EFFECTS OF INTEREST RATES ON FINANCIAL PERFORMANCE OF TIER THREE

BANKS IN KENYA.

A RESEARCH PROPOSAL SUBMITTED IN PARTIAL FULFILLMENT OF THE

REQUIREMENTS FOR THE AWARD OF THE DEGREE OF BACHELOR OF
BUSINESS MANAGEMENT, SCHOOL OF BUSINESS, RONGO UNIVERSITY.

2021

AKECHI CLARE OCHIENG

BBM/062/2016.
TABLE OF CONTENT

DECLARATION…………………………………………………………………………………3
DEDICATION……………………………………………………………………………………4
ACKNOWLEDGMENT…………………………………………………………………………5
LIST OF ABBREVIATIONS……………………………………………………………………6
ABSTRACT…………………………………………………………………………………….7
INTRODUCTION……………………………………………………………………………….1
1.1 INTRODUCTION…………………………………………………………………………….1
1.2 BACKGROUND OF THE
STUDY…………………………………………………………..1
1.2.1 Interest rates……………………………………………………………………………….2
1.2.2 Financial performance of tier three banks in
Kenya………………………………………..3
1.3 PROBLEM STATEMENT……………………………………………………………………4
1.4 OBJECTIVES OF THE STUDY
……………………………………………………………...5
1.4.1 General objectives…………………………………………………………………………5
1.4.2 Specific objectives……………………………………………………………...................5
1.5 RESEARCH QUESTIONS……………………………………………………………………
5
2.0 SIGNIFICANCE OF THE
STUDY………………………………………………...................6
1.6 SCOPE OF THE
STUDY……………………………………………………………………...6
1.7 LIMITATIONS & DILIMITATIONS……………………………………………...................7

LITERATURE
REVIEW………………………………………………………………………..8
2.1INTRODUCTION……………………………………………………………………………..8
2.2 THEORETICAL FRAMEWORK…………………………………………………………….8
2.2.1 Liquidity preference theory………………………………………………………………….8

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2.2.2 loan-able funds theory……………………………………………………………………….9
2.2.3 Efficiency theory…………………………………………………………………………...11
2.3 EMPIRICAL FRAMEWORK………………………………………………….....................11
2.3.1 Lending rate and financial performance of tier three
banks………………………………...11
2.3.2 Deposit rates and financial performance of tier three banks
………………………………..12

2.3.3 Central bank rates and financial performance of tier three banks
………………..................12
2.3.4 Short-term rates and financial performance of tier three banks
…………………………….13
2.4 RESEARCHGAPS…………………………………………………………………………..14
2.5 CONCEPTUALFRAMEWORK…………………………………………………………….16
2.6 CONCLUSION………………………………………………………………………………17
RESEARCH METHODOLOGY……………………………………………………...............18
3.1INTRODUCTION……………………………………………………………………………18
3.2 RESEARCH DESIGN……………………………………………………………………….18
3.3 TARGET POPULATION……………………………………………………………………19
3.4 SAMPLING TECHNIQUES………………………………………………………………...19
3.5DATA COLLECTION…………………………………………………………….................19
3.6 DATA ANALYSIS…………………………………………………………………………..20
3.7REFERENCES……………………………………………………………………………

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 DECLARATION

This research proposal is my original work and has not been submitted for any award of degree
to any other college, institution or university. Where materials have been used from other
sources, they have been used properly, acknowledged and referred.

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DEDICATION

I dedicate this work to the Almighty God for enabling me to complete this work. To my parents
for their financial and spiritual support and to my supervisor for sacrificing his time to guide me
through this research proposal.

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ACKNOWLEDGMENT

I thank the Almighty God, the most gracious, the most powerful for enabling me to pursue my
career in finance. Many thanks to my supervisor, Mr. Robinson Ouma; his guidance and
encouragement through the process made me to come out successful.

To all my family members, relatives, colleagues and friends, I say thanks so much for your
support and assistance, may God bless you abundantly.

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LIST OF ABREVIATIONS.

CBK –Central bank of Kenya

ROA –Return on assets

ROE – Return on investments

ROI – Return on investments

CBR – Central bank rates

SPSS – Statistical package for social science

CBA – Central bank authority

SSA – Sub Saharan Africa

SACCOS – Savings and credits cooperatives society

SHRM – Strategic human resource management

DER – Dividend equalization reserve

DR – Deposit rates

ICR – Interest coverage ratio

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ABSTRACT

Over the years tier three banks in Kenya have been performing tremendously. In Kenya, the
bank lending interest rate are charged on loans by tier three banks to private individual
companies .Interest charged to borrowers rose to thirty percent and above in 2012 while interest
earned by the savers remains relatively low. This resulted to debate by members of parliament to
control banks interest rate due to their skewed way of increasing interest rate, the argument was
banks only increase interest rate charged to customers only, on the other side banks argued if
interest rate is controlled many banks will collapse. Banks as other business seeks to maximize
profit and one way of achieving this is enlarging spread. This study seeks to determine to what
extent the lending rate, deposit rates, short- term rates and central bank rates affect the financial
performance of tier three banks.

The study will use descriptive research design, using secondary data that will be obtained from
the central bank of Kenya for a period of eight years i.e. from 2010 to 2018 as well as bank’s
published annual reports. The target population will be the 23 tier three banks in Kenya. The
data that will be obtained will be analyzed using multiple regression analysis with the help of
SPSS to find out whether a relationship exists between interest rates and the financial
performance of tier three banks in Kenya.

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 CHAPTER ONE
1.1 INTRODUCTION

This chapter gives the background of the study, statements of the problem, research objectives,
research questions, significance of the study, scope of the study, limitations and di-limitations of
the study.

1.2 BACKGROUND OF THE STUDY

The banking sector in Kenya is governed by companies Act CAP 488, the banking Act CAP 488,
the Central bank of Kenya Act Cap 491 and the various prudential guidelines issued by the
central bank of Kenya. According to Ochanda (2018), banking sector plays a critical role in the
economy and they play a financial intermediation role.

According to Mustaq and Amhed (2016), the banking sector is the backbone of any country
economy and size of bank deposits are the major tools for banking sector. To sustain their
operations and pay interest returns to shareholders, banks charge interest rates (Miller,
2013).According to Were and Wambua (2014), a bank is a commercial entity in business of
borrowing money at lower rate and lending the same at a higher rate to make or generate income.
The profit and cost incurred is denoted by the margins between the two rates.

In Sub-Saharan Africa (SSA), (Were and Wambua 2014) most countries experience double digit
interest rates despite structural adjustments to form having been initiated end undertaken by them
which led to interest rates liberalization among several countries. These high interest rates have
locked out customers and thus government intervened. Interest rates often lead to market
distortion leading to adverse biasness by banking institutions where the focus on providing
credit to low risk clients which can culminates in financial inefficiencies in the inter mediation
process(Rasmsi,2013).

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1.2.1 INTEREST RATES
Ali 2014 defines interest rates as a charge a borrower pays to a lender for use of lenders funds for
unspecified returns. Devereux &Vet man 2002 gave the definition of the interest rates as cost
incurred by the borrower for using money or capital not owned by them.

According to CBK report 2017, Commercial banks’ average lending interest rates remained
stable within the interest rate caps. The average commercial bank lending rate declined to 13.67
percent in 2017 compared to 16.59 percent in 2016. The interest rate capping law was effected in
14th September 2016. Average commercial banks’ deposit rate increased to 8.22 percent in 2017
from 7.07 percent in 2016, also driven by the interest rate capping law. The interest rate spread
declined from a peak of 6.64 percent in April 2017 to 5.41 percent in December 2017.

Interest rate cap has resulted in a decline in commercial banks profit. Many commercial banks
recorded decreased profits resulting from reduced interest rate spread (CBK, 2017). In 2017 the
average pretax profit for commercial banks was 73.3 billion compared to 85.53 billion 2016, a
14% drop. However, in 2018, profitability in the banking sector has improved owing to a
decrease in general expense. Pretax profits increased by 2.1% in first and second quarter of 2018.
Similarly, pre-tax profit increased by 3.2% from 36.5 billion in the 4th quarter of 2017 to 37.7
billion in the first quarter of 2018(James Ochieng, 2018). CBK rates at 2018 were; lending rate
12.61%, deposit rate 7.57%, Central bank rate 9%, short-term rates (Treasury bill rate) 7.016%
but as 2019 CBK left Central bank rate unchanged at 9%.

High interest risks will either push the lenders out of the business or borrower will be unable to
pay (Ariemba, Kiweru& Rito 2015). Two types of interest rates that influence the profitability of
banks, interest expenses and interest income. Interest expenses and interest income affects nets
interest income and therefore bank profitability. Loans are the bank’s assets whereas deposits are
banks liabilities (Rusiah, 2010). Interest rates dictates the maximum rate that a bank can charge
its customers on loans (Villegas, 1982).

The financial sector in Kenya was liberalized in the early 1990 to enable interest rates to be
determined by the market factors. The banking (Amendment bill 2015) introduced the bill to
CAP interest rates in Kenya .The bill was accented by president to law in the year 2016 and it
amended the Banking Act Sec 33A by introducing a new Sec 33B which provides for interest

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rates ceilings introduced laws on interest rates paid to deposit accounts held by Kenyans (CBK,
2016)

1.2.2 FINANCIAL PERFORMANCE OF TIER THREE BANKS IN KENYA

The central bank of Kenya (CBK) classifies commercial banks in Kenya into three tiers ,these
classifications is based on market share, asset base , amount of capital; and a number of deposits(
CBK, 2016). A bank tier is the size of the bank in relation to other banks depending on the
relative size to the overall banking market in terms of total banking assets provided by the
balance sheet of the bank (Gartner, 2016).

Tier one consists of large banks which have billions of shillings in assets, capital and customer
deposits. In Kenya there are current six banks classified as tier one. These six banks
approximately control 65.4% of commercial market, 66.7% of total deposits, 90.3% of deposits
accounts and 94.10% of loan accounts (CBK, 2017). The second Tier consists of eleven
commercial banks, which control 26 % of the commercial bank market, 0.25% of total deposits,
7.6% of deposits accounts and 3.8% of loan accounts (CBK, 2017)

Tiers three commercial banks consists of twenty three banks which controls 8.9% of commercial
bank market share, 8.2 % of total deposits,1.8% of deposits account and 1.8% of loan
accounts(CBK,2017). Tier three banks are considered to be among the few banks whose assets
happen to be below 10billion. This means that their performance may not be compared to other
banks that have assets that are more than ten billion.

Over the last few years, the banking sector has shown a robust growth. However when analyzed
by tier classification it was established that the pretax profits of tier three commercial banks
decreased by 2.2% during the period 2015 to 2016(CBK, 2017). This decline was attributed to
five commercial banks in this category posting losses. First community bank realized a loss of
Kshs.41 million, Jamii bora bank Kshs.490 million, consolidated bank Kshs.277 million (CBK
2016; 2017). Dubai bank and Empirical bank were placed under receivership of their failure to
maintain adequate capital and liquidity ratio, large non-performing loans and weak corporate
governance structures. This indicates that tier three commercial banks in Kenya have challenges
and therefore there is need for this study to examine in details what really is the main cause of
unpleasant performance among these banks.

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1.3 PROBLEM STATEMENT

Interest rates determine the profitability of a commercial bank among other factors (Gregory et
al., 2005). Interest rate volatility has negative impact on the financial performance of commercial
banks posing challenge to commercial banks managers in their core function of credit
management and profitability (Baum, Caglayan & Ozkan 2009). A rise in interest rates translates
to higher returns on new investments, increased profit margins on loans, and improved earnings
from bond trading.

Various studies have been performed investigating interest rates and profitability in advanced
economies. Enyioko (2012) examined the performances of banks in Nigeria based on the interest
rate policies. The study found that interest rate policies have not improved the overall
performances of banks significantly. Aburime (2008) found that real interest rate, inflation,
monetary policy and foreign exchange regime are positively associated with banks’ return on
assets of the banks in Nigeria. Bosson and Jog-kun (2002), however found out that profitability
of Ghanaian banks is skewed towards large banks and that there is correlation between bank size
and profitability. Kipngetich (2011) examined the effect of interest on the financial performance
of commercial banks in Kenya. The study found there is a positive relationship between interest
rates and financial performance of commercial banks in Kenya.

Most studies have focused on the major commercial banks Kenya ignoring the tier three banks
that are also of greater importance to the economic development of Kenya. Given the volatile
macroeconomic environment in Kenya, there is need for up to date research on the complex
relationship between interest rates and financial performance of tier three banks. This study
therefore seeks to answer the question: what is the effect of interest rates on the financial
performance of tier three banks in Kenya? Hence bridge the knowledge gap existing.

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1.4 OBJECTIVES OF THE STUDY

1.4.1 GENERAL OBJECTIVES

The general objective of this study is to investigate the effects of interest rates on financial
performance of tier three banks in Kenya

1.4.2 SPECIFIC OBJECTIVES

i. To determine the effects of Central Bank Rate on the financial performance of tier three
banks in Kenya.
ii. To establish the effects of lending rates on the financial performance of tier three banks
in Kenya.
iii. To find out the effects of deposit rates on financial performance of tier three banks in
Kenya.
iv. To establish the effects of short-term rates on financial performance of tier three banks in
Kenya.
1.5 RESEARCH QUESTIONS
i. How does Central Bank Rate affect the financial performance of tier three banks in
Kenya?
ii. What are the effects of lending rates on the financial performance of tier three banks in
Kenya?
iii. Does deposit rate affect the financial performance of tier three banks in Kenya?
iv. What are the effects of short-term rates on the financial performance of tier three banks in
Kenya?

1.6 SIGNIFICANCE OF THE STUDY

Shareholders and investor of tier three banks in Kenya will be keen to explore and diversify into
non- traditional, non- intermediary income generating activity after understanding the effects of
interest rates on financial performance. Shareholders will be able to determine whether they
should buy or sell the stock of various banks.

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Banks regulator will identify banks that are experiencing CBA problems so that they can be
remedied. Investment analysts would be able to advice investor on which banks to select for
investment. Tier three commercial banks will be able to evaluate their performance over time to
determine the outcome of previous management decision so that changes can be made where
appropriate.

The management will also be able to incorporate the factor-affecting employees that the study
shall highlight. Several employees have been affected by interest rates, some banks have
retrenched staff and closed branches moving away from brick and mortar options for workforce
and going digital, the executive management would want to incorporate SHRM into their bank
strategy since SHRM would have looked at strategic issues surrounding employees holistically.

Academics and researchers will contribute to the body of knowledge on the effects of interest
rates on tier three performance and research gaps in the ranking industry. Consumers of the tier
three banks will benefit from the study, as they will be more informed on the available options
when selecting banks that will effectively address their needs and who have a variety of products
on offer to choose from.

1.7 SCOPE OF THE STUDY

The study will be based on the effects of interest rates on financial performance of tier three
banks; the study will be based in Kenya and shall cover a period of two months. The study will
utilize tier three banks operating in Kenya and registered with the central bank of Kenya. The
study will utilize the 23 tier three banks operating in Kenya. In view of the above , managers
,director and chief executive officers should take thorough research on the same field to ensure
that our economy continue to grow by ensuring maximization of wealth.

1.8 LIMITATIONS AND DILIMITATIONS

The study shall fully depend on the utilization of secondary data, which is not reliable as
compared to primary data and due to inadequate funds and time that will be required to collect
actual data from the field. The researchers will be required to source material information from
various libraries and this may take time and resources to access that information.

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The study shall make good use of secondary data that is easier and cheaper to acquire as
compared to primary data. The researchers have adequate knowledge in finance.

CHAPTER TWO

LITERATURE REVIEW

2.1 INTRODUCTION

This chapter presents the literature on various theories that further define the relationship
existing

between interest rates and financial performance of tier three banks in Kenya. It also

brings together and summarize other researchers’ work in the other fields of the study.

It specifies the objectives, methodologies and findings of other researchers. Finally, it gives a

Summary on the theoretical and empirical relationship of the variables while also outlining the

research gaps in past studies done by other researchers.

2.2 THEORITICAL FRAMEWORK.

2.2.1 Liquidity Preference Theory

Liquidity preference theory was developed by Maynard Keynes in his book General theory in
1936. The theory is based on the assumption that people hold money for three motives:
transactionary motive: precautionary motive and speculative motive. The theory states that one
needs money because one has expenditure plans to finance, or is speculating on the future path of
interest rates, or finally, because one is uncertain about what the future holds so it’s advisable to
hold some fraction of ones resources in the form of pure purchasing power.

According to the theory, interest rate was the reward for parting with liquidity (Lekachman &
Keynes, 1964). Keynes argued that other things held constant people prefer to hold cash. The
theory suggest that interest rate changes with changes in money demand and money supply. The
money supply is fixed by the central bank and therefore the quantity of money does not depend

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on interest rates. The theory states that there is one interest rate called equilibrium interest rate at
which the quantity of money demanded equal to the quantity of money supplied.

Were and Wambua (2014) urged that the liquidity preference theory of interest suffers from a
fallacy of mutual determination. Keynes argued that the interest rates is determined by liquidity
preference. However, Keynes treats the rate of interest being determined by the liquidity
preference. Therefore, Keynesian treat the rate of interest not as they believe they do so as
determined by liquidity preference but rather as some sort of mysterious and unexplained force
imposing itself on the elements of economic system.

In relevance to the study, the theory views interest rates as being mainly driven by the liquidity
level in the economy. The theory does not recognize the role of macroeconomic policies
formulated by the central bank but interest rates are purely driven by the demand of money in the
economy. Therefore, interest rates will go up and down according to the level of liquidity in the
economy and preference for the liquidity by the users of funds.

2.2.2 Loan-able Funds Theory.

Froyen (1996) first developed loan-able funds theory. The theory is an attempt to improve upon
classical theory of interest rates. The theory assumes that interest rates are determined by supply
of loan-able funds and demand for credit. It recognizes that money can play a disturbing role in
the saving and investment process and thereby cause variations in the level of income. The
determination of interest rate in case of loan-able funds theory of the rate of interest depend
essentially on the availability of loan amount. The availability of such loan amounts is based on
certain factors like the net increase in currency deposit, the savings made willingness to enhance
cash balances and opportunities for the formation of fresh capital. The loan-able funds theory
breaks down both monetary and non-monetary aspects of interest rate. (Wensheng, Wung and
Shu, 2002).

According to Fixler & Zieschang (1998), loan-able funds theory is a dynamic and optimizing
theory of the bank operation that combines insights of production theory, portfolio theories and
financial inter-mediation. This model clarifies the relationship between the risk of asset
portfolios and a banks output of services. Portfolio risks determines the rate of returns on loans

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and the bank’s borrowed funds and the discount used to drive the present value of future profits
generated by bank services. The quantity of the service output is affected by risks that have
different portfolios risks hence different amounts of information processing. Furthermore, the
model shows that the loan-able funds are merely an intermediate input that passes through banks,
whereas true bank value added is the only services facilitating the provision of funds. The model
also establishes the difference between the use of funds and production functions of value added
in a bank’s overall optimization problem.

According to this theory, the rate of interest rate is the price that equates the demand for and
supply of loan-able funds. At the equilibrium level where the demand equals to supply of loan-
able funds, savers and investors are the happiest possible. Changes in the rate of interest arise
from variation either in demand for loan or in the supply of loans or credit funds available for
lending. According to Ngugi (2001), interest rates is the price that equates the demand for loan-
able funds with the supply for loan-able funds.

The relevance of the theory to the study is that, in loan-able funds theory of interests the nominal
rate is determined by the interaction between the demand and supply of loan-able funds. At the
same level of supply, an increase in the demand for loan-able funds would lead to an increase in
the interest and vice versa. In addition, an increase in the supply of loan-able funds would lead to
a fall in the rate but only if both the supply and demand of the loan-able funds changes. The
result would depend much on the magnitude and direction of movement of the demand and
supply of loan-able funds.

2.2.3 Efficiency Theory.

Demsentz (1973), to compliment systems theory, formulated this theory. The theory states that,
superior management and scale efficiency results to higher absorption leading to greater and
higher profits. Thus, management efficiency may not only increase profits for a business
organization, but also results to a gain in a larger market share and improved market
concentration (Athanasoglou, Brissimis & Delis, 2005). This theory explains that attaining
improved profit margins results from efficiency, which allows banks to obtain both good
financial performance and improved market shares (Mirzlei, 2012). Efficiency theory
presupposes that profitability and high intensification results from efficient cost management

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practices and better management strategies across the organization (Fisseha, 2015). Thus,
efficient firms in the market are seen to increase in their market share and organically grow the
size their firm through aggressive operational and management technique (Barhanu, 2012).

According to Onuong’a (2014), efficiency theory is premised on the argument that banks attain
profits if they operate more efficient than their competitors do. It also assumes that internal
efficiencies influence profitability of commercial banks (Obumuyi, 2013). The theory further
postulates that banks that operate efficiently in comparison to their competitors increase their
profits due to low operating costs. According to Mensi & Zouari (2010), the efficiency
hypothesis prevails when a positive significant correlation exist between profitability and the
market share.

The theory is of much relevance to our study as it shows that, with increased efficiency in bank
operations, high profit margins can be realized and hence a good financial performance with
improved market share. However, this can only be accomplished if banks operate efficiently
better than their competitors.

2.3 EMPIRICAL FRAMEWORK.

2.3.1 Lending rates and financial performance of tier three banks.

Kirimi (2015) sought to determine the effects of interest rate on financial performance of
commercial banks in Kenya. He used descriptive research design to analyze all 43 registered
commercial banks in Kenya. He found out that lending rates have a positive impact on
performance of commercial banks thus, commercial banks need to evaluate their lending rates
and management efficiency need to be increased as a recommendation.

Using regression analysis, Okoye & Onyekachi 2013, a study conducted on lending money
banks in Nigeria on impact of banks’ lending rates on performance. It was concluded that
lending interest rates have an impact on performance. Recommendation of the study is that,
lending rate policy needs to be strengthened to improve their performance.

Ngure (2014) investigated the effect of interest rates volatility on the performance of
commercial banks in Kenya. The study found that interest rates have significant linear positive
effect on financial performance of commercial banks in Kenya. Further, the study concluded

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that bank size and interest rate volatility had an effect on profitability of commercial banks.
The study recommended policies be put in place to shield bank lending rates and ensure
monitoring the same. To cushion consumers from exploitation by commercial banks, the study
recommended that the Central Bank of Kenya exercise its monitoring roles strictly and
discipline any commercial banks that may be increasing the interest rates arbitrary to boost
their profitability.

Okech 2013 undertook a study on effect on lending rates on performance of commercial banks in
Kenya. The study found out that there is a weak positive relationship between lending rates and
performance since interest rates accounted for only 14.4% of the revenue. Study recommended
for income source diversification.

2.3.2 Deposit rates and financial performance of tier three banks.

Wambari & Mwangi 2017, investigated on impacts of interest rates on performance of

commercial banks using explanatory research design and multiple regression analysis. He
concluded that deposit rates have a negative impact on performance of commercial banks. As a
recommendation for the study, banks need to monitor carefully their deposit rates.

Mwangi 2014 strive to establish whether there was a relationship between deposits rates and
financial performance on deposit taking institutions in Kenya. Using regression analysis, he
established a negative relationship.

Omuondo 2003 found out that the face of inter-mediation in the financial sector is changing.
Banks take money from depositors and pass to borrowers and since borrowers are not willing to
top up anymore, banks are bringing down deposit rates continuously. The study found out there
is a negative impact on performance of commercial banks.

Okun (2012) studied the effects of level of deposit rates and financial performance of
commercial banks in Kenya. He found out that there is a positive and significant relationship
between customer deposits ratio and performance. Following the study, he recommended that
commercial banks in Kenya should invest in attracting more low cost deposit by adopting other
banking channels innovation, e.g. agency banking to attract deposits at lowest cost possible.

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2.3.3 Central Banks Rates and financial performance of tier three banks.

Using a regression research design to find out the relationship of central bank rates and
commercial bank performance (Bennaceur & Goaied, 2008), the research found that central bank
of Kenya use tools to control amount of money to control inflation by either increasing the rate
to control amount of money or during deferential, and thus banks are affected differently as
different banks reacts differently to changes of central bank rates.

According to Mungai, 2013, to investigate the role of central bank rate effects on performance of
commercial banks. The study found that taking all factors constant (central bank rates) at zero,
commercial banks profitability in Kenya would be 1.147. The study recommends that bank
management should invest in economic research to predict changes in the economy so that they
are prepared for any changing trends in the market that negatively impacts on banks profitability.

Langat 2013, while studying the effect of interest rate on performance of banking sector found
out that central bank rate affects the performance of commercial banks through central bank
regulation and macroeconomic variables.

Waweru (2013) conducted a study on effects of monetary policy on commercial banks financial
performance in Kenya. The study focused on central banks base rate and financial performance.
The results of the study indicates that the average base rate of central banks of Kenya i.e. central
banks base rate has a significant effect on the Kenyan commercial banks financial performance.

2.3.4 Short Term Rates and financial performance of tier three banks.

Nampewo 2013 studied the determinants of interest rates on banking sector in Uganda using time
series data. The study applies an eagle and granger two-step procedure to test for co-integration
between bank rates and tertiary bills. The results showed treasury bills have positive impacts on
the performance of commercial banks.

Ngugi (2001), on her study on interest rates on financial performance, she found out that fiscal
policy action saw an increase in treasury bill rates and high inflationary pressure that called for
monetary policy tightening. As a result, banks increased their lending rates but they reluctant to
reduce the lending rates when the treasury bills rates came down because of declining income

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from assets. Using monthly data for the study period, he recommended for tightening of
monetary policy.

Federal Reserve Bank of San Francisco (2005), a study on attractiveness of treasury bills to
investors. He found out that a risk averse investor would always opt for treasury bills than other
securities whenever treasury bills offer higher returns. This is because as demand on treasury
bills increase, interest rates will always goes down. When financial institutions purchase treasury
bills the amount of money available for private investment and development is curtailed and is
expensive.

Robinsons (1985) established that bank stock returns appeared to be more negatively correlated
with unanticipated short-term interest rate. He concluded that bank market values were more
sensitive to changes in interest rate in the long run than in the short run.

2.4 RESEARCH GAPS

According to Manyuanda (2014), the effects of nonperforming loans on the financial

performance of SACCO’S in Nairobi County had a negative and significant effect on
performance. This study focused on Sacco’s in Nairobi County and did not look at the tier three
commercial banks in Kenya.

According to Ibe (2013), the effect of liquidity management on the profitability of commercial
banks in Nigeria whereby cash and short term funds had a negative effect on the profitability
while bank balances an treasury bills were found to have a negative and insignificant effect. This
study focused majorly on the largest banks in Nigeria. This study will seek to provide answers
about the effects of tier three banks in Kenya.

The effects of capital structure on the financial performance of listed cement manufacturing
companies in Kenya where it was established that the capital structure had an influence on
financial performance although not exclusively. This study focused on listed cement companies
in Kenya and it will fill the research gaps on tier three commercial banks in Kenya (Kihumba,
2013).

According to Edson (2015), the effects of financial leverage and commercial banks profitability
in Tanzania where anova analysis indicated that, the effect of financial leverage on return on

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asset average and return on average equity was negative and statistically insignificant at the1 5%
confidence level. The findings of Edson (2015) are in consistent with those of Kariuki (2014).
This study will focus on tier three commercial banks in Kenya

According to Kariuki (2013), the study established that financial distress has a significant and
negative effect on the financial performance of commercial banks selected for the study. It
measured the financial distress using the Altman Z-score model; this study will measure
financial distress using non-performing loans, liquidity and leverage. Kariuki focused on all
commercial banks in Kenya, these would have given skewed results given that smaller banks are
more susceptible to financial distress.

Enekwe, Agu & Nnagbogu (2014), the effects of financial leverage on financial performance of
pharmaceutical companies in Nigeria, the results of the regression analysis indicated that the
effects of DR and DER on ROA was negative and statistically insignificant while ICR had a
positive and statistically insignificant effect of the ROA. The regression model only explained
16.4% variation in performance. This study has increased the variables to include non-
performing loans and liquidity to better understand the effects of financial performance on tier
three banks in Kenya.

Ibrahim (2017), the impact of liquidity of profitability in the banking sector of Iraq, the study
found out that the effect of liquidity on profitability was positive and significant; these results are
inconsistent with theoretical literature, which finds that liquidity has a negative effect on
profitability. This research will seek to determine if this relationship holds in tier three banks in
Kenya.

Otuori (2013) investigated the determinant factor of exchange rates and their effects on the
performance of commercial banks in Kenya. The study found out that exports and imports
interest rates, inflation and exchange rates were all highly correlated. By manipulating interest
rates, central bank could exert influence over both inflation and exchange rates and exchanging
interest rates impact inflation and currency. Higher interest rates offered lenders in an economy a
higher return relative to other countries, which attract foreign capital and cause the exchange rate
to rise.

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2.5 CONCEPTUAL FRAMEWORK

INDIPENDENT VARIABLES DEPENDENT VARIABLE

Source; Researchers (2019)

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Conceptualization

The central banks rates are rates at which borrowings are effected between central banks and tier
three banks. The central rates are composed of inter-bank rates and government Treasury bill
rates. The short-term rates are rates at which borrowings are effected between financial
institutions or the rate at which short-term government paper is issued or traded in the market.
They consist of; general government deficits, general government revenue, inflation and gross
domestic product. The lending rates are composed of expectation of central bank rate cut and
domestic macroeconomic condition. The deposit rate are determined by factors such as liquidity,
bank capital, operation efficiency and market power. The central bank rate, short-term rates,
lending rates and deposit rates affects the performance of tire three banks in terms of
profitability, return on investment and return on equity.

2.6 CONCLUSION

From the above empirical reviews, it is clear that numerous work have been done on effects of
interest rates on financial performance commercial banks in Kenya. There is still a gap that exists
with regard to empirical review that this study were done. As such there is need to carry out a
study on interest rates in tier three banks in Kenya in order to come up with findings that will
add value to the field of academic research in Kenya. This study will seek to bridge that existing
gap.

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 CHAPTER THREE

RESEARCH METHODOLOGY

3.1 INTRODUCTION

This chapter presents research methodology that will be used to conduct the study and the
various stages and phases that will be followed in completing study. It covers the research
design, target population, sampling techniques, data collection methods, data analysis techniques
and ethical considerations in order to produce the desired information of the study.

3.2 RESEARCH DESIGN.

According to Bachman & Schutt (2016), research design refers to the approach to be used to
bring together the different components of the study in a logical and coherent manner, in order to
ensure that the objectives of the study are met. Research design outlines how the research will be
undertaken. It specifies the, methods and procedures that will be used to collect and analyze data
Borg (2007).

The study will use descriptive research design; descriptive research describes data and
characteristic about population of the phenomenon being studied. Descriptive study are more
formalized and typically structured with clearly stated hypothesis or investigative questions
Coopers & Schindler (2004).

3.3 TARGET POPULATION.

According to Ngechu (2004), a population is a well-defined set of people, services, elements,

group of things or households that are being investigated. The target population of the study will
be the 23 tier three banks in Kenya which are registered, and have in operation from 2010-2018
and licensed to carry out banking activities in Kenya under the banking act Cap-488.

3.4 SAMPLING TECHNIQUES.

A sample is a small number of the population that is used to make conclusions regarding the
whole population, Mugenda & Mugenda (2009). This study will used census sampling where all
the 23 tier three commercial banks in Kenya of will be used for analysis. This technique is

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preferred because the study population is small thus making it possible to collect data. In
addition, census eliminates accuracy problems associated with the sampling.

3.5 DATA COLLECTION.

Mugenda & Mugenda (2003) acknowledged there are two types of data i.e. primary and
secondary data. Primary data refers to information that is gathered from the field while
secondary data refers to information obtained from articles, published work and casual
interviews.

Data that will be utilized in this study is secondary data, which is collected from a number of
sources such as central of Kenya reports, financial statements of commercial banks and
published journals and business articles from 2010 to 2018 regarding banking sector
performance as well as prevailing lending interest rates from commercial banks. The study will
cover 23 tier three banks in Kenya for the period between 2010 and 2018.

3.6 DATA ANALYSIS.

Bogdan & Biklen (2003) argued that data analysis involves working with the data, organizing
them, breaking them in manageable units, coding them, synthesizing them and searching for
patterns. The collected data will be coded and entered in the statistical package for social
sciences and then will be summarized using statistical methods that are descriptive like the mean,
standard deviation, skewness and kurtosis. Additionally, correlation will be used to establish the
degree of relationship among the variables and multiple linear regression model will be used to
establish the association between the dependent and independent variables.

The model will be expressed as;

Y=β0+ β1χ1+β2χ2+β3χ3+β4χ4+£…….

Whereby;

Y denotes financial performance of tier three banks.

β0 denotes constant variable that will lead to financial performance regardless of interest rates

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β1, β2, β3, β4 denotes regression coefficients which indicates rate of change of the dependent
variable as a function of the independent variable.

χ1 - central banks rates

χ2 - deposit rates

χ3 -lending rates

χ4 - short-term rates

£ - error term

3.7 ETHICAL CONSIDERATIONS

Ethics refers to a set of principles of right and wrong behavior guiding a specific culture, society,
group or individuals. The research will uphold professional ethics and ensure that there is no
falsification of data and therefore promote knowledge, which is the most important goal of this
research. The research will ensure collaborative work since there is mutual respect among the
researchers and observe accountability. It is hopeful that in increasing the validity of the research
we shall be aware of one own values and biasness in active engagement which will help to
achieve the aim of the entire research proposal and providing opportunity for tier three banks to
improve the quality of its programs.

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