The mediating effect of income diversification on the relationship between board characteristics and non-performing loans among commercial banks in Kenya

Abstract

Non-performing loans is a major problem facing commercial banks globally. Priorstudies suggests that board characteristics such as size, financial expertise, independence, and meeting frequency may influence the level of NPLs because the board formulates the overall strategic decisions relating to the banking business. However, extant literature shows mixed findings on the relationship between board characteristics and NPLs. Recent studies further reveal that banks are gradually shifting towards income diversification to cushion themselves against deteriorating interest income and souring NPLs. Additionally, studies confirm that income diversification has an indirect impact on NPLs through cross-subsidization and cross-selling. Thus, this study sought to determine whether income diversification mediates the relationship between board characteristics and non-performing loans among commercial banks in Kenya. The specific objectives of this study were to; assess the effect of board size, board independence, board financial expertise, and board meeting frequency on NPLs. The study further determined the mediating effect of income diversification on the relationship between; board size, board independence, board financial expertise, board meeting frequency and non-performing loans. The study was grounded on the the agency theory, information asymmetry theory, resource dependency theory and modern portfolio theory. The study was premised on the explanatory and longitudinal research design. The target population consisted of 42 commercial banks operating in Kenya. Inclusion/ exclusion criteria was applied and thE final sample size comprised of 31banks. The study period was from 2008 to 2019. Data was secondary and quantitative and was extracted from the individual bank’s audited financial reports and the Central Bank of Kenya Annual Supervisory Report. Data was analyzed through descriptive and inferential statistics. The Hausman test guided the choice between the fixed effect and random effect model. The findings showed that board size (β=0.813, ρ<0.05) had a positive and significant effect on non-performing loans among commercial banks in Kenya. However, board independence (β=-0.618, ρ<0.05), board financial expertise (β=-0.092, ρ<0.05) board meeting frequency (β=-0.276, ρ<0.05) had a negative and significant effect on non-performing loans among commercial banks in Kenya. Besides, the study found that income diversification had a significant and positive effect on NPLs (β=0.382 ρ<0.05). In addition, the findings indicated that income diversification had a significant mediating effect on the relationship between board size (β=0.233 ρ<0.05), board independence (β= -0.053 ρ<0.05), board financial expertise (β=-0.026, ρ<0.05), board meeting frequency (β=-0.260, ρ<0.05) and non-performing loans among commercial banks in Kenya. Therefore, the study concluded that board size, board independence, board financial expertise and board meeting frequency were key predictors of NPL. Further, the study established there existed an indirect effect of board characteristics on NPLs through income diversification. The study recommends policy intervention on board characteristics and income diversification to minimize the rising level of non-performing loans among commercial banks in Kenya. Specifically, banks boards should be relatively small, have a higher proportion of independent directors, and have directors who are well vast with financial and accounting knowledge. There is also a need for a mandatory board meeting to discuss bank lending policies and problematic loans. The study recommends that bank managers should be cautious while engaging in income diversification due to the positive association between nonlending activities and NPLs.