Effects of Non-Performing Loans on Technical Efficiency of Commercial Banks in Kenya
Abuga, Frankline Kianyaga
MetadataShow full item record
With the formation of very large banks and increased interbank connectivity, the 1992 financial sector reforms resulted in a shift in market power. They also improved the banking sector's resilience and sustainability. The reforms aimed at doing away with regulatory and structured issues hindering efficiency of the sector. However, the increasing trend of Non-performing loans since 2008 as well as the commercial banks’ decline in profitability since 2014, has been a cause of alarm and distress to customers and stakeholders. Although there exists an authority to monitor the operation of banks still their operations are sub-optimal. To improve operations of banks and create assurance to customers and stakeholders this study investigated the role of non-performing loans on technical efficiency of commercial banks in Kenya. The research was motivated by the enormous evidence that the Kenyan financial system is dominated by the banking sphere but little is known about efficiency statistics and determinants of efficiency scores. The study used Data Envelopment Analysis to measure efficiency scores in Kenya's 26 commercial banks; 9 in tier 1, 7 in tier 2, and 10 in tier 3, that existed over the study period (2014-2019); inputs as well as outputs variables were selected depending on the intermediation roles performed by banks. The variables were split into inputs and outputs. The income (a linear combination of non-interest income and interest income) was treated as output. The inputs were non-interest expenditure, equity capital and interest expenditure. The results revealed that there was inefficiency across all the banking categories. Tier one banks operated at 79.5 percent efficiency scores, tier 2 at 78.4 percent and tier 3 at 68.8 percent level. Tobit regression was utilized to examine the impacts of Non-performing loans on the technical efficiency of commercial banks in Kenya. The study regressed Non-performing loans, total loan to total assets ratio, total assets, equity to total assets ratio, and non-interest expenses to total assets ratio on technical efficiency level obtained in the first part. The findings indicated that Non-performing loans have -0.00000000262 effect on technical efficiency of the commercial banks, however the effect is not significant. This study concluded that if the commercial banks need to keep improving their efficiency indices, they need to minimize their non-performing loans by implementing the following recommendations; investing heavily on loan recovery a customer credit score monitoring, relying on private credit collection agencies, that look to solve disputes and seek to refer accounts to the credit reference bureau. This will avoid pilling of non-performing loans on the financial statement of commercial banks and other long term legal process such as court cases.