The Effect of Loan Quality on the Profitability of Commercial Banks in Kenya

Abstract

The study aimed at assessing whether profitability is affected by loan quality in commercial banks in Kenya. The study adopted information asymmetry theory, capital asset pricing model and adverse selection theory. The study conducted descriptive, correlation and regression analysis on an unbalanced dataset of 39 licensed commercial banks in Kenya all the way from 2012 to 2021. The research primarily used secondary data sources of published reports from the Central Bank of Kenya. F-statistic were used in establishing the model significance. Regression results suggest that loan quality has a significant positive influence on performance of large banks. Profitability is not influenced by loan quality in medium as well as small banks. Banks sizeð€‚¶s influence on performance of all commercial banks as well as small banks is significant (+vely). Size has a positive insignificant influence on performance of medium sized as well as large commercial banks. Operational efficiencyð€‚¶s effect on the profitability of commercial banks is negative. However, operational efficiency has an insignificant positive impact on the performance of all commercial banks as well as large ones. Medium and small banksð€‚¶ profitability is not affected by operational efficiency. Capital ratioð€‚¶s effect on profitability of all commercial banks is significant(+vely). Capital ratio has a positive significant influence on performance of large and small commercial banks but a positive insignificant effect for medium banks. The effect of deposit ratio profitability of all banks is significant (-vely). There is no effect of deposit ratio on the profitability of large commercial banks. Deposit ratioð€‚¶s effect on performance of medium and small banks is significant (-vely). This study findings suggest that tier 1 banks have the lowest loan quality among Kenyan commercial banks. This study advocates for commercial banks to increase their asset levels, increase their loan quality, increase their deposits, increase their capitalization as well as the operational efficiency for them to achieve higher profitability levels.