THE EFFECT OF NON PERFORMING LOANS ON

PROFITABILITY OF COMMERCIAL BANKS IN KENYA

BY
SIMION KIRUI
D61/62701/2013

A RESEARCH PROJECT SUBMITTED FOR PARTIAL

FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF A

MASTER OF BUSINESS ADMINISTRATION DEGREE,

UNIVERSITY OF NAIROBI

OCTOBER 2014
 DECLARATION

STUDENT’S DECLARATION

I declare that this research project is my original work and has not been submitted for a degree in
any other university or college for examination/academic purposes.

Signed ………………………………………………Date………………………………………..

SIMION KIRUI

REG. NO: D61/62701/2013

This research project has been submitted for examination with my approval as the university
supervisor

Signed ………………………………………………Date………………………………………..

MR. HERICK ONDIGO

LECTURER, DEPARTMENT OF FINANCE AND ACCOUNTING

SCHOOL OF BUSINESS, UNIVERSITY OF NAIROBI

 ACKNOWLEDGEMENTS
I am very grateful to the Almighty God for his grace and mercy which enable me complete this
rewarding task. Second my appreciation goes to all parties whose diverse contributions enabled
me complete this work successfully.

I am particularly grateful to my supervisor, Mr. Herick Ondigo for his valuable guidance and
support. I would also like to thank him for his inspiration and constructive criticism throughout
the research process. My sincere thanks also go to Mr. Mirie Mwangi for his suggestions and
comments which contributed immensely towards the success of this work.

My most profound gratitude goes to my employer National Housing Corporation, my wife, my

loving Parents, University colleagues, workmates, friends and relatives for their unconditional
and steadfast support throughout the research.
 DEDICATION

This work is dedicated to my entire family, especially to my Mother Mrs. Esther Towet , my
Father Mr. Henry Kipkemoi Towet whom both have always encouraged me to pursue hard work
and Higher Education. To my children Ann, Joshua, Debra and Boni whom I always encouraged
to work hard and pursue higher education.
 TABLE OF CONTENTS

DECLARATION…………..........................................................................................................ii
ACKNOWLEDGEMENTS........................................................................................................iii
DEDICATION………………............................................................................................ .........iv
LIST OF TABLES......................................................................................................................viii
LIST OF ABBREVIATIONS ….................................................................................................ix
ABSTRACT………………….......................................................................................................x

CHAPTER ONE: INTRODUCTION.............................................................................................. 1

1.1 Background of the Study ........................................................................................................... 1

1.1.1 Non- Perfoming Loans ..................................................................................................... 2

1.1.2 Profitability ...................................................................................................................... 4

1.1.3 The Effect of Non Peforming Loans on Profitability ...................................................... 5

1.1.4 Commercial Banks in Kenya ............................................................................................ 6

1.2 Research Problem ...................................................................................................................... 7

1.3 Research Objective .................................................................................................................... 8

1.4 Value of the Study ..................................................................................................................... 8

CHAPTER TWO: LITERATURE REVIEW................................................................................. 9

2.1 Introduction................................................................................................................................ 9

2.2 Theoretical Review.................................................................................................................... 9

2.2.1 Asymmetric Information theory ....................................................................................... 9

2.2.2 Agency theory ……………………………………………………...……............10

2. 2.3 Modern Portfolio theory ............................................................................................... 11

 2.3 Determinants of profitability in commercial Banks ................................................................. 12

2.3.1 Capital Adequacy............................................................................................................ 12

2.3.2 Assets Quality................................................................................................................. 13

2.3.3 Liquidity ......................................................................................................................... 14

2.3.4 Operational Cost Effeciency........................................................................................... 15

2.3.5 Diversification of Income ............................................................................................... 15

2.3.6 Ownership....................................................................................................................... 16

2.3.7 Market Concentration ..................................................................................................... 17

2.4 Empirical Review ...................................................................................................................... 18

2.4.1 International Empirical Review....................................................................................... 18

2.4.2 Local Empirical Review ................................................................................................. 21

2.5 Summary of Literature Review ................................................................................................ 23

CHAPTER THREE: RESEARCH METHODOLOGY .............................................................. 25

3.1 Introduction.............................................................................................................................. 25

3.2 Research Design ...................................................................................................................... 25

3.3 Population ............................................................................................................................... 25

3.4 Data Collection ........................................................................................................................ 25

3.5 Data Analysis........................................................................................................................... 26

3.5.1 Analytical Model ............................................................................................................ 26

3.5.2 Test of Significance ........................................................................................................ 27

 CHAPTER FOUR : DATA ANALYSIS , RESULTS AND DISCUSSION...........................28

4.1 Introduction ..........................................................................................................................28

4.2 Findings.............................................................................................................................. ..28

4.2.1 Descriptive statistics..................................................................................................... 29

4.2.2 Inferential Statistics...................................................................................................... 29

4.2.2.1 Findings before Control variables are incorporated....................... ………..... .30

4.2.2.2 Univariate Analysis of Dependent Variables and Control Variables..... ……..30

4.2.2.3 Bivariate Analysis of Variables ……..………..………....................... …. …..31

4.2.2.4 Findings when effects of control variables are incorporated................. .. ……32

4.3 Interpretation of the Findings………………………............................................................33

CHAPTER FIVE: SUMMARY, CONCLUSION AND RECOMMENDATIONS ............34

5.1 Introduction ........................................................... ...............................................................34

5.2 Summary ……………...........................................................................................................34

5.3 Conclusion ...................................................................... .....................................................35

5.4 Recommendations for Policy …………..…..........................................................................35

5.5 Limitations of the Study .......................................................................................................36

5.6 Suggestions for Further Studies ............................................................................................36

REFERENCES ................................................................................................................................ 37

APPENDIXES................................................................................................................................ ..47
 LIST OF TABLES

PAGE

Table 4.1: Descriptive Statistics of all the Variables ………………………..………............... 29

Table 4.2: Model summary of ANOVA of Profitability (Y) and Non-performing loans (X1)…30

Table 4.3: Univariate Analysis of Dependent Variable and Control Variables...……................31

Table 4.4: Bivariate Analysis of Variables………………………..……………………………32

Table 4.5: Partial Correlations when Control variables are incorporated…..................... …….32

.
 LIST OF ABBREVIATIONS

CAMEL: Capital Adequacy, Asset Quality, Management efficiency, Liquidity

CBK: Central Bank of Kenya

CL: Consumer Loans

GLLP: General Loan Loss Provision

LLR: Loan Loss Reserve

NIM: Net Interest Margin

NPA: Non-Performing Asset

NPL: Non-Performing Loans

PM: Profit Margin

ROA: Return on Assets

ROE: Return on Equity

SPSS: Statistical packages for social sciences

TLP: Total Loan Portfolio

 ABSTRACT
Kenya commercial Banks have remained with persistent challenge of managing non performing
loans that are considered to have effects on its profitability. The government together with the
banking sector has established various ways of reducing non performing loans. Measures intro-
duced include licensing of Credit reference Bureaus. This study seeks to find out the effects of
nonperforming loans on profitability of commercial banks in Kenya. The study used commercial
banks registered and operational in Kenya as at CBK (2013). Profitability measured by return on
assets is used as dependent variable and non performing loans measured by non performing loans
ratio is used as independent variable. To improve the accuracy and reliability of the tests Capital
adequacy, Operational efficiency and Liquidity are used as control variables. The control vari-
ables used are part of CAMEL factors that also affect profitability of commercial banks. At the
end of the study the effect of nonperforming loans measured by non performing loans over total
loans on profitability measured by return on assets (ROA) was determined. The effects of control
variables on the relationship between non performing loans and return on assets were also
determined in the study. The research covered all commercial banks in Kenya for the last ten
years that is 2004-2013. The study used secondary data to analyze and draw conclusions and
recommendations. Multi-linear regression model similar to one used by Kaaya and Pastory
(2013) to analyze the effect of credit risk on banks’ performance in Tanzania by controlling the
effect of deposits and bank size was used. The study indicates that there is negative effect of
nonperforming loans ratio on return on assets, confirming that non performing loans negatively
affects profitability of commercial banks in Kenya. The study is in agreement with Kaaya and
Pastory (2013) in the fact that other factors other than non performing loans affect profitability of
commercial Banks. Managers of Commercial banks in Kenya have to work hard to enhance
profitability of commercial banks and reduce occurrences of nonperforming loans. This includes
taking measures to mitigate against moral hazard and adverse selections in advancing loans,
example, use of credit reference bureaus. Central bank of Kenya should enhance supervision of
commercial banks and consider analysis of relationship between ratios of nonperforming loans
and profitability to enhance understandability and avoid concentrating on quantum figures alone.
Central bank and shareholders should also take action to caution against possible use of provi-
sions for losses on non performing loans for smoothing earnings by the managers. This paper
therefore provides an insight to commercial banks, central bank and other stake holders on the
effect of nonperforming loans on profitability of commercial banks in Kenya and provides a
basis for further research.

Key words: Non-Performing Loans, profitability, Kenya, Commercial banks.

 CHAPTER ONE: INTRODUCTION

1.1 Background of the Study

Kenya’s banking sector involves 43 registered and licensed commercial banks providing
banking and financial services to customers (CBK, 2013). The commercial Banks had assets
worth 2.7 trillion as at December 2013 (CBK, 2013). Commercial banks in Kenya play an
important role in mobilizing financial resources for investment by extending credit to various
businesses and investors. Like any other business, success of banking is assessed based on
profit and quality of asset it possesses. Lending represents the heart of the banking industry
and loans are the dominant assets as they generate the largest share of operating income.
Loans however expose the banks to the greatest level of risk. Prudent credit risk assessment
and creation of adequate provisions for bad and doubtful debts can cushion the banks risk.
However, when the level of non-performing loans (NPLs) is very high, the provisions are not
adequate protection.

Kenya has experienced banking problems in the past, with report of major bank failures (37
failed banks as at 1998) following the crises of; 1986 - 1989, 1993/1994 and 1998 (Kithinji
and Waweru, 2007; Ngugi, 2006). Nonperforming loans has been attributed as one of the
causes of bank failures in Kenya and government and Banking sector has taken some meas-
ures to reduce non performing loans. Among the measures that have been put in place is
introduction of credit reference bureaus. (CBK 2013), reported that the ratio of non-
performing loans to gross loans increased from 4.7 percent in December 2012 to 5.2 percent
in December 2013, and the pre-tax profit for the sector increased by 16.6 percent from Ksh.
107.9 billion in December 2012 to Ksh. 125.8 billion in December 2013. While some few
past previous studies have confirmed effects of nonperforming Loans on profitability, some
studies have failed to confirm existence of effects of nonperforming loans on profitability.
This paper therefore, investigates on the effect of non- performing loans on profitability of
commercial banks in Kenya.
1.1.1. Non Performing Loans
Non Performing Loans (NPLs) are also called Non Performing Assets (NPAs). A Non-
performing Loan/ Asset is a credit facility in respect of which the interest and or principal
amount has remained past due for a specific period of time. A loan is an asset for a bank as
the interest payments and the repayment of the principal create a stream of cash flows. It is
from the interest payments that a bank makes its profits. Banks usually treat assets as non-
performing if they are not serviced for some time. If payments are late for a short time, a loan
is classified as past due and once a payment becomes really late (usually 90 days), the loan is
classified as non-performing. A high level of non-performing assets, compared to similar
lenders, may be a sign of problems.

Stuti & Bansal (2013), stated that the best indicator for the health of the banking industry in a
country is its level of Nonperforming assets (NPAs). Nonperforming loans reflects the per-
formance of banks. Decline in the ratio of Nonperforming loans indicates improvement in the
asset quality of public sector banks and private sector banks. Increase in the ratio of nonper-
forming loans to total loans on the other hand should worry commercial banks. The decline in
gross NPAs to gross advances indicates the improvement in the credit portfolios of both the
sector banks. Gross NPAs to total assets has direct bearing on return on assets as well as
liquidity-risk management of the bank. Non-performing Assets are threatening the stability
and demolishing bank’s profitability through a loss of interest income, write-off of the princi-
pal loan amount itself.

Non- performing loans are also commonly described as loans in arrears for at least ninety
days (Guy, 2011). Quality of assets in lending technologies is normally measured by the
quantum of non-performing loans and has been found a direct and interlinked relationship
between both (Guy 2011). Michael et al. (2006) emphasized that NPL in loan portfolio affect
operational efficiency which in turn affects profitability, liquidity and solvency position of
banks. Batra (2003) noted that in addition to the influence on profitability, liquidity and
competitive functioning, NPL also affect the psychology of bankers in respect of their dispo-
sition of funds towards credit delivery and credit expansion. According to Kroszner (2002),
non-performing loans are closely associated with banking crises. NPL generate a vicious
effect on banking survival and growth, and if not managed properly leads to banking failures.
When banks' amounts of disposal of non-performing loans exceed their profits, it will reduce
banks' net worth and lower their risk-taking capacity, making it difficult to invest funds in
risky projects and to realize potentially productive businesses. White (2002) links the Japa-
nese financial crisis to non - performing loans. According to White (2002), Japanese banks
still suffer under the weight of thousands of billions of yen of bad loans resulting from the
collapse in asset prices a decade ago in the country’s financial system.

According to Bloem and Gorter (2001) non-performing loans are mainly caused by an inevi-
table number of wrong economic decisions by individuals and plain bad luck (inclement
weather and unexpected price changes for certain products). Under such circumstances, the
holders of loans can make an allowance for a normal share of nonperformance in the form of
bad loan provisions, or they may spread the risk by taking out insurance. Nishimura at el
(2001) state that one of the underlying causes of Japan’s prolonged economic stagnation is the
non - performing or bad loan problem. Non– performing loans can be treated as undesirable
outputs or costs to a loaning bank, which decrease the bank’s performance (Chang, 1999).
The problem of non-performing loans can put serious adverse effects on the economy; the
government has implemented various policy measures for management of non-performing
loans and securing confidence in the financial system. This includes licensing of credit
reference Bureaus.

Two common measurements for Non Performing Loans/Assets are; Non performing Loans
ratio and Non performing Loans coverage ratio. Non performing coverage ratio refers to the
ratio of allowance for probable losses on non-performing loans to total nonperforming Loans
and its computed as follows; Provisions for Losses on non performing Loans over non per-
forming Loans. NPL ratio refers to the ratio of non-performing loans (NPL) to total loans
(gross of allowance for probable losses). It is measured as non performing loans over total
loans and advances. In this study non performing loans ratio measured by non performing
loans over total loans and advances has been used.
1.1.2 Profitability

Profitability of the banking sector is a subject that has received a lot of attention in recent
years and there is now a large literature which has examined the role played by management
of resources in determining bank profitability. Indicators used to measure profitability are
many and includes Return on Assets, Return on Equity and Net Interest Margin. There are
however divergent views among scholars on the superiority of one indicator over the others as
a good measure of profitability. For instance, Goudreau and Whitehead (1989) and Uchendu
(1995) believed that the three indicators are all good namely ROA, ROE and NIM . Hancock
(1989) used only ROE to measure profitability in her study. Odufulu (1994) used only the
gross profit margin in measuring profitability. Ogunleye (1995) did not believe that profit
level perse could constitute a good Measure of profitability and therefore used ROA and ROE
Uchendu (1995) believed that the three indicators are all good namely ROA, ROE and NIM .

Ahmed (2003) identified the three indicators, namely: Net Interest Margin (NIM), Return on
Assets (ROA) and Return on Equity (ROE) to be widely employed in the literature to measure
profitability. Profitability connotes a situation where the income generated during a given
period exceeds the expenses incurred over the same length of time for the sole purpose of
generating income (Sanni, 2006). The fundamental requirements here are that the income and
the expenses must occur during the same period of time using the Matching Concept and the
income must be a direct consequence of the expenses. The period of time may be one week,
three months, one year etc (Sabo, 2007). It is not immaterial whether or not the income has
been received in cash nor is it compulsory that the expenses must have been paid in cash. For
a profit-oriented organization, profit is the soul of business.

A company remains in operation because it expects to make profits. Once that expectation is
confirmed unattainable, the most rational decision is to close shop or exit the business.
According to Akinola (2008) Profitability measures, include Profit Before Tax (PBT), Profit
After Tax (PAT), ROE, Rate of Return on Capital (ROC) and ROA. Sanni (2009) used
Earnings Per Share (EPS). In this study, Return on Assets (ROA) considered as a good and
most widely used as a measure of profitability has been used. Return on Assets has been
measured as; Return on Assets (ROA) = Net Earnings/Total Assets.
1.1.3 The Effect of Non Performing Loans on Profitability

Performance in terms of profitability is a benchmark for any business enterprise including

commercial banks. However, increasing Non Performing Loans have a direct impact on
profitability of banks by diluting returns on assets. Non-performing assets therefore have
negative effect on return on Assets (ROA), a measurement of profitability. Non-performing
loans erode banks' profitability in that banks could incur heavy disposal expenses. Nonper-
forming Loans Assets have opportunity costs, in that the non interest earning assets (mainly in
form of money) could have been invested elsewhere and provide earns. Beside this, Banks
are also required to make provisions for losses on non performing assets which in turn affect
profitability and there is cost associated to attempts to recover bad loans. Managers however,
can use provisions for losses on non performing loans for their own objectives which could
include, use for profits smoothening ass supported by asymmetry of information theory and
agency theory.

Berger et al. (1997) in study of Problem Loans and Cost Efficiency in Commercial Banks
linked Problem Loans with Cost efficiency, which in turn affects profitability. Non– perform-
ing loans can be treated as undesirable outputs or costs to a loaning bank, which decrease the
bank’s performance (Chang, 1999). According to Kroszner (2002), non-performing loans are
closely associated with banking crises. Batra (2003) noted that in addition to the influence on
profitability, liquidity and competitive functioning, NPL also affect the psychology of bankers
in respect of their disposition of funds towards credit delivery and credit expansion.

Focus on Nonperforming loans leads to the credit risk management assuming priority over
other aspects of bank’s functioning Batra (2003). The bank’s whole machinery would thus be
pre-occupied with recovery procedures rather than concentrating on expanding business. Thus
NPL impact the performance and profitability of banks. The most notable impact of NPL is
change in banker’s sentiments which may hinder credit expansion to productive purpose.
Banks may incline towards more risk-free investments to avoid and reduce riskiness, which is
not conducive for the growth of economy. Michael et al. (2006), emphasized that NPA in loan
portfolio affect operational efficiency which in turn affects profitability, liquidity and sol-
vency position of banks.
1.1.4 Commercial Banks in Kenya

Kenya’s banking sector involves 43 registered and licensed commercial banks providing
banking and financial services to customers (CBK, 2013). The commercial Banks have asset
worth 2.7 trillion as at December 2013 (CBK, 2013) and offers financial services to many
industries, institutions and individuals in Kenya. Profit is the ultimate goal of commercial
banks. All the strategies designed and activities performed thereof are meant to realize this
grand objective. They have however remained with persistent challenge of reducing non
performing loans that have effects on profitability. Nonperforming Loans have continued to
rise.

The success of commercial banks is assessed based on profitability and quality of assets it
possesses therefore. Non-performing loans of Commercial banks affects quality of assets
which in turn affect profitability. To reduce growth of nonperforming loans, private credit
reference bureaus have been licensed and operationalised in Kenya, but has not lead to
reductions in non-performing Loans as expected. CBK (2013), The ratio of non-performing
loans to gross loans increased from 4.7 percent in December 2012 to 5.2 percent in December
2013. In the same period the pre-tax profit for the sector increased by 16.6 percent from Ksh.
107.9 billion in December 2012 to Ksh. 125.8 billion (CBK 2013). The report is likely to
confuse stake holders as to thinking there are positive correlations between non performing
loans and profitability.

Loans are the dominant assets of commercial banks as they generate the largest share of
operating income, however it expose commercial banks to the risks of default from borrowers
resulting in nonperforming Loans which in turn affects profitability. Commercial Banks
makes Provisions for Losses on non-performing loans and write off bad debts arising from
non performing Loans, thus reducing profit reserves. Nonperforming Loans of commercial
banks have opportunity costs, in that the non–interest earning Loans (money) could have been
invested elsewhere, to earn returns and increase profitability. There are also costs associated
to attempts to recover non performing loans and the costs affects profitability of commercial
banks.
1.2 Research Problem

Non Performing Loans have a direct impact on profitability of commercial banks by diluting
Returns on Assets (ROA), a measurement of profitability. Non-performing Loans Assets have
opportunity costs, in that the non–interest earning assets could have been invested elsewhere
and provide earnings. Managers also may use provisions for losses on non performing loans
for their own objectives which could include profits smoothening. There are other factors that
affect profitability of commercial banks which includes but not limited to CAMEL factors.

Kenya commercials Banks have remain with persistent challenge of reducing non performing
loans that is considered to have effects on profitability of Commercial Banks. Despite actions
that have been taken to reduce non performing loans that include licensing of Credit reference
Bureaus, non performing loans have continued to grow and commercial banks have recently
reported both increase in nonperforming loans and profits of the banks in the same periods.
Non-performing loans (NPLs) has maintained an increasing trend in commercial banks in
Kenya. CBK (2013), reported that the ratio of non-performing loans to gross loans increased
from 4.7 percent in December 2012 to 5.2 percent in December 2013, the pre-tax profit for the
sector increased by 16.6 percent from Ksh. 107.9 billion in December 2012 to Ksh. 125.8
billion in December 2013.

Berger et al., (1997) study Problem Loans and Cost Efficiency in Commercial Banks, the
study linked Problem Loans with Cost efficiency, which in turn affects profitability. Batra
(2003) noted that in addition to the influence on profitability, liquidity and competitive
functioning. Michael et al., (2006) emphasized that NPA in loan portfolio affect operational
efficiency which in turn affects profitability, liquidity and solvency position of banks. Kithinji
(2011), study Credit risk management and profitability of commercial banks in Kenya, and
found out that there is no relationship between profits, amount of credit and the level of
nonperforming loans. Macharia (2012) study the relationship between the level of nonperforming
Loans and the financial performance of commercial banks in Kenya. The study found that the bulk of
the profits of commercial banks is not influenced by the amount of credit and nonperforming loans
suggesting that other variables other than credit and nonperforming loans impact on profits. Kithinji
(2011) ,and Macharia (2012), did not consider other CAMEL factors affecting profitability of
commercial banks as control variables and did not use non-performing loans coverage ratio as
a measure of non- performing loans and used only non performing loans ratio as a measure-
ment of nonperforming loans in their studies.

This study intends to fill the research gap by taking into account other factors affecting
profitability of commercial banks as control variables in the regression analysis. The duration
of year 2004 to 2013 was considered appropriate to give the latest period of the study in
Kenya. The study therefore seeks to answer the question; Does non-performing Loans have
effects on profitability of commercial banks in Kenya?

1.3 Research Objective

To determine the effect of non-performing loans on profitability of commercial banks in

Kenya.

1.4 Value of the Study

The finding of the study is of interest to Commercial Banks managers as they will get to know
effects of nonperforming loans on profitability and encourage them take necessary measures
to control occurrences of nonperforming loans. The Central Bank of Kenya could employ the
findings of this research in the establishment of guidelines that helps in management of
nonperforming loans in the commercial banks in Kenya, while protecting the interest of the
public.

The study will also enable Financial Consultants to understand the sensitivity of return on
assets to non performing loans ratio and non performing loans coverage ratio and thereon
make financial advice to the commercial banks and other stake holders. The findings from this
study will also assist in providing more literature to support existing theoretical propositions
on the effects of nonperforming loans on profitability of commercial banks in Kenya and
provide a basis for further studies.
 CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction

This chapter contains the review of various studies that are relevant to non Performing Loans
and profitability of Banks.

2.2 Theoretical Review

This presents review of the relevant theories that explains the effects of nonperforming loans
on profitability of commercial banks in Kenya. The theoretical reviews covered are; Asym-
metric Information Theory, Agency Theory and Modern Portfolio Theory

2.2.1 Asymmetric Information Theory

This is a theory relevant for situations where there is imperfect knowledge. In particular it
occurs where one party has different information to another. Asymmetric information is a
problem in financial markets such as borrowing and lending. In these markets the borrower
has much better information about his financial state than the lender. Akerlof (1970) first
presented this theory in the easy; "The Market for Lemons”. It is the single most important
study in the literature on economics of information. Mirrlees (1996) study Asymmetry of
information related to access to information among participants in the process of making
economic decisions.

Pagaon and Jappelli (1993) show that information sharing reduces adverse selection by
improving banks information on credit applicants. Auronen ( 2003) The theory of asymmetric
information tells us that it may be difficult to distinguish good from bad borrowers, which
may result into adverse selection and moral hazards problems. The theory explains that in the
market, the party that possesses more information on a specific item to be transacted (in this
case the borrower) is in a position to negotiate optimal terms for the transaction than the other
party (in this case, the lender) (Auronen, 2003). The party that knows less about the same
specific item to be transacted is therefore in a position of making either right or wrong deci-
sion concerning the transaction. Adverse selection and moral hazards have led to significant
accumulation of non-performing loans in banks (Bofondi and Gobbi, 2003). Commercial bank
managers may know more about effects of nonperforming loans on profitability of commer-
cial banks than other stakeholders. In this case, they could fail to disclose nonperforming
loans and/ or use provisions for losses on non performing loans for profit smoothening.

2.2.2 Agency Theory

The first scholars to propose, explicitly, that a theory of agency be created, and to actually
begin its creation, were Ross (1973) and Mitnick (1973), independently and roughly concur-
rently. Ross (1973) is responsible for the origin of the economic theory of agency, and Mit-
nick (1973) for the institutional theory of agency, though the basic concepts underlying these
approaches are similar. Indeed, the approaches can be seen as complementary in their uses of
similar concepts under different assumptions.

The agency theory is gaining a lot of popularity in explaining the financial performance of
organizations. The theory seeks to explain the relationship that exists between the manage-
ment of an organization and the owners of the organization who are usually the people
holding stocks for the organization. The theory posits that there is an agency conflict. The
management of an organization is usually considered as an agent who has been contracted by
the stockholders to work towards enhancing the stockholder value through good financial
performance. The management is therefore expected to act in the best interests of the owners
and enhance the financial performance of the organization.

However, the theory suggests that the managers who are agents may be involved in activities
that are aimed at serving personal interest at the expense of the owners of the organization.
The theory suggests that when this happens, the financial performance of the organization
may easily suffer. Stockholders therefore can employ a number of strategies to ensure the
management acts in the interest on the organization. The theory suggests that management
can be rewarded financially in order to motivate them to work for the interests of the com-
pany. The owners can also issue threats such as hostile takeover to force management to
perform the required duties.
2.2.3 Modern Portfolio Theory

Markowitz (1952) Modern portfolio theory (MPT) is one of the most important and powerful
economic theories dealing with finance and investment. Modern portfolio theory measures the
benefits of diversification, known as “not putting all your eggs in one basket”. Modern
portfolio theory (MPT) is an investment theory which tries to explain how investors could
maximize their returns and minimize their risks by diversification in different assets. Tobin
(1958) expanded the theory of Markowitz’s (portfolio theory) by adding the analysis of risk-
free assets which made it possible to influence portfolios on the efficient frontier. Markowitz
(1952) and Tobin (1958) showed that it was possible to identify the composition of an optimal
portfolio of risky securities, given forecasts of future returns and an appropriate covariance
matrix of share returns.

The portfolio theory approach is the most relevant and plays an important role in bank per-
formance studies (Atemnkeng & Nzongang, 2006). According to the Portfolio balance model
of asset diversification, the optimum holding of each asset in a wealth holder’s portfolio is a
function of policy decisions determined by a number of factors such as the vector of rates of
return on all assets held in the portfolio, a vector of risks associated with the ownership of
each financial assets and the size of the portfolio. It implies portfolio diversification and the
desired portfolio composition of commercial banks are results of decisions taken by the bank
management. Further, the ability to obtain maximum profits depends on the feasible set of
assets and liabilities determined by the management and the unit costs incurred by the bank
for producing each component of assets, Atemnkeng & Nzongang, (2006. Commercial Banks
should consider diversifying investments portfolio to minimize risk of credit takers defaulting
in loans repayments and causing non-performing loans portfolios that affects profitability.
The concept of revenue diversifications follows the concept of portfolio theory which states
that individuals can reduce firm-specific risk by diversifying their portfolios. The proponents
of activity diversification or product mix argue that diversification provides a stable and less
volatile income, economies of scope and scale, and the ability to leverage managerial effi-
ciency across products and for the case of commercial banks, reduce non performing Loans
and increase Return on Assets which is a measure of profitability.
2.3 Determinants of Profitability of Commercial Banks

There are two categories of determinants of profitability of commercial banks, these are;
internal and external drivers or factors of Profitability. Internal drivers of bank performance or
profitability can be defined as factors that are influenced by a bank’s management decisions.
Such management effects will definitely affect the operating results of banks. Internal factors
includes; Capital Adequacy, Liquidity Risk, Credit Risk and Efficiency of Management

External determinants of bank profitability are factors that are beyond the control of a bank’s
management. They represent events outside the influence of the bank. However, the manage-
ment can anticipate changes in the external environment and try to position the institution to
take advantage of anticipated developments. The two major components of the external
determinants are macroeconomic factors and financial structure factors (Krakah and Ameyaw,
2010). Elyor (2009) and Uzhegova (2010) have used CAMEL to examine factors affecting
bank profitability with success. CAMEL stands for Capital adequacy, Asset quality, Man-
agement efficiency, Earnings performance and Liquidity. The system was developed by the
US Federal Deposit Insurance Corporation (FDIC) for “early identification of problems in
banks‟ operations” (Uzhegova, 2010). Though some alternative bank performance evaluation
models have been proposed, the CAMEL framework is the most widely used model and it is
recommended by Basle Committee on Bank Supervision and IMF (Baral, 2005). The follow-
ing are key determinants of profitability of commercial banks;

2.3.1 Capital Adequacy

Capital adequacy refers to the sufficiency of the amount of equity to absorb any shocks that
the bank may experience (Kosmidou, 2008). The Capital requirement of banks is highly
regulated by governments. This is because capital adequacy plays a crucial role in reducing
the number of bank failures and losses to depositors when a bank fails as highly leveraged
firms are likely to take excessive risk in order to maximize shareholder value at the expense
of finance providers (Kamau, 2009). Capital adequacy refers to amount of capital a bank or
other financial institution has to hold as required by its financial regulator. This is expressed
as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets.
The ratio of Equity to total Asset is employed as a measure for bank Capital Adequacy. This
measures the percentage of the total asset that is financed with equity capital. Capital ade-
quacy therefore describes the sufficiency of the amount of equity that can absorb shocks that
banks may experience. It is expected that the higher the Equity to Asset ratio, the lower the
need for external funding and therefore the higher the profitability of the commercial bank.
Bank with higher capital to asset ratio are considered relatively safer and tend to have a better
margin of cushion, remaining profitable even during economically difficult times. Conversely,
banks with lower capital adequacy are considered riskier relative to highly capitalized banks.
Capital adequacy is therefore considered to have effect on profitability of commercial banks.

2.3.2 Assets Quality

Asset quality is one of the CAMEL factors that determine profitability of commercial banks.
The quality of assets held by a bank depends on exposure to specific risks, trends in non-
performing loans, and the health and profitability of bank borrowers (Baral, 2005). Aburime
(2008) asserts that the profitability of a bank depends on its ability to foresee, avoid and
monitor risks, possibly to cover losses brought about by risks arisen. The asset quality meas-
ures an ability to manage credit risk of a commercial bank. The asset quality reflects the
composition and productivity of the assets. Thus, asset quality has a direct impact on the
profitability of a bank. Poor asset quality can be considered as major cause for banks poor
profitability. It is evaluated by understanding the performance of assets category wise and
estimating future performance factoring in the likely distribution of the assets in future
Commercial banks are negatively affected by raising levels of non-performing loans through
provisioning made, interest in suspense and opportunity costs of nonperforming As-
sets/money. Loan is the major asset of commercial banks from which they generate income.
The quality of loan portfolio determines the profitability of banks.

The loan portfolio quality has a direct bearing on bank profitability. Nonperforming loan
ratios are the best proxies for asset quality and affects profitability. The issue of Non-
Performing Assets (NPAs) has gained growing attention in the last few decades in view of the
established fact that the immediate consequence of bubbling up of NPAs in the banking
system is bank failure. Nonperforming assets/loans lowers overall Returns on Assets (ROA)
because loans is part of commercial banks assets. Return on Assets is a measure of profitabil-
ity of commercial banks. Negative the quality of Loans portfolio is predictor of insolvency
and cause of bank failures, failing banking institutions always have high level of non-
performing loans prior to failure. The problem of NPAs has also become synonymous to
functional efficiency of commercial banks and it’s believed to be the major causes of poor
financial performance. Asset quality aids improvement in profitability. In order to improve
profitability, it is important for commercial banks to manage their asset quality because it’s a
determinant of profitability.

2.3.3 Liquidity

Liquidity is another factor that determines Return on assets which is a measure of profitabil-
ity. Commercial banks should have liquid money to advance as loans to customers and in
another perspective liquid money should be advanced to earn returns because if they remained
in liquid form un-utilized will not earn any returns. Liquidity measures the ability of banks to
meet short-term obligation or commitments when they fall due. Traditionally, banks take
deposit from customers and give out loans. For this reason, the ratio of bank’s advances to
customer deposits is used as proxy for liquidity. Liquidity is a prime concern for banks and
the shortage of liquidity can trigger bank failure. Banking regulators also view liquidity as a
major concern.

According to CBK (2013) in Kenya the statutory minimum liquidity requirement is 20%.,
however, the average liquidity ratio for the sector was 39.8% in 2012, 38.6 % in 2013, and
way above the minimum requirements. Commercial Banks without sufficient liquidity to meet
demands of their depositors risk experiencing bankruptcy. Holding assets in a highly liquid
form tends to reduce income as liquid asset are associated with lower rates of return. For
instance, cash which is the most liquid of all assets is a non-earning asset. It would therefore
be expected that higher liquidity would negatively correlates with profitability. It is argued
that when banks hold high liquidity, they do so at the opportunity cost of some investment,
which could generate high returns (Kamau, 2009). The trade-offs that generally exist between
return and liquidity risk are demonstrated by observing that a shift from short term securities
to long term securities or loans raises a bank’s return but also increases its liquidity risks and
the inverse in is true. Thus a high liquidity ratio indicates a less risky and less profitable bank
(Hempel et al, 1994). Liquidity therefore is a determinant of profitability and management is
faced with the dilemma of liquidity and profitability.

2.3.4 Operational Cost Efficiency

Poor expenses management is the main contributors to poor profitability (Sufian and Chong
2008). Management too has potential of doing illegal acts such; using provisions for losses on
non performing Loans (assets) to smoothen profits. It is worth noting that income smoothing
is considered as a violation of the international accounting standards (IAS.39), which deter-
mined provisioning solely based on evidence of incurred losses or impairment (IASB, 2005).
The primary friction driving the smoothing is information asymmetry as insiders are averse to
choosing actions that would unduly raise outsiders' expectations about future income. Evi-
dence of the existence of earnings smoothing through provisions remains fairly strong, at least
for industrialized countries Pérez et al. (2008).

Cost efficiency and profit efficiency correspond respectively to two economic objectives of
cost minimization and profit maximization. Cost efficiency is the ratio between the minimum
cost at which it is possible to attain a given volume of production and the realized cost. The
Expense to Income ratio is used as proxy for operating efficiency and it is used to measure the
impact of efficiency on bank profitability. A negative correlation is expected between the
operating cost and profitability implying that higher operating cost means lower profit and
vice- versa. The objective of maximizing profits requires that goods and services be produced
at a minimum cost and maximizing of revenues and this is applicable to commercial banks.

2.3.5 Diversification of Income

The concept of revenue diversifications follows the concept of portfolio theory which states
that individuals can reduce firm-specific risk by diversifying their portfolios. The proponents
of activity diversification or product mix argue that diversification provides a stable and less
volatile income, economies of scope and scale, and the ability to leverage managerial effi-
ciency across products (Choi and Kotrozo, 2006). Chiorazzo et al. (2008) noted that as a
result of activity diversification, the economies of scale and scope caused through the joint
production of financial activities leads to increase in the efficiency of banking organizations
and consequently increase profitability. They further argued that product mix reduces total
risks because income from non-interest activities is not correlated or at least perfectly corre-
lated with income from fee based activities and as such diversification should stabilize
operating income and give rise to a more stable stream of profits (Uzhegova, 2010).

Albertazzi and Gambacorta (2006) as cited by Uzhegova (2010) noted that the decline in
interest margins that results in low profitability, has forced banks to explore alternative
sources of revenues, leading to diversification into trading activities, other services and non-
traditional financial operations. The opposite argument to activity diversification is that it
leads to increased agency costs, increased organizational complexity, and the potential for
riskier behavior by bank managers. Choi and Kotrozo (2006) mentioned that activity diversi-
fication results in more complex organizations which “makes it more difficult for top man-
agement to monitor the behavior of the other divisions/branches. They further argued that the
benefits of economies of scale/scope exist only to a point and costs associated with a firm’s
increased complexity may overshadow the benefits of diversification. As such, the benefits of
diversification and performance would resemble an inverted-U in which there would be an
optimal level of diversification beyond which benefits would begin to decline and may
ultimately become negative. Olweny & Shipho (2011) study effects of banking sectoral
factors on the profitability of commercial banks in Kenya and noted that the more banks
generate their revenue from different activities, the more profitable they become, thus linking
diversification of income with profitability of commercial Banks.

2.3.6 Ownership

The relationship between commercial banks profitability and ownership identity, emanate
from Agency Theory. This theory deals with owners and manager’s relationship, which one
way or the other refers to ownership and profitability. According to Ongore (2011), the
concept of ownership can be defined along two lines of thought: ownership concentration and
ownership mix. The concentration refers to proportion of shares held (largest shareholding) in
the firm by few shareholders and the later defines the identity of the shareholders. The domi-
nant shareholders can have the power and incentive to closely monitor the performances of
the management leading to better efficiency and better profitability. Close monitoring of the
management can reduce agency cost and enhance profitability of commercial banks. On the
other hand concentrated ownership can create a problem in relation to overlooking the right of
the minority and also affect the innovativeness of the management, negatively affecting
profitability.

Agency theoretic viewpoints argue that different ownership structure and different roles
people have in organizations are the main reasons for the existence of information asymmetry
and the divergence of interest between owners and managers. Claessens and Jansen (2000) as
cited by Kamau (2009) argued that foreign banks usually bring with them better know-how
and technical capacity, that spill over banking system and increase efficiency and in turn
increase profitability. Beck and Fuchs (2004) argued that foreign-owned banks are more
profitable than their domestic counterparts in developing countries and less profitable than
domestic banks in industrial countries, perhaps due to benefits derived from tax breaks,
technological efficiencies and other preferential treatments. Ownership therefore is one of the
factors that affect profitability of commercial banks, the level & direction of its effect how-
ever remained contentious.

2.3.7 Market Concentration

Market concentration is one important factor that affects profitability. The term concentration
emerged from the structure-conduct-performance theory (SCP theory) which postulates that
market concentration fosters collusion among firms in the market and earns monopoly profits.
On the one hand, concentration may act as a barrier to entry when entering markets where
domestic banks are highly concentrated, implying a negative impact on profits. On the other
hand, in a market dominated by foreign banks that have been found to be more efficient than
domestic banks, such as in less developed countries, concentration may in fact be positively
related to foreign banks’ profitability

According to Atemnkeng and Nzongang and (2006) high degrees of market share concentra-
tion are inextricably associated with high levels of profits at the detriment of efficiency and
effectiveness of the financial system to due decreased competition. According to the structure
conduct profitability of banks in highly concentrated markets earn monopoly rents, as they
tend to collude (Gilbert, 1984). As collusion may result in higher rates being charged on loans
and lower interest rates being paid on deposits, a higher bank concentration have a positive
impact on profitability. On the other hand, a higher bank concentration might be the result of
a tougher competition in the banking industry, which would suggest a negative relationship
between profitability and market concentration as stated in (Boone and Weigand 2000).

Market concentration influenced profitability and growth in the market created more opportu-
nities for the bank, thus generating more profits because banks gain market share and an
increase in earnings and an increase in profitability.

2.4 Empirical Review

Several empirical studies have been conducted on non performing Loans and profitability of
commercial banks and confirm that adverse changes in economy contribute to non-performing
loans and adversely affect the banks’ performance.

2.4.1 International Empirical Review

Hou and Dickinson (2007), which examined the non-performing loans on microeconomics,
specifically at the bank level to empirically evaluate how non-performing loans (NPLs) affect
commercial banks' lending behavior. In particular, it is discussing some consequences of non-
performing loans (NPLs) on the economics. They have used empirical methodology for
testing the effect of non-performing loans (NPLs) which the data taken from individual bank's
balance sheet to assess whether non-performing loans (NPLs) will negatively affect bank's
lending behavior.

Kolapo, et al. (2012) also analyzed the influence of credit risk on performance of five banks
in Nigeria by taking data from 2000-2010. Credit risk is measured by taking ratio of non-
performing loans to loans plus advances, total loans to advances plus deposits and ratio of
loan loss provisions while performance is measured by return on assets. Fixed effect model
used in the study and according to results of regression analysis, non-performing loans and
loan losses provisions are adversely affecting the performance while total loans to advance
plus deposit ratio has positive significant effect on the performance. This is evident from the
study that banking industry needs to improve their loan administration processes for maximi-
zation of profits.

Mohammed (2012) studied the bank performance in context of corporate governance for
which mainly the ratios of non-performing loans and loan deposits have been used. Study was
conducted on 9 banks of Nigeria for a period of 10 years from 2001-2010. According to
generalized least square regression results, non-performing loans ratio has significant negative
effect while loan deposit ratio has insignificant negative effect on performance. So, survival
of banks is strongly dependent upon the better asset quality means dependent upon minimiz-
ing the non-performing loans ratio.

Azeem & Amara (2013) study Impact of profitability on quantum of non-performing loans in
Pakistani Banks. The Data of one business cycle of sixteen Pakistani banks were collected
from 2006 to 2012. The sample comprised of sixteen public and private banks with different
sizes. Three models were adopted to check the relationship between profitability and non-
performing loans. Model one represented return on asset as dependent variable while non-
performing loans were taken as independent variable. Model two represented Return on
Equity as dependent variable while non-performing loans were taken as independent variable.
Model three represented Stock Return as dependent variable while non-performing loans were
taken as independent variable.

The results of the study were as follows; Model one using Returns on Assets indicated that
profitability and non-performing loans have negative relationship and that One thousand
increases in non-performing loans may decrease the profitability up to 0.00527 %. Model two
with Return on Equity indicated that profitability and non-performing loans have negative
relationship and that One thousand increases in non-performing loans may decrease the
profitability up to 0.00371%. Model three revealed that stock returns and non-performing
loans have no significant relationship and no room for generalization of results is possible on
this finding. The study found that NPLs disturb the profitability of banks and every other
financial institution, which is involved in lending activity and that in State Bank of Pakistan,
there are some reasons noted to have intensify this issue which are namely; marks up on mark
up, embezzlement in amount, wrong calculation procedures and divergent practices in calcu-
lating amount of NPLs. However, data of non- performing loans in Pakistan was only avail-
able from six years 2006 to 2012 and a Short panel of sixteen Banks only was used in the
study.

Shingjergji (2013) studied the impact of different bank specific factors on non-performing
loans of Albanian banks by taking quarterly data from 2002-2012. Dependent variable used in
the study is non-performing loans (NPLs) while independent variables include capital ade-
quacy ratio (CAR), loan to asset ratio (LTA), return on equity (ROE), natural log of total
loans, and natural log of net interest margin (NIM). Regression results obtained by using
ordinary least square revealed negative insignificant relation of CAR with NPLs. Relation of
loan to asset ratio has been found negative but total loans level is positively influencing the
NPLs means increased loans level will result in increased level of NPLs. On the other hand,
NIM and ROE are negatively linked with NPLs depicting that high NPLs deteriorate the
performance of banks.

Kaaya and Pastory (2013) analyzed effect of credit risk (measured by ratios of non-
performing loan, loan loss to gross loan, loan loss to net loan and impaired loan to gross loan)
on banks’ performance (measured by return on assets) by controlling the effect of deposits
and bank size. A sample of 11 banks in Tanzania has been used for this analysis. According to
correlation and regression results, credit risk measures of non-performing loans, loan loss to
gross loan, loan loss to net loan have significant negative influence on banks’ performance. It
is concluded that performance of banks can be increased by effective risk management as it
help to reduce non-performing loans and loan losses. Vatansever and Hepsen (2013) investi-
gated the presence of any significant relation (if exists) of non-performing loans with macro-
economic indicators, global and bank level factors in Turkey for a period of January 2007 to
March 2013. Results obtained from ordinary least square regression helped in categorizing the
factors significantly affecting the non-performing loans. Among various macroeconomic,
global and bank level factors used in the study, only the variables of industrial production
index, Istanbul stock exchange 100 Index, inefficiency ratio of all banks have significant
negative effect while unemployment rate, ROE and capital adequacy ratio have positive
significant effect on non-performing loans.

2.4.2 Local Empirical Review

Mausya (2009), study the impact of non-performing loans on the Performance of the bank-
ing sector in Kenya, an MBA project submitted to University of Nairobi and in his findings,
indicated that commercial banks are negatively affected by raising levels of non-performing
loans through provisioning made and interest in suspense. She outlines that majority of such
factors include under staffing, under qualified staff among others for years 2004-2008. In the
study, a sample of thirteen banks is used to show how these factors affect the performance of
these banks where the performance is represented by the profit before tax of the 13 sampled
banks. The research used a single regression equation approach to analyze the impact of non-
performing loans to financial sector stability. A second test with all the variables was run and
finally one with just NPLs interest income and provision as per the study framework Tests of
significance was be done to determine whether the effect of nonperforming loans on profit-
ability is significant. From the equation in chapter for the findings indicate that commercial
banks will be negatively affected by raising levels of non-performing loans through provision-
ing made and interest in suspense. From the study, the findings indicate that commercial
banks are negatively affected by raising levels of non-performing loans through provisioning
made and interest in suspense.

Kithinji (2011), study Credit risk management and profitability of commercial banks in
Kenya, paper submitted to Aibuma conference, Nairobi, Kenya. Non-performing loans was
measured using nonperforming loans/ total loans, and profits were measured using ROTA
(Return on Total assets). The trend of level of credit, nonperforming loans and profits were
established during the period 2004 to 2008. A regression model was used to establish the
relationship between amount of credit, non-performing loans and profits during the period of
study. R2 and t-test at 95% confidence level were estimated. Her findings reveal that the bulk
of the profits of commercial banks is not influenced by the amount of credit and nonperform-
ing loans suggesting that other variables other than credit and nonperforming loans impact on
profits. The results indicated that there is no relationship between profits, amount of credit
and the level of nonperforming loans. The research did not use other factors affecting profit-
ability of commercial banks as control variables in the study and the study covered only 6
year period.

Macharia (2012) study the relationship between the level of nonperforming Loans and the
financial performance of commercial banks in Kenya an MBA project submitted to University
of Nairobi. Multi linear analytical model was used to determine the relationship between the
NPLs and the financial performance of commercial banks. The relationship between these
‘’bad loans’’ and the financial performance represented by ROA was regressed. After deter-
mining the level of NPLs across the banks and the total outstanding shares, the relationship
between these variables was obtained. This involved regressing the NPLs with the ROA of the
firm for entire period of the study. NPLs were the independent variable in the regression
equation while ROA was the dependent variable. The study regression results indicate that
there is no relationship between profits, amount of credit and the level of non-performing
loans. The findings reveal that the bulk of the profits of commercial banks is not influenced
by the amount of credit and nonperforming loans suggesting that other variables other than
credit and nonperforming loans impact on profits. The study however did not consider other
factors affecting profitability of commercial banks such as Capital, Liquidity and management
efficiency as controlling variables.

Mombo (2013) study the effect of non-performing Loans on financial performance of deposit
taking micro finance Institutions in Kenya an MBA project submitted to University of Nai-
robi. The researcher used simple linear regression model used by Macharia (2012) in estab-
lishing the effect of non-performing loans on commercial banks in Kenya. One control
variable which was operating expenses of microfinance institutions and it was measured as a
percentage of the total revenue by microfinance institutions. The study made use of secondary
data that was obtained specifically from the financial stations of the microfinance institutions.
The study found out that non performing loan in deposit taking microfinance institutions
account for the greatest percentage of the variance in the profitability of the institutions. All
the three independent variables in the study; non performing loans, rate of loan repayment and
operational expenses largely affect the profitability of the institutions and that non performing
loans and operational expenses have more significant effect than the rate of loan repayment
that is achieved by the organization.

Mugwe (2013) study the relationship between firm-specific factors and financial performance
of commercial banks in Kenya. The study determine and evaluate the relationship between
bank-specific factors; capital adequacy, asset quality, liquidity and management efficiency on
the financial performance of Commercial Banks in Kenya. Secondary data of the 43 Kenyan
commercial banks from 2008 to 2012 obtained from published Audited Accounts of the
Commercial Banks, the Central Bank of Kenya Annual Reports and Oloo (2014). The data
was analyzed using Multiple Regressions method. The findings show that bank specific
factors considered are significantly associated with financial performance as indicated by the
positive mean values and their respective standard deviations. This means that bank specific
factors variables considered in the study Capital Adequacy, Liquidity, Management Effi-
ciency and Asset Quality are very crucial in affecting financial performance of commercial
banks in Kenya. The study results show that the capital strength of a bank is of paramount
importance in affecting its profitability and the asset quality affects the performance of banks
adversely.

2.5 Summary of Literature Review

From the studies above, it is evident that there exist theoretical concepts and empirical studies
that touches on effects of nonperforming Loans on profitability of Commercial banks in
Kenya. Asymmetry of information, agency theory and modern portfolio theory as important
theories that need further studies and applications. Empirical reviews have however given
different results on whether non-performing loans affects profitability of commercial banks in
Kenya. Some Empirical studies confirm that an indeed non performing loan affects profitabil-
ity of commercial banks in Kenya whereas others failed to confirm.
Studies did earlier have revolved much around how non performing loans have come to exist
as well as how to avoid the accumulation of such loans. For the few studies on effects of
nonperforming loans and financial performance of Commercial banks, did not consider other
factors affecting profitability of commercial banks such as Capital, operational efficiency and
Liquidity as controlling variables. Some studies also used as few as sixteen and a small
duration of a maximum of six years. Previous studies also gave little attention to asymmetric
information theory, agency theory and modern portfolio theory on the studies. For Local
studies in Kenya, none of the study used CAMEL factors as control variables in their studies
and failed to agree with previous international studies that allude to the fact that on perform-
ing loans affects profitability of commercial banks.

This study aimed to contribute to the gap in this field of study on effects of nonperforming
loans on profitability of commercial banks in Kenya. The study covered all the licensed 43
commercial banks in Kenya for a wide period of ten years. The study specifically established
the effects of non- performing loans on profitability of commercial banks in Kenya. The study
also focused on the following financial theories in the course of the study; Asymmetric
information theory, agency theory and modern portfolio theory. Bank specific factors affect-
ing profitability mainly; Capital Adequacy, Liquidity and Operational efficiency were used in
the study as controlling variables.
 CHAPTER THREE: RESEARCH METHODOLOGY

3.1 Introduction

This chapter discusses the methodology the researcher employed in investigating the effect of
nonperforming Loans on profitability of commercial banks in Kenya. Among the elements
discussed in this section are the target population, techniques used in data collection and as
well as the techniques used to analyze the collected data.

3.2 Research Design

The study is of descriptive survey design nature. A descriptive survey is a design that involves
establishing what is happening as far as a particular variable is concerned and the design has
been used to investigate the effect of non-performing loans on profitability of commercial
banks in Kenya. The study covered the period between 2004 and 2013. Profitability measured
by Return on Assets (ROA) has been taken as dependent variable and non performing loans
measured by non performing loans ratio of nonperforming loans over total loans and advances
has been taken as independent variable. CAMEL factors affecting profitability namely;
Capital adequacy, Operational costs efficiency and Liquidity have been considered in the
analysis as controlling variables.

3.3 Population

The targeted population for the study includes all the commercial banks that are registered by
Central Bank and operational in Kenya as at 31st December 2013. According to the Central
Bank of Kenya, there were 43 commercial banks that were operating in the country (CBK,
2013). The study collected data from all the 43 commercial banks since the population was a
small population and implied that a census was more applicable.

3.4 Data Collection

The data utilized in the study is secondary data. It comprised of Return on assets (ROA), Non
performing Loans ratio computed from the financial statements of the commercial banks for
the period year 2004 to 2013. Beside this the ratios for computing; Capital adequacy, Opera-
tional costs efficiency and Liquidity were computed from the financial statements of the
commercial banks for period under study and used as control variables. The data were
collected from; The Central Bank of Kenya reports, audited published accounts of commercial
banks in Kenya, Banking Survey (East Africa) Report and the Kenya National bureau of
statistics. A data collection sheet was prepared to assist in gathering the data.

3.5 Data Analysis

The data collected was sorted and organized before capturing the same in Statistical packages
for social sciences (SPSS) for analysis. ANOVA, Univariate, Multivariate analysis of Multi-
Factor ANOVA and Partial Correlation Analysis was done.

3.5.1. Analytical Model

The multi-linear regression model similar to one used by Kaaya and Pastory (2013) to ana-
lyzed effect of credit risk on banks’ performance in Tanzania by controlling the effect of
deposits and bank size was used. Profitability measured by return on Assets was taken as
dependent variable, non-performing loans measured by non performing loans over total loans
and advances was taken as independent variable and Capital adequacy, Operational costs
efficiency and Liquidity were taken as controlling variables in the multi-linear regression as
follows;
Y = α + β1X1+ β2X2+ β3X3+ β4X4+ е

Where:
Y= Profitability measured using Return on Assets
α = Constant
βi = Beta Coefficient of variable i which measures the responsiveness X to unit change of in i
X1= Non performing Loans, measured using Non performing loans ratio. Computed as total
non-performing Loans over Total Loans and advances (Total non-performing Loans / Total
loans and advances).
X2-X4: Control Variables
The Controlling variables have been added to take consideration of the CAMEL factors that
also affects profitability in the analysis.
Where:
X2- Capital Adequacy. Measured as a ratio of Core Capital over Total Risk Weighted Asset
Computed as (Core Capital / Total Risk Weighted Assets)
X3- Operational Cost Efficiency – Measured as Cost income ratio and computed as; (total
expenses/Total Revenue)
X4- Liquidity – Measured as Ratio of Liquid Assets to Total Liabilities. Computed as (Quick
Assets/ Total liabilities)
e= error term

3.5.2 Test of significance

Parametric tests were estimated to determined the significance of the relationship using; The
correlation coefficient (r), coefficient of determination ( r²), coefficient of multiple correlation
(R²), Univariate Analysis, Bivariate Analysis, Partial correlation, and ANOVA using F-Test.
Correlation coefficients, r, measures the strength and the direction of a linear relationship
between the two variables. The coefficient of determination, r², determines the degree of
linear-correlation of variables ('goodness of fit') in regression analysis. The coefficient of
multiple correlation R² measures how well a dependent variable could be predicted using a
linear function of a set of other variables (covariates).

Bivariate analysis of variables showed the relationships between any two variables for the
purpose of determining the empirical relationship between them. Partial Correlation tests
examined relationship between dependent variable and independent variable, while control-
ling for other variables that may be related to the dependent variable. ANOVA provided
statistical test of whether or not the means of several groups are equal. F-test showed if
variances of two variables were equal and two-tailed test was used to test against the alterna-
tive that the variances are not equal. Univariate analysis of dependent variable and Control
Variables shows the relationships between dependent variable and control variables.
 CHAPTER FOUR: DATA ANALYSIS, RESULTS AND DICUSSION
4.1 Introduction
This chapter presents data analysis, results and discussion made from the study on the effects
of nonperforming Loans on profitability of commercial banks in Kenya.

4.2 Findings
The regression analysis was performed with the independent variables being non performing
Loans ratio and non performing loan coverage ratio. Profitability measured by Return on
assets (ROA) was the dependent variable. Capital Adequacy, Operational efficiency and
Liquidity have been used as control variables. The population consisted of 43 commercial
banks licensed by the Central bank of Kenya and operational in Kenya in the period (2004-
2013) and the data was collected from the financial statements of each commercial bank and
annual mean aggregates for all the commercial banks were obtained for each period under the
study. Data obtained were transferred to SPSS as variables for regression analysis and results
were obtained.

Results are as indicated in tables 4.1 to 4.5. The findings of the study show; descriptive
statistics, Univariate analysis of dependent variables and control variables, findings before
control variables are incorporated, the findings when effects of control variables are incorpo-
rated and interpretations of the findings. The adjusted R-square measures the degree of
variability of the dependent variable due to the change in the independent variable. Two tail
Test of significance was carried out for all variables studied at 5 % test of significance and
95% confidence level. From the observation, any p-value that is greater than 0.05 was
deemed to show significant relationship between variables tested, else the relationship was
considered insignificant. The dispersion of all observations is divided into variance explained
by the regression and residual variance, unexplained. R² has been taken as the proportion of
variance explained in relation to the total variance. The standardized coefficient and the F-
statistic indicated the strength of the relationship between the variables and the appropriate-
ness of the set of data to the regression model and/or test.
4.2.1 Descriptive statistics
Table 4.1: Descriptive Statistics of all the Variables

Std.
N Minimum Maximum Mean Deviation Skewness Kurtosis

Std. Std. Std.

Statistic Statistic Statistic Statistic Error Statistic Statistic Error Statistic Error

Y 10 10.88 15.21 12.7410 .34514 1.09142 .896 .687 3.282 1.334

X1 10 3.67 21.27 9.0670 1.94886 6.16284 1.143 .687 .048 1.334
X2 10 13.06 16.15 14.6470 .36487 1.15382 -.370 .687 -1.569 1.334
X3 10 50.36 60.13 55.6910 1.13189 3.57936 -.196 .687 -1.440 1.334
X4 10 31.35 40.29 37.0420 .94450 2.98677 -.933 .687 -.340 1.334
Valid N
10
(listwise)

Source: Research Findings

The table shows the summary of minimum, maximum, mean, standard deviation, Skewness
and Kurtosis of data used to analyze the variables. Minimum, and maximum, mean and
standard deviation from the mean of the variables in 10 year period/ time series in the study.
Skewness indicates asymmetry and deviation from a normal by data in the distribution
analysis. Kurtosis indicates flattening or "peakedness" of data in the distribution

4.2.2 Inferential Statistics

This shows the findings of the regression analysis obtained. It shows findings on effects on
non performing loans on profitability of commercial banks before incorporating control
variables on regression analysis, then correlations between all variables and finally the effect
of nonperforming loans on profitability when control variables are incorporated in the regres-
sion analysis.
4.2.2.1 Findings before Control variables are incorporated
The findings show ANOVA of Return on Assets (Y) and Non Performing Loans (X1) and
before control variables are incorporated.

Table 4.2 Model Summary of ANOVA of Profitability (Y) and Non Performing Loans
(X1 )

Std. Error Change Statistics

Mod R Adjusted R of the R Square F Sig. F
el R Square Square Estimate Change Change df1 df2 Change
a
1 .705 .497 .434 .82077 .497 7.914 1 8 .023
a. Predictors: (Constant), X1
Source: Research Findings

Table 4.2 above show ANOVA of Return on Assets (Y) and non performing Loans (X1)
before control variables are incorporated. The F test of 7.914 and significance tests of 0.023
indicates that test is appropriate and significant. The adjusted R square of 0.434 indicates that
non performing Loans ratio explains 43.4% of the variation between non performing Loans
ratio and profitability of commercial banks. The result also indicates correlation coefficient R
of negative (-) 0.705. This indicates that there is a negative relationship between profitability
measured by ROA (Y) and Non performing Loans measured by Non Performing Loans Ratio
(X1) and the test is statistically significant.

4.2.2.2 Univariate Analysis of Dependent variable and Control variables

Univariate analysis of dependent variable and Control Variables shows the relationships
between dependent variable and control variables. Table 4.3 shows the effect of control
variables X2,X3, and X4 on Return on Assets (Y). It gives F test and R squared and Adjusted R
squared results between the dependent variable and control variables.
Table 4.3: Univariate Analysis of Dependent Variable and Control Variables

Dependent Variable: Y

Type III Sum of

Source Squares df Mean Square F Sig.
a
Corrected Model 6.396 3 2.132 2.958 .120
Intercept .976 1 .976 1.355 .289
X2 1.022 1 1.022 1.418 .279
X3 .697 1 .697 .967 .363
X4 .023 1 .023 .032 .864
Error 4.325 6 .721
Total 1634.052 10
Corrected Total 10.721 9

a. R Squared = .597 (Adjusted R Squared = .395)

Source: Research Findings

The Table 4.3 above shows the relationships between dependent variable and control vari-
ables. The results shows Adjusted R squared of 0.597 meaning that control variables can
explain up to 39.5 % of the variances between dependent variable and control variables. The
fact that significance tests are greater than 0.05 indicates that not all control variables are
significant in explaining the variance between dependent variable and the control variables.

4.2.2.3 Bivariate Analysis of Variables

This shows the findings of relationships between any two variables for the purpose of deter-
mining the empirical relationship between them. The table 4.4 indicates that independent
variable X1 and control variables X2 and X3 are significant and appropriate in explaining
relationships with dependent variable Y because it has significant tests of 0.23, 0.017 and
0.029 respectively when regressed with Y. The table also show that shows that variables X1,
X2,X3, and X4 have relationships between themselves meaning there is Multicollinearity
between the variables. It also and show that control variable X4 is not appropriate and is not
significant because it has significant tests of 0.544 when regressed with dependent variable Y.
This indicates that Liquidity has no significant linear relationship with return on assets and
other control variables used in the test.
Table 4.4: Bivariate Analysis of Variables

Y X1 X2 X3 X4
* * *
Y Pearson Correlation 1 -.705 .729 -.684 .219

Sig. (2-tailed) .023 .017 .029 .544

* * *
X1 Pearson Correlation -.705 1 -.732 .706 .203
Sig. (2-tailed) .023 .016 .023 .573
* * *
X2 Pearson Correlation .729 -.732 1 -.688 .322
Sig. (2-tailed) .017 .016 .028 .364
* * *
X3 Pearson Correlation -.684 .706 -.688 1 -.052
Sig. (2-tailed) .029 .023 .028 .886
X4 Pearson Correlation .219 .203 .322 -.052 1

Sig. (2-tailed) .544 .573 .364 .886

*. Correlation is significant at the 0.05 level (2-tailed).

Source: Research Findings

4.2.2.4 Findings when effects of control variables are incorporated

This shows regression results of dependent variable and independent variables when control
variables are incorporated

Table 4.5: Partial Correlations when Control variables are incorporated

Control Variables Y X1
X2 & X3 & X4 Y Correlation 1.000 -.404

Significance (2-tailed) . .368

Df 0 5

X1 Correlation -.404 1.000

Significance (2-tailed) .368 .

Df 5 0

Source: Research Findings

Table 4.5 above shows the results of independent and dependent variables when effects of
control variables are considered. Observation in respect to independent variable X1 indicate
that Return on Assets (Y) give negative (-) 0.404 correlation with Non performing Loans
ratio (X1) after incorporating control variables X2,X3, and X4. This indicates that non per-
forming loan ratio can explain relationship between nonperforming loans and profitability of
commercial banks even when control variables are incorporated.

4.3 Interpretation of the Findings

Result of tests without taking into account effects of Control Variables indicates that return on
assets (Y) and Non performing Loans Ratio (X1) have correlation coefficient of negative (-
)0.705 and significance test of 0.023. The results also gives the adjusted R square of 0.434
which indicates that non performing Loans explains 43.4% of the variation between non
performing Loans and profitability of commercial banks. The test of correlation of coeffi-
cients to establish effects of incorporating control variables into the relationship between
dependent variable and independent variables shows that non performing loans ratio nega-
tively affects profitability of commercial banks to extend of negative 40.4 %.

It is evident from the findings that non performing loans negatively affect profitability of
commercial banks in Kenya. This can be illustrated by the results of test of nonperforming
loans measured by non performing loans ratio and profitability measured by return on Assets.
The findings also established that some control variables such as; Capital adequacy and
operational cost efficiency are significant in explaining variances with profitability while
other control variables like liquidity are in appropriate and insignificant in explaining the
variances with profitability and non performing loans.
 CHAPTER FIVE: SUMMARY, CONCLUSION AND RECOMMENDATIONS

5.1 Introduction

The study set out to find the effect of nonperforming loans on profitability of commercial
banks in Kenya. This chapter presents discussions of the key findings, conclusion and rec-
ommendations from the findings.

5.2 Summary

The study is on the effect of nonperforming loans on profitability of commercial banks in

Kenya. The key concepts in the study are non performing loans and profitability in context of
commercial banks in Kenya. Profitability is measured by Return on Assets (ROA) and non
performing Loans are measured by non performing Loans ratio. Other CAMEL factors
affecting profitability were considered as control variables. The control variables considered
are; Capital Adequacy, Operational Efficiency and Liquidity. This study was conducted
through the use of a descriptive design. The Population of study comprised of the entire 43
Commercial Banks that have been licensed by Central Bank of Kenya. The secondary data in
this analysis covered a period of 10 years from 2004 to 2013.

Multi linear regression model was used to analyze the data. The findings established that non
performing loans negatively affects profitability of commercial banks. It also indicate that non
performing loans ratio measured by non performing loans over total loans and advances is a
good measure of nonperforming loans as the findings indicate that it is appropriate and
statistically significant in explaining variance with return on assets. The study also indicates
that Capital Adequacy and Operational cost efficiency affects profitability of commercial
banks in Kenya. In essence, the study informs that mere reporting of increases in profits and
increases in nonperforming loans could be misleading and that financial ratios have impor-
tance of enhancing understandability of financial performance. In particular non performing
loans ratio and return on assets ratio analysis can inform better on the effects of nonperform-
ing loans on profitability of commercial banks than mere comparison of quantum figures.
5.3 Conclusion

This study examines the effect of nonperforming Loans on profitability of commercial banks
in Kenya. The regression results indicate that non performing loans negatively affects profit-
ability of commercial banks in Kenya. The study found that non performing loans ratio
measured by non performing loans over total loans and advances is appropriate and signifi-
cant in explaining effect of non-performing loans on profitability of commercial banks. The
findings also indicated that Multi linear regression model is appropropriate for testing the
effects of nonperforming loans on profitability using non performing loans ratio as indepen-
dent variable and return on assets are dependent variable respectively. This study therefore
confirmed that non performing loans negatively affects profitability of commercial banks in
Kenya. The findings are supported by Berger et al (1997), Batra (2003), Michael et al (2006)
and Mausya (2009).

5.4 Recommendations for policy

On the basis of the foregoing Analysis, discussion and observations in the study it would be
appropriate to make the following recommendations; Central bank of Kenya being the regula-
tor of banking sector should consider reporting on ratios rather than mere changes in trends of
specific items especially non performing loans and profitability. The reporting of mere
increases in nonperforming loans and profits by commercial could be misleading as ratios
such as return on assets, Non performing Loans ratio and Non performing Loans coverage
ratio can enhanced understandability of relationships between changes in profitability and non
performing Loans gross volumes. Central bank and share holders of commercial banks should
be aware of possible use of provisions for losses on non performing Loans by managers for
smoothening of profits & develop financial reporting models that can help prevent occurrence
of the menace. The share holders specifically should be ready to meet agency costs to reduce
manager’s information asymmetry by hiring competent internal and external auditors.

Management of commercial banks should mitigate against Moral hazard and adverse selection
risks when advancing loans to minimize occurrences of nonperforming loans. This can be
achieved by good credit appraisal procedures, effective internal control systems, diversifica-
tion along with efforts to improve asset quality in the balance sheets. Maintaining profitability
is a challenge too for commercial banks in Kenya and commercial banks should remain
innovative especially on cost cutting techniques which include leveraging in technology and
minimizing occurrences of nonperforming loans.

5.5 Limitations of the Study

The scope of the current study was limited to the secondary data obtained from financial
statements of commercial banks in Kenya for the last ten (10) years. The researcher faced a
problem with accessing financial data from the Central Bank of Kenya and commercial banks
directly because of lengthy processes involved in obtaining the information and published
financial statements and reports were used to extract data. Secondly the limitation of time was
much pronounced since the sources of the data operate on working days and the researcher is
equivalently an employee. The data for the period under the study were also posing a chal-
lenge especially the year 2013 where some financial ratios were not available and had to be
computed and consumed a lot of time. The study also indicated multicolinearity between the
dependent variable, independent variable and some control variables; this means that the
estimate of nonperforming loans impact on the profitability while controlling for the Control
variables may be less precise.

5.6 Suggestions for Further Studies

Future research could expand this scope to include other parameters that are used to measure
profitability and non performing Loans of commercial banks in Kenya. Other factors such as
the interest rates charged on the loans and diversification of portfolios and how they relate to
the overall profitability of the commercial banks can be considered as moderating or control-
ling variables in future studies. Further studies should be done on possible use of provisions
for losses on non performing loans for profit smoothening by managers of commercial banks
in Kenya. The study on effect of non-performing loans on profitability should also be done on
other financial institutions such as Micro Finance Institutions to find out if the same results
would be achieved
 REFERENCES:
Aburime, T. U. (2008). Determinants of bank profitability: Macroeconomic evidence from
Nigeria. Available at SSRN 1231064.

Ahmed, A. (2003). Trends in Profitability of Banks in Nigeria: Before and During Interest
Rate Deregulation a Comparative Analysis. NDIC Quarterly, 12, 59-83.

Akerlof, G. A. (1970). The market for" lemons": Quality uncertainty and the market mechanism.
The quarterly journal of economics, 488-500.

Akinola, G. O. (2008). Effect of globalization on market structure, conduct and performance

in Nigerian banking industry. In An Unpublished PhD Post Field Seminar, Depart
ment of management and Accounting, Obafemi Awolowo University, Ile-Ife.

Albertazzi, U., & Gambacorta, L. (2009). Bank profitability and the business cycle. Journal
of Financial Stability, 5(4), 393-409.

Angklomkliew, S., George, J., & Packer, F. (2009). Issues and developments in loan loss
provisioning: the case of Asia. BIS Quarterly Review, 69-83.

Arim, M.A,, Ekpo I.C., & Mustapha A.M. (2013). Determinants of banks profitability In a
developing economy: Evidence from Nigerian banking industry, Ilorin, Nigeria.

Atemnkeng, J., & Nzongang, J. (2006). Market structure and profitability performance in the
Banking industry of CFA countries: The case of commercial banks in Cameroon.

Alton, R.G. and Hazen J.H. (2001). As Economy Flounders, Do We See A Rise in Problem
Loans? Federal Reserve Bank of St. Louis.

Auronen, L. (2003). Asymmetric information: theory and applications. In Seminar in

Strategy and International Business.
Azeem, A & Amara (2013), Impact of profitability on quantum of non-performing loans,
Virtual University of Pakistan.

Banwo, S. (1997). The Funds flow Statement: Towards Enhanced Utility. 1997 ICAN News,
Structural Issues in the Kenyan Financial System:

Baral, K.J. (2005).Health Check-up of Commercial Banks in the Framework of CAMEL: A

Case Study of Joint Venture Banks in Nepal. The Journal of Nepalese Business studies
2(1) 14-35.

Batra, S. (2003). Developing the Asian markets for non-performing assets—developments in

India. In 3rd Forum on Asian Insolvency Reform (FAIR), Seoul, Korea, November (pp.
10-11).

Beck, T. & Fuchs, M. (2004). Structural issues in the Kenyan financial system: Improving
Competition and access (Vol. 3363). World Bank Publications

Berger, A. N. & De Young R., (1997). Problem loans and cost efficiency in commercial
banks, Journal of Banking & Finance.

Bloem, A. M., & Goerter, C. N. (2001). The Macroeconomic Statistical Treatment of

Non-Performing loans. Discussion Paper, Statistics Department of the IMF.

Bofondi, M. and Gobbi G. (2003), Bad Loans and Entry into Local Credit Markets,
Bancad’Italia, mimeo.

Boone, J., & Weigand, J. (2000). Measuring competition: how are cost differentials mapped
into Profit differentials?. CPB, bj@ cpb. nl, WP, (131).
Brownbridge, M. (1998). The Causes of Financial Distress in Local Banks in Africa and
Implementations for Prudential Policy, UNCTAD OSG/DP/132.

Caprio, G. Jr. and Klingebiel D. (1996). Bank Insolvency: Bad Luck, Bad Policy or Bad
Banking, Annual World Bank Conference on Development Economics.

Central Bank of Kenya, (2009), (2010), (2011),(2012) & (2013). Annual Supervisory report:
Nairobi, Kenya.

Chang, C. C. (1999). The nonparametric risk-adjusted efficiency measurement: an application

to Taiwan's major rural financial intermediaries. American Journal of Agricultural
Economics, 81(4), 902-913.

Choi, S., & Kotrozo, J. (2006). Diversification, Bank Risk and Performance: A Cross-country
Comparison.[Online]. October 2006.

Chiorazzo, V., Milani, C., & Salvini, F. (2008). Income diversification and bank performance:
Evidence from Italian banks. Journal of Financial Services Research, 33(3), 181-203.

Claessens, S., & Jansen, M. (2000). The Internationalization of Financial Services: issues and
Lessons for developing countries.

Elyor, S. (2009). Factors affecting the performance of foreign banks in Malaysia. Master of
Science (Banking), College of Business, University Utara Malaysia.

Fofack, H. (2005). Nonperforming loans in Sub-Saharan Africa: causal analysis and macro-
economic implications. World Bank Policy Research Working Paper, (3769).

Gaitho E. W. (2010), A survey of the causes of non - performing loans of Commercial banks
in Kenya. An MBA project submitted to the University of Nairobi
Goudrean, R.E. & Whitehead D.D. (1989). Commercial bank profitability improved in 1988.
Economic Review, Federal Reserve Bank of Atlanta, July/August

Guy, K. (2011). Non-performing loans. Research and Economic Analysis, 37(1), 10.

Hancock, D. (1989). Bank Profitability, Deregulation and the Production of Financial Services.
Research Working Paper, Federal Reserve Bank of Kansas City, December, 1998.

Hempel, G., Simonson, D., and Coleman, A. (1994). Bank Management: Text and Cases. 4th
Edition, John Wiley & Sons, Inc.

Hennie, V. G (2003), Analyzing and Managing Banking Risk: A Framework for Assessing
Corporate Governance and Financial Risk, 2nd Edition, Washington DC: World Bank
Publications.

Hou,Y., & Dickinson, D. (2007). The non-performing loans: some bank-level evidences.
In 4th International Conference on Applied Financial Economics, Samos Island,
Greece.

IASB, I.A.S.B (2005). International Financial Reporting Standards (IFRS) 2005. London:
International accounting standard Committee Foundation.

Kaaya, I., & Pastory, D. (2013). Credit Risk and Commercial Banks Performance in Tanza-
nia: a Panel Data Analysis. Research Journal of Finance and Accounting, 4(16), 55-62

Kamau, A.W. (2009). Efficiency in the Banking Sector: An Empirical Investigation of

Commercial Banks in Kenya. A thesis submitted in partial fulfillment of the Require-
ments of Nairobi University for the Degree of Doctor of Philosophy. Nairobi: Univer-
sity of Nairobi
Kamunge, E. M. (2013). The effect of interest rate spread on the level of nonperforming loans
of commercial banks in Kenya, An MBA project submitted to the University of Nairobi

KithinJi, A & Waweru. N.M. (2007). Merger Restructuring and Financial Performance of
Commercial banks in Kenya. Economic, Management and Financial Markets Journal,
2 (4), 9-39.

Kithinji, M. A. (2011). Credit risk management and profitability of commercial banks in

Kenya. Aibuma conference. Nairobi, Kenya.

Kutsienyo L. (2011). The determinant of profitability of banks in Ghana. A Thesis submitted

to Institute of Distance Learning, Kwame Nkrumah University of Science and Tech-
nology. Accra, Ghana.

Kolapo, T. F., Ayeni, R. K., & Oke, M. O. (2012). Credit risk and commercial banks’ per-
formance in Nigeria: A panel model approach. Australian Journal of Business and
Management Research, 2(2),pg 31-38.

Kosmidou, K. (2008). The determinants of banks' profits in Greece during the period of EU
financial integration. Managerial Finance, 34(3), 146-159.

Krakah, A. K. & Ameyaw, A. (2010). The Determinants of Bank’s Profitability in Ghana:

The Case of Merchant Bank Ghana Limited (MBG) and Ghana Commercial Bank
(GCB). A Master’s Thesis in Business Administration, MBA programme. Accra ,
Ghana.

Kroszner, P. (2002). Non-Performing Loans, Monetary Policy and Deflation: The Industrial Country
Experience. Economic and Social Research Institute Cabinet Office, Government of Japan.
Laurin, A., & Majnoni, G. (2003). Bank loan classification and provisioning practices in
selected developed and emerging countries (No. 1). World Bank Publications.

Macharia, J. N (2012). The relationship between the level of nonperforming Loans and the
financial performance of commercial banks in Kenya, An MBA project submitted to
the University of Nairobi

Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 12(7): 77-91.

Mausya, W. B. (2009). The Impact Of Non-Performing Loans on The Performance of The

Banking Sector in Kenya. An MBA project submitted to the University of Nairobi.

McNulty, J., Akhigbe, A. & Verbrugge, J. (2001). Small Bank Loan Quality in a Deregulated
Environment: The Information Advantage Hypothesis. Journal of Economics and
Business, 53, 325-39

Michael, JN., Vasanthi, G., & Selvaraju, R. (2006). Effect of Non-Performing Assets on
operational Efficiency of Central-Cooperative Banks, Indian Economic Panorama,
6(3). 33-39.

Mirrlees, J. A. (1997). Information and incentives: the economics of carrots and sticks. The
Economic Journal, 107(444), 1311-1329.

Mitnick, B. (1973). Fiduciary rationality and public policy: the theory of agency and some
Consequences. Available at SSRN 1020859.

Mohammed, F. (2012). Impact of Corporate Governance on Banks Performance in Nigeria.

Journal of Emerging Trends in Economics & Management Sciences, 3(3), 257-260.
Mombo, C.A. (2013). The effect of Non-performing Loans on the Financial Performance of
Deposit taking micro finance in Kenya. An MBA proposal submitted to the Univer-
sity of Nairobi.

Mugwe, M.N (2013). The relationship between Firm-specific factors and Financial Perform-
ance of commercial Banks in Kenya. MBA proposal submitted to the University of
Nairobi.

Nishimura, K., Kazuhito, I. And Yukiko, O (2001). The Disposal of Non-Performing

Loans and Its Potential Influence.
http://www5.cao.go.jp/keizai3/2001/0628furyousaiken-e.pdf

Ngendo, K. (2012). The relationship between non interest income and financial performance
of commercial banks in Kenya. An MBA proposal submitted to the University of Nairobi.

Ngugi, N., Amanja D. & Maana L. (2006). Capital Market, Financial Deepening and Eco-
nomic growth in Kenya. [Online]. Available from: http://www.csae.ox.ac.uk/ confer-
ences/2009-EDiA papers/513-Isaya.pdf [Accessed: 06 June 2014]

Nzongang, T. & Atemnkeng, J. (2006). Market Structure and Profitability Performance in the
Banking Industry of CFA countries: the Case of Commercial Banks in Cameroon.
[Online]May2006.Available from: http://www.jsdafrica.com/Jsda/Summer_2006/PDF
[Accessed: 28 June 2010]

Odufulu, O. (1994). Monetary Policy and Banks’ Profitability in Nigeria. First Bank of
Nigeria Plc Bi-Annual Review, December.

Ogunleye, R.W. (1995). Monetary Policy Influence on Banks’ Profitability. NDIC Quarterly,
5(4), December.
Okpara, G. C. (2009). A Synthesis of the Critical Factors Affecting performance of the
Nigerian Banking System. European Journal of Economics and Administrative sci-
ences. [Online]. Issue 17 ISSN 1450-2887. Available from:
http://www.eurojournals.com [Accessed: 05/06/2014]

Ongore, V.O. (2011) The relationship between ownership structure and firm performance:
An empirical analysis of listed companies in Kenya. African Journal of Business
Management, 5(6),2120-2128.

Ongore, V. and Kusa, G. (2013) Determinants of Financial performance of Commercial

Banks in Kenya. International Journal of Economics and Financial Issues, 3 (1): 237-252.

Olugbenga, S. & Olankunle, A. (1998). Bank Performance and Supervision in Nigeria: Analysing
the Transition to Deregulated Economy. RP 71. [Online]. March 1998.Available
from;:http://idl-bnc.idrc.ca/dspace/bitstream/10625/22919/1/113309.pdf
[Accessed: 8 June 2014]

Oloo, O. (2014). The Banking Survey East Africa. Think Business. Nairobi.

Olweny, T., & Shipho, T. M. (2011). Effects of banking sectoral factors on the profitability of
commercial banks in Kenya. Economics and Finance Review, 1(5), 1-30.

Pagaon, M., & Jappelli, T. (1993). Information sharing in credit markets. The Journal of
Finance, 48(5), 1693-1718.

Pazarbasioglu, C. (1999). Determinants and Leading Indicators of Banking Crises: Further

Evidence.

Perez, D., Salas-Fumas, V., & Saurina, J. (2008). Earnings and capital management in alterna
tive Loan loss provision regulatory regimes. European Accounting Review, 17(3), 423-
445.
Rajput, N., Gupta, M., & Chauhan, M. A. K. (2012). Profitability and credit culture of NPAs:
An empirical analysis of PSBs. International Journal of Marketing, Financial Services
& Management Research, 1(9), 91-109.

Ross, S. A. (1973). The economic theory of agency: The principal's problem. The American
Economic Review, 134-139.

Rouse, C. N. (2002). Bankers' lending techniques. Global Professional Publication.

Sabo, B. (2007). An Assessment of the Determinants of the Nigerian Banking Industry

Profitability: Using Panel Evidence from Nigerian Commercial Banks. The Informa-
tion Manager Vol. 7 (2) 2007.

Sanni, M.R. (2006). Consolidated Accounts Made Simple. Ilaro, Ogun State, Nigeria, IPS
Educational Press, 178-180.

Sanni, M.R. (2009). The effects of the 2006 consolidation on profitability of Nigerian Banks.
Nigerian Research Journal of Accountancy (NRJA), a Publication of The Institute of
Chartered Accountants of Nigeria (ICAN), Lagos, 1(1): 107-120.

Sethi, J., & Bhatia, N. (2007). Elements of Banking and Insurance, 2nd Edition, Prentice Hall
India Publications

Shingjergji, A. (2013). The Impact of Bank Specific Variables on the Non Performing Loans
Ratio in the Albanian Banking System. Research Journal of Finance and Accounting,
4(7), 148-152.

Song, I. (2002). Collateral in Loan Classification and provisioning (No. 2002-2122).

International Monetary Fund.
Stuti, M., & Bansal, (2013). S. An analysis of non-performing assets in Indian
Banking sector.

Sufian, F. & Chong, R. R. (2008). Determinants of Bank Profitability in a Developing Econ-

omy: Empirical Evidence from Philippines. Asian Academy of Management Journal of
Accounting and Finance, 4(2) p.91-112.

Thygerson, K.J.(1995),Management of Financial Institutions. Harper Collins College Publishers,

Tobin, J.1958.Liquidity Preference as Behavior towards Risk. Review of Economic Studies

25(1): 65–86.

Uchendu, O.A. (1995). Monetary policy and the performance of commercial banking in
Nigeria. Monograph, Research Department, CBN.

Uzhegova, O. (2010). The relative importance of bank-specific factors for bank profitability
In developing economies.

Vatansever, M., & Hepsen, A. (2013). Determining Impacts on Non-Performing Loan Ratio
In Turkey. Journal of Finance and Investment Analysis, 2(4), 119-129.

Warue, B. N. (2013). The Effects of Bank Specific and Macroeconomic Factors on Nonper-
forming Loans in Commercial Banks in Kenya: A Comparative Panel Data Analysis.
Advances in Management & Applied Economics, 3(2), 135-164.

White, S. S. (2002). Banking Crisis in Japan: Prediction of Non-Performing Loans.

 APPENDIX. 1

List of commercial banks in Kenya as at 31 December 2013 as per CBK Report, 2013.

1. African Banking Corporation Ltd. 23. Giro Commercial Bank Ltd.

2. Bank of Africa Kenya Ltd. 24. Guardian Bank Ltd

3. Bank of Baroda (K) Ltd. 25. Gulf African Bank Limited

4. Bank of India 26. Habib Bank A.G Zurich

5. Barclays Bank of Kenya Ltd. 27. Habib Bank Ltd.

6. CFC Stanbic Bank Ltd. 28. Housing Finance

7. Chase Bank (K) Ltd. 29. Imperial Bank Ltd

8. Citibank N.A Kenya 30. Investment & Mortgages Bank Ltd

9. Commercial Bank of Africa Ltd. 31. Jamii Bora Bank.

10. Consolidated Bank of Kenya Ltd. 32. Kenya Commercial Bank Ltd

11. Co-operative Bank of Kenya Ltd. 33. K-Rep Bank Ltd

12. Credit Bank Ltd. 34. Middle East Bank (K) Ltd

13. Development Bank of Kenya Ltd. 35. National Bank of Kenya Ltd

14. Diamond Trust Bank (K) Ltd. 36. NIC BANK

15. Dubai Bank Kenya Ltd. 37. Oriental Commercial Bank Ltd

16. Ecobank Kenya Ltd 38. Paramount Universal Bank Ltd

17. Equatorial Commercial Bank Ltd. 39. Prime Bank Ltd

18. Equity Bank Ltd. 40. Standard Chartered Bank (K) Ltd

29. Family Bank Ltd 41. Trans-National Bank Ltd

20. Fidelity Commercial Bank Ltd 42. UBA Kenya Bank.

21. Fina Bank Ltd 43. Victoria

22. First community Bank Limited

Source: CBK (2013)

 APPENDIX - II

COMMERCIAL BANKS IN KENYA

INDUSTRY GROSS FIGURES

GROSS NON PERFORMING LOANS AND GROSS PROFITS FIGURES

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

KSHS. KSHS. KSHS. KSHS. KSHS. KSHS. KSHS. KSHS. KSHS. KSHS.
Millions Million Million Million Million Million Million Million Million Million

NON PERFORMING LOANS 68,397 66,868 63,281 40,314 47,939 51,278 50,391 43,609 50,118 67,395

PROFIT BEFORE TAX 13,907 18,346 25,578 34,214 43,982 48,696 73,600 89,000 106,120 123,619

SOURCE: RESEARCH FINDINGS

 APPENDIX - III

COMMERCIAL BANKS IN KENYA

INDUSTRY GROSS FIGURES

GROSS NON PERFORMING LOANS AND GROSS TOTAL LOANS & ADVANCES ANNUAL AGGREGATES

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

KSHS. KSHS. KSHS. KSHS. KSHS. KSHS. KSHS. KSHS. KSHS. KSHS.

Millions Million Million Million Million Million Million Million Million Million

NON PERFORMING LOANS 68,397 66,868 63,281 40,314 47,939 51,278 50,391 43,609 50,118 67,395

TOTAL LOANS & ADVANCES 321,557 395,813 448,936 519,195 689,639 761,458 956,564 1,189,331 1,335,531 1,575,923

SOURCE: RESEARCH FINDINGS

 APPENDIX - IV

VARIABLES USED: - INDUSTRIAL AGREGATES OF ALL BANKS

ANALYSIS OF DATA COLLECTED
PERIOD : YEAR 2004 - YEAR 2013

Description of items 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
% % % % % % % % % %
Dependent Variable:
Return on assets(total income/total assets) 10.88 12.2 12.6 12.09 12.91 12.88 12.62 12.68 15.21 13.34

Independent Variable:
Non perfoming Loans Ratio 21.27 16.89 14.1 7.76 6.95 6.73 5.27 3.67 3.75 4.28

Control Variables:
Capital Adequacy 13.38 13.06 14.62 13.07 14.21 15.53 15.48 15.63 16.15 15.34
Operational Cost Efficiency 60.13 59.27 55.48 57.48 56.48 59.88 54.28 52.16 51.39 50.36
Liquidity 37.6 37.96 40.29 33.87 31.35 38.79 39.22 33.81 39.75 37.78

Source: Research Findings