Capital allocation and efficiency of banking institutions in Kenya.(the case of quoted banks at Nairobi Stock Exchange)

Abstract

Banking institutions as key participants in the economy's payment system leverage their equity capital with demandable debt. This debt creates risks that could disrupt a country's payment system, which could affect the general economy as a whole. The threat of a banking institutions falling into liquidity problems can be reduced by reducing moral hazard problems, reducing adverse selection problems, insuring depositors funds and instilling banking regulations that constrain risk-taking and defining standards of capital adequacy (Hughes et al 1997). Banks however, could also reduce risks of liquidity or financial distress by injecting in more capital, which could act as safety net of a banks exposure to risks. While this could lower profits in the short term, it could increase the bank's value in the long run. To investors such banks have a high market value than the others. Therefore, this paper examines the effidencv of banking institutions in Kenya and measures efficiency by comparing the market value and book value using stochastic frontier technique. The paper further examines how the input-output factors of the production plan affect efficiency; the study finally compares efficiency scores of highly capitalized banks with those of low capitalized banks. By high capitalization the bank considers the banks with above average capital to assets ratio and vice versa for the low capitalized. The findings of the study were quite different from findings of other studies, the low capitalized banks were more efficient than the highly capitalized banks for each year from 1999-2001 and for the overall average of the period 1999-2001. This showed that capital ratio cannot be used to discriminate efficient banks from inefficient banks it also showed banks over reliance on customer deposits as a sourceof funds rather than injecting in more capital. It also signaled the safety of Kenya'sfinancial market.