4 2project

JOMO KENYATTA UNIVERSITY OF AGRICULTURE AND TECHNOLOGY
TO ANALYSE THE RELATIONSHIP BETWEEN CREDIT RISK MANAGEMENT
INDICATORS, PERFORMANCE, AND PROFITABILITY OF COMMERCIAL
BANKS IN KENYA
A research proposal submitted in partial fulfilment of the requirements of the degree of
Bachelor of Science in Financial Engineering at the Jomo Kenyatta University of
Agriculture and Technology
SUPERVISOR: Dr. Victor Musau
(2021)
DECLARATION
We declare that this research is our original work and it has not been submitted anywhere for
a degree award. Acknowledgments have been made where we have used other people's
ideas. We take full responsibility for any shortcomings that may be found in this project.
Signature........................................Date.......................
AMOS MUTENDE SCM222-0722/2017
Signature........................................Date.......................
CLIFF MUCANGI SCM222-0346/2017
Signature........................................Date.......................
GRACE KINYUA SCM222-0336/2017
Signature........................................Date.......................
LILIAN KATUNYU SCM222-0364/2017
Signature........................................Date.......................
SOLOMON KARANJA SCM222-0398/2017
This research has been submitted for examination with my approval as a university
supervisor
Signature....................................Date.........................
Dr. Victor Musau
ii
ACKNOWLEDGEMENT
We would like to express our deep and sincere gratitude to the Almighty God for bringing us
this far. He has been gracious to us by giving us wisdom and understanding. Secondly, we
would like to thank our research supervisor, Dr. Victor Musau, for providing invaluable
guidance throughout this research. His dynamism, vision, sincerity, and motivation deeply
inspired us. It was a great privilege and honour to work and study under his guidance. Lastly,
we would like to thank our friends and family who supported us and offered deep insights
into the study.
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TABLE OF CONTENTS
DECLARATION......................................................................................................................ii
ACKNOWLEDGEMENT......................................................................................................iii
TABLE OF CONTENTS........................................................................................................iv
LIST OF ABBREVIATIONS...............................................................................................vii
ABSTRACT.............................................................................................................................ix
CHAPTER ONE.......................................................................................................................1
INTRODUCTION....................................................................................................................1
1.1 Background of Study.................................................................................................1
1.1.1 Credit Risk Management....................................................................................2
1.1.2 Financial Performance and Profitability of Commercial Banks.........................2
1.2 Statement of the Problem..........................................................................................3
1.3 Study Objectives.......................................................................................................4
1.3.1 Main Objective...................................................................................................4
1.3.2 Specific objectives..............................................................................................4
1.4 Justification of Study.................................................................................................4
CHAPTER TWO.....................................................................................................................5
LITERATURE REVIEW........................................................................................................5
2.1 Introduction...............................................................................................................5
2.2 Credit Risk................................................................................................................6
2.3 Credit Risk Management...........................................................................................7
2.4 Performance and Profitability...................................................................................9
iv
2.5 Conclusion and Summary.......................................................................................11
CHAPTER THREE...............................................................................................................12
RESEARCH METHODOLOGY.........................................................................................12
3.1 Introduction.............................................................................................................12
3.2 The Research Design...............................................................................................12
3.3 The population of Study..........................................................................................12
3.4 Data Collection........................................................................................................13
3.5 Data Analysis..........................................................................................................13
3.6 Panel Data...............................................................................................................16
3.6.1 Balanced and Unbalanced Panels.....................................................................16
3.6.2 Panel Data Models............................................................................................18
3.7 Properties of Panel Data Estimators........................................................................23
3.8 Choosing between Pooled OLS and Random effects: Breusch-Pagan Lagrange
Multiplier (LM) Test.....................................................................................................24
3.9 Choosing Between Fixed and Random Effects: Hausman Test..............................24
3.10 Diagnostic Tests....................................................................................................25
REFERENCES.......................................................................................................................27
APPENDICES........................................................................................................................32
Workplan..............................................................................................................................32
Budget Estimation.........................................................................................................33
v
LIST OF TABLES
Table 3.1: Variables, Description, and Formulas..................................................................24
Table 3.2: An example of a Panel Data Table........................................................................29
vi
LIST OF ABBREVIATIONS
ABSA Amalgamated Banks of South Africa
CAR Capital Adequacy Ratio
CBK Central Bank of Kenya
CR Credit Risk
DR Debt Ratio
DW Durbin Watson
EL Expected Loss
FE Fixed Effects
FGLS Feasible Generalised Least Squares
GLS Generalized Least Squares
LM Lagrange Method
LGD Loan Given Default
LSDV Least Squares Dummy Variable
NCBA National Cooperative Business Association
NPLR Non-Performing Loan Ratio
NSE Nairobi Stock Exchange
OLS Ordinary least squares
ROA Return On Assets
ROE Return On Equity
vii
RE Random Effects
UL Unexpected Loss
TL Total Loans
viii
ABSTRACT
Credit risk management in the banking sector is important not only because of the Financial Crisis
experienced in recent years but also due to its greater impact on bank’s financial performance,
growth and survival. Credit loans is one of the key sources of income of commercial banks,
therefore managing the risk related to credit greatly impacts the bank’s profitability. This study
analyses the relationship between credit risk management indicators, financial performance and
profitability of the Kenyan commercial banks. Data from 6 selected commercial banks listed in NSE
for the period 2016 to 2020 has been collected and analyzed using Random Effect model which was
the consistent model based on Hausman test. In the model specification, return on Equity(ROE) and
return on Assets (ROA) were used as banks’ profitability and performance indicators while capital
adequacy ratio (CAR), debt ratio (DR), bank size (BS), loan loss provision ratio (LLPR), non-
performing loan ratio (NPLR) were used as indicators of credit risk management.
The findings indicate that credit risk management has significant impact on the profitability and
performance of the Kenyan commercial banks. Results show that non-performing loans, capital
adequacy ratio, and bank loan loss provision have a negative impact on banks’ performance and
profitability. On the other hand, debt ratio, size of bank are found to have a negative impact
profitability while size of banks has a positive impact on performance of the commercial banks.
However, size of bank and debt ratio turned out to be not significant variables in explaining the
bank’s performance and profitability. The study thus recommends an effective credit risk
management for commercial banks of Kenya by maintaining an optimum level of capital adequacy
ratio, controlling and monitoring non-performing loan, ensure leverage to enhance financial
performance and profitability of the commercial banks.
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CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
The financial sector in Kenya comprises insurance companies, commercial banks, pension
funds, and mortgages oriented historically to meet the needs of external trade and large-scale
commerce. Commercial banks are the most active players in the financial system and, in
particular, in the financial markets among the various financial institutions. Commercial
banks are regarded as financial institutions that primarily intermediate between the lenders
and borrowers. This means that they receive deposits from their clients who have a surplus
and lend the money to the clients with cash deficits (borrowers). They also provide capital for
the development of infrastructure and the creation of jobs. Therefore, commercial banks have
become an inherent part of society, in the industries and individual consumers.
Financial intermediation, however, may give rise to different types of risks with different
weights. Some of the risks include credit, liquidity, market, reputational, and operational
risks. Among the plethora of risks, the literature reveals that the commonly investigated risk
is credit risk. It’s the oldest form of risk in the capital market and is probably the main risk
for commercial banks. Anthony (1997) asserts that credit risk arises when non-performing
borrowers are unable or unwilling to perform in the pre-committed contract. Many
commercial banks have suffered losses due to the high non-performing loans ratio, which
indicates credit risk management. As a result, credit risk management in commercial banks
has become a crucial concept that influences the continuity, growth, and profitability of
commercial banks.
Commercial banks have varying regulatory policies which determine how well they mitigate
their risks. This, to a greater extent, affects the type of credit facilities they give to clients and
1
their investment decisions, thus affecting their performance and profitability. According to
Umoh (2002), not many banks can withstand a persistent run; even when a good lender of
last resort exists, depositors withdraw all their funds. The bank runs short of funds, hence
lacking liquidity support. At long last, the commercial bank forcefully closes its doors. This
means that the risks the banks are exposed to are endogenous while others are exogenous.
Although banks have been developing new policies to guide their daily activities and protect
themselves against such risks, they are still vulnerable to shocks mainly due to credit risks.
1.1.1 Credit Risk Management
Credit risk management is the practice of mitigating losses by understanding the adequacy of
a bank’s capital and loan loss reserves at any given time. This process has long been a
challenge for financial institutions. Credit risk management involves minimizing bank risk
and adjusting the risk rate of return by maintaining credit risk exposure. This is done with a
view of shielding the bank from the adverse effects of credit risk.
Basel Committee on Banking Supervision (1999) observed that banks increasingly face credit
risk (or counterparty risk) in various financial instruments other than loans, including
acceptances, interbank transactions, trade financing foreign exchange transactions, financial
futures, swaps, bonds, equities, and options. Since credit is one of the primary sources of
revenue-generating activity in commercial banks, credit risk management affects the
profitability and performance of banks. Moreover, poor management and poor control of
credit risk lead to excessive risk of a bank and impacts its profitability and performance.
1.1.2 Financial Performance and Profitability of Commercial Banks
The financial performance of a commercial bank refers to its ability to generate new
resources from daily operations over a given period. Several factors determine this within the
external and internal environment. Bobakovia (2003) explains that the profitability of any
2
The commercial bank highly depends on their ability to envisage, avoid and monitor risk.
Credit risk has a higher impact on commercial banks than the other risks since it has a direct
solvency threat to these financial institutions. The banks should therefore be able to
cover losses caused by uncertainties and risks as they occur.
The non-performing loans (NPLs) have a notable adverse effect on the banks’ performance
and profitability. Thus, poor risk management leads to poor financial performance hence the
closure of such commercial banks. In addition to the non-performing loans, the size of the
bank, debt ratio, capital adequacy ratio, loan loss provision also affect the performance and
profitability of banks and will be used in our study. Return on Assets (ROA) and the Return
on Equity (ROE) are the leading profitability indicators in banks.
1.2 Statement of the Problem
This research seeks to answer the question, “What is the impact of credit risk management
indicators on the performance and profitability of the commercial banks in Kenya since 2015-
2020?”. Previous studies have been conducted on the effects of credit risk management on
banks’ performance however, this research question has barely been covered by analysts
from the viewpoint of the Kenyan context in general, and in the context of the top-performing
commercial banks listed in Nairobi Securities Exchange. In particular, Kenya Commercial
Bank, Equity Bank, Cooperative Bank, Standard Chartered Bank, I&M, and DTB Bank will
serve as the sample commercial banks over the period 2015-2020. This study, therefore, aims
to investigate the viability of investing in credit risk management in commercial banks and
also to examine the impacts of the credit risk management determinants on the banks’
performance and profitability. This study will involve panel data analysis techniques mainly,
focusing on the fixed and random-effects models.
3
1.3 Study Objectives
1.3.1 Main Objective
To study the relationship between credit risk management indicators, performance, and
profitability of commercial banks in Kenya.
1.3.2 Specific Objectives
I. To model credit risk management indicators using a Fixed or Random-Effects model.

II. To determine the most efficient model between; Pooled OLS, Random Effects, and
Fixed Effects, using the Breusch-Pagan Langrage Multiplier Test and the Hausman
Test.
III. To test the significance of credit risk management indicators on banks' performance
and profitability using ANOVA.
1.4 Justification of the Study
Commercial banks are the most dominant in many world economies compared to other
financial institutions offering instalment loans. As a result, the financial intermediation role
banks play can’t be overlooked. They are vital for developing economies to achieve higher
economic growth. However, their role gives rise to different types of risks, mainly credit risk.
Therefore, this study is important in understanding how credit risk impacts the performance
of Kenyan banks, the type and strength of such impact, and the appropriate strategies that
increase banks’ efficiency in managing credit risk
4
CHAPTER TWO
LITERATURE
REVIEW
2.1 Introduction
This chapter presents the literature related to credit risk and credit risk management. It
includes how an increase in credit risk will raise the marginal cost of debt and equity, which
in turn increases the cost of funds for the bank.
Previous studies involving measuring the performance and profitability of banks have
traditionally used financial ratios; Return on Assets and Return on Equity as measures of
performance and profitability (Mathuva 2009; Wet & Toit 2006). The financial ratios have
proved to be useful in the interpretation of a company’s financial status and management
(Halkos & Salamouris, 2004). ( Wet &Toit,2006) asserts that ROE is one of the best
determinants of a bank’s performance since it combines the aspect of profitability, financial
leverage, and efficiency. Halkos and Salamouris (2004) also stress that ROE and ROA are
useful when making internal and external comparisons and predictions can easily be done.
The review of the related studies on the impact of credit risk on banks’ performance and
profitability has revealed mixed results, which are either positive or negative relationships
(Abbas et al., 2019). Ogboi & Unuafe (2013) analysed the impact of credit risk and capital
adequacy on the financial banks in Nigeria. Time series data obtained from the annual
financial reports of banks in Nigeria since 2004-2009 was used. They used the fixed-effect
model to determine the relationship between different credit risks which include (loans and
loan losses, capital adequacy, loans and advances, and bad loans) and ROA. The empirical
results pointed out that good management of credit risk and capital adequacy has a significant
5
positive impact on ROA while, loans and advances were reported to hurt the ROA of the
banks during the specified period.
2.2 Credit Risk
Basel Committee on Banking Supervision (1999) has defined credit risk as to the potential
that a bank borrower or counterparty will fail to meet its obligation by agreed terms.
Heffernan (1996), observed that credit risk is the risk that causes an asset or a loan to become
irrecoverable in the case of outright default, or the risk of delay in the servicing of the
loan. Bessis (2002), opined that Credit risk is critical since the default of a small number of
important customers can generate large losses, which can lead to insolvency. This risk is
determined by factors extraneous to the bank such as general unemployment levels, changing
socio-economic conditions, debtors’ attitudes, and political issues.
Kithinji (2010) analyzed the effect of credit risk measured by the ratio of loans and advances
on total assets and the ratio of non-performing loans to total loans and advances on return on
the total asset in Kenyan banks from 2004 to 2008. The study found that the bulk of the
profits of commercial banks are influenced by the amount of credit and non-performing
loans. The study provides the rationale to consider other variables that could impact on
bank’s performance and also a longer period of the study to capture the real picture of the
banks’ performance. Hence this study included the impact of liquidity and market risk as
components of the financial risk.
Afriyieet al. (2011) examined the impact of credit risk on the profitability of rural and
community banks in the BrongAhafo Region of Ghana. The study used the financial
statements of ten rural banks from the period of 2006 to 2010 (five years) for analysis. The
panel regression model was employed for the estimation. In the model, of Return on Equity
(ROE) and Return on Asset (ROA) were used as profitability indicators while Non-
Performing
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Loans Ratio (NLPR) and Capital Adequacy Ratio (CAR) as credit risk management
indicators. The findings indicated a significant positive relationship between non-performing
loans and rural banks’ profitability revealing that there are higher loan losses but banks still
earn profit. He found that there is a relationship between credit risk management and
profitability of selected rural banks in Ghana.
Credit risk remains widely regarded as the major influence on a bank’s performance and the
major cause of bank failures, largely due to their limited capacity to absorb losses from bad
loans (AlMazrooei & Al-Tamimi,2007; Boffey & Robson,1995). According to Boffey and
Robson (1995), a bank’s capacity to absorb bad loans comes mainly from its profits and its
capital. A single substantial bad loan can have such a significant impact on the business.
Therefore, banks must manage their credit risks proactively. These losses are generally
categorized into three namely:
I. Expected loss (EL), which is classed as predictable and counted as part of the cost of
business thus is factored in the pricing.
II. Unexpected Loss (UL) which are unanticipated losses above the expected.
III. Loss Given Default (LGD), which refers to the loss incurred by the bank with loan
default.
2.3 Credit Risk Management
Athanasoglou et al. (2005) observe that the bank's role remains central in financing economic
activity, and its effectiveness could positively impact the overall economy. A sound and
profitable banking sector can withstand negative shocks and contribute to the financial
system's stability. Bank performance determinants have attracted the interest of academic
research as well as of bank management.
7
Studies dealing with internal determinants employ variables such as size, capital adequacy,
NPLR, LLPR, and DR. Poor asset quality and low levels of liquidity are the two major causes
of bank failures and are represented as the key risk sources in terms of credit and liquidity
risk. However, credit risk is by far the most significant risk faced by banks. The success of
their business depends on accurate measurement and efficient management of this risk to a
greater extent than any other risk (Gieseche, 2004). However, every bank needs to identify,
measure, monitor, and control credit risk to determine how credit risks could be lowered.
This means that a bank should hold adequate capital against these risks to compensate for the
risks incurred adequately.
The statistical evidence from the research conducted by Sparaford (1988) showed that
98 % of bank failures resulted from incidents related to poor asset quality due to poor loan
policies, non-compliance with policies and guidelines, and inadequate supervision. Sparaford
(1988) further asserts that the factors highlighted above are a result of poor credit culture, a
position confirmed by Colquitt (2007) and Boffey and Robson (1995). Expounding on this
concept, Colquitt (2007) proposes that a bank's credit culture determines the attitude, style,
perception, and behavior that will be exhibited by the bank and is primarily determined by the
attitude of management towards credit risk and could be in conflict with the policies of the
bank.
Credit risk management arises any time bank funds are extended, committed, invested, or
otherwise exposed through actual or implied contractual agreements, whether reflected on or
off the balance sheet. Literature review reveals that bank-specific or macroeconomic
variables are used as explanatory variables of the studies on the main determinants of credit
risk. Basel Committee on Banking Supervision (2006) observed that historical experience
8
shows that the concentration of credit risk in asset portfolios has been one of the major causes
of bank distress.
According to Robert and Gary (1994), the most apparent characteristic of failed banks is not
poor operating efficiency, however, but an increased volume of non-performing loans. Non-
performing loans in failed banks have typically been associated with regional macroeconomic
problems. DeYoung and Whalen (1994) observed that superior managers run their banks
cost-efficiently and thus generate large profits relative to their peers and impose better loan
underwriting and monitoring standards than peers, which results in better credit quality.
2.4 Performance and Profitability
Bobakovia (2003) asserts that a bank's profitability depends on its ability to foresee, avoid
and monitor risk, possibly to cover losses brought about by chance. The net effect of
increasing the ratio of substandard credits in the bank's credit portfolio decreases its
profitability. The bank's supervisors are well aware of this problem. However, it is
challenging to persuade bank managers to follow more prudent credit policies during an
economic upturn, especially in a highly competitive environment.
The conservative managers might find market pressure for higher profits tough to overcome.
For instance, Philip (1994) observed that the deregulation of the financial system in Nigeria
embarked upon from 1986 allowed the influx of banks into the banking industry. As a result
of alternative interest rates on deposits and loans, credits were given out indiscriminately
without proper credit appraisal. These inappropriate credit appraisal systems make banks
have non-performing loans that exceed 50 percent of the bank's loan portfolio.
Bourke (1989) reported that the effects of credit risk on profitability appear to be negative.
This result may be explained by taking into account that the more financial institutions are
exposed to high-risk loans, the higher the accumulation of unpaid loans. This implies that
9
these loan losses have produced lower returns to many commercial banks (Miller and Noulas,
1997; Kolapo et al., 2012). The findings of Felix and Claudine (2008) also show that return
on equity (ROE) and return on asset (ROA), which point to profitability, were negatively
related to the ratio of non-performing loans to total loans (NPL/TL) of financial institutions.
This, in turn, shows that there is a decrease in profitability.
However, the ratios are not oblivious of their shortcomings. Highlighting some of the
deficiencies, Oberholzer and Westhuizen (2004) and Chen and Yeh (1997) assert that these
ratios have limitations in their capacity to give a robust measurement of a bank's performance
and indeed the performance of firms in general. According to them, the ratios are inadequate
as measures of future performance since they are drawn from past performance. They further
emphasize that the ratios are measures of short-term performance. They lump together all the
aspects of the bank's performance, making it impossible to identify specific areas where
actual performance has been outstanding or below expectation. Thus, analysis drawn from
them can be seen as the starting point for any future research.
In addition, Lei (2005), while emphasizing that financial ratios remain a quick, helpful, and
reliable means of analyzing the performance of banks, acknowledges that the accuracy of
financial ratios may be distorted by inflation and the timing of the release of financial reports.
Other criticisms state that ratios ignore the importance of different parameters, such as the
cost of capital (Colquitt 2007). Others say that they are subject to manipulation within
acceptable accounting standards (Wet and Toit 2006). Consequently, several other
approaches have been employed to measure the all-around performance of banks, one of
which is the Data Envelopment Analysis. The Data Envelopment Analysis is being
researched, adopted, and compared to financial ratios (Ho and Zhu, 2004; Halkos and
Salamouris, 2004; Oberholzer and Westhuizen, 2004; Chen and Yeh, 1997).
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2.5 Conclusion and Summary
Credit risk management is essential in optimizing financial institutions’ performance and
profitability, from almost all the literature reviewed. Additionally, effective credit risk
management practices involve establishing an appropriate credit risk environment, managers
operating a sound credit granting process, maintaining appropriate credit administration
involving the identification, analysis, and monitoring process, and adequate control over
credit risk.
Considering the empirical evidence, there is a need therefore to adopt the best credit risk
management practices that minimize losses arising from loans. This needs to be an active
process that enables banks to proactively manage their loan portfolios, minimize provisions
and lost interest income. Banks shall improve their performance and profitability through the
adoption of better credit risk management practices that involve methods, procedures,
processes, and rules used in minimizing loan losses facing them in their lending functions.
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CHAPTER THREE
RESEARCH METHODOLOGY
3.1 Introduction
This chapter discusses the overall methodology of the study. It covers the research design, the
population of the study, data collection methods, and data analysis methods that we will
adopt for this study.
3.2 The Research Design
According to Saunders, Lewis & Thornhill (2011), descriptive research design involves
measuring a set of variables as they exist naturally. In this research project, we shall adopt
descriptive analysis. It helps answer immediate questions about the current state of affairs
(Mathews & Kostelis, 2011). A particular field of study may provide in-depth information
about the subject's characteristics under study (Houser, 2011). It emphasizes producing data
based on real-world observation through a purposeful and structured approach (Denscombe,
2003).
3.3 Population of the Study
The study population includes the people or items from which a study sample comes
(Zikmund et al., 2013). According to Mugenda and Mugenda (2003), It consists of the sets of
individuals or objects with similar observable characteristics distinct from the attributes of
other populations. In line with these definitions, the population of this study includes six
commercial banks in Kenya. The said banks are Kenya Commercial Bank, Equity Bank,
Cooperative Bank, Standard Chartered Bank, ABSA Bank, and Stanbic Bank.
12
3.4 Data Collection
The study will utilize secondary data contained in the CBK’s website and library. The audited
annual financial reports are reliable and readily available as all the commercial banks file
yearly performance reports with the CBK yearly.
3.5 Data Analysis
Data analysis systematically describes, illustrates, condenses, and evaluates data using
statistical and logical techniques. A variety of analytical procedures provide ways of drawing
inductive inferences from the data that has been collected by highlighting the phenomena of
interest from statistical fluctuations that may be in the data (Shamoo & Resnik,2003). This
research will utilize quarterly data for five years. The data will be presented in the form of a
panel and, R-program will be used to analyze the data by running pooled OLS, fixed, and
random-effects models. The best fit model will then analyze the relationship between the
credit risk management indicators with the banks’ performance and profitability.
This research paper will employ the panel data technique with the following econometric
model where the variables are explained in Table 3.1
𝑌𝑖𝑡 = 𝛽0 + 𝛽1𝑋1𝑖𝑡 + 𝛽2𝑋2𝑖𝑡 + 𝛽3𝑋3𝑖𝑡 + 𝛽4𝑋4𝑖𝑡 + 𝛽5𝑋5𝑖𝑡 + 𝜖𝑖𝑡 (3.1)
where: 𝛽0 represents the constant coefficient of variation.
Β𝑖 for 𝑖>0 shows the slope coefficient for the independent variables.
𝜖𝑖𝑡 refers to the error term
The subscript 𝑖 represents the index of the commercial bank.
The subscript t represents the quarterly time.
13
Table 3.1: Variables, Description, and Formulas.
Variables Description Formula

Y1= ROA Return on Total Assets Net Income/
Total Assets
Y2= ROE Return on Total Equity Net Income/
Shareholder Equity
X1= NPLR Non-performing Loans Ratio Non-performing loans/
Total loans
X2= CAR Credit Adequacy Ratio Total Capital/
Total Risk-Weighted Assets
X3= DR Debt Ratio Total debt/
Total Assets
X4= LLP Loan Loss Provision Ratio Loan Loss Provision/
Gross Loan
X5 =SIZE OF BANK Size of bank The logarithm of Total
Assets
Return on equity (ROE)- Return on equity (ROE) is a dependent variable and measures the
bank's return on shareholders' investment. ROE has been used as an indicator of profitability
in regression analysis because ROE and ROA have been used extensively in previous
research.
Return on assets (ROA)- Return on assets (ROA) is a dependent variable and measures the
bank's earnings before interest and taxes against its total net assets. It measures the efficiency
in managing banks to generate profits from their scarce resource. In addition, this ratio is
strongly influenced by the credit institution's provisioning policy since the net result
incorporates the cost of risk and the assets appear net of the provision in the bank balance
sheet. It is used to evaluate the performance of a credit institution (Sylvie de Goussergues et
al., 2010).
14
Non-performing loan ratio (NPLR)- Non-performing loans (NPL) are independent
variables that indicate how banks manage their credit risks. It defines the proportion of non-
performing losses to the total amount of the loan (Hosna et al., 2009). When the quantity of
this ratio increases, it will send a wrong message for management at the bank level because it
shows a high probability of not recovering funds granted to customers by banks. We expect
non-performing loans to have a negative relationship with profitability.
Capital adequacy ratio (CAR)- (CAR) is also an independent variable. It measures the basis
of a bank's financial strength from the point of view of a regulator. This ratio protects
depositors from unexpected losses. The capital adequacy ratio consists of the types of
financial capital considered the most reliable and the most liquid, mainly the bank's equity,
with a good sufficiency ratio.
Bank size- There exists a direct relation between a bank's size and profitability. When all
other factors are kept constant, the size of the banks determines the level of risks that its
clients are exposed to. A good-performing bank has more assets to keep it operating its
activities even in times of financial crisis. This means that loans offered by big banks are
most likely to be repaid compared to small banks.
Debt ratio (DR)-This measures the extent of a company's leverage. The debt ratio is defined
as total debt to total assets, expressed as a decimal or percentage. It's the proportion of a
company's assets that is financed by debt.
Loan Loss Provision Ratio (LLPR)- The loan loss provision ratio indicates how protected a
bank is against future losses. A higher ratio means the bank can withstand future losses
better, including unexpected losses beyond the loan loss provision.
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3.6 Panel Data
This is a combined time-series cross-sectional dataset containing repeated observations on a
selection of variables from a set of observational units. A cross-sectional data set consists of
observations on a certain number of variables at a certain point in time, whereas a time-series
data set consists of a variable or several variables of observations over several periods.
3.6.1 Balanced and Unbalanced Panels
A panel data set consists of n sets of observations on individuals, which are usually denoted
as i = 1. . . N. If each individual in the panel data set is observed the same number of times,
usually denoted T, the data set is then referred to as a balanced panel. In our research, the
panel will be balanced, with N observations being equal to 6. An unbalanced panel data set,
on the other hand, is one in which individuals are observed different numbers of times. This
time is denoted as Ti.
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Table 3.2: An example of a Panel Data Table
Dependent Independent variables

variables
Bank Year ROE ROA CAR NPLR DEBT SIZE LLPR
(quarterly RATIO OF
period) FIRM
KCB 2015
Q1 9.8 1.20 14.21 9.39 1.13 9.89 0.0048
Q2 6.34 0.75 13.77 8.50 1.35 9.98 0.0076
Q3 11.62 1.84 14.33 9.22 1.40 9.32 0.0023
Q4 11.94 1.44 14.73 10.05 1.26 9.45 0.0049
EQUITY 2015
Q1 5.60 1.50 11.47 7.98 1.76 12.87 0.0018
Q2 6.00 1.40 15.90 9.76 0.98 11.23 0.0023
Q3 9.61 0.63 17.45 9.90 0.76 10.50 0.0043
Q4 7.64 1.20 17.83 9.98 1.87 11.34 0.0054
ABSA 2015
Q1 9.76 1.11 13.05 8.90 1.76 8.89 0.0065
Q2 7.09 1.54 16.65 9.98 1.56 8.78 0.0017
Q3 10.60 1.17 20.54 11.00 1.43 9.02 0.0053
Q4 9.05 0.78 17.07 10.74 1.22 9.13 0.0032
There are three important types of variations in panel data;
Overall Variation- Variation over time and individuals.
Between variation- variation between individuals.
Within variation- variation within individuals.
1
Individual mean 𝑥̅ = ∑ ∑𝑥 (3.2)
𝑇 𝑖 𝑡 𝑖𝑡
17
𝟏
Overall mean ̅𝐱 = 𝚺 𝚺𝐱 (3.3)
𝐍𝐓 𝐢 𝐭 𝐢𝐭
𝟏
Overall variance 𝐒 𝟐 = 𝚺 𝚺 (𝐱 − 𝒙̅ )𝟐 (3.4)
𝐎 𝐍𝐓−𝟏 𝐢 𝐭 𝐢𝐭
𝟏
Between variance 𝐒 𝟐 = 𝚺 (𝐱̅ − 𝐱̅ )𝟐 (3.5)
𝐁 𝐍𝐓−𝟏 𝐢 𝐢
𝟏 𝟏
Within variance 𝐒 𝟐 = 𝚺 𝚺 (𝐱 − 𝐱̅ )𝟐 = 𝚺 𝚺 (𝐱 − 𝐱̅ + 𝐱̅ )𝟐 (3.6)
𝐖 𝐍𝐓−𝟏 𝐢 𝐭 𝐢𝐭 𝐢 𝐍𝐓−𝟏 𝐢 𝐭 𝐢𝐭 𝐢
The overall variation can be decomposed into between variation and within the variation
𝟐
𝐒𝐎 = 𝐒𝟐𝐁+ 𝐒𝟐 𝐖 (3.7)
We need to check the data to see if the between or within variation is larger for each variable.
3.6.2 Panel Data Models
Panel data models describe the individual behaviour both across time and across individuals.
There are three types of models;
3.6.2.1 The Pooled Model
In the panel data context, this is also called the population-averaged model. The pooled
model specifies constant on the coefficients α and β. The model is given by
𝐲𝐢𝐭 = 𝛂 + 𝐱β𝐢𝐭′ + 𝐮𝐢𝐭 (3.8)
It assumes that any form of heterogeneity in the model has averaged out during the cross-
sectional analysis. It applies OLS estimation ignoring the fact that it is panel data.
The OLS Estimator of β
A simple linear regression equation is given by:
Y = Xβ + ϵ (3.8.1)
18
Where: Y represents the vector of dependent/response variables.
Β represents the vector of regression parameters.
X represents the vector of explanatory/independent/regressor variables.
ϵ represents the vector of independent normal variables.
The OLS estimator of β is given as:
β̂ = (X′X)−1 X′Y (3.8.2)
However, the model cannot be applied in this research since the error terms are correlated.
This calls for other improved models, as discussed further below.
3.6.2.2 Individual-specific Effects Model
We assume that there is unobserved heterogeneity across individuals captured by αi.
The main question is whether the individual-specific effects αi are correlated with the regressors,
if they are correlated, a fixed-effects model is used. If they are not correlated, the random-effects
model is used.
The Fixed-effects Model. (FE)
A fixed-effect model examines individual differences in intercepts, assuming the same slopes
and constant variance across individuals (group and entity).
𝐲𝐢𝐭 = αi + 𝐱β𝐢𝐭′ + 𝐮𝐢𝐭 (3.9)
Since an individual-specific effect is time-invariant and is considered as part of the intercept,
αi is allowed to be correlated with other regressors. The model is estimated by within and
between effect estimations.
19
Within Estimation
Within estimation analyzes the variation within each individual or entity.
The “within” estimation is given by:
Yit−Yi=β1(xit−xi)+(uit−ui),for t=1,2,3…T
The left-hand side is called the time demeaned.
The OLS is applied on the time demeaned equation whereby the errors will not be correlated
and we will have cross-sectional error uj uk.
Between Estimation
The “between groups” estimation, also known as the group mean regression, analyses the
variation between individual entities (groups). To be specific, this estimation calculates group
means of the dependent and independent variables and thus reduces the number of
observations down to n. OLS is then performed on the transformed aggregated data: y = α +
x+ε
The FE model assumes that there is a correlation between the individual-specific effects αi
with the regressors x. We include αi as intercepts.
Each individual has a different intercept term and the same slope parameters.
𝐲𝐢𝐭 = αi + 𝐱β𝐢𝐭′ + 𝐮𝐢𝐭 (3.9.2)
We can recover the individual-specific effects after estimation as:
𝛂̂ 𝐢 = 𝐲̅𝐢 − 𝐱β𝐢𝐭 (3.9.3)
In other words, the individual-specific effects are the leftover variation in the dependent
variable that cannot be explained by the regressors.
20
21
3.6.2.3 Random Effects Model (RE)
A random-effects model assumes that individual effect (heterogeneity) is not correlated with
any regressor and estimates error variance specific to groups (or times). Thus, 𝛂𝐢 is an
individual-specific random heterogeneity or a component of the composite error term. This
explains why the random effect model is also called an error component model. The slopes
and intercepts of the regressors are the same across the individual. The difference among
individuals (or periods) lies in their specific errors, not in their intercepts. i.e.
The composite error term 𝛆𝐢𝐭 = 𝛂𝐢 + 𝐞𝐢𝐭
𝐲𝐢𝐭 = 𝐱′ 𝐢𝐭𝛃 + (𝛂𝐢 + 𝐞𝐢𝐭 )
Here 𝐯𝐚𝐫(𝐞𝐢𝐭 ) = 𝛔𝟐 + 𝛔𝟐 and 𝐜𝐨𝐯(𝛆 𝛂

𝛂 𝐞 𝐢𝐭 , 𝐢𝐬 ) = 𝛔𝟐
𝛆
𝛔𝟐𝛂
So 𝛒 = 𝐜𝐨𝐫(𝛆 𝛆 ) = (3.10)
𝛆 𝐢𝐭 𝐢𝐬 (𝛔𝛂𝟐 +𝐞𝛔𝟐 )
Rho is the fraction of the variance in the error due to the individual-specific effects. It
approaches 1 if the individual effects dominate the idiosyncratic error. A random-effect
model reduces the number of parameters to be estimated but produces inconsistent estimates
when an individual-specific random effect is correlated with regressors. (Greene, 2008: 200-
201).
The model is estimated by generalized least squares (GLS) when a covariance structure Σ
(sigma), is known.
22
Generalized Least Square Method
Introduce P to a linear equation Y=Xβ+ϵ, where P is an n×n matrix.
From this, the new linear equation is given by:
Y = PXβ + Pϵ
From the derivation of the estimate β using the OLS method, we get the estimate as shown
below:
β̂ = (X′X)−1 X′Y becomes (X′P′XP)−1 X′ PY = (X′P′PX)−1 X′P′PY
But P’P= Ω-1
Therefore, the new estimate
β̂ = (X′Ω−1 X)−1 X′Ω−1 Y (3.11)
Which is an efficient estimator of β and thus it is known as the GLS.
It should be known that the GLS estimators are unbiased if they have a zero-conditional
mean;
E[(ϵ|X)] = 0
Similarly, the variance of the estimator is given by:
Var(β̂) = δ2 (X′P′XP)−1 (3.11.1)
The GLS becomes OLS under homoscedasticity whenΩ−1 = I, where I represent the identity
matrix.
23
Limitation of GLS Method
The method is not sufficient since it cannot determine Ω or Σ. This leaves one with two
options; either to assume Σ or estimate it empirically. FGLS is the most efficient method in
solving this problem.
The Feasible Generalized Least Squares Method (FGLS)
The feasible generalized least squares (FGLS) is used to estimate the entire variance-
covariance matrix when Σ is not known. This is done by estimating Σ empirically. This
method replaces Ω in GLS to Ω̂ . Therefore, the FGLS estimator of β is given as:
β̂ = (X′Ω−
̂ 1 X)−1 X′Ω−
̂ 1Y (3.12)
Wooldridge provides a more flexible approach to estimating the FGLS;
Var(ϵ|X) = ϵ2 = δ2exp(δ0 + δ1x1 + δ2x2 + ⋯ + δnxn
By introducing the natural log on both sides, we get:
ln(ϵ̂2 ) = α0 + δ1 x1 + δ2 x2 + ⋯ δn xn + e
Assume that the predicted value from this model is given by
̂
ĝi = ln(ϵ2 )
This can be converted by introducing exponential into weights assigned wi such that:
̂
ŵi = exp(ĝi ) = exp (ln (ϵ2 )) = ϵ̂̂ (3.13)
3.7 Properties of Panel Data Estimators
We prefer estimators that are consistent and efficient. We check for consistency first then for
efficiency.
24
Consistency
The distribution of 𝛃̂𝐧 collapses on β as n becomes large:
𝐩𝐥𝐢𝐦 𝛃̂𝐧 = 𝛃
Consistency is established based on the law of large numbers.
If an estimator is consistent, more observations will tend to provide more precise and
accurate estimates.
Efficiency
Efficiency (minimum variance) is usually established relative to specific classes of estimators
Example: OLS is efficient (minimum variance) among the class of linear, unbiased estimators
3.8 Choosing between Pooled OLS and Random effects: Breusch-Pagan Lagrange
Multiplier (LM) Test
This test will check for the random-effects model based on the OLS residual. The LM test
helps to decide between a random effect regression and a simple OLS regression.
𝑯𝟎=Pooled OLS is appropriate than the Random Effects Model.
If P-value > 0.05 then fail to reject the null hypothesis and go for Pooled OLS and If P-
value<
0.05 reject the null hypothesis and go for Random Effects Model.
3.9 Choosing Between Fixed and Random Effects: Hausman Test
The null hypothesis is that the preferred model is random effects vs. the alternative fixed
effects. It tests whether the unique errors (αi) are correlated with the regressors. The null
hypothesis is they are not correlated.
25
Since the random effects estimator is more efficient, it is used if the Hausman test supports it.
If the null hypothesis is rejected, the fixed-effect model will be preferred as the most efficient
model.
3.10 Diagnostic Tests
A regression diagnostic test seeks to evaluate the validity of a model in different ways.
Applying the assumptions of linear regression models, the following tests will be used to
validate the model.
Durbin Watson (DW) test
Durbin Watson (DW) test is used to check for autocorrelation. A correlation matrix shows the
relationship between the dependent and independent variables to ensure no correlation exists
between them.
• 𝐻0=The residuals from an OLS regression are not autocorrelated.
• DW=2 , No autocorrelation
• DW= 0 to <2 ,Positive autocorrelation
• DW= >2 to 4, Negative autocorrelation
Dicky-Fuller & Phillips –Peron Test
Dicky-Fuller & Phillips –Peron test is used to test the stability of the time series of the study
variables. The null hypothesis is that the series has a unit root (no-stationarity). If the unit
root is present, the first difference estimation is used. However, the test is not able to reject
the hypothesis that the data is non – stationary. If p-value < 0.05 then no unit roots present.
26
Breusch- Pagan test.
The Breusch- Pagan test is used to test for homoscedasticity. If heteroscedasticity is detected,
a robust covariance matrix is used to control it.
• 𝐻0=Homoscedasticity is present in the model.
• If P-value <0.05, reject the null hypothesis and conclude heteroscedasticity is present
in the model.
The Breusch –Pagan LM test of independence and the Pasaran CD test is also used to test for
contemporaneous correlation, for instance, cross-sectional dependence.
Jarque -Bera Test
Normality is tested by use of the Jarque – Bera test. This test checks whether the sample
panel data has the skewness and kurtosis that matches a normal distribution. The test is
always non-negative. If it appears to be far from zero, it implies that the sample data does not
have a normal distribution.
Ho: data matches a normal distribution
If P-value <0.05, reject the null hypothesis. The distribution is not normal.
Testing for cross-sectional dependence / contemporaneous correlation: Using Pasaran CD
test
According to Baltagi, cross-sectional dependence is a problem in macro panels with a long time
series. The Pasaran-CD tests whether the residuals are correlated across entities. Cross-sectional
dependence can lead to bias in the test results.
Ho: Residuals across entities are not correlated.
27
CHAPTER FOUR
DATA PRESENTATION, ANALYSIS, AND RESULTS
4.1 Introduction.
This chapter is comprised of data analysis, findings, and interpretation. Results were presented in
tables and diagrams. The analysed data was arranged under themes that reflected the research
objectives.
4.2 Descriptive Analysis of Statistical Data
The descriptive analysis of the dependent and independent variables is presented in Table 4.2 .The
dependent variables are profitability and performance measured by the ROE and ROA respectively,
and the independent variables are: the non-performing loan ratio (NPLR), capital adequacy ratio
(CAR), Non-performing loan ratio (NPLR), the loan loss provision ratio (LLPR), Debt ratio (DR)
and size of the bank (SB). In order to give a brief overview of our data, we present the following
table 4.2 which contains the descriptive statistics of our variables calculated from data obtained in
financial statements of the best performing banks listed on NSE for the period from 2016-2020. The
number of observations for each variable is 120.
28
Table4.2: Descriptive Statistics of the Variables
Variable variables N Mean SD MIN MAX
Dependent ROA 120 0.00734 0.00316 0.00092 0.02654
ROE 120 0.04555 0.01802 0.00470 0.14904
Independent NPLR 120 0.09981 0.03644 0.03970 0.18256
LLPR 120 0.01153 0.01149 0.00117 0.05675
CAR 120 0.31149 0.04059 0.00121 0.24800
DR 120 0.05767 0.07481 0.01990 0.83777
SB 120 13.3200 3.19823 8.05000 19.6100
Source: Research data
The mean value for the dependent variables ROA and ROE is 0.00734 and 0.04555 respectively.
The result shows that the average value of the bank's performance (ROA) is 0.734% indicating that
during the period 2015-2020, on average, the total assets of the banks generated a return of
0.734% .The standard deviation of the ROA is 0.316%, which shows the absence of substantial
variation. The average ROE in the last five years is 4.555%, with standard deviations of 1.802%.
The difference between the minimum value (0.470%) and the maximum (14.904%) and the
standard deviations showed that there was a great variability with the ratio of bad debts. The result,
in general, implies that the accumulation of NPLR that has been claimed as a critical problem of the
banking sector in previous studies (Ogbulu et al., 2016).
The mean scores of independent variables i.e. NPLR, LLPR, CAR, DR, SB are 9.981%, 1.153%,
31.149%, 5.767%, 13.32 respectively. The non-performing loans ratio varies from 3.970% to
18.256% with the average and Standard deviation of 9.981% for all the banks for the period 2020-
2015, and 3.644% respectively, which indicates a high volatility of the bank's ability to manage
29
credit risk. The average capital adequacy ratio is 31.149 %, which is way higher than the regulatory
requirements of 8%. In addition, the banks have an average of 1.153% of the provision for loan
losses with a standard deviation of 1.149%. The maximum and minimum values were respectively
5.675% and 0.117%.
The column of standard deviation denotes how much the variables deviate from the mean, here
NPLR, LLPR, CAR have the lowest standard deviation while SB has the highest standard deviation
of 3.1982, the higher the standard deviation, the higher the variability of that factor.
30
4.3 Analysis of the Evolution of the Dependent and Independent Variables.
Figure 1: Evolution of the Variables
Source: Research Data.
31
Figure 2: Evolution of the Variables
From 2016 to 2019, debt ratio and Capital adequacy ratio exhibit the same trend with a slight
32
increase of Capital Adequacy ratio for the year 2020. As non-performing loans ratio increases, loan
loss provision ratio increases resulting in a decrease in ROE and ROA. In addition, CAR increased
between 2016 and 2020 from all the banks with an exception of I&M and Coop bank. The decrease
can be explained by a decrease in deposits in 2020 or an increase in loans granted to individuals,
which tends to a slight decrease in ROE and ROA.
33
4.3.1 Analysis of the Evolution of Size of the Bank: A Control Variable
DTB
13.2
13.1
13
12.9
12.8
12.7
12.6
12.5
12.4
12.3
2020 2019 2018 2017 2016
KCB
14
13.8
13.6
13.4
13.2
13
12.8
2020 2019 2018 2017 2016
STANCHART
19.65
19.6
19.55
19.5
19.45
19.4
19.35
19.3
19.25
19.2
2020 2019 2018 2017 2016
Figure 3: Evolution of Bank Size
The size of the banks for the six banks is seen to increase from 2016 onwards to 2020 with an
exception of I&M bank which decreased in 2020 and Equity bank which decreased in 2019. This
can be explained by the fact that these banks acquired more customers and this acquisition led to
34
growth of the deposits and the overall size of the bank.
4.4 Box Plots
The box plots presented below were used to show overall patterns of response for a group. They
provide a useful way to visualize the range and other characteristics of responses for a large group.
35
CAR box plot
The box plot is comparatively short and thus suggesting that values for CAR are close to each other
and that we have only one outlier value. Our median value lies between 0.10 and 0.20.
NPLR box plot
The box plot is comparatively tall suggesting that values for NPLR vary from each other, we have
no outliers. Our median value lies between 0.08 and 0.12.
ROA box plot
The box plot is comparatively short implying that values for ROA are close to each other, we have
two outlier values. Our median value lies between 0.00 and 0.001
ROE box plot
The box plot is comparatively short implying that values for ROE are close to each other, we have
three outlier values. Our median value lies between 0.00 and 0.05.
36
SB box plot
The box plot is comparatively short suggesting that values from SB are close to each other, we have
few outlier values. Our median value lies between 10.00 and 14.00.
4.4 Coefficient of Correlation
Table 4.4: Coefficient of Correlation among variables
ROA ROE NPLR CAR DR LLPR SB
ROA 1.0000
ROE 0.9614 1.0000
NPLR -0.1040 -0.1496 1.0000
CAR -0.2702 -0.3050 -0.2854 1.0000
DR 0.0319 0.0240 -0.1811 0.0441 1.000
LLPR -0.2823 -0.2968 0.2882 -0.0252 -0.0448 1.0000
SB -0.0607 -0.0337 0.6139 -0.4124 -0.1772 0.2705 1.0000
37
The above table demonstrates the coefficient of correlation between the dependent and independent
variables. Independent variables are correlated to ROA and their coefficients of correlation are as
follows 0.9614, -0.1040, -0.2702, 0.0319, -0.2823, -0.0607 the coefficient of correlation between
ROE and the independent variables are as follows -0.1496, -0.3050, 0.0240, -0.2968, -0.0337
respectively. We find that the highest correlation between all variables in absolute value is -0.3050,
which is the correlation between CAR and ROE. This means that a small change in one of the
observations or the number of observations leads to a profound change in the estimated values of
the coefficients.
As can be seen, there is a strong positive correlation between ROA and ROE at 96%. There is also a
weak positive significant correlation between DR and ROA, ROE, and CAR at 3.19%, 2.40%,
4.41% respectively. We also have a strong positive correlation between SB and NPLR, LLPR at
61.39% and 27.05% respectively. There is a negative weak correlation between NPLR, ROA, and
ROE at 10.40% and 14.96%. CAR is also negatively correlated to ROA, ROE, and NPLR at
27.02%, 30.50%, and 28.54 %. LLPR had a negative correlation with all the other variables except
for NPLR.
4.5 Diagnostic Tests
Several diagnostic tests were performed on the data as had earlier been stated in chapter 3. Below
are the listed results.
4.5.1 Heteroscedasticity test: Breusch-Pagan
Breusch Pagan test was used to test for homoscedasticity in the data, the null hypothesis for the test
was that there is a presence of homoscedasticity. Below are the results
Table 4.5.1.1: Heteroscedasticity Test
BP df P-value
ROA 46.624 5 0.000836
ROE 35.495 5 0.00297

38
Our p-values for both ROA and ROE were less than 0.05, therefore we reject the null hypothesis
and conclude that there is heteroscedasticity in the data.
As a solution to the presence of heteroscedasticity, Robust Standard errors were utilized to solve its
presence in the data. The function VcovHc () was used to estimate a heteroscedastic consistent (HC)
variance-covariance matrix for the parameters, below are the results for the regression model that
utilized the heteroscedastic-consistent estimation of the covariance matrix as the solution to the
heteroscedasticity present in the data.
Table:4.5.1.3 Heteroscedastic Consistent Variance-covariance matrix.
intercept lnNPLR LLPR lnCAR lnDR SB
inercept 0.00001603
lnNPLR 0.00000167 0.00000035
LLPR -0.00000216 0.00000046 0.00033996
lnCAR 0.00000180 0.00000011 -0.0000070 0.0000006
lnDR 0.00000078 0.00000009 0.00000206 -0.00000002 0.00000026
SB -0.00000052 -0.00000003 -0.00000037 -0.00000004 0.00000001 0.00000003
ROE results:
Table: 4.5.1.2 ROE Heteroscedastic Test Results
Estimate Std. Error t value Pr(>|t|)
intercept 0.01269817 0.02269521 0.5595 0.5769122
lnNPLR -0.0118689 0.00348484 -3.4059 0.0009116
39
LLPR -0.3928214 0.11949730 -3.2873 0.0013452
lnCAR -0.0072616 0.00063261 -11.4789 0.00000
lnDR 0.00270278 0.00535043 0.5052 0.6144275
SB 0.00031120 0.00071902 0.4328 0.6659699
Table: 4.5.1.3 ROA Heteroscedastic Test Results
Estimate Std. Error t value Pr(>|t|)
intercept 0.145134 0.179910 0.8067 0.421518
lnNPLR -0.083099 0.150217 -2.0351 0.044161
LLPR -0.882399 -0.327860 - -2.6916 0.008182
lnCAR -0.066496 0.018410 -13.2868 0.00000
lnDR 0.049869 0.110527 0.4512 0.652703
SB -0.014922 0.024431 -0.1660 0.868428
From the above results a conclusion was made that after the use of the Heteroscedastic-Consistent
estimation of the covariance matrix, it is evident that the values of our standard errors do not differ
that much in comparison to the random-effects model, leading us to the conclusion that the presence
of heteroscedasticity in our data is not significant enough to change the efficiency of our estimates.
Also, the sample size of our data could be sufficiently large enough to the extent that the variance of
our estimators is still small enough to get precise estimates.
4.5.2 Serial- Correlation test
The Durbin-Watson test for serial correlation was utilized. The null hypothesis for the test was no
serial correlation in idiosyncratic errors. Below are the results
Table: 4.5.2 Serial Correlation Test Results

40
DW P-value
ROA 2.0279 0.5666
ROE 2.0806 0.4511
The p-values obtained are higher than 0.05 hence we fail to reject the null hypothesis and conclude
that there is no serial correlation in the data.
4.5.3 Stationarity test
To enable efficient predictions using our data, it had to be stationary. Stationarity tests were done
for each variable and three independent variables were found to be non-stationary in our data.
Levin-Lin-Chu unit root tests were done to check for stationarity the null hypothesis for the test was
the presence of a unit root, below are the results.
Results for the three variables were found to be non-stationary.
Table: 4.5.3.1 Levin-Lin-Chu Unit Root Test Results
Independent Variable Z P-value
NPLR -0.23553 0.4069
CAR -1.1274 0.1298
DR 0.01769 0.5071
All three variables had a p-value greater than 0.05. As a result, we fail to reject the null hypothesis
and conclude that the variables are non -stationary.
To address the issue of non-stationarity, log-transformed variables were used to control non -
stationarity. Dickey-Fuller test for unit root was used to check for non-stationarity. The null
hypothesis was that unit root is present. Below are the results;
Table: 4.5.3.2 Dickey-Fuller test

41
Dickey-fuller Lag p-value
NPLR -5.2767 4 0.01
CAR -4.8458 4 0.01
DR -9.3591 4 0.01
From the above results, the p-value for all three values is less than 0.05, and thus we reject the null
hypothesis and conclude that the three variables are stationary.
4.5.4 Poolability Test
Test for poolability was done to check whether the pooled OLS regression would provide efficient
estimates. The null hypothesis for the test states that the Pooled OLS is an efficient estimator.
Below are the results.
Table: 4.5.4 Poolabilty Test Results
F P-value
ROA 1.5261 0.07915
ROE 1.2053 0.2597
Both ROA and ROE had a p-value greater than 0.05. Therefore, fail to reject the null hypothesis and
conclude that a pooled OLS is an efficient estimator.
To choose the most efficient model among the three, Pooled OLS, Fixed Effects, and Random
Effects two more tests were done. The first test is the Breusch Pagan Lagrange Multiplier test to
choose between the pooled OLS and Fixed Effects Models. The second test was the Hausman test
that was used to choose between the Random Effects model and the fixed effects model.
42
Below, we post the results for the two tests.
4.6.1 Breusch Pagan Lagrange Multiplier test.
The test is used to choose between the Pooled OLS and Random Effects Models.
Table 4.6.1 Breusch Pagan Lagrange Multiplier test
Dependent Variable F P-value
ROA 7.5767 0.009553
ROE 5.8641 0.052232
The null hypothesis for this test was that the pooled OLS is the efficient model. From the results,
the p-values for the two variables were less than 0.05. Therefore, we reject the null hypothesis and
conclude that the Random Effects model is the efficient model compared to the Pooled OLS.
4.6.2 Hausman test
The test is used to choose between the Random Effects model and the fixed effects model.
Table 4.6.2 Hausman Test Results
Chisq P-value
ROA 4.4847 0.4819
ROE 5.0949 0.4044
The null hypothesis for the test was that the Random Effects model was the efficient model. From
our results, the p-value for the two variables was greater than 0.05. Therefore, we fail to reject the
null hypothesis and conclude that the Random Effects model is the efficient model between the two.
From, the above two tests it is evident that the Random Effects model is the most efficient model to
be used to estimate and fit the model.
The Random Effects model was fitted and below we post the results obtained from fitting the
model:
43
4.7 Discussion of the Results
4.7.1 Regression model 1: ROA
Table: 4.7.1.1 Regression results: ROA
Estimate Std. Error z-value Pr(>|z|)
intercept 0.145134 1.188437 0.7532 0.451350
ln (NPLR) -0.083099 -0.144027 -2.1226 0.033790 *
LLPR -0.882400 0.297156 -2.9695 0.002983 **
ln (CAR) -0.066495 0.051795 -4.7228 0.005768***
ln (DR) 0.049869 0.114125 0.4370 0.662130
SB -0.014922 0.0311585 -0.1302 0.896420
The estimated equation under the Random Effects model is:
ROA= 0.14513 intercept -0.08309 ln (NPLR) -0.88240 LLPR - 0.06640 ln (CAR) + 0.04987 ln
(DR) -0.01492 SB.
The results indicate that the Debt Ratio (DR) had the highest positive relationship with Return on
Assets. This implies that a change in one unit of DR will result in the improvement of 4.98% on
Return on Assets. For the rest of the variables, a change in one unit leads to a negative change in the
Return on Asset. The p-value indicates the significance of the independent variables in explaining
the dependent variable. If the significance number found is less than the critical value also known as
the probability value (P) which is statistically set at 0.05. Then the conclusion would be that the
model is significant in explaining the relationship, else the model would be regarded as non-
significant (Bagozzi, 1988). From our above results there were three significant variables; Non-
performing Loan Ratios, Loan Loss Provision, Credit Adequacy Ratio with values 0.033790,
0.002983, 0.005768 .Two variables were non-significant: Debt Ratio and Size of the bank.
44
Table: 4.7.1.2 Model Fitness
Total Sum of Squares 0.0010181
Residual sum of squares 0.00071819
R-Squared 0.2946
Adj. R-Squared 0.26366
The results presented in the above table show the fitness of the model as used in the regression
model to explain the study phenomena. Non-performing Loan Ratios, Loan Loss Provision, Credit
Adequacy Ratio, Debt Ratio, and Size of the bank provide a moderately good fit in predicting
changes in the financial performance of commercial banks. The model had an R-squared of 29.46%
and an adjusted R-squared of 26.366%. This means that the Non-performing Loan Ratios, Loan
Loss Provision, Credit Adequacy Ratio, Debt Ratio, and Size of the bank explain 29.46 of the
variation in the dependent variable, which is the profitability of commercial banks explained by the
ROA.
Discussion on ROA:
Bank Size
Based on Pearson’s correlation, table 14.10 (first table under Findings on ROA) shows that there is
a negative relationship between the size of the bank and the ROA. Equally, the variable is less
significant to explaining to the model since it has a p-value of 0.896, which exceeds 0.05. When all
other factors are held constant, a 1% increase in SB will lead to a decrease of 0.0149225 in the
performance of commercial institutions.
Non –Performing Loans Ratio
From table 14.10, there is a negative relationship between the NPLR and the ROA. However, the
variable is significant to explaining to the model since it has a p-value of 0.0338, which is below
0.05. When all other factors are held constant, a 1% increase in NPLR will lead to a decrease of
45
0.083116 in the performance of commercial institutions.
Capital Adequacy Ratio
Concerning table 14.10, CAR has a negative relationship with the ROA. However, it is worth noting
that the variable is significant to explain the model. This is justified by having a p-value of 0.0058,
which is below 0.05. When all other factors are held constant, a 1% increase in NPLR will lead to a
decrease of 0.066496 in the performance of commercial institutions.
Debt Ratio
Table 14.10, implies the existence of a positive relationship between ROA and the Debt Ratio
(CAR), even though the variable is less significant in explaining the mode. This is so because the
variable has a p-value of 0.6621 that is beyond the statistically set 0.05. A 1% increase in DR will
result in a decrease in the performance of commercial institutions by 0.0149225.
Loan Loss Provision.
The tabulated results on Pearson’s Correlation coefficients as presented in table 14.10 show that
there is a negative relationship between LLPR and the performance of commercial institutions,
concerning the ROA. Nevertheless, the variable is significant in explaining to the model as can be
seen by its p-value of 0.0029, which falls below the statistically set 0.05. A 1% increase in LLPR
will result in a decrease in the performance of commercial institutions by 0.882316.
4.7.2 Regression Model 2: ROE

46
Table: 4.7.2.1 Regression results: ROE
coefficients Estimate Std. Error z-value Pr(>|z|)
(Intercept) 0.01735853 0.02128392 0.8156 0.414746
NPR -0.01153641 0.00466401 -2.4735 0.013380 *
LLPR -0.36469183 0.13220492 -2.7585 0.005806 **
ln (CAR) -0.00609536 0.00154833 -3.9367 8.26e-05 ***
ln (DR) 0.00250625 0.00365696 0.6853 0.493132
SB 0.00012753 0.00071961 0.1772 0.859335
Thus, the optimal model for the study is;
ROE = 0.01735853 + (-0.01153641) ln (NPLR) + (-0.36469183) LLPR + (-0.00609536) ln (CAR)
+ 0.00250625 ln (DR) + 0.00012753 SB
The results indicate that the Debt Ratio has the highest impact on the Return on Equity of
commercial banks with a change of one unit leading to an improvement of 0.25% of the Debt ratio.
A change in a unit of size of the bank will lead to an improvement of 0.0127% of the Return on
Equity, while a one-unit change in loan loss provision ratio will lead to a negative change of 36% of
the Return on Equity. A unit change of capital adequacy ratio will lead to a negative change of
0.61% of the Return on Equity of a bank. Lastly, a unit change of the non-performing loans ratio
will lead to a negative change of 1.15% of the return on Equity.
In statistics, the p-value indicates the level of the relation of the independent variable to the
dependent variable. If the significance number found is less than the critical value also known as the
probability value (p) which is statistically set at 0.05. Then the conclusion would be that the model
is significant in explaining the relationship else the model would be regarded as non-significant
(Bagozzi, 1988). In our data, the Non-Performing Loans Ratio, the Loan Loss Provision Ratio, and
47
the Capital Adequacy Ratio are significant in explaining the dependent variable ROE since their p-
values are less than 0.05.
Table: 4.7.2.2 Model Fitness
Total Sum of Squares 0.035591
Residual sum of squares 0.025856
R-Squared 0.24168
Adj R-Squared 0.24168
The results presented in the above table present the fitness of the model used in the regression
model to explain the Return on Equity. The size of the bank, loan loss provision ratio, non-
performing loans ratio and capital adequacy ratio provide a moderately good fit in predicting
changes in the Return on Equity of banks which shows the profitability of banks. The model has an
R-Squared of 0.24168 and an Adjusted R-Squared of 0.24168 which means that the Size of the
Bank, Loan Loss Provision Ratio, Non-Performing Loans, and Capital Adequacy Ratio explain
24.17% of the variations in the dependent variable which is the Return on equity of commercial
banks. These results further imply that the model for the relationship of the variables provided a
relatively good fit.
The results of the panel data analysis on ROE are presented in Table 4.7.2.1 and discussed below.
Table 4.7.2.1 summarizes the outcome of the random effect model using ROE as the dependent
variable. The Hausman test for ROE calculated the p-value to be 0.4819 which is greater than the
alpha of 0.05, implying that the random effect model is a better model specification than the fixed
effect model. Under the random effect model, the variations across entities are assumed to be
random and uncorrelated with the independent variables.
The Random Effects model on ROE shows that the independent variables NPLR, LLPR, and CAR
48
are the only variables that are statistically significant in explaining ROE. On the other hand, the
other remaining independent variables; SB and DR are not statistically significant in explaining
ROE.
Discussion on ROE.
Bank size
Bank size is found to be significantly affecting the conventional banks’ credit risk in Kenya and a
negative relationship existed between bank size and credit risk. This inverse relationship implies
that the larger the bank size the lower the credit risk is. This result is similar to the findings by Salas
and Saurina (2002) and Hu et al., (2004) who also found that bank size and credit risk have a
negative relationship. While Bardhan and Mukherjee (2016) establish that larger banks are more
exposed to default risk than smaller banks. Besides that, larger banks will have more capital to
buffer the risk related to credit as compared to smaller size banks.
The results presented in Table 4.7.2.1 indicates that SB and ROE have a negative relationship and
that SB is not statistically significant at a 5 percent level of significance. Keeping all the other
factors constant, a 1 percent increase in size of the bank leads to an increase in ROE by 0.012753
percent. From the above results, it can be concluded that an increase in size of the bank leads to an
increase in performance.
Non –Performing Loans Ratio
Non-Performing Loan Ratio (NPLR) is identified as an important factor in managing credit risk in
the banks. It is hypothesized to have a negative relationship with bank profitability. The result in
Table 14.2 indicates that NPLR is negative and statistically significant at a 5 percent level of
significance which confirms the expectations. Further, the result shows that NPLR indeed
influences the ROE of Kenyan commercial banks. Keeping all the other factors constant, a 1 percent
increase in NPLR leads to a decrease in ROA by 0.1107 percent.

49
Capital Adequacy Ratio
Capital Adequacy Ratio (CAR) in this study is used as an independent variable and is hypothesized
to have a positive relationship with bank profitability. On the contrary, the result in Table 4.7.2.1
shows that CAR is negative and statistically significant in explaining the ROE at a 5 percent level of
significance as expected. It indicates that CAR is also an important variable affecting the ROE of
the 6 commercial banks under study. Keeping all the other factors constant, a 1 percent increase in
CAR leads to a decrease in ROE by -0.00609536.
Debt Ratio
The result in Table 4.7.2.1 indicates that DR is positively correlated with ROE but not statistically
significant in explaining the dependent variable at a 5 percent level of significance. A 1 percent
increase in DR leads to a 0.00250625 percent increase in ROE.
Loan Loss Provision.
From our results obtained LLPR is negatively significant at a 5% level of significance, this shows
that LLPR affects the profitability of a bank; for one unit increase in LLPR, there is a decrease in
the profitability of the banks. If seen from a logical point of view an increase in loan loss provision
leads to a decrease in banks profitability, since funds needed for investments are utilized to establish
a cushion in case of losses suffered from loans.
50
Analysis of Variance: ROE
df F-value P-value
lnNPLR 1 3.755 0.0551
LLPR 1 10.730 0.0014
lnCAR 1 22.493 0.0152
lnDR 1 2.123 0.1478
SB 1 0.005 0.9415
Residuals 114
The null hypothesis states that the mean values of our five variables are equal. In our case for the
variables lnNPLR, lnDR and SB have P-values greater than our significance value of 0.05.
Therefore we fail to reject the null hypothesis and conclude that the above-mentioned variables
have equal means.
For, the two remaining variables LLPR and lnCAR they have a p-value of less than our significance
value therefore we reject the null hypothesis and conclude that the two variables have different
means.
Analysis of Variance: ROA
df F-value P-value
lnNPLR 1 1.583 0.21087
LLPR 1 10.807 0.00134
lnCAR 1 23.130 0.01157
lnDR 1 4.007 0.04769
SB 1 0.501 0.48042
Residuals 114
51
From the above data two variables, lnNPLR and SB had a p-value greater than our significant value
of 0.05. We fail to reject our null hypothesis (that the mean value of our variables is equal) and
conclude that for the two mentioned variables their mean values are equal. For the rest of the
variables LLPR, lnCAR and ln DR had a p-value less than our significant value of 0.05. We reject
the null hypothesis and conclude that the three variables have different mean values.
52
CHAPTER FIVE
CONCLUSIONS AND RECOMMENDATIONS
5.1 Conclusions
At the beginning of our research, it is explained that the goal of this paper is to analyse the
relationship between credit risk management indicators, financial performance, and profitability of
commercial banks in Kenya. This was done by collecting data from 6 Kenyan commercial banks
from 2016 to 2020. To determine the relationship between credit risk management, financial
performance, and profitability, we chose ROE and ROA as the proxies for bank profitability and
financial performance, and CAR, NPLR, LLPR, DR, and DR as proxies for credit risk management.
After the data collection, R (a statistic program) was used to test for the research questions. For this
study, a panel data analysis was applied for the 6 selected commercial banks of Kenya for the
period 2016 to 2020. The random-effect model was the consistent model and used for the analysis.
According to the empirical findings of this study, the conclusion was that there exists a relationship
between credit risk management and profitability of Kenyan Commercial banks from the period of
2016 to 2020.
To begin with, the findings reveal that NPLR is negatively correlated with both ROE and ROA.
This is consistent with most of the previous relating researches. This relationship signifies that
having a high number of non-performing loans in a portfolio reduces the financial performance and
profitability of commercial banks since there is less capital for the commercial banks to invest and
operate. Secondly, CAR is significant and negatively correlated with both ROA and ROE. This
suggests that the bank has a lot of capital to carry out its operational activities and can bear the risk
if the bank is liquidated. Therefore we cannot sufficiently conclude that an increase in CAR reduces
the financial performance and profitability of the commercial banks.
The size of the bank also has a negative correlation with both ROE and ROA. It is not significant in
explaining the financial performance and profitability of commercial banks. This means that the
53
small and large banks can enjoy profitability influenced by factors other than their size. In addition,
the Debt Ratio is not significant and has a positive correlation with both ROE and ROA. This means
that banks can increase their leverage for better performance. LLPR was significant and had a
negative correlation between ROE and ROA. This implies that the selected banks have set aside a
huge amount of capital for cushion purposes instead of using such an amount to invest and operate
their businesses. This would enable them to mitigate the credit risk as it arises.
In summary, the conclusion is that there is a positive relationship between credit risk management
and the profitability of commercial banks in Kenya. The better and more effective the credit risk
management, the less the exposure to credit risk and the higher the profitability to the commercial
banks.
5.2 Recommendations
The following suggestions are derived from the research findings:-
 For commercial Banks to design an effective credit risk management system, they need to
establish a suitable credit risk environment; operate under a sound credit granting process,
maintain an appropriate credit administration that involves monitoring, processing as well as
enough controls over credit risk.
 Even though the Debt ratio is insignificant in explaining the financial performance and
profitability of commercial banks in our study, banks should pay much attention to its trend
since leveraging a bank means improving its performance in general.
 Banks should also ensure they have enough cushion to absorb a reasonable amount of losses
before they become insolvent keeping an eye on their investment strategies to ensure the
operations generate profitable cash flows to also cater for the losses too in case they occur.
 Banks must adhere to prudential banking practices and even diversify more in lending to
54
avoid repetitive losses in particular types of loans issued to their customers.
5.3 Areas for Further Research
A suggestion for further research could be performing research on the relationship between
financial risk management and financial performance of Kenyan commercial banks focusing on
other risk management such as liquidity risk, market risk, or operational risk.
Another area of research could be the inclusion of microfinance banks, Sacco’s and other finance
companies, and cooperatives that are successfully operating in the Kenyan market.
55
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63
APPENDICES
Workplan
ACTIVITY APRIL MAY JUNE JULY AUGUST
2021 2021 2021 2021 2021
Conceptualization of
the proposal
Development of
proposal
Data collection
Data entry
Data analysis
Data interpretation
Project presentation
64
Budget Estimation
CATEGORY REMARKS UNITS UNIT COSTS TOTAL COST
(KSHS) (KSHS)
Proposal Printing drafts 300 5 1500
development
Stationary 4 20 80
Proposal copies 3 copies 200 600
Data collection Data abstraction 50 10 500
forms
Transport 10 100 1000
stationary 10 20 200
Total 3880
R-Codes
65
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JOMO KENYATTA UNIVERSITY OF AGRICULTURE AND TECHNOLOGY

TO ANALYSE THE RELATIONSHIP BETWEEN CREDIT RISK MANAGEMENT

INDICATORS, PERFORMANCE, AND PROFITABILITY OF COMMERCIAL

A research proposal submitted in partial fulfilment of the requirements of the degree of

Bachelor of Science in Financial Engineering at the Jomo Kenyatta University of

Agriculture and Technology

SUPERVISOR: Dr. Victor Musau

AMOS MUTENDE SCM222-0722/2017

CLIFF MUCANGI SCM222-0346/2017

GRACE KINYUA SCM222-0336/2017

LILIAN KATUNYU SCM222-0364/2017

SOLOMON KARANJA SCM222-0398/2017

Dr. Victor Musau

into the study.

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

1.1.1 Credit Risk Management....................................................................................2

1.1.2 Financial Performance and Profitability of Commercial Banks.........................2

1.2 Statement of the Problem..........................................................................................3

1.3 Study Objectives.......................................................................................................4

1.3.1 Main Objective...................................................................................................4

1.3.2 Specific objectives..............................................................................................4

1.4 Justification of Study.................................................................................................4

2.2 Credit Risk................................................................................................................6

2.3 Credit Risk Management...........................................................................................7

2.4 Performance and Profitability...................................................................................9

3.2 The Research Design...............................................................................................12

3.3 The population of Study..........................................................................................12

3.4 Data Collection........................................................................................................13

3.5 Data Analysis..........................................................................................................13

3.6 Panel Data...............................................................................................................16

3.6.1 Balanced and Unbalanced Panels.....................................................................16

3.6.2 Panel Data Models............................................................................................18

3.7 Properties of Panel Data Estimators........................................................................23

Multiplier (LM) Test.....................................................................................................24

3.9 Choosing Between Fixed and Random Effects: Hausman Test..............................24

3.10 Diagnostic Tests....................................................................................................25

Table 3.1: Variables, Description, and Formulas..................................................................24

Table 3.2: An example of a Panel Data Table........................................................................29

ABSA Amalgamated Banks of South Africa

CAR Capital Adequacy Ratio

CBK Central Bank of Kenya

FGLS Feasible Generalised Least Squares

GLS Generalized Least Squares

LGD Loan Given Default

LSDV Least Squares Dummy Variable

NCBA National Cooperative Business Association

NPLR Non-Performing Loan Ratio

NSE Nairobi Stock Exchange

OLS Ordinary least squares

ROA Return On Assets

ROE Return On Equity

performance and profitability of the commercial banks.

1.1 Background of the Study

become an inherent part of society, in the industries and individual consumers.

borrowers are unable or unwilling to perform in the pre-committed contract. Many

1.1.1 Credit Risk Management

acceptances, interbank transactions, trade financing foreign exchange transactions, financial

revenue-generating activity in commercial banks, credit risk management affects the

1.1.2 Financial Performance and Profitability of Commercial Banks

cover losses caused by uncertainties and risks as they occur.

on Equity (ROE) are the leading profitability indicators in banks.

1.2 Statement of the Problem

commercial banks listed in Nairobi Securities Exchange. In particular, Kenya Commercial