Effect Of Credit Risk Administration On Financial Performance Of Commercial Banks In Kenya

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.