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Liquidity, Capital Adequacy and Operating Efficiency of
Commercial Banks in Kenya

&dunga R.+
1
( N,angweso !.+
2
and N-o.e /. 0
*
.
1. Assistant 1ecturer( /e"art2ent of Accounting and Finance( School of 3usiness and 4cono2ics( +oi
5ni6ersit,( !.&. 3o7 16)2 8 *)1))( 4ldoret.
2. Associate "rofessor( /e"art2ent of Agricultural 4cono2ics and Resource +anage2ent( School of
3usiness and 4cono2ics +oi 5ni6ersit,( !.&. 3o7 *9)) 8 *)1))( 4ldoret.
*. Assistant 1ecturer( /e"art2ent of Accounting and Finance( School of 3usiness and 4cono2ics( +oi
5ni6ersit,( !.&. 3o7 16)2 8 *)1))( 4ldoret.
4-2ail of corres"onding author9 rodunga:,ahoo.co2

Abstract
;his stud, ai2ed at e7a2ining the effect of li<uidit, and ca"ital ade<uac, on the o"erating efficienc, of
co22ercial .an-s in 0en,a. S"ecificall,( we sought to esta.lish the effect of .an- s"ecific li<uidit, ratios
Inter.an- ratio( loan ratio( net loans to total de"osits( li<uid assets to short ter2 lia.ilities ratio# and ca"ital
ade<uac, ratios core ca"ital ratio( ris- .ased ca"ital ratio( total ca"ital ratio( e<uit, ca"ital to total asset ratio#
on their o"erating efficienc,. ;he findings of the stud, indicate that the "re6ious ,ear o"erational efficienc, ratio(
li<uid assets to short-ter2 lia.ilities ratio and total ca"ital ratio "ositi6el, and significantl, affect the .an-
o"erating efficienc,. ;he stud, ado"ted an e7"lanator, research design and anal,sed the data using Fi7ed
4ffects Regression. Fro2 the regression results( the o6erall R
2
of ).%1)$ was deri6ed 2eaning that %1.)$= of
.an-s o"erational efficienc, is as a result of the stud, 6aria.les. ;his i2"lies that the histor, of a fir2>s
"erfor2ance will definitel, influence how a fir2 2o6es forward in an effort to strea2line its o"erational
strategies. ;herefore( .an-s should see- on 2echanis2s to i2"ro6e their li<uid assets to de"osits ratio and total
ca"ital ratio in readiness to i2"ro6e o"erating efficienc, and re2ain co2"etiti6e in the 2ar-et.
Keywords9 ?o22ercial 3an-s( &"erating 4fficienc,( 1i<uidit,( ?a"ital Ade<uac,

1 !ntroduction
?o22ercial .an-s "la, an i2"ortant role as financial inter2ediaries for sa6ers and .orrowers in 0en,a.
According to 0en,a ?redit !ro6iders Association 0?!A# co22ercial .an-s in the countr, dis.ursed o6er
5S@1) .illion in loans. Non-for2al financial institutions ser6ed the re2ainder of the loans 2ar-et. ;hese
included credit unionASA??&s( which dis.ursed 5S@2 .illion in loans( and 2icro finance institutions +FI#(
which 2anaged onl, 5S@*)) 2illion 0?!A( 2)1)#. &loo 2))9# descri.ed the .an-ing sector in 0en,a as the
.ond that holds the countr,>s econo2, together. Sectors such as the agricultural and 2anufacturing 6irtuall,
de"end on the .an-ing sector for their 6er, sur6i6al and growth.
&"erational efficienc, is narrowl, defined as the a.ilit, to deli6er "roducts and ser6ices cost effecti6el, without
sacrificing <ualit,. It can also .e defined as what occurs when the right co2.ination of "eo"le( "rocess( and
technolog, co2e together to enhance the "roducti6it, and 6alue of an, .usiness o"eration( while dri6ing down
the cost of routine o"erations to a desired le6elShaw-( 2))$#. ;he end result is that resources "re6iousl, needed
to 2anage o"erational tas-s can .e redirected to new( high-6alue initiati6es that .ring additional ca"a.ilities to
the organiBation. Relati6el, fir2s that are 2ore efficient tend to 2aintain 2ore sta.le le6els of out"ut and
o"erating "erfor2ance co2"ared to their industr, "eers +ills and Schu2ann 19$C#.
3an-s o"erate efficientl, ., directing societ,Ds sa6ings toward those enter"rises with highest e7"ected social
returns and 2onitoring the2 carefull, after lending societ,Ds scarce resources are allocated 2ore efficientl,. In
contrast( .an-s that si2"l, o"erate with waste and inefficienc, will slow down econo2ic growth and reduce
societ,Ds welfare Athanasoglou et al( 2))$#. 4fficienc, in inter2ediation of funds fro2 sa6ers to .orrowers
ena.les allocation of resources to their 2ost "roducti6e uses. ;he 2ore efficient a financial s,ste2 is in such
resource generation and in its allocation( the greater its contri.ution to "roducti6it, and econo2ic growth 3ec-(
et al. 2)))#. +anage2ent of o"erations has .een usuall, a secondar, concern( "artl, .ecause it has .een
considered( for so2e reason( to .e less critical to "rofita.ilit, Said( 2)12#. ;he i2"ortance of o"erating
efficienc, for .an-s was "ut into e6idence ., a stud, done on Indian scheduled co22ercial .an-s SiraE and
!illai 2)11#. Its findings were that -e, deter2inants of o"erational efficienc, were affected ., the glo.al
financial crisis. ;his reinforces the need to understand the dri6ers of o"erational efficienc, for "ro"er
2anage2ent of co22ercial .an-s.
Fhilst the 0en,an .an-ing sector is the largest in ter2s of assets in the financial ser6ices industr,( it is not the
largest su""lier of credit 0?!A( 2)1)#. ;he "erfor2ance of the .an-ing industr, in 0en,a has i2"ro6ed
tre2endousl, o6er the last decade( since onl, two .an-s ha6e .een "ut under ?30 statutor, 2anage2ent
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co2"ared to *7 .an--failures .etween 19$6 and 199$ +wega( 2))9#. Gowe6er( in the sa2e "eriod the le6el of
interest rates ha6e re2ained high i2"l,ing an atte2"t of co22ercial to "ass their inefficiencies to consu2ers.
;his could .e attri.uted to the ina.ilit, to "ush their o"erational costs downwards.
/es"ite the growth in the 0en,an .an-ing sector( the sector still faces 2an, challenges with res"ect to
2anage2ent of ris-s that .an-s the, are e7"osed to. According to ?30( o"erating efficienc, was one of the
2ost critical ris-s faced ., financial institutions in 0en,a and 0en,an .an-s are ,et to ado"t 2odel-.ased
a""roaches in assessing their o"erating efficienc, ?30( 2)11a#. Ris--ta-ing is an inherent ele2ent of .an-ing
and( indeed( "rofits are in "art the reward for successful ris- ta-ing in .usiness. Gowe6er( e7cessi6e or "oorl,
2anaged ris- can lead to losses and thus endanger the safet, of a .an->s de"osits. ;he 2anage2ent of financial
institutions should recogniBe 2easure( 2onitor and control the o6erall le6els of ris-s underta-en. Sound ris-
2anage2ent s,ste2s ena.le 2anagers to ta-e ris-s -nowingl,( reduce ris-s where a""ro"riate and stri6e to
"re"are for a future that cannot .e "redicted with a.solute certaint,.
A few studies on the 0en,an .an-ing sector ha6e addressed issues of cor"orate go6ernance( e6olution of e-
.an-ing and "rofita.ilit, a2ong others. Gowe6er( no stud, has e7a2ined o"erating efficienc, of co22ercial
.an-s in 0en,a( ,et it is "ara2ount for the sector to o"erate efficientl,. Anal,sis of the effect of li<uidit, and
ca"ital ade<uac, on o"erating efficienc, is intended to offer an insight to 2anagers on one of the a""roaches to
ris- 2anage2ent in the .an-ing sector. ;his "a"er e7a2ines the effect of .an- li<uidit, and ca"ital ade<uac, on
o"erating efficienc, of co22ercial .an-s in 0en,a.

" #$eoretical considerations
;his stud, was guided ., three 2ain theories na2el,9 -econo2ic efficienc, theor,( 2odern theor, of financial
inter2ediation and regulator, and efficient 2ar-eting 2onitoring h,"othesis. 4cono2ic efficienc, theor, states
that co2"anies should achie6e their out"ut at the lowest "ossi.le cost "er unit "roduced. According to this
theor,( o"ti2al "roduction can .e achie6ed ., econo2ies of scale. ;hus( in the short run( 2a7i2u2 o"erational
efficienc, is attained at the le6el of out"ut at which all accessi.le econo2ies of scale are ta-ing ad6antage of
such efficienc,. In the long run( lifting the ca"acit, of e7isting s,ste2s can increase the o"ti2al le6el of
"roducti6e efficienc, Her.e( 2))1I Said( 2)11#. ;here are two "ers"ecti6es of econo2ic efficienc, theor,I
allocati6e "rice# efficienc, criteria that states that for .an-s to o"erate at efficient le6el( then all .an- "roducts
ha6e to .e "riced o"ti2all,. ;his will in turn reduce unfair co2"etition in the 2ar-et and reduction in interest
rate s"reads. ;he "roducti6e efficienc, technical efficienc,# which ta-es "lace when the .usiness e2"lo,s all of
its resources efficientl,( "roducing the 2ost out"ut fro2 the least in"ut Sath,e( 2))1I 3arr( et al 2))2I Saad J
4l-+oussawi( 2))9I Said 2)11#.
+odern theor, of financial inter2ediation argues that the role of .an-s in the econo2, is to create li<uidit, .,
funding illi<uid loans with li<uid de2and de"osits /ia2ond 19$%( Ra2a-rishnan and ;ha-or( 19$%#. 3an-s
create li<uidit, on the .alance sheet ., transfor2ing less li<uid assets into 2ore li<uid lia.ilities. 1i<uid .an-s
2a, .e 2ore efficient in the sense that( all other things .eing e<ual( an efficient .an- can "roduce 2ore out"ut
"art of which includes li<uid and other assets. According to Korton and Guang( 2))2#( .an-s and .an-ing
s,ste2s that "roduce 2ore li<uidit, than others "erha"s can .e 6iewed as .oth 2ore Dli<uidit, efficient> and also
less ris-,. 0ash,a"( et.al( 2))2# suggested that .an-s 2ight also create significant li<uidit, off the .alance sheet
through loan co22it2ents and si2ilar clai2s to li<uid funds.
Regulator, and efficient 2ar-eting 2onitoring h,"othesis states that regulators encourage .an-s to increase their
ca"ital to co22ensurate with the a2ount of ris- ta-en ., the .an-s. ;his 2a, .e achie6ed through efficient
2ar-et 2onitoring( 2echanis2s that will call for increase in ca"ital when ca"ital "ositions are dee2ed
inade<uate ?alo2iris and 0ahn( 1991I 3erger( 199C#. ;hus( an i2"ortant factor contri.uting to a "ositi6e
relationshi" .etween ca"ital ade<uac, and credit ris- 2anage2ent to .an-s efficienc, relates to the actions of
regulators and su"er6isors Shrie6es and /ahl( 1992I Jac<ues and Nigro( 1997I Aggarwal and Jac<ues( 199$I
4ditB et al.( 199$#. 3an-s could res"ond to regulator, actions forcing the2 to increase their ca"ital ., increasing
asset ris- 0ahane 1977( 0oehn and Santo2ero( 19$) and 0i2 and Santo2ero( 19$$.
;he need to control the high incidence of loan default occasioned ., increased lending acti6ities was a "o"ular
2oti6e for refor2s in financial s,ste2s in de6elo"ing econo2ies. ;he statutor, 2ini2u2 ca"ital ade<uac, ratio
for co22ercial .an-s in 0en,a is 12=( which is 2easured ., the ratio of ;otal ?a"ital to ;otal Ris- Feighted
Assets ?30( 2)11a#
According to Korton and Finton 199$#( Altun.as et al 2))7#( an, e2"irical a""roach that is used to 2odel the
relationshi"s .etween ca"ital and ris- also needs to ta-e account of .an- efficienc,. Garle, 2)11#( states that
go6ern2ent should regulate in6est2ent "olic, for .an-s for the2 to .e 2ore efficient and .e glo.all,
co2"etiti6e.


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% &odel specification
;he following 2odel was usedI


+ + + + + + + = + + +

X X X X X X X X
y
y
$
$
7
7
6
6
C
C
%
%
*
*
2
2
1
1 1

Fhere9
L M 3an- o"erating efficienc,
o, z,
1

8
M 4sti2ated coefficients
y
-1
M 1agged 3an- &"erating 4fficienc,
X
1
M Inter.an- Ratio
X
2
M 1oans Ratio
X
3
M Net 1oans to ;otal /e"osits
X
4
M 1i<uid Assets to /e"osits
X
5
M ?ore ?a"ital Ratio
X
6
M Ris- 8 .ased ?a"ital Ratio
X
7
M ;otal ?a"ital Ratio
N
$ M
4<uit, ?a"ital to ;otal Asset Ratio
O M 4rror ter2
&"erating 4fficienc, ratio M Interest inco2e P non-interest inco2e P securities gains#A Interest e7"ense
P non- interest e7"ense P "ro6ision for loan losses P ta7es#

' &et$odology
;his stud, used an e7"lanator, a""roach ., using "anel research design. /ata was collected fro2 %) co22ercial
.an-s out of %%( which e7isted and had the re<uired data during the entire stud, "eriod. ;he stud, used
secondar, data( which was retrie6ed fro2 "u.lished state2ents of accounts of the %) co22ercial .an-s .oth
fro2 the central .an- of 0en,a and the res"ecti6e co22ercial .an-s for se6en-,ear "eriod 2))C-2)11. ;he
res"ecti6e ratios were then co2"uted fro2 the data retrie6ed fro2 the state2ents of accounts of the .an-s. ;he
collected data was anal,Bed using stata software. /escri"ti6e statistics for "anel data( correlation 2atri7 and
esti2ation of "anel data were run. Inferential statistics using the Gaus2an test chec-s were done in order to
deter2ine a 2ore efficient 2odel against a less efficient one. ;he stud, carried out the fi7ed effects regression
anal,sis to e7a2ine the effects of .an- s"ecific li<uidit, ratios and ca"ital ade<uac, ratios on their o"erating
efficienc,.

( )esults and discussion
;a.le 1 shows regression results of the fi7ed effect 2odel. Results show that( "re6ious ,ear>s o"erational
efficienc,( total ca"ital ratio and li<uid asset to short-ter2 lia.ilities ratio were significantl, different fro2 Bero
at o = u.uS. ;his i2"lies that the histor, of a fir2>s "erfor2ance will definitel, influence how a fir2 2o6es
forward in an effort to strea2line its o"erational strategies. Si2ilarl,( the significance of the ca"ital ratio i2"lies
that co22ercial .an-s well endowed with ca"ital resources are 2ore sta.le o"erationall, and are a.le to cushion
the2sel6es fro2 financial shoc-s in the ca"ital 2ar-ets. ;his is inconsistent with "re6ious findings Altun.as
2))7# ;hereforeI the central .an-s should endea6our to -ee" the .ase lending rate as low as "ossi.le to i2"ro6e
access to ca"ital resources ., co22ercial .an-s. In addition( co22ercial .an-s in 0en,a need to engage in
"rudent in6est2ent of their ca"ital resources to a6oid o6ere7"osure to ris-s consistent with the findings .,
Garle, 2)11#. ;he results also indicate that co22ercial .an-s with enough li<uid assets tend to draw 2ore
confidence with custo2ers .ecause of the a.ilit, to address short-ter2 financial o.ligations. It is therefore
i2"ortant for the central .an- to ensure full co2"liance with the 2ini2u2 li<uidit, re<uire2ent ., co22ercial
.an-s. ;he other ratios( inter.an- ratio( loan ratio( net loans to de"osits ratio( core ca"ital ratio( ris- .ased ca"ital
ratio and e<uit, to total asset ratio( were not significantl, different fro2 Bero.
?onclusion
;his stud, in6estigates the effect of li<uidit, and ca"ital ade<uac, on o"erating efficienc, of co22ercial .an-s
in 0en,a. ;he results show that "re6ious ,ear>s o"erational efficienc,( li<uidit, and ca"ital ade<uac,
co2.ined e7"lain a.out %1= of the .an->s o"erating efficienc,. Further( total ca"ital ratio and li<uid asset to
de"osits ratio "ositi6el, affect o"erating efficienc, of the .an-s. ;he other li<uidit, ratios- inter.an- ratio( loan
ratio( net loans to de"osits ratio and ca"ital ade<uac, ratios - core ca"ital ratio( ris- .ased ca"ital ratio and e<uit,
to total asset ratio insignificantl, effect o"erating efficienc, of the .an-s. Fe reco22end co22ercial .an-s to
stri6e to increase their total ca"ital ratio in order to reduce their o"erational ris-s and therefore increase
o"erational efficienc,. Si2ilarl,( the, should increase the ratio of li<uid assets to de"osits and short ter2
funding in order to increase their o"erational efficienc,. Future research should .e concerned with factors
influencing the o"erating efficienc, of co22ercial .an-s. +oreo6er( a full 2odel for o"erating efficienc, for
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.an-s will go a long wa, in assisting .an- 2anagers to e6aluate and atte2"t to 2ini2iBe ris-s that .an-s are
e7"osed to.

* +olicy )ecommendations
&"erational efficienc, as the stud, has found out will .e .rought ., the factors under this stud,. ;he histor, of a
fir2>s "erfor2ance will definitel, influence how a fir2 2o6es forward in an effort to strea2line its o"erational
strategies. Si2ilarl,( .an-s well-endowed with ca"ital resources are 2ore sta.le o"erationall, and are a.le to
cushion the2sel6es fro2 financial shoc-s in the ca"ital 2ar-ets. ;herefore( .an-s should see- on 2echanis2s to
i2"ro6e their li<uid assets to de"osits ratio and total ca"ital ratio in readiness to i2"ro6e o"erating efficienc,
and re2ain co2"etiti6e in the 2ar-et. A 2odel for o"erating efficienc, of .an-s will go a long wa, in assisting
.an- 2anagers to e6aluate and atte2"t to 2ini2iBe ris-s that .an-s are e7"osed to.

, Areas of furt$er researc$
Since the stud, 6aria.les onl, account for %1.)$= of the changes in o"erational efficienc,( it 2eans that C2= of
the .an-s o"erational efficienc, is deter2ined ., other factors. ;herefore( a stud, should .e done using
different 6aria.les to deter2ine their effect on o"erational efficienc,. So2e of the factors can .e .oard of
/irectors co2"osition( s-ills and <ualifications of the staff( 6alues of collateral used and auto2ations of the
o"erations.

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Shaw-( 2))$# &"erational 4fficienc, a 3rand !oint +anage2ent !ers"ecti6e( htt"9AAwww.schaw-.co2
Shaw-( 2))$ &"erational 4fficienc, a 3rand !oint +anage2ent !ers"ecti6e htt"9AAwww.schaw-.co2
Shrie6es( R. 4. and /ahl /. 1992#( the relationshi" .etween ris- and ca"ital in co22ercial .an-s( ournal o!
,an#ing an% Finance, 1), 439- 4*7
SiraE.0.0. J !illai( !.S.!. 2)11#( Asset Tualit, and !rofita.ilit, of Indian Scheduled ?o22ercial 3an-s during
Klo.al Financial ?risis( "nternational /e$earc6 ournal o! Finance an% Economic$, "$$ue '0, pp.**-)*.
Her.e( R. &.( Jr. 2))1#( 4cono2ic efficienc, in law and econo2ics( ?heltenha2( <=- E%1ar% Elgar Pu9li$6ing.

#able 1- .i/ed Effects )egression )esults


R-s<9 within M ).)$*6 F 9( *9# M 1%29.**
3etween M ).%*6$
corruQi( N.# M ).%C77
!ro. U F M ).))))
&6erall M ).%1)$
+arameters Coef 0td Err t +12t2 34(5 Conf !nter6al7
&".efficienc, lag ).2*7* ).1)$2 2.19)) ).)*%) ).)1$% ).%C61
?ore ca"ital ratio ).)697 ).)7$* ).$9)) ).*79) -).)$$7 ).22$1
Ris- .ased ca"ital ratio ).2C)7 ).*219 ).7$)) ).%%1) -).%))C ).9)1$
;otal ca"ital ratio ).)))2 ).)))1 2.1%)) ).)*9) ).)))) ).)))%
e<uit,Aasset ratio -).196C ).62%9 -).*1)) ).7CC) -1.%6)C 1.)67%
inter.an- ratio ).)))) ).)))) ).26)) ).79C) ).)))) ).))))
loan ratio -).)*C2 ).2112 -).17)) ).$6$) -).%62C ).*92)
net loansAde"osits ratio -).)%$C ).1C19 -).*2)) ).7C1) -).*CC$ ).2C$$
li<uid assetsAde"osits ratio ).))79 ).))2) *.$9)) ).)))) ).))*$ ).)12)
Qcons ).$$$2 ).2221 %.)))) ).)))) ).%*9) 1.**7%

sig2aQu ).1*1$
sig2aQe ).)912
rho ).676%
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