Credit risk, capital adequacy ratio, and financial performance of Commercial Banks In Kenya

Abstract

Commercial banks play a significant role in economic development and support economic growth in any nation through their role as financial intermediaries and providers of financial services to communities and international organizations. With the help of the financing facilities they provide, both private investors and institutional investors can explore and widen their options for profitable investment. Considered a stand-in for a bank's financial stability is the credit quality. The risk of default and non- performing loans, which increases the likelihood that assets and loans would no longer be recovered, is known as the credit risk. Despite the fact that numerous research on credit risk have been done in the past, the issue is still up for debate. Therefore, this study sought to examine whether capital adequacy ratio moderates the relationship between credit risk and financial performance of commercial banks in Kenya. The specific objectives were to examine the effect of non-performing loan rate, net charge- off rate and pre-provision profit/ loss rate on financial performance of commercial banks. The study further examined whether capital adequacy moderated the relationship between non-performing loan rate, net charge-off rate, pre-provision profit/ loss rate and financial performance of commercial banks in Kenya. The study was grounded on the stakeholder theory and the agency theory of firms. The target population was forty- two commercial banks in Kenya over the period between 2011 and 2021. After the application of an inclusion and exclusion criteria the final sample was 35 banks that yield 385 firm-year observations. The secondary data and was extracted from the Central bank of Kenya and the individual bank’s financial statements. The data was analyzed through descriptive and inferential statistics with the aid of STATA. The study employed hierarchical multiple regression to test the hypotheses. The results of Hausman guided the choice of either the random effect or the fixed effect regression models. The finding revealed that non-performing loan rate (β = -0.1802 and ρ- value<0.05), net charge-off rate (β = -0.0704 and ρ-value<0.05); and pre-provision profit/ loss rate (β= 0.141 and ρ-value<0.05); on financial performance had a significant effect on financial performance of commercial banks in Kenya. Additionally, the regression results confirmed that capital adequacy moderated the association between non-performing loan rate (β = 0.222 and ρ-value<0.05), net charge-off rate (β = 0.357 and ρ-value<0.05), and pre-provision profit/ loss rate (β = 0.295 and ρ-value<0.05); on financial performance. In light of this, the study concluded that credit risk significantly contributes to Kenyan banks' profitability and that capital sufficiency has an impact on this relationship. This study advises banks to strengthen their credit management strategies as a way of improving their profitability. Additionally, in an effort to enhance bank performance, bank management and the regulator should comprehend the critical balance between credit risk and bank capital. Future research might take into account additional aspects of bank financial performance and investigate how they relate to each other in rations with various regulatory capital requirements and credit exposure.