Asset Quality and Financial Stability: An Empirical Review of Commercial Banks in Kenya

The purpose of this paper is to evaluate the role of asset quality on the financial stability of commercial banks in Kenya. The study employed an unbalanced panel dataset comprising 43 commercial banks in Kenya spanning the period from 2000 to 2021, resulting in 789 bank-year observations. Asset quality was assessed using non-performing loans (NPLs), while financial stability was measured using Z-scores. Utilizing panel data estimation methods, the findings indicate a negative relationship between asset quality and financial stability, emphasizing that an increase in NPLs leads to a decrease in financial stability within the banking sector. The findings are consistent even after using different measures of financial stability i.e., Risk adjusted return on assets (RAROA) and Risk adjusted return on equity (RAROE). Moreover, capital adequacy which is employed as a control variable, reveal that improving capital adequacy can provide the commercial banks with the required stability to absorb losses and improve the ability to encounter unexpected financial shocks. The research results provide important policy implications for regulators, bank managers and policy makers on the better methods of customer screening to reduce the level of non-performing loans and prudent management of credit risk.