4 5764900847825716996

Financial Risks and Profitability of Commercial Banks in Ethiopia
Eneyew Lake
A Thesis Submitted to
The Department of Accounting and Finance
Presented in Partial Fulfillment of the Requirements for the
Degree of Master of Science (Accounting and Finance)
Addis Ababa University
Addis Ababa, Ethiopia
November 2013
DECLARATION
I, Eneyew Lake declare that this thesis entitled “Financial risks and Profitability of
Commercial Banks in Ethiopia” is outcome of my own effort and study and that all sources
of materials used for the study have been duly acknowledged. I have produced it
independently except for the guidance and suggestion of the thesis Advisor.
This study has not been submitted for any degree in this University or any other University. It
is offered for the partial fulfillment of the degree of Masters of Science in Accounting and
Finance.
By: Eneyew Lake
Signature__________________________
Date_______________________________
Advisor: Wollela Abehodie (PhD)
Signature______________________
Date__________________________
CERTIFICATE
This is to certify that thesis entitled, “Financial Risks and Profitability of
Commercial Banks in Ethiopia”, undertaken by Eneyew Lake for the partial
fulfillment of degree of Master of Science in Accounting and Finance at Addis Ababa
University, is an original work and not submitted earlier for any degree either at this
University or any other University.
Wollela Abehodie (PhD) _________________________
Thesis Advisor
iii
School of Graduate Studies
This is to certify that the thesis prepared by Eneyew Lake, entitled: Financial Risks
and Profitability of Commercial Banks in Ethiopia and submitted in partial fulfillment
of the requirements for the degree of Degree of Master of Science (Accounting and
Finance) complies with the regulations of the University and meets the accepted
standards with respect to originality and quality.
Signed by the Examining Committee:
Examiner Ashenafi Beyene (PhD) Signature_____________ Date___________
Examiner P. Laxmikantham (PhD) Signature__________ Date _____________
Advisor Wollela Abehodie (PhD) Signature__________ Date ________________
__________________________________________________________________
Chair of Department or Graduate Program Coordinator

Abstract
Financial risks and Profitability of Commercial Banks in Ethiopia
Eneyew Lake
Addis Ababa University, 2013
Commercial banks assume various kinds of financial risks which are related to the
financial operation of a business and arise due to the uncertainty in movement of
foreign exchange rates, interest rates, credit quality, and liquidity position. Risk may
have positive or negative outcomes or may simply result in uncertainty. Therefore in
order to increase the return, banks should know which risk factors have greater effect
on profitability. Thus, this study examines the impact of financial risks on the
profitability of commercial banks for a total of eight commercial banks in Ethiopia,
covering the period of 2000-2011. To this end, the study adopts a mixed methods
research approach by combining documentary analysis and in-depth interviews. The
study reviews the financial records of eight commercial banks in Ethiopia and
relevant data on macroeconomic factors considered. The findings of the study show
that Credit risk and liquidity risk have a negative and statistically significant
relationship with banks’ profitability. However, the relationship for interest rate risk
and foreign exchange rate risk is found to be statistically insignificant. The study
suggests that focusing in credit risk management and keeping optimal level of
liquidity which enables banks to meet their contractual commitments could maximize
return on assets of Ethiopian commercial banks.
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Acknowledgements
I would like to express my appreciation to all who have helped me in conducting this
study. First of all; I would like to express my genuine thank to my advisor, Wollela
Abehodie Yesegat (PhD) for her invaluable comments, inspiration and guidance at
various stage of the study. I am very much grateful to my friends who commented on
my study and provided their assistance in any form during the pilot study. I am
thankful to Debiremarkos University and Addis Ababa University for sponsoring me
throughout my work. At last but not least my deep gratitude goes to my brother
Getenet Lake, his moral support was an immense help throughout my work.
iv
Table of Contents ............................................................................................................... Pages
List of Figures ......................................................................................................................... viii
List of Tables............................................................................................................................. ix
List of Acronyms ................................................... ………………………………………………x
Chapter one Introduction ........................................................................................................ 1
1.1. Statement of the Problem.................................................................................................. 3
1.2.Broad objective, hypotheses and research question ............................................................ 5
1.3.Research Methodology ...................................................................................................... 6
1.4.Significance of the study. .................................................................................................. 7
1.5.Scope of the study. ............................................................................................................ 7
1.6.Limitation of the study. ..................................................................................................... 8
1.7. Structure of the report. ...................................................................................................... 8
Chapter 2: Review of the Literature. ..................................................................................... 10
2.1.Theoretical review. .......................................................................................................... 10
2.1.1. Financial risks in banking. ...................................................................................... 10
2.1.1.1. Credit risk ............................................................................................................. 10
2.1.1.2. Liquidity Risk. ...................................................................................................... 13
2.1.1.3. Interest Rate Risk .................................................................................................. 15
2.1.1.4. Foreign exchange rate risk. ................................................................................... 20
2.1.1.5. Off-Balance Sheet Risks. ...................................................................................... 22
2.1.2. Banks profitability and its measurement. .................................................................. 24
2.1.3.The Relationship between financial risks and profitability . .................................... 26
2.2. Empirical review. ....................................................................................................... 28
2.3. Conclusion and knowledge gaps . .............................................................................. 37
Chapter 3: Research design and methodology. ..................................................................... 39
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3.1. Variables selection, hypotheses and research questions ................................................ 39
3.1.1. Dependent Variables .................................................................................................. 39
3.1.2. Independent Variables and hypotheses. ........................................................................ 40
3.2. Research approaches. ..................................................................................................... 47
3.3. Research method planned to be used ............................................................................ 50
3.3.1. Research method: quantitative aspect........................................................................... 50
3.3.2. Research method: Qualitative aspect. .......................................................................... 57
Chapter 4: Results and Analysis ............................................................................................ 60
4.1. Research Hypotheses and Questions ............................................................................... 60
4.2. Results ........................................................................................................................... 61
4.2.1. Documentary analysis (structured review of financial records) .................................... 61
4.2.1.1. Descriptive statistics ............................................................................................. 62
4.2.1.2. Correlation analysis .............................................................................................. 65
4.2.1.3.Tests for the Classical Linear Regression Model (CLRM) Assumptions ................. 67
4.2.1.4. Results of Regression analysis ............................................................................. 72
4.2.2. In-depth interview results ......................................................................................... 77
4.3. Discussions of the Results........................................................................................... 79
4.3.1. Credit risk ............................................................................................................. 79
4.3.2. Liquidity risk ......................................................................................................... 80
4.3.3. Interest Rate Risk................................................................................................... 81
4.3.4. Foreign exchange risk ............................................................................................ 82
4.3.5. Capital strength...................................................................................................... 84
4.3.6. Bank size ............................................................................................................... 85
4.3.7. Gross domestic product.......................................................................................... 85
4.3.8. Inflation ................................................................................................................. 86
Chapter 5: Conclusions and Recommendations ....................................................................... 88
vi
5.1. Conclusions .................................................................................................................... 88
5.2. Recommendations .......................................................................................................... 90
References............................................................................................................................ 92
Appendices ......................................................................................................................... 100
vii
List of Figures
Figure 3.1: Rejection and non-rejection regions for Durbin-Watson test ………56
Figure4.1: Normality test for residuals: Bera-Jarque ………………..………….69
viii
List of Tables ............................................................................................................... …. Pages
Table 3.1: Description of the variables and their expected relationship ..............................….47
Table 3.2: Link between research question/hypotheses, variables and the different
data source ............................................................................................................................ 58
Table 4.1: descriptive statistics for dependent and independent variables............................... 62
Table 4.2 Correlation matrix of dependent and independent variables ................................... 66
Table 4.3: Heteroskedasticity Test: White ............................................................................. 68
Table 4.4: Autocorrelation Test: Durbin-Watson ................................................................... 68
Table 4.5: Correlation matrixes of independent variables ...................................................... 70
Table 4.6: Collinearity Statistics ............................................................................................ 71
Table 4.7: Model specification error (linearity) test: Ramsey RESET Test ............................ 72
Table 4.8: First Step Regression Results ................................................................................ 74
Table 4.9: Second Step Regression Results ........................................................................... 76
ix
List of Acronyms
AIB Awash International Bank
BOA Bank of Abyssinia
CAP Capital
CBB Construction and Business Bank

CBE Commercial Bank of Ethiopia
CR Credit risk
CLRM Classical Linear Regression Model
DB Dashen Bank
GDP Gross Domestic Product

HP Hypotheses
INFL Inflation
LIQ Liquidity risk

MoFED Ministry of Finance and Economic Development
NBE National Bank of Ethiopia
NIB Nib International Bank
NIM Net interest margin
OLS Ordinary Least Square
ROA Return on Asset

ROE Return on Equity
RQ Research Question
SSA Sub Saharan Africa
UB United Bank
WB Wegagen Bank
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Chapter 1 Introduction
Profitable and strong banking system promotes broader financial stability and
increases the economy‟s resilience to adverse macroeconomic shocks. A healthy and
sustainable profitability is important in maintaining the stability of the banking system
and for sustainable economic growth in general (Tafri, et al., 2009).
The banking system in Ethiopia has witnessed a significant expansion following
banking reform program which undertaken in 1994. The reform encouraged private
banks to enter and expand their operations in the industry. Although such growth has
taken place, as indicated in the National Bank of Ethiopia (NBE) 2010/11 annual
report the banking system in Ethiopia is underdeveloped. Ethiopia is still one of the
most under banked countries in the world with one bank branch serving over 82,000
people and the sector contributing little to GDP (NBE 2011). Ethiopian banks are
characterized by operational inefficiency and insufficient competition (Lelissa (2007)
and Abera (2012)). Thus these indicate the banking sector inefficiencies. As noted in
Demirguc-Kunt and Huizinga (1999) Bank profitability can be seen as indicator of the
(in) efficiency of the banking system. To improve banking sector efficiency it is
therefore, worthwhile to identify the main factors which affect banks profitability.
Hence, identification and analysis of the determinants of bank profitability have
attracted for many years the interest of academic researchers as well as bank
management, supervisors and financial service participants. Both internal and external
factors have been affecting the profitability of banks over time. And most studies in
the literature find that internal bank characteristics explain a large proportion of banks
profitability. Among others Shafiq & Nasr (2010), Achou and Tenguh (2008), Al-
1
Khouri (2011), Kithinji (2010), Baesens and Gestel (2009), found that internal bank
characteristics such as risks explain a large proportion of banks profitability.
In the process of providing financial services, commercial banks assume various kinds
of financial risks such as credit risk, liquidity risk, foreign exchange risk and interest
rate risk which are related to the financial operation of a business and arise due to the
uncertainty in movement of foreign exchange rates, interest rates, credit quality, and
liquidity position (Bessis, 2002).
Coming back to the case of Ethiopia, Ethiopian commercial banks (ECBs) were also
confronted with various kinds of financial risks, which may possibly intimidate the
survival and success of the banks (NBE 2010).
In spite of this and the fact that banks are in the business of taking risk, it should be
recognized that an institution need not engage in business in a manner that
unnecessarily imposes risk upon it: nor it should absorb risk that can be transferred to
other participants.
Thus examining the impact that the financial risks have on the profitability of the
commercial banks in Ethiopia is essential for all banks as it enable them to manage
those risks effectively. In order to increase the return, banks should know which risk
factors have greater effect on profitability.
In light of the above, a lot of research work has so far taken place concerning the issue
of determinants of bank profitability. Some earlier studies in the case of Ethiopian
banks tried to identify factors contribute for the performance of the banks. However
as the review of the literature presented in the second chapter indicated, the previous
2
studies conducted in Ethiopia in relation to this problem area do not incorporate
specific risks in their models. Thus to the knowledge of the researcher, there appears
to be very limited work on examining the impact of financial risks on profitability of
banks. This topic is still relatively under-explored area in the banking literature in
Ethiopia. So Conclusion about the impact of financial risks on the banks performance
remains ambiguous.
Hence the intent of this study is to examine the impact level of financial risks (credit
risk, liquidity risk, interest rate risk and foreign exchange rate risk) on profitability of
commercial banks in Ethiopia.
The next part of this chapter of the study is structured in seven sections. In the first
section statement of the problem is presented. The second section presents broad
objective, hypotheses and research question. The research methodology is presented
in third section and the subsequent two sections deal with significance of the study
and scope of the study respectively. And section six presented limitation of the study.
Lastly structure of the report is presented in the seventh section.
1.1. Statement of the problem
Commercial banks are exposed to different risks. In the process of providing
financial services, they assume various kinds of financial risks (Santomero 1997).
Without a doubt, in the present-day‟s unpredictable and explosive atmosphere all
banks are in front of hefty risks like credit risk, liquidity risk, operational risk, market
risk, foreign exchange risk, and interest rate risk, along with others risks, which may
possibly intimidate the survival and success of the banks‟ (Akhtar et al. 2011, p.122)
3
Banking is a business mostly associated with risk because of its large exposure to
uncertainty and huge considerations. Risk management is one of the most important
practices to be used especially in banks, for getting assurance about the reliability of
the operations and procedures being followed. An efficient risk management system is
the need of time.
After the introduction of the reform in 1994 the banking industry in Ethiopia has
experienced considerable changes such as entry of new banks in the industry which is
expected to increase the competition among the commercial banks. The competition
leads the banks to extend huge amounts of credit with the main objective of increasing
profitability which may result in non-performing loans. For instance as the NBE‟s
report presented during the review fiscal year 2009/10, deposit mobilized and
outstanding loans of the banking system surged by 56.7 and 20.6 percent,
respectively. The banking system disbursed fresh loans amounting to Birr 28.9 billion,
13.5 percent higher than last year, despite NBE‟s credit ceiling. Given lending
restrictions imposed by the central bank during the fiscal year 2009/10, the increase in
banks‟ lending was of course not as fast as the growth of deposits but still managed to
rise by 21 percent (NBE2009/10).
With the recent development in the banking industry in Ethiopia, all banks are
exposed to financial risks. Credit risk, operational risk and liquidity risk are dominant
risks in Ethiopian banking industry. The volume of assets and liabilities carried by
banks in Ethiopia that cannot be re-priced easily is increasing overtime thereby
exposing banks to interest rate risk (NBE 2010).
4
Risk may have positive or negative outcomes or may simply result in uncertainty.
Therefore, risks may be considered to be related to an opportunity or a loss or the
presence of uncertainty for an organization. Every risk has its own characteristics that
require particular management or analysis. Managing risk is one of the basic tasks to
be done, once it has been identified. Risk management as commonly perceived does
not mean minimizing risk; rather the goal of risk management is to optimize risk-
reward tradeoff (Shafiq & Nasr 2010). Theoretically the tradeoff between risk and
return is well acknowledged - the higher return comes with higher risk (Tafri, et al.,
2009). Therefore in order to increase the return, banks should know which risk
factors have greater effect on profitability.
To practice good risk management in the banks, it is necessary that an empirical study
be conducted on evaluating the impact that these risks may have on profitability.
However, to the knowledge of the researcher, no study to date provides a
comprehensive analysis of the impact of financial risks on profitability of commercial
banks in Ethiopia. Therefore, the deficiencies of the previous studies to be discussed
in the next chapter along with the above discussed issues call for the current research.
1.2. Broad objective, hypotheses and research question

The broad objective of this study is to examine the impact of financial risks on
profitability of commercial banks in Ethiopia controlling the influence of some
selected macro and bank specific variables.
Research question (RQ)
In line with the broad objective of this study described above, the following specific
research question was formulated:

5
RQ1. Which financial risks mostly occur and affect the profitability of
commercial banks in Ethiopia?
Hypotheses of the study
In line with the broad objective describe above, the following hypotheses were also
formulated for investigation based on theories and past related empirical studies.
Hypothesis 1: Credit risk has significant negative impact on the profitability of the
banks.
Hypothesis 2: Liquidity risk has significant negative impact on the profitability of the
banks.
Hypothesis 3: Interest rate risk has a significant positive relationship with banks
profitability
Hypothesis 4: foreign exchange rate risk has a significant negative relationship with
banks’ profitability
1.3. Research method used
In order to meet the objective of the study mixed methods approach was used. This
method was adopted as it can provide stronger evidence. As noted in Creswell (2009)
the use of mixed methods approach provides a better understanding of research
problems. Considering the nature of the study, quantitative research approach was
primarily applied. To have a better insight and to gain a richer understanding about
the research problem, the quantitative method was supplemented with the qualitative
one. The study covered eight commercial banks operated in Ethiopia for the twelve
6
years (2000-2011), the two government owned commercial banks Commercial Bank
of Ethiopia (CBE) and Construction and Business Bank (CBB) and, the six private
commercial banks in the country Awash International Bank (AIB), Bank of Abyssinia
(BoA), Dashen Bank (DB), Nib International Bank (NIB), United Bank (UB) and
Wegagen Bank (WB). Survey was carried out by means of structured document
review. The data related to a documentary analysis which is necessary to undertake
this study is gathered from the audited financial statements of the banks and NBE for
twelve consecutive years (2000-2011) and for some controlled macroeconomic
variables in this study the researcher used data taken from NBE and Ethiopian
Ministry of Finance and Economic Development (MoFED). To supplement the data
obtained through the structured document reviews in-depth interview was also
conducted with the finance managers of the selected banks.
Thus, the results obtained from the above mentioned data source was analyzed using
both descriptive as well as inferential statistics.
1.4. Significance of the study
This study helps to enhance local literatures on the subject matter. In addition, it also
signifies commercial banks of the country to evaluate their risk management
mechanisms in order to reduce loss and be profitable and more liquid than before.
Beside to that it add knowledge for concerned bodies by identifying the impact level
of financial risks towards profitability„s of commercial banks of the country.
Moreover, the researcher also believes that the study helps further researchers who are
interested in this area as a reference.
1.5. Scope of the study
7
The scope of the study was restricted to all commercial banks that are registered by
the NBE and operating in the Ethiopian banking industry and have at least twelve
years data for the period 2000 to 2011. Therefore, the two publically owned banks
(CBE and CBB), and six private commercial banks namely AIB, BOA, DB, NIB, UB
and WB were included in this study.
1.6. Limitation of the study
Due to confidentiality policy of banks, the study limited to the officially disclosed
financial data of banks and the personal perception of credit officers of selected
Ethiopian commercial banks towards the issue.
The quantitative part of this study was mainly analyzed by the ordinary least square
(OLS) method, which has basic assumptions to be tested (Brooks 2008). Therefore,
diagnostic tests were performed to ensure the validity of the data and econometrics
model. However, result of the autocorrelation test measured by the Durbin-Watson
(DW) test statistics could not give support to the absence autocorrelation problem in
this particular study. Hence this might impair the outcome of the study.
Moreover in this study the proxies used for most variables were expressed in terms of
ratios. However ratio does not perfectly reveal the amount of its components and the
quality of its components. Furthermore, there are a number of ratios in terms of
measurement for individual variables. The ones which were selected in the model
might possess certain bias as they cannot fully represent the accurate measurement for
the tested variable. This is due to the data availability and the nature of ratio analysis.
1.7. Structure of the report
8
The research is organized as follows: Chapter one presents introduction of the study.
Chapter two contains a review of the literature. The research design and methodology
is presented in chapter three. Chapter four presents data presentation, analysis and
interpretation of the results. Finally, chapter five presents conclusion and
recommendations.
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Chapter 2 Review of the Literature
In this literature review part concepts related to profitability, financial risks, and their
relationships and review of previous related studies which serve as background for
this study and help to indentify knowledge gaps are presented. Hence, this chapter is
arranged into three sections. Section 2.1 presents theoretical review of profitability
and financial risks. This is followed by a review of the relevant empirical studies
which are related with this study presented in section 2.2. Finally conclusion and
identification of knowledge gap are presented in section2.3.
2.1. Theoretical review
This section of the chapter presents theoretical review related to financial risks,
commercial banks profitability and its measurement and the relation between financial
risks and profitability. Accordingly, section 2.1.1 presents different financial risks in
banking. Then section 2.1.2 presents banks profitability and its measurement. Finally
section 2.1.3 presents the relation between financial risks and profitability.
2.1.1. Financial risks in banking
Financial risks associated with the provision of banking services are risks related to
the financial operation of a business, such as credit risk, liquidity risk, interest rate
risk and currency risk. Then the following subsections discuss these risks in an
orderly.
2.1.1.1. Credit risk
This is the uncertainty attached with the collection of loans. The probability that some
banks asset value, especially its loans will decline and perhaps became worthless is
known as credit risk. None performing loan is a loan that is not earning income and
10
full payment of principal and interest is no longer anticipated, the maturity date has
passed and payment in full has not been made.
The real risk from credit is the deviation of portfolio performance from its expected
value. Accordingly, credit risk is diversifiable, but difficult to eliminate completely.
This is because a portion of the default risk may, in fact, result from the systematic
risk. In addition, the idiosyncratic nature of some portion of these losses remains a
problem for creditors in spite of the beneficial effect of diversification on total
uncertainty. This is particularly true for banks that lend in local markets and ones that
take on highly illiquid assets. In such cases, the credit risk is not easily transferred,
and accurate estimates of loss are difficult to obtain (Santomero, 1997).
Credit risk indicator can be represented by different measurements including loans
loss provision to total loans ratio as well as growth in bank deposits. Higher
provisions for loan losses could signal the likelihood of possible future loan losses,
though it could also indicate a timely recognition of weak loans by prudent banks.
The ratio of non-performing loans to total loans and loses is one of the most widely
used indicators of bank credit risk. In most countries central banks set some specific
standards for the level of loan-loss provisions to be adopted by the country‟s banking
system. In view of these standards, bank management should adjust provisions held
for loan losses portfolio, and in most studies credit risk are modeled as a
predetermined variable.
Credit risk measurement system attempts to quantify the risk of losses due to
counterparty default. Credit risk management encompasses identification,
measurement, matching mitigations, monitoring and control of the credit risk
exposures to ensure that:

11
- The individuals who take or manage risks clearly understand it
- The organization‟s Risk exposure is within the limits established by Board of
Directors with respect to sector, group and country‟s prevailing situation
- Risk taking Decisions are in line with the business strategy and objectives set
by BOD
- The expected payoffs compensate the risks taken
- Risk taking decisions are explicit and clear
- Sufficient capital as a buffer is available to take risk (Motlagh, et al.,2011, p.5)
The basis for an effective credit risk management process is the identification and
analysis of existing and potential risks inherent in any product or activity.
Consequently, it is important that banks identify the credit risk inherent in all the
products they offer and the activities in which they engage. This is particularly true
for those products and activities that are new to the bank where risk may be less
obvious and which may require more analysis than traditional credit-granting
activities. Although such activities may require tailored procedures and controls, the
basic principles of credit risk management will still apply. All new products and
activities should receive board approval before being offered by the bank.
The goal of credit risk management is to maintain a bank‟s credit risk exposure within
parameters set by the board of directors and senior management. The establishment
and enforcement of internal controls, operating limits and other practices will help
ensure that credit risk exposures do not exceed levels acceptable to the individual
bank. Such a system will enable bank management to monitor adherence to the
established credit risk objectives.
12
Experiences elsewhere in the world suggest that the key risk in a bank has been credit
risk. Indeed, failure to collect loans granted to customers has been the major factor
behind the collapse of many banks around the world. Credit risk is not confined to a
bank‟s loan portfolio, but can also exist in its other assets and activities. Likewise,
such risk can exist in both a bank‟s on-balance sheet and its off-balance sheet
accounts (NBE, 2010).
2.1.1.2. Liquidity Risk
Liquidity risk is the potential for loss to an institution arising from either its inability
to meet its obligations or to fund increases in assets as they fall due without incurring
unacceptable cost or losses. This risk is one of the risks a bank faces. According to the
definition of the Basel Committee on Banking Supervision (1997), liquidity risk arises
from the inability of a bank to accommodate decreases in liabilities or to fund
increases in assets. When a bank has inadequate liquidity, it cannot obtain sufficient
funds, either by increasing liabilities or by converting assets promptly, at a reasonable
cost, thereby affecting profitability.
This risk results from the inability of the bank to repay liabilities and obligations due
on their maturity dates because the bank does not harmonize the maturities dates of
assets and liabilities through investment in assets with maturities dates greater than
those of liabilities, something which leads to the inability to meet the demands for the
withdrawal of deposits when they are due (Blume, 1971 cited in Claudiu and Daniela,
2009). Liquidity risk can be divided into two types: Funding Liquidity Risk (it results
from the inability of the bank in normal circumstances to obtain adequate liquidity to
repay its obligations, or obtain new deposits or a new loan or its inability to liquidate
13
its assets); Market Liquidity Risk (it results from sudden withdrawal of deposits
resulting in the inability of the bank to pay without incurring unexpected loss)
(Claudiu and Daniela, 2009). The concept of liquidity is increasingly important in
managing financial risk. It is driven by; the structure and depth of markets; volatility
of market prices/rates; the presence of traders willing to make markets and commit
capital to support trading; and, trading / leverage strategies deployed. It has
historically been thought of as associated with funding, however, it can be separated
into two distinct risk types Funding Liquidity Risk and Trading Liquidity Risk.
In any case, risk management here centers on liquidity facilities and portfolio
structure. Recognizing liquidity risk leads the bank to recognize liquidity itself as an
asset, and portfolio design in the face of illiquidity concerns as a challenge
(Santomero, 1997).
Banks provide maturity transformation. Taking deposits that are callable on demand
or that on average has shorter maturity than the average maturity of the financing
contracts they sell. While maturity transformation provides liquidity insurance to the
depositors, which is valued by them, it exposes banks to liquidity risk themselves.
Since banks specialize in maturity transformation they take pool deposits and take
care to match their cash inflows and outflows in order to address the liquidity risk
they face.
However, maturity mismatch at a given time is not the only source of liquidity risk.
The risk of this kind can arrive from many directions and its pinch depends on various
factors. Its sources; on assets side depend on the degree of inability of bank to convert
14
its assets into cash without loss at time of need, and on liabilities side it emanates
from unanticipated recall of deposits.
Determining what is adequate liquidity for banking organizations has always been a
rather subjective and difficult task, because banks rarely have liquidity problems as
long as they are viewed as sound and deposit inflows are positive. Failure to properly
manage liquidity can quickly result in significant unanticipated losses. The purpose of
liquidity management is to ensure that every bank is able to meet fully its contractual
commitments. The ability to fund increases in assets and meet obligations as they
come due is critical to the ongoing viability of any bank. Therefore, managing
liquidity is among the most important activities conducted by banks. Sound liquidity
management can reduce the probability of serious problems. Since a bank‟s future
liquidity position will be affected by factors that cannot always be forecasted with
precision, assumptions need to be reviewed frequently to determine their continuing
validity. These assumptions should be made under the different categories of assets,
liabilities and off-balance sheet activities (NBE, 2010).
The bank‟s intermediation activity is characterized by the acceptance of short-term
deposits (demand and term deposits) and the granting of medium and long term loans.
They must be prepared to meet their withdrawals of deposits at any moment of time.
In order to do so, banks hold two types of reserves: required reserves, imposed by the
central bank; and excess reserves, demanded by precautionary reasons. Holding
reserves entails an opportunity cost but it represents an insurance against liquidity
risk.
2.1.1.3. Interest Rate Risk:
15
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, leading to potential
losses for the bank when interest rate increases or declines and this influences the net
asset value in the budget, which some call risk gap (Claudiu and Daniela, 2009)
In the scenario of rising interest rate, when liabilities re-price faster than assets,
interest spread would fall and hence profitability of the bank would be adversely
affected. Accepting this risk is a normal part of banking business and can be an
important source of profitability. However, excessive interest rate risk can pose a
significant threat to banks' earnings and capital base. Changes in interest rates affect
banks' earnings by changing their net interest income and the level of other interest-
sensitive income and operating expenses. Companies face interest-rate risks from the
interest-rate sensitivity of their debts and/or their investments. However, for non-
financial services companies, the risks from interest-rate sensitivity of their debts
would usually outweigh the risks from their investments. The impact of interest rates
on the business will depend on the choice of funding: the mix between capital and
debt; the mix between fixed and floating rate debt; and the mix between short-term
and long-term debt.
There are a number of factors that need to be considered when deciding whether to
use fixed-rate or floating-rate instruments:
- The expectation of future interest-rate movements. If interest rates were
expected to fall, a floating rate would be more attractive to a borrower.
16
- The term of the loan or investment. Interest-rate changes would be easier to
predict in the short-term than in the long-term.
- Differences between the fixed rate and the floating rate.
- The company‟s goals, risk management strategy and risk appetite.
- Current levels of debt and the current interest-rate exposure. A mix of fixed
and floating-rate instruments ensures diversification of interest rate exposure
and acts as a natural hedge (Collier 2009).
Fluctuations in interest rates may affect different companies in different ways but
almost every company is affected by changes in interest rates.
A company that borrows or invests surplus funds does so at either a fixed rate of
interest or at a floating (variable) rate. Fixed rates provide certainty as interest
payments or receipts are known regardless of future interest-rate movements.
However, there are also risks associated with fixed-rate debts. For long-term debts the
company risks being locked in to a high interest rate if interest rates fall during the life
of the loan. A floating-rate borrowing (or investment) varies through the life of the
loan (or investment). Floating rates are usually expressed as a margin over an agreed
reference rate and are reset at regular intervals.
Literature indicates three main methodologies for interest rates 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 its sensitivity for interest rate shift. Reappraisal date
is the date when corresponding financial instrument may change the interest rate and
thus influence the bank profit receivable from interest.

17
Another very important factor while conducting the difference analysis is evaluating
bank„s assets and liabilities sensitivity to the interest rate shifts. Not all the assets and
liabilities are sensitive to interest rate shifts. In difference 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. Calculated positive gap means that
more assets would be reappraised comparing with liabilities at the given period.
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 (Martirosianien, 2008).
Duration Analysis helps to evaluate the interest rate risk more simply but more
mathematical calculations must be done. One dimension, describing the financial
measure, which could be used in order to evaluate the riskiness of this measure in the
case of interest rate fluctuations, is calculated.
Duration is a dimension describing the financial measure value sensitivity to interest
rate shifts and may be considered as mean measure lifetime, while evaluating money
flows it has created weighted by a time. The theory of duration calculation was
developed by Macauley in 1938 and it may be described as follows: The core of
Duration-Difference Analysis is calculations of duration discrepancies for bank„s
assets and liabilities, i.e. evaluation of duration of money flows created by all assets
and duration of money flows created by all liabilities. The difference between assets
and liabilities durations help to evaluate the bank riskiness from the interest rate risk
18
view and to explain which course of interest rate shift would be useful for the bank
and which would be harmful (Mark et al., 2011).
The compatibility (and/ or controlled incompatibility) of bank assets and liabilities
terms and interest rates are crucial factors in bank management. In practice it is not
common that banks would completely match the terms of assets and liabilities,
because there are many different type and duration transactions taking place in the
bank very often. Incompatible position potentially increases the profitability, but also
disguises the risk of possible loss. The terms of assets and liabilities and the
possibility to change interest expenditures in acceptable price when its term arrives
are crucial factors while evaluating bank„s liquidity and facing risk, related with the
fluctuations of interest rates and currency exchange rates. Some banks manage
interest rate risk by analyzing, forecasting interest rates in the market and managing
asset-liabilities discrepancies according to reappraisal terms (Martirosianien, 2008).
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 risk taking 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
19
with 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 board of directors 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.
2.1.1.4. Foreign exchange rate 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 which 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 (2010) defines foreign exchange risk as incurring losses due to changes in
exchange rates. Such loss of earnings may occur due to a mismatch between the value
of assets and that of capital and liabilities denominated in foreign currencies or a
mismatch between foreign receivables and foreign payables that are expressed in
domestic currency.
Currency volatility is a major risk faced by companies doing business outside their
home countries. There are a number of factors that influence a currency‟s exchange
rate:
- Speculation. Speculators enter into foreign exchange transactions not because
they have a need for the currency but with a view to profit from their
expectations of the currency‟s future movements. If speculators expect a
20
currency to devalue, they will short sell the currency with the hope of buying it
back cheaply in the future.
- Balance of payments. The net effect of importing and exporting will result in a
demand for or a supply of the country‟s currency.
- Government policy. Governments from time to time may wish to change the
value of their currency. This can be achieved directly by devaluation,
revaluation or through the use of foreign exchange markets.
- Interest-rate differentials. A higher rate of interest can create a demand for a
particular currency. Investors will buy that currency in order to hold financial
securities in the currency with the higher interest rate.
- Inflation rate differentials. Where countries have different inflation rates the
value of one country‟s currency is falling in real terms in comparison with the
other. This will result in a change in the exchange rate.
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 a 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 bank due to the fluctuations in the
exchange rates. No one can predict what the exchange rate will be in the next period.
21
This uncertain movement poses a threat to the earnings and capital of bank, if such a
movement is in undesired and unanticipated direction.
Unhedged position in a particular currency gives rise to foreign currency risk and
such a position is said to be Open Position in that particular currency. If a bank has
sold more foreign currency than he has purchased, it is said to be Net Short in that
currency, and the alternative is Net Long position when sold less than purchased.
Both of these positions exposed to risk as the foreign currency may fall in value as
compared to local or home currency and becomes a reason for substantial loss for the
bank if it is in Net Long position or the foreign currency may rise in value and cause
losses if the bank is Net Short in that currency. Net Foreign Currency Exposure which
is the sum of these two positions gives the information about the Foreign Exchange
Risk that has been assumed by the bank at that point of time. This figure represents
the unhedged position of bank in all the foreign currencies. A negative figure shows
Net Short Position whereas positive figure shows Net Open Position (Sounder and
Cornet 2007).
2.1.1.5. Off-Balance Sheet Risks
As part of their operations, banks get involved in originating financial contracts that
may result in the acquisition of assets and liabilities at some future date, under certain
conditions. Generally accepted accounting principles do not consider these contracts
in themselves to be assets or liabilities and therefore do not recognize them on the
face of the balance sheet but rather off balance sheet. Off Balance sheet items are
diverse in nature and purpose and may include letters of credit (L/C), unused loan
commitments, guarantees, acceptances and performance bonds.
22
Off-Balance sheet business to banks means exposure to several risks. The bank must
have basic understanding of the risks associated with off-balance sheet business
which, in principle, are not different from on-balance sheet business and should in
fact be regarded as an integral part of the bank's overall risk profile. The major risks
associated with off balance sheet business are summarized below:
Off balance sheet activities can either reduce or increase exposure to exchange rate
changes. In managing foreign exchange risk, banks must constantly monitor their
foreign exchange positions whether arising from off or on balance sheet business.
Off balance sheet activities have an impact on interest rate risk exposure, entered into
as a hedge against on balance sheet interest rate exposure. Furthermore, some
individual transactions may be undertaken to increase net interest rate exposures. In
such cases, this may lead to an increase in interest rate as well as credit risk. Interest
rate risk measurement and control calls for banks to perform sensitivity analyses so
that management can estimate the effect of a given change in interest rates.
Liquidity risk is risk that a bank shall not be able to obtain the necessary funds to
meet its obligations as they fall due e.g., maturing deposits, drawings under approved
facilities. The bank may therefore be unable to obtain funds from the market at
competitive rates which may convey wrong signals that the bank is facing serious
problems.
Credit risk is risk that one or more counterparties might fail to perform on- of off-
balance sheet obligation e.g., guarantees, non-cash covered L/Cs. Banks run the risk
of losses arising from failure to apply adequate control mechanisms regarding off
balance sheet items.

23
In order to explain the relationship of bank profitability and the above discussed
financial risks first it is necessary to discuss banks profitability and its measurement.
Then the following section presents the theoretical explanation related to Banks
profitability and its measurement.
2.1.2. Banks profitability and its measurement
Commercial banks make profit by earning more money than what they pay for
expenses and taxes. The most important portion of a bank's profit comes from the fees
that it charges for its services and the interest that it earns on its assets. Its major
expense is the interest paid on its liabilities. Loans dominate asset holding at most
banks and generate the largest share of operating income. Loans are the dominant
asset in most banks‟ portfolios, comprising from 50 to 70 percent of total assets
(Claudiu and Daniela (2009).
The major assets of a bank are its loans to individuals, businesses, and other
organizations and the securities that it holds, while its major liabilities are its deposits
and the money that it borrows, either from other banks or by selling commercial paper
in the money market. Return on asset (ROA) and return on equity (ROE) are the
commonly used ratios to measure profitability of a business. Assets are used by
businesses to generate income. Loans and securities are a bank's assets and are used to
provide most of a bank's income. However, to make loans and to buy securities, a
bank must have money, which comes primarily from the bank's owners in the form of
bank capital, from depositors, and from money that it borrows from other banks or by
selling debt securities. A bank buys assets primarily with funds obtained from its
liabilities. However, not all assets can be used to earn income, because banks must
have cash to satisfy cash withdrawal requests of customers.

24
The ROA is determined by the amount of fees that it earns on its services and its net
interest income.Net interest income depends partly on the interest rate spread, which
is the average interest rate earned on it assets minus the average interest rate paid on
its liabilities. Net interest margin shows how well the bank is earning income on its
assets.
High net interest income and margin indicates a well managed bank and also indicates
future profitability.
The measurement of bank performance has been developed over time. At the
beginning, many banks used a purely accounting-driven approach and focused on the
measurement of Net income, for example, the calculation of ROA. However, this
approach does not consider the risks related to the referred assets, for instance, the
underling risks of the transactions, and also with the growth of off-balance sheet
activities. Thus the riskiness of underlying assets becomes more and more important.
Gradually, the banks notice that equity has become the scarce resource. Thereby,
banks turn to focus on the ROE to measure the net profit to the book equity in order to
find out the most profitable business and to do the investment (Gerhard .S 2002 cited
in Ara et al., 2008). Net interest margin (NIM) ratio is also used to measure bank
profitability in the baking literature. Studies that explore the factors that influence the
profitability of banks use one or a combination of these ratios alternatively as
measures of bank profitability in their analysis.
Ratios (net profit to total asset, net profit to equity, and NIM) instead of the real value
of profits are used in measuring bank profitability because ratios are not influenced by
variations in the general price level. Ratios are time invariant, the real value of profits
25
may be affected by the time varying inflation rates. That is, ratios are time invariant
because both the numerator and the denominator in the period-t would be measured in
monetary terms based on period-t price levels (Guru et al., 1999)
2.1.3. The Relationship between financial risks and profitability
Risks are usually defined by the adverse impact on profitability of several distinct
sources of uncertainty. It is also commonplace to argue that the expected return on an
asset should be positively related to its risk. That is, individuals will hold a risky asset
only if its expected return compensates for its risk. Both the Capital asset pricing
model (CAPM) developed in the early 1960s and Arbitrage pricing theory (APT)
imply a positive relationship between expected return and risk. Even, the APT views
risk more generally than just the standardized covariance or beta of a security with the
market portfolio. The relevant risk of an individual stock, which is called its beta
coefficient, is defined under the CAPM as the amount of risk that the stock
contributes to the market portfolio. And the CAPM states that the expected returns on
stocks should be related only to beta, which represents Market risk or systematic risk;
it is the risk that remains after diversification. Standard asset pricing models also
imply that arbitrage should ensure that riskier assets are remunerated with higher
returns.
The basic concepts of the CAPM were developed specifically for common stocks, and
fundamental assumptions for the positive risk-return trade off are that investors are
risk averse, and thus investors demand compensation for bearing risk, Any investor
can lend and borrow an unlimited amount at the risk free rate of interest, There are no
taxes or transaction costs, and All investors have access to the same information at the
26
same time. However, In reality, every investor has a credit limit, and Real financial
products are subject both to taxes and transaction costs, and taking these into account
will alter the CAPM's trade-off assumption of higher risk for higher return.
An alternative to the CAPM, called the arbitrage pricing theory (APT), has been
developed more recently. The differences between the two models stem from the
APT‟s treatment of interrelationship among the returns on securities. The APT
assumes that returns on securities are generated by a number of industry wide and
market wide factors. Correlation between a pair of securities occurs when these two
securities are affected by the same factor or factors. By contrast, though the CAPM
allows correlation among securities, it does not specify the underlying factors causing
the correlation (Wang et al., 2012).
CAPM is widely used by analysts, investors, and corporations. However, despite the
CAPM‟s intuitive appeal, a number of studies have raised concerns about its validity.
In particular, a study by Fama and French doubt on the CAPM. Fama and French
(1992) found two variables that are consistently related to stock returns: (1) the firm‟s
size and (2) its market/book ratio. After adjusting for other factors, they found that
smaller firms have provided relatively high returns, and that returns are relatively high
on stocks with low market/book ratios. At the same time, and contrary to the CAPM,
they found no relationship between a stock‟s beta and its return (Jaffe 2003).
The main source of revenue or main sources of profit of banks came from lending
money to their customers. Which means Risk-taking is an inherent element of
banking and, indeed, profits are in part the reward for successful risk taking. In
contrary, excessive, poorly managed risk can lead to distresses and failures of banks.
27
The prime reason to adopt risk management practices is to avoid the probable failure
in future. But, in realistic terms, risk management is clearly not free of cost. In fact, it
is expensive in both resources and in institutional disruption. But the cost of delaying
or avoiding proper risk management can lead to some adverse results, like failure of a
bank and possibly failure of a banking system (Meyer, 2000).
The following section presents reviews of the prior empirical studies conducted in
relation to financial risks and profitability of commercial banks.
2.2. Empirical review
There are prior studies conducted in different countries which are related to the
topic/problem of this study. In order to show the research gap and justify the
importance of this study the following section presents review of the empirical
evidence that have examined financial risks and profitability of commercial banks.
A study made by Tafri et al. (2011) examined the relationship between financial risks
(credit risk, interest rate risk and liquidity risks.) and profitability of the conventional
and Islamic banks in Malaysia for the period between 1996 and 2005. They used
panel data regression analysis of Generalized Least Squares of fixed effects and
random effects models and found that credit risk has a significant impact on
profitability of the conventional as well as the Islamic banks. The relationship
between interest rate risk and ROE were found to be weakly significant for the
conventional banks and insignificant for the Islamic banks. The effect of interest rate
risk on ROA is significant for the conventional banks. And also they found liquidity
risk to have an insignificant impact on profitability.
28
Imad et al. (2011) examined that the credit risk is associated with significant inverse
relationship with profitability in Jordan, thus, increased exposure to credit risk in
Jordanian banking sector lowers profits.
Akhtar et al. (2011) studied factors influencing the profitability of Conventional
Banks of Pakistan. They intend to study the bank-specific determinants of
conventional banks in Pakistan to highlight and identify the significant factors that are
influencing on bank‟s profitability. They reported none performing loans ratio is
found to have negative and significant effect on the profitability of commercial banks.
Olweny & Shipho (2011) examined the effects of banking sector factors on the
profitability of commercial banks in Kenya. They adopted an explanatory approach by
using panel data research design. Annual financial statements of 38 Kenyan
commercial banks from 2002 to 2008 were obtained were used for the analysis
purpose. The data was analyzed using multiple linear regressions method. The results
of the analysis showed that all the bank specific factors had a statistically significant
impact on profitability, while none of the market factors had a significant impact.
Al-Khouri (2011) also investigated the impact of bank‟s specific risk characteristics,
and the overall banking environment on the performance of 43commercial banks
operating in the 6 of the Gulf Cooperation Council (GCC) countries over the period
1998-2008 by using fixed effect regression analysis. The results showed that credit
risk, liquidity risk and capital risk are the major risk factors that affect bank
performance when profitability is measured by return on assets and the only risk that
affected the profitability as measured by return on equity is the liquidity risk.
29
Gachua (2011) study the effect of foreign exchange exposure on a Firm‟s financial
performance of listed Companies in Kenya for the period covering years 2001 to
2010. The study is to find out whether foreign exchange exposure is minimized where
firms have been able to match their foreign currency revenues and costs leaving them
with little net exposure. From the findings the study found that listed firms use the
income statement and the owner„s equity account to record foreign exchange
differences. The study concluded that unrealized foreign exchange gains/losses had an
effect on the Net Income of listed companies as it was posted to either income
statement or owners‟ equity. The study also found that there had been significant
percentage growth in imports and exports for firms listed in the Nairobi Stock
Exchange. The study further concluded that the use of foreign exchange has an effect
on import costs and accounts payables, export revenues and accounts receivables with
the net effect on the Net Income of the companies.
On the other hand Kithinji (2010) determined the relationship between the credit risk
management and profitability of commercial banks in Kenya and the findings reveal
that the bulk of the profits of commercial banks is not influenced by the amount of
credit and nonperforming loans suggesting that other variables other than credit and
nonperforming loans impact on profits. Commercial banks that are keen on making
high profits should concentrate on other factors other than focusing more on amount
of credit and nonperforming loans.
Bordeleau and Graham (2010) studied the impact of liquidity on bank profitability.
They present empirical evidence regarding the relationship between liquid asset
holdings and profitability for a panel Canadian and U.S. banks over the period of
1997 to 2009. The result suggest that a nonlinear relationship exists, whereby
30
profitability is improved for banks that hold some liquid assets, however, there is a
point beyond which holding further liquid assets diminishes a banks‟ profitability, all
else equal.
Valentina et al. (2009) measure credit risk using the ratio of loans to deposits and
short-term funding since this provide a forward-looking measure of bank exposure to
default and asset quality deterioration. Given that the portfolio of outstanding loans is
non tradable, credit risk is modeled as a predetermined variable in their specification.
Based on standard asset pricing arguments, they expect a positive association between
profits and bank risk and found that credit risk has a positive and significant effect on
profitability. This suggests that risk-averse shareholders target risk adjusted returns
and seek larger earnings to compensate higher credit risk.
Shen et al. (2009) carried out a study on twelve advanced economies commercial
banks over the period 1994-2006 with the title Bank liquidity risk and performance.
The study investigates the causes of liquidity risk and the relationship between bank
liquidity risk and performance for those banks with the specified period and they find
that liquidity risk is the endogenous determinant of bank performance. The causes of
liquidity risk include components of liquid assets and dependence on external
funding, supervisory and regulatory factors and macroeconomic factors.
Ara et al. (2009) studied Credit Risk Management and Profitability of Commercial
Banks in Sweden using the quantitative method. They try to find out how the credit
risk management affects the profitability in banks. The main purpose of this study is
to describe the impact level of credit risk management on profitability in four
commercial banks in Sweden. They took four banks to study this area and data is
31
collected from the sample banks annual reports (2000-2008) and capital adequacy and
risk management reports (2007-2008) and used multiple regression models to do the
empirical analysis. The findings of the analysis reveal that credit risk management has
effect on profitability in all four banks. Among the two credit risk management
indicators, NPLR has a significant effect than CAR on profitability (ROE). The
analysis on each bank level shows that the impact of credit risk management on
profitability is not the same. The researchers obtained that there is a reasonable effect
of credit Risk Management on profitability of those banks.
Shamsuddin (2009) conducted a study with the topic Interest rate and foreign
exchange risk exposures of Australian Banks. This study estimates systematic risk
exposure of publicly listed Australian banks with respect to market, interest rate and
foreign exchange rate using a GARCH-in-Mean model. Not surprisingly, the results
suggest that nearly all banks exhibit varying degrees of market risk exposure.
However, stock returns of large banks are highly sensitive to interest rate changes,
while most small banks are almost immune to both interest and exchange rate
changes.
Delport and Li (2009) also conduct study with the purpose of evaluating the effect of
exchange rates movement on fourteen listed Chinese banks‟ equity returns, by using
the Arbitrage Pricing Theory Model. In particular, this study analyses the three
foreign currencies holding the largest trading position with China, namely the Euro,
US Dollar, and Japanese Yen. This empirical study finds that Chinese banks are on
average most sensitive to exchange-rate movements with regards to Japanese yen.
32
Achou and Tenguh (2008) examined the relationship between bank performance and
credit risk management This study shows that there is a significant relationship
between bank performance (in terms of profitability) and credit risk management (in
terms of loan performance). Better credit risk management results in better bank
performance. Their study also reveals that banks with good or sound credit risk
management policies have lower loan default ratios (bad loans) and higher interest
income (profitability) and also banks with higher profit potentials can better absorb
credit losses whenever they crop up and therefore record better performances.
Furthermore, the study shows that there is a direct but inverse relationship between
profitability (ROE, ROA) and the ratio of non-performing loans to capital (NPL\C).
Li (2007) carried out a study which aimed to identify the main internal determinants
of banks profitability and to what extent these determinants exert impact on banks
profitability. This study investigates the impact bank‟s specific factors and
macroeconomic factors on bank‟s profitability, which is measured by return on
average assets (ROAA) in the UK banking industry over the period 1999-2006 with
aim to indicate the strengthen of risk management in banks. The results show that the
impact of loan loss reserves has a negative impact on profit and statistically
significant. This implies that higher credit risks result in lower profits. The result for
liquidity is mixed and not significant, indicates that conclusion about the impact of
liquidity remains questionable and further research is needed.
Pasiouras & Kosmidou (2007) examined the effects of internal and external variables
on profitability, including the capital ratio, cost to income ratio, loans to customers
and short-term funding, bank size, inflation, GDP growth, concentration, and three
determinants reflecting the development of banking and stock markets on bank

33
returns for 584 domestic and foreign commercial banks in the 15 developed European
Union countries over the period 1995-2001. The effects of all variables are found to
be significant, regardless of bank.
Hedging allows the commercial banks to manage foreign exchange risk but hedging
itself poses additional risk to bank. Gandhi (2006) mentioned that currency
derivatives like currency futures, currency forwards, currency swaps and currency
options help in hedging foreign exchange risk of firms and other ways of hedging
including off-setting positions against the underlying assets and money markets are
themselves risky. Hedging and hedging right are two different things. If the hedging is
not done properly in the right way, it itself can become a serious source of risk and
have potential to pose a serious financial loss to the firm.
Athanasoglou et al. (2005) examined Bank-specific, Industry specific and
macroeconomic determinants of bank Profitability, bank of Greece and as expected,
credit risk is negatively and significantly related to bank profitability. This shows that
in the Greek banking system managers, attempting to maximize profits, seem to have
adopted a risk-averse strategy, mainly through policies that improve screening and
monitoring credit risk.
Zhang and Epperson (2004) conducted their paper on “Profitability and risk of U.S.
agricultural banks” The researcher believed that Study of profitability and risk of
agricultural banks is very important in assessing the ability to adequately finance
agricultural production and rural development. A recursive system of profitability and
risk equations is estimated to compare the performance of agricultural with
nonagricultural banks and to identify factors which affect performance. A linear
34
regression model which measures risk-adjusted profitability confirms the results from
the recursive system. The finding of the researcher was agricultural banks perform
better than nonagricultural counterparts on average even after controlling for risks and
other factors. Further, off-balance-sheet business is found to be negatively related to
the risk-adjusted profitability of agricultural banks.
Popov and Stutzmann (2003) investigated how two Swiss companies manage their
foreign exchange risk and examined that forward and netting are the most used
instruments and transaction exposure is the most managed foreign exchange risk. And
translation and economic exposures are not well identified and managed mainly
because firms believe it is unnecessary or too complex. And also they observed that
firms hedge their exposure but never fully due to high cost of hedging.
In Ethiopia also there are prior studies conducted which are related to the
topic/problem of this study.
A study was conducted by Abera (2012) with the topic factors affecting profitability
of commercial banks in Ethiopia. He examined the bank-specific, industry-specific
and macro-economic factors affecting bank profitability for a total of eight
commercial banks in Ethiopia, covering the period of 2000-2011 Using a mixed
methods research approach and found that capital strength, income diversification,
bank size and gross domestic product have statistically significant positive
relationship with banks‟ profitability and variables like operational efficiency and
asset quality have a negative and statistically significant relationship with banks‟
profitability. And also the relationship for liquidity risk measured with a ratio of
35
liquid assets to total assets, concentration and inflation is found to be statistically
insignificant.
Tesfaye (2012) conducted a study with the intent of examining Determinants of banks
liquidity and their impact on financial performance of commercial banks in Ethiopia.
She used balanced fixed effect panel regression for the data of eight commercial
banks in the sample covered the period from 2000 to 2011. She selected and analyzed
eight factors affecting banks liquidity. Then after identifying determinants of
commercial banks liquidity in Ethiopia she tried to see the impact of banks liquidity
up on financial performance through the significant variables explaining liquidity and
then among the statistically significant factors affecting banks liquidity capital
adequacy and bank size had positive impact on financial performance whereas, non-
performing loans and short term interest rate had negative impact on financial
performance. Interest rate margin and inflation had negative but statistically
insignificant impact on financial performance. And she concluded as the impact of
bank liquidity on financial performance was non-linear/positive and negative.
Tefera (2011) studied Credit risk management and profitability of Commercial Banks
in Ethiopia. He used nonperforming loan ratio and capital adequacy ratio as a proxy
for credit risk and the result showed that both proxies has a negative impact on
profitability of commercial banks in Ethiopia.
Kapur and Gualu (2011) investigated the impact of macroeconomic factors, financial
system, banking sector variables and bank-specific characteristics on Ethiopian
commercial banks‟ profits measured using return on assets (ROA) measure of profit.
36
They examined that nonperforming loans and advances to the total loans and
advances ratio (NPL) has negative and significant impact on Ethiopian banks profit.
Damena (2011) conducted study with the title “Determinants of commercial banks
profitability: empirical study on Ethiopian Commercial Banks”, with the aim to
examine the impact of bank-specific, industry-specific and macroeconomic
determinants of Ethiopian commercial banks profitability applying the balanced
panel data of seven Ethiopian commercial banks that covers the period 2001- 2010.
This study showed that all bank-specific determinants, with the exception of saving
deposit, significantly affect commercial banks profitability in Ethiopia. He examined
as credit risk is the main significant factor which challenges the profitability of banks
in Ethiopia.
NBE, 2009, Results of banking sector risk management survey suggests existence of
some positive steps taken so far by banks to strengthen their risk management
practices. The survey revealed that credit, operational and liquidity risks have been
dominant risks over the last two years, and will continue to be key risks over the next
five years.
2.3. Conclusion and knowledge gaps
In order to measure the impact level of financial risks (like credit risk, liquidity risk
and market risks; interest rate risk and foreign exchange rate risk) on profitability of
commercial banks it necessitates study in each country since we cannot describe the
impact level from the scratch or simple from the theory. The review of the literature
discussed in this chapter reveals the existence of many gaps of knowledge in this
37
regard, particularly in the context of Ethiopia. To my knowledge the above mentioned
issue has not been adequately investigated in Ethiopia.
Although a very limited number of studies such as Kapur and Gualu (2011), Damena
(2011), and Abera (2012), conducted in Ethiopia appear to include credit risk as
explanatory variables for commercial banks profitability, this relationship is not the
focus of those papers and credit risk is generally included as a control variable in
these studies with very limited discussion around the estimated parameter. Abera
(2011) also included liquidity as explanatory variable for commercial banks
profitability and found its impact insignificant and point to a need for further
investigation in this regard. The study conducted by Tefera (2011) also tried to
examine only the impact of credit risk on profitability of commercial banks in
Ethiopia using quantitative methods.
The recent study of Tesfaye (2012) mainly assessed the determinants of Ethiopian
commercial banks liquidity risk. Then after identifying determinants of liquidity, the
impact of banks liquidity up on financial performance is examined through the
significant variables explaining liquidity such as short term interest rate, non-
performing loans, capital adequacy and bank size. However liquidity risk is not
directly used in this study; instead factors affecting it significantly are used.
Therefore information about the impact of financial risks on the banks performance
remains ambiguous. This study therefore, is an attempt to address this gap of
information on Ethiopian commercial banking sector. Then, the intent in this study is
to measure the impact level of financial risks on profitability of commercial banks in
Ethiopia using mixed method approach.
38
Chapter 3 Research design and methodology
The preceding chapter presented the review of the existing literature on the financial
risks of banks and factors affecting the profitability of banks and identified the
knowledge gap. This chapter presents the methodology used in order to address the
research questions and hypotheses and hence achieve the broad objective
The chapter is organized in three sections. Section 3.1 presents the research
hypotheses with the description of variables used in the study and research questions.
Section 3.2 discusses the research approaches while section 3.3 presents the methods
adopted in the study including the data collection tools and methods of data analysis.
3.1. Variables selection, hypotheses and research questions
As already shown in the first chapter, the broad objective of this study is examining
the impact of financial risks on profitability of commercial banks in Ethiopia
controlling the influence of some selected macro and bank specific variables.
To achieve these objectives, testable hypothesis and research questions were
developed. The following subsections present the dependent variable and the
independent variables with testable hypotheses.
3.1.1. Dependent Variables
The dependent variable in this study is profitability. Theoretically the measures of
profitability are Return on Equity (ROE) and Return on Assets (ROA) while a
measure of spread is the Net interest/income margin (NIM). For this study, the
measure of profitability employed is return on assets (ROA) which reflects the ability
of a bank‟s management to generate profit from the bank‟s assets and is defined as the
ratio of net income to average of total assets. ROA is used as the key proxy for bank
39
profitability, instead of the alternative return on equity (ROE), because an analysis of
ROE disregards financial leverage and the risks associated with it. And also ROA is a
more comprehensive measure of profitability and, second, it is widely used in the
literature, which allows comparison with previous studies in Ethiopia or other
countries.
3.1.2. Independent Variables and hypotheses
Following the work of prior studies which are related to this study such as Li 2007,
Tafri et al.(2009), Ramlall 2009, Bordeleau and Graham (2010), Al-Khouri, 2011, and
many others researchers work this section presents the independent variables that are
used in the econometric model to estimate the dependent variable. The independent
variables credit risk, liquidity risk, interest rate risk and foreign exchange rate risk
have been selected on the basis of their potential relevancy to this model.
Credit Risk:
The ratio of non-performing loans to total loans is used to proxy the credit risk. The
higher the ratio the poorer the quality and therefore the higher the risk of the loan
portfolio will be. An implication of asset pricing models (e.g., the capital asset
pricing model (CAPM) of Sharpe (1964) and Lintner (1965)) is the positive
relationship between the risk premium on all invested wealth and the variance of its
return. It implies a positive relation between risk and expected return. These asset
pricing theories propose this hypothesis taking assumptions as described in the
literature. On the other hand, most empirical studies found that credit risk negatively
affected the profitability of commercial banks. This may be due to the practicality of
40
the assumptions and stock return volatility might not be used as risk measure in the
studies.
Recent empirical studies examined that increased exposure to credit risk is normally
associated with decreased firm profitability. Miller and Noulas (1997) point out that
credit risk should unleash a negative impact on profitability since the higher the level
of high-risk loans, the higher the level of unpaid loans. And also Tafri et al.(2009),
Ara (2009), Kithinji (2010), Tefera (2011) Al-Khouri, (2011),among others found a
negative relationship between profitability and credit risk. Hence, credit risk is
expected to have a negative relationship with banks profitability.
Hypothesis 1: Credit risk has significant negative impact on the profitability of the
banks.
Liquidity risk:
As Golin (2001) mentions it is critical that a bank guard carefully against liquidity
risk; the risk that it will not have sufficient current assets such as cash and quickly
saleable securities to satisfy current obligations e.g. those of depositors especially
during times of economic stress. Without the required liquidity and funding to meet
obligations, a bank may fail. However, liquid assets are usually associated with lower
rates of return. The higher this percentage the more liquid the bank is and less
vulnerable to a classic run on the bank. Ramlall, (2009), also noted as low levels of
liquidity constitute the main causes of bank failure. The proxy for liquidity risk that is
to be used in this study is the ratio of liquid assets to deposits and short term
borrowings. The expected relationship with profitability is negative.
41
Hypothesis 2: Liquidity risk has significant negative impact on the profitability of the
banks.
Interest rate risk:
Another important financial risk which can affect performance of commercial banks
is interest rate risk. Faure (2002 cited in Williamson 2008, p.15) recognizes that banks
can theoretically avoid interest rate risk by perfectly matching assets and liabilities “in
terms of currency [term to maturity], and have the rates on both sides fixed or
floating, and thus enjoy a fixed margin.” If a positive sloping (or normal) yield curve
is assumed, an ideal portfolio can be constructed for both a falling and rising interest
rate environment. During falling interest rates, the most beneficial portfolio would be
to have all liabilities short with floating rates and assets long with fixed rates (and
vice versa for a rising interest rate environment).
A large portion of commercial banks‟ revenue stems from net interest income that is
generated from the difference between various assets and liabilities that are held in the
balance sheet. The bank's position in relation to interest rates sensitivity can be
measured in several ways. One of the methods is the ratio between the interest
sensitive assets and the interest sensitive liabilities. A ratio of interest sensitive assets
to interest sensitive liabilities equal to 1 shows a balanced position. The proxy for
interest rate risk used is the ratio of maturity gap (Rate Sensitive Assets less Rate
Sensitive Liabilities) to total capital.
Tafri et al. (2009) found that the effect of interest rate risk on profitability (ROA) of
Malaysian Commercial is positive. Following this prior research in the present study,
42
the interest rate risk is predicted to have a positive relationship as the profitability is
expected to increase with a positive increase in interest rate risk exposure.
profitability
Foreign Exchange rate risk:
Fourthly, the researcher anticipated that foreign exchange rate risk may have a
relation with the commercial banks‟ profitability in Ethiopia.
Foreign exchange risk arises from open or imperfectly hedged positions in a particular
currency. These positions may arise as a natural consequence of business operations,
rather than from any conscious desire to take a trading position in a currency.
Exchange rate fluctuations might affect the overall performance of banks through
foreign currency transactions and operations (Sounder and Cornet, 2007).
Exchange rate volatility gives information about the foreign exchange risk that has
been assumed by the bank (Demerguc-Kunt & Huizinga 1999). In this study, foreign
exchange rate risk would be measured by the exchange rate volatility. Exchange rate
volatility for each year is calculated as the standard deviation of the percentage
change in the real US dollar exchange rate for the three preceding years. To measure
exchange rate volatility this study uses inter-bank foreign market rate at period
weighted average.
Papaioannou (2006) pointed out that the risk of changes in foreign exchange rates
affect a firm‟s stock returns, profitability and cash flows. Foreign currency exposure
and risk management is very important for the firm to avoid any vulnerability from
43
exchange rates fluctuation which can affect the profits and assets values in a negative
way.
In a similar study on Canadian banks (Atindehou & Gueyie, 2001), it is found out for
the Canadian Banks that stock prices responded positively with depreciation of
foreign currencies. The exchange rate volatility affect a firm‟s competitive position on
its home market and as a consequence its profitability (Popov & Stutzmann, 2003).
Hence, basing the above discussion hypothesis relating to foreign exchange risk is
developed as follows:
Hypothesis 4: Foreign exchange rate risk has a significant negative relationship with
banks profitability
Controlled Variables
In order to isolate the effects of risk factors on performance, it is needed to control for
other factors that are expected to have some influence on profitability. The control
variables which are expected to influence bank‟s profitability are:
Bank size: The size of the bank is also included as an independent variable. As noted
in Kapur and gualu (2011) inclusion of this independent variable helps to account for
size related economies (scale economies with reduced costs, or scope economies that
result in loan and product diversification, thus providing access to markets that a
small bank cannot entry) and diseconomies of scale. The banks that enjoy economies
of scale incur a lower cost of gathering and processing information resulting in high
financial flexibility and ultimately high spreads (Afzal, 2011). This means bigger
banks can have lower costs per unit of income and therefore higher net interest
44
margin. Similarly, banks with larger branch network can penetrate deposit markets
and mobilize savings at a lower cost.
Size is used to capture the fact that larger banks are better placed than smaller banks
in harnessing economies of scale in transactions to the plain effect that they will tend
to enjoy a higher level of profits. Size of the bank is being measured using yearend
natural log of total assets. Most empirical studies reviewed find size to be positively
related to profitability. Consequently, a positive relationship is expected between size
and profits.
Bank capital: it is measured by the ratio of equity capital to total asset. Well
capitalized banks have higher net interest margins and are more profitable. Banks
with higher capital ratios tend to face lower cost of funding as they need to borrow
less. Thus we can say that they are less exposed to liquidity risk, so the higher the
ratio the lower the liquidity risk exposure of the banks (Tafri et al. 2009). Bank capital
is expected to have a positive relationship with profitability. Among others, Tafri et
al. (2009), and Li (2007), found that capital is positively related with profitability. In
this proposed study Bank capital is expected to have a positive relationship with
profitability.
GDP Growth: The macroeconomics variable that is used to control for the effect of
the economic environment on banks‟ profitability is growth. Economic growth is
measured by the real GDP growth and it is expected to have a positive impact on the
profitability according to the literature on the association between economic growth
and financial sector performance.
45
Inflation: annual growth rate for inflation is also used as an explanatory variable in
model of this study. An inflation rate that is fully anticipated raises profits as banks
can appropriately adjust interest rates in order to increase revenues, while an
unexpected change could raise costs due to imperfect interest rate adjustment might
increase bank cost and have a negative effect on profitability if banks are unable to
adjust accordingly (Flamini et al. (2009).
Previous researches documented mixed result positive relationship between inflation
and bank profitability in Ethiopian commercial banks. Kapur and Gualu (2011) and
Damena (2011) indicated positive association of inflation and profitability and Abera
(2012) found negative association of inflation and profitability of commercial banks
in Ethiopia. Thus, the expected sign of the inflation is unpredictable based on prior
researches.
In addition, the following research question is developed by the researcher in order to
achieving the research objective qualitatively as far as mixed method approach is used
in this particular study.
Research Question
The next table summarizes the above specified dependent and independent variables
of the study with their respective notation, measurement and expected signs.
46
Table 3.1 Descriptions of the variables and their expected relationship
Variables Measure Notation Expected Sign
Dependant Profitability Net income/total ROA NA

variable assets
Independent Credit risk Non-performing CR -

variables loans/total loans
Liquidity risk Liquid assets/ LIQ -

deposits and
borrowings
Interest rate risk Rate sensitive Assets- IRR +

Rate sensitive
liabilities/total capital
Foreign Exchange rate FORX -

exchange rate
Volatility
risk
Capital Equity / total Asset CAP +
Bank Size Natural log Total SIZE +

Asset
Growth GDP growth GDP +
Inflation The annual inflation INFL ?

rate
3.2. Research approaches
A research approach can be either qualitative or quantitative or mixed. Critical
decision should be made which design to be used for specific topic. The selection of
47
appropriate research approach helps a researcher to plan and implement the study in a
way that will help to obtain the intended results. On the basis of the research problem,
the researcher should decide which research approach is going to lead him/her easily,
swiftly and most efficiently to the most reliable findings that adequately answer the
research questions (Devetak, et al. 2010). The following discussions presents the basic
features of the three research approaches.
A quantitative approach is one in which the investigator primarily uses postpositive
claims for developing knowledge effect thinking, reduction to specific variables and
hypotheses and questions, use of measurement and observation, and the test of
theories, employs strategies of inquiry such as experiments and surveys, and collect
data on predetermined instruments that yield statistics data. This approach is based on
the numerical observations and aims at generalizing a phenomenon through
formalized analysis of selected data (Creswell, 2003). Quantitative research design
provides precise, quantitative, numerical data and allows for statistical comparison
between various groups (Johnson and Onwuegbuzie, 2004). But quantitative research
design has also some limitations. The researcher may miss out on phenomena
occurring because of the focus on theory or hypothesis testing rather than on theory or
hypothesis generation (called the confirmation bias). Knowledge produced may be too
abstract and general for direct application to specific local situations, contexts, and
individuals (Johnson and Onwuegbuzie, 2004).
The second approach is qualitative approach and it is characterized by more of
description instead of numerical data and aim to create a common understanding of
the subject being studied. Qualitative methods provide a depth of understanding of
issues that is not possible through the use of quantitative, statistically based
48
investigations. In this approach data is gathered more in a verbal and visual than in a
numeric form. The researcher collects open-ended, emerging data with the primary
intent of developing themes from the data. A major strength of the qualitative
approach is the depth in which explorations are conducted and descriptions are
written, usually resulting in sufficient details for the reader to grasp the idiosyncrasies
of the situation. The ultimate aim of qualitative research is to offer a perspective of a
situation and to provide well written research reports that reflect the researcher's
ability to illustrate or describe the corresponding phenomenon (Devetak, et al. 2010).
Qualitative approach is useful for describing complex phenomena (Johnson and
Onwuegbuzie, 2004). However, knowledge produced may not generalize to other
people or other settings (i.e., findings may be unique to the relatively few people
included in the research study). It is difficult to make quantitative predictions and it is
more difficult to test hypotheses and theories, it may have lower credibility with some
administrators and commissioners of programs due to the impression that the results
are more easily influenced by the researcher‟s personal biases.
The third approach is mixed methods research approach which involves philosophical
assumptions, the use of qualitative and quantitative approaches, and the mixing of
both approaches in a study. This research design is useful to capture the best of both
quantitative and qualitative approaches (Creswell, 2003, p. 24). The combined use of
quantitative and qualitative methods has a number of benefits. Quantitative research
may complement qualitative research and benefit the production of knowledge.
Numbers can be use to add precision to words and narrative and words, pictures, and
narrative can be used to add meaning to numbers so can provide stronger evidence.
Therefore this method answers a broader and more complete range of research
49
questions because the researcher is not confined to a single method or approach
(Johnson and Onwuegbuzie 2004). The following section hence presents the method
assumed for this study.
3.3. Research methods adopted
A mixed methods design is useful to capture the best of both quantitative and
qualitative approaches (Creswell, 2003). This method can provide stronger evidence.
Also as noted in Creswell (2009) the use of quantitative and qualitative approaches in
combination provides a better understanding of research problems than either
approach alone. Therefore considering this advantage and taking into consideration
the research problem and objective described earlier mixed research approach is
found to be appropriate for this study. Hence, the following sections present
consecutively the quantitative and qualitative aspects of the research method.
3.3.1. Research method: quantitative aspect
The quantitative aspect of the research method aimed to obtain data needed to explain
the relationship between financial risks and the profitability of commercial banks in
Ethiopia. Hence, survey design (structured review of documents) is applied for this
study. A survey design provides a quantitative or numeric description of trends,
attitudes, or opinions of a population by studying a sample of that population. From
sample results, the researcher generalizes or makes claims about the population
Creswell (2003, p. 153). In this rationale, consider the advantages of survey designs,
such as the economy of the design and the rapid turnaround in data collection, survey
was carried out by means of structured document review. The data related to a
documentary analysis which is necessary to undertake this study was gathered from
the audited financial statements of the banks and NBE for twelve consecutive years
50
(2000-2011) and for some controlled macroeconomic variables in this study the
researcher used data taken from NBE and Ethiopian Ministry of Finance and
Economic Development (MoFED).
Sampling design
The population of the study is all commercial banks registered by NBE. There are 18
banks operating in the Ethiopian banking sectors. In this study, two criteria are used to
determine the study sample. The first criterion is the nature of the bank. In the study,
only commercial banks registered by NBE and under operation in the country
currently are included. The main reason to include only commercial banks is to ensure
that the econometric estimations are robust; it is preferable to work on a homogeneous
sample. Availability of data is the second criteria, to this the study consider only
banks that have data for the years 2000 to 2011. Therefore, based on the above two
criterion only eight banks were included in the study from the total banks operating in
the Ethiopian banking sectors. The eight commercial banks included in the study are,
Awash International Bank (AIB), Bank of Abyssinia, commercial bank of ethiopia
(CBE), Construction and Business Bank (CBB), Dashen Bank (DB), Nib International
Bank (NIB), United Bank (UB), Wegagen Bank (WB) .
Data analyzing methods
To identify and measure the impact level of financial risks on banks profitability, the
study was done primarily based on panel data, which was collected through structured
document review. In this study, a panel data set which was employed comprises of 8
banks for which the same variables is collected annually for twelve years. Thus this
pooled data contains a total of 96 observations. Panel data is preferred because of its
many advantages over either cross-section or time series data. As noted in Brook
51
(2008) it is possible to address a broader range of issues and tackle more complex
problems with panel data than would be possible with pure time-series or pure cross-
sectional data alone and it is often of interest to examine how variables, or the
relationships between them, change dynamically (over time). To do this using pure
time-series data would often require a long run of data simply to get a sufficient
number of observations to be able to conduct any meaningful hypothesis tests. But by
combining cross-sectional and time series data, one can increase the number of
degrees of freedom, and thus the power of the test, by employing information on the
dynamic behavior of a large number of entities at the same time. Also as noted in
Baltagi (2005) the advantage of using panel data is that it controls for individual
heterogeneity, less collinearity among variables and tracks trends in the data
something which simple time-series and cross-sectional data cannot provide.
Thus, the collected panel data was analyzed using descriptive statistics, correlations
matrix and multiple linear regression analysis. The descriptive statistics was used to
quantitatively describe the important features of the variables and to analyze the
general trends of the data from 2000 to 2011 based on the sector sample of 8 banks
using statistical results mean, maximum minimum and standard deviations. In
addition, the correlation analysis was conducted to identify the degree of association
between the independent and explanatory variables. The correlation analysis shows
only the degree of association between variables and does not permit the researcher to
make causal inferences regarding the relationship between variables. However
regression is more flexible and more powerful than correlation and permits making
causal inferences regarding the relationship between variables (Brooks 2008).
52
Therefore, in order to test the hypothesis of this study and to determine the relative
importance of each independent variable in influencing profitability of the
commercial banks in Ethiopia multiple linear regression analysis was done.
Accordingly, a two step multiple linear regression equations were run. In the first
step (general) regression equation, all the proposed independent variables (i.e., CR,
LIQ, IRR, FORX, SIZE, CAP, INFL and GDP) were regressed with respect to the
dependent variable (ROA). Whereas, in the second step only the significant variables
that were found from the first step regression equation were regressed to investigate
there effect on ROA of Ethiopian commercial banks. The multiple linear regressions
model was conducted by the ordinary listing square (OLS) method.
The researcher does not develop a new model instead specifies a model with some
improvement following the work of Akhtar et al. ( 2011), Al-Khouri (2011), Imad et
al. (2011), Bordeleau and Graham (2010), Kithinji (2010), Ramlall (2009), Ara et
al. (2009), Tafri et al. (2009), and Li (2007).
The basic linear equation for the model is as follows:
Yit = α + βi X it+µit
Where Yit = a dependant variable which represents bank profitability
- X it = a vector of financial risks and a set of macroeconomic variables
reflecting the state of the economy and bank specific variables which have an
impact on profitability.
- µit = the residual term to reflect all other market imperfections and regulatory
restrictions affecting profitability.
53
- α i , i = 1,..., N, are constant coefficients specific to each bank
- i =1,…, N, is the i th cross-sectional unit and t =1,..., T, is the tth time period,
In the light of the above model and on the base of selected variables the current study
used econometric model which is specified as follows:
PROFITABILITY = F (RISKS, BANK, MACRO)
RISK represents the four financial risks of the banks namely credit risk, liquidity risk,
interest rate risk and foreign exchange rate risk while MACRO and BANK are the
control variables which denotes a set of macroeconomic variables reflecting the state
of the economy and bank specific variables respectively.
Specifically the model is:
ROAit =β0 +β1CRit + β2IRRit +β3 LIQit + β4FORXit+ β5SIZEit + β6CAPit + β7GDPit +
β8INFLit +µit
Where
ROA it = Return on Assets of bank i for year t
CR it = Credit Risk of bank i for year t
IRR it= Interest Rate Risk of bank i for year t
LIQ it = Liquidity risk of bank i for year t
FORX it = Foreign exchange rate risk of bank i for year t
SIZE it= Log of Total Assets of bank i for year t
CAP it= Bank Capitalization of bank i for year t

54
GDP t = GDP Growth Rate for year t
INFLit = Inflation growth rate for year t
Βi = Coefficients of the variables
µ it = Error term
The regression analysis is done using Econometric/statistical software package 1
Eviews2 6 software.
There are basic assumptions of Classical Linear Regression Model (CLRM) and if
the assumptions hold true, then the estimators determined by OLS will have a number
of desirable properties, and are known as Best Linear Unbiased Estimators(Brooks
2008). Therefore, diagnostic tests are performed to ensure whether the assumptions of
the CLRM are violated or not in the model. Thus, the following section discussed the
CLRM assumptions and performed diagnostic tests.
Test for Heteroscedasticity: as indicated in Brooks (2008), and Gujirati, 2004 the
assumption of homoscedasticity is that the variance of the errors is constant. If the
errors do not have a constant variance, they are said to be heteroscedastic. In order to
test the presence of heteroscedasticity the popular white test3 was used.
1
There are a number of Econometric software packages for modeling financial data. EViews, GAUSS,
LIMDEP, MATLAB, RATS, SAS, SHAZAM, SPLUS, SPSS, TSP are a set of widely used packages
for modeling financial data (Brook 2008).
2
This software is preferred as the researcher is more familiar with it.
3
This test involves testing the null hypothesis that the variance of the errors is constant
(homoscedacticity) or no heteroscedasticity versus the alternative that the errors do not have a constant
variance.
55
Test for Autocorrelation: It is assumed that the errors are not correlated with one
another. If the errors are correlated with one another, it would be stated that they are
„serially correlated‟ (Brooks 2008). As noted in Brooks (2008), DW has 2 critical
values: an upper critical value (dU) and a lower critical value (dL), and there is also
an intermediate region where the null hypothesis of no autocorrelation can neither be
rejected nor not rejected. The rejection, non-rejection, and inconclusive regions are
shown on the number line in figure 3.1 bellow.
Figure 3.1: Rejection and Non-Rejection Regions for DW Test
Reject Do not reject Reject

H0: No evidence H0:Negative
H0:Positive of Autocorrelation
Autocorrelation Autocorrelation
Inconclusive Inconclusive
0 Dl dU 2 4-dU 4-dL 4
Test for normality: This assumption requires the disturbances to be normally
distributed. Bera-Jarqu normality test which is the most commonly used normality test
was conducted. If the residuals are normally distributed, the histogram should be bell-
shaped and the Bera-Jarque statistic would not be significant at 5% significant level
(Brooks 2008).
Test for Multicollinearity: This assumption is concerned with the relationship exist
between explanatory variables. An implicit assumption that is made when using the
OLS estimation method is that the explanatory variables are not correlated with one
another (Brooks2008). On the other hand, multicollinearity means that there is linear
56
relationship between explanatory variables which may cause the regression model
biased (Gujarati, 2004). Thus a correlation matrix of the selected explanatory
variables was used to test multicollinearity. As stated by Hair et al. (2006) correlation
coefficient below 0.9 may not cause serious multicollinearity problem. Kennedy
(2008) also suggests that any correlation coefficient above 0.7 could cause a serious
multicollinearity problem leading to inefficient estimation and less reliable results.
Besides the variance of inflation factor (VIF)4 method was used to test the existence
of this problem. If the results show that the variance of inflation factor VIF is more
than 10, the regression results affected by a multicollinearity problem (Gujarati 2004).
3.3.2 Research method: Qualitative aspect
In this study, to gather the qualitative data needed for addressing some of the research
questions, interviews and document analysis was employed.
In-depth interview is the primary data collection technique for gathering data in
qualitative approach. The research demands data gathering through unstructured
interviews and deep analysis and interpretation of them, to derive the underlying
methods of handling risks. The interview was conducted with six Ethiopian
commercial banks Officers/managers of finance and risk management departments.
The interviewees were from both private and state owned banks namely Construction
and Business Bank, Commercial Bank of Ethiopia, Awash international bank, Dashen
bank, United bank and Bank of Abyssinia. The respondents contacted once and each
respondent was contacted at different times. As a result, the response of the
4
The variance analysis is done using SPSS 16.0 Software package.
57
interviewees‟ for the interview questions was used for supporting the result obtained
from analysis of structured record reviews.
Finally, links between research question/hypotheses and variables on the one hand
and different data sources on the other hand are presented in table 3.2 below.
Table 3.2 Link between research question/hypotheses, variables and the different data
sources
Research questions and hypotheses Data sources
RQ1. Which financial risks mostly occur In-depth unstructured face-to-face

and affect the profitability of commercial interviews with Ethiopian commercial
banks in Ethiopia? banks finance managers
HP1: Credit risk has significant negative Bank-specific data from Income
impact on the profitability of the banks. statement and Balance sheet held by
NBE and the banks
HP2: Liquidity risk has significant

negative impact on the profitability of the
banks.
HP3: Interest rate risk has a significant

positive relationship with banks
profitability
HP4: foreign exchange rate risk has a

significant negative relationship with
58
Controlled variables and their expected

relationships with the dependant variable
HP5: There is a significant positive Bank-specific data from Income

relationship between the amount of statement and Balance sheet held by
capital of a bank and the banks’ NBE and the banks
profitability.
HP6: There is a significant positive

relationship between the size of a bank
and profitability.
HP7: There is a significant positive Bank-specific data from Income

relationship between real gross domestic statement and Balance sheet held by
product growth and bank profitability NBE and the banks and macroeconomic
data from the records held by NBE and
HP8: There is a significant
MOFED
positive/negative relationship between
inflation and bank profitability
In summary, this chapter presented the basic features of qualitative, quantitative and
mixed methods research approaches and the features of the methods selected for this
study with the justifications. The subsequent chapter discusses the results and
analysis
59
Chapter 4 Results and Analysis
The previous chapter presents the research methodology adopted in the study. The
purpose of this chapter is to present and discuss results of data obtained from different
methods involved in this study. Therefore, the chapter is organized into three sections.
The first section 4.1 presents research hypotheses and questions as presented in the
previous chapter. This is followed by the results of both documentary analyses
(structured review of documents) and in-depth interviews in section 4.2. Finally,
Section 4.3 discusses the results of the study.
4.1. Research Questions and Hypotheses
As stated in chapter one the broad objective of this study is examining the impact of
financial risk (credit risk, liquidity risk, interest rate risk and foreign exchange rate
risk) on the profitability of Ethiopian commercial banks. So as to achieve this broad
objective the following four hypotheses and one specific research question were
formulated:
Hypothesis 1: Credit risk has significant negative impact on the profitability of banks.
Hypothesis 2: Liquidity risk has significant negative impact on the profitability of t
banks.
profitability
Hypothesis 4: foreign exchange rate risk has a significant negative relationship with
60
In addition to the above hypotheses, the following specific research question was also
formulated:
4.2. Results
The purpose of this section is to present the results of data obtained from different
methods involved in this study. Therefore, the results of the documentary analysis
(structured reviews of financial records) and in depth interviews are presented in the
following subsections.
4.2.1. Documentary analysis (structured review of financial records)
As mentioned earlier, quantitative research approach along with survey design
(structured review of financial records) was primarily used. The necessary data
gathered from the documents held by NBE, MoFED and the banks were analyzed
using descriptive statistics, correlation matrix and multiple linear regression analysis.
Therefore, the following subsections present the results of the documentary analysis
as follows. Section 4.2.1.1 presents results of the descriptive statistics followed by the
correlation analysis among the dependent and independent variables in section
4.2.1.2. Section 4.2.1.3 presents tests for the classical linear regression model
assumptions. Finally, the outcomes of the panel data regression analysis are presented
in section 4.2.1.4.
61
4.2.1.1. Descriptive statistics
Table 4.1 presents the outcomes of the descriptive statistics for main variables
involved in the econometrics model of this study. The total number of observation for
each variable was 96 (i.e., data for 8 banks for the period from the year 2000 to 2012).
Key figures, including mean, median, standard deviation, minimum and maximum
value were reported. This was generated to give overall description about data used in
the model and served as data screening tool to spot unreasonable figure.
Table 4.1: Summary of descriptive statistics for dependent and independent
variables
Variables Observations Mean Median Max Min Std. Dev.
ROA 96 0.032 0.035 0.057 0.006 0.012
CR 96 0.133 0.087 0.535 0.000 0.118
LIQ 96 0.506 0.483 1.115 0.273 0.144
IRR 96 -0.900 -0.580 3.955 -8.668 1.934
FORX 96 3.63 3.71 9.34 0.21 3.011
SIZE 96 21.797 21.679 25.462 18.778 1.365
GDP 96 0.086 0.108 0.126 -0.021 0.045
CAP 96 0.116 0.110 0.294 0.037 0.048
INFL 96 0.107 0.090 0.364 -0.106 0.118
Note: Return on asset (ROA), Credit risk (CR), Liquidity risk (LIQ), Interest rate risk
(IRR), foreign exchange rate risk (FORX), Size (SIZE), Capital (CAP), Inflation
(INFL) and Growth domestic product (GDP)
Source: Financial statements of banks, MoFED reports and own computation
As can be seen from table 4.1, for the total sample, the mean of ROA was 3.2% with a
minimum of 0.6% and a maximum of 5.7%. This indicated that, Ethiopian
commercial banks that were considered in this study were earned an average of 3.2
62
cents of profit before tax for a single birr invested in their assets. More specifically,
the most profitable bank among the sampled banks earned 5.7 cents of profit before
tax for a single birr invested in the assets of the bank. On the other hand, the least
profitable bank of the sampled banks earned 0.6 cents of profit before tax for each birr
invested in the assets of the bank. The standard deviation statistics for ROA was
0.012 which indicates that the profitability variation between the selected banks was
very small.
Regarding the independent variables of the model there are some interesting statistics
that have to be mentioned. For instance, the descriptive statistic of exchange rate risk
which was measured by exchange rate volatility has shown the highest standard
deviation (3.011). The result indicates the existence of relatively higher volatility of
Ethiopian birr in exchange with U.S dollar for the period under consideration. The
size of banks which was measured by natural log of total asset also revealed the
highest standard deviation (1.365). This indicates the existence of high variation
among ECBs in terms of their size. On the other hand, the mean value of interest rate
risk which was measured by ratio of the gap between rate sensitive assets and rate
sensitive liabilities capital was -0.90 with a minimum of -8.67and a maximum of 3.95.
This implies that, on average, Ethiopian commercial banks had been liability sensitive
over the period under consideration.
Another interesting observation was the equity-to-asset ratio of banks which
indicated by the range between 29.4% and 3.7%. The average equity-to-asset ratio
of banks was 11.6%, which was considerably above the statutory requirement of
8% set by NBE based on Basel II recommendation. The standard deviation
statistics was 0.048 which shows the existence of relatively higher variation of equity
63
to asset ratio between the selected banks compared to the variation in ROA. On the
other hand, the outputs of the descriptive statistics indicate that, the average ratio of
liquid assets to deposits and liabilities was 50.6%, with a minimum of 27.3%
and a maximum of 111.5%. This means despite the inverse relationship that
exists between liquidity and profitability, the liquidity measure indicates that the
Ethiopian commercial banks have, on average, a higher liquidity position which was
somewhat higher than the statutory requirement of 20% for the last twelve years.
In addition, the mean of CR (measured by the ratio of nonperforming loans to total
loans) was 13.3% with a minimum of 0.86 % and a maximum of 53.5%. This
indicates that, from the total loans that ECBs disbursed, an average of 13.3% were
being default or uncollected over the sample period. The disparity between the
minimum 0.86 % and the maximum 53.5% of NPLs indicate the margin that CR ratio
of ECBs ranged over the sample period. The standard deviation (0.118) of CR also
shows the existence of high variation among ECBs in terms their loan recovering
capacity as compared to other variables like ROA. On the other hand, the mean real
GDP growth in Ethiopia for the last twelve years was 0.086 (8.6%), with a maximum
of 12.6% and a minimum of -2.1 %. The standard deviation was 0.045; this implies
that economic growth in Ethiopia during the period of 2000 to 2011 remains
reasonable stable and the result was more or less in agreement with the
government‟s report regarding economic growth. The other macro-economic variable
employed in this study was INFL, had somewhat a higher standard deviation (0.118)
compared to GDP; this implies that inflation rate in Ethiopia during the study period
remains somewhat unstable.
64
4.2.1.2. Correlation analysis
As mentioned in the third chapter, the purpose of correlation matrix in this particular
study was to show the linear association between the dependent and independent
variables.
As can be seen in table 4.2, credit risk (CR) is the most negatively correlated variable
and significantly correlated at 1 percent significance level with the movement of
bank‟s profitability (ROA) with a correlation coefficient of -0.669. Moreover IRR
(Interest rate risk (interest rate change exposure)) had shown insignificant negative
correlation with the movement of bank‟s profitability with a correlation coefficient of
-0.101. Those correlation results clearly indicate the existence of inverse linear
association among the above mentioned variables and ROA of Ethiopian banks. In
other words, as CR and IRR increases, bank‟s profitability moves to the opposite
direction. The magnitude of the correlation coefficient for credit risk was the highest
of all the variables used in this study implying the existence of strong inverse linear
association among CR and ROA.
However, the liquidity of banks and foreign exchange risk measured by exchange rate
volatility had shown insignificant positive correlation with the movement of bank‟s
profitability with a correlation coefficient of 0.149 and 0.164 respectively. This
implies that, as these variables increase, profitability of Ethiopian commercial banks
also moves towards the same direction. The direct linear association among the
liquidity of banks and ROA was surprise. However, the association was not
significant and strong since the magnitude of the correlation coefficient was small as
compared to other variables like CR and the controlled variable GDP.
65
Moreover, as shown in the correlation matrix all control variables are significantly
correlated with return on asset. Bank size, capital (equity to asset ratio), real GDP
growth and inflation had shown a positive linear association with the movement of
bank‟s profitability with a correlation coefficient of 0.316, 0.261, 0.608 and 0.410
respectively. This implies that, as the abovementioned variables increase, profitability
of Ethiopian commercial banks also moves towards the same direction. The
magnitude of the correlation coefficient for real GDP growth (0.608) and inflation
rate (0.410) had shown a strong positive linear association with the movement of
ROA as compared to other variables. On the other hand, the correlation coefficient of
interest rate risk was the least of all the variables used in this study indicating the
existence of slight linear association with the movement of ROA.
Table 4.2 Correlation matrix of dependent and independent variables
Correlation
Probability ROA CR LIQ IRR FORX CAP SIZE GDP INFL
ROA 1
-----
CR -0.668 1
0.000 -----
LIQ 0.149 -0.174 1
0.148 0.089 -----
IRR -0.101 -0.054 -0.210 1
0.335 0.600 0.040 -----
FORX 0.164 -0.147 0.221 -0.254 1
0.111 0.154 0.030 0.013 -----
CAP 0.261 -0.399 0.304 0.396 0.140 1
0.010 0.001 0.003 0.000 0.168 -----
SIZE 0.316 -0.019 0.112 -0.766 0.142-0.546 1
0.002 0.854 0.280 0.000 0.168 0.000 -----
GDP 0.608 -0.450 0.156 -0.151 -0.119-0.080 0.369 1
0.000 0.000 0.128 0.142 0.247 0.442 0.000 -----
INFL 0.410 -0.359 0.253 -0.183 -0.117-0.041 0.392 0.383 1
0.000 0.000 0.013 0.075 0.256 0.695 0.000 0.000 -----
66
As noted in Brooks (2008), regression is more flexible and more powerful than
correlation and permits making causal inferences regarding the relationship between
variables. In order to show the casual relationships among dependent variable (ROA)
and independent variables regression analysis were conducted in this study.
Accordingly, test results for the classical linear regression model (CLRM)
assumptions and the regression results are presented and discussed in the following
sub sections.
4.2.1.3. Test results for the classical linear regression model assumptions
In this study as mentioned in chapter three diagnostic tests were carried out to ensure
that the data fits the basic assumptions of classical linear regression model.
Consequently, the results for model misspecification tests are presented as follows:
Test for Hetroscedasticity
To test for the presence of heteroscedasticity, the popular white test was employed
(Brooks 2008). As shown in table 4.3, both the F-statistic and Chi-Square versions of
the test statistic gave the same conclusion that there is no proof for the
presence of heteroscedasticity in this particular study, since the p-values were
significantly in excess of 0.05. The third version of the test statistic, „Scaled
explained SS‟ also gave the same conclusion that there is no evidence for the presence
of heteroscedasticity problem, since the p-value was considerably in excess of 0.05.
Therefore, the null hypothes that the variance of the errors is constant
(homoscedasticity) should not be rejected.
67
Table 4.3 Heteroskedasticity Test: White
F-statistic 1.602178 Prob. F(44,51) 0.0562

Obs*R-squared 55.70232 Prob. Chi-Square(44) 0.1110
Scaled explained SS 40.86005 Prob. Chi-Square(44) 0.6070
Test for Autocorrelation
As noted in Brooks (2008) this is an assumption that is assumed the errors are
uncorrelated with one another. As mentioned in the previous chapter to empirically
examine the impact of financial risks on the profitability of Ethiopia commercial
banks 96 observations and eight regressors along with an intercept term were used
in the model. Therefore, the relevant critical values for 96 observations and 8
regressors in Durbin-Watson test statistic table have shown an upper critical value
(dU) of 1.715 and a lower critical value (dL) of 1.358 and 4 - dU = 4-1.715=2.285; 4 -
dL = 4-1.358 =2.642. As shown in table 4.4, the Durbin-Watson test statistic of this
study is 1.687 which is clearly between the lower limit (dL) which is 1.358 and the
upper limit which is 1.715 and thus the null hypothesis of no autocorrelation is neither
rejected nor not rejected.
Table 4.4 Autocorrelation Test: Durbin Watson
Variables DW test static result
All bank-specific & macro-Economic 1.687
Test for normality
68
In this study, the normality of the data was checked with the popular Bera-Jarque test
statistic (Brooks 2008). According to Bera-Jarque test statistic, normally distributed
data is not skewed and has a coefficient kurtosis of 3. As shown in figure 4.1, the
coefficient kurtosis(3.06) of the data in this particular study was very much closer to
3, and the Bera-Jarque statistic had a P-value of 0.5112 implying that there
was no evidence for the presence of abnormality in the data. Thus, the null
hypothesis that the data is normally distributed should not be rejected since the p-
value was considerably in excess of 0.05 and the coefficient of kurtosis very much
closer to 3.
Figure 4.1 Normality test for residuals: Bera-Jarque
12
Series: Standardized Residuals
Sample 2000 2011
10
Observations 96
8 Mean -1.26e-19
Median -0.000392
Maximum 0.014939
6 Minimum -0.014959
Std. Dev. 0.005913
4 Skewness 0.287973
Kurtosis 3.061647
2 Jarque-Bera 1.342055
Probability 0.511183
0
-0.015 -0.010 -0.005 0.000 0.005 0.010 0.015
Test for Multicollinearity
According to Hair et al. (2006) multicollinearity problem exists when the correlation
coefficient among the variables are greater than 0.90. As shown in table 4.5, in this
study there was no correlation coefficient that exceeds 0.90 (since the highest
69
correlation coefficient was 0.77). However, Kennedy (2008) suggested that any
correlation coefficient above 0.7 could cause a serious multicollinearity problem.
Table 4.5 Correlation matrixes of independent variables
CR LIQ IRR FORX SIZE GDP CAP INFL
CR 1
LIQ -0.174 1
IRR -0.054 -0.210 1
FORX -0.147 0.221 -0.254 1
SIZE -0.019 0.112 -0.766 0.142 1
GDP -0.450 0.156 -0.151 -0.119 0.369 1
CAP -0.398 0.305 0.396 0.140 -0.546 -0.079 1
INFL -0.359 0.253 -0.182 -0.117 0.392 0.383 -0.042 1
So as to mitigate the above controversy among Hair et al. (2006) and Kennedy (2008),
variance inflation factor which is considered as standard statistical technique for
testing data for multicollinearity was run (Gujarati 2004). According to this test,
multicollinearity problem exist when the pair wise correlation values is in excess of
10 score. As shown in table 4.6, there is no pair wise correlation values that exceeds
10 score. Therefore, it can be concluded that there is nomulticollinearity problem in
this particular study.
70
Table 4.6 Collinearity Statistics

Coefficientsa
Unstandardized Standardized Collinearity
Coefficients Coefficients Statistics
Model B Std. Error Beta T Sig. Tolerance VIF
1 (Constant) -.079 .024 -3.339 .001
CR 1.91
-.033 .008 -.322 -3.939 .000 .522
4
IRR 2.83
.001 .001 .182 1.834 .070 .353
4
LIQ -.012 .006 -.142 -2.015 .047 -.024 .000
FORX .000 .000 .112 1.628 .107 .000 .001
GDP .094 .021 .345 4.461 .000 .052 .136
INFL .006 .008 .058 .764 .447 -.010 .021
size_ .005 .001 .519 4.287 .000 .002 .007
Cap .102 .023 .401 4.439 .000 .056 .147
a. Dependent
Variable: ROA
Test for model misspecification error
So as to ensure the reliability and the validity of the model, Ramsey reset test (model
misspecification error test) was conducted. As shown in table 4.7, both the F-statistic
and Log likelihood ratio of the test statistic gave the same conclusion that there is
no evidence for the presence of model misspecification error. There is no apparent
non-linearity in the regression equation of this particular study, since the p-values
were considerably in excess of 0.05. Therefore, the null hypothesis that the models
functional form is appropriate should not be rejected.
71
Table 4.7. Ramsey RESET Test:

Log likelihood ratio 0.231208 Prob. Chi-Square(1) 0.6306
In general based on diagnostic tests of the CLRM assumptions presented in the above
sections, it can be concluded that both the data and the model are free from major
threat of misspecifications (diagnostic) problems. Hence the next section presents
results of regression analysis.
4.2.1.4. Results of Regression Analysis
There are broadly two classes of panel estimator approaches that can be employed in
financial research: fixed effects models (FEM) and random effects models (REM)
(Brooks 2008). The general accepted way of choosing between fixed and random
effects is running a Hausman test. To conduct a Hausman test the number of cross
section should be greater than the number of coefficients to be estimated. But, in this
study the numbers of coefficients are greater than the number of cross sections so it is
not possible to conduct a Hausman test.
Moreover according to Gujarati (2004), if T (the number of time series data) is large
and N (the number of cross-sectional units) is small, there is likely to be little
difference in the values of the parameters estimated by fixed effect model/FEM and
random effect model/REM. Also according to Brooks (2008) and Verbeek (2004), the
REM is more appropriate when the entities in the sample can be thought of as having
been randomly selected from the population, but a FEM is more plausible when the
entities in the sample effectively constitute the entire population/sample frame. Since
72
the number of time series (i.e. 12 year) is greater than the number of cross-sectional
units (i.e. 8 commercial banks), and the sample for this study was not selected
randomly and equals to the sample frame FEM is considered as appropriate for this
study. Thus, also considering its computational convenience a fixed cross-sectional
effect is specified in the estimation in this study.
As mentioned earlier, the purpose of regression analysis in this study was to examine
the importance of each independent variable in explaining the variation of
profitability in Ethiopian commercial banks. Accordingly, the estimation result of
the operational panel regression model used in this study is presented in table
4.8. As shown in table 4.8 the R-squared statistics and the adjusted-R squared
statistics of the model were 76.35% and 71.91% respectively. The adjusted- R2 of this
study indicates that, 71.91% of the variation on the dependent variable (ROA) was
explained by the changes in the independent variables. Thus it can be concluded that,
all the independent variables used in this study collectively, were good explanatory
variables of profitability in Ethiopian commercial banks (ECBs). Hence the null
hypothesis of F-statistic (the overall test of significance) that the R2 is equal to zero
was rejected at 1% significance level (p-value =0.0), which enhanced the reliability
and validity of the model.
73
Table 4.8 First Step (General) Regression Results
Variable Coefficient Std. Error t-Statistic Prob.
C -0.130218 0.029361 -4.435017 0.0000

CR -0.027858 0.009267 -3.006176 0.0035*
LIQ -0.016752 0.005744 -2.916247 0.0046*
IRR -8.77E-05 0.000672 -0.130619 0.8964
FORX 9.22E-06 0.000299 0.030853 0.9755
CAP 0.147610 0.026728 5.522620 0.0000*
SIZE 0.006931 0.001350 5.135458 0.0000*
GDP 0.078192 0.021374 3.658321 0.0005*
INFL -0.003115 0.008127 -0.383236 0.7026
R-squared 0.763450 Durbin-Watson stat 1.686658

Adjusted R-squared 0.719096
F-statistic 17.21294
Prob(F-statistic) 0.000000
* denote significance at 1% level.
As shown in table 4.8, the coefficient estimate of real GDP growth and capital (equity
to total asset ratio) were positive and statistically significant at 1% significance level.
The coefficient estimates of the aforementioned variables were 0.0782 and 0.148
indicating the existence of strong positive relationship between ROA and the above
mentioned independent variables. In addition, the coefficient estimate of bank size
was positive that implying a direct association with ROA. The association was
significant at 1% significance level. Thus, it can be concluded that, an increase on
those variables would also increase the profitability (ROA) of Ethiopian commercial
74
banks. On the other hand, the coefficient estimates of credit risk and liquidity risk
were negative and statistically significant at 1% significance level. This clearly
indicates that, an increase in the credit risk and liquidity risk of Ethiopian commercial
banks leads to a decrease in their profitability. The coefficient estimate of foreign
exchange rate risk was positive but it was statistically insignificant. In addition, the
coefficient estimates of inflation and interest risk have shown a negative association
with ROA. The inverse association indicated that, an increase on those variables
would decrease the profitability (ROA) of Ethiopian commercial banks. However, the
association was not statistically significant. That means, the importance of the
abovementioned variables in explaining the variation of profitability in Ethiopian
commercial banks was statistically inconsiderable.
As mentioned earlier in chapter three of this paper, only the variables CR, LIQ, CAP,
SIZE, and GDP that were found significant in the first step regression analysis were
regressed once again in order to ensure the reliability and the consistency of the first
step regression results both in terms of the coefficient estimates and the level of
significance. Table 4.9 shows the second step multiple regression results in which the
insignificant variables were dropout. Comparing the results of the two regression
analysis, major differences were not found in R-squared statistics, adjusted-R squared
statistics and Durbin-Watson stat in both regression results. The R-squared statistics
and adjusted-R squared in the second regression were 76.28% and 72.85%
respectively. In comparison to the first regression result there were no exaggerated
difference in both R-square and adjusted square statistics which were 76.35% and
71.91% respectively. Similarly, the results of Durbin-Watson statistics in both the
first and second step regression were almost equal. In addition, significant variables
75
that were found in the first step regression were remained significant with the same
significance level in the second step regression. Moreover, the sign and the magnitude
of coefficient estimates in both the first and second step regression were almost
similar.
Table 4.9 Second Step Regression Results
C -0.127610 0.022792 -5.598939 0.0000

CR -0.027196 0.008700 -3.125818 0.0024*
LIQ -0.016849 0.005269 -3.197686 0.0020*
CAP 0.146968 0.024707 5.948376 0.0000*
SIZE 0.006805 0.001008 6.747913 0.0000*
GDP 0.077742 0.019216 4.045674 0.0001*
R-squared 0.762759 Durbin-Watson stat 1.695646

Adjusted R-squared 0.728459
F-statistic 22.23791
* denote significance at 1% level.
Based on the above discussions, it can be concluded that the results obtained from the
first (general) regression analysis were consistence with the result of the second
regression analysis, which enhanced the reliability and validity of the data used in the
model.
76
4.2.2. In-depth interview results
In supplement to the structured review of financial records, this study employed in-
depth interviews with commercial banks officials. In depth interviews were conducted
with six Ethiopian commercial banks Officers/managers of finance and risk
management departments. The interviewees were from both private and state owned
banks namely Construction and Business Bank, Commercial Bank of Ethiopia, Awash
international bank, Dashen bank, United bank and Bank of Abyssinia. All the
interviewees were interviewed independently at different times. The interview
questions were fully unstructured and focused on the identification of financial risks
affecting Ethiopian banks profitability in general. More specifically, the interview
questions were also tried to identify how those risks can influence profitability, the
major determining factors among the influential factors, measures taken by the banks
to reduce the negative influence of controllable factors and their general opinion
regarding the matter.
According to an interview conducted with the abovementioned finance managers,
Credit risk, liquidity risks, operational risk and market risk were found to be the major
risks that affected profitability of commercial banks over the sampled period.
Among all the risks mentioned above, all the interviewees agreed that credit risk was
the main and the most important financial risk that negatively affects the profitability
of Ethiopian commercial banks. The interviewees also suggested that Credit risk is by
far the most significant risk faced by banks and the success of their business depends
on accurate measurement and efficient management of this risk to a greater extent
than any other risk. The interviewees also suggested liquidity risk (the risk that banks
do not have sufficient cash or borrowing capacity to meet deposit withdrawals or new
77
loan demand) as the second major financial risk that can negatively affect the
profitability of Ethiopian banks. Hence, So as to ensure the availability of sufficient
funds to meet demands of deposit withdrawals and borrowers at reasonable costs,
Ethiopian banks gave greater emphases to efficient and effective management of
liquidity risk.
Despite the prior expectation and theory that suggested financial risk like, interest rate
risk, and foreign exchange rate risk (volatility of exchange rate) are the major factors
that determine the variation of banks profitability, as per the interviewees the above
financial risks were not found to be the major factors that can affect profitability of
Ethiopian banks. All the interviewees agreed that the abovementioned financial risk
have an inverse relationship with profitability of Ethiopian banks. However, as result
of different factors that existed in the banking industry of Ethiopia, the influence of
the abovementioned variables was not considerable.
In addition to the financial risks that affect the profitability of Ethiopian banks, the
interviewees also suggest that other factors like capital strength, size of banks and
growth in GDP had a positive effect on the profitability of Ethiopian banks. On the
other hand, other factors like, government regulations which imposed on private
banks like the credit cap and the new regulation by the government require all
commercial banks to purchase National Bank of Ethiopia bonds (contribution for the
long-term investment and infrastructural development projects) worth 27% of their
gross loan disbursements with a maturity of 5 years at a relatively minimum interest
rate (3%) which was even below the average 5% deposit rate paid by most of the
privately owned banks for their depositors also considered as a factor that affects
Ethiopian private banks profitability. Similar to the above factors absence of active
78
secondary stock market and inflation were also considered as factors that affect
Ethiopian banks profitability.
4.3. Discussions of the Results
The preceding sections presented the result of the documentary analysis and in-depth
interviews. The purpose of this section is to discuss the results obtained from
different data sources. The analysis is based on the results of the documentary
analysis mainly using the results of the regression analysis between the dependent
variable and the independent variables presented in table 4.8 and in-depth interview
presented in the preceding section. The results obtained under these different methods
are jointly analyzed. Hence the subsequent discussions try to present the analysis of
results in light of the specific research question and hypotheses stated in section 4.1.
4.3.1. Credit risk
As shown in the literature review part of this study, there appears to be a consensus
that banks profitability is inversely associated with credit risk. The decisive argument
here is that, an increase in credit risk (non performing loans), which do not accrue
income, requires a bank to allocate a significant portion of its gross margin to
provisions to cover expected credit losses; thus, profitability will be lower. As shown
in table 4.8, the coefficient estimate of credit risk measured by the ratio of
nonperforming loan to total loans was -0.0279 and statistically significant at 1%
significant level(p=0.0035). This implies that an increase in credit risk, certainly lead
to a decrease in profit as measured by ROA. This means banks which fail to monitor
their credit loans tend to be less profitable than those which pay particular attention to
assets quality. The finding was in consistent to the results of Kosmidou (2008), Tafri
79
et al. (2009), Ara (2009), Kithinji (2010), Tefera (2011), Olweny & Shipho (2011)
and Al-Khouri (2011). Therefore, it can be conclude that credit risk was a key driver
of profitability in commercial banks of Ethiopia. Similarly, the result obtained from
interview also clearly supports the regression output. As per the interview conducted
with finance managers of selected Ethiopian commercial banks, credit risk was the
major factor that affects the profitability of Ethiopian commercial banks negatively.
So as to minimize this risk, Ethiopian banks began to establish a close relationship
with the borrowers through customer relation managers (CRMs). Hence, the
segregated duty provided to each CRMs increase their influence on borrowers
management through frequent dealings over time and enables a bank to reduce
risk and uncertainty associated with lending. Moreover, the traditional lending system
of Ethiopian banks in which every branch managers approved a loan had been
changed and currently loan applications can only be approved at district or at head
office level. Hence, the existing centralized loan application evaluation system
enables banks to use their management expertise and reduce risk associated with
lending and ultimately came up with high profit as measured by ROA.
4.3.2. Liquidity risk
The coefficient estimate of liquidity risk measured by the ratio of liquid asset to
liabilities revealed negative association with profitability reported by Ethiopian
commercial banks. The negative coefficient estimate (-0.017) implies the existence of
inverse association among liquidity risk and profitability. Moreover, the magnitude
the coefficient estimate was statistically significant at 1% significance level. That
means the importance of liquidity risk in explaining the variation of profitability in
80
the Ethiopian banking industry was significant under the period of consideration. As
far as liquidity risk is the risk that banks do not have sufficient amount of cash to meet
the demand of deposit withdrawals or new loan applications, banks may be forced to
borrow emergency funds at excessive cost that may adversely affect the profitability
of banks. The finding was in consistent with prior expectation and theory that
suggested banks that are exposed to liquidity risk are usually associated with lower
rates of return. In addition, this result was also consistence with previous studies of
Shen et al. (2009), Bordeleau and Graham, (2010). The result generated from the
interview also suggested liquidity risk was one of the major factors that determine the
variation of profitability in Ethiopian commercial banks. Hence, it can be concluded
that liquidity risk was the major factor that adversely affects profitability of Ethiopian
commercial banks over the sampled period.
4.3.3. Interest Rate Risk
The coefficient estimate of interest risk measured by the ratio of rate sensitive assets
to rate sensitive liabilities revealed a negative association with the profitability of
Ethiopian banks. The negative coefficient estimate suggested the existence of inverse
relationship between interest rate risk and profitability. The indicates that in the
scenario of rising interest rate, when liabilities re-price faster than assets, interest
spread would fall and hence profitability of the bank would be adversely affected.
However, this negative relationship was not found statistically significant even at 10
% significance level (p-value =0.8964). Hence, the findings suggested that, there was
no significant association among interest rate risk and profitability of Ethiopian
commercial banks as far as the parameter for this variable was statistically
81
insignificant as illustrated by the p-values of 0.89. In the same way, the findings from
interviews data were also provide further support for the findings of the regression
result which demonstrates that, interest rate risk was not a proper factor that determine
the variation of profitability in Ethiopian commercial banks. As per the interview
conducted with finance manager of selected Ethiopian commercial banks, Ethiopian
banks are not freely allowed to make adjustment on their lending and deposit rates so
as to cover time value of money, inflation and investment risk. For instance, the
minimum deposit rate (5%) was determined by the national bank of Ethiopia.
Consequently, the volatility of interest rate risk in Ethiopian commercial banks was
very small under the period of consideration. Therefore, the significance of interest
rate risk in explaining the variation of profitability would also be very small or
insignificant.
4.3.4. Foreign exchange risk
Foreign exchange rate risk was considered to be one of the key factors which can
affect the profitability of commercial banks in Ethiopia. Despite this as shown in table
4.8 foreign exchange rate risk measured with volatility of exchange rate revealed a
positive association with the profitability of Ethiopian commercial banks but it is
statistically insignificant. As shown in the regression results of the first regression and
general model the p-value of foreign exchange rate risk was 0.98. The finding is in
contrary to the findings of empirical study of Popov & Stutzmann, (2003) which
indicated negative relationship between foreign exchange rate risk and profitability of
Swiss companies. The finding is not also as anticipated. The insignificant parameter
indicates that the volatility of exchange rate (in terms of dollar) was not a factor
82
considerably influenced the profitability of the banking sector in Ethiopia under the
period of consideration. Thus the hypothesis that states there is a significant negative
relationship between foreign exchange rate risk and profitability may be rejected or
data did not support the hypothesis. This result is somewhat surprising and the
possible reason for this may be as a result of that banks are allowed to take open
positions in foreign currencies subject to regulatory limits set by the NBE.
The result obtained from interview was also supported the result of the regression
output. As per the interview, as the value of Ethiopian birr depreciated in terms of
dollar, it can increase the competitiveness export-oriented Ethiopian firms in the
international market. Consequently, the debt-servicing capacity of export-oriented
Ethiopian firms would improve and ultimately increase the performance of banks. On
the other hand, the devaluation of Ethiopian birr in terms of dollar may adversely
affect the performance of import-oriented Ethiopian firms. However, as per the
interviewee‟s opinion, the import market in Ethiopia was dominated by limited
numbers of importers that have strong relationship with banks. Hence, the profit
originated from the monopolistic advantage of importers enables their debt servicing
easier and ultimately improve the performance of Ethiopian banks. In this general
setting, it can be concluded that, the influence of exchange rate volatility on the
profitability of Ethiopian banks inconsiderable.
As mentioned earlier, in this study four major independent variables (financial risks)
namely; credit risk, interest rate risk, liquidity risk and foreign exchange risk and four
controlled variables (namely; capital strength, size of a bank, GDP growth and
inflation) were incorporated. The importance of each financial risks in explain the
83
variation of profitability in Ethiopian commercial banks have been discussed so far.
Accordingly, the following sections discuss the result of the controlled variables
obtained from the regression analysis output.
4.3.5. Capital strength
The coefficient estimate of capital strength which was measured by the equity to asset
ratio was positive and statistically significant at 1% significance level (p-value=0).
Moreover, the magnitude of the coefficient estimate (0.140) was relatively higher as
compared to other variables indicated the existence of strong positive relationship
between capital and profitability. This is in line with the prior expectation as a bank
with a sound capital position is able to pursue business opportunities more effectively
and has more time and flexibility to deal with problems arising from unexpected
losses, thus achieving increased profitability. The finding was consistent with the
resultes of previous studies of Athanasoglou et al. (2005), Li (2007), Tafri et al.
(2009), Ramlall (2009), Damena (2011) and Abera (2012). Similarly, the result
obtained from interview clearly supports the regression output. As per the interview
conducted with the finance managers of the selected banks, capital strength is one of
the major factors that can affect Ethiopian banks profitability certainly. That means an
increase in capital will lead to an increase in profitability by bringing good will to
them, which gives for them the ability to finance their financial needs through debt
without the need for collateral. That means having more and more capital leads to
more and more profitability by increasing their loan providing capacity. Therefore,
the finding concluded that, capital strength was the major factor that can determine
the variation of profitability in Ethiopian commercial banks.
84
4.3.6. Bank Size
As shown in table4.7, bank size which was measured by the natural log of total assets
had positive association with the profitability of Ethiopian commercial banks. The
variable was also statistically significant at 1% significance level (p value=000). The
finding was in accordance with the theory and prior expectation that suggested larger
banks may incur lower cost for efficient information gathering, processing and
analyzing due to economies of scale. That means bigger banks can have lower costs
per unit of income and therefore higher profit margin. Similarly, banks with larger
branch network can penetrate deposit markets and mobilize savings at a lower cost as
compared to smaller banks and ultimately came up with higher profit. Therefore, in
Ethiopia larger banks were better placed than smaller banks of the country in
harnessing economies of scale in transactions over the sampled period. From this one
can conclude that, profitability tends to be higher in larger banks of Ethiopia as
compared to smaller banks through economies of scale. The finding was in consistent
with the findings of Kapur and gualu (2011), Damena (2011) and (Afzal, 2011).
Similarly, the result generated from the interview also supports the output of the
regression analysis fully. That is Ethiopian banks profitability increases as the size of
the banks increase, which strengths the fact that larger banks are enjoying higher
profit than smaller banks of the country.
4.3.7 Gross domestic product
The coefficient estimate of real GDP growth revealed a positive and statistically
significant association with the profitability of Ethiopian commercial banks at 1%
significance level (p-value of =0.0005). The magnitude of the coefficient estimate
85
(0.077) indicates the existence of strong positive relationship between real GDP
growth and profitability of Ethiopian banks. The findings was in accordance with
prior expectation and theory that suggested whenever there was a positive GDP
growth, the economic activities in general were increasing and the volume of cash
held for either businesses or households was increasing. These conditions contributed
to decrease the likelihood that borrowers delay their financial obligations. In addition,
strong positive growth in real GDP creates a new and potential demand for financial
services that can easily translates into more income. Hence, it can be concluded that,
the existing ever increasing economic growth in Ethiopia over the sampled period
creates a new and potential demand for financial services and ultimately increase the
profitability of Ethiopian commercial banks. The findings suggested that, real GDP
growth was one of the vital determinants of NPLs in Ethiopian commercial banks.
This result was in consistent with the findings of Pasiouras & Kosmidou (2007),
Abera (2012) and Ponce (2012). Similarly, the result obtained from the interview
also highly supported the output of the regression analysis. Moreover, this result also
consistent with the existing reality in the Ethiopian banking industry where the
profitability of Ethiopian banks shows a parallel increase as the economy grows up.
4.3.8. Inflation
As mentioned in the literature review part, inflation affects banks performance
through different channels and its impact on profitability can be positive or negative.
If the inflation is not anticipated, the banks may be slow in adjusting their interest
rates and this adversely or negatively affects bank performance. On the other hand, if
the inflation is anticipated, banks may get an opportunity to adjust their interest rates
accordingly and resulted with revenues that increased faster than costs. Despite this
86
fact, the coefficient estimate of inflation in this particular study revealed a negative
association with the profitability of Ethiopian commercial banks. This implies the
existence of inverse relationship among inflation and profitability of Ethiopian
commercial banks. However, this negative association was not statistically
significant; thus, the findings suggested that inflation was not a major factor that
determine the profitability of Ethiopian banks Ethiopia as far as the parameter for this
variable is insignificant as illustrated by a p-values of 0.70. This is because of the
existence of a lower real interest rate which is obviously lower than the real
inflationary rate, resulting in costs increased faster than revenues. In Ethiopia the
maximum lending rate is determined by National bank of Ethiopia and banks are not
unable to adjust their lending rate in accordance with inflation rate. For instance, the
average annual inflation rate in Ethiopia over the period of consideration was 11%
with a maximum of 36.4%. Despite this fact, the average lending rate never exceeds
12.75% over the sample period. This clearly indicates the lending rate in Ethiopia was
far below from the market interest rate. In conclusion the result clearly reveals as
Ethiopian banks profitability is not influenced by inflation.
87
Chapter 5 Conclusions and Recommendations
The previous chapter discussed the findings of the study obtained from different data
sources. The purpose of this chapter is to discuss the conclusions and
recommendations. Accordingly, the chapter is organized in two sections, the first
section, 5.1 presents the conclusions of the study. And, the second section, 5.2
presents the recommendations that provided based on the findings of the study.
5.1. Conclusions
The main objective of this study was to examine the impact of financial risks in
profitability of Ethiopian commercial banks. To achieve this objective, a mixed
methods research approach was adopted. However, by considering the nature of the
study, quantitative research approach was dominantly used. To collect the necessary
data the study mainly used survey of documents (structured review of financial
records). In addition to this, in order to support the results obtained from the
quantitative method, in depth interview with selected finance managers of Ethiopian
commercial banks were also conducted. To this end, the collected data from a sample
size of eight Ethiopian commercial banks over the period of 2000 to 2011were
analyzed using descriptive statistics, correlation matrix and multiple linear regression
analysis. The analyses were made in accordance to the stated hypotheses and specific
research questions formulated in the study.
In order to conduct the empirical analysis, one dependent variable (profitability
measured by ROA), and eight independent variables were selected; namely, credit
risk liquidity risk, interest rate risk , foreign exchange risk, size, capital, GDP growth
and inflation. The variables were selected by refereeing different theories and
empirical studies that have been conducted on banks profitability and financial risks.
88
Consequently, the empirical findings of this particular study suggested the following
conclusions:
First, among all financial risks that were involved in this study, credit risk was the
major factor that determines the variation of profitability in Ethiopian commercial
banks under the period of consideration. The finding suggested a negative and
statistically significant association with 1% significance level. This was in accordance
with prior expectation and theory that suggested banks which fail to monitor their
credit loans tend to be less profitable than those which pay particular attention to
assets quality. In addition, the coefficient estimate of liquidity risk was also revealed a
negative association with the profitability of Ethiopian commercial banks. The
association was statistically significant at 1% significance level. This indicated that,
the existence of high liquidity risk may force banks to borrow emergency funds at
excessive cost that can adversely affect their profitability.
Second, the coefficient estimate of interest rate risk and inflation were revealed a
negative association with profitability of Ethiopian commercial banks. However, the
coefficient estimates of the above mentioned variables were not statistically
significant. Hence, interest rate risk and inflation were not a proper factor that
determines the variation of profitability in Ethiopian commercial banks. Whereas, the
coefficient estimates foreign exchange rate risk revealed a positive association with
profitability of Ethiopian commercial banks but statistically was not significant.
Therefore, foreign exchange rate risk was not found to be the major factor that
determined the profitability of Ethiopian banks.
89
Third, among controlled variables, namely; bank size, capital strength and GDP
growth were found to be the major factors determining the volatility of profit in
Ethiopian commercial banks. The coefficient estimates of the above mentioned
controlled variables were positive and statistically significant at 1% significance level.
The magnitude of the coefficient estimate of capital was relatively high as compared
to other variables, showing that an increase in capital strength will result in increased
profitability. This is in line with the expectation as a bank with a sound capital
position is able to pursue business opportunities more effectively and has more time
and flexibility to deal with problems arising from unexpected losses, thus achieving
increased profitability. The magnitude of the coefficient estimate of bank size was
relatively small. This indicates that as larger banks of the country relatively
experience more significant increases in profitability through economies of scale.
5.2. Recommendations
In line with the findings of the study, the following recommendations have been
forwarded.
Both the results obtained from the regression analysis and the interview result
suggested that, among all the risks that Ethiopian banks faced credit risk was the
major factor that can adversely affect the profitability of Ethiopian banks. Therefore,
Ethiopian banks should focus on credit risk management on the bases of maximizing
return on its assets while keeping its credit exposure within acceptable limits. To do
so, the bank should regularly review their credit portfolio quality, provisioning
requirements, and customer exposure.
90
Liquidity risk was one of the factors that can affect the profitability of Ethiopian
banks negatively since failure to properly manage liquidity can quickly result in
significant unanticipated losses. Therefore, Ethiopian banks should have optimal level
of liquidity which enables banks to meet their contractual commitments.
Finally, the study sought to investigate the impact of financial risks on the
profitability of Ethiopian commercial banks. For comprehensive investigation future
researcher could increase the number of observations by increasing the sample size
and extending the period of time with unbalanced data. In addition, future research
could cover cross countries to capture countries differences and to uncover difference
from financial system and regulation factors.
91
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100
Appendices
Appendix –I: Tests for the Heteroskedasticity Test: White
Heteroskedasticity Test: White

Obs*R-squared 55.70232 Prob. Chi-Square(44) 0.1110
Scaled explained SS 40.86005 Prob. Chi-Square(44) 0.6070
Test Equation:
Dependent Variable: RESID^2
Method: Least Squares
Date: 8/06/13 Time: 03:20
Sample: 1 96
Included observations: 96
C 0.002436 0.007212 0.337811 0.7369

CR 0.002907 0.004042 0.719097 0.4754
CR^2 0.000313 0.001344 0.232682 0.8169
CR*LIQ 0.000895 0.001271 0.704094 0.4846
CR*IRR 2.44E-06 8.55E-05 0.028542 0.9773
CR*FORX 3.34E-05 5.50E-05 0.607514 0.5462
CR*CAP -0.003992 0.007343 -0.543660 0.5890
CR*SIZE -0.000155 0.000178 -0.870438 0.3881
CR*GDP 0.002902 0.002451 1.184189 0.2418
CR*INFL 0.001929 0.001565 1.232891 0.2233
LIQ -0.004987 0.002781 -1.793503 0.0788
LIQ^2 0.000429 0.000620 0.691814 0.4922
LIQ*IRR 0.000183 9.37E-05 1.956480 0.0559
LIQ*FORX 2.02E-05 3.76E-05 0.537825 0.5930
LIQ*CAP 0.001449 0.003301 0.439046 0.6625
LIQ*SIZE 0.000184 0.000122 1.506342 0.1381
LIQ*GDP 0.002697 0.004077 0.661681 0.5112
LIQ*INFL 0.001408 0.001028 1.369005 0.1770
IRR 0.000288 0.000428 0.672823 0.5041
IRR^2 2.18E-06 4.16E-06 0.523365 0.6030
IRR*FORX 3.87E-06 3.80E-06 1.019867 0.3126
IRR*CAP -0.000553 0.000358 -1.543019 0.1290
IRR*SIZE -1.62E-05 2.00E-05 -0.808941 0.4223
IRR*GDP -1.48E-05 0.000293 -0.050500 0.9599
IRR*INFL 0.000147 0.000113 1.292514 0.2020
101
FORX -3.92E-05 0.000141 -0.278023 0.7821
FORX^2 4.44E-06 3.14E-06 1.414095 0.1634
FORX*CAP -0.000148 0.000159 -0.929582 0.3570
FORX*SIZE 3.93E-07 6.21E-06 0.063293 0.9498
FORX*GDP 2.98E-06 0.000419 0.007109 0.9944
FORX*INFL 2.56E-06 6.61E-05 0.038754 0.9692
CAP 0.007078 0.012144 0.582826 0.5626
CAP^2 -0.005259 0.007727 -0.680572 0.4992
CAP*SIZE -0.000206 0.000512 -0.403529 0.6882
CAP*GDP -0.009742 0.007917 -1.230521 0.2241
CAP*INFL -0.006510 0.003291 -1.977926 0.0534
SIZE -0.000158 0.000658 -0.239881 0.8114
SIZE^2 2.59E-06 1.55E-05 0.166972 0.8681
SIZE*GDP -0.000751 0.000544 -1.378513 0.1741
SIZE*INFL 3.17E-05 0.000155 0.203774 0.8393
GDP 0.013766 0.011845 1.162123 0.2506
GDP^2 0.005281 0.016098 0.328027 0.7442
GDP*INFL 0.013339 0.007810 1.707988 0.0937
INFL -0.001189 0.003521 -0.337546 0.7371
INFL^2 -0.001385 0.001337 -1.036159 0.3050
R-squared 0.580232 Mean dependent var 4.44E-05

Adjusted R-squared 0.218080 S.D. dependent var 5.97E-05
S.E. of regression 5.28E-05 Akaike info criterion -16.55623
Sum squared resid 1.42E-07 Schwarz criterion -15.35419
Log likelihood 839.6989 Hannan-Quinn criter. -16.07034
F-statistic 1.602178 Durbin-Watson stat 2.361930
102
Appendix –II: Model specification error (linearity) test: Ramsey RESET Test
Ho: The models functional form is appropriate
Ha: The models functional form is inappropriate
Ramsey RESET Test:

Log likelihood ratio 0.231208 Prob. Chi-Square(1) 0.6306
Test Equation:
Dependent Variable: ROA
Method: Least Squares
Date: 10/06/13 Time: 03:45
Sample: 1 96
Included observations: 96
C -0.049930 0.068220 -0.731900 0.4662

CR -0.025881 0.018070 -1.432287 0.1557
LIQ -0.008453 0.009783 -0.864130 0.3899
IRR 0.000813 0.000964 0.844212 0.4009
FORX 0.000319 0.000402 0.792754 0.4301
CAP 0.072781 0.067600 1.076637 0.2847
SIZE 0.003181 0.003340 0.952326 0.3436
GDP 0.075634 0.045752 1.653130 0.1020
INFL 0.004210 0.008673 0.485449 0.6286
FITTED^2 4.193124 9.207910 0.455383 0.6500
R-squared 0.697085 Mean dependent var 0.032320

Adjusted R-squared 0.665385 S.D. dependent var 0.012158
S.E. of regression 0.007033 Akaike info criterion -6.978052
Sum squared resid 0.004254 Schwarz criterion -6.710933
103
Appendix –III: First Step Regression Results

Method: Panel Least Squares
Date: 10/06/13 Time: 00:24
Sample: 2000 2011
Periods included: 12
Cross-sections included: 8
Total panel (balanced) observations: 96
C -0.130218 0.029361 -4.435017 0.0000

CR -0.027858 0.009267 -3.006176 0.0035
LIQ -0.016752 0.005744 -2.916247 0.0046
IRR -8.77E-05 0.000672 -0.130619 0.8964
FORX 9.22E-06 0.000299 0.030853 0.9755
CAP 0.147610 0.026728 5.522620 0.0000
SIZE 0.006931 0.001350 5.135458 0.0000
GDP 0.078192 0.021374 3.658321 0.0005
INFL -0.003115 0.008127 -0.383236 0.7026
Effects Specification
Cross-section fixed (dummy variables)

104
Appendix –IV: second step regression results

Method: Panel Least Squares
Date: 10/26/13 Time: 02:49
Sample: 2000 2011
Periods included: 12
Cross-sections included: 8
Total panel (balanced) observations: 96
C -0.127610 0.022792 -5.598939 0.0000

CR -0.027196 0.008700 -3.125818 0.0024
LIQ -0.016849 0.005269 -3.197686 0.0020
CAP 0.146968 0.024707 5.948376 0.0000
SIZE 0.006805 0.001008 6.747913 0.0000
GDP 0.077742 0.019216 4.045674 0.0001
Effects Specification
Cross-section fixed (dummy variables)

105
Appendix- V: Ratio Data
year Bank CR IRR LIQ FORX GDP INFL ROA size Cap
2000 CBE 0.2644 -3.37238 0.35232 4.903008 0.059 0.054 0.031269 23.71036 0.065
2001 CBE 0.3377 -4.03766 0.28553 5.61426 0.074 -0.003 0.02536 23.79081 0.061
2002 CBE 0.5209 -7.15923 0.35914 5.953267 0.016 -0.106 0.022894 23.82092 0.037
2003 CBE 0.535 -3.00548 0.47397 1.12064 -0.021 0.109 0.01264 23.90962 0.053
2004 CBE 0.3768 -2.64439 0.78058 0.541248 0.117 0.073 0.017408 24.05458 0.053
2005 CBE 0.2752 -8.6683 0.74973 0.216986 0.126 0.061 0.023787 24.22488 0.043
2006 CBE 0.2245 -4.41899 0.68869 0.220841 0.115 0.106 0.031242 24.30258 0.042
2007 CBE 0.1452 -2.19669 0.73761 0.601927 0.118 0.158 0.026924 24.49501 0.097
2008 CBE 0.0533 -2.97916 0.69092 2.528459 0.112 0.253 0.037052 24.64357 0.091
2009 CBE 0.0366 -3.23911 0.42795 5.816814 0.099 0.364 0.045715 24.80775 0.085
2010 CBE 0.0188 -4.72975 0.34921 9.345763 0.104 0.028 0.03785 25.02985 0.075
2011 CBE 0.0086 -5.16832 0.43621 6.754427 0.114 0.181 0.037089 25.46179 0.055
2000 CBB 0.137 3.942029 0.27435 4.903008 0.059 0.054 0.02252 20.69692 0.071
2001 CBB 0.4812 3.955224 0.28317 5.61426 0.074 -0.003 0.007231 20.69074 0.069
2002 CBB 0.4155 0.922078 0.29685 5.953267 0.016 -0.106 0.008351 20.68036 0.08
2003 CBB 0.4009 1.392405 0.35935 1.12064 -0.021 0.109 0.014862 20.66352 0.084
2004 CBB 0.3547 1.253012 0.48684 0.541248 0.117 0.073 0.006623 20.7787 0.079
2005 CBB 0.2776 -0.07547 0.58617 0.216986 0.126 0.061 0.014192 21.32867 0.058
2006 CBB 0.1942 2.866242 0.57554 0.220841 0.115 0.106 0.043962 21.30938 0.087
2007 CBB 0.1706 1.825472 0.51056 0.601927 0.118 0.158 0.04288 21.35931 0.112
2008 CBB 0.1556 -0.59833 0.62694 2.528459 0.112 0.253 0.048077 21.5954 0.108
2009 CBB 0.1145 -1.43047 0.51527 5.816814 0.099 0.364 0.040895 21.6757 0.104
2010 CBB 0.0656 -2.09426 0.52945 9.345763 0.104 0.028 0.041429 21.87447 0.101
2011 CBB 0.0681 -2.17084 0.54215 6.754427 0.114 0.181 0.035093 21.97746 0.104
2000 DB 0.1595 0.896104 0.53884 4.903008 0.059 0.054 0.020809 20.57824 0.089
106
2001 DB 0.1092 -0.03226 0.39842 5.61426 0.074 -0.003 0.032727 20.81858 0.085
2002 DB 0.1422 -0.19672 0.42737 5.953267 0.016 -0.106 0.026245 21.11935 0.082
2003 DB 0.0889 -0.22481 0.40037 1.12064 -0.021 0.109 0.018584 21.4119 0.065
2004 DB 0.0744 -0.36047 0.40037 0.541248 0.117 0.073 0.029137 21.70796 0.064
2005 DB 0.0672 -0.93416 0.3604 0.216986 0.126 0.061 0.028363 21.95291 0.071
2006 DB 0.0621 -0.17098 0.31121 0.220841 0.115 0.106 0.040695 22.23751 0.085
2007 DB 0.0595 -0.59688 0.34376 0.601927 0.118 0.158 0.042708 22.52184 0.09
2008 DB 0.0589 -1.42654 0.47395 2.528459 0.112 0.253 0.042534 22.7811 0.093
2009 DB 0.0739 -3.21082 0.5934 5.816814 0.099 0.364 0.036166 22.99879 0.093
2010 DB 0.03 -2.60436 0.51805 9.345763 0.104 0.028 0.037076 23.23716 0.091
2011 DB 0.0338 -2.53352 0.52577 6.754427 0.114 0.181 0.042974 23.40839 0.095
2000 AIB 0.3027 0.393617 0.46531 4.903008 0.059 0.054 0.030303 20.44751 0.124
2001 AIB 0.205 -0.56731 0.40746 5.61426 0.074 -0.003 0.019846 20.62565 0.115
2002 AIB 0.3402 -0.92366 0.43333 5.953267 0.016 -0.106 0.017086 20.82943 0.118
2003 AIB 0.2513 0.058394 0.4768 1.12064 -0.021 0.109 0.012848 21.06045 0.098
2004 AIB 0.1839 -1.07742 0.50837 0.541248 0.117 0.073 0.019774 21.29425 0.088
2005 AIB 0.1202 -1.00000 0.44639 0.216986 0.126 0.061 0.024708 21.52347 0.102
2006 AIB 0.0956 -0.73026 0.3619 0.220841 0.115 0.106 0.037576 21.80643 0.103
2007 AIB 0.0736 -0.65283 0.36247 0.601927 0.118 0.158 0.053264 22.06613 0.113
2008 AIB 0.0866 -0.99904 0.47662 2.528459 0.112 0.253 0.042324 22.29604 0.124
2009 AIB 0.0578 -2.08124 0.64218 5.816814 0.099 0.364 0.031449 22.58315 0.117
2010 AIB 0.0547 -1.22805 0.66207 9.345763 0.104 0.028 0.044179 22.79581 0.118
2011 AIB 0.0381 -2.07831 0.52275 6.754427 0.114 0.181 0.049921 23.03738 0.129
2000 BOA 0.0421 0.731707 0.33402 4.903008 0.059 0.054 0.029248 20.39198 0.171
2001 BOA 0.032 0.693878 0.27343 5.61426 0.074 -0.003 0.039063 20.61345 0.164
2002 BOA 0.3795 -1.36879 0.47855 5.953267 0.016 -0.106 0.007005 20.85605 0.123
2003 BOA 0.2843 -1.26174 0.47119 1.12064 -0.021 0.109 0.006002 21.0107 0.112
107
2004 BOA 0.1751 -0.46632 0.49255 0.541248 0.117 0.073 0.034069 21.18385 0.122
2005 BOA 0.124 -1.02756 0.4665 0.216986 0.126 0.061 0.039864 21.44451 0.123
2006 BOA 0.0494 -0.1791 0.35875 0.220841 0.115 0.106 0.043049 21.76495 0.142
2007 BOA 0.1054 -0.15881 0.3756 0.601927 0.118 0.158 0.027974 21.94586 0.119
2008 BOA 0.1287 -1.46839 0.41482 2.528459 0.112 0.253 0.02983 22.17487 0.098
2009 BOA 0.1475 -3.22886 0.59995 5.816814 0.099 0.364 0.027574 22.42375 0.095
2010 BOA 0.0698 -2.70107 0.57639 9.345763 0.104 0.028 0.03121 22.56064 0.093
2011 BOA 0.0397 -3.45512 0.47667 6.754427 0.114 0.181 0.035449 22.70812 0.091
2000 WB 0.191 -0.14 0.63539 4.903008 0.059 0.054 0.013619 20.05773 0.097
2001 WB 0.1366 -0.82759 0.50334 5.61426 0.074 -0.003 0.024014 20.1837 0.099
2002 WB 0.1294 -1.01563 0.44272 5.953267 0.016 -0.106 0.018576 20.28631 0.099
2003 WB 0.1086 -0.23656 0.44602 1.12064 -0.021 0.109 0.016873 20.60561 0.105
2004 WB 0.1224 0.031008 0.46689 0.541248 0.117 0.073 0.039474 20.85429 0.113
2005 WB 0.0841 0.072222 0.48137 0.216986 0.126 0.061 0.038985 21.20322 0.111
2006 WB 0.0485 -0.0549 0.37177 0.220841 0.115 0.106 0.041611 21.53819 0.113
2007 WB 0.0525 0.095533 0.48467 0.601927 0.118 0.158 0.043966 21.9703 0.116
2008 WB 0.0839 -0.22048 0.60796 2.528459 0.112 0.253 0.046061 22.14033 0.147
2009 WB 0.077 -1.5676 0.78199 5.816814 0.099 0.364 0.05002 22.35603 0.163
2010 WB 0.0347 -0.22828 0.77387 9.345763 0.104 0.028 0.055381 22.47107 0.183
2011 WB 0.0351 -1.59095 0.69511 6.754427 0.114 0.181 0.056817 22.8103 0.166
2000 UB 0.0795 0.75 0.46053 4.903008 0.059 0.054 0.034965 18.77836 0.28
2001 UB 0.0775 0.460317 0.53488 5.61426 0.074 -0.003 0.037383 19.18149 0.294
2002 UB 0.1595 0.397727 0.75132 5.953267 0.016 -0.106 0.022293 19.5649 0.28
2003 UB 0.0993 0.725275 0.60279 1.12064 -0.021 0.109 0.014925 19.96611 0.194
2004 UB 0.099 0.333333 0.54511 0.541248 0.117 0.073 0.014837 20.32874 0.142
2005 UB 0.0845 -0.04 0.55954 0.216986 0.126 0.061 0.040075 20.79372 0.116
2006 UB 0.0418 -0.40838 0.48607 0.220841 0.115 0.106 0.037523 21.19264 0.119
2007 UB 0.0459 0.818056 0.49189 0.601927 0.118 0.158 0.039853 21.50397 0.165
2008 UB 0.0398 -0.48672 0.56714 2.528459 0.112 0.253 0.038769 21.90192 0.144
108
2009 UB 0.0462 -1.75669 0.68744 5.816814 0.099 0.364 0.028805 22.26056 0.112
2010 UB 0.0376 -2.41905 0.69309 9.345763 0.104 0.028 0.042062 22.49754 0.108
2011 UB 0.0335 -2.26381 0.58677 6.754427 0.114 0.181 0.041812 22.76773 0.117
2000 NIB 0.0000 0.875 1.11538 4.903008 0.059 0.054 0.02213 18.87811 0.253
2001 NIB 0.019 0.903226 0.44231 5.61426 0.074 -0.003 0.02898 19.79692 0.157
2002 NIB 0.0864 0.717172 0.48406 5.953267 0.016 -0.106 0.041199 20.09591 0.185
2003 NIB 0.1234 0.536 0.41497 1.12064 -0.021 0.109 0.021469 20.6011 0.141
2004 NIB 0.0877 0.554913 0.39784 0.541248 0.117 0.073 0.039294 20.94401 0.139
2005 NIB 0.1122 0.28125 0.37939 0.216986 0.126 0.061 0.038106 21.27254 0.129
2006 NIB 0.0847 0.610526 0.29959 0.220841 0.115 0.106 0.039961 21.42982 0.141
2007 NIB 0.0556 0.294118 0.37041 0.601927 0.118 0.158 0.04066 21.68147 0.163
2008 NIB 0.0673 -0.4323 0.53956 2.528459 0.112 0.253 0.043562 22.01799 0.164
2009 NIB 0.1116 -1.32457 0.70822 5.816814 0.099 0.364 0.045559 22.29334 0.152
2010 NIB 0.0737 -0.59211 0.74338 9.345763 0.104 0.028 0.047731 22.51018 0.153
2011 NIB 0.0504 -1.23079 0.70659 6.754427 0.114 0.181 0.048369 22.68505 0.165
109
Appendix-VI: Interview Instrument
School of Business and Public Administration
Department of Accounting and Finance
Interview questions for the higher officials/finance managers of Ethiopian Commercial
Banks
1. What are the financial risks that affect your banks‟ profitability?
2. How do those identified risks affect/influence your banks‟ profitability in general?
3. Among the identified factors that can influence your banks‟ profitability, which of them
are the major factors which affect your banks‟ profitability?
4. What are the other factors contribute to the existence of poor or good performance of
banks‟ when measured in terms of profitability?
5. Any comments?
110

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Financial Risks and Profitability of Commercial Banks in Ethiopia

The Department of Accounting and Finance

Presented in Partial Fulfillment of the Requirements for the

Degree of Master of Science (Accounting and Finance)

Addis Ababa University

Addis Ababa, Ethiopia

By: Eneyew Lake

Advisor: Wollela Abehodie (PhD)

This is to certify that thesis entitled, “Financial Risks and Profitability of

Commercial Banks in Ethiopia”, undertaken by Eneyew Lake for the partial

fulfillment of degree of Master of Science in Accounting and Finance at Addis Ababa

University or any other University.

Wollela Abehodie (PhD) _________________________

School of Graduate Studies

and Profitability of Commercial Banks in Ethiopia and submitted in partial fulfillment

standards with respect to originality and quality.

Signed by the Examining Committee:

Examiner Ashenafi Beyene (PhD) Signature_____________ Date___________

Examiner P. Laxmikantham (PhD) Signature__________ Date _____________

Advisor Wollela Abehodie (PhD) Signature__________ Date ________________

Chair of Department or Graduate Program Coordinator

Financial risks and Profitability of Commercial Banks in Ethiopia

Addis Ababa University, 2013

financial operation of a business and arise due to the uncertainty in movement of

have positive or negative outcomes or may simply result in uncertainty. Therefore in

profitability of commercial banks for a total of eight commercial banks in Ethiopia,

research approach by combining documentary analysis and in-depth interviews. The

return on assets of Ethiopian commercial banks.

thankful to Debiremarkos University and Addis Ababa University for sponsoring me

List of Figures ......................................................................................................................... viii

List of Acronyms ................................................... ………………………………………………x

Chapter one Introduction ........................................................................................................ 1

1.1. Statement of the Problem.................................................................................................. 3

1.2.Broad objective, hypotheses and research question ............................................................ 5

1.3.Research Methodology ...................................................................................................... 6

1.4.Significance of the study. .................................................................................................. 7

1.5.Scope of the study. ............................................................................................................ 7

1.6.Limitation of the study. ..................................................................................................... 8

1.7. Structure of the report. ...................................................................................................... 8

Chapter 2: Review of the Literature. ..................................................................................... 10

2.1.Theoretical review. .......................................................................................................... 10

2.1.1. Financial risks in banking. ...................................................................................... 10

2.1.1.1. Credit risk ............................................................................................................. 10

2.1.1.2. Liquidity Risk. ...................................................................................................... 13

2.1.1.3. Interest Rate Risk .................................................................................................. 15

2.1.1.4. Foreign exchange rate risk. ................................................................................... 20

2.1.1.5. Off-Balance Sheet Risks. ...................................................................................... 22

2.1.2. Banks profitability and its measurement. .................................................................. 24

2.1.3.The Relationship between financial risks and profitability . .................................... 26

2.2. Empirical review. ....................................................................................................... 28

2.3. Conclusion and knowledge gaps . .............................................................................. 37

Chapter 3: Research design and methodology. ..................................................................... 39

3.1.1. Dependent Variables .................................................................................................. 39

3.1.2. Independent Variables and hypotheses. ........................................................................ 40

3.2. Research approaches. ..................................................................................................... 47

3.3. Research method planned to be used ............................................................................ 50

3.3.1. Research method: quantitative aspect........................................................................... 50

3.3.2. Research method: Qualitative aspect. .......................................................................... 57

Chapter 4: Results and Analysis ............................................................................................ 60

Examiner Ashenafi Beyene (PhD) Signature___ Date_

Examiner P. Laxmikantham (PhD) Signature Date ___

Advisor Wollela Abehodie (PhD) Signature Date ______