Effect of Credit Risk on Financial Soundness of Commercial Banks in Kenya

Abstract

This study examined credit risk relationship with and financial soundness of Kenyan commercial banks. Financial soundness of commercial banks is an important indicator on the performance of a nation’s financial position and this has been inconsistent since the onset of the pandemic as important indicators of financial soundness were threatened by various factors including their credit risks. Using asymmetric information and modern portfolio theories and descriptive research design, the 42 commercial banks were included into the sample by employing census sampling method and purposive sampling for the 2016 – 2021 period. However, 33 banks met the standard for analysis. Secondary data was collected to analyze relationship between NPLs ratio and sensitivity to market risk as indicators for credit risk and financial soundness respectively. Diagnostic tests including normality, multicollinearity, and autocorrelation were followed by descriptive, correlational, and multiple linear regression analysis. The results indicated that an increase in credit risk would lead to a decrease in financial soundness by a factor of 0.001 and this was statistically significant. The findings benefit policy and decision to introduce regulations and policy for enhancing management of credit risk for commercial banks. Second, top leadership benefits from this information to adopt strategies for reducing credit risks in their institutions. Lastly, it also provides support for the Charter Value Theory which proposes that credit risks facing commercial banks threaten the future value of a commercial bank which was confirmed from the results. There is also need for further research to identify actions and strategies adopted by commercial banks to improve their financial soundness.