Capital Adequacy, Asset Quality, Earnings and Liquidity on Operational Efficiency of Commercial Banks in Kenya

Abstract

The study investigates the capital adequacy, asset quality, earnings quality, liquidity on operational efficiency of commercial banks in Kenya. This was guided by analyzing the effect of capital adequacy, asset quality, earnings quality, bank liquidity and operational efficiency while mark share was used as the moderating variable. Operational efficiency is viewed as a pre-requisite for the financial soundness of any banking institution. In banking literature, empirical review indicated mixed findings on the effect of capital adequacy, asset quality, earnings quality, bank liquidity and market share on the operational efficiency of the respective banks. Thus the issue of agency problems between managers and shareholders, asset liability mismatch and inefficiency remain unclear in Kenyan commercial banks. Thus this study is anchored on theories from agency theory, conventional economic efficiency theory and asset liability management theory. Quantitative research design was embraced as it aligns with the choice of positivism philosophy. Positivism philosophy was used as it allows the researcher to explore measurable and credible results from the financial statements to establish the cordial relationship amongst the variables. A census was applied with the target population being all the 43 banks listed under the Central Bank of Kenya. The study covered a period of 14 years from 2008-2022. The period is appropriate for the research since it incorporates banking sector financial reforms and issues of financial efficiency that shook the Kenyan financial system in 2008. Data was extracted from the verified audited financial statements of the banks available in the Central Bank of Kenya and the official websites of respective commercial banks. The independent variables were capital adequacy, asset quality, earnings quality and liquidity; moderating variable was market structure and dependent variable operational efficiency. In testing Panel regression model, normality, heteroscedasticity and autocorrelation, Shapiro Wilk Test, Variance Inflation Factor (VIF) and Breauch Pagan Test were used. The study used a two-step model of analysis. The first step involved the use of the Stochastic Frontier Analysis approach, where scores were estimated for each of the cross-sections under study. Second, the panel Generalized Method of Moments (GMM), was applied to regress efficiency scores on the regression model. The regression results indicate that capital adequacy demonstrates a substantial positive influence on operational efficiency of banks; however, liquidity has no significant influence on efficiency while asset quality and earnings quality lead to an increase in operational efficiency. Furthermore, the results indicated previous years’ earnings are important in determining the current year’s operational efficiency. Market structure was found to moderate effect of capital adequacy, earnings quality and liquidity on operational efficiency of banks. This implies that large banks with higher core capital often benefit from economies of scale, allowing them to spread fixed costs over a larger asset base. This can lead to lower average costs per unit of output and greater operational efficiency. Furthermore banks should seek mechanisms to improve these variables to enhance operational efficiency and ensure market readiness.