Abstract:
Credit risk has for a long time been an area of interest not just to bankers but to the whole
business community. This is so since the uncertainties of a trading companion not fulfilling
his responsibilities on due date can extremely put at risk the affairs of the other companion.
This study aimed to determine the relationship between credit risk administration and
financial performance of commercial banks in Kenya. It was guided by 3 specific objectives;
to determine the effect of default rate on financial performance of commercial banks in
Kenya, to analyze the effect of capital adequacy on financial performance of commercial
banks in Kenya and to determine the effect of cost to loan on financial performance of
commercial banks in Kenya. The research design for this study was descriptive survey.
Secondary data was sourced from the published annual financial reports of the banks
covering a period of 5 years (2011-2015). An empirical investigation into the quantitative
effect of credit risk on the performance of commercial banks in Kenya over the period of 5
years (2011-2015) was done. 40 commercial banking firms were selected on a cross sectional
basis for 5 years. The traditional profit theory was employed to formulate profit, measured by
Return on Average Assets (ROAA), as a function of the ratio of default rate, ratio capital
adequacy and the ratio of cost to loan as measures of credit risk. Panel model analysis was
used to estimate the determinants of the profit function. The data contained both the cross
sectional and time series data and therefore panel data model was used. Hausman test was
carried out to determine the model to be used for estimates reporting. Fixed effects Panel
Data model was used to analyze and report on the finding. The result showed that credit risk
management is an important predictor of commercial bank financial performance. This
research indicates that Non-performing loans/Gross loans ratio is employed to estimate the
effectiveness and suitability of a banks’ credit risk management. The empirical results show a
negative effect of non-performing loans on banks profitability. The results also reveal that the
Capital adequacy ratio has a positive affect the profits of the Kenyan commercial banks as
measured by ROAA, suggesting as CAR ratio increases performance of commercial banks do
also increase. This research indicates that cost to loan asset ratio (CLA) is employed to
estimate the effectiveness and suitability of a banks’ credit risk management. The empirical
results show a negative effect of CLA on banks profitability. The study recommends that
bank management should put into place credit risk administration policies that would
improve the performance of the banks. Banks also need to place and devise strategies that
will reduce exposure as far as capital adequacy is concerned. Finally, operating costs should
be managed prudently so as to maximize returns to shareholders.