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Effect of Adverse Selection On Non Performing Loans and Financial Health of Commercial Banks in Kenya
Subject area: Management and Commerce · Area of research: Finance
Abstract
This study uses hypothetical data to investigate the impact of adverse selection on non-performing loans (NPLs) and how they influence the financial health of commercial banks in Kenya. Grounded in the theory of asymmetric information it explains how imperfect borrower screening and limited credit information increase credit risk, leading to a rise in defaulted loans. This study utilizes a conceptual framework linking adverse selection, NPLs, and financial performance, and employs two Ordinary Least Squares (OLS) regression models. The results reveal a strong and statistically significant positive relationship between adverse selection and NPLs, indicating that poor credit risk assessment substantially elevates the proportion of defaulted loans. Furthermore, the second model demonstrates that higher NPL ratios significantly reduces bank profitability, as measured by Return on Assets (ROA), while capital adequacy and liquidity ratios positively influence financial performance. These findings suggest that adverse selection do not only deteriorates asset quality but also undermines long-term financial resilience. The study demonstrates that strengthening credit information systems, enhancing borrower screening mechanisms, and reinforcing prudential regulation are vital policy priorities. By mitigating the effects of adverse selection, commercial banks can better manage credit risk and preserve financial stability. The research offers valuable insights for policymakers, regulators, and bank managers seeking to build a more robust and transparent credit market in Kenya?s banking sector.
Keywords
Adverse Selection, Commercial banks, Financial Health and Non-Performing Loans
References
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[3] Central Bank of Kenya. (2022). Financial Stability Report. CBK
[4] Chantal, M., Namusonge, G. S., & Shukla, J. (2019). Influence of Adverse Selection due to Asymmetric Information on Commercial Banks’ Lending Performance in Rwanda. INTERNATIONAL JOURNAL OF ACADEMIC RESEARCH IN BUSINESS AND SOCIAL SCIENCES, 9(11).
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[10] Olivares-Caminal, R., & Miglionico, A. (2017). Non-performing loans: Challenges and options for banks and corporations. In Non-Performing Loans and Resolving Private Sector Insolvency: Experiences from the EU Periphery and the Case of Greece (pp. 17-45). Cham: Springer International Publishing
How to cite this paper
@article{1708949,
author = {Patience Petronila Oduori, Dr. Yasin Ghabon},
title = {Effect of Adverse Selection On Non Performing Loans and Financial Health of Commercial Banks in Kenya},
journal = {Iconic Research And Engineering Journals},
year = {2025},
volume = {8},
number = {12},
pages = {975-981},
issn = {2456-8880},
url = {https://www.irejournals.com/formatedpaper/1708949.pdf},
abstract = {This study uses hypothetical data to investigate the impact of adverse selection on non-performing loans (NPLs) and how they influence the financial health of commercial banks in Kenya. Grounded in the theory of asymmetric information it explains how imperfect borrower screening and limited credit information increase credit risk, leading to a rise in defaulted loans. This study utilizes a conceptual framework linking adverse selection, NPLs, and financial performance, and employs two Ordinary Least Squares (OLS) regression models. The results reveal a strong and statistically significant positive relationship between adverse selection and NPLs, indicating that poor credit risk assessment substantially elevates the proportion of defaulted loans. Furthermore, the second model demonstrates that higher NPL ratios significantly reduces bank profitability, as measured by Return on Assets (ROA), while capital adequacy and liquidity ratios positively influence financial performance. These findings suggest that adverse selection do not only deteriorates asset quality but also undermines long-term financial resilience. The study demonstrates that strengthening credit information systems, enhancing borrower screening mechanisms, and reinforcing prudential regulation are vital policy priorities. By mitigating the effects of adverse selection, commercial banks can better manage credit risk and preserve financial stability. The research offers valuable insights for policymakers, regulators, and bank managers seeking to build a more robust and transparent credit market in Kenya?s banking sector.},
keywords = {Adverse Selection, Commercial banks, Financial Health and Non-Performing Loans},
month = {June},
}