Effect of Loan Default on Profitability of Commercial Banks in Kenya

Abstract

The loan portfolio is the principal operating and income factor for most banks entities. However, loans at times are idle or in default, thus negatively affecting the profitability of banks. Default is acknowledged as a key factor that affects the banks survival and profitability. Most banks cannot fail to be competitive due to high default rates. Thus, in the preceding 10 years, the worth and portfolio of credit in many of the world's economies was relatively stable until the financial crisis of 2007-08. Ever since, loan quality has declined rapidly owing to the world economic downturn and the Covid 19 pandemic. This study sought to investigate how loan default influences the profitability of commercial banks in Kenya. The independent variable for the research was loan default measured as the ratio of NPLs to total loans. Liquidity, firm size and capital adequacy were the control variables while the dependent variable was profitability measured using ROA. The study was guided by information asymmetry theory, financial intermediation theory as well as loanable funds theory. Descriptive research design was utilized in this research. The 39 commercial banks in Kenya as at December 2021 served as target population. The study collected secondary data for five years (2017-2021) on an annual basis from CBK and individual banks annual reports. Descriptive, correlation as well as regression analysis were undertaken and outcomes offered in tables followed by pertinent interpretation and discussion. The research conclusions yielded a 0.604 R square value implying that 60.4% of changes in banks ROA can be described by the four variables chosen for this research. The multivariate regression analysis further revealed that individually, loan default exhibited a negative effect on ROA of banks as shown by (β=-0.346, p=0.000). Liquidity has a positive and significant effect on ROA of banks (β=0.318, p=0.000). Firm size and capital adequacy exhibited a positive and significant influence on ROA of banks in Kenya as shown by (β=0.484, p=0.000) and (β=0.282, p=0.000) respectively. The study recommends the need for banks to ensure that loan default management policies are crafted based on appropriate strategies for profitability enhancement. The policy makers such as CBK should come up with policy guidelines to direct firms on ways to enhance their quality of assets without risking their profitability. The study recommends the need for further studies focusing on other financial institutions in Kenya such as microfinance banks and SACCOs.