CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

In the epicenter of the modern financial theory we have important ideas that are relevant for managers planning risk management strategies. One such overriding idea is that investors require higher returns to take on higher levels of risk. Investors therefore require risk premium for the risk that they cannot eliminate through diversification. Risk taking is therefore an inherent element of banking and, indeed, profits are in part the reward for successful risk taking in business. Risk is defined as anything that can create hindrances in the way of achievement of certain objectives. It can be because of either internal factors or external factors, depending upon the type of risk that exists within a particular situation. Risk may be often referred as the systematic or unsystematic risk. Systematic risk also referred as un-diversifiable risk or market risk is the risk that is inherent to the entire market or market segment. Unsystematic risk also known as diversifiable risk is the risk which is specific to a firm. Diversifiable risk can be managed through appropriate diversification. The term financial risk may be used like an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Jorion and Khoury (1996) say that financial risk arises from possible losses in financial markets due to movements in financial variables. It is usually associated with leverage with the risk that obligations and liabilities cannot be met with current assets. Our focus in this study will use the term financial risks to broadly cover credit risk, market (price) risk, interest rate risk, liquidity risk and foreign exchange rate risk. Managing risk is one of the basic tasks to be done, once it has been identified and known. The risk and return are directly related to each other, which means that increasing one will subsequently increase the other and vice versa. The financial risk has three components based

In the epicenter of the modern financial theory we have important ideas that are relevant for managers planning risk management strategies. One such overriding idea is that investors require higher returns to take on higher levels of risk. Investors therefore require risk premium for the risk that they cannot eliminate through diversification. Risk taking is therefore an inherent element of banking and, indeed, profits are in part the reward for successful risk taking in business. Risk is defined as anything that can create hindrances in the way of achievement of certain objectives. It can be because of either internal factors or external factors, depending upon the type of risk that exists within a particular situation. Risk may be often referred as the systematic or unsystematic risk. Systematic risk also referred as un-diversifiable risk or market risk is the risk that is inherent to the entire market or market segment. Unsystematic risk also known as diversifiable risk is the risk which is specific to a firm. Diversifiable risk can be managed through appropriate diversification. The term financial risk may be used like an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Jorion and Khoury (1996) say that financial risk arises from possible losses in financial markets due to movements in financial variables. It is usually associated with leverage with the risk that obligations and liabilities cannot be met with current assets. Our focus in this study will use the term financial risks to broadly cover credit risk, market (price) risk, interest rate risk, liquidity risk and foreign exchange rate risk. Managing risk is one of the basic tasks to be done, once it has been identified and known. The risk and return are directly related to each other, which means that increasing one will subsequently increase the other and vice versa. The financial risk has three components based

(2014). However, Ramlall (2009) in a study on Taiwanese banking firms using the quarterly categorized financial data of 31 local commercial banks, found a negative impact for real interest rate on bank profitability. Starting with credit risk, Athanasoglou et al. (2008), on bank-specific, industry-specific and macroeconomic determinants of bank profitability used the GMM technique for a panel of Greek banks covering the period from 1985 to 2001. They found that financial risk in the form of credit risk is a bank specific factor, and that credit risk negatively affects the performance of conventional banks. In addition, Tafri et al. (2009), in their examination of the impact of financial risks on the profitability of Malaysian commercial banks for the period of 1996-2005, using panel data regression analysis of generalized least squares, showed that credit risk has a negative and significant impact on ROA and ROE for both conventional banks and Islamic banks. Qin and Pastory (2012) observed that the level of nonperforming loan has a negative effect on profitability. Dimitropoulos et al. (2010) also found that credit risk has a negative and significant influence on return-earnings. It has been recognized that credit risk has a negative significant effect on both ROA and ROE (Ruziqa, 2013; Tabarin et al., 2013). Financial risk comprises: credit risk, liquidity risk, interest rate risk and exchange rate risk; all of them contribute to the volatility of financial performance (Dimitropoulos et al., 2010). The credit risk is the core of financial risk that hinders corporate performance mostly in Africa. This risk varies net worth of assets due to the failure of the contractual debt of the counterpart to meet the regulations. Liquidity risk concerns to the inability of the company to reduce its liabilities and increase its assets. Liquidity risk of any company is measured taking the liquid assets over deposits (Al-Khouri, 2011). When corporate borrowing interest rate is greater than the market rate, the company may face interest rate risk. The interest rate factors measure as total loans and deposits (Al-Khouri, 2011). When a firm fails to manage risk, the risk is high and the profit is low, and when the firm succeeds in managing risk, the risk is low and the profit is high. Similarly, (Boermans 2011), in his study regarding firm performance under financial constraints and risks: recent evidence from microfinance clients in Tanzania has shown a strong negative connection between financial constraints, risk and profits.

1.2. Statement of the Problem

 The recent global financial crisis between mid-2007 and early 2009 revealed the importance of MFIs regulations to hedge against high risks attributed to imbalances in MFIs. René Stulz (2008) argued that there are five ways in which financial risk management systems can break down, all exemplified in the global crisis and other recent ones: failure to use appropriate risk metrics; miss-measurement of known risks; failure to take known risks into account; failure in communicating risks to top management; failure in monitoring and managing risks. (Central Bank Supervision Report, 2015) indicates that many MFIs that collapsed in Kenya in the late 2010’s was as a result of the poor management of credit risks which was portrayed in the high levels of non-performing loans. It’s important therefore to study how MFIs are

1.3 The Research Questions

1.3.1.Main Research Question

• What is the effects of financial risk management on the financial performance of micro finance institutions?

1.3.2. Specific Research Questions

• What is the effect of credit risk management on the financial performance of micro finance institutions in Bamenda?
• What is the effect if liquidity risks management on the financial performance of micro finance institutions in Bamenda?
• What is the effect of operational risk management on the financial performance of micro finance institution in Bamenda?

1.4 Main Objective

To examine the effect of financial risk management on the financial performance of micro finance institutions in Bamenda.

1.4.1 Specific Objectives

This study is guided by the following objectives

• To examine the effect of credit risk management on the financial performance of micro finance institutions in Bamenda.
• To examine the effect of liquidity risk management on the financial performance of micro finance institutions in Bamenda.
• To examine the effects of operational risk management on the financial of micro finance institutions in Bamenda