Effect Of Asset Quality On Financial Performance Of Commercial Banks In Kenya

Abstract

Loan portfolio constitutes the largest proportion of banks’ assets and therefore when loans become non-performing, they negatively impact financial performance along with overall financial activity by banks. High levels of NPLs indicate a vulnerable financial system since it influences the financial performance of banks in reducing levels of interest income, whereas low standards of NPLs indicate the presence of a sound effective financial system. It is hypothesised that deterioration in the asset quality of commercial banks negatively affects its financial performance. This study sought to investigate how asset quality influences the financial performance of commercial banks in Kenya. The independent variable for the research was asset quality measured as the ratio of NPLs to total loans. Liquidity, firm size and capital adequacy were the control variables while the dependent variable was financial performance measured using ROA. The study was guided by information asymmetry theory, financial intermediation theory as well as loanable funds theory. Descriptive research design was utilized in this research. The 39 commercial banks in Kenya as at December 2021 served as target population. The study collected secondary data for five years (2017-2021) on an annual basis from CBK and individual banks annual reports. Descriptive, correlation as well as regression analysis were undertaken and outcomes offered in tables followed by pertinent interpretation and discussion. The research conclusions yielded a 0.604 R square value implying that 60.4% of changes in banks ROA can be described by the four variables chosen for this research. The multivariate regression analysis further revealed that individually, asset quality exhibited a negative effect on ROA of banks as shown by (β=-0.346, p=0.000). Liquidity has a positive and significant effect on ROA of banks (β=0.318, p=0.000). Firm size and capital adequacy exhibited a positive and significant influence on ROA of banks in Kenya as shown by (β=0.484, p=0.000) and (β=0.282, p=0.000) respectively. The study recommends the need for banks to ensure xi that asset quality management policies are crafted based on appropriate strategies for performance enhancement. The policy makers such as CBK should come up with policy guidelines to direct firms on ways to enhance their quality of assets without risking their financial performance. The study recommends the need for further studies focusing on other financial institutions in Kenya such as microfinance banks and SACCOs.