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.