Capital Adequacy, Cost Income Ratio and the Performance of Commercial Banks: The Kenyan Scenario

This study provides evidence that supports the Central Bank of Kenya`s move to gradually raise bank capital levels by 2012 and to tightly monitor the operations of banks so as to ensure that Kenyan banks are more efficient in their operations while at the same time being profitable. With the present global credit crunch, capital adequacy and the cost-income ratio being critical for banks, the present study examines the relationship between these variables and profitability. Using the return on assets and the return on equity as proxies for bank profitability for the period 1998 to 2007, the study finds that bank profitability is positively related to the core capital ratio and the tier 1 risk-based capital ratio. This implies that an increase in capital may raise expected earnings by reducing the expected costs of financial distress, including bankruptcy. The study also establishes that there exists negative relationship between the equity capital ratio and profitability. The study also finds out that Kenyan banks are not competitive enough globally in terms of their efficiency as measured by the Cost-Income Ratio (CIR). The study reveals that the CIR is inversely related to both bank profitability measures. The study also reveals that the CIRs of Kenyan banks are higher than those of developed countries. This means that Kenyan banks should strive to keep their CIR to a minimum level, if possible below the 50% threshold for them to be more efficient so as to be globally competitive.