Determinants of Cost Effeciency Level of Commercial Banks in Kenya

Abstract

The Kenyan banking sector has experienced tremendous structural changes over the years. Initially, during the 1980s to 1990s the banking sector was characterized by high level of undercapitalization, increased number of non-performing loans and weak corporate governance. This led to a high aggregate inefficiency level of the banking sector and costs associated with operation of banks that existed. In addition, corruption was also a major factor that led to the collapse of some of the major banks. It is evident that efficiency is an important element of enhancing a stable banking sector. Therefore, cost efficiency becomes an important study to inform proper policy formulation and the establishment of sound supervisory framework. In recent years commercial banks in Kenya have been grappling with increased costs attributed to the rising employee and interest expenses amongst other factors. The banking sector has been expanding in terms of size and network. This has increased competition and capitalization in the strategic expansion. Therefore, it becomes important to determine the factors that affect bank cost efficiency level Kenya. This research paper applies the Stochastic Frontier Analysis (SFA) model where the intermediation approach of determining bank efficiency is used. The intermediation approach is superior to the production approach as it is characterized by fewer data problems. Secondary data is extracted from the balance sheets and income statements of commercial banks in Kenya listed in the NSE for the period of 2002-2011. The cost efficiency level in Kenya is found to be 99.2% on average. The local banks are found to be more efficient than both the local private and foreign banks. The parameter estimates of branch size, government securities, advanced loans and inflation have positive and significant effects on the efficiency level. These and other results of the empirical findings suggest that in order to enhance banking efficiency in Kenya, the government through the CBK should continue implementing bank reforms. Particularly, the banking markets should be opened to foreign competition, formulate bank risk management and corporate governance policies. This should be done in an attempt to encourage bank expansion in Kenya. Keywords: Cost efficiency, Stochastic Frontier Analysis, banking.