EFFECT OF CAPITAL ADEQUACY ON FINANCIAL PERFORMANCE OF MICROFINANCE BANKS IN KENYA

Sammy Mutiria Murige - Tharaka University, Kenya

Dr. Tumaini Mwikamba - Tharaka University, Kenya

Dr. James Nyamu - Tharaka University, Kenya

ABSTRACT

Microfinance banks (MFBs) play a critical role in ensuring financial inclusion for low-income individuals and small businesses excluded from commercial banking. However, the sector’s financial performance has deteriorated sharply in recent years, with the Central Bank of Kenya reporting a sector-wide pre-tax loss of approximately Ksh 3.5 billion in 2024, up from Ksh 2.4 billion in 2023, alongside a negative return on assets of 6.1 percent, attributed to high non-performing loans, capital erosion, shrinking deposits and operational inefficiencies. Despite the sector’s economic importance, literature remains inconclusive regarding the precise relationship between capital adequacy and the financial performance of MFBs in Kenya. This study therefore assessed the effect of capital adequacy, measured through the Capital Adequacy Ratio, on the financial performance of Kenyan MFBs, measured using Return on Assets (ROA). The study was anchored on Capital Buffer Theory and adopted a positivist research philosophy together with an explanatory and descriptive research design. A census of all 14 Central Bank of Kenya-licensed MFBs was undertaken, yielding secondary panel data spanning 2011 to 2024. Data were analysed using STATA version 19.0 and R version 4.6.1, employing robust Fixed Effects panel regression to draw empirical inferences following diagnostic testing for multicollinearity, heteroskedasticity and model specification. The Hausman specification test favoured the Fixed Effects estimator (χ² = 16.152, p < 0.001), under which Capital Adequacy demonstrated a positive and statistically significant effect on Return on Assets (β = 0.0165, p < 0.05). The model was statistically significant overall (F = 6.535, p < 0.05), leading to rejection of the null hypothesis that capital adequacy has no statistically significant effect on financial performance. The findings imply that capital buffers above minimum statutory requirements are a fundamental driver of MFB profitability, a conclusion of particular urgency given that at least half of Kenya’s fourteen licensed MFBs are estimated to require a combined Ksh 2.9 billion in fresh capital to meet the tiered core-capital requirements proposed under the Microfinance Bill, 2026. The study recommends that MFB management prioritise maintaining capital buffers above minimum statutory requirements to absorb operational risks, and that the Central Bank of Kenya adopt a differentiated, risk-based regulatory framework for capital requirements that accounts for the scale and risk profile of individual institutions.

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