Onjala - Determinants of Financial Performance of Commercial Banks in Kenya
Onjala - Determinants of Financial Performance of Commercial Banks in Kenya
Onjala - Determinants of Financial Performance of Commercial Banks in Kenya
BANKS IN KENYA
BY
NAIROBI
DECLARATION
This research project is my original work and has not been presented for examination in
This research project has been submitted for examination with my approval as university
supervisor.
HERICK ONDIGO
i
ACKNOWLEDGEMENTS
I thank God for giving me the wisdom and courage and for guiding me throughout my
life for without Him I would not have come this far.
invaluable and active guidance throughout the study. His immense command and
knowledge of the subject matter enabled me to shape this research project to the product
that it is now.
Thirdly, I also thank my family for letting me use their valuable time to work on this
Finally, I owe my gratitude to a number of people who in one way or another contributed
ii
DEDICATION
This work is dedicated to my wife Dr. Brenda Walaba, son Ryan Onjala and my mother
Felistas Onjala.
iii
ABSTRACT
Commercial banks financial performance in Kenya is an important subject given the
significant role the banks play in the economy. With the number of banks increasing over
the years and competition for customers increase, an analysis of what factors influence
banks’ financial performance is important to the banks as this can aid them in
ascertaining the determinants of performance and by extension know the areas to improve
in order to perform better. This study was designed to examine the determinants of
In order to achieve the objectives of this study, the research was designed as an
explanatory study. The population was all the 43 commercial banks by December 2011.
All the banks were used in the study. A ten year secondary data from 2001 to 2010 was
collected from Banking Survey and the Central Bank of Kenya. Descriptive analysis,
correlation analysis and regression analysis were used to perform the data analysis.
The study found that capital adequacy and exchange rates were negatively correlated with
ROE while liquidity, operating cost efficiency, size, risk, GDP, and inflation had a
positive influence on ROE. Overall, the independent variables accounted for 95.3% of the
variance in ROE. Further, the results revealed that exchange rate was negatively related
with ROA while capital adequacy, liquidity, operating cost efficiency, size, risk, GDP,
and inflation had positive effects on ROA. It was noted that the independent variables
accounted for 95.6% of the variance in ROA. However, none of these effects were
significant at 5% level of confidence. None of the models was also significant at 5%.
iv
The study concludes that none of the determinants tested in this study had a significant
recommends that there is need for commercial banks to improve their performance in
terms of their ROEs and ROAs. The study also recommends that banks should improve
on their liquidity more so the ability of the banks to promptly repay the depositors.
v
TABLE OF CONTENTS
DECLARATION................................................................................................................ i
ACKNOWLEDGEMENTS ............................................................................................. ii
DEDICATION.................................................................................................................. iii
ABSTRACT ...................................................................................................................... iv
LIST OF TABLES ......................................................................................................... viii
LIST OF FIGURES ......................................................................................................... ix
LIST OF ABBREVIATIONS .......................................................................................... x
CHAPTER ONE ............................................................................................................... 1
INTRODUCTION............................................................................................................. 1
1.1 Background of the Study ...................................................................................... 1
1.2 Research Problem ................................................................................................. 5
1.3 Research Objective ............................................................................................... 6
1.4 Value of the Study ................................................................................................ 6
CHAPTER TWO .............................................................................................................. 8
LITERATURE REVIEW ................................................................................................ 8
2.1 Introduction .......................................................................................................... 8
2.2 Theoretical Review .............................................................................................. 8
2.3 Measures of Financial Performance ................................................................... 11
2.4 Determinants of Financial Performance ............................................................. 12
2.5 Summary and Research Gap .............................................................................. 22
CHAPTER THREE ........................................................................................................ 23
RESEARCH METHODOLOGY .................................................................................. 23
3.1 Introduction ........................................................................................................ 23
3.2 Research Design ................................................................................................. 23
3.3 Population........................................................................................................... 23
3.4 Data Collection................................................................................................... 23
3.5 Data Analysis ..................................................................................................... 24
CHAPTER FOUR ........................................................................................................... 26
DATA ANALYSIS, RESULTS AND DISCUSSION................................................... 26
4.2 Introduction ........................................................................................................ 26
vi
4.2 Descriptive Analysis Results.............................................................................. 26
4.3 Correlation and Regression Results ................................................................... 37
4.4 Interpretation of Findings ................................................................................... 41
CHAPTER FIVE ............................................................................................................ 44
SUMMARY, CONCLUSION AND RECOMMENDATIONS .................................. 44
5.1 Introduction ........................................................................................................ 44
5.2 Summary ............................................................................................................ 44
5.3 Conclusion.......................................................................................................... 45
5.4 Recommendations for Policy ............................................................................. 45
5.5 Limitations of the Study ..................................................................................... 46
5.6 Suggestions for Further Research ...................................................................... 46
REFERENCES ................................................................................................................ 48
APPENDICES ................................................................................................................. 54
Appendix 1: List of Commercial Banks in Kenya ..................................................... 54
Appendix 2: Data Analysis Output from SPSS ........................................................ 55
vii
LIST OF TABLES
Table 3.1: Operationalization of Variables .................................................................. 25
Table 4.1: Descriptive Statistics on Dependent and Independent Variables ............... 26
Table 4.2: Correlation Matrix of Independent Variables ............................................. 39
Table 4.3: Determinants of Financial Performance of Banks in Kenya ...................... 40
viii
LIST OF FIGURES
Figure 4.1: Trend of Return on Equity of Commercial Banks 2001 – 2010 ................. 27
Figure 4.2: Trend of Return on Assets of Commercial Banks 2001 – 2010 ................. 28
Figure 4.3: Trend of Capital Adequacy of Commercial Banks 2001 – 2010 ................ 29
Figure 4.4: Trend of Asset Quality of Commercial Banks 2001 – 2010 ....................... 30
Figure 4.5: Trend of Liquidity of Commercial Banks 2001 – 2010 .............................. 31
Figure 4.6: Operating Cost of Efficiency of Commercial Banks 2001 – 2010 ............. 32
Figure 4.7: Trend of Size of Commercial Banks 2001 – 2010 ...................................... 33
Figure 4.8: Trend of Risk of Commercial Banks 2001 – 2010 ..................................... 34
Figure 4.9: Trend of GDP Growth Rate 2001 – 2010 ................................................... 35
Figure 4.10: Trend of Annual Inflation Rate 2001 – 2010 .......................................... 36
Figure 4.11: Trend of Exchange Rate 2001 – 2010 ..................................................... 37
ix
LIST OF ABBREVIATIONS
AIR - Annual Inflation Rate
AQ - Asset Quality
CA - Capital Adequacy
ER - Exchange Rate
ES - Efficient Structure
FO - Foreign Ownership
MP - Market Power
SCP - Structure-Conduct-Performance
x
CHAPTER ONE
INTRODUCTION
primary mode of business and generate revenues. It is also a general measure of a firm's
overall financial health over a given period of time, and can be used to compare similar
There are many different ways to measure financial performance, but all measures should
be taken in aggregation. Line items such as revenue from operations, operating income or
cash flow from operations can be used, as well as total unit sales. Furthermore, the
analyst or investor may wish to look deeper into financial statements and seek out margin
growth rates or any declining debt. Other measures of financial performance include
liquidity, solvency, profitability, debt repayment capacity and financial efficiency of the
firm.
The factors that determine the financial performance of banks in general have been
extensively studied. Amongst the various approaches, a number of studies have focused
performance (SCP) hypothesis and the efficient-structure (EFS) hypothesis widely tested.
market structure of the banking industry, such as the number of participating banks in the
market and the market shares of banks, and bank-specific factors, such as cost efficiency,
1
scale efficiency, and the risk attitude of banks. Macroeconomic factors, such as real GDP
growth and unemployment, may also be important determinants (Wong, Fong, Wong, &
Choi, 2007).
instance, Heffernan & Fu (2010) found that some macroeconomic variables and financial
ratios significantly influenced financial performance. The study also found that the type
of bank was an influential determinant of bank financial performance. Clair (2004) found
that the most important macroeconomic indicators were changes in interest rates,
found that liquidity and concentration were the most significant determinants of
conventional national banks’ performance while cost and number of branches were the
According to Demirgüç-Kunt & Huizinga (1999), a larger bank asset to GDP ratio and a
lower market concentration ratio lead to lower margins and profits. The authors also note
that foreign banks have higher margins and profits compared to domestic banks in
2
A study in China by Wong, Fong, Wong, & Choi (2007) found that cost efficiency of
banks was a major determinant of banks’ profitability. No evidence was found for the
effect of market structure (market concentration and market shares). Most of these banks
were large and therefore efficient hence the conclusion that efficiency was indeed a major
A study by Aburime (2008) revealed that capital size, size of credit portfolio and extent
profitability in Nigeria. In the same study, size of deposit liabilities, labour productivity,
insignificant; and the relationship between bank risk and profitability was inconclusive.
measured against its intended outputs (or goals and objectives). According to Richard et
al. (2009) organizational performance encompasses three specific areas of firm outcomes:
(a) financial performance (profits, return on assets, return on investment, etc.); (b)
product market performance (sales, market share, etc.); and (c) shareholder return (total
and measured in multiple dimensions such as: financial performance (e.g. shareholder
3
return); customer service social responsibility (e.g. corporate citizenship, community
According to the Central Bank of Kenya, there are 43 licensed commercial banks in
Kenya (see list in appendix 1). Three of the banks are public financial institutions with
majority shareholding being the Government and state corporations. The rest are private
financial institutions. Of the private banks, 27 are local commercial banks while 13 are
Commercial banks in Kenya play a major role in Kenya. They contribute to economic
growth of the country by making funds available for investors to borrow as well as
financial deepening in the country. Commercial banks therefore have a key role in the
Bank financial performance in the recent past has significantly improved since 2000.
Data from the Central Bank of Kenya shows a significant growth in the industry in all
areas including financial performance. While this is the case, some banks, especially the
foreign banks, have been performing better than others. The factors leading to this needs
an investigation as has been the focus of many studies in other countries such as China,
4
1.2 Research Problem
A large number of empirical studies have been conducted about factors influencing bank
factors have been used by researchers such as shareholders’ equity to total assets; liquid
assets to assets; total loans to total deposits; fixed assets to total assets; total borrowed
funds to total assets; reserves for loans to total assets ; market concentration; the market
capitalization; financial interrelation ratio (FIR); M2/ GDP; the level of capitalization;
age of the bank; per capita GDP, the cost to-income ratio and customer satisfaction.
significant role the banks play in the economy. With the number of banks increasing over
the years and competition for customers increase, an analysis of what factors influence
banks’ financial performance is important to the banks as this can aid them in
ascertaining the determinants of performance and by extension know the areas to improve
Most of the studies on bank financial performance determinants have covered developed
economies, whereas much less studies covered developing economies such as Kenya’s
economy. Some of these studies include Aburime (2008) in Nigeria, Al-Tamini (2010) in
UAE, Clair (2004) in Singapore, Heffernan & Fu (2010) and Wong, Fong, Wong, & Choi
(2007) in China. Moreover, results of these studied have been inconclusive and /or
5
Studies that are close to determinants of bank performance in Kenya include Njihia
(2005), Mwania (2009), Okutoyi (1988), and Ndungu (2003). These studies were
however designed to focus on each factor of bank financial performance to the exclusion
of the other factors while some only focused on listed commercial banks as in the case of
Ndungu (2003). There is no study that has been done on a larger sample of commercial
banks hence a gap that needs to be filled in by carrying out the present study. This study
builds on the study by Njihia (2005) as the former study was limited by the scope as it
only focused on one aspect of commercial banks financial performance. Given the
passage of time and limitations of case studies as far as generalisation of results to the
population is concerned, there is need for the present study to be conducted. The study
poses the following research question: What factors influence financial performance of
governors of commercial banks will have an empirical basis upon which they can base
This study will also guide policy makers in the banking sector especially the Central
Bank of Kenya and the Treasury in coming up with policies which will spur growth and
6
Researchers will also find this study a very useful study as regards the variables measured
in the study. Future research in Kenya and especially in the financial sector can be based
on this study. The recommendations for future studies will also guide future researchers
in this area.
7
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
This chapter presents the literature review on the determinants of financial performance
summarizes the empirical studies from various researchers who have carried out research
efficient structure theory, market power theory, and the balanced portfolio theory. A
The ES hypothesis, on the other hand posits that banks earn high profits because they are
more efficient than others. There are also two distinct approaches within the ES; the X-
more efficient firms are more profitable because of their lower costs. Such firms tend to
gain larger market shares, which may manifest in higher levels on market concentration,
al, 2006). The scale approach emphasizes economies of scale rather than differences in
management or production technology. Larger firms can obtain lower unit cost and
8
higher profits through economies of scale. This enables large firms to acquire market
Applied in banking the MP hypothesis posits that the performance of bank is influenced
by the market structure of the industry. There are two distinct approaches within the MP
hypothesis (RMP). According to the SCP approach, the level of concentration in the
banking market gives rise to potential market power by banks, which may raise their
profitability. Banks in more concentrated markets are most likely to make “abnormal
profits” by their ability to lower deposits rates and to charge higher loan rates as a results
concentrated markets, irrespective of their efficiency (Tregenna, 2009). Unlike the SCP,
the RMP hypothesis posits that bank profitability is influenced by market share. It
assumes that only large banks with differentiated products can influence prices and
increase profits. They are able to exercise market power and earn non-competitive profits.
The portfolio theory approach is the most relevant and plays an important role in bank
balance model of asset diversification, the optimum holding of each asset in a wealth
such as the vector of rates of return on all assets held in the portfolio, a vector of risks
9
associated with the ownership of each financial assets and the size of the portfolio. It
banks are results of decisions taken by the bank management. Further, the ability to
obtain maximum profits depends on the feasible set of assets and liabilities determined by
the management and the unit costs incurred by the bank for producing each component of
The above theoretical analysis shows that MP theory assumes bank profitability is a
function of external market factors, while the ES and Portfolio theory largely assume that
models of the banking firm have been developed to deal with specific aspects of bank
behavior but none is acceptable as descriptive of all bank behavior. Some of these
analysis, canonical correlations analysis and neural network method. Olugbenga and
Olankunle (1998) noted that a major limitation of the univariant analysis approach is that
it does not recognize the possibility of joint significance of financial ratios, while the
independent variables on the dependent variable. Nor can the significance of individual
correct for these limitations and they produce comparable results to the discriminant
analysis method.
10
Bakar and Tahir (2009) evaluated the performance of the multiple linear regression
technique and artificial neural network techniques with a goal to find a powerful tool in
predicting bank performance. Data of thirteen banks in Malaysia for the period 2001-
2006 was used in the study. ROA was used as a measure of bank performance and seven
variables including liquidity, credit risk, cost to income ratio, size, concentration ratio,
were used as independent variables. They note that neural network method outperforms
the multiple linear regression method but it lacks explanation on the parameters used and
they concluded that multiple linear regressions, not withstanding its limitations (i.e.
violations of its assumptions), can be used as a simple tool to study the linear relationship
between the dependent variable and independent variables. The method provides
significant explanatory variables to bank performance and explains the effect of the
contributing factors in a simple, understood manner. This study will adopt this approach
together with the correction analysis to determine the effects of various factors on bank
performance in Kenya.
investment, etc.); product market performance (sales, market share, etc.); and shareholder
return (total shareholder return, economic value added, etc.) (Richard et al. 2009). In
their study, Papadakis et al (1998) used two objective measures of performance. These
were return on assets (ROA) and growth in profits. Performance measures in this study
11
Zahra and Bogner (2000) measured firm’s performance using sales growth, employment
growth, and pretax net profit percentage of total sales. Baum and Wally (2003) in their
study measured firm performance as growth and profit. In the study, self-reported
objective measures were used where the respondents were asked in a questionnaire to fill
in the figures for total sales and the number of employees for two years as well as profit
In a study by Zehir and Ozsahin (2008), a Likert Response Format (LRF) was used to
measure innovation performance. A five point Likert scale was used where the
financial performance using return on total assets (ROTA) and return on sales (ROS)
based on archival objective measures. Hsu and Huang (2011) measured performance
affecting bank profitability with success. CAMEL stands for Capital adequacy, Asset
quality, Management efficiency, Earnings performance and Liquidity. The system was
alternative bank performance evaluation models have been proposed, the CAMEL
12
framework is the most widely used model and it is recommended by Basel Committee on
Capital adequacy refers to the sufficiency of the amount of equity to absorb any shocks
that the bank may experience (Kosmidou, 2009). 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 maximize shareholder value at the expense of finance
Although there is general agreement that statutory capital requirements are necessary to
reduce moral hazard, the debate is on how much capital is enough. Regulators would like
to have higher minimum requirements to reduce cases of bank failures, whilst bankers in
contrast argue that it is expensive and difficult to obtain additional equity and higher
requirements restrict their competitiveness (Koch, 1995). Beckmann (2007) argue that
high capital leads to low profits since banks with a high capital ratio are risk-averse, they
expected return, highly capitalized banks face lower cost of bankruptcy, lower need for
Thus well capitalized banks should be profitable than lowly capitalized banks.
13
Heffernan & Fu (2010) looked at how well different types of Chinese banks had
performed between 1999 and 2006, and tested for the factors influencing performance. It
also evaluates four measures of performance to identify which one, if any, was superior.
The independent variables included the standard financial ratios, those which reflected
more recent reforms and macroeconomic variables. The results suggested that Economic
Value Added (EVA) and the Net Interest Margin (NIM) did better than the more
Return On Average Assets (ROAA). Some macroeconomic variables and financial ratios
were significant with the expected signs. Though the type of bank was influential, bank
size was not. Neither the percentage of foreign ownership nor bank listings had a
discernible effect.
Neceur (2003) using a sample of 10 Tunisian banks from 1980 to 2000 and a panel linear
regression model, reported a strong positive impact of capitalization to ROA. Sufian and
Chong (2008) also reported the same results after examining the impact of capital to the
Credit risk is one of the factors that affect the health of an individual bank. The extent of
the credit risk depends on the quality of assets held by an individual bank. The quality of
loans, and the health and profitability of bank borrowers (Baral, 2005). Aburime (2008)
asserts that the profitability of a bank depends on its ability to foresee, avoid and monitor
risks, possibly to cover losses brought about by risks arisen. Hence, in making decisions
14
on the allocation of resources to asset deals, a bank must take into account the level of
Poor asset quality and low levels of liquidity are the two major causes of bank failures.
Poor asset quality led to many bank failures in Kenya in the early 1980s. During that
period 37 banks collapsed following the banking crises of 1986-1989, 1993-1994 and
1998 (Mwega, 2009). According to Waweru and Kalani (2009) many of the financial
institutions that collapse in 1986 failed due to non-performing loans (NPLs) and that
politicians.The CBK measures asset quality by the ratio of net non-performing loans to
gross loans. However Koch (1995) argues that a good measure of credit risk or asset
quality is the ratio of loan loss reserve to gross loans because it captures the expectation
that banks with high loan growth often assume more risk as credit analysis and review
procedures are less rigorous, however returns are high in such loans indicating a risk and
return trade-off.
Kosmidou (2008) applied a linear regression model on 23 Greece commercial banks data
for 1990 to 2002, using ROA and the ratio of loan loss reserve to gross loans to proxy
profitability and asset quality respectively. The results showed a negative significant
impact of asset quality to bank profitability. This was in line with the theory that
increased exposure to credit risk is normally associated with decreased firm profitability.
15
Indicating that banks would improve profitability by improving screening and monitoring
of credit risk.
Another important decision that the managers of commercial banks take refers to the
liquidity management and specifically to the measurement of their needs related to the
process of deposits and loans. The importance of liquidity goes beyond the individual
bank as a liquidity shortfall at an individual bank can have systemic repercussions (CBK,
2009). It is argued that when banks hold high liquidity, they do so at the opportunity cost
of some investment, which could generate high returns (Kamau, 2009). The trade-offs
that generally exist between return and liquidity risk are demonstrated by observing that a
‟s return but
shift from short term securities to long term securities or loans raises a bank
also increases its liquidity risks and the inverse in is true. Thus a high liquidity ratio
indicates a less risky and less profitable bank (Hempel et al, 1994). Thus management is
Myers and Rajan (1998) emphasized the adverse effect of increased liquidity for financial
Institutions stating that, “although more liquid assets increase the ability to raise cash on
strategy that protects investors” which, finally, can result in reduction of the firm’s
Poor expenses management is the main contributors to poor profitability (Sufian and
16
usually used to assess managerial efficiency in banks. Mathuva (2009) observed that the
CIR of local banks is high when compared to other countries and thus there is need for
local banks to reduce their operational costs to be competitive globally. Beck and Fuchs
(2004) examined the various factors that contribute to high interests spread in Kenyan
banks. Overheads were found to be one of the most important components of the high
interests rate spreads. An analysis of the overheads showed that they were driven by staff
wage costs which were comparatively higher than other banks in the SSA countries.
implying that higher expenses mean lower profits and the opposite, this may not always
be the case. The reason is that higher amounts of expenses may be associated with higher
markets where banks enjoy market power, costs are passed on to customers; hence there
would be a positive correlation between overheads costs and profitability (Flamini et al,
2009). Neceur (2003) found a positive and significant impact of overheads costs to
profitability indicating that such cost are passed on to depositors and lenders in terms of
Financial institutions in recent years have increasingly been generating income from “off-
balance sheet” business and fee income. Albertazzi and Gambacorta (2006) as cited by
Uzhegova (2010) noted that the decline in interest margins, has forced banks to explore
follows the concept of portfolio theory which states that individuals can reduce firm-
17
specific risk by diversifying their portfolios. However there is a long history of debates
about the benefits and costs of diversification in banking literature. The proponents of
activity diversification or product mix argue that diversification provides a stable and less
volatile income, economies of scope and scale, and the ability to leverage managerial
efficiency across products (Choi and Kotrozo, 2006). Chiorazzo et al (2008) noted that as
a result of activity diversification, the economies of scale and scope caused through the
organizations. They further argued that product mix reduces total risks because income
from non-interest activities is not correlated or at least perfectly correlated with income
from fee based activities and as such diversification should stabilize operating income
The opposite argument to activity diversification is that it leads to increased agency costs,
increased organizational complexity, and the potential for riskier behavior by bank
managers. Kotrozo and Choi (2006) mentioned that activity diversification results in
more complex organizations which “makes it more difficult for top management to
monitor the behavior of the other divisions/branches. They further argued that the
benefits of economies of scale/scope exist only to a point. The costs associated with a
firm’s increased complexity may overshadow the benefits of diversification. As such, the
18
Using annual bank level data of all Philippines commercial banks Sufian and Chong
(2008) found a positive relationship between total non-interest income divided by total
assets, a proxy for income diversification and bank profitability. Uzhegova (2010) using a
income and other operating income found empirical support of the idea that banks
involved in diversification activities expect some benefits. While Kotrozo and Choi 2006,
using a similar index found that activity diversification tends to reduce performance
Claessens and Jansen (2000) as cited by Kamau (2009) argued that foreign banks usually
bring with them better know-how and technical capacity, which then spills over to the
rest of the banking system. They impose competitive pressure on domestic banks, thus
increasing efficiency of financial intermediation and they provide more stability to the
financial system because they are able to draw on liquidity resources from their parents
banks and provide access to international markets. Beck and Fuchs (2004) argued that
foreign-owned banks are more profitable than their domestic counterparts in developing
countries and less profitable than domestic banks in industrial countries, perhaps due to
benefits derived from tax breaks, technological efficiencies and other preferential
treatments. However domestic banks are likely to gain from information advantage they
However the counter argument is that unrestricted entry of foreign banks may result in
their assuming a dominant position by driving out less efficient or less resourceful
19
domestic banks because more depositors may have faith in big international banks than in
small domestic banks. They cream-skim the local market by serving only the higher end
of the market, they lack commitment and bring unhealthy competition, and they are
responsible for capital flight from less developed countries in times of external crisis
(Bhattachrya,1994).
The market power theory, as it was discussed under bank performance theories, posits
that the more concentrated the market, the less the degree of competition (Tregenna,
2009). According to Nzongang and Atemnkeng (2006) high degrees of market share
concentration are inextricably associated with high levels of profits at the detriment of
Secondly, since commercial banks are the primary suppliers of funds to business firm, the
availability of bank credit at affordable rates is of crucial importance for the level of
investments of the firms, and consequently, for the health of the economy. In situation of
reduction of the demand for bank loans and the level of business investments. The effect
multiplies many folds in as much as bank management capitalizes on the market share
concentration factor.
However there is a long held view that market power is necessary to ensure stability in
banking. Banks that are profitable and well-capitalized are best positioned to withstand
shocks to their balance sheet. Hence banks with market power, and the resulting profits,
are considered to be more stable Northoctt (2004). Large banks with market power have
20
typically been viewed as having incentives that minimize their risk-taking behavior and
improve the quality of their assets (the screening theories). Keeley (1990) as cited by
Northoctt (2004) argues that the rise in bank failures in the United States during the
1980s was due in part to an increase in competition in the banking industry. Flamini et al
(2009) noted that if high returns are the consequence of market power, this implies some
degree of inefficiency in the provision of financial services. In this case it should prompt
policymakers to introduce measures to lower risk, remove bank entry barriers if they
exist, as well as other obstacles to competition, and reexamine regulatory costs. But bank
profits are also an important source for equity. If bank profits are reinvested, this should
lead to safer banks, and, consequently high profits could promote financial stability.
Tregenna (2009) using a sample of USA commercial banks and savings institutions from
1995 to 2005 and a linear regression panel model, found robust evidence that
concentration increases profitability in USA banks and then concluded than the high
profitability of banks in the USA before the 2007/2008 financial crisis was not earned
through efficient processes, but through market power and the profits were not reinvested
to strengthen the capital base of the financial institutions. Nzongang and Atemnkeng
commercial banks from 1987 to 1999. Unlike Tregenna (2009), who used the
concentration ratio of the 3 largest banks in the USA to model market concentration,
market concentration in Cameroon. The results indicate that market concentration power
21
Olweny & Shipho (2011) studied the effects of banking sectoral factors on the
profitability of commercial banks in Kenya. The first objective of this study was to
determine and evaluate the effects of bank-specific factors; Capital adequacy, Asset
profitability of commercial banks in Kenya. The second objective was to determine and
evaluate the effects of market structure factors; foreign ownership and market
explanatory approach by using panel data research design to fulfill the above objectives.
Annual financial statements of 38 Kenyan commercial banks from 2002 to 2008 were
obtained from the CBK and Banking Survey 2009. The data was analyzed using multiple
linear regressions method. The analysis showed that all the bank specific factors had a
statistically significant impact on profitability, while none of the market factors had a
significant impact.
by bank-specific factors and external factors. Bank-specific factors are those factors
within the direct control of managers and can be best explained by the CAMEL
The review of literature also revealed that the multiple linear regressions method is the
most used in modelling the relationship between bank financial performance and its
factors.. Finally, it is clear from the reviewed literature that few local studies have been
dedicated on this particular area of bank performance and that studies that have attempted
to do so have tended to study each factor of performance to the exclusion of other factors.
22
CHAPTER THREE
RESEARCH METHODOLOGY
3.1 Introduction
This chapter presents the research methodology. It contains the research design,
explanatory design is to explain quantitative results. Since the present study aimed to
explain the factors that affect performance of commercial banks, an explanatory design
3.3 Population
The population of this study comprised of all licensed commercial banks in Kenya
between the period of 2001 and 2010. As at 31 December 2011, there were 43 registered
commercial banks comprising of 14 large banks and, 29 small and medium banks
(Appendix 1). A census of the commercial banks in Kenya was carried out.
Kenya and Banking Survey 2011. The Banking Survey is an annual publication that
publishes annual financial statement of all banks in Kenya covering a period 10 years,
while the Central Bank of Kenya publishes annually, major financial indicators of the
sector.
23
3.5 Data Analysis
The collected data was analyzed using descriptive statistics, correlations, multiple linear
regression analysis and inferential statistics. Mean values were used to analyze the
general trends of the data from 2001 to 2010 based on the census (43 banks). Correlation
matrix was used to examine the relationship between the dependent variable and
Where: α - Regression constant, β1 – Coefficient of the predictor (CA) and e – error term
24
The table below presents the measurements that were used to operationalize the study
A multiple linear regression model and t-statistic was used to determine the relative
used to test the hypotheses at a maximum of 5% significance level. The multiple linear
regressions model is shown on the equation below. This model was run using SPSS
version 20.
25
CHAPTER FOUR
DATA ANALYSIS, RESULTS AND DISCUSSION
4.2 Introduction
This chapter presents the results of the study. Data was analysed for a period of ten years
and the descriptive results are shown in section 4.2. The correlation analysis and
regression analysis results are presented in section 4.3. Section 4.4 presents the
discussion of findings.
results are shown in terms of minimum, maximum, mean, and standard deviation.
Table 4.1 reveals that ROE ranged from 0.83 to 1.13 with a mean of 0.96 and a standard
deviation of 0.09. From Figure 4.1 below, it can be observed that the ROE generally fell
26
over the period of study from 2001 – 2010. Thus the performance of banks in terms of
1.1
1.05
0.95
0.9
0.85
0.8
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Table 4.1 shows that return on assets (ROA) ranged from 0.11 to 0.15 with a mean of
0.12 and a standard deviation of 0.01. As can be observed from Figure 4.2 below, there
was a general fall in return on assets from 2001 – 2010. This means that performance of
27
Figure 4.2: Trend of Return on Assets of Commercial Banks 2001 – 2010
0.16
0.15
0.14
0.13
0.12
0.11
0.1
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Table 4.1 shows that capital adequacy ratios (measured as total equity divided by total
assets) ranged from 0.12 to 0.15 with a mean of 0.13 and a standard deviation of 0.01.
Figure 4.3 shows the trend analysis of capital adequacy of banks and the results show that
it has been improving over the years. The improvement in this ratio can be attributed to
the strict guidelines provided by the Central Bank of Kenya and the Basel requirements.
28
Figure 4.3: Trend of Capital Adequacy of Commercial Banks 2001 – 2010
0.16
0.15
0.14
0.13
0.12
0.11
0.1
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Table 4.1 also shows that asset quality (measured as the ratio of non-performing loans to
gross loans) ranged from 0.05 to 0.33 with a mean of 0.16 and a standard deviation of
0.10. Figure 4.4 shows the trend analysis of the asset quality. As shown, the asset quality
has improved over the years as the ratio has been declining meaning that non-performing
loans have been reducing as the gross loans have grown over the years.
29
Figure 4.4: Trend of Asset Quality of Commercial Banks 2001 – 2010
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Table 4.1 shows that liquidity (measured as the ratio of current assets to total deposits)
ranged from 0.33 to 0.52 with a mean of 0.42 and a standard deviation of 0.05. Figure 4.5
shows the trend of liquidity over the years and as it can be observed, this ratio has also
been declining. Since this measure was intended to gauge how quickly banks can respond
to demands for cash from their depositors, it means that banks have become less liquid
over the years. This could mean that banks may not be able to promptly settle their
30
Figure 4.5: Trend of Liquidity of Commercial Banks 2001 – 2010
0.55
0.5
0.45
0.4
0.35
0.3
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Table 4.1 further shows that Operating Cost Efficiency (measured as the ratio of
operating costs to net operating income) ranged from 0.54 to 0.65 with a mean of 0.58
and a standard deviation of 0.03. The trend of operating cost efficiency is also shown in
Figure 4.6. As shown, there was a general decline in this ratio. Since lower ratios mean
better efficiency, this means that banks have improved their efficiency over the years.
31
Figure 4.6: Operating Cost of Efficiency of Commercial Banks 2001 – 2010
0.66
0.64
0.62
0.6
0.58
0.56
0.54
0.52
0.5
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Table 4.1 also shows that size (measured as the natural logarithm of total assets) ranged
from 12.86 to 14.38 with a mean of 13.52 and a standard deviation of 0.52. Figure 4.7
shows the trend of bank size over the period. The results show that there was a general
rise in bank size over the period of study. Size of banks rose steadily over the period of
analysis.
32
Figure 4.7: Trend of Size of Commercial Banks 2001 – 2010
15
14.5
14
13.5
13
12.5
12
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Table 4.1 shows that risk (measured as total liabilities divided by the total assets) ranged
from 0.85 to 0.89 with a mean of 0.86 and a standard deviation of 0.01. The results in
Figure 4.8 show the trend of risk of commercial banks over the period of analysis. As the
results show, there was a general decline in risk of commercial banks. This can be
33
Figure 4.8: Trend of Risk of Commercial Banks 2001 – 2010
0.9
0.89
0.88
0.87
0.86
0.85
0.84
0.83
0.82
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Table 4.1 further shows that GDP rate ranged from 0.30 to 6.90 with a mean of 4.13 and
a standard deviation of 2.21. Figure 4.9 shows the trend of growth rate over the period.
As shown, there was a general rise in GDP growth rate over the period of analysis. Thus,
the economy has been improving over the period under study.
34
Figure 4.9: Trend of GDP Growth Rate 2001 – 2010
8
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Table 4.1 shows that inflation rate ranged from 2 to 26.2 with a mean of 10.31 and a
standard deviation of 6.69. From Figure 10, it can be observed that there was a general
rise in inflation.
35
Figure 4.10: Trend of Annual Inflation Rate 2001 – 2010
30
25
20
15
10
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Table 4.1 also shows that exchange rate (dollar to shilling) ranged from 67.32 to 79.23
with a mean of 75.31 and a standard deviation of 4.33. Figure 4.11 also shows the trend
36
Figure 4.11: Trend of Exchange Rate 2001 – 2010
82
80
78
76
74
72
70
68
66
64
62
60
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
As shown, over the period of analysis, there was a general fall in exchange rates
suggesting that the shilling grew stronger over the period of analysis.
all the independent variables in the study. These were capital adequacy, asset quality,
liquidity, operating cost efficiency, size, risk, GDP, inflation rate, and exchange rate. This
analysis was carried out in order to determine whether there were serial correlations
between these variables. As serial correlations are a problem when performing regression
analysis, this preliminary test was carried out first. The results show that there was a very
high and significant correlation between asset quality and liquidity (R = .812), asset
37
quality and size (R = - .947) and asset quality and risk (R = .926). Size was also highly
and significantly correlated with risk (R = .960). There is therefore serial autocorrelations
between some of the variables and asset quality is therefore dropped from the regression
38
Table 4.2: Correlation Matrix of Independent Variables
CA AQ LIQ OCE Size Risk GDP AIR ER
CA Pearson Correlation 1 -.546 -.220 -.449 .731* -.600 .200 -.015 -.023
Sig. (2-tailed) .102 .541 .192 .016 .066 .579 .967 .950
AQ Pearson Correlation 1 .812** .754* -.947** .926** -.258 -.414 .487
Sig. (2-tailed) .004 .012 .000 .000 .471 .234 .153
LIQ Pearson Correlation 1 .658* -.646* .598 -.276 -.752* .680*
Sig. (2-tailed) .039 .044 .068 .441 .012 .030
OCE Pearson Correlation 1 -.695* .687* -.523 -.460 .462
Sig. (2-tailed) .026 .028 .121 .181 .179
Size Pearson Correlation 1 -.960** .131 .276 -.273
Sig. (2-tailed) .000 .718 .440 .446
Risk Pearson Correlation 1 -.089 -.188 .237
Sig. (2-tailed) .806 .603 .510
GDP Pearson Correlation 1 -.084 -.234
Sig. (2-tailed) .818 .515
AIR Pearson Correlation 1 -.661*
Sig. (2-tailed) .037
ER Pearson Correlation 1
Sig. (2-tailed)
*. Correlation is significant at the 0.05 level (2-tailed).
**. Correlation is significant at the 0.01 level (2-tailed).
Source: Research Findings
39
Table 4.3 shows the regression results for the determinants of bank performance as
modelled by two models – ROE and ROA. Significance of the relationships is shown in
parentheses.
The study found that the independent variables had a very high correlation with ROE and
ROA (R = 0.976 and 0.978 respectively). The results also show that the variables
accounted for 95.3% of the variance in ROE (R2 = 0.953) and 95.6% of the variance in
ROA (R2 = 0.956). ANOVA results show that the F statistics were insignificant at 5%
level. This means that none of the performance models was fit to explain the
relationships.
As the results show, capital adequacy and exchange rate had negative effects on ROE (β
= - 1.727 and - 0.009 respectively) but these effects were not significant at 5% level. The
40
rest of the variables (liquidity, operating cost efficiency, size, risk, GDP, and inflation)
had positive effects on ROE but none of these effects were significant at 5% level.
The results also show that exchange rate had a negative effect on ROA (β = - 0.001) but
this relationship was not significant at 5% level. Further, capital adequacy, liquidity,
operating cost efficiency, size, risk, GDP and inflation rate had positive effects on ROA.
lower capital adequacy ratios led to higher ROE. On the other hand, the results showed
that capital adequacy had a positive influence on ROA suggesting that higher capital
adequacy ratios translated to higher ROA. Since both effects were insignificant, it can be
Liquidity had a positive impact on both ROA and ROE. These results suggest that higher
liquidity led to better firm performance. But these results were not significant hence lead
Operating cost efficiency had a positive effect on ROE as well as on ROA. The results
suggest that higher OCE led to better firm performance. The effects were however not
significant hence lead to the conclusion that bank financial performance is not influenced
by OCE.
41
Size was found to be positively correlated with both ROA and ROE. This suggests that
larger banks performed better than smaller banks. The results were not significant hence
lead to the conclusion that bank financial performance is not influenced by size.
The study also found that risk had a positive effect on both ROA and ROE. The results
mean that higher bank risk lead to higher bank performance. These results were however
insignificant hence lead to the conclusion that bank financial performance is not
The effect of macroeconomic factors on bank financial performance was also tested.
GDP and inflation had positive effects on both ROE and ROA. The results mean that
higher GDP growth as well as higher inflation rates leads to better bank performance.
These results were not significant and therefore indicate that bank financial performance
The study also found that exchange rate had a negative effect on both ROE and ROA.
The results mean that lower exchange rates (stronger shilling) lead to better bank
performance. These results were insignificant and therefore mean that bank financial
This study did not find any statistically significant effects of the factors studied on the
performance of banks. This is a sharp contrast with the findings of Olweny and Shipho
42
(2011) who found that bank specific factors (capital adequacy, asset quality, liquidity,
These results can be attributed to the way the data analysis was carried out in this study.
While the previous study used individual data from each of the banks (cross-sectional
approach), the present study used aggregate data for all the banks for each year (a
longitudinal approach). Secondly, this study covered a period beginning 2001 – 2010 (a
ten year period) while the previous study covered 2002 to 2008 (7 year period).
43
CHAPTER FIVE
SUMMARY, CONCLUSION AND RECOMMENDATIONS
5.1 Introduction
This chapter presents the summary of the study in section 5.2, conclusion in 5.3,
recommendations in 5.4, limitations of the study in 5.5, and suggestions for further
research in 5.6.
5.2 Summary
This study was designed to examine the determinants of financial performance of
commercial banks in Kenya. In order to achieve this, the research was designed as an
explanatory study. The population was all the 43 commercial banks by December 2011.
All the banks were used in the study. A ten year secondary data from 2001 to 2010 was
collected from Banking Survey and the Central Bank of Kenya. Descriptive analysis,
correlation analysis and regression analysis were used to perform the data analysis.
The study found that there was a general fall in both ROA and ROE over the sample
period. Over the same period, capital adequacy, total assets (size), GDP, and inflation
rose while asset quality, liquidity, operating cost efficiency, risk, and exchange rates fell.
The regression results showed that capital adequacy and exchange rates were negatively
correlated with ROE while liquidity, operating cost efficiency, size, risk, GDP, and
inflation had a positive influence on ROE. Overall, the independent variables accounted
44
Further, the results revealed that exchange rate was negatively related with ROA while
capital adequacy, liquidity, operating cost efficiency, size, risk, GDP, and inflation had
positive effects on ROA. It was noted that the independent variables accounted for 95.6%
of the variance in ROA. However, none of these effects were significant at 5% level of
5.3 Conclusion
The study concludes that none of the determinants tested in this study had a significant
found out, though most of the variables had a positive effect on performance as measured
by ROA and ROE, none of the effects were statistically significant at 5% level of
confidence. Further, even though the variables studied accounted for more than 95% of
the variance in bank performance, they were not significant influencers of bank
performance in Kenya.
performance in terms of their ROEs and ROAs. There has been a general decline in
performance on these two specific ratios and it is clear that the overall performance has
The study also recommends that banks should improve on their liquidity more so the
ability of the banks to promptly repay the depositors. As the results show, this ability has
45
been steadily declining over the years and it is important that the banks maintain a certain
commercial banks and any attempt to generalise findings to other firms outside this scope
concept. The interpretation of these results should therefore be limited to the concept and
Lastly, this study is country specific to Kenya. The study therefore suffers from the
limitation of country specific studies. The results are therefore applicable only to Kenya
and any attempt to generalise findings to other countries should be approached with care.
performance are. Thus studies can be done in other sectors of the economy such as
manufacturing sector to determine the firm specific factors that influence their
performance.
46
There is also need to carry out the same study in the banking industry in Kenya but by
employing a different model and approach in order to test the determinants of bank
financial performance. This is because the variables in this study failed to influence bank
performance.
The study also suggests that another study be done in the banking industry covering a
longer period of time in order to establish trends and determine what factors influence
bank performance.
47
REFERENCES
Abu Bakar, N. & Tahir, I. M. (2009). Applying Multiple Linear Regression and Neural
http://ssrn.com/abstract=1106825.
Aburime, U. (2008, May 31). Determinants of bank profitability: company level evidence
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=%201106825
http://ssrn.com/abstract=1106825.
Baltagi, B.H. (2005). Econometric Analysis of Panel Data. John Wiley & Sons Publish.
CAMEL: A Case Study of Joint Venture Banks in Nepal. The Journal of Nepalese
index.php/JNBS/article/viewFile/55/483
48
Beck, T. & Fuchs, M. (2004). Structural Issues in the Kenyan Financial System:
http://siteresources.worldbank.org.
Choi, S. & Kotrozo, J. (2006). Diversification, Bank Risk and Performance: A Cross-
38, 1-34.
Cooper, D. C., & Schindler, P. S. (2009). Business Research Methods. 9th edn.Tata
Dougherty, C. (2007). Introduction to Economics. 3rd edn. Oxford University Press Inc.
New York.
49
Malaysia for the Degree of Master of Science (Banking). [Online]. Available
from: www.ep3.uum.edu.my/1760/1/Saidov_Elyor_Ilhomovich.pdf
www.imf.org/external/pubs/ft/wp/2009/wp0915.pdf.
Gavila, S. & Santabarbara, D. (2009). What Explains the low Profitability in Chinese
http://dspace.fsktm.um.edu.my/bitstream/1812/752/1/abstract.pdf
Hempel, G. H., Simonson, D. G. & Coleman, A.B. (1994). Bank Management. 4th edn.
King, G.R. & Levine, R. (1993). Finance and Growth: Schupter Might be Right. The
Quarterly Journal of Economics. [Online]. 108 (3). pp. 717-737. Available from:
www.jstor.org
50
Koch, T.W. (1995). Bank Management. 3rd edn. The Dryden Press. London Mathuva, D.
ScienceAlert.com.
Kosmidou, K. (2008). The determinants of banks „profits in Greece during the period of
of Nairobi.
Mwega, F.M. (2009). Global Financial Crisis: Kenya: Discussion series. Paper 7.
www.mafhoum.com/press6/174E11.pdf
Ngugi, N., Amanja D. & Maana L. (2006). Capital Market, Financial Deepening and
conferences/2009-EDiA papers/513-Isaya.pdf
Available at http://www.aercafrica.org/documents/rp106.pdf.
51
Njihia, J. (2005). Determinants of bank profitability: the case of commercial banks in
24.pdf
africa.com/Jsda/Summer_2006/PDF
http://www.eurojournals.com.
Okutoyi, P. (1988). The relationship between the use of strategic marketing and bank
from: http://idl-bnc.idrc.ca/dspace/bitstream/10625/22919/1/113309.pdf
http:// www.usm.my/journal/aamjaf/vol%204-2-2008/4-2-5.pdf.
52
Tregenna, F. (2009), The fat years: the structure and profitability of the US banking
http://ssrn.com/abstract=1595751.
vol4-article2.pdf.
Wong, J., Fong, T., Wong, E., & Choi, K. (2007). Determinants of the performance of
banks in Hong Kong. Hong Kong Monetary Authority Working Paper 06/2007.
53
APPENDICES
Appendix 1: List of Commercial Banks in Kenya
54
Appendix 2: Data Analysis Output from SPSS
Summary Descriptive Statistics
55
Correlation Matrix for the Independent Variables
Capital Asset Liquidity Operating Size Risk GDP AIR ER
adequacy quality cost
efficiency
Pearson * - -
1 -.546 -.220 -.449 .731 -.600 .200
Correlation .015 .023
Capital
Sig. (2-
adequacy .102 .541 .192 .016 .066 .579 .967 .950
tailed)
N 10 10 10 10 10 10 10 10 10
Pearson ** * - ** - -
-.546 1 .812 .754 ** .926 .487
Correlation .947 .258 .414
Asset
Sig. (2-
quality .102 .004 .012 .000 .000 .471 .234 .153
tailed)
N 10 10 10 10 10 10 10 10 10
Pearson ** * - - - *
-.220 .812 1 .658 * .598 * .680
Correlation .646 .276 .752
Liquidity Sig. (2-
.541 .004 .039 .044 .068 .441 .012 .030
tailed)
N 10 10 10 10 10 10 10 10 10
Pearson * * - * - -
-.449 .754 .658 1 * .687 .462
Operating Correlation .695 .523 .460
cost Sig. (2-
.192 .012 .039 .026 .028 .121 .181 .179
efficiency tailed)
N 10 10 10 10 10 10 10 10 10
Pearson * ** * * - -
.731 -.947 -.646 -.695 1 ** .131 .276
Correlation .960 .273
Size Sig. (2-
.016 .000 .044 .026 .000 .718 .440 .446
tailed)
N 10 10 10 10 10 10 10 10 10
Pearson ** * - - -
-.600 .926 .598 .687 ** 1 .237
Correlation .960 .089 .188
Risk Sig. (2-
.066 .000 .068 .028 .000 .806 .603 .510
tailed)
N 10 10 10 10 10 10 10 10 10
Pearson - -
.200 -.258 -.276 -.523 .131 -.089 1
Correlation .084 .234
GDP Sig. (2-
.579 .471 .441 .121 .718 .806 .818 .515
tailed)
N 10 10 10 10 10 10 10 10 10
Pearson * - -
-.015 -.414 -.752 -.460 .276 -.188 1 *
Correlation .084 .661
AIR Sig. (2-
.967 .234 .012 .181 .440 .603 .818 .037
tailed)
N 10 10 10 10 10 10 10 10 10
Pearson * - -
-.023 .487 .680 .462 -.273 .237 * 1
Correlation .234 .661
ER Sig. (2-
.950 .153 .030 .179 .446 .510 .515 .037
tailed)
N 10 10 10 10 10 10 10 10 10
*. Correlation is significant at the 0.05 level (2-tailed).
**. Correlation is significant at the 0.01 level (2-tailed).
56
Model summary for determinants of ROE
Model R R Square Adjusted R Std. Error of the
Square Estimate
a
1 .976 .953 .577 .05965
Total .076 9
57
Excluded variable in the ROE model
Model Beta In t Sig. Partial Collinearity
Correlation Statistics
Tolerance
b
1 Asset quality -1822.075 . . -1.000 1.415E-008
Total .001 9
58
Coefficients for ROA model
Model Unstandardized Coefficients Standardized t Sig.
Coefficients
Tolerance
b
1 Asset quality -1757.584 . . -1.000 1.415E-008
59