EFFECT OF INTERNAL CREDIT RATING ON FINANCIAL PERFORMANCE OF COMMERCIAL BANKS IN KENYA

Abstract

Internal credit rating (ICR) was used in evaluating the level of risk associated with a loan applicant and assign probabilities that an applicant with a given credit score would be good or bad. It could also be used as abasis for loan approval, pricing, monitoring and capital allocation. Lending difficulties may arise due to Internal Credit Rating (ICR) systems failure to consider and analyze potential borrower’s information before loans are approved and released to them, making loan monitoring and capital allocation based on the associated risk profile difficult. In recent years spanning 2011 to 2014, there have been growing trend of bad loans, this study aimed at investigating the effects of ICR on the financial performance of commercial banks operating in Kenya for 10 year duration from 2006 to 2015. The specific objectives of the study were to: Establish the effects of ICR-based loan origination process on the financial performance of commercial banks in Kenya; examine the effects of ICR-based setting of credit terms and conditions on the financial performance of commercial banks in Kenya; assess the effects of ICR-based credit monitoring on the financial performance of commercial banks in Kenya; and analyze the effects of ICR-based capital allocation on the financial performance of commercial banks in Kenya. The study was intended to be useful to bankers, bank supervisors, and other stakeholders including scholars and the general public. The study used the longitudinal research design to describe and provide a profile of the relationship between the bank ICR systems and risk adjusted financial performance of the various commercial banks. The population of the study consisted of 20 commercial banks registered, licensed and operating in Kenya as at the period of the study. The20 banks was purposively analysed after a preliminary survey carried out to establish the availability of data for all Commercial banks. Therefore, the study population comprised the 20 commercial banks in Kenya, arrived at using the purposive selection criterion. The main data collection instrument was the secondary data collection schedule with data being collected from the yearly bank reports, Central Bank of Kenya annual reports and Kenya Bankers Association. Data analysis was conducted with the help of STATA computer program, providing descriptive and inferential statistics. The descriptive statistics comprised the mean, median, standard deviations, minimum and maximum. The inferential statistics on the other hand consisted of; correlation analysis and panel data regression analyses. The study findings indicated that ICR-based setting of credit termsand conditions(r = 0.2697***; p = -0.0016); (β = 0.177**; SE = 0.0849)as well as ICR-based capital allocation (r = -0.061; p = 0.4679); (β = 0.0720; SE = 0.0500)related positively with financial performance of banks, Additionally, the results in respect to the effects of ICR-based loan origination (r= 0.1828**; p = 0.0345); (β = 0.0217; SE = 0.0619) and ICR-based credit monitoring(r = -0.1765**; p = 0.0445); (β = 0.0818; SE = 0.121)showed that it did not have any effect on the financial performance of the commercial banks in Kenya.The study therefore concluded that the effects of ICR and firm performance is multidimensional and is influenced by firm specific as well as contextual factors. Hence the study recommended continual ICR updating, intense use of loan covenants and collateral, and improving information sharing capabilities. As an area for further research, the study recommended the same research factoring in all the banks and automated credit risk analysis for remote lending transactions.