Effect of risk-based lending on the financial performance of Tier III commercial banks in Kenya

Abstract

Risk-based lending was authorized by Central Bank of Kenya in 2019, enabling lenders to adjust loan interest rates depending on the risk profile of a borrower. This was meant to increase access to credit among economic agents. The general objective of the study is to determine the effect of risk-based lending on the financial performance of Kenyan commercial banks before and after the introduction of risk-based lending. The particular objectives were to explore the effect of risk based credit scoring and risk-based lending interest rates levied on bank financial performance before and after the introduction of risk-based lending. The study was anchored on credit risk theory supplemented by loan pricing theory and credit scoring theory. Positivist research philosophy was adopted and guided by correlational research design. The target population was 22 tier III commercial banks covering the period of 2016 to 2023, the period before the risk-based lending was introduced (2016-2019), and the period during the risk- based lending (2020-2023). Secondary data was extracted from tier III banks’ financial statements and records between the periods 2016-2023. In addition, primary data was collected from lending officers of the tier III banks using interviews. The investigation utilized content analysis approach in the analysis of qualitative data collected through interviews with lending officers. Stata software version 16 was utilized in the analysis of panel data. The analysis involved descriptive and inferential statistics. The descriptive tests comprised maximum and minimum values, Kurtosis, Skewness, standard deviation and the means. Inferential statistics were in the form of panel analysis with structural breaks. From the results, the correlation between risk-based credit scoring and financial performance was both positive and significant statistically (r=0.5517, p = 000<0.05). Regression results before the introduction of risk-based lending in Kenya (2016-2019) indicate that the coefficient of risk-based credit scoring was positive 0.0000073 and statistically significant (0.000 < 0.05) while after the advent of risk-based lending in Kenya, (2020-2023), the coefficient of risk based credit scoring was positive 0.0000077 and statistically significant (0.000 < 0.05). The correlation between risk-based lending interest rate and financial performance in Kenya was both positive and significant statistically (r = 0.5427, p = 000<0.05). The effect of risk-based lending in Kenya (2016-2019) indicate that the coefficient of risk-based lending interest rate was positive 0.000205 and statistically significant (p = 0.000<0.05). After the introduction of risk-based lending in Kenya (2020-2023), the coefficient of risk-based lending interest rate was positive 0.000188 and statistically significant (0.000 < 0.05) implying a decline in the aggregate effect of risk-based lending interest rate compared to the period before. The correlation between bank size and financial performance was both significant statistically and positive (r = 0.5603, p = 000<0.05). The coefficient of bank size was positive 0.00035 and statistically significant (p=0.000<0.05) implying that a unit improvement in bank size would yield 0.00035 units significant improvement in the performance of the Kenyan commercial banks financially. Thus, bank size has a significant strengthening effect on the relationship between risk-based lending and the financial performance of tier III commercial banks. The study concluded that risk-based credit scoring, risk-based lending interest rate and bank size are significant determinants of variations in the performance of Kenyan tier III commercial banks financially. The investigation recommended that the tier III commercial banks ought not to focus so much on the credit scores while advancing loans to its customers. The banks ought not to segregate customers based on the levels of their credit risks. Finally, the banks ought to focus on building their asset bases. Key Words: Commercial banks, financial performance, Kenya, risk-based lending