The relationship between interest rate risk and net interest income of commercial banks quoted at the Nairobi Stock Exchange

Abstract

Changes in banks' competitive environment, products, and services have heightened the importance of prudent interest rate risk management. Historically, the interest rate environment for banks has been fairly stable. More recently, interest rates have become more volatile, and banks have arguably become more exposed to such volatility because of the changing character of their liabilities. Each year, the financial products offered and purchased by banks become more various and complex and many of these products pose risk to the banks. Many commercial banks have increased their holdings of long-term assets and liabilities, whose values are more sensitive to interest rate changes. Such changes mean that managing interest rate risk is far more important and complex than it has been in the past. This study set out to determine the relationship between interest rate risk and net interest income of commercial banks in Kenya. Net interest income observed for 5-year period was regressed against interest rate risk in each year. Interest rate risk was measured as the interest rate sensitivity gap between assets and liabilities maturing/repricing in time bands of less than three months, between three and twelve months and maturities in periods above one year. These three categories formed the independent variables for use in the study. The study found that there is a strong direct relationship between interest rate risk and net interest income of commercial banks. Specifically, interest rate sensitivity gap movements account for 58.0% of variations in net interest income. Each of the three categories of interest rate sensitivity gap was found to positively contribute to net interest income. A unit increase in short term sensitivity gap (maturities in less than three months) results in 0.141 units increase in net interest income, while a unit increase in medium term sensitivity gap (maturities in between three and twelve months) results in 0.426 units increase net interest income. The study also found that a unit increase in long term sensitivity gap (maturities in periods above one year) results in 0.176 units increase in net interest income. These results imply that proper interest rate risk management not only reduces a bank's exposure to the risk, but it also provides banks with an opportunity to stabilize and improve their net interest income. Overall, net interest income is increased by maintaining high positive medium term sensitivity gaps in an increasing interest rate environment and low negative medium term sensitivity gaps in a declining interest rate environment.