Financial Liberalization and Bank Efficiency: The Case of Commercial Banks in Kenya

This study examines profit efficiency of commercial banks in Kenya after the financial sector reforms were undertaken in the early 1990s. By utilizing the stochastic frontier approach it estimates the annual profit efficiency scores for 17 commercial banks for the period, 1995-2004. The results show an average of 65.6% profit efficiency over the study period. However, the mean profit efficiency declines from 67.9% in 1995 to 62.9% in 2000, thereafter it increases consistently to 68% in 2003. The initial decline in profit efficiency could be due to the oligopolistic nature of the Kenyan banking sector and unfavorable macroeconomic environment that prevailed after the financial sector reforms. The improvement in efficiency towards the end of the study period, could be explained by increased competition in the banking sector, adoption of new technology and introduction of innovative products targeting different customer segments. The study further finds that bad debts are concentrated in banks that reported low levels of profit efficiency. The study concludes that financial liberalization improves profit efficiency of the banks in the long run, and non-performing loans negatively affect banks profit efficiency. To further improve the profit efficiency of the banks, the study recommends formulation of policies that reduce the non-performing loan burden, and encourage competition and sharing of infrastructure and technology.