Chapter two : LITERATURE REVIEW

INTRODUCTION
This chapter deals with different points about risk management which starts from defining risk and risk
management and followed by some general points about it, the importance of risk management, bank risk
management, types of risks in the banking business, measuring and managing risk, risk management
guideline for Somalia banks. Finally, reviews of other studies conducted in different countries on issues
regarding risk management in the banking industry were presented.
2.1 Theoretical literature review
A theory is a contemplative and rational type of abstract or generalizing thinking or the results of such
thinking. It is a coherent group of tested general propositions, commonly regarded as correct, that can be
used as principles of explanation and prediction for a class of phenomena (Kombo & Tromp, 2009). A
theoretical framework is a collection of interrelated concepts, like a theory but not necessarily so well
worked out. According to Trochim (2006), a theoretical framework guides research, determining what
variables to measure, and what statistical relationships to look for in the context of the problems under
study. Theoretical frameworks are critical in deductive, theory-testing sorts of studies. Scientists when
performing research studies to formulate a theory use a theoretical framework. The theoretical framework
is a foundation for the parameters, or boundaries, of a study.
Definition of risk
The definition given for risk by many authors is more or less the same, in which many authors add their
wordings to the same thing. Some of them define risk as risk is the probability and magnitude of a loss,
disaster, or other undesirable events, (Hubbard, 2009). The risk is an uncertain potential event and
condition that raises the chance of losses/gains which could influence the success of financial institutions,
(Khalid & Amjad, 2012). Likewise, the risk is the uncertainty surrounding future events and outcomes or
it is the expression of the likelihood and impact of an event with the potential to influence the
organization’s objective achievement (Berg, 2010). On the other hand, Rejda & McNamara,
(2017)defined; risk as uncertainty concerning the occurrence of a loss. According to this definition, a risk
exists only if an uncertain action or event happens that leads to the occurrence of that risk.
Risk Management Theory
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and
economical application of resources to minimize, monitor, and control the probability and/or impact of
unfortunate events or to maximize the realization of opportunities (Wenk, 2005). Risk management is a
constant process of evolution. In general, risks include credit risk, market risk (include liquidity risk,
interest rate risk, and exchange rate risk), and operational risk. If banks ignore the risks, they could not
have a normal operation. Therefore, every organization should learn to apply effective methods and make
these methods positively identify, analyze, evaluate, treatment and control business risks (Aliu, M.,
Sahiti, A., 2019).
The study anchored its variables on three theories namely: (i) Finance distress theory which is linked with
the credit and liquidity risks, (ii) Shiftability Theory is linked with liquidity risks, and (iii) Extreme value
theory that is linked with market risks.
Finance distress theory
Baldwin & Mason, (1983) purported that when a firm’s business deteriorates to the purpose where it
cannot meet its liability, the firm is claimed to possess entered a state of financial distress. The primary
signals of financial distress are violations of debt payments and failure or reduction of dividends pay-outs.
Whitaker, (1999) defines an entry in financial distress because the first year during which cash flows is
less than current maturities’ long-term debt. The firm has enough to pay its creditors as long because the
cash flows exceed the present debt obligations. The key considers identifying firms in financial distress is
their inability to fulfill contractual debt obligations. However, substantial financial distress effects are
incurred well before default. Wruck, (1990) stated that firms enter into financial distress as a result of
economic distress, declines in their performance, and poor management, especially on risks. Boritz,
(1997) depicts a process of financial distress that begins with a period characterized by a collection of bad
economic conditions and poor management which commits costly mistakes. Other creditors also have to
be compelled to be taken into consideration when firms are setting up place risk management measures.
Credit risks in banks also have to be compelled to be 12 addressed since it's going to cause financial
distress. Loan portfolio management is a vital determinant of the firm’s liquidity. The banks should
manage the credit and liquidity risk to avoid financial distress.
The theory of financial distress emanates from the liquidity and credit risk facing a firm. This theory
provides for a non-biased perspective on the link between credit risk and financial performance variables
employed by the study. By providing information that the results of financial distress occur before default
risk, the theory offers a neutral platform to undertake an incisive empirical analysis of this relationship
within the commercial banks.
Shiftability theory of liquidity
Formally developed by Harold G, Moulton in 1915, the shiftability theory held that banks could most
effectively protect themselves against massive deposit withdrawals by holding, as a type of liquidity
reserve, credit instruments that there existed a ready secondary market. the theory relies on the proportion
that the bank's liquidity is maintained if it holds assets that would be shifted or sold to other lenders or
investors for cash. Also, these assets can be shifted to the central bank for cash without material loss just
in case necessarily than hopping on maturities to resolve their liquidity problems (Ngwu, 2006).
This theory posits that a bank’s liquidity is maintained if it holds assets that would be shifted or sold to
other lenders or investors for cash. Now of view contends that a bank’s liquidity might be enhanced if it
always has assets to sell and provided the central bank and also the discount market stands able to
purchase the asset offered for a discount. Thus, this theory recognizes and contends that shiftability,
marketability, or transferability of a bank's assets could be a basis for ensuring liquidity. This theory
further contends that the highly marketable security held by a bank is a superb source of liquidity. Dodds,
(1982) contends that to confirm convertibility immediately and appreciable loss, such assets must meet
three requisites. liquidity management theory consists of the activities involved in obtaining funds from
depositors and other creditors and determining the appropriate mix of funds for a particularly bank.
Liquidity theory has been subjected to critical review by various authors.
The consensus is that during the period of distress, a bank may find it difficult to obtain the desired
liquidity since the confidence of the market may have seriously affected and credit worthiness would
invariably be lacking. However, for a healthy bank, the liabilities constitute an important source of
liquidity. The liquidity shiftability theory provides for an explicit understanding of how the liquidity risk
affects the financial performance using liquidity coverage and net stable funding ratios as stated by the
new Basel III framework. The analysis of this study provides information as to whether liquidity
maintained by the commercial banks affects the returns to the shareholders.

Extreme value theory

In 1709, Bernoulli discussed the mean largest distance from the origin when n points lie haphazardly on a
line of length (Johnson et al., 1995). A century later Fourier stated that, within the Gaussian case, the
probability of a deviation being over 3 times the square root of two standard deviations from the mean is
about 1 in 50,000, and consequently can be omitted (Kinnison, 1985). The financial institutions with
significant amounts of trading activity proved to be very susceptible to extreme market movements and,
in time, the measurement of market risk became a primary concern for regulators and also for internal risk
control. This requires indicators showing the risk exposure of firms and also the effect of risk-reducing
measures.
Value-at-Risk (VaR) has been established as a regular tool among financial institutions to depict the
downside risk of a market portfolio. It measures the utmost loss of the portfolio value which will occur
over some period at some specific confidence level because of risky market factors (Jorion, 1997). Banks
and bank holding companies with a vital trading portfolio are subject to plug risk requirements. they need
to be required to carry capital against their defined market risk exposures, and, the required capital could
be a function of banks' risk estimates. As a result, several alternative methods have been proposed for
estimating VaR, one among which being the intense Value Theory (EVT). EVT methods make VaR
estimations based only on the information within the tails as against fitting the complete distribution and
can make separate estimations for left and right tails (Diebold, F.X., Schuermann, T., & Stroughhair,
2000). Proper estimation of VaR is critical in this it has to accurately capture the extent of risk exposure
that the firm is exposed to, but if it overestimates the risk level, then the firm will set unnecessarily put
aside excess capital to cover the risk when that capital could have been better invested elsewhere (Hull,
2012).
Extreme value theory helps in determining the minimum and therefore the maximum capital that ought to
be put aside to cover the market risks. to attain this goal, the banks, have to be compelled to manage the
market risk by managing the financial leverage.
Risk Management in Banking
Kanchu & Kumar, (2013) defined risk management as the application of proactive strategy to plan, lead,
organize, and control the wide range of risks that are rushed into the material of an organization’s daily
and long-term functioning. Rejda & McNamara, (2017) also defines risk management as a systematic
process for the identification, evaluation of pure loss exposure faced by a company or a private, and for
the choice and implementation of the foremost appropriate techniques for treating such exposures. The
process involves the identification, measurement, and management of the risks. Bessis, (2011) also adds
that being a process, risk management also involves a collection of tools and models for measuring and
controlling risk.
The objectives of risk management include the minimization of foreign exchange losses, reduction of the
volatility of cash flows, protection of earnings fluctuations, and increment in profitability and assurance
of survival of the firm (Fatemi & Glaum, 2000). Another group of researchers stated that RM is about
ensuring that risks are taken consciously with full knowledge, clear purpose, and understanding so that
they will be measured and mitigated to forestall a firm from suffering unacceptable loss causing it to fail
or materially damage its competitive position. to confirm that banks operate in a very sound risk
management environment with minimal impact of uncertainty and potential losses, managers need
reliable risk measures to direct capital to activities with the most effective risk/reward ratios. Management
needs estimates of the dimensions of potential losses to remain within limits set through careful internal
considerations and by regulators. They also need mechanisms to watch positions and make incentives for
prudent risk-taking by divisions and individuals.
Major types of risks faced by banks
Banking is the intermediation between financial savers on one hand and also the funds seeking business
entrepreneurs on the opposite hand. As such, within the process of providing financial services, banks
assume various types of risk both financial and non-financial. Today, banks' financial risk management is
one of the foremost important key functions in banking operations as commercial banks are within the
risk business. Al-Tamimi, H.., (2007) Notes that in today’s dynamic environment, all banks are exposed
to an outsized number of risks like credit risk, liquidity risk, exchange risk, market risk, and rate of
interest risk, among others – the risks which can create some source of threat for a bank's survival and
success.
Credit risk
The analysis of the financial soundness of borrowers has been at the core of banking activity since its
inception. This analysis refers to what nowadays is thought of as credit risk, that is, the risk that the
counterparty fails to perform any obligation owed to its creditor. This can be the uncertainty attached to
the gathering of loans. The probability that some bank's asset value, especially its loans will decline and
maybe became worthless is thought of as credit risk. A non-performing loan could be a loan that is not
earning income and full payment of principal and interest is not any longer anticipated, the due date has
passed and payment fully has not been made (Saunders & Lewis, 2012).
Coyle, (2000) defines credit risk as losses from the refusal or inability of credit customers to pay what is
owed fully and on time. It arises mainly from direct lending and certain off-balance sheet products like
guarantees, letters of credit, exchange, forward contracts, and derivatives and also from the bank’s
holding of assets within the kind of debt securities. it should take the shape of delivery or settlement risk.
It is critical to bank survival or failure because banks traditionally earn huge profits from interest on their
risk exposures. The management of credit risk could be a critical component of a comprehensive
approach to risk management and is crucial to the longterm success of a commercial bank. SARWAR et
al., (2020), in their study of Pakistani banks, concluded that credit risk is a significant predictor of bank
margins, which is usually a key indicator of the bank’s level of efficiency in terms of its fundamental role
of financial intermediation. The higher the credit risk faced by banks, the greater their profitability (DAO
& NGUYEN, 2020).
As per NBE (2010), risk management guideline credit risk is the risk of financial loss, despite the
realization of collateral security or property, resulting from the failure of a debtor to honor its obligations
to the bank. The area of credit risk includes default risks related to a bank’s portfolio of bonds (credit
through investment) and other fixed-income investments, counterparty risk on derivative contracts, and
the risk of default on loans or insured debts and trade debtors. The major risk that arises from a
weakening of the credit portfolio is the impairment of capital or liquidity. For most banks, extending
credit through investment and lending activities banks an important portion of their business. Therefore,
the quality of an institution's credit portfolio contributes to the risks borne by policyholders (liquidity) and
shareholders (capital impairment). Additionally, according to Tseganesh, (2012), credit risk management
comprises all management functions such as identification, measurement, monitoring, and control of
credit risk exposure.
Solvency risk
The solvency risk defines the risk that a bank cannot meet maturing obligations because it has a negative
net worth; that is; the value of its assets is smaller than the number of its liabilities. This may happen
when a bank suffers some losses from its assets because of the write-offs on securities, loans, or other
bank activities, but then the capital base of the institution is not sufficient to cover those losses. In such a
case, the bank unable to meet its obligations defaults and loses its franchise value. To avoid such risk,
banks need to keep an adequate buffer of capital, so that in case of losses, the bank can reduce capital
accordingly and remain solvent. On this reasoning, we may consider the solvency position of a bank as
determined by two main factors: the availability of an appropriate buffer of capital and the profitability of
bank activities. (Raja Almarzoqi., et, al., 2015). With the rising prominence of stress tests in recent years,
increased attention is being paid to the interaction between bank solvency risks and funding costs.
Increased solvency risk is associated with higher marginal funding costs (ie market discipline); rising
funding costs, in turn, are linked to reduced regulatory capital ratios and thereby to increased solvency
risk.
Solvency is the ability of a financial institution to meet its obligations in the event of cessation of activity
or liquidation. It refers to a company’s long-run financial viability and its ability to cover long-term
obligations. A bank is considered solvent if the total assets exceed total liabilities. If the total assets are
lower than total liabilities, the bank faces an insolvency risk and is said to be „technically insolvent‟.
Insolvency risk shows the probability of default of a representative bank. The solvency problem tends to
be more long-term than the previously described liquidity issue and historically, banks have always held
on to funds and stopped lending when there is a solvency crisis (Mason, 2009). Financial ratios that
measure solvency include total debt to total capital, total debt to equity capital, long-term debt to equity
capital, and short-term debt to equity ratios.
Operational risk
Malfunctions of the data systems, reporting systems, internal monitoring rules, and procedures designed
to require timely corrective actions, or compliance with the interior risk policy rules lead to operational
risks (Bessis, 2011). Operational risks, therefore, appear at different levels, like human errors, processes,
and technical and data technology. Because operational risk is an occurrence risk, within the absence of
efficient tracking and reporting of risks, some important risks are going to be ignored, there will be no
trigger for corrective action and this could lead to disastrous consequences. Developments in a modern
banking environment, like increased reliance on sophisticated technology, expanding retail operations,
growing e-commerce, outsourcing of functions and activities, and greater use of structured finance
(derivative) techniques that claim to cut back credit and market risk have contributed to higher levels of
operational risk in banks(Van Greuning & Brajovic Bratanovic, 2009).
Basel Committee on Banking Supervision (1997) addressed operational risk in its Core Principles for
Effective Banking Supervision by requiring supervisors to confirm that banks have risk management
policies and processes to spot, assess, monitor, and control or mitigate operational risk. In its 2003
document, Sound Practices for the Management and Supervision of Operational Risk, the Committee
further guided banks for managing operational risk, in anticipation of the implementation of the Basel II
Accord, which needs a capital allocation for operational risks. Despite these efforts by the regulators at
addressing operational risk, practical challenges exist when it involves its management.
The importance of operational risk management cannot be overemphasized. Inadequate operational risk
management can result in unpredictable financial performances. It also can impact negatively on banks’
revenues and erode banks’ net worth, most significantly, it can have calamitous systemic consequences as
was highlighted on the part alluded to possess been played by operational risk in the 2008 financial crisis
(Muriithi & Waweru, 2017). Therefore, as for the objectives of putting in place an operational risk
management framework to be accomplished, it's going to require a change within the behavior and culture
of the firm. Management must also not only ensure compliance with the operational risk policies
established by the board but also report regularly to senior executives. a definite amount of self-
assessment of the controls in place to manage and mitigate operational risk is going to be helpful.
Interest Rate Risk
The real interest rate is expected to have a positive relationship with profitability in the essence of the
lend-long and borrow-short argument (Vong and Hoi Si Chan, 2008). Interest rate risk arises from
movements in interest rates. A bank is exposed to interest rate risk when it experiences a situation of
imbalance in terms of size or maturity dates between assets and liabilities sensitive to interest rates. This
leads to potential losses for the bank when the interest rate increases or declines and this influences the
net asset value in the budget, which some call risk gap (Cicea & Hincu, 2009).
According to Martirosianien, (2008), there are three main methodologies for interest rate risk
management: difference (gap) analysis, duration analysis, duration-difference analysis. Difference (Gap)
Analysis includes the analysis of all bank balance items according to possible reappraisal dates and their
sensitivity for interest rate shift. Another very important factor while conducting the difference analysis is
evaluating the bank’s assets and liabilities sensitivity to the interest rate shifts. Not all assets and liabilities
are sensitive to interest rate shifts. Indifference analysis only assets and liabilities that are sensitive to
interest rate shifts, i.e., the instruments whose prices will change if the interest rate will vary in the
market, are used. Firstly, all the assets and liabilities delivering no interest must be excluded. A calculated
positive gap means that more assets would be reappraised comparing with liabilities at the given period.
A negative gap means that at the given moment more liabilities will be reappraised comparing to the
assets.
Consequently, after the increase of interest rate, interest outcomes will grow more than interest incomes,
i.e., when the interest rate increases, net income received from the interest will decline. If the interest rate
declines, net income from the interest will grow. The goal of interest rate risk management is to maintain
a bank's interest rate risk exposure within self-imposed parameters over a range of possible changes in
interest rates. As expressed in Basel Committee on Banking Supervision (2003), a system of interest rate
risk limits and risktaking guidelines provides the means for achieving that goal. Such a system should set
boundaries for the level of interest rate risk for the bank and where appropriate, should also provide the
capability to allocate limits to individual portfolios, activities, or business units. Limit systems should also
ensure that positions that exceed certain predetermined levels receive prompt management attention. An
appropriate limit system should enable management to control interest rate risk exposures, initiate
discussion about opportunities and risks and monitor actual risk-taking against predetermined risk
tolerances. Limits should be consistent with an overall approach to measuring interest rate risk. Aggregate
interest rate risk limits clearly articulating the amount of interest rate risk acceptable to the bank should be
approved by the top management and re-evaluated periodically. Such limits should be appropriate to the
size, complexity, and capital adequacy of the bank as well as its ability to measure and manage risk.
Foreign Exchange Risk
Exchange rates tell us how many units of one currency may be bought or sold for one unit of another
currency. The spot rate is the exchange price for transactions for immediate delivery. The forward rate
applies to a deal that is agreed upon now but where the actual exchange of currency is not due to take
place until some future date. The exchange of currencies at the future date will be at the rate agreed upon
now. Bessis, (2011) defines foreign exchange risk as incurring losses due to changes in exchange rates.
Exchange rate risk occurs as a result of either transaction risk or economic risk. Transaction risk occurs
from the effect of changes in nominal exchange rates that affect the company’s contractual cash flows in
foreign currencies. It relates to contracts already entered into but which have yet to be settled. Thus, a
company is subject to transaction risk whenever it imports goods from or export goods to another country
which are paid at a later date, or where a company borrows or invests in a foreign currency or uses
derivatives denominated in a foreign currency (Collier, 2009).
Foreign Exchange risk arises when a bank holds assets or liabilities in foreign currencies and impacts the
earnings and capital of the bank due to the fluctuations in the exchange rates (Sabri, 2011). An exchange
rate can move in either upward or downward direction at any time. This uncertain movement poses a
threat to the earnings and capital of commercial banks. The direct foreign exchange risk can be either
Transactional or it can be Translational. Transactional risk, as the name implies is because of transactions
in foreign currencies and translational risks is an accounting risk arising because of the translation of the
assets held in foreign currency. The indirect exchange rate risk is emanated from economic exposure
which reflected through demand for a bank loan and bank loan performance. Additionally, as to Sabri
(2011) foreign exchange risk of a commercial bank comes from its very trade and non-trade services.
2.2 Conceptual framework
A conceptual framework is a research tool intended to assist a researcher to develop awareness and
understanding of the situation under scrutiny and communicate it. When clearly articulated, a conceptual
framework has potential usefulness as a tool to assist a researcher to make meaning of subsequent
findings. It forms part of the agenda for negotiation to be scrutinized, tested, reviewed and reformed as a
result of an investigation and it explains the possible connections between the variables (Smith, 2004).
To guide the study, the interrelationship between variables discussed above was presented in the
conceptual framework model.
2.3 Review of related literature
Kargi, (2011), studied the impact of credit risk on the profitability of Nigerian banks. Financial ratios as
measures of bank performance and credit risk were collected from the annual reports and accounts of
sampled banks from 2004-2008. The findings revealed that credit risk management has a significant
impact on the profitability of Nigerian banks inversely influenced by the levels of loans and advances,
nonperforming loans, and deposits thereby exposing them to great risk of illiquidity and distress.
Adeusi and Akeke (2013) in their study they focus on the association of risk management practices and
bank financial performance in Nigeria. Using a panel of secondary data for 10 banks and four years
reported an inverse relationship between financial performance of banks and doubt loans, capital asset
ratio was found to be positive and significant. Similarly, it suggests 22 that the higher the managed funds
by banks, the higher the performance. The study concludes a significant relationship between a bank's
performance and risk management.
Puji Indah and mirza Dianate (2018), also examined the effect of risk management proxied by the capital
adequacy ratio, operating efficiency, and non-performing loan, to the financial performance projected
with return on asset (ROA) in Islamic banking companies listed on the Indonesia stock exchanged in the
period 2011 to 2016. After passing through a stage of purposive sampling, the worth of the used sample is
5 companies. The result of the study showed that the variable of Capital Adequacy Ratio (CAR), and
Non-Performing Loan (NPL) had a negative and insignificant effect on Return on Asset (ROA), and
Operating Efficiency (BOPO) had a negative and significant effect on Return on Assets (ROA). The
researcher recommends that companies need to improve risk management to obtain the expected returns
by improving the company`s financial performance as reflected in risk management such as CAR, BOPO,
and NPL
Chukwunulu et al., (2019), examined the effect of risk management on bank performance in Nigeria.
Two bank performance indicators (return on assets and return on equity) were used as the dependent
variables while unsystematic risk management measures including credit risk, liquidity risk, operational
risk, and capital adequacy risk are the independent variables. The data for the study covers 23 years from
1994 to 2016. The coefficient of determination showed that risk management variables explained 41%
and 23% of changes in return on equity and return on assets respectively. Furthermore, credit risk has a
significant negative effect on return on equity and an insignificant negative effect on return on assets.
Liquidity Management has no significant effect on bank performance. Operational risk has no significant
effect on bank performance in Nigeria; while capital adequacy has a significant positive effect on return
on equity but a negative insignificant effect on return on assets. The researchers recommended that the
CBN and other regulators should endeavor to enforce risk identification, assessment, measurement, and
control mechanisms in line with global best practices in other to avoid financial crises and also improve
commercial banks’ performance.
Abu Noruwa (2020) examined the impact of risk management on the profitability of deposit banks in
Nigeria from the year 2008-2016. In his study, loan to deposits, capital adequacy, non- performing loan,
and loan loss provision as independent and profitability (i,e., ROA) as a dependent variable. The study
used secondary data and panel data was collected from fourteen banks (14) in Nigeria. The study adopted
a panel regression to evaluate the causality between the variables and to test the hypothesis. Operational
hypotheses were formulated and results revealed that risk management has a positive association with
profitability. Specifically, the study indicated that loan loss provision has a significant positive
relationship with profitability; it also indicated that loan to deposit ratio, bank size has a positive and no
significant relationship with profitability, and also the study found that their capital adequacy was the
negative and insignificant impact on profitability. Finally, the researcher recommends that banks should
upgrade their risk management and control systems by establishing sound and competent strategies for
risk management and increased capital for sustainable liquidity.
Sathyamoorthi et al., (2020), examined the impact of financial risk management practices on the financial
performance of commercial banks in Botswana. The study used Return on Assets and Return on Equity to
measure financial performance. Inflation, Interest rates, total debt to total assets, total debt to total equity,
total equity to total assets, and loan deposit ratios were used as proxies for financial risk management.
The research population was all the 10 commercial banks in Botswana and the study covered a period of
8 years from 2011 to 2018. This descriptive study sourced monthly secondary data from the Bank of
Botswana Financial Statistics database. Descriptive statistics, correlation, and regression analyses were
applied to analyze the data. The results from regression analysis showed that interest rates had a negative
and significant impact on return on assets and return on equity. On the other hand, total debt to total assets
showed a negative and insignificant effect on return on assets. However, total debt to total assets revealed
a positive and insignificant effect on return on equity. The loan deposit ratio indicated a negative and
significant impact on return on assets and return on equity. Based on the outcome of the study, Bank's
engagement inappropriate market, credit, and liquidity risk management efforts that will yield profits for
the banks were recommended.
Echwa & Atheru, (2020), examine the impact of risk management on commercial banks’ performance in
the context of Kenya. The specific aims were to assess the impact of credit, liquidity, and interest risks on
the performances of Kenya’s banks. The examination made use of 24 the theories of Risk Theory, Moral
Hazard Theory, Modern Portfolio Theory, and Agency Theory. Descriptive design was utilized in this
examination where the target populace comprised of the forty Kenyan banks. The study, therefore, was a
census as it covered all the 40 commercial banking organizations in Kenya. It was based on the period
2013 to 2017. Secondary data was utilized. The analysis was based on descriptive analysis (means and
standard deviations) and inferential analysis (multiple regression techniques). Based on the panel
regression approach, the study concluded that credit risk was not major in affecting the financial
performance of commercial banks in Kenya. The study also concluded that liquidity risk is not a key
determinant of the financial performance of commercial banks in Kenya. Likewise, the study concluded
that interest rates were key factors that influenced commercial banking performances. Thus, the study
recommended that bank management to be in line with the prevailing economic conditions should
continually adjust interest rates.

Kinyanjui (2014) argued that the problem of loan recovery in Somalia has been of major factor that
hinders the growth of many financial institutions in our country. Banks in Somalia have not been
seeming to be successful in their lending functions and this is because of cries from the public on the
small percentage of population with access to banks credits. Also, huge amounts of bad debts (Non-
performing loans) declared by banks each year shows their failure in lending functions. A debit is
incurred from a loan, a credit line, or an accounts receivable that is recovered either in whole or in part
after it had been written off or classified by the lender as a bad debt. This recovery can often actually
produce income because it will typically generate loss when it is written off by the lender. For the bank
industry to grow, banks need to have an average drain in deposits less than the new funds deposits.
Demand deposits are core deposits providing a relative long-term source of funds for financial
institution (Saunders, 1994). When demand deposit decreases, the bank ‘s liquidity is affected and
situation may cause net deposit drain. The decrease in bank ‘s deposit reduces the supply of loan able
funds and this may force banks to seek growth by engaging other financial services/products. When the
demand for funds (deposits) is high the interest rates on deposits increases while the interest rates for
loans decreases and thus the banks profit decreases.

The increase in interest earnings assets implies the increase in cost to the banks which as a result will be
compelled to adjust their lending rates (Haron, 2007). The loans thus become an attractive and reduce
the ability of banks to make profit out of loans. When the interest rates on deposit is low, large
depositors will utilize their excess funds by buying the treasury bills, commercial paper, and other
market instruments where as individuals will shift their surplus funds from demand deposit to interest
bearing accounts such as savings and loan association. This is referred to as Disinter mediation (Ndenda,
1999).

Lending is the principal business activity for commercial and development banks. The loan portfolio is
typically the largest asset and the major source of revenue. In the other hand the loan portfolio is one of
the greatest sources of risk to the bank ‘s safety and soundness (comptroller, 1998). Whether due to lax
credit standards, poor credit risk management, or weakness in the economy, loan portfolio problems
have historically been the major cause of bank losses and failures. However, the performance of the
banks has to be viewed both in terms of profitability and stability. Profitability ratios show a bank's
overall efficiency and performance. Profitability ratios can be divided into two types: margins and
returns. Ratios that show margins represent the bank's ability to translate sales dollars into profits at
various stages of measurement. Ratios that show returns represent the bank's ability to measure the
overall efficiency of the bank in generating returns for its shareholders (Diamond, 2000).

The commercial bank's asset is another indicator that affects the performance of a commercial bank.
The commercial bank asset includes current asset, credit portfolio, fixed asset, and other investments.
Often a growing asset (size) related to the age of the bank (Athanasoglou et al., 2005). More often than
not the loan of a bank is the major asset that generates the major share of the commercial bank ‘s
income. Loan is the major asset of commercial banks from which they generate income. The quality of
loan portfolio determines the profitability of banks and hence bank performance. The loan portfolio
quality has a direct bearing on performance of a commercial bank.

Summary of a knowledge gap

This section summarized the existing literature on risk management and bank financial performance.
Financial performance is influenced by a combination of factors facing the firm; a review of the
literature provides evidence as to why firms should concern themselves with risk management. The
studies revealed that the awareness and willingness of companies in managing their risks have increased
in the emerging economies due to the impact of events such as the European financial crisis. That is, the
demand for risk management is increasing, especially in the past few years.

Most studies on the relationship between risk management practice and financial performance of banks
mostly have been conceptual, often drawing the theoretical link between good risk management
practices and improved bank performance. It is evident from the above review of the relevant literature
that research in the area of bank risk has been carried out, but not in a comprehensive approach. Most
of the reviewed literature indicated that previous researchers concentrated only on credit risks,
liquidity, operational risk, leaving out market risk elements.

Generally, the current study has a broader scope, covering additional important interest rate risk and
foreign exchange risk variables in the market and this makes this study more comprehensive. A survey of
the relevant literature found that there are few studies specific to Somalia on the link between risk
management and the financial performance of the commercial bank. The aim of this study was,
therefore, to fill these relevant gaps in the literature by studying the effect of risk management on
financial performance by incorporating different components of risk such as credit risk, liquidity risk,
operational risk, and market risk i.e. interest rate risk and foreign exchange rate risk.