The moderating effect of credit risk on the relationship Between financing structure and financial performance of microfinance institutions in Kenya

Abstract

Microfinance institutions provide loans to low-income borrowers including SME’s who traditionally lack access to mainstream sources of finance from Banking Institutions as they are considered as high-risk borrowers. Despite the key role the MFIs plays in the economy – in poverty eradication and entrepreneurial activities, these firms ‘reported poor financial performance .The decline is caused by declining financial support from donors and this has prompted them to opt for debt and the credit risk associated with it. Prior Studies claimed that financing structure affects financial performance however the findings are not conclusive therefore moderating effect of credit risk. The general objective of the study was to examine the moderating effect of credit risk on the relationship between financing structure and financial performance among microfinance institutions in Kenya. The specific objectives were to establish the effect of equity capital, debt capital, retained earnings and deposits on financial performance of MFI. The study also sought to investigate the moderating effect of credit risk on the relationship between: equity capital, debt capital, deposits and retained earnings on financial performance. This study was guided by Pecking order theory, The Agency Theory and The Modigliani-Miller Theorem. The study adopted longitudinal and explanatory research design. The target population consisted of all 53 Microfinance Institutions in Kenya for the period between 2010 and 2019. However, after applying an inclusion/exclusion criterion the final sample comprised of 31 Microfinance Institutions in Kenya. Data was extracted from World bank MIX market database and the annual reports of the selected microfinance banks. The data was analyzed through descriptive and inferential statistics. The study found out that equity capital (β=0.252, ρ<0.05), debt capital (β=0.383, ρ<0.05), retained earnings (β=0.339, ρ<0.05 and deposits (β=0.225, ρ<0.05 had a significant and positive effect on financial performance of microfinance institutions in Kenya. Moreover, the study found that credit risk significantly moderates the relationship between equity capital (β= 0.6994, ρ<0.05), debt capital (β=-0.878 ρ<0.05), retained earnings (β=0.9128, ρ<0.05), deposits (β=0.6036, ρ<0.05) and financial performance. This study's findings are supported by the pecking order theory, emphazing the hierarchical order of financing to financial performance. Therefore, the study concluded that equity capital, debt capital, retained earnings and deposits had a significant effect on financial performance. Further, the study showed that credit risk significantly moderate the relationship between financing equity capital, debt capital, retained earnings and deposits a contribution to the existing literature. This study contributes to the pecking order theory emphazing the hierarchical order of finance to financial performance. The study recommends that microfinance institutions should mobilize on minimizing credit risk by adopting more stringent lending guidelines and cost saving measures thus ultimately improving performance.