Changing market structure in the banking sector following financial liberalization and macroeconomic
shocks have the potential to adversely impact banking risk exposure. This research paper
investigates the effect of these factors on the risk exposure of commercial banks in Kenya. It is
argued that competition resulting from financial liberalization and the impact of macroeconomic
shocks may increase bank risk taking incentives and risk exposure. Specifically, it is hypothesized
that financial liberalization increases banking fragility by reducing franchise value which induces
risk taking and that positive and negative macroeconomic shocks increase banking risk exposure.
Annual bank financial performance panel data for the period 2008 to 2013 is used to analyse the
impact of market structure and macroeconomic variables on borrowing and lending risk exposure
using GMM estimation. The results indicate that there is some support for both hypotheses.
Borrowing risk exposure was found not to be persistent, being mainly affected by the degree of
concentration and external economic shocks. Interestingly, the results also suggest that changes
in the short-term interest rate do not affect the net interest margin; which may imply that bank
deposit and lending rates are rigid and that the interest rate channel is ineffective. Lending risk
exposure was found to be persistent, being mainly affected by the degree of concentration, internal
economic shocks and external economic shocks. Further analysis of the factors contributing to the
persistence of lending risk exposure using a PVAR model found that the banks’ loan growth rate
and the market interest rate were the key determinants; though the impact of the loan growth
rate was about double the impact of interest rate risk, implying that bank risk taking is the key
determinant of the persistence of lending risk exposure.