 2006/7 financial year. There has always been the intention by the government to plan the banks initial public offering (IPO). Currently, the bank has 10 branches and one agency located in various parts of the country.

5.2.1 Strength and performance of the banking industry It was found out that the banking industry was performing well. From the data collected there was a considerable increase of the total assets of the banks. It was also found out that the increase in profits in these banks was twice the increase of the assets. From the above results, then it can be established that if assets of banks are well managed, then an increase in these assets or growth in assets would translate to a growth in the profits (income) of the banks. Hence, there is need for managers to manage their assets well.

5.2.2 Risk management function It was also established that the risk management function did not have adequate staff given its importance in the functioning of a bank. It was only in one bank that the percentage of risk management employees was of the total staff. Of great importance is that this bank had reported the highest percentage increase in the value of its assets and that of its profits. Risk management is therefore an essential function of any financial institution. There is therefore need to give it the weight it requires and support staff and information and Communication Technology (ICT).

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5.2.3 Credit Risk This happened to be the most significant and heavily focused type of risk in banks. It was found out that all banks were offering business loans, Education loans, and medical loans. These types of loans, it was established, were the ones carrying the lowest risk. It was only one bank that was found out to be offering asset financing. Asset financing was generally considered a risky venture. However, the bank that was offering this type of financing was generally performing well, leading in the percentage increase in both assets and profits. Though there could be no direct correlation, other factors, like how they handled screening of potential borrowers in this type of finance, were to be considered.

On the issue of collaterals, share certificates and title deeds were the most considered form of collaterals. However, the bank that was offering asset financing was considering Log books as collaterals but only in asset financing. The general finding here was that Banks were giving a lot of consideration on the issue of collateral but the trend is now changing. There is a lot of competition and this can be proved by the confessions of the other two banks that they had been forced by competition to consider venturing into asset financing. These calls for banks therefore to review their collaterals and evaluation of the potential of a customer to finance the loans borrowed.

5.2.4 Currency Risk It was found out that the Kenya shilling had gradually appreciated by close to 8 shillings over the 3 years preceding data collection. This perhaps could have been the major boost to the economy and managers of this bank were attributing growth to an economically conducive environment. However, all banks had most of their cash and balances with the central bank in the Kenyan currency. The Kenyan currency is not such a stable currency and that could be a quite risky condition. However, these banks could be having a higher demand of Kenyan currency for local transactions.

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5.2.5 Interest Rate Risk As far as customer deposits were concerned (those not bearing interest) the banks were doing well. The deposits were exposed to a period of less than a year. However, borrowed funds were very exposed with more than 40% in the banks running for more than 1 year. Given the uncertainties that the future holds, such a trend was a very dangerous one. Borrowed funds had to be repaid and if the rate of interest hiked then these banks would find if hard to repay the principal and interest.

5.2.6 Liquidity Risk Though data was only available from bank, the data can be generalized given that data on previous risks in chapter 4 did not deviate that much. This particular bank had most of its advances to customers maturing in less than 6 months. This risk was well managed. Banks have to be quite liquid so as to meet customer demands. This bank had also reported the highest increase in assets. The growth could be attributed to wise investment in very liquid but profitable assets.

5.3 Limitations of the study Time: It was difficult to get appointments with the managers of bank given their tight schedules. Some appointments had to get rescheduled. It was also difficult to elicit and collect all data given the short time that these managers set for the interview. The researcher thus used data as at January 2010. Given the nature of banks operations, bank managers were not quite comfortable with revealing all information during the interview.

5.4 Conclusion The study aimed to identify the various risk categories, their magnitude, how they were managed and their effect on the performance of the banking industry. The results affirmed that banks needed to manage interest rate risks and liquidity risk well. This was due to future uncertainties. Though credit risk was fairly managed, there was a lot to be done in screening of potential clients and monitoring of loans advanced to them. The research

34

generally established that good management of risk especially credit risk had resulted in better performance and growth of the banking industry.

5.5 Recommendations The staff dedicated to the financial management function should be increased and the function should be given equal consideration in the bank not as a support function to e.g. finance department but as an autonomous function.

More loan products should be added. There is a lot of competition and this is unavoidable, however banks should start concentrating on other methods of assessing the capacity of a customer, like strength of the pay slips, other forms of collaterals e.g. logbooks in case of asset financing should also be accepted.

On the issue of liquidity risk, banks should consider investing n short term marketable securities e.g. treasury bills that are very liquid on the deposits they get from banks. Holding such deposits in cash does not even earn interest and such securities can earn some interest, though low they are easily marketable.

On interest rate risk banks should not borrow long term funds due to the risk involved. To meet immediate needs of cash, it is less risky to borrow short term with high interest rates. The cost of interest rate should be cancelled with interest rate charged to depositors and interest paid by investment e.g. in treasury bills as discussed in the above recommendation.

Finally, banks need to have a continuous review of their financial management guidelines, policies and structures. Risk management appraisals should be carried periodically to establish any gaps and the staff of these banks should be made aware of and enlightened on these banks should be made aware of and enlightened on these practices for there to be sustained growth in the banking industry.

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5.6 Recommendations for further research There is need to look at other emerging but equally important classes of risks such as strategic risk, reputation risk and regulatory risk. There is also, need to research further on the financial management policies, frameworks and guidelines, their formulation and extent of implementation on each of the banks.

There is need to look at other banks such as family bank, cooperative bank, consolidated banks as well as foreign banks such as Barclays bank and standard chartered bank.

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APPENDIX 1
INTERVIEW SCHEDULE 1. How is the bank performing currently in terms of assets and profits? Did the bank perform well in the past financial year? Did financial management practices contribute to the banks current performance?

2. What financial management decisions were made in regard to the financial management performance of the bank? What type of financial management decisions were made in the past year? Were the decisions effective? Can any improvements be made on the decisions?

3. What were the difficulties encountered by the bank in management of finances? Did the bank encounter any difficulties in its financial management? Did the difficulties affect the banks financial management? Were there measures put in place to counter the difficulties?

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APPENDIX 2
COMMERCIAL BANKS ASSESTS. BANKING (2010) BANK Barclays bank Kenya commercial bank Standard chartered bank Cooperative bank National bank of Kenya Citibank Kenya Commercial bank of Africa C.F.C Standard Bank (Stanbic) I&M (investment and Mortgages) Diamond Trust Equity Bank of Baroda Housing Finance Prime Bank EABS Imperial Bank of India Bank of Africa Fina Habib AG Zurich ABC Giro Guardian K-Rep Southern Credit Victoria Charter house Equatorial Middle East Consolidated Chase Development bank of Kenya Habib Bank Credit Transnational Fidelity Paramount universal Oriental (formerly Delphis) City finance Source www.bankelele.com 38 BILLION (KSH) 217.17 184.92 184.09 155.17 139.37 135.43 135.12 125.04 123.29 121.79 119.14 116.33 111.43 19.8 19.26 18.55 18.47 18.15 16.23 16.15 15.07 14.95 14.93 14.66 14.52 14.27 14.19 13.94 13.67 13.45 13.45 13.29 13.05 13.02 12.77 12.44 12.11 12.05 11.37 10.53