Efficiency in the banking sector: an empirical investigation of commercial banks in Kenya

Abstract

The main objective of the study is to investigate efficiency in the banking sector in the post liberalization period in Kenya. The study is in two major parts and addresses three main objectives. The first part measures efficiency scores and the productivity gains in the post liberalization period. The second part measures X-inefficiency and the factors determining-inefficiencies in the banking sector in Kenya. Thus, three forms of efficiency are analyzed - technical, scale and managerial efficiency referred to as X-inefficiency in the study. The study is motivated by the fact that though the banking sector constitutes a large part of the financial system in Kenya, little is known about the efficiency status and factors that determine inefficiency. Further banks are awash with liquidity despite private sector credit demand indicating some inefficiency in the intermediation process in Kenya.

This study adopts a non-parametric Data Envelopment Analysis (OEA) and a parametric stochastic frontier approach to analyze measures of various aspects of efficiency in the banking sector. Malmquist Productivity Index (MPI) is used to measure productivity gains of banks in Kenya. Panel (fe) and GMM have been used to estimate the factors determining-inefficiency in the banking sector. The study makes use of secondary annual financial data for ten years period. Input and output variables are defined to represent the intermediation role of banks.

The results show that although the banks were not fully efficient in all respects, they performed fairly well during the period under study. Banks still have reason and scope to improve performance by improving their technology, skills and enlarging their scale of operations so as to be fully efficient. Analysis of determinants of X-inefficiency shows that there was a positive relationship with variables such as profitability, asset quality, proxy for financial liberalization, capital adequacy, GOP, market structure and liquidity, whereas variables such as size and multibank holding company were negatively related to X-inefficiency. GOPshows weak significance in the models. Based on the main conclusions, the study recommends policies that will encourage competition, product diversification, risks minimization and proper supervision of banks.