Relationship between cost efficiency and non-performing loans of commercial banks in Kenya

Abstract

In third world countries, efficiency of the banking system is particularly vital because the banking organization serves as the central nerve for the total financial development in terms of economic growth. A large bulk of non-performing loans in failing institutions has been named as the source of bank and thrift decline and that a significant predictor of insolvency is statistically asset quality. Failing bank, according to researchers, usually drift far from the best system perimeter. Large number of problem loans and low cost efficiency are often a characteristic of banks heading towards failure. The growing level of NPLs has led to incompetency and even placement of banks under receivership including the latest case of Chase Bank. None of the previous researchers have considered the relationship amid NPLs loans and cost efficiency of commercial banks in Kenya. The aim of this research study was to find the correlation among problem loans and cost efficiency regarding banks in Kenya that are commercial. As per the research, the four independent variables that were studied (non-performing loans, asset quality, bank liquidity and credit risk) explain a substantial 80.7% of cost efficiency between commercial banks in Kenya. The study also settles that credit risk negatively and significantly impacts the cost efficiency between banks in Kenya that are commercial. The analysis advocates that the Central bank of Kenya, being the regulator of banking sector should consider reporting on ratios rather than mere changes in trends of specific items especially NPL sand profitability. The reporting of mere increases in NPLs by commercial could be misleading as ratios such as return on, NPLs ratio, assets and NPLs coverage ratio can enhance understandability of relationships between changes in profitability and non-performing loans gross volumes. Central bank and shareholders of commercial banks in Kenya should be aware of the probable use of provisions for losses on non-performing loans used by managers for the purpose of smoothening of profits & develop financial reporting models that can help prevent occurrence of the menace. The shareholders specifically should be ready to meet agency costs to reduce manager’s information asymmetry by hiring competent internal and external auditors. The main regulator of all commercial banks being The Central Bank of Kenya, they should undertake the task of controlling the credit risk by setting the maximum limits of credit to be imposed by commercial banks on loans and earned on deposits. The firms should consider cost efficiency analysis as an important factor in their profitability and risk analysis and management. Moral hazard and adverse risks selection mitigation should be encouraged when in the process of giving out loans by management of commercial banks and this will help to lessen the transpiration of non-performing loans. Through lessening of moral hazard and adverse selection risk when giving out loans, non-performing loans will tend to reduce in number. This can be accomplished by, effective internal control systems, good credit appraisal procedures, diversification, followed by an attempt to better the quality of assets in the balance sheets. A challenge faced by commercial banks in Kenya is maintaining profitability, and this can be curbed through remaining innovative specifically on cost cutting techniques which includes lessening occurrences of non-performing loans and leveraging in technology. The central banks should apply stringent regulations on bank liquidity so as to regulate their cost efficiency. Policies that promote, advance and support competition in the financial sector, coupled with measures which foster the growth and advancement of the image of small and medium sized banks in a bid to enter the market, should be utilized to further increase competition in the banking sector