Abstract:
This paper examines how macroeconomic shocks affect credit risk in the Kenyan banking sector. Using an autoregressive distributed lag (ARDL) model within a time-series framework, we establish the existence of both a short-run and long-run nexus between macroeconomic variables and bank-credit risk. We establish a negative relationship between credit risk and GDP growth although not significant. We also find that the relationship between bank profitability and asset quality is negative in the short-run but positive in the long-run. The paper also documents a positive short-run relation between asset quality and private sector credit growth, which turns negative in the longrun. Furthermore, the bank asset quality-capital nexus is positive in the short-run but turns negative in the long-run. The concave relationship suggest that NPLs will rise with increases in capital to a certain threshold (moral hazard effect), after which more capital build ups decrease NPLs (disciplinary or regulatory effect). Finally, the speed of adjustment coefficient is negative and statistically significant. A shock in any period is self-correcting at a rate of 24.96%, implying that the long-run market equilibrium is restored within a period of four quarters.