Muiruri, Paul Munene- PhD Business Administration ( Finance)-2015

8/15/2019 Muiruri, Paul Munene- PhD Business Administration ( Finance)-2015

1/161

EFFECTS OF CENTRAL BANK REGULATORYREQUIREMENTS ON FINANCIAL PERFORMANCE OFCOMMERCIAL BANKS IN KENYA

PAUL MUNENE MUIRURI

DOCTOR OF PHILOSOPHY

(Business Administ !ti"n#

$OMO KENYATTA UNI%ERSITY OF

AGRICULTURE AND TECHNOLOGY

&' )


2/161

E**e+ts "* Cent !, B!n- Re.u,!t" / Re0ui ements "n Fin!n+i!,

Pe *" m!n+e "* C"mme +i!, B!n-s in Ken/!

P!u, Munene Mui u i

A T1esis Su2mitted in P! ti!, *u,*i,,ment *" t1e De. ee "* D"+t" "*

P1i,"s"31/ in Business Administ !ti"n "* $"m" Ken/!tt! Uni4e sit/ "*

A. i+u,tu e And Te+1n","./5

&' )


3/161

DECLARATION

This thesis is my original work and has not been presented for a degree in any other

University.

Signature ……………………….…….. Date … ………………

P!u, Munene Mui u i

This thesis has been submitted for examination with our approval as UniversitySupervisors.

5 Signature ……………………….…….. Date …………………

D 5 F," en+e Si.! ! Mem2!

$KUAT6 Ken/!

&5 Signature ……………………….…….. Date …………………

D 5 A.nes N7e u

$KUAT6 Ken/!

ii


4/161

DEDICATION

This thesis is dedicated to my late father Muiruri who never lived long enough to see the

academic achievement of his son. also dedicate this work to my mum !eris "angari and

my family specifically my wife Margaret "aithira# my lovely children $oy "angari and

%rnest Muiruri. Many were the times they missed my attention when i was preparing thisthesis. Thank you very much for your encouragement& support and prayers.

iii


5/161

ACKNO8LEDGMENT

This thesis has been the fruit of a long 'ourney& during which have seen support of wide

range of people who made my dream a reality. My gratitude goes to the (lmighty )od who

enabled me to come this far in my studies by giving me peace of mind& grace and good

health when preparing this thesis.

Secondly& would like to express my profound gratitude to my supervisors& Dr. (gnes

*'eru and Dr. +lorence Memba for their inspiration& support& motivation and professional

guidance in writing this thesis. am indeed grateful and do appreciate the knowledge and

research skills that have gained from them.

Thirdly& appreciate my !h.D graduate classmates of the year ,- ,& particularly Mr.

Macharia and )atuhi for the teamwork and encouragement in this 'ourney. +inally& amindebted to my dear wife Margaret and children $oy and %rnest whose patience& love and

understanding saw me through during the ups and downs in the process of writing this

thesis. appreciate their encouragement and understanding particularly for the many

weekends was not with them as worked on this thesis.

would also want to say a big thank you to the managers of the commercial banks who

allowed me to collect data in their banks.

+or those not mentioned but played a key role behind the scenes in making this thesis a

success say& /Thank you very much./

iv


6/161

TABLE OF CONTENTS

DECLARATION55555555555555555555555555555555555555555555555555555555555555555555555555

DEDICATION5555555555555555555555555555555555555555555555555555555555555555555555555555

ACKNO8LEDGMENT555555555555555555555555555555555555555555555555555555555555555555555

TABLE OF CONTENTS55555555555555555555555555555555555555555555555555555555555555555555

LIST OF TABLES555555555555555555555555555555555555555555555555555555555555555555555555

LIST OF FIGURES55555555555555555555555555555555555555555555555555555555555555555555555

LIST OF APPENDICES55555555555555555555555555555555555555555555555555555555555555555555

ACRONYMS AND ABBRE%IATIONS55555555555555555555555555555555555555555555555555555555

DEFINITION OF TERMS555555555555555555555555555555555555555555555555555555555555555555

ABSTRACT55555555555555555555555555555555555555555555555555555555555555555555555555555

CHAPTER ONE5555555555555555555555555555555555555555555555555555555555555555555555555

INTRODUCTION5555555555555555555555555555555555555555555555555555555555555555555555555

. 0ackground of the Study...............................................................................................

. . 1istory of 2entral 0ank 3egulatory 3e4uirements....................................................5

. ., %ffects of 2entral 0ank regulatory re4uirements and 0ank performance................ ,

. .6 0anking ndustry in 7enya....................................................................................... 8

., Statement of the !roblem.............................................................................................,-

.6 9b'ectives 9f the Study...............................................................................................,,

.6. )eneral 9b'ective.....................................................................................................,,

.6., Specific 9b'ectives...................................................................................................,,

.: 3esearch 1ypotheses...................................................................................................,6

.; $ustification of the Study.............................................................................................,6

.< Scope of the Study.......................................................................................................,:

.= >imitations...................................................................................................................,:

CHAPTER T8O55555555555555555555555555555555555555555555555555555555555555555555555555

v


7/161

LITERATURE RE%IE855555555555555555555555555555555555555555555555555555555555555555555

,.- ntroduction..................................................................................................................,;

,. Theoretical >iterature 3eview.....................................................................................,;

,., %mpirical >iterature 3eview........................................................................................66

,.,. 2orporate )overnance...............................................................................................66

,.,., 2apital 3e4uirement.................................................................................................6<

,.,.6 2redit 3isk Management..........................................................................................65

,.,.: >i4uidity Management.............................................................................................:6

,.,.; 0ank 9wnership and +inancial !erformance...........................................................:=

,.,.< 2entral 0ank 3egulatory 3e4uirements and +inancial !erformance......................;-

,.6 2riti4ue of existing literature relevant to the study.....................................................;;

,.: 3esearch )aps and Summary......................................................................................;8

,.; 2onceptual +ramework................................................................................................;5

CHAPTER THREE55555555555555555555555555555555555555555555555555555555555555555555555

METHODOLOGY555555555555555555555555555555555555555555555555555555555555555555555555

6.- ntroduction..................................................................................................................<

6. 3esearch !hilosophy....................................................................................................<

6., 3esearch Design..........................................................................................................


8/161

6.8. Moderating effect model..........................................................................................


9/161


10/161

T!2,e >5&>= (*9@( >i4uidity Management and 39% ESecondary DataF ............ 5-

T!2,e >5&)= +iveBGearA !erformance of 2ommercial 0anks in 7enya. ....................... 5-

T!2,e >5&:= 0anksA !erformance and %ffects of 207 regulatory re4uirement ............. 5,

T!2,e >5&;= 3egression 2oefficients with 39( .......................................................... 5<

T!2,e >5&@=3egression 2oefficients with 39% ........................................................... 5=

T!2,e >5&?= Model Summary with 39% ...................................................................... 55

T!2,e >5


11/161

LIST OF FIGURES

Fi.u e &5 = 2onceptual framework .......................5 CDistribution of respondentsA profile ......................................................... =-

Fi.u e >5& C3espondents work experience ................................................................ =6 -Fi.u e >5isting of the banks ....................................................................... =6

Fi.u e >5>= 0ank 9wnership Structure ........................................................................ 8

x


12/161

LIST OF APPENDICES

A33endi9 i C >etter 9f (uthori?ation ............................................................................... ,,

A33endi9 ii C >etter 9f ntroduction ................................................................................ ,6

A33endi9 iii C Study Huestionnaire ................................................................................ ,:A33endi9 i4 C Secondary Data 2ollection Sheet ........................................................... ,8

A33endi9 4 C 3anking of 2ommercial 0anks in 7enya ................................................. 6-

A33endi9 4i= >ist 9f nvestment 0anks n 7enya ....................................................... 6,

A33endi9 4ii C Secondary data ....................................................................................... 6,

A33endi9 4iii= >ist of 207 !rudential 3egulations E,--


13/161

ACRONYMS AND ABBRE%IATIONS

BCBS 0asel 2ommittee on 0anking Supervision

BIS 0ank for nternational Settlement

CAMEL 2apital ade4uacy& (sset Huality& Management& %arning and >i4uidity

CBK 2entral 0ank of 7enya

2 BN 2entral 0ank of *igeria .

CMA 2apital Market (uthority

ERS %conomic 3ecovery Strategy

FIs +inancial nstitutions

FSI +inancial Stability nstitution

GDP )ross Domestic !roduct

NBFI *onB0anking +inancial nstitution

P15D Doctor of !hilosophy

P 4!,ue !robability @alue

ROA 3eturn on (ssets

ROE 3eturn on %4uity

S5E Standard %rror

SPSS Statistical !ackage for Social Sciences

US United States of (merica Dollar

%IFs @ariance nflation +actors

xii


14/161

DEFINITION OF TERMS

This study adopted the following definition of key termsC

Li0uidit/ M!n!.ement= t is defined as the ability of a financial institution to meet all

legitimate demands for funds.

B!n- Re.u,!t" / Re0ui ements= are form of government regulation & which sub'ect

banks to certain re4uirements& restrictions and guidelines.

C!3it!, e0ui ement C Ealso known as regulatory capital or capital ade4uacyF is the

amount of capital a bank or other financial institution has to hold as re4uired by its

financial regulator . t acts as a buffer in case of adverse situation.

C"mme +i!, 2!n-= t is a financial institution& which provides services such as accepting

deposits& giving business loans and auto loans& mortgage lending and basic investment

products like savings accounts and certificates of deposit.

C edit is- M!n!.ement C 3efers to identification& analysis and assessment& monitoring

and control of credit and this has direct implications on the amount of loans and advances

extended to customers as well as on the level of nonBperforming loans.

Fin!n+i!, 3e *" m!n+e "* 2!n-s= t is defined as profitability& which accounts for the

impact of better financial soundness on bank risks bearing capacity and on their ability to

perform li4uidity transformation.

C" 3" !te G"4e n!n+e= it is the accountability of the management with regard to the

routine financial decisionBmaking process. t is also the ratios that show what percentage of gross from revenue went to pay interest& operating expenses and depreciation& and how

much balance left for net bank income.

xiii

https://en.wikipedia.org/wiki/Governmenthttps://en.wikipedia.org/wiki/Governmenthttps://en.wikipedia.org/wiki/Regulationhttps://en.wikipedia.org/wiki/Bankhttps://en.wikipedia.org/wiki/Bankhttps://en.wikipedia.org/wiki/Financial_institutionhttps://en.wikipedia.org/wiki/Financial_regulatorhttps://en.wikipedia.org/wiki/Financial_regulatorhttps://en.wikipedia.org/wiki/Governmenthttps://en.wikipedia.org/wiki/Regulationhttps://en.wikipedia.org/wiki/Bankhttps://en.wikipedia.org/wiki/Bankhttps://en.wikipedia.org/wiki/Financial_institutionhttps://en.wikipedia.org/wiki/Financial_regulator


15/161

ABSTRACT

The purpose of the study was to assess the effects of central bank regulatory re4uirements

on financial performance of commercial banks in 7enya. The study specifically focused on

the effects ofC corporate governance& capital re4uirement& li4uidity management and credit

risk management on financial performance of commercial banks. The study also assessed

the moderating effect bank ownership had on the relationship between effects of central

bank regulatory re4uirements and financial performance of commercial banks in 7enya.

The study employed descriptive research design. 0oth primary data and secondary data

were collected and that analy?ed. +or primary data collection& the study targeted =, key

bank officials who were randomly sampled and data were collected by use of a

4uestionnaire. Secondary data was collected from most recent published annual financial

statements and banks supervision records at the 2entral 0ank of 7enya& from ,--5 to ,- 6.The data obtained was cleaned# coded and statistical outputs generated using S!SS.

Descriptive and inferential statistics were employed to analy?e the data. To determine the

effects of central bank regulatory re4uirements on financial performance of banks in

7enya& measures of central tendency& dispersion and multiBregression analysis model were

used. The study results showed continuous growth 2(M%> rating in all the key ratios over

the years under review. This continuous growth 2(M%> rating could be attributed to 207

regulatory re4uirements effects such as corporate governance& capital re4uirement& credit

risk management and li4uidity management E+I .:66# ! valueI-.== with 39% and +I-.5:#

! valueI-.::, with 39(F. This confirms that 207 regulatory re4uirements are in factors

that influence bank performance. The findings further indicated that there was a strong and

positive correlation between effects of 207 regulatory re4uirements and financial

performanceE3I-.=5: with 39% and 39(F.This confirms that these are part of the effects

central bank regulatory re4uirements and are important. +urther from study results it was

evident that the 2entral 0ank 3egulatory re4uirements have positively contributed to

financial performance of commercial banks in 7enya. There was great variation on thefinancial performance of commercial banks due to changes in 2orporate )overnance&

capital re4uirement& credit risk management and li4uidity Management. This is an

indication that central bank regulatory re4uirements had great effects on the financial

performance of commercial banks. +inally the study found that bank ownership did not

xiv


16/161

have moderating effect on the relationship between bank performance and central bank

regulatory re4uirements in 7enya. The study concluded that corporate governance& capital

re4uirement& credit risk Management and li4uidity management influenced the profitability

of commercial banks in 7enya. The study recommended that bank management should

leverage on volatile earnings .0ank managers should invest in li4uid assets and also check

their credit policy and practices to boost their performance. Secondly& the regulator and

banksA unions should design most applicable and convenient loan management protocols inthe industry that considers shortening of long channels. >astly& shareholders need to know

that they have an important role in ensuring that the banks management are following and

implementing good corporate governance

xv


17/161

CHAPTER ONE

INTRODUCTION

5 B!+-. "und "* t1e Stud/0ank regulations are a form of government regulation which sub'ected the banks to

certain re4uirements& restrictions and guidelines. This regulatory structure creates

transparency between banking institutions and the corporation with whom they conduct

business& among other factors. 3egulations aimed at ensuring the safe and sound

operation of financial institutions& set by both state and federal authorities. )iven the

interBconnectedness of the banking industry and its reliance on national and global

economy& it is important for regulatory agencies to maintain control over standardi?ed

practice of these financial institutions. Supporters of such regulation often hinge their

arguments on the Jtoo big to failA notion. This holds that many financial institutions hold

too much control over economy to fail without enormous conse4uences E+inancial

Stability 9versight (nnual 3eport& ,--6F

"ell established banking systems are important factors of functioning financial systems.

These have been vividly proven by recent developments around the world. "hen

banking or more generally& financial systems temporarily break down or operateineffectively. The capacity of these firms to obtain funds necessary for ongoing existing

pro'ects and pursuing new endeavors is curtailed. Severe interferences in the

intermediation process can even lead to financial crisis and in some cases& undo years of

economic and social development. Since 58- more than 6- countries have

experienced banking problems that have been costly to resolve and disruptive to

economic development. This troublesome situation has led to calls for banking reform

by national governments and such international organi?ations as the "orld 0ank and the

nternational Monetary +und E 0arth& 2aprio K >evine &,-- F.

2entral bank is widely regarded as a vital part of the public safety net supporting the

stability of the banking system and financial markets. ( central bank that is financially

independent and has a si?eable portfolio of securities can provide large amounts of

1


18/161

li4uidity to institutions on very short notice. ndeed& central bank lending has been a

prominent part of regulatory assistance to troubled financial institutions for a long time.

The 2entral 0ank of 7enya E207F& like most other central banks around the world& is

entrusted with the responsibility of formulating and implementing monetary policy

directed at achieving and maintaining low inflation as one of its two principal ob'ectives#

the other being to maintain a sound marketBbased financial system. The 207 wasestablished under the 2entral 0ank (ct E2(! :8 F in 5


19/161

financial systems is the fact that various financial institutions& especially cooperatives

and intermediaries in rural areas& operate completely outside prudential regulations.

Some countries have one single general banking law& which tries to assemble all

regulations& but in many countries the operational issues are left to statutory notes&

circulars or even simply the routine decisions of the supervisory institution. @arious

other laws can have an impact on the operation of financial institutions& e.g. companylaws& securities laws& debt recovery laws and laws on li4uidation and bankruptcy

EThumbi& ,- :F.

7enya is currently using most aspects of 0asel # however& it is worth noting that the

207 has decided to incorporate certain features of 0asel in the !rudential

)uidelines& particularly in relation to capital ade4uacy. 7enya is not a member of the

0asel 2ommittee on 0anking Supervision& but the 207 does adopt and incorporate

0asel standards when possible. The government of 7enya through its regulatory body&

the 2entral 0ank of 7enya& has introduced prudential regulations to guide commercial

banks in conducting their business while cultivating a culture of fair competition in the

industry. The introduction of prudential guidelines reflect 7enyaAs continued efforts

towards strengthening its banking environment so that she can achieve its goal under

@ision ,-6- to be an international financial stability country E3ichard& Devinney&Gip K

$ohnson& ,--5F. 1owever despite introduction of 207 prudential regulations ,--<

governing commercial banks in 7enya& there are very few systematic studies that

critically assess how regulations have affected the financial performance of commercial

banks.

2ommercial banks propel the entire economy of any nation by transmitting monetary

policy impulses to the economic system. During their operation& the banks face

competition and other challenges that expose them to risks and therefore the need for

bank supervision and regulations. 0anking regulation plays a ma'or role in determiningthe cost of services of banks such as if interests are unregulated it will create a great

discrepancy from one bank to another. This aims at is for ensuring stability in the

banking industry EGona K nanga& ,- :F.

3


20/161

0anking regulation originates from microeconomic concerns over the ability of bank

creditors EdepositorsF to monitor the risks originating from the lending side and from

micro and macroeconomic concerns over the stability of the banking system in the case

of a bank crisis. n addition to statutory and administrative regulatory provisions& the

banking sector has been sub'ect to widespread Linformal regulation& i.e. the

governmentAs use of its discretion& outside formali?ed legislation& to influence bankingsector outcomes (for example& to bail out insolvent banks& decide on bank mergers or

maintain significant State ownershipF. 0anks are believed to be inherently unstable

because they are structurally fragile. The perceived fragility comes from maintaining

low ratios of cash reserves to assets Efractional reservesF and capital to assets Ehigh

leverageF relative to their high short term debt. This appears to be the case in most of

countries in the world E0enston and 7aufman& 55osseBMueller K"itte& ,- ,F. +urthermore& there have been an

unprecedented number of disruptive banking crises in recent decades. The recent bank

crisis has created calls for introduction of reforms in bank regulation and supervision.

The appropriate role of bank regulation or whether they should be regulated at all has

been a matter of controversy E0enston and 7aufman& 55


21/161

policymakers in countries worldwide would implement particular regulatory and

supervisory practices& then bank Lsafety and soundness would improve& thereby

promoting growth and stability E0arth& 2aprio K >evine& ,-- F.

The 0asel 2ommittee on 0anking 3egulation and Supervisory !ractices devoted

significant resources and considerable attention to the development of the capitalade4uacy framework for internationally active banks. This is known as the 588 0asel

(ccord E0asel F. n 588& the 2ommittee decided to introduce a capital measurement

system commonly referred to as 0asel . n $une ,--: this framework was replaced by a

significantly more complex capital ade4uacy framework commonly known as 0asel .

+ollowing the financial crisis of ,--=B,--8 & 0asel was replaced by 0asel & which

will be gradually phased in between ,- 6 and ,- 5 EThumbi& ,- :F. 0anks shareholders

have increased pressure on their management to increase banks return on e4uity

E39%F &li4uidity and capital costs. n particular& 0asel creates incentives for banks to

improve their operating processes not only to meet re4uirements but also to increase

efficiency and lower costs E7ombo& ,- :F.

Maintaining financial stability is a ma'or concern of every countryAs central banks have

been mandated to supervise and regulate banks as way ensuring financial stability of a

country. The ,--8 global crisis consisted of a financial crisis in the *orth (tlantic

economies and a trade and expectations crisis in the rest of the world. +ive years on& US

and %uropean policymakers are still struggling to put in place regulation and supervision

regimes aimed at avoiding future crisis EDanielsson& $ames& @alen?uela K Ner& ,- :F.

2urrently attention has been on the role of government in the financial sector& its

participation as owner of financial intermediaries K its role in regulating and supervising

financial intermediaries is not surprising in view of recent events around the world. Get&

for decades the si?e& composition and functioning of the financial system were generally

considered to be unimportant for economic development and growth and thereforeusually omitted from standard macroeconomic models and development E0arth& 2aprio

K >evine& 558F.

+urthermore& a crossBcountry comparison conducted by "illiamson and Mahar E 558F

concluded that prudential regulation and supervision was stronger in countries

5

http://en.wikipedia.org/wiki/Basel_Ihttp://en.wikipedia.org/wiki/Basel_IIhttp://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%9308http://en.wikipedia.org/wiki/Basel_Ihttp://en.wikipedia.org/wiki/Basel_IIhttp://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%9308


22/161

experiencing less severe financial crisis as compared to those experiencing more severe

crisis. 0esides& average level of prudential regulation and supervision in the fiveByear

period preceding a crisis is found not to be independent from the occurrence of a

banking crisis. The financial sector policies adopted by the government in 7enya had

very varied effects on the development of the banking system. 1owever the banking

system in Uganda is among the weakest in SubBSaharan (frica. The financial policies of the preBreform period aimed to control banking markets& ostensibly for developmental

and other nonBcommercial ob'ectives. )overnment intervention took the form of

establishing publicly owned commercial banks& imposing direct controls over interest

rates and some components of the asset portfolios of financial institutions E+ sF and

bringing informal pressures to bear on government owned + s to influence lending

decisions E0rownbridge& 55evine E 558F argues that even proponents of laisse?Bfaire admits that

if policyBmaking positions during a crisis affecting large banks. 0anks should not ignore

their own management advice because there is no bank which too big not to fail. Thissituation suggests that perhaps one should consider a framework for financial regulation

in which one set of rules would operate during normal times& designed to minimi?e the

likelihood of a financial crisis and another set of rules would operate during crisis.

6


23/161

!igouAs E 568F classic treatment of regulation holds that monopoly power& externalities&

and informational asymmetries create a constructive role finance and growth. 0ased on

the view of helping hand of government of bank regulation& the strong helping hand of

government helps in poverty eradication and growth improvement by offsetting market

failures and thus enhances social welfare. 1owever everyone does not share this helping

hand view of regulation& but Shleifer and @ishny E 558F& for instance& argues thatgovernments fre4uently do not implement regulations to ameliorate market failures.

1owever& governments implement regulations in a grabbingBhand manner that supports

political constituencies E0arth at el& ,-- F.

9lsonAs insight stimulated members of the 2hicago School& beginning with Stigler& to

explain how regulations ac4uired by industry are designed and operated primarily for its

benefit EStigler& 5= F. Stigler asserted that there is a market for regulation& 'ust as there

is a market for other goods and services. n StiglerAs model& government regulators are

suppliers of regulatory services Eexchanging regulatory rents for various forms of

political income or personal gainF& while the regulated industry is the primary source of

demand E"illiams& ,--:F. The assumptions that market behavior is normally motivated

by fairly narrow considerations of selfBinterest is plausible because most market interests

are promoted by regulatory agencies& are fre4uently influence on the regulatory process

of interest groups.

( substantial literature has shown the causes and conse4uences of financial

performances especially for most banks during crisis relied on various reforms that

might help prevent future crises. (lthough the proposed changes are all important

aspects& these changes focus on existing financial regulations and supervisory standards.

The financial crisis in countries ranging from the United States and $apan& to 7orea and

Mexico& to 2hile and Thailand& to ndia and 3ussia& and to )hana and 1ungary have

been blamed at least on part of Lbad regulation and supervision. The fact that 2anadadid not experience a subprime crisis supports the view that the tradeoff between the

scope of regulation and of intermediation can be improved by broader and more efficient

regulation than those that existed in the US prior to ,--8. !rior to the crisis& 2anada had

integrated regulation of banks& insurance companies and large investment dealers. The

2anadian office of the superintendent of financial institutions regulated banks on a

7


24/161

consolidated basis Eretail& commercial K investment and wealth activitiesF worldwide in

contrast to the US. 2anada had a regulatory cap on leverage at an assetBtoBcapital ratio of

,- to E@ianney& ,- 6F.

Ma'ority studies done on central bank regulatory re4uirements in commercial banks

have focused on developing countries with a few exceptions from (frica Efor example&0otswana& *amibia& South (frica& Swa?ilandF. 1owever& although past research had

focused on the U.S. banking industry this is not representative. +or example& the U.S.

has over ,6&--- banking institutions& which is large even compared to $apan E:&aeven K

>evine& ,--6F.

n %gypt& the central bank is the supervisory authority for depositBtaking banks& with

wide powers vested in it by the banking law. !rior to reforms in the early 55-s& the

banking sector was heavily regulated through credit controls and portfolio restrictions.

The 2entral 0ank of 3wanda in the year ,--- made a ma'or effort to studying banksA

performance in 3wanda and agreed that Jinefficient supervisory action and inade4uacy

of regulatory frameworkA were among factors that could have contributed to banking

distress in 3wanda E@ianney& E,- 6F.

9ver the years& a considerable literature has shown that there is a relationship between

bank ownership and performance. Two clear messages from that literature areC EiF that

ownership is important# and EiiF that it is helpful to view the issue in the context of the

principalBagent framework and public choice theory. 1owever& whilst that literature has

provided considerable understanding of the effects of ownership& its primary focus is on

nonBfinancial firms. The reasons why different ownership forms may lead to differentefficiency levels have been extensively explored in the literature and the dominant

model of the effect of ownership utili?es the principal agent framework and public

choice theory to highlight the importance of the extent to which management is

constrained by capital market discipline. (gency issues associated with different types of

firm ownership are an area of concern in many banking systems where stateBowned

8


25/161

banks operate alongside mutual and privateBsector institutions. The )erman banking

market study has shown that little evidence to suggest that privately owned banks are

more efficient than their mutual and publicBsector counterparts ( (ltunbas& %vans K

Molyneux& ,-- F .

>ope?BdeBSilanes and Shleifer E,---F argued that on average& greater state ownership of banks tends to be associated with more poorly operating financial systems. These

findings were particularly notable in the wake of the %ast (sian crisis and the haste with

which many have concluded that all things (sian including close ownership links lead to

crisis. The greater state ownership of many banks tends to be associated with more

poorly developed banks& nonbanks and securities markets. n an independent study using

alternative measures of bank ownership& >a !orta >ope?BdeBSilanes and Shleifer E,---F

studied the relationship between government ownership and financial development.

They convincingly showed that government ownership retards financial development.

The existing literature has shown that 2hina has been reforming its banking system. She

has been reforming its banking system by partially privati?ing and taking on minority

foreign ownership of three of its dominant L0ig +our stateBowned banks. ( study

conducted on 0ank ownership and efficiency showed that big four banks were by far

the least efficient &foreign banks are most efficient and minority foreign ownership is

associated with significantly improved efficiencyE(ltunbas e tal & ,-- F. annotta&

*ocera K Sironi E,--=F argued that public sector banks have poorer loan 4uality andhigher insolvency risk than other types of banks while mutual banks have better loan

4uality and lower asset risk than both private and public sector banks. They concluded

that ownership concentration does not significantly affect a bankAs profitability# a higher

ownership concentration is associated with better loan 4uality& lower asset risk and lower

insolvency risk.

+ama E 586F argued that accountability of the managers of mutual to their owners may

be greater than that of the managers of private organi?ations simply because mutual

claim holders can each independently exercise the right to withdraw funds when faced

with evidence of managerial inefficiency. n turning to the banking industry& it is clear

that not only is the industry highly competitive& but also that in many countries mutual

ownership must be considered alongside that of public and private ownership forms.

9


26/161

(lso& there is relatively little guidance from the literature about the relative efficiency of

these three ownership forms of financial firms. )orton and 3osen E 55;F address the

issue of ownership and control for US commercial banks during the 58-s and they find

that ownerBmangers tend to take on excessive risks when the banking industry is

performing poorly. Due to above literature& this study was carried to find out the

moderating effects of relationship between 207 regulatory re4uirement and bank financial performance in 7enya

5 5 Hist" / "* Cent !, B!n- Re.u,!t" / Re0ui ements5

The term prudential regulation refers to central bank regulatory re4uirements that were

first used in 5=-s in unpublished documents of 2ooke committees Ethe precursor of

0asel 2ommittees on 0anking SupervisionF K the banking of %ngland. 0ut only in the

early ,---s after two decade of recurrent financial crisis in banking industry in emerging

markets& prudential approach to regulation and supervisory framework becomeincreasingly promoted. This was done especially by authorities of bank for international

Settlement. ( wider agreement on 2entral bank regulatory re4uirements relevance

have been reached as a result of the late ,---s financial crisisE 2lement&,- -F

The history of U.S. banking regulation is written largely on history of government and

private response to banking panics. mplicitly or explicitly& each regulatory response is

as result of crisis which is presumed to be model origin of banking panics. The founding

father of US central bank strongly opposed to the formation of central banking

system&the fact that %ngland tried to place the colonies under monetary control of bank

of %ngland. This was seen by many as the Jlast strawA oppression which led to direct

(merican 3evolution war. The other who was strongly in favor of a central bank was

3obert Morris a superintended of +rance who helped to open bank of *orthern (merica

n =8,. 1e has been called by Thomas )oddard as the father of system of credit and

paper circulation in the U.S. E+inancial Stability 9versight (nnual 3eport& ,--6F

n United 7ingdom the first U7 (ct to put banking regulation on a statutory footing was

in 5=5. !rior to 5== there was no regulation of the sector. This was around the same

time as %2 Directive *o ==O=8- of , Dec 5==E F intended to promote harmoni?ation

in financial services. This (ct introduced the re4uirement for institutions to be licensed

10

https://en.wikipedia.org/wiki/Robert_Morris_(financier)https://en.wikipedia.org/wiki/Robert_Morris_(financier)


27/161

in order to accept deposits from the public. t made no attempt to define a bank or

Lbanking business and its provisions were applicable only to deposit taking institutions.

The 58= (ct increased the 0o%As supervisory rule significantly& including the power to

vet shareholders of U7 banks. There was an absolute prohibition on the accepting of

deposits by a person in the course of carrying on a depositBtaking business& unless that

person was an Lauthori?ed institution in the words of the (ct as per sec


28/161

bank approach to assessing capital ade4uacy. The convergence of macroeconomic

weakness& more bank failures and diminishing bank capital triggered a regulatory

response in 58 when& for the first time& the federal banking agencies introduced

explicit numerical regulatory capital re4uirements E0eatty K >iao& ,- :F.

9ver the last thirty years& the mandate of central banks around the world has been progressively narrowed to the goal of price stability. This convergence was prompted by

the chronic inflation that characteri?ed most advanced economies in the 5=-B8-s and

independent central banks anchored to an inflation target seemed to be the optimal

institutional arrangement to the problem of inflation. 1owever& the ,--8B-5 global

financial crisis reopened the debate on central bank design E(lesina and Stella& ,- -F.

n 7enya the first and most known milestone of 207 regulatory re4uirements was based

on the 0asel (ccord of $uly 588 which re4uired the ma'or international banks in a

group of , countries to attain an 8Q ratio between capital and riskBweighted assets

from the beginning of 55,. Subse4uently& the increasing range and sophistication of

financial instruments made the limitations of the probably too simple design of the 588

capitalBade4uacy framework become apparent. n 55= the 0asel 2ommittee on 0anking

Supervision& sought enhance further banking supervision in both ) - countries and a

number of emerging economies and it released a set of L2ore !rinciples which set out

minimum re4uirements for banking EThumbi& ,- :F.

n 5


29/161

adhered to by institutions in order to maintain a stable and efficient banking and

financial system. The effective date for implementation of the regulations was st

$anuary ,--< E*'eule& ,- 6F.

5 5& E**e+ts "* Cent !, B!n- e.u,!t" / e0ui ements !nd B!n- 3e *" m!n+e5

Most economists have agreed that unregulated system of enterprise tends to achieve

optimal resource. The argument of DowdAs defense of panoply of government

intervention into financial sector is that the central government sponsors deposit

insurance. 1e further argued that government regulation of financial system should be

abolished E0enston and 7aufman& 55


30/161

recent crisis have brought attention to the idea that conventional monetary policy aimed

only at price stability in fact may increase financial instability. (s a result& a wave of

reforms concerning the involvement of central banks in banking and financial

supervision followed Efor example in U7 in ,- ,& 1ungary in ,- 6& 3ussia in ,- 6 and

%uro area members in ,- :F. 2entral banks are now perceived as public policy

institutions with the goal to promote monetary and financial stability& a double mandatethat might bring a new form of time inconsistency problem EUeda K @alencia& ,- :F.

+rom bank owner perspective& the optimal level of bank capital is decreasing in the

extent of regulatory forbearance. n contrast& from regulatorsA perspective& the optimal

minimum level of re4uired bank capital is increasing in the extent of regulatory

forbearance E(charya& ,--6F. !oorly regulated firms are expected to be less profitable&

have more bankruptcy risks& lower valuations and pay out less to their shareholders&

while wellBgoverned firms are expected to have higher profits& less bankruptcy risks&

higher valuations and pay out more cash to their shareholders. 9n the other hand& it has

been stated that weak regulation in the banking sector not only leads to poor firm

performance and risky financing patterns& but can also provide a conducive ground to

macroeconomic crisis. 9ther researchers contend that good regulations are important for

increasing investor confidence and market li4uidity E2laessens& ,--6F.

The measures of financial performance as pointed out by 0oehlie& Michael& 2raig& (lan&

Dawn and +reddie E 555F include profitability& li4uidity& solvency& financial efficiency

and repayment capacity. !andey E,- -F defines financial performance as a sub'ective

measure of how well a firm uses assets from its primary mode of business to generate

revenues. 1e further says that the term can also be used as a general measure of a firmPs

overall financial health position over a given period of time. !andey also cites return on

asset E39(F and return on e4uity E39%F as the measures of profitability. +inancial

performance measures how well a firm is generating value for the owners. Much of thecurrent bank performance literature describes the ob'ective of financial organi?ations as

that of earning acceptable returns and minimi?ing the risks taken to earn this return

E(lam et al., ,- F.

14


31/161

The prudent economic policies and improved macroeconomic fundamentals result in

low inflation and increased investor confidence which then is translates into consistent

financial performance. 0etter regulations benefit firms through greater access to

financing& lower cost of capital& better performance and more favorable treatment of

all stakeholders EMathenge& ,--=F. The banking environment in 7enya has& for the past

decade& undergone many regulatory and financial reforms E7amau& ,--5F.

The 7enyan @ision ,-6- advocates for three key pillars of the 7enyan financial sector

which are efficiency& stability and access to financial services. Thus& for 7enya to reali?e

@ision ,-6-& the banking sector is a critical element that remains the cornerstone of the

targeted economic growth tra'ectory E*dungu& ,- -F. The 207 issued a new set of 207

regulatory re4uirement that came into force on st$anuary& ,- 6. 0anks& financial

institutions and mortgage finance companies need to adhere to these prudential

guidelines. The 207 regulatory re4uirement deal with a wide range of issues including

licensing re4uirements& corporate governance& capital ade4uacy re4uirements& >i4uidity

Management& stress testing& foreign exchange exposure limits& prohibited business& antiB

money laundering& consumer protection& enforcement of banking laws and regulations&

agent banking and representative offices EThumbi& ,- :F. The review has been

necessitated by developments in the national& regional and global arenas and the need to

proactively strengthen the regulatory framework for banks and other institutions licensed

pursuant to the 0anking (ct.

This study concentrated on 207 regulatory re4uirementsC two E207O!),F to five

E207O!);F only out of ,, in order to establish the effects of 207 regulatory

re4uirements on commercial bank financial performance EprofitabilityF in 7enya. These

effects were on corporate governance& capital ade4uacy& risk classification asset and

provisioning and li4uidity management. The reason why the study concentrated on 207

regulatory re4uirements is because these are based on the 2(M%> framework. 2(M%>is a widely used framework for evaluating bank performance. The 2entral 0ank of

7enya also uses the same to evaluate the performance of commercial banks in 7enya.

Though some alternative bank performance evaluation models have been proposed& the

2(M%> framework is the most widely used model and it is recommended by 0asel

2ommittee on 0ank Supervision and M+.

15


32/161

The studies carried out on commercial banksA performance and their regulations& are not

uni4ue to U.S. banks. (ccording to 2ornett and Tehranian& E,--:F the study on

!ortuguese 0anking focused on a structural model of competition in the deposits market

looked at the !ortuguese banking industry. The study also examined how the removal of

entry barriers in the early 55-s which affected competition in the deposits market. Theresults suggested that the !ortuguese deposits market was operating under conditions

that were far from perfect competition in the early 55-s. 1owever& following

deregulation progress towards more competition in the deposits market could be clearly

detected.

%pure and >afuente E,- ,F study on bank performance in the presence of risk for 2ostaB

3ican banking industry during 558B,--= showed that performance improvements

follow regulatory changes. The study further confirmed that appointing 2%9s from

outside the bank is associated with significantly higher performance ex post executive

turnover& thus suggesting the potential benefits of new organi?ational practices. *asieku

E,- :F study revealed that average capital levels of commercial banks in 7enya

remained significantly above statutory minimum. 0anks chose to hold capital cushion

for economic benefits but not because of regulatory. Maintaining a specific stand in

credit market& 0asel risk sensitive measure of capital does not 'eopardi?e ability of banks

to service the economy. Thus she advocated for looser regulatory policy on minimum

capital re4uirement as measured by leverage ratio while encouraging banks to hold

capital levels that add value at risk as proposed base .

n 7enya the 207 0ank statutory minimum li4uidity re4uirement is ,-Q. 1owever&

according to 207 0ank Supervision (nnual 3eport E,- F& the average li4uidity ratios

for the sector were 6=.- Q in ,--8& and this was way above the minimum re4uirements.

This has baffled many financial analysts as to how banks could withhold such amountof cash in a credit needy economy such as 7enya E7amau& ,--5F. The 207 attributes

this to the banking industryAs preference to invest in the less risky government securities&

while *dungAu and *gugi E,---F as cited by 7amau E,--5F attributed this li4uidity

problem to the restrictions placed on commercial banks at the discount window& coupled

16


33/161

with thin interbank market& a high reserve re4uirement and preference of government

securities .

(ccording to 0enston and 7aufmanE 55


34/161

@ianney& E,- 6F argues that effective bank regulation has two main ob'ectivesC the first

is to protect private interests of depositors& investors& and creditors# the second is to

safeguard public or collective interest by promoting the integrity and reputation of

financial services markets. Sentero E,- 6F recommended that central bank should be

keen on commercial banks capital ade4uacy ratio by laying down financial regulations

on li4uidity since the goal of financial regulation is to enable banks to improve li4uidityand solvency. The regulation that is more strict may be good for bank stability& but not

for bank efficiency. 3estricting banks may not only lower bank efficiency but also

increase the probability of a banking crisis. The capital structure of banks is highly

regulated. This is because capital plays a crucial role in reducing the number of bank

failures and losses to depositors when a bank fails as highly leveraged firms are likely to

take excessive risk in order to maximi?e shareholder value at the expense of finance

providers E7amau& ,--5F.

5 5< B!n-in. Indust / in Ken/!

9ne key component to any financial market is the banking system. 0anks facilitate

financial development by mobili?ing and allocating funds to investment pro'ects with

the greatest long term economic benefits. Moreover& it is widely acknowledged that a

wellBstructured banking system& defined by its supervisory practices& risk taking& and

governance& promotes greater financial performance and economic stability E@ianney&

,- 6F.

The economic pillar of the 7enya @ision ,-6- identifies the banking sector as one of the

six key sectors that are intended to move the economy up the value chain. The strategies

taken by the banking industry should therefore be analy?ed in the view of understanding

their contribution to improve the health of the entire financial system in 7enya

E)overnment of 7enya& ,--8F. 2urrently& 7enyaAs financial system is made up of the

2entral 0ank commercial 0anks& the nonBbank financial nstitutions& development

finance companies funded mainly by the government and external development

agencies& a *ational Social Security +und& nsurance companies& !ension +unds and the

*airobi Security %xchange E*S%F.

18


35/161

Table . C 7enyaAs +inancial System in 2omparison to other +inancial Systems

!rivate creditO)D!R DepositsO)D!R 0ank 2oncentration7enya , .= 6-.5 :;Uganda 6.5 ,


36/161

Societies. The first to go into business was Savings and >oan Society. t started its

operations in 7enya in 5:5. t was 'oined by the +irst !ermanent 0uilding Society of

*orthern 3hodesia in 5;-& the first permanent E%ast (fricaF >td in 5< & the %ast

(frican building society in 5;5& 7entanda mutual building society in 5;8& and the

7enya 0uilding Society in 5td. %4uity building society and +amily finance building society were bothstarted in 58: to satisfy a growing demand for mortgage and small loan services in the

unattractive lowBincome population of the central region of 7enya. They have now

ac4uired licenses to operate as fully fledged commercial banks E9loo& ,- F.

(ccording to 7enya 0ankers (ssociation& the formation of government owned banks

had the effect of speeding up the provision of affordable banking services to ma'ority of

the population. Seven new (fricanBowned banks and 66 nonBbank financial institutions

came up as rivals to 2ooperative 0ank& the only private indigenous bank E70(& ,- -F.

(fter 5=8& a number of the institutions were closed after encountering li4uidity

troubles. The 2entral 0ank at that time lacked ade4uate capacity to regulate the highly

politici?ed sector. Twelve banks collapsed between 58: and 585. This made the

government to pass the 0anking (ct 585& which tightened the re4uirement for the

licensing of new financial institutions. This development led to an increase in the

minimum capital re4uirement& with the deposit insurance made compulsory for all banks

E207& ,- 6F. More banks would go under between 556 and 55; despite the new

stringent regulations. n 558 0ullion 0anks& +ortune +inance& Trust 0anks& 2ity

finance& 3eliance 0ank and !rudential 0anks were also affected. Some indigenous banks

E%4uity and +amilyF especially those that target low income earners and workers in the

informal sector have become a success. The %4uity has reali?ed tremendous growth in

the last five years and has expanded to %ast (frican region E207& ,- 6F.

5& St!tement "* t1e P "2,em

n recent decades& many countries have experienced banking problems re4uiring ma'or

reforms of the banking systems. The problems are largely due to domestic causes& such

as weak banking supervision and inade4uate capital. ( key part of bank regulation is to

make sure that firms operating in the industry are prudently managedE0erg& ,- -F Thus&

20


37/161

examining effects of 2entral bank regulatory re4uirements in bank financial

performance in countries is a critical area of in4uiry.

"ithout sound measures of banking policies across countries and over time& researchers

are constrained in assessing which policies work best to promote wellBfunctioning

banking systems and in proposing socially beneficial reforms to banking policies in needof improvement. This helps in explaining why the study of effect of 2entral 0ank

regulatory re4uirements in bank financial performance in 7enya was needed. @arious

studies carried out on bank regulations across the globe have focused to mitigate the

effects of economic crises and lead the stability of the banking system. *aceur and

7andil& E,--5F studying the effects of capital regulations on the stability and

performance of banks in %gypt for the period 585B,--: in %gypt.

Despite introduction of 207 prudential regulations ,--< governing commercial banks

in 7enya& there are very few systematic studies that critically assess how regulations

have affected the financial performance of commercial banks. These studies includeC

The banking sector regulatory framework in 7enyaC ts ade4uacy in reducing bank

failure 9biero& E,--,F. +inancial regulatory structure reform in 7enya and the perception

of financial intermediaries in 7enya and *'eule E,- 6F studied the effects of 2entral

0ank of 7enya !rudential 3egulations on financial performance of 2ommercial 0anks

in 7enya.

207 ,--< regulation spelt out the guidelines and regulations to ensure that there is

prudential management in the banking industry. Some of these guidelines relate to

licensing of new institutions& corporate governance& capital ade4uacy re4uirements&

li4uidity management& risk classification and asset provisioning& foreign exchange

exposure limits& publication of financial statements among others. *'eule E,- 6F study

focused on 207O!)O, to 207O!)O


38/161

re4uirements on commercial bank financial performance E39( and 39%F in 7enya. The

reason for the study to concentrate on this central bank regulatory re4uirements is that

they are based on the 2(M%> framework. 2(M%> is a widely used framework for

evaluating bank performance. The 2entral 0ank of 7enya also uses the same to evaluate

the performance of commercial banks in 7enya. Though some alternative bank

performance evaluation models have been proposed& the 2(M%> framework is the mostwidely used model and is recommended by 0asel 2ommittee on 0ank Supervision and

M+ also it. n all the studies cited& it was evident that the findings were conflicting with

studies from different regions providing different conclusions. This study therefore

sought to investigate the effectsA of central bank regulatory re4uirements on financial

performance of commercial banks in 7enya hence the research gap that the current study

sought to fill. This study was built on the premise that the passage of time and the

numerous and significant changes in the commercial banks operating environment have

led to different operating environment after the central bank regulatory re4uirements.

5< O27e+ti4es O* t1e Stud/

5


39/161

v. To assess the moderating effects of 0ank 9wnership on the relationship between

the effectsA of 2entral 0ank 3egulatory 3e4uirements on financial performance

of commercial 0anksA in 7enya.

5> Rese! +1 H/3"t1eses

This study collected data on the following testable hypotheses and sub'ected them to

empirical investigation. These hypotheses were stated in a null context as followsC

i. 1 - C There is no significant effect between corporate governance and

financial performance of commercial banks in 7enya.

ii. 1 - ,C 2apital re4uirement has no significant effect on the financial

performance of commercial banks in 7enya.

iii. 1 - 6C There is no significant effect between credit risk management andfinancial performance of commercial banks in 7enya.

iv. 1 - :C >i4uidity management has no significant effect on the financial

performance of commercial banks in 7enya.

v. 1 - ;C The 0ank ownership has no moderating effect on the relationship

between the effectsA of central bank regulatory re4uirements on financial

performance of commercial banks in 7enya

5) $usti*i+!ti"n "* t1e Stud/5

The study has great contribution to the existing knowledge in the area of finance in

7enya& by broadening the available knowledge. The study benefits various stakeholders

such as academicians& regulators& )overnment of 7enya and commercial banks

5)5 A+!demi+i!ns

The researchers& students and academicians would use this study as a basis for

discussions on implementation of such regulations in the commercial banking industry

and performance. The study would be a source of reference material for future

researchers on other related topics.

23


40/161

5)5& Re.u,!t" s

The investment regulators in the country such as the 2apital Markets (uthority E2M(F&

7enya 0anker (ssociation E70(F and 2entral bank of 7enya can use these study

findings to understand the bottom line impact of bank regulatory re4uirements and in

understanding banks decision on to its customers. The study would provide insights on

the possible approaches that can enhance the sectorAs growth& performance andmonitoring& and hence guide in regulation and policy formulation. This would therefore

help policy makers of the 0anking sector with the development and review of existing

policies to achieve synergy in line with the existing circumstances.

5)5< C"mme +i!, B!n-s

Through this research& commercial banks in 7enya as well as the various firms in the

financial services sector would benefit immensely from the findings. The top

management would be informed on how to leverage on these regulatory re4uirements to

ensure long term financial survival of the banks.

5: S+"3e "* t1e Stud/

The study concentrated on the effects of central bank regulatory re4uirements on

financial performance of commercial banks in 7enya. The choice of the banking

industry was because it has been earmarked as a key pillar to the achievement of 7enya

@ision ,-6-and makes a significant contribution to the gross domestic product E)D!F.

The study was limited to corporate governance& capital re4uirement& credit risk

management and li4uidity management and their effects on financial performance of :6

registered commercial banks in 7enya from ,--5 to ,- 6. The period of study was

recent enough to ensure data was readily available and reliable for the study.

5; Limit!ti"ns5

The ma'or constraints that were encountered in this study were restrains and

confidentiality from the respondents to the 4uestionnaire as most banks consider someinformation as confidential and hence were not willing to reveal most of it. To

overcome these limitations& the study used a letter of introduction from the university to

assure the respondents that the information provided was used for academic purpose and

thereby to be treat with confidentiality.

24


41/161

CHAPTER T8O

LITERATURE RE%IE8

&5' Int "du+ti"nThis chapter attempts to gain an inBdepth view into what is already known in connection

with the research topic being studied. The chapter is divided into three main parts. The

first part covers the theoretical review on corporate governance& capital re4uirement

credit risk management and li4uidity management. This led to the development of the

conceptual framework that guided this study. The second part deals with the review of

existing literature in accordance with the study variables. The third part deals with

empirical studies carried out in the past and in accordance with the variables presented

in the research model& criti4ue& and summary and research gaps.

&5 T1e" eti+!, Lite !tu e Re4ie

There are several theories advanced by different scholars to explain the effectsA of

central bank regulatory re4uirements on financial performance of commercial banks in

7enya. This study was guided by six ma'or theories discussed below.

&5 5 Pu2,i+ Inte est T1e" / "* B!n- Re.u,!ti"n

!ublic interest theory lies with !igouvian welfare economics& which portrayed the state

as an omnipotent& yet benevolent& maximi?er of social welfare that could efficiently

correct market failures E!igou& 56,F. t was first developed by (rthur 2ecil !igou who

holds that regulation is supplied in response to the demand of the public for the

correction of inefficient or ine4uitable market practices. 3egulation is assumed initially

to benefit whole society rather than particular vested interests. The regulatory body is

considered to represent the interest of the society in which it operates rather than the

private interests of the investors. The origins of this approach may be found in the

writings of 0entley E 8=- 5;=F. 0entley argued that groups capture control of

regulatory agencies to advance their interests. 1e dismissed the idea of public interest as

a fiction that represented only the interests of group E 1antkeBDomas& ,--6F.

25

https://en.wikipedia.org/wiki/Arthur_Cecil_Pigouhttps://en.wikipedia.org/wiki/Market_(economics)https://en.wikipedia.org/wiki/Arthur_Cecil_Pigouhttps://en.wikipedia.org/wiki/Market_(economics)


42/161

!ublic interest approach is a conventional view of regulation rooted on welfare

economics of !igouAs E 56,F. Samuelson E 5:=F responded to the deficiencies and

unfitted market by focusing on interest of consumersA regulations in response to demand

of relief from ine4uitable and inefficient market. The main focus of !ublic interest

approach is public good from which group or some citi?en will benefit. Under public

interest approach bank regulation exist for exclusive benefit of depositors and investors.!ublic interest theory is usually contrasted with public choice theory that is more cynical

about government behavior and motives and sees regulation as being socially inefficient.

Moreover& Stiger E 5=,F argued that regulation can be captured by incumbent firms to

protect market from entry to competitors. 2ritics believe that this will only occur when

the public demands a better allocative efficiency. This /theory/ has no verified

predictions or outcomes# therefore it is not viewed as a valid theory& 2riticism does not

mean that !ublic interest theory should be abandoned because it does explain well about

bank regulation. !igouAs& E 568F classic treatment of regulation argues where market is

imperfect& (dam smith invisible hand will not work. n addition 1e further argued that

monopoly power& externalities& and informational asymmetries create a constructive role

for finance and growth& and the strong helping hand of government to help offset market

failures and thus enhance social welfare.

The growth of regulation in 56-As was simply a functional response to the changing

public needs and interests of an evolving industrial society. Despite its romantic appeal&

the public interest theory has been theoretically and practically discredited for its

inability to take into account competing conceptions of the public good& its ascription of

heroic and unrealistic attributes to regulators& its underestimation of the power of

organi?ed interests& and its failure to explain why regulation often fails to deliver public

interest outcomes E0aldwin K 2ave& 555F. The public interest theory of regulation also

holds that firms re4uire regulations in order to guarantee the choice theory of regulation&which rests on the premise that all individuals& including public servants& are driven by

selfBinterest E1antkeBDomas& ,--6F. The above theory instigated the general ob'ective of

the study on the effects of central bank regulatory re4uirements on financial performance

of commercial banks in 7enya.

26

https://en.wikipedia.org/wiki/Public_choice_theoryhttps://en.wikipedia.org/wiki/Public_choice_theoryhttps://en.wikipedia.org/wiki/Public_choice_theory


43/161

&5 5& Se,* Inte est t1e" / "* e.u,!ti"n

(s response to criticism of !ublic interest theory of regulation& are ideologies evolve

focusing on pursuit of private interest. The main thrust of Self nterest theory of

regulation was propose by stigler and !elt?man is regulation developed as result of

demand from different interest groups for government intervention .There no divergence

between politician and optimal policiesE as interest to group demandsF and their implementation. (gency problem arise between politician and regulators because

regulators are intrusively unobservable ESpiller& 55-F. The Self nterest theory of

regulation Etheory of regulatoryF capture provides much more accurate predictions about

recent regulatory experience. t contends that regulatory developments are driven not by

the pursuit of public interest but rather by private interests that lobby for special

privileges or regulatory rents E"illiams& ,--:F. This interest group theory of regulation&

however& owes more to the work of Mancur 9lson than it does to the interest group

pluralism of Truman E 5; F and Dahl E 5< F.

n the >ogic of 2ollective (ction E 5


44/161

&5 5< Fin!n+i!, Inte medi! ies T1e" /

The +inancial intermediaryAs theory is built on the economics of imperfect information

that began to emerge during the 5=-s with the seminal contributions of (kerlof E 5=-F&

Spence&E 5=6F & 3othschild K Stiglit? E 5=


45/161

lender of last resort can no longer be as credible as deposit insurance. f the lender of last

resort were always re4uired to bail out banks with li4uidity problems& there would be

perverse incentives for banks to take on risk. Deposit insurance on the other hand is a

binding commitment that& in theory& can be structured to retain punishment in the case of

bank runs& according to Demirgu B7unt and 7ane E,--,F cited by 7aras& !yle K

Schoors &E,- 6F.

+inancial intermediaries are able to transform the risk characteristics of assets because

they can overcome a market failure and resolve an information asymmetry problem.

nformation asymmetry in credit markets arises because borrowers generally know more

about their investment pro'ects than lenders do. +inancial intermediaries are then more

likely to be lending to highBrisk borrowers& because those who are willing to pay high

interest rates will& on average& be worse risks. The information asymmetry problem

occurs exBpost when only borrowers& but not lenders& can observe actual returns after

pro'ect completion. This leads to a moral ha?ard problem. Moral ha?ard arises when a

borrower engages in activities that reduce the likelihood of a loan being repaid. (n

example of moral ha?ard is when firmsA owners Lsiphon off funds Elegally or illegallyF

to themselves or to associates& for example& through lossBmaking contracts signed with

associated firms. The problem with imperfect information is that information is a Lpublic

good . f costly privatelyBproduced information can subse4uently be used at less cost by

other agents& there will be inade4uate motivation to invest in the publicly optimal

4uantity of information E1irschleifer K 3iley& 5=5F.

Diamond E 58:F argues that diversification within the financial intermediary is the main

reason financial intermediaries exist. 1e also develops a model& in which the outcome

from firmsA investment pro'ect is not known exBpost to external agents& unless

information is gathered to assess the outcome& i.e. there is Lcostly state verification

ETownsend& 5=5F. This leads to a moral ha?ard problem because it provides anincentive for borrowers to default on a loan even when the pro'ect is successful. The

above theory instigated the first specific ob'ective of the study on the effects of corporate

governance on financial performance of commercial banks in 7enya.

29


46/161

&5 5> T1e" / "* Li0uidit/ !nd Re.u,!ti"n "* Fin!n+i!, Inte medi!ti"n

The Theory of >i4uidity and 3egulation of +inancial ntermediation was formulated by

+arhi& )olosov and Tsyvinski E,--5F. The theory postulates that there are two

informational frictionsC agents receive unobservable shocks and can participate in

markets by engaging in trades unobservable to intermediaries. "ithout regulations&

intermediaries provide no risk sharing because of an externality arising from arbitrageopportunities. "ith regulations& intermediaries provide risk sharing because of an

externality arising from arbitrage opportunities.

+arhi et al., E,--5F identified a simple regulation a li4uidity re4uirement that corrects

such an externality by the interest rate on the markets. They showed that whether

markets under provide or over provide li4uidity and whether li4uidity cap or li4uidity or

should be used depends on the nature of the shocks that agentAs experience. Moreover&

they proved that the optimal li4uidity ade4uacy re4uirement implements a constrained

client allocation sub'ect to unobservable types and trades. They provide closed form

solutions for the optimal li4uidity re4uirement and welfare gains of imposing such

re4uirements for two important special cases. n contrast with the existing literature& the

necessity of regulation does not depend on exogenous incompleteness of markets for

aggregate shock. t is difficult for an individual financial intermediary to preclude an

agent to enter in additional risk sharing contracts with other intermediaries. !ossibility of

hidden trades can significantly worsen and even eliminate risk sharing.

(llen and )ale E,--:F then conclude that& in the absence of aggregate shocks and

incompleteness of the markets for aggregate risk& there is no regulation that can improve

upon the market e4uilibrium. n contrast to the literature& +arhi et al& E,--5F proposed

that imposing a li4uidity re4uirement on the minimal Eli4uidity capF or the maximal

Eli4uidity capF amount of li4uidity holdings of the short asset for an intermediary. They

identify a reason for the market failure and externality in which intermediaries do notinternali?e how li4uidity they provide aspects other intermediaries via the possibility of

trades on private markets. mportantly& this externality exists even when there are no

aggregate shocks. This contrasts with the conclusions of 1olmstrom and Tirole E 558F

and (llen and )ale E,--:F that the government has a role in regulating li4uidity only if

there are aggregate shocks. They also provide a closed form solution for the optimal

30


47/161

regulation in two casesC for a setup with logarithmic utility and for the environment

studied by Diamond and Dybvig E 586F. Their model suggests practical implications for

regulation of financial intermediation. @arious types of intermediaries or different

regions in a country& depending on the primary nature of the shocks that the agents

whom they serve experience& should have different forms of li4uidity regulations.

The above theory instigated the fourth specific ob'ective of the study on the effects of li4uidity management on financial performance of commercial banks in 7enya.

&5 5) C!3tu e T1e" / !nd M"n"3",/ C"nt ",

The publicBspirited vision of the public interest theory of regulation began to be

challenged systematically in the early 5=-s when researchers suggested that the

individual regulatory agencies of government did not work for the public interest at all.

nstead& they worked for private interests who actually demanded to be regulated as way

of enhancing profits. )oing further& some even argued that each individual government

agency was /captured/ by the leading organi?ed interest Ea company or business

associationF in the industry over which a particular agency operated. This view rests on

the understanding that the political actors most interested in the regulation of a particular

industry are the companies in that very industry. 0ecause of this tightly focused interest

orientation among economic actors& it is thought that each regulating agency has been

isolated and essentially taken over by a single powerful interest or interest association

representing the very industry under regulation.

+urthermore& it is believed that powerful interests in one industry generally do not

interfere with the regulating activities in other industries. This line of analysis implies

that there is little or even no competition over control of public policy among economic

interests. "ithin each industry a single company or industry association dominates& and

each industry minds its own business being careful not to interfere with other industries

and their particular public agencies. 2iti?ens& meanwhile& are thought to be largelyabsent from the processes of economic regulation. This exclusion of citi?ens is thought

to result from two thingsC the issues and processes involved are complex and arcane& and

the impact of regulation on any individual citi?en is relatively light compared to the

impact on the businesses under regulation. ( citi?en paying a few dollars more per

month for electricity is relatively insignificant compared to the millions of dollars at

31


48/161

stake for an electric utility company. n short& regulation exists not because citi?ens need

it& but because the regulated industry wants it. The capture theory of economic

regulation provides some of the theoretical foundation for the concept of /iron triangles/

Ealso known as policy subBgovernmentsF& which depict a threeBway relationship between

a government agency& the industry over which it has responsibility and the relevant

legislative committees EStigler& 5= F.&5 : Li0uidit/ P e*e en+e T1e" /

The third theory that guided the study was li4uidity preference theory proposed by

United 7ingdom economist $ohn Maynard 7eynes. 7eynes observed that all factors

held constant& people prefer to hold cash Eli4uidityF rather than any other form of assets

and they will demand a premium for investing in illi4uid assets such as bonds& stocks

and real estates. The theory continues to contend that the compensation demanded for

parting with li4uidity increases as the period of getting li4uidity back increases.

>i4uidity preference theory continue to dominate the central concepts in economic and

finance in its application on the theory of demand for money. "ith regards to 7eynes

theory& central banks set the rate of interest in order to control the price of assets through

the demand for money. 9n emphasis on why people will at all times prefer holding cash&

The economist explained these to the existence of three motivesC the motive to keep cash

for daily transactional need& the motive to keep cash for precautionary tendencies and

finally the speculative motive so as to take advantage of opportunities E0ibow& 55;F.

The analogy of 7eynes theory is imperative on the assets and liabilities functions of a

commercial bank. The theory explains why banks will undertake to compensate for

liabilities and provides essence of why banks will seek compensation for their assets.

This compensation describes the interest rate factor that is a risk factor affecting credit

risk in commercial banks. Therefore& banks will charge higher interest rates where

possibility of default is higher hence li4uidity preference theory The above theory

instigated the second ob'ective of the study on the effects of capital re4uirement onfinancial performance of commercial banks in 7enya.

32


49/161

&5& Em3i i+!, Lite !tu e Re4ie

There have been debates and controversies on the effects of 207 regulatory re4uirement

on banksA financial performance below are empirical review of independent and

dependent variables.

&5&5 C" 3" !te G"4e n!n+e

2orporate governance broadly refers to the mechanisms& processes and relations by

which corporations are controlled and directed. )overnance structures and principles

identify the distribution of rights and responsibilities among different participants in the

corporation Esuch as the board of directors& managers& shareholders& creditors& auditors&

regulators& and other stakeholders F and includes the rules and procedures for making

decisions in corporate affairs& E(rcot& 0runo K (ntoine& ,--;F.

%mpirical studies have shown that bank efficiency is best explained using theintermediation approach. This is largely because balance sheet and income account data

are more readily available than what would be re4uired for the production approach.

%fficiency in intermediation of funds from savers to borrowers enables allocation of

resources to their most productive sectors. (n efficient banking system reflects a sound

intermediation process and hence the banksA due contribution to economic growth

E(ikeli& ,--8F.

2orporate governance plays a big role in determining the future of the bank. The

management has an overview of a bankAs operations& manages the 4uality of loans and

has to ensure that the bank is profitable. The performance of management capacity is

usually 4ualitative and understood through the sub'ective evaluation of management

systems& organi?ation culture& control mechanisms. 1owever& the capacity of the

management of a bank can also be gauged with the help of certain ratios of offBsite

evaluation of a bank in the capacity of the management to deploy its resources

aggressively to maximi?e the income& utili?e the facilities in the bank productively and

reduce costs E0 S& ,- 6F.

7amau E,--5F affirms that foreign banks are more efficient than local banks. The author

attributed this to the fact that foreign banks concentrate mainly in different operational

33

https://en.wikipedia.org/wiki/Stakeholder_(corporate)https://en.wikipedia.org/wiki/Stakeholder_(corporate)https://en.wikipedia.org/wiki/Stakeholder_(corporate)


50/161

modalities from the local& which affects the efficiency and profitability. (ccording to

Sangmi and *a?ir E,- -F management efficiency can be evaluated with reference to

expenditure to income ratio& credit to deposit ratio& (sset utili?ation ratio& diversification

ratio& earnings per employee ratio and expenditure per employee ratio. 7amau E,--5F

investigated the intermediation efficiency and productivity on banks in the period after

liberali?ation of banking sector in 7enya& using nonBparametric measures. 7amau

Muiruri, Paul Munene- PhD Business Administration ( Finance)-2015

Documents

Transcript of Muiruri, Paul Munene- PhD Business Administration ( Finance)-2015