Effects of interest and exchange rates on bank stock returns. Evidence from Kenya

Banks are believed to be more sensitive to interest rates risk because of a mismatch of maturities between assets and liabilities (Lloyd and Shick 1977, Faff and Howard 1999 and Kasman et al 2011). Faff et al (1999) stated that banks are more sensitive to interest rates because interest rates are directly fed into input costs, the operating margin and the demand for services by customers. Globalisation is another factor that increases exposure to interest rate risk (Kutty 2010, Choi et al 1992, Atindehou and Gueyie 2001, Kurman 2014 and Kasman et al 2011).

Empirical literature document mixed evidences on the effect of interest rate (IR) on bank stock returns (Lynge and Zumwalt, 1980; Lloyd and Shick 1977; Sweeney and Warga, 1986; Kane and Unal, 1988 and Faff et al, 1999). In the context of developed countries some studies have attributed the relationship between IR and bank stock returns (BSR) on economic policies like deregulation (Flannery and James 1984 and Faff et al 1999). Empirical literature on the relationship between foreign exchange rates (FX) and BSR were reported as negative (Choi et al, 1992 and AtindeÂhou and Gueyie, 2001). Recent studies state that BSR are becoming less sensitive to interest rate and exchange rate risk due to improved risk mitigation strategies such as IR derivative markets and expansion of corporate bond markets (Alam and Uddin, 2009; Mayo et al 2013 and Kurman 2014). Kurman (2014) found that European bank returns were less sensitive to changes in interest rate risk as opposed to bank stock return in the US market. However this risk declined over time due to improved risk management methods such as use of derivatives. Kurman (2014) also documented that US banks were more sensitive to FX risk as opposed to European banks for the whole sample period. However the sensitivity of bank stock returns to FX was reported to be insignificant only after introduction of the Euro in the late 90’s (Kurman, 2014 and Francis and Hunter, 2004). This was attributed to counterparty risk the banks were exposed due to hedging through currency swaps.

In the context of developing countries, Kasman et al (2011) and Alam and Uddin (2009) found that banks were exposed to IR and FX risks due to lack of mitigation techniques in these countries. Hooy et al (2004) showed that during the post-crisis period IR and FX had a significant relationship with BSR accrediting this to unsystematic risk due to Government policies such as mandatory consolidation programs for all large banks. Uddin and Alam (2007) and Mukit (2012) found a negative and significant relationship between IR and BSR and positive and significant relationship between FX and BSR in the context of Asian market. Similar evidence was also obtained by Kutty (2010) in the context of Mexican economy. Kurman (2014) documented a negative relationship between interest rates and bank stock returns. Overall the empirical studies from both developed and developing countries provide mixed evidences on the effects of IR and FX on BSR. In addition very few studies are based on developing countries.

Since 2000, Kenya has witnessed significant FDI from several countries. For instance, China has embarked on roughly 65 projects ranging from $108 million in Kenya. For example the construction of the North and East Ring Road sections in Nairobi and the Kenyatta University Teaching, Research and Referral Hospital (Strange et al, 2013). This also makes this research timely to investigate the relationship between Kenyan bank stock returns and interest rates and foreign exchange rates.

This research is motivated by the Portfolio Adjustment Approach theory which states that bank stock returns are positively related to exchange risk (Kutty 2010 and Tabak 2006). This theory also documents that that cash flow of foreign capital is dependent on stock prices. Higher stock prices lead to an inward flow of foreign capital into the economy and vice versa. When the latter occurs, there is a decline in demand for money that then leads to a reduction of interest rates in an effort to increase the demand. As a result foreign country investment increases to take advantage of lower interest rates consequently leading to depreciation of the local currency.

The key contributions of this research are the following: This is the first research in Kenyan context to empirically examine effects of both interest and exchange rates on bank stock returns. This is also the first research to examine this relationship during the 2007-2008 election violence period.