Interest Rate Capping and Financial Performance of Commercial Banks in Kenya

Abstract

Interest is the main source of income for commercial banks and therefore capping of interest rate may affect the performance of commercial banks and resort into measures such as downsizing to minimize the operational costs in order to remain sustainable. Put differently, the imposition of interest rate capping may have a bearing on the performance of commercial banks through interest margins generated. Against this background, the general objective of this study is to determine the effect of interest rate capping on financial performance of commercial banks in Kenya. Specifically, the study seeks to establish the effect of credit supply on financial performance of commercial banks in Kenya as well as to analyze the effect of asset quality on financial performance of commercial banks in Kenya. Moreover, the study seeks to determine the effect of cost of credit on financial performance of commercial banks in Kenya. The study is anchored on three key theories: Financial intermediation theory, fractional reserve theory of banking, the credit creation theory of banking; and theory of rational expectation. The study used quarterly secondary data from 2013 to 2017 collected from forty commercial banks licensed in Kenya. The choice of period is justified on the ground of data availability and the period when this study was started. The data was obtained from the bank’s financial statements and other publications by the Central Bank of Kenya. To analyze the data, the study used descriptive analysis approach and Ordinary Least Square (OLS) regression method. The descriptive statistics and the regression results indicate that Interest rate capping has a positive effect on financial performance of commercial banks. It is evident from the results that capping interest rate has impacted commercial banks positively. In addition, the results reveal that the quality of assets measured by the share of Non-performing loans affects financial performance negatively. Further, it was evident that credit supply measured by gross loans and advances has negative effect on banks’ financial performance. Based on the findings, this study recommends commercial banks to look into ways of reducing the proportion of non-performing loans in their books in order to improve their returns on assets. This can be achieved by assessing credit worthiness of individuals and companies before advancing loans. The cost of credit measured by the interest rate shows it has positive effect on financial performance and therefore the study recommends the government through the Central Bank to continue monitoring the cost of credit so as to make loans accessible to low income earners. This can contribute to increases in the uptake of loans thereby raising bank’s profitability through interest payments. Commercial banks should also find alternative ways of increasing their interest income thereby improving returns on assets.