Determinants of Banking Sector Efficiency in Kenya: Application of Non-parametric Data Envelopment Analysis (DEA) Model

Abstract

The financial system plays an important role in the economic development and financial stability of a country. Banks play a critical role in facilitating stability of the financial system and economic development. Evaluating the determinants of banking efficiency therefore provides insight to establish the target factors that influence efficiency to facilitate inefficiency identification and elimination. The study’s objective was to evaluate the determinants of banking sector efficiency in Kenya for the period 2006 to 2017. Secondary data were collected from the annual reports and financial statements of 10 commercial banks listed on the Nairobi Securities Exchange (NSE). The analysis was carried out in two stages. In the first stage, the non-parametric Data Envelopment Analysis (DEA) approach was used to compute the efficiency scores. In the second stage, panel regression analysis was then performed to evaluate the determinants of efficiency. The results showed that Capital Adequacy and Market Capitalization are significant in determining the Efficiency of a bank, p =0.0315< 0.05 and p=0.0253< 0.05 respectively. Further, bank size (p = 0.000< 0.05), capital adequacy (p = 0.0014< 0.05), leverage (p = 0.0000< 0.05) and Liquidity risk (p = 0.0000< 0.05) have a significant effect on Scale Efficiency. Market capitalization (p = 0.5056>0.05) is statistically insignificant in influencing the Scale Efficiency of the bank. From the findings, the study, therefore, concludes that, bank size, capital adequacy, liquidity risk, leverage and market capitalization have a significant effect on bank efficiency. The study recommends that bank managers should focus on improving management quality by ensuring compliance with prudential guidelines issued by the Central Bank of Kenya. Particularly, bank managers should ensure capital adequacy and market capitalization requirements are met since they are found to be the key drivers of efficiency and performance. Further, maintaining an optimal bank size, market capitalization, appropriate liquidity risk and leverage level is significant in guaranteeing improved performance.