Mediation Effect of Macro-Economic Factors on the Relationship between Banks’ Financial Soundness and Financial Performance

Abstract

Analyzing the effect of macro-economic factors is essential for business growth. The study analyzed mediation effect of macroeconomic factors on the relationship between financial soundness and financial performance of 39 commercial banks in Kenya using data from 2009 to 2018. The study was modeled on the theory of production with CAMEL variables as factor inputs and financial performance measures as factor outputs mediated by macro-economic factors. The study found that gross domestic product growth, interest rate, exchange rate and inflation had a mediating effect on the relationship between banks financial soundness and net interest margin. In addition, gross domestic product growth, interest rate and exchange rate were not mediators on the relationship between financial soundness and earnings per share as a financial performance measure. The study also established that exchange rate had mediation effect on the relationship between financial soundness and net interest margin and return on assets respectively. Further, inflation was found to have a positive mediation effect net interest margin, earnings per share and return on assets as measures of financial performance, there was absence of mediation effect when return on equity was used as financial performance measure. Bank management needs to understand the direction of the effect of mediation of macro-economic factors on banks’ financial soundness for effective financial soundness policy formulation to improve financial performance.