Financial risk management and bank profitability in South African banks.

Abstract

This study examined the connection between financial risk management and banks’ profitability in a South African context. The relationship was segmented into three major financial risks; credit risk, liquidity risk and market risk. Theory assumes risk to have a negative relationship with profitability; however, some studies have proved otherwise. This study used top five banks in South Africa over a10-year period spanning 2006 to 2015 and employed Fixed Effect Model based on the Hausman Test to estimate the relationship between credit, liquidity and market risk with profitability measure return on equity. “The credit risk indicators (independent variables) employed in this study are non-performing loans to total loans, and loans and advances to total deposit. Two control variables leverage ratio and logarithm of total asset as proxy for firm size were also used. All variables were regressed against ROE as a profitability measure (dependent variable). The findings indicate a significant relationship between profitability and non-performing loans, and leverage ratio at 1%, loans and advances to total deposit at 5%; while firm size (log total assets) is significant at 10% significance level. The liquidity risk indicators (independent variables) employed are loans and advances to total deposit, non-performing loans to total loans, LOG(total assets), market capitalisation to total assets, non-deposit dependence/external finance, equity to total assets. Control variables are non-performing loans, firm size (log total assets), GDP growth rate, and ratio of financing gap. The findings indicate that loans and advances to total deposit, non-performing loans, market capitalisation to total assets, and non-deposit dependence are significant at 1% significance level, firm size (log total assets), at 5% ; while equity to total assets, GDP growth and ratio of financing gap are insignificant. The market risk indicators (independent variables) employed with three main variables are market capitalisation (log stock) to proxy equity risk, exchange rate to proxy foreign exchange risk, and lending interest rate to proxy interest rate risk. Three control variables were employed; inflation rate, GDP and monetary supply (M3). The findings show market capitalisation (log stock) is significant at 1%, exchange rate and GDP are significant at 10% significance level. An insignificant and negative relationship with lending interest rate was found. With the control variables, the findings showed that there is an insignificant and positive relationship between inflation rate and return on equity and a negative relationship between GDP and return on equity. The results are in conflict with the expected sign. The study suggests that, with regards to credit risk, banks in South Africa should enhance their capacity in credit analysis and loan administration while the regulatory authorities should pay more attention to banks’ compliance to relevant regulatory requirements by the Basel Committee on Banking Supervision, put more effort in attracting deposits as they are a major determinant of liquidity followed by external funding liability and seek for effective hedging strategies to deal with the market risk volatilities.