Relationship of Credit Risk and Profitability of Microfinance Institutions in Kenya

Abstract

Microfinance institutions (MFIs) play a crucial role in offering financial services to marginalized and economically disadvantaged populations. However, these institutions face the challenge of credit risk, which has the potential to greatly impact their profitability and long-term viability. This study examined the relationship between credit risk and the financial performance of MFIs in Kenya. The study aims to investigate the connection between Capital Adequacy, Operational Efficiency, Interest Rate Spread, and the profitability of microfinance institutions in Kenya. The research utilizes a comprehensive dataset from 14 licensed and regulated MFIs in Kenya, covering the period from 2020 to 2022.The study utilized a research design based on census data. Secondary data was utilized. The Study examines the previous financial reports to find secondary data on performance. The data collected underwent analysis using both descriptive and inferential statistical tools. Given that the current study focused on the relationship study, a regression model was used as the analysis tool. The results obtained were then presented in the form of tables. The results of this study will benefit policy makers, managers, administrators, entrepreneurs, researchers, consultants, scholars, and trainers involved in strategic Microfinance Institutions. Results from the analysis suggest that the Kenyan microfinance sector encountered significant financial difficulties in the past. The profitability metrics, specifically return on assets (ROA) and return on equity (ROE), showed negative mean values of -8.89% and -8.72%, respectively. Based on the findings, it appears that MFIs incurred losses, as their assets and equity were not fully utilized. The study also discovered There is a strong positive relationship between Capital Adequacy and Operational Efficiency, as indicated by a correlation coefficient of 0.811. When Capital Adequacy increases, Operational Efficiency also increases, The correlation was highly significant, indicating a robust relationship. However, it is worth noting that there is a strong positive relationship between Capital Adequacy and Profitability Metrics, as indicated by a correlation coefficient of 0.961. Capital Adequacy has improved, leading to a significant increase in Profitability Metrics. The relationship between Operational Efficiency and Profitability Metrics was found to be highly positive, with a correlation coefficient of 0.875. The correlation between improved operational efficiency and higher profitability metrics is incredibly important. The relationship between Interest Rate Spread and Profitability Metrics has shown a strong positive correlation, with a correlation coefficient of 0.943. The profitability metrics were greatly impacted by the increased interest rate spread. The study found that it is recommended for Microfinance institutions in Kenya to diversify their income streams and give priority to improving credit risk management practices in order to effectively navigate the complexities of the sector. Additional research is needed to understand the factors that influence credit risk and profitability in the microfinance sector in Kenya.