Asset Quality and Its Effect on Operational Efficiency of Commercial Banks in Kenya

Abstract

In the dynamic landscape of banking, the quality of assets held by financial institutions plays a pivotal role in determining their operational efficiency and overall stability. Deterioration in asset quality not only poses immediate challenges to a bank's financial performance but also reverberates through the broader financial system. Utilizing secondary data from 2008 to 2022, a period marked by notable financial reforms and challenges, this research examines the relationship between asset quality and operational efficiency in Kenya's banking sector. The study employed a two-step approach analysis. First, Stochastic Frontier Analysis was utilized to determine operational efficiency scores for each cross-section. Second, the panel Generalized Method of Moments (GMM) was applied to regress efficiency scores on independent variables. The findings indicated a significant positive association between asset quality and operational efficiency in Kenya's banking sector, with significance levels observed at 1%, 5%, and 10%, a unit improvement in asset quality corresponds to a 1.2% increase in operational efficiency. These results highlighted the symbiotic relationship between asset quality and operational efficiency in Kenya's banking landscape. In light of these findings, policymakers are urged to adopt a multifaceted policy framework aimed at nurturing and strengthening the interplay between asset quality and operational efficiency within Kenya's banking sector.