The Link Between Cost Efficiency and Non-Performing Loans of Community Banks in Tanzania

Abstract

The link between bank efficiency and non-performing loans (NPLs) has generally been
used to predict the effect of either variable on bank failure. The results have, by and
large, remained inconclusive in the bank efficiency literature, falling mainly under
either ‘bad management’ or ‘bad luck’ hypothesis camps. This study applied the Tobit
simultaneous regression to explore the effects of ‘bad management’ and ‘bad luck’ on
the incidence of low cost efficiency and NPLs of community banks (CBs) in Tanzania.
Secondary data from 9 CBs in a span of 13 years were sourced from the Bank of
Tanzania (BoT); and from audited accounts of CBs. The paper establishes that
although both bad management and bad luck contribute to NPLs increase, bad luck
was the dominant source of high NPLs and cost inefficiency in CBs. The policy
implications of the results are that the banks regulator (BOT) should limit risk
exposures of CBs by controlling excessive risk-taking and loan concentration; and by
insisting on diversification. Further, the BoT should provide managerial training and
knowledge-sharing aimed at increasing management efficiency. The government and
other stakeholders can also provide financial and technical support to CBs to enable
them to effectively serve risky sectors, including agriculture, as a way of enhancing
financial inclusion of the avoided rural sector.

Key words: community banks, cost efficiency, NPLs ratio, bad management, bad luck.