Risk Management on the Profitability of Financial Institutions;
RISK MANAGEMENT ON THE PROFITABILITY OF FINANCIAL INSTITUTIONS;
A CASE OF STANBIC BANK UGANDA.
BY
TUSIIME JUDITH
07/U/15660/EXT
SUPERVISOR:
MR NZIBONERA ERIC
A RESEARCH REPORT SUBMIITED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF A BACHELORS DEGREE IN COMMERCE OF MAKERERE UNIVERSITY
JUNE 2011
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DECLARATION
I, hereby declare that this research report is my own work and has not been produced by any previous researcher for any academic purposes.
TUSIIME JUDITH
Date………………………………………………Signature……………………………….
APPROVAL
This work has been submitted with my approval as a University Supervisor
SIGNITURE………………………………
MR. NZIBONERA ERIC
DATE…………………………………..
DEDICATION
This dissertation is dedicated to my Father Arinaitwe Emmanuel who has frequently told me as a growing woman that “with hard work you can accomplish anything and become what you desire.”
Also, I dedicate this work to my Mother Nkundeki Jesca. Her word of encouragement and prayers has remained lingering in my mind and has helped me succeed. I also dedicate this work to my friends Pastor Alex, Sarah, Dorothy, Deo, Godwin, Palmer and Allen who were there for me encouraging me when things were tough, I say this, “God is able”.
Also to my beloved Brothers Alex Nelson and Derrick of which their words of encouragement and support kept me strong all through, thank you indeed. Lastly to my dear Sisters Stella, Victor, Mercy, Juliana, Cindy God bless you all.
ACKNOWLEDGEMENT
My first appreciation and thanks go to the Almighty God who has given me the life and strength to accomplish this academic work. With special thanks, I would like to extend my appreciation to my Supervisor Mr. Nzibonera Eric for giving me his valuable time and technical guidance while working on the document. To all who stood by me and supported me during my studies, God bless you all.
TABLE OF CONTENTS PAGE
DECLARATION
APPROVAL
DEDICATION
ACKNOWLEDGEMENT
ABSTRACT
CHAPTER ONE
GENERAL INTRODUCTION
1.0 Introduction
1.1 Background of the study
1.2 Problem statement
1.3 Purpose of the study
1.4 Objectives of the study
1.5 Research questions
1.6 Scope of study
1.7 Significance of study
CHAPTER TWO
LITERATURE REVIEW
2.0 Introduction
2.1 Risk management defined
2.3 Risk management techniques
2.4 Profitability indicators in a bank
2.5 Relationship between risk management and profitability
CHAPTER THREE
METHODOLOGY
3.0 Introduction
3.1 Research design
3.2 Population
3.3 Sample size
3.4 Sampling procedure
3.5 Research Instruments
3.5 Data sources
3.6 Data presentation and analysis
3.7 Procedure
4.2 Techniques of risk management in Stanbic bank-Wandegeya branch
4.3 Indicators of profitability in Stanbic bank
4.4 Risk management and profitability in Stanbic bank
5.4 Relationship between risk management and profitability in Stanbic bank-Wandegeya branch.
CHAPTER FIVE
SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS
5.1 Introduction
5.2 Risk management techniques
5.3 Profitability indicators
5.4 Relationship between risk management and profitability in Stanbic bank-Wandegeya branch.
5.5 Conclusion
5.6 Recommendations
REFERENCES
QUESTIONNAIRE
INTRODUTORY LETTER………………………………….…………………………………..38
LIST OF TABLES
Table 1: Category of respondents
Table 2: Sex of respondent
Table 3: Age of respondent
Table 4: Marital status
Table 5: Level of qualification
Table 6: Experience of the employee in Stanbic bank
Table 7: Rating the risk management in stanbic bank
Table 8: Techniques of risk management used in the bank
Table 9: Rating the level of profitability in the stanbic bank
Table 10: Stanbic bank experiencing increased profitability
Table 11: Reporting revenue in Stanbic bank
Table 12: Indicators of profitability in Stanbic bank
Table 13: Relationship between risk management and profitability in Stanbic bank
Table 14: Correlation analysis showing the relationship between the risk management and profitability in Stanbic bank.
ABSTRACT
The purpose of the study was to establish the effect of risk management on profitability in Stanbic bank-Wandegeya branch and the objectives were to evaluate the techniques of risk management used in financial institutions, to establish the profitability indicators of financial institutions and to establish the relationship between risk management and profitability in financial institutions.
This study was a case study design. Case studies have the advantage of providing manageable study area which is representative of other similar areas. The researcher employed both quantitative and qualitative research methods. The population was 77 employees who are both staff and administrators and a sample was 60 respondents who were selected through simple and purposive sampling techniques. A questionnaire is a series of questions asked to individuals to obtain statistically useful information about a given topic. Data from the field was sorted, coded and entered in Statistical Package for Social Scientists (SPSS) which was used to establish the relationship between risk management and profitability. Data from questionnaires was presented in form of frequency tables, pie charts and bar graphs.
Basing on the study findings therefore, it is evident that risk management is positively related with the level of profitability in Stanbic bank. This is so because most of the statements regarding the effect of risk management on profitability were scored positively by the participants in the study. The researcher recommended that banks need to always identify their legal risk profile and target these hot spots earlier not to be caught off guard. Determining the legal risk profile allows your company to target training and cultivate legal literacy where it is needed most. It helps you create a prioritized agenda. If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of losses that are not likely to occur. There is need to employ enterprise risk management in banks because risks are possible events or circumstances that can have negative influences on the enterprise in question.
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CHAPTER ONE
GENERAL INTRODUCTION
1.0 Introduction
This chapter gives the details of the background, problem statement, purpose, objectives, research questions, significance and the scope of the study.
1.1 Background of the study
Risk management is simply a practice of systematically selecting cost effective approaches for minimising the effect of threat realisation to the organisation. All risks can be never fully avoided or mitigated simply because of financial and practical limitations (Moteff John, 2005).
According to Hubbard (2009), risk management is defined as the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary. The strategies to manage risk include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk.
The risk management plan should propose applicable and effective security controls for managing risks. A good risk management plan should contain a schedule for control implementation and responsible persons for those actions (Edward, 2005) and should also select appropriate controls or countermeasures to measure each risk. Risk mitigation needs to be approved by the appropriate level of management in order to increase profitability in a company. For example, a risk concerning the image of the organization should have top management decision behind.
Profitability refers to the positive gain from an investment or business operation after subtracting for all expenses opposite of loss (Proimos, 2009). Profitability on a company is the difference between the income of the business and all its costs/expenses. A business that does not make profits will fail, potentially affecting employees, suppliers and the local community because their overall operations depend on profits.
Profitability is the measure of the overall success of a company. It is a necessary coordination for survival. Investors could prefer a single measure of profitability that would be meaningful in all situations. Test of profitability focuses on measuring the adequacy if income by comparing it with one or more primary activity that are measured in the financial statements (Sheffrin, 2003).
Effective risk management system will minimize the complexities involved in planning, executing and controlling overall running of a business which is critical to success and this maximizes profitability in a business. A customer is happy and secure when he/she invests in a risk free business and wants to be equally happy on each further occasion.Therefore, risk management and profitability are closely related aspects and need to be handled with extra emphasis if a business is to hit high profitability over a given period of time.
1.2 Problem statement
Financial institutions while undertaking risk management, prioritization process is followed whereby the risks with the greatest loss and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled in descending order
However despite all this low profitability levels have been reported in some of commercial banks. For example in the case of Stanbic bank-Wandegeya branch through the application of approaches like risk reduction, risk avoidance, risk sharing and risk retention to manage risks, low profitability has levels have been realized Stanbic bank registered 4% drop in making profit to shs. 44.7b in the first half of 2010 cmpared to Shs. 46.8b in June 2009 (unaudited financial statement 2010). This decline was attributed to lower interest income, poor risk management and the substantial decrease in yields on treasury bills had a negative impact on profitability (report by Phillip Odera, The managing director 2010) which could affect the going concern of the business. Its however for that reason which has prompted the researcher to find out whether the low profitability levels are due to inappropriate risk management techniques.
1.3 Purpose of the study
The purpose of the study was to establish the effect of risk management on profitability in Stanbic bank-Wandegeya branch.
1.4 Objectives of the study
- To evaluate the techniques of risk management used in financial institutions.
- To establish the profitability indicators of financial institutions.
- To establish the relationship between risk management and profitability in financial institutions.
1.5 Research questions
- What techniques of risk management are used in financial institutions?
- What are the indicators of profitability in financial institutions?
- What is the relationship between risk management and profitability in financial institutions?
1.6 Scope of study
Geographical scope
The study was carried out in Stanbic bank Wandegeya branch. The bank is located 4 kilometres from Kampala city along Bombo road.
Subject scope
The study specifically focused on different risk management technique and different aspects of profitability that is the revenues earned and the expenses incurred in Stanbic bank –Wandegeya branch.
Time scope
The study took a period from 2005 to 2010 to act as the reference years the purposes of this study.
1.7 Significance of study
- The study may be of help to the management of stanbic bank on how to carry out risk management in their business in order to reduce losses and increase profitability.
- The study may also act as a source of literature for other scholars who intend to carry out further research on the effect of risk management on profitability of businesses with specific reference to banking institutions.
- The study may also enable the researcher to fulfill one of the requirements for the award of the Bachelors degree in Commerce of Makerere University.
CHAPTER TWO
LITERATURE REVIEW
2.0 Introduction
This chapter presents what other scholars have written about risk management in relation to profitability of an organization and it is arranged in accordance to the objectives of the study.
2.1 Risk management defined
Risk is defined as the effect of uncertainty on objectives (whether positive or negative). Risk management is thus considered the identification, assessment, and prioritization of risks followed by strict coordinated and economical application of resources to minimize, monitor, and control the probability of unfortunate events and maximize the realization of opportunities. Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary (Hubbard Douglas, 2009).
According to Mesler (2004), risk management is simply a practice of systematically selecting cost effective approaches for minimizing the effect of threat realization to the organization and all risks can never be fully avoided or mitigated simply because of financial and practical limitations. Therefore all organizations have to accept some level of residual risks. Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Financial risk management requires identifying its sources, measuring it, and plans to address them. Financial risk management can be qualitative and quantitative. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk.
2.3 Risk management techniques
Risk avoidance
If a company wants to effectively manage risks, there is need to engage in programs of risk avoidance. The use of risk avoidance sounds obvious but most companies which fail to identify risky areas in their business in order to avoid risks associated with those areas fail to manage their risks but those which ably identify where risks are in the company, risk management can be effectively done (Deventer & Donald, 2004).
Risk reduction/optimization
Tapiero (2004) notes that risk reduction or optimization involves reducing the severity of the loss or the likelihood of the loss from occurring. Acknowledging that risks can be positive or negative, optimizing risks means finding a balance between negative risk and the benefit of the operation or activity; and between risk reduction and effort applied. Risk management through optimization can optimize risk to achieve levels of residual risk that are tolerable (Roehrig, 2006).
Use of Modern software development methodologies
Modern software development methodologies reduce risk by developing and delivering software incrementally. Early methodologies suffered from the fact that they only delivered software in the final phase of development; any problems encountered in earlier phases meant costly rework and often jeopardized the whole project. By developing iterations, software projects can limit effort wasted to a single iteration.
Outsourcing to manage risks
According to Frederick (1999), outsourcing could be an example of risk reduction if the outsourcer can demonstrate higher capability at managing or reducing risks. For example, a company may outsource only its software development, the manufacturing of hard goods or customer support needs to another company, while handling the business management itself. This way, the company can concentrate more on business development without having to worry as much about the manufacturing process, managing the development team, or finding a physical location for a call center.
Risk transfer
The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that you can transfer a risk to a third party through insurance or outsourcing. In practice if the insurance company or contractor go bankrupt or end up in court, the original risk is likely to still revert to the first party. As such in the terminology of practitioners and scholars alike, the purchase of an insurance contract is often described as a "transfer of risk." However, technically speaking, the buyer of the contract generally retains legal responsibility for the losses "transferred", meaning that insurance may be described more accurately as a post-event compensatory mechanism. For example, a personal injuries insurance policy does not transfer the risk of a car accident to the insurance company. The risk still lays with the policy holder namely the person who has been in the accident. The insurance policy simply provides that if an accident (the event) occurs involving the policy holder then some compensation may be payable to the policy holder that is commensurate to the suffering/damage (Dorfman & Mark, 2007).
Risk retention
According to Englewood Cliffs (2007), risk retention pools are technically retaining the risk for the group, but spreading it over the whole group involves transfer among individual members of the group. This is different from traditional insurance, in that no premium is exchanged between members of the group up front, but instead losses are assessed to all members of the group. Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible.
2.4 Profitability indicators in a bank
According to Kaplan (2001), the profitability ratios are used to measure how well a business is performing in terms of profit. The profitability ratios are considered to be the basic bank financial ratios. In other words, the profitability ratios give the various scales to measure the success of the firm. The profitability ratios can also be defined as the financial measurement that evaluates the capacity of a business to produce yield against the expenses and costs of business over a particular time period.
Profitability is the first concern of all businesses. Profit and Loss risk management is at the top of every executive's list. Quality and compliance/legal liability risk management are also important concerns. No longer is it necessary to have separate, often conflicting and expensive systems to meet these needs (Conroy, 2005).
Quite often a very small percentage of the firm’s best customers will account for a large portion of firm profit. Although this is a natural consequence of variability in profitability across customers, firms benefit from knowing exactly who the best customer are and how much they contribute to firm profit. At the other end of the distribution, firms sometimes find that their worst customers actually cost more to serve than the revenue they deliver. These unprofitable customers actually detract from overall firm profitability. The firm would be better off if they had never acquired these customers in the first place (Helgesen, 1999).