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Commercial Banks play a significant role in the economic growth of a country

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Commercial Banks play a significant role in the economic growth of a country

CHAPTER ONE

INTRODUCTION

 

Background information.

Commercial Banks play a significant role in the economic growth of a country. This is because they have the power to control the supply of money, which is the key trigger of economic development (Malakolunthu & Rengasamy, 2012). Bank performance can be described as a representation of the use of the bank’s resources that helps it to accomplish its goals.  Bank performance also means the adoption of a set of indicators indicating the status of the bank and the extent of its capacity to achieve its goals (Malakolunthu & Colorado, 2012). Over the years, the financial sector has expanded rapidly in Kenya. This has been an increase driven by the banking sector’s creativity and dynamism. While development is remarkable, there have been many challenges in the banking sector in Kenya. The major challenges, however, are the financial distress factors (Kithinji and Waweru 2017). This study will mainly focus on the following distress factors, Capital adequacy, asset quality, management efficiency, Earnings, and Liquidity.

Financial distress factors have a major effect on the performance and competitiveness of commercial banks (Hotchkiss and Altman 2013). It drives banks to poor productivity and cash shortages. Financial distress factors may also cause market productivity issues through cash flow and depletion of sales or operating profits. They also affect operating profits which contributes to short-term insolvency, which will decrease the capacity of the firm by reducing working capital and rising debt.

Distress factors affect the financial performance of banks. Such aspects are affected by the internal decisions of the board and administration. These considerations often come into the domain of the bank to exploit them and differ from one bank to another. These include money, the value of the bank liabilities, the size and structure of the loan portfolio, interest rate policy, labor efficiency, and the economy. Information infrastructure, the standard of risk control, the scale of the branch, and ownership among other issues (Dang, 2011).

 

 

Capital adequacy is the amount of capital required by a commercial bank to enable them to face risks like credit, business, and operating uncertainties that they are likely to incur to cover future liabilities and shield the debtors of the company. Capital is one of the big bank unique factors that have a significant effect on the amount of productivity of the bank. Capital reflects the sum of own funds available to fund the operation of a commercial bank. The capital of a bank serves as a hedge in situations that it is detrimental to the bank. Besides, the capital provides liquidity for banks, since deposits are more vulnerable and sensitive to banking. A good capital amount minimizes the risk of distress within the company. Capital adequacy is calculated based on the capital adequacy ratio (CAR) (Nyanga, 2012). The minimum CAR that is approved is 8%. A higher ratio indicates the bank has a high risk of insolvency. While a lower CAR value suggests a bank has a high potential to deal with the insolvency risk under the minimum limit threshold (Mulualem 2015).

Asset quality is a measure of the probability that a loan is defaulted combined the marketability. The quality of assets, therefore, is the measure of the price, as determined by the borrower a bank would sell the loan to a third party. Bank assets include credit portfolio, fixed, and current assets among other investments. Loans represent the largest share of an asset of a bank and are the biggest danger to its resources (Nyanga, 2012). Many products that have a potential effect on asset quality include real estate, many properties, off-balance-sheet products, and cash due from accounts and premises. The CBK measures the quality of the assets by the non-performing loans to gross loans. A higher ratio shows a poor quality of assets.

Management efficiency is the capacity of the board of directors and management to identify actions, control the risk associated with operations of a banking institution, and to ensure safe and effective operation in compliance with the relevant rules and regulations. A bank’s management efficiency is measured by various financial ratios such as total asset growth, the rate of credit growth, and the growth rate of profits. Subjective evaluation of management systems, organizational discipline, and management systems, as well as the quality of employees among other factors, demonstrate the performance of management (Ongore and Kusa, 2013). Furthermore, management’s willingness to use its resources appropriately, optimize income, minimize operating costs capital can be calculated by financial ratios. In terms of measuring quality management, operating profit to income ratios is particularly useful. About operational performance and income production the higher the operating profits the more easily management can generate overall sales. The number of operating costs and in turn effects on the income of the bank is calculated substantially by the performance of the management system (Ongore and Kusa, 2013).

Earnings ability is the potential for a bank to make profits so that it can be able to expand, be competitive in the market, and to increase capital. The main purpose of this is to absorb the loss and boost the bank’s capital, from the regulatory standpoint of the bank. A variety of accounting rations (including the asset return (ROA), return on equity ( ROE), and the net interest income margin (NIM), can also be used to measure earning ability (Ongore and Kusa, 2013). A score of 1 indicates that a bank is high in terms of earning potential profits needed to retain appropriate capital and loan allowance which can fund operations effectively. A rating of 5 indicates persistent losses in a bank and is a direct threat to the solvency of a bank through capital erosion (Mulualem, 2015).

Liquidity refers, in particular, to the ability of the bank to fulfill its obligations. The bank’s profitability is based on adequate levels of liquidity. Management will use the capital and liquid liquidity ratio, available to sell securities and government securities to total assets, as a proxy metric (Ongore & Kusa, 2013). To calculate capital and liquidity. Commercial banks with a reduced liquid asset level run the risk of not financing their daily operations. Liquidity is measured using the common financial ratios that show a bank’s liquidity position. The ratios include customer deposits to total assets and total loan to customer deposits and cash to deposit ratio (Nyanga, 2012).

 

Tier III Banks in Kenya

Kenya Central Bank (CBK) has categorized commercial banks into three groups in Kenya. The ranking is based on market share, asset base, resources, and amount of Deposits of consumers (CBK, 2016). Tier I is consisting of major banks with billions in terms of capital, customer deposits, and assets. There are presently eight banks in Kenya ranked as tier I. Those eight banks are responsible for about 65.4% of the overall market. 66.7% of deposits, deposit accounts of 90.3 percent, and credit accounts of 94.10% (CBK 2017). Tier II banks consist of 11 commercial banks that dominate 26% of the business banking industry, 0.25% of total deposits, 7.6% of accounts receivable, and 3.8% of the total loan accounts. Tier Three commercial banks consist of 23 banks with 8.9% of market share, 8.2% of gross deposits, 1.8% of savings accounts, and 1.8% of credit accounts (CBK 2017).

Over the last few years, the banking sector has shown robust growth. However, when analyzed by tier classification, it was established that the pre-tax profits of tier three commercial banks decreased by 2.2% during the period 2015 to 2016. This decline was attributed to five commercial banks in this category posting losses. The first community bank realized a loss of Kshs. 41.0 million, Jamii Bora Bank realized a loss of Ksh.490.0 million, and Consolidated Bank realized a loss of Kshs. 277.0 million (CBK2016;2017). While Dubai Bank and Imperial Bank were placed under receivership for their failure maintains adequate capital and liquidity ratios, large non-performing loans, and corporate governance structures. This indicates that tier three commercial banks in Kenya have challenges that can result in or do result in financial distress.

 

Problem statement

The banking sector is one of the sectors to promote the achievement of the 2030 vision by ensuring that successful financial and investment services can be provided in Kenya. This will create a vibrant global competitive financial system (ROK, 2007). However, this can only be achieved if can manage properly the distress factors. The banking sector is the engine that drives economic growth. Through efficient resource allocations in any economy, this will result in global competitiveness. This is noted in the Kamau (2011) and Mwega (2011). Commercial banks provide financial systems with an efficient and key source of liquidity. Despite this, between 2005 and 2017 over 10 financial institutions either failed, liquidated or they were placed under receivership.  (CBK, 2017). Most of these banks fall under tier III. This means that, on average, every year over the eleven years a financial institution collapsed, making it a worrying trend.

Literature review shows that several local and research studies have been carried out relevant considerations based on the international arena. Research done by Obamuyi (2013) in Nigeria shows that bank-specific factors such as efficient management of expenses and higher interest incomes affect the profitability of a company. The same study has also shown that macro-environmental variables such as favorable economic conditions contribute to increased earnings of banks. Irungu (2013) identified that the rise of non-performing loans increases banks’ financial risks but it doesn’t impact the companies earning ability. Irungu (2013) states, however, that the rise in risk was a problem because financial instability could be triggered which leads to the collapse of the company. Other studies carried out in Islamic banks and the United Arab Emirates (UAE), by Hassan and Al-Mazrooei (2007), and Zaabi (2011) indicate that financial distress factors do not impact the financial performance. The financial performance was most influenced by the UAE bank’s corporate management and efficiency standard according to AlMazrooei (2007) and Zaabi (2011).

Ongore and Kusa (2013) study focused on factors affecting the performance of the Kenyan banking sector. They observed in their study that management decisions affect commercial banks ‘ performance in Kenya and that macro-economic conditions have minimum impact on banks’ performance. The study, however, excluded the effect of distress factors on banks’ financial performance. Most studies conducted on commercial banks’ effects on performance have been focussed on macro-economic and other factors like corporate governance with little focus on the CAMEL distress factors, especially on tier III banks. There are also contradicting results on the effects of distress factors from literature. This research intended to fill this research gap by concentrating on these distress factors effects on the financial performance of tier III banks as well as establish whether they affect the banks. Besides, the research will focus on the Kenyan market as a developing country as previous studies in this area are concentrated in developed or emerging markets with a focus on the impacts of distress factors on the financial performance of tier III banks. Tier III banks are also not doing well in the market and there is a need for research to establish what the cause might be. This will help them improve and have a good competitive advantage in the market.

1.3 Research objectives

1.3.1 General Objective

The main objective of this study will be to analyze the impact of financial distress factors on the financial performance of tier III commercial banks in Kenya.

1.3.2 Specific objectives

  1. To establish the impact of Capital adequacy on the financial performance of tier III banks in Kenya.
  2. To determine the impact of Asset quality on the financial performance of tier III banks in Kenya.
  3. To determine the impact of Management efficiency on the financial performance of tier III banks in Kenya.
  4. To establish the impact of Earnings on the financial performance of tier III banks.
  5. To determine the Liquidity impact on the financial performance of tier III banks in Kenya.

 

1.3.3 Research questions

  1. What is the impact of Capital adequacy on the financial performance of tier III banks in Kenya?
  2. What is the impact of Asset quality on the financial performance of tier III banks in Kenya?
  3. What is the impact of Management efficiency on the impact of the financial performance of tier III banks in Kenya?
  4. What is the impact of Earnings efficiency on the impact of the financial performance of tier III banks in Kenya?
  5. What is the impact Liquidity on the financial performance of tier III banks in Kenya?

 

1.5 Value of the study

This study through its findings and recommendations will provide the financial organization with information on how various elements of distress factors have had on the financial performance of the banks in the past and the impacts they are likely to have in the future for:

Policymakers/regulators.

The study will enable policymakers in the financial sector to realize the important role of the financial distress factor plays for the overall success of the sector as a whole.

Practitioners.

This study, through its findings and recommendations, will provide the financial organization with information on how various elements of the distress factors have affected the financial performance of the banks in the past and the impacts they are likely to have in the future. Therefore, the study will provide a framework through which strategies will be implemented by the banks to address the risks and challenges faced by banks due to the distress factors.

Researchers.

This study will contribute to the existing knowledge in the same field and also provide additional data and information for future research in the same field.

 

1.6 Scope of the study

The study will focus on the impact of financial distress factors on the financial performance of tier III banks in Kenya. Therefore, data will be collected from tier III banks.

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