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Impact of Credit Risk Management On Financial Performance of Commercial Banks in Kenya PDF
Impact of Credit Risk Management On Financial Performance of Commercial Banks in Kenya PDF
Impact of Credit Risk Management On Financial Performance of Commercial Banks in Kenya PDF
This study analysed the impact of credit risk management on the financial performance
of commercial banks and also attempted to establish if there exists any relationship
between the credit risk management determinants by use of CAMEL indicators and
financial performance of commercial banks in Kenya. A causal research design was
undertaken in this study and this was facilitated by the use of secondary data which was
obtained from the Central Bank of Kenya publications on banking sector survey. The
study used multiple regression analysis in the analysis of data and the findings have
been presented in the form of tables and regression equations. The study found out that
there is a strong impact between the CAMEL components on the financial performance
of commercial banks. The study also established that capital adequacy, asset quality,
management efficiency and liquidity had weak relationship with financial performance
(ROE) whereas earnings had a strong relationship with financial performance. This
study concludes that CAMEL model can be used as a proxy for credit risk management.
Key Words: Credit Risk, Management, Financial Performance, Commercial Banks, Kenya
1
Lecturer, School of Business, Department of Finance and Accounting, Mombasa Campus,
University of Nairobi, Kenya
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DBA Africa Management Review
2012, Vol 3 No 1 pp. 22-37
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DBA Africa Management Review
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system. In the 1980's and early 1990's, the RMGs remained relevant, current and
several countries in developed, developing reflective of circumstances in the operating
and transition economies experienced environment. Their finding was that
several banking crises requiring a major generally the institutions revealed that the
overhaul of their banking systems (IMF, Risk Management Guidelines issued in
1998). As the banking sector continues to 2005 had, for the majority of them;
embrace innovations, the intensity and enhanced risk-awareness and risk-
variety of risks that the players are management at the institutions, increased
exposed also continue to increase in the efficiency and effectiveness of risk
tandem. To ensure that the growth in the management, helped reduce financial
banking sector does not jeopardize its losses, led to the establishment of effective
stability, risk management is crucial. and better-resourced risk management
functions, and enhanced the overall
In view of this, the CBK carried out a risk decision making processes in their
management survey on the Kenyan institutions (CBK, 2010).
banking sector in September 2004. The
survey’s objective was to determine the
Credit Risk Management Measurement
needs of the local banking sector with
regard to risk management. The survey Operating and financial ratios have long
was necessitated by the drive to fully adopt been used as tools for determining the
Risk Based Supervision and to incorporate condition and the performance of a firm.
the international risk management best Modern early warning models for financial
practices envisioned in the 25 Basel Core institutions gained popularity when Sinkey
Principles for Effective Banking (1975) utilized discriminant analysis for
Supervision. The survey culminated in the identifying and distinguishing problem
issuance of the Risk Management banks from sound banks and Altman
Guidelines (RMGs) in 2005 and the (1977) examined the savings and loan
adoption of the Risk Based Supervision industry. To anticipate banks’ financial
approach of supervising financial deterioration, procedures have been
institutions in 2005. In response to this, developed to identify banks approaching
commercial banks embarked upon an financial distress. These procedures,
upgrading of their risk management and though varying from country-to-country,
control systems (CBK, 2005). are designed to generate financial
In order to assess the adequacy and impact soundness ratings and are commonly
of the Risk Management Guidelines, 2005 referred to as the CAMEL rating system
on Kenyan banking institutions, CBK (Gasbarro et al., 2002). In Kenya, the
issued risk management survey 2010. The Central Bank also applies the CAMEL
goal of the CBK risk management survey rating system to assess the soundness of
2010 was to determine whether the RMGs financial institutions which is an acronym
issued in 2005 have had any impact on the for Capital Adequacy, Asset Quality,
institutions and as to whether the RMGs Management Quality, Earnings and
are adequate, as well as establishing the Liquidity (CBK, 2010). Numerous prior
necessary amendments and/or additions studies have examined the efficacy of
that needed to be introduced to ensure that CAMEL ratings and they generally
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DBA Africa Management Review
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DBA Africa Management Review
2012, Vol 3 No 1 pp. 22-37
ROE C A M E L
Average ROE Pearson Correlation 1
Sig. (2-tailed)
Average Capital Pearson Correlation -.250* 1
Adequacy Sig. (2-tailed) .035
Average Asset Pearson Correlation -.324* .398 1
Quality Sig. (2-tailed) .041 .109
Average Pearson Correlation -.512** .108 .158 1
Management Quality Sig. (2-tailed) .001 .507 .331
Average Earnings Pearson Correlation .891** .155 -.115 -.415 1
Sig. (2-tailed) .000 .341 .480 .408
Average Liquidity Pearson Correlation .362* -.250 -.276 -.566 .251 1
Sig. (2-tailed) .022 .119 .085 .540 .118
N 40 40 40 40 40 40
*. Correlation is significant at the 0.05 level (2-tailed).
**. Correlation is significant at the 0.01 level (2-tailed).
Pearson correlation was used to analyse the 0.324) at p=0.041. Management quality
correlations between the variables and also has correlation with financial
financial performance. Table 1 reveals the performance given R values of -0.512 at
correlation coefficients between the p=0.001. A correlation was also
variables and financial performance. Table 1 established between earnings quality and
shows that capital adequacy has a ROE at 95% confidence levels with R
correlation coefficient of -0.25 at p=0.035 values of 0.89 at p<0.001. A correlation
with financial performance. The was also observed between liquidity and
correlation coefficient between asset financial performance of 0.362 at p=0.022.
quality and financial performance is (R=-
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DBA Africa Management Review
2012, Vol 3 No 1 pp. 22-37
Table 2 illustrates that the strength of the models were not auto correlated since
relationship between financial independence of the residuals is one of the
performance and independent variables basic hypotheses of regression analysis.
(liquidity, management quality, earnings Being that the DW statistics were close to
quality (ROA), capital adequacy and asset the prescribed value of 2.0 for residual
quality). The correlations results depicted independence, it can be noted that there
a linear relationship between the was no autocorrelation.
dependent and the independent variables
aggregates with R having lowest values of Multicollinearity Test
0.771 in 2007 and highest values of 0.971 The study conducted formal detection-
in 2009. The determination coefficients, tolerance or the variance inflation factor
denoted by R2 had higher values of 0.912, (VIF) for multicollinearity. For tolerance,
0.949, 0.971 and 0.929 in the years 2006, value less than 0.1 suggest
2008, 2009 and 2010 respectively. multicollinearity while values of VIF that
exceed 10 are often regarded as indicating
The study also used Durbin Watson (DW) multicollinearity. The average data for the
test to check that the residuals of the 5 year period was used.
Tolerance VIF
Capital Adequacy .768 1.567
Asset Quality .752 1.678
Management Quality .675 1.559
Earnings .987 1.672
Liquidity .876 1.457
Source: Research data
Table 3 shows that the values of tolerance variables. It, therefore, omitting variables
were greater than 0.1 and those of VIF with insignificant regression coefficients,
were less than 10. This shows lack of would be in appropriate.
multicollinearity among independent
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Table 4 reveals the regression coefficients quality and management efficiency all had
for the year 2006. Table 4.4 shows that negative coefficients of -0.102, -0.282 and
holding capital adequacy; asset quality, -28.709 respectively. Earnings quality had
management efficiency, earnings and a positive coefficient of 4.326 and liquidity
liquidity constant financial performance also had a positive coefficient of 8.403.
will be 8.790. Capital adequacy, asset
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DBA Africa Management Review
2012, Vol 3 No 1 pp. 22-37
Table 5 shows the regression coefficients 12.414. Capital adequacy had a negative
for the year 2007. Table 5 reveals that coefficient of -0.009 and asset quality also
holding independent variables constant had a negative coefficient of -0.261.
(capital adequacy, asset quality, Management efficiency, earnings quality
management efficiency, earnings and and liquidity all had positive coefficients
liquidity), financial performance will be of 20.600, 2.764 and 0.796 respectively.
Table 6 depicts the regression coefficients for the year 2008. Table 6 illustrates that financial
performance will be 13.214 if the with Capital adequacy, asset quality,
independent variables (capital adequacy, management efficiency and liquidity
asset quality, management efficiency, having negative coefficients of -21.850, -
earnings and liquidity) are held constant. 0.119, -88.597 and -0.684 respectively.
All the independent variables had negative Earnings quality had a positive coefficient
coefficients except for earnings quality of 5.473.
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Table 7 depicts the regression coefficients will be 6.129. Capital adequacy, asset
for the year 2009. Table 7 shows that quality and management efficiency all had
holding capital adequacy, asset quality, negative coefficients of -0.149, -0.054 and
management efficiency, earnings and -46.856 respectively. Earnings quality had
liquidity constant financial performance a coefficient of 6.316 and liquidity 4.983.
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2012, Vol 3 No 1 pp. 22-37
Table 8 shows the regression coefficients Analysis from tables 4 to 8 shows the
for the year 2010. Table 8 reveals that regression coefficients for the years 2006
holding capital adequacy, asset quality, to 2010 and it was established that the
management efficiency, earnings and intercept value was positive ranging from
liquidity constant financial performance the lowest value of 6.129 in 2009 to
will be 8.416. Capital adequacy, asset 13.214 in 2008. Table 4 depicts that a unit
quality and management efficiency all had increase in capital adequacy will lead to a
negative coefficients of -16.913, -0.079 decrease in financial performance by
and -97.887 respectively. Earnings quality 0.102, a unit increase in asset quality will
had a positive coefficient of 5.737 and lead to a decrease in financial performance
liquidity also had a positive coefficient of by a factor of 0.282 and a unit increase in
18.387. management efficiency will further lead to
Impact of Credit Risk Management a 28.709 decrease in financial
Determinants on the Financial performance. Table 4 also implies that a
Performance of Commercial Banks in unit increase in earnings quality of the
Kenya company will cause a 4.326 increase in
financial performance whereas a unit
The study found that there is a significant increase in liquidity will cause an 8.403
impact between the CAMEL components increase in financial performance.
on the financial performance of
commercial banks as depicted on Table 2 Table 5 depicts that a unit increase in
which shows the regression model of capital adequacy will cause a 0.009
goodness fit for the respective years under decrease in financial performance and a
study. From Table 2, the value for R2 is unit increase in asset quality will lead to a
0.832 in the year 2006, which means that 0.261 decrease in financial performance.
CAMEL components explain 83.2 percent Table 4.5 also reveals that that a unit
variations in the financial performance of increase in management efficiency will
banks. 2007 has the lowest value of R2 at lead to an increase in financial
0.594 which means that CAMEL performance by a factor of 20.6 and a unit
components explain 59.4 percent increase in earnings quality would cause a
variations of the financial performance of 2.764 increase in financial performance.
banks. Similarly years 2008, 2009 and Likewise a unit increase in liquidity would
2010 have R2 values of 0.901, 0.943 and cause a 0.796 increase in financial
0.862 implying that CAMEL components performance.
explain 90.1 percent, 94.3 percent and 86.2
percent variations of financial performance Analysis from Table 6 shows that a unit
of banks respectively. The CAMEL rating increase in capital adequacy would cause a
system can thus be used as a credit risk 21.85 decrease in financial performance,
management indicator in the determination asset quality causes a 0.119 decrease in
of financial performance of commercial financial performance and a unit increase
banks. in management quality will lead to a
decrease in financial performance by
88.597. An increase in earnings quality
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DBA Africa Management Review
2012, Vol 3 No 1 pp. 22-37
Relationship between Credit Risk The study also established the relationship
Management Determinants and between credit risk management proxied
Financial Performance Of Commercial by CAMEL indicators and financial
Banks in Kenya performance of commercial banks in
Table 1 shows the correlation matrix of the Kenya. The study concludes that capital
CAMEL indicators to financial adequacy, asset quality, management
performance. From table 1, capital efficiency and liquidity have weak
adequacy has values of R=-0.250 at relationship with financial performance of
p=0.035. This implies that capital banks in Kenya. Earnings have a strong
adequacy has a weak relationship with relationship with financial performance.
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2012, Vol 3 No 1 pp. 22-37
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DBA Africa Management Review
2012, Vol 3 No 1 pp. 22-37
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