A Survey of the Effect of Credit Risk Stress Testing Levels on Financial Performance of Commercial Banks in Kenya

Abstract

This study examined the effects of credit risk stress testing level on the performance of banks in Kenya. Financial sector stress test presents information on a system’s possible losses beneath extraordinary but plausible shocks, helping policymakers evaluate the significance of the system’s vulnerabilities. The specific objective of the study is to establish how credit stress testing levels affect the financial performance of commercial banks in Kenya. Profitability indicator used that is the Return on Assets (ROA) was used to assess the bank performance. The research was conducted using a Crosssectional survey with a target population of 42 banks. The sample of the study consisted of listed commercial banks in the Nairobi Stock Exchange. Data was collected from secondary sources annual reports and accounts of targeted banks from the period 2013/2014 and 2014/2015. Descriptive, correlation and regression techniques were used in the data analysis. The study found that there is a relationship between Expected Loan Loss and Return on Assets at statistically significant (r= .785, p<0.05) at 95% confidence level. This indicates that if commercial banks in Kenya do not keenly scrutinize Return on Assets, then the expected Loan Loss might tremendously increase thus, high chances of credit risk testing. The study found that there was a significant relationship between credit risk testing levels and Expected Loan Loss -ELL, Exposure at Default - EAD, Probability of Default-PD, and Loss Given Default- LGD in Kenya Commercial Banks. As far as credit risk testing is concerned the study recommends that banks put in a strong policy that increases the loss given default so as only to allow the clients who are sure of not defaulting in the process repaying the borrowed loan. About the probability of default, the Kenya Commercial banks should introduce an active policy that allows them to access all financial and asset accounts of the defaulter to be able to reduce the probability of the borrower defaulting when he has obtained the loan. The study further recommends that commercial banks in Kenya should introduce policies that allow external monitoring and evaluation offices with the help of external auditors to thoroughly analyze the banks’ exposure at default to curb the menace of banks closing down due to huge exposure at defaults.