The Impact of Corporate Governance Mechanisms on Firm's Financial

Performance: Evidence from Commercial Banks in Ethiopia

Yenesew Ferede

A Thesis Submitted to
The Department of Accounting and Finance

Presented in Partial Fulfillment of the Requirements for the Degree of

Master of Business Administration in Finance

Addis Ababa University

Addis Ababa, Ethiopia
June 2012

i
 Addis Ababa University
School of Graduate Studies
This is to certify that the thesis prepared by Yenesew Ferede, entitled: The Impact of
Corporate Governance Mechanisms on firm's Financial Performance: Evidence from
Commercial Banks in Ethiopia and submitted in partial fulfillment of the requirements
for the Degree of Master of Business Administration in Finance complies with the
regulations of the University and meets the accepted standards with respect to originality
and quality.

Approved by the examining committee

Examiner _________________________ Signature ___________Date______________

Examiner__________________________ Signature ___________ Date______________

Advisor Signature ____________Date_____________

________________________________
Chair of department or Graduate program coordinator

ii
 Abstract
The Impact of Corporate Governance Mechanisms on Firm's Financial Performance:
Evidence from Commercial Banks in Ethiopia

Yenesew Ferede
Addis Ababa University, 2012

Corporate governance has become an issue of global significance and has received new

urgency due to various corporate scandals and failure. This paper investigates the impact

of corporate governance mechanisms on firms' financial performance using five years

data from the year 2007 to 2011 with a sample of eight Ethiopian commercial banks.

Three financial performance indicators such as return on asset, return on equity and net

interest margin were used. Corporate governance mechanisms considered in this study

include board size, board gender diversity, board members educational qualification,

board members business management and industry specific experience, and audit

committee size. The study controls the effect of size, leverage and growth of banks. The

regression results show that large size board and audit committee negatively influences

financial performance; whereas board members educational qualification positively

associated with financial performance. While industry specific experience of director

positively related with return on asset but it has a negative effect on net interest margin.

Finally, the percentage of female directors and board members business management

experience does not have a significant effect. In general, the findings suggest that banks

with effective corporate governance mechanisms improve financial performance

depending on the measure used although not all corporate governance mechanisms are

significant.

Keywords: Corporate Governance Mechanisms, Agency Theory, Financial Performance

Commercial Banks and Ethiopia.

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 Acknowledgments

First and foremost, thanks to the Almighty God and St. Mary for helping me in every

aspects of my life.

I would like to extend my heartfelt gratitude and indebtedness to my thesis advisor,

Abebe Yitayew (Associate Prof.), whose unreserved guidance, invaluable assistance and

constructive comments encouraged me to timely and successfully carry out my thesis. I

greatly benefited from his quick response, expertise and exceptional practical advice

during the course of my research work.

I am also indebted to the employee of national bank of Ethiopia, and all respective

commercial banks board chair man and board chair man secretary for their willingness

and valuable contribution in providing me necessary data. Without their unreserved help,

completion of this paper will not be possible.

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 Table of Contents
List of Figure ........................................................................................................................ viii

List of Tables .......................................................................................................................... ix

Acronyms and Abbreviations ..................................................................................................x

Chapter One: Introduction

1.1 Background of the study.....................................................................................................1

1.2. Statement of the problem ..................................................................................................3

1.3. Hypotheses ........................................................................................................................4

1.4 Objectives of the study .......................................................................................................5

1.4.1 General objective of the study....................................................................................5

1.4.2 Specific objectives of the study..................................................................................5

1.5 Significance of the study ....................................................................................................6

1.6 Delimitation of the study ....................................................................................................6

1.7 Limitation of the study .......................................................................................................7

1.8 Structure of the study .........................................................................................................7

Chapter Two: Literature Review

2.1 Theoretical framework of the study ...................................................................................9

2.1.1 Agency theory ..........................................................................................................10

2.1.2 Stakeholders theory ..................................................................................................14

2.1.3 Resource dependency theory....................................................................................16

2.2 Conceptual framework of the study .................................................................................19

2.3 Corporate governance and the special nature of banks ....................................................19

2.4 Overview of Ethiopian banking industry .........................................................................22

2.5 Corporate governance mechanisms and firm financial performance ...............................24

2.5.1 Board size .................................................................................................................27

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 2.5.2 Board gender diversity .............................................................................................28

2.5.3 Educational qualification..........................................................................................29

2.5.4 Business management experience ............................................................................30

2.5.5 Industry specific experience .....................................................................................30

2.5.6 Audit committee size................................................................................................31

2 .6 Review of previous empirical studies..............................................................................32

Chapter Three: Methodology

3.1 Research design ................................................................................................................42

3.2 Source of data and collection methods .............................................................................42

3.3 Sampling design ...............................................................................................................43

3.4 Description of variables and measurements .....................................................................43

3.4.1 Dependent variables .................................................................................................44

3.4.2 Independent variables ...............................................................................................45

3.4.3 Control variables ......................................................................................................47

3.5 Specifications of empirical research model ......................................................................48

3.6 Operational definitions .....................................................................................................50

3.7 Method of data analysis ...................................................................................................50

Chapter Four: Results and Discussion

4.1 Descriptive statistics of the study variables......................................................................51

4.2 Correlation analysis of the study variables .......................................................................55

4.2.1 Correlation analysis of ROA and corporate governance mechanisms .....................56

4.2.2 Correlation analysis of ROE and corporate governance mechanims .......................59

4.2.3Correlation analysis of NIM and corporate governance mechanism ........................61

4.3 Regression Results and Discussion ..................................................................................64

4.3.1 Diagnostic tests of the data set ................................................................................65

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 4.3.2 Corporate governance mechanisms: Results and Discussion ..................................71

4.3.3 Control variables: Results and Discussion ...............................................................79

Chapter Five: Conclusion and Recommendations

5.1 Conclusion ........................................................................................................................82

5.2 Recommendations ............................................................................................................85

5.3 Avenue for future research ...............................................................................................86

References
Appendices
Appendix I: Research questionnaire
Appendix II: Diagnostic test result for OLS assumption
Appendix III: List of sample commercial banks

vii
 List of Figure

Figure No. Title of Figure Page

Figure 2.1 Conceptual framework of the study .......................................................................19

viii
 List of Tables

Table No. Title of tables Page

Table 4.1 Descriptive statistics of the study variables...............................................................52

Table 4.2 Correlation analysis of ROA and corporate governance mechanisms.......................57

Table 4.3 Correlation analysis of ROE and corporate governance mechanisms.......................60

Table 4.4 Correlation analysis of NIM and corporate governance mechanisms.......................62

Table 4.5 Summary of regression results of the three models...................................................70

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Acronyms and Abbreviations

AUDSIZE Audit committee size

BG Bank growth

Birr Ethiopian currency

BLEV Banks Leverage

BMEXP Board members Business Management Experience

BQUAL Board members Educational Qualification

BS Bank Size

BSIZE Board Size

FD Female Directors on the board

ICGN International Corporate Governance Network

INDUEXP Board members industry specific experience

NIM Net Interest Margin

OECD Organization for Economic Cooperation and Development

OLS Ordinary Least Square

Q. No Question Number

ROA Return on Asset

ROE Return on Equity

VIF Variance Inflation Factor

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 Chapter One
Introduction
1.1 Background of the study

Corporate governance has become an issue of global significance. The improvement of

corporate governance practices is widely recognized as one of the essential elements in

strengthening the foundation for the long-term economic performance of countries and

corporations (Ibrahim et al., 2010). It has received new urgency because of global

financial crisis and major corporate failures that shock major financial centers of the

world (Imam & Malik, 2007). Hence, corporate governance has become an important

factor in managing organizations in the current global and complex environment.

Corporate governance can be defined as a frame work that protect stakeholders rights by

illustrating an effective board of directors, efficient internal control and audit in addition

to reliable financial reporting and disclosure (Hassn, n.d.). Melvin and Hirt (2005)

described corporate governance as referring to corporate decision-making and control,

particularly the structure of the board and its working procedures.

The separation of ownership and control in modern corporations leads to an agency

problem where the agent operates the firm in line with their own interests, instead of

shareholders (Jensen & Meckling, 1976). The need for corporate governance arises from

these potential conflicts of interest among stakeholders such as shareholders, board of

directors and managers in the corporate structure. According to Imam and Malik (2007)

these conflicts of interest often arise from two main reasons. First, different participants

have different objectives and preferences. Second, the participants have imperfect

information as to each other’s actions, knowledge, and preferences. Corporate

1
governance is intended at reducing divergence of interest and monitoring of controlling

interests of the firm, the absence of which firm value is declined (Nanka-Bruce, 2009).

There are different mechanisms adopted that safeguard the interests of the stakeholders

(Sanda et al., 2005). Such corporate governance mechanisms include board size, board

gender diversity, size of audit committee, and board of directors’ educational

qualification and experience. Many researchers have studied the impact of corporate

governance mechanisms on firms’ performance from different perspectives in different

environments using a number of variables of interest (see for instance Sanda et al., 2005;

Abu-Tapanjeh, 2006; Aljifri & Moustafa, 2007; Ibrahim et al., 2010; Al-Hawary, 2011;

Khatab et al., 2011). The researchers’ found mixed results on the relationship between

corporate governance mechanisms and firms’ performance.

According to Abu-Tapanjeh (2006) good corporate governance is a fundamental

necessity to keep on running a firm successfully. It has long been played a crucial role for

enhancing the long-term value of stakeholders in the business environment. Corporate

governance provides a structure that works for the benefit of the firm and can help in

increasing firm’s performance by reducing agency problem (Khan et al., 2011).

According to Lupu and Nichitean (2011) corporate governance of banks in developing

economies is of even greater importance given the dominant position of banks as

providers of fund. In developing economies banks are typically the most important source

of finance for the majority of firms. A sound financial system is based on profitable and

adequate capitalized banks. As it is said by different researchers performance of banks is

affected by good corporate governance practice and policies. Despite this aspect, little

2
attention has been paid to the research of corporate governance mechanisms in less

developed economies in general and particularly in Ethiopia. The aim behind this effort is

to aware the banking industry of Ethiopia about the benefits of good corporate

governance mechanisms and its impact on financial performance so that they can avail all

opportunities to compete not only at national level but also at international level as well.

1.2 Statement of the problem

Given the importance of corporate governance, several studies have been conducted in

developed countries on the relationship between corporate governance mechanisms and

firms’ financial performance and found mixed results (See for example Bauer, et al.,

2008; Ibrahim, et al., 2010; Lupu & Nichitean, 2011). However, most of the prior studies

have been undertaken on large firms operating within well organized corporate

governance mechanisms in developed economic system. Various governance

mechanisms operate differentially for different sizes of firms (Habbash, 2010). Therefore,

it is difficult to generalize the same result from the findings of those studies for relatively

small size Ethiopian commercial banks governance mechanisms.

Furthermore, Ethiopia’s corporate governance landscapes are embedded in a setting that

differs from a western context in several ways (Dessalegn & Mengistu, 2011). Ethiopian

banks corporate governance is characterized by the absence of an organized share market

and the country has different regulations, practices, and economic features which needs to

conduct a separate study. Nevertheless, as far as the researcher’s knowledge concerned,

research studies exclusively on the impact of corporate governance mechanisms on

banks’ financial performance are scanty in less developed countries and in Ethiopia it is

3
an ignored area of research. Hence, given this gap, this study contributes to the existing

body of knowledge and bridge the gap by studying the issue with Ethiopian commercial

banks.

Banking industry is the subject of analysis for corporate governance for two reasons;

firstly, even though information asymmetries exist in all sectors it is larger in banking

industry since banks are generally more opaque than non-financial firms (Levine, 2003).

This greater informational asymmetry between insiders (bank management) and outsiders

(shareholders and depositors), and the opacity of their assets and activities in banking

sector amplifies the agency problem. Thus, it requires giving special attention for banks

corporate governance mechanisms. Secondly, banks are corporations which activate

different areas of business. Banks have a dominant position in developing economic

financial systems, and are important engines of economic growth (Levine, 1997). Hence,

banking failure would affect the entire financial system and economy. Keeping this in

view and the potential contribution of the banking industry to the economy of developing

countries, this study is conducted to measure and analyze the impact of corporate

governance mechanisms on firms' financial performance using commercial banks in

Ethiopia.

1.3 Hypotheses
In this study the following testable hypotheses were developed.

(Ha: alternative hypothesis)

Ha1: There is a significant negative relationship between board size and financial

performance

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Ha2: There is a significant positive association between board gender diversity and

financial performance

Ha3: There is a significant positive association between board members educational

qualifications and financial performance

Ha4: There is a significant positive association between board members business

management experience and financial performance

Ha5: There is a significant positive association between board members industry specific

experience and financial performance

Ha6: There is a significant negative relationship between size of audit committee and

financial performance

1.4 Objectives of the study

1.4.1 General objective of the study

The general objective of this study is to examine the impact of corporate governance

mechanisms on firms’ financial performance by taking evidence from commercial banks

in Ethiopia controlling the influence of some selected bank specific variables using five

years data from the year 2007 up to 2011.

1.4.2 Specific objectives of the study

Given the overall objective of examining the impact of corporate governance

mechanisms on firms' financial performance using some selected commercial banks in

Ethiopia, this study had several specific objectives. Specifically, the study sought to:

1. Investigate the relationship between board size and bank performance

2. Examine the association between board gender diversity and bank performance

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 3. Ascertain the influence of the directors educational qualification on bank

performance

4. Identify whether directors business management experience affect bank

performance

5. Find out the influence of industry specific experience of directors on bank

performance

6. Explain the relationship between size of audit committee and bank performance

1.5 Significance of the Study

The result of this study will contribute to commercial banking firms by identifying

relevant corporate governance mechanisms and how these governance mechanisms affect

financial performance. The result of this study contributes to the existing literature by

providing evidence on the relation between corporate governance mechanisms and banks'

financial performance. The empirical results would also be the general indicators of

corporate governance mechanisms useful for regulators, policy makers, managers and

business people in making policies and decisions. It can serve as a stepping stone for

future researchers who want to conduct study on related topic.

1.6 Delimitation of the study

This study is delimited to examining the impact of corporate governance mechanisms on

firms’ financial performance by taking evidence from commercial banks in Ethiopia for

the period of five years, from 2007 to 2011. The dependent variables are delimited to

return on asset, return on equity and net interest margin. The explanatory variables are

delimited to board size, board gender diversity, directors' educational qualification,

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director's business management experience, directors' industry specific experience and

size of audit committee and the control variables are bank size, bank growth rate and

banks leverage. The study area of this research is delimited to commercial banks in

Ethiopia.

1.7 Limitations of the study

As with any other study, this study is subject to some limitations. In this study the

sample banks were selected purposively based on the age and availability of data. This

may introduce bias inherent with non-probability sampling method. However, this is

because there are only eight commercial banks that have complete data for the study

period others are established recently. Therefore, these banks were selected purposively.

The other limitation of this research is the financial performance of commercial banks in

Ethiopia is only measured by using accounting based measures. Therefore, only the

accounting measure of bank performance was used. These may limit the findings of this

study.

1.8 Structure of the Study

The thesis consists of five chapters. The first chapter introduces what the study is about,

the problem to be examined, the objectives, hypotheses, significance, delimitation and

limitations of the study. Chapter two provides a highlight of pertinent theoretical and

empirical reviews of the literature and conceptual framework relevant to the study. The

third chapter provides description about the methodology and the variables used in this

study. The fourth chapter presents the results and discussions of the study, based on data

collected from secondary and primary sources. The results of the descriptive statistics,

7
correlation analysis and regression analysis were also presented in the fourth chapter of

this study. The study ends with the conclusion and recommendations chapter that brings

to light the major findings of the study and possible recommendations in a manner that

relates to the topic, namely impact of corporate governance mechanisms on firms'

financial performance.

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 Chapter Two
Literature Review

2.1 Theoretical framework of the study

Corporate governance is the relationship among shareholders, board of directors and the

top management in determining the direction and performance of the corporation. It

includes the relationship among the many players involved (the stakeholders) and the

goals for which the corporation is governed (Kim & Rasiah, 2010).

According to Imam and Malik (2007) the corporate governance theoretical framework is

the widest control mechanism of corporate factors to support the efficient use of

corporate resources. The challenge of corporate governance could help to align the

interests of individuals, corporations and society through a fundamental ethical basis and

it fulfills the long term strategic goal of the owners. It will certainly not be the same for

all organizations, but will take into account the expectations of all the key stakeholders

(Imam & Malik, 2007). So maintaining proper compliance with all the applicable legal

and regulatory requirements under which the company is carrying out its activities is also

achieved by good practice of corporate governance mechanisms.

There are a number of theoretical perspectives which are used in explaining the impact of

corporate governance mechanisms on firms’ financial performance. The most important

theories are the agency theory, stakeholders’ theory and resource dependency theory

(Maher & Andersson, 1999).

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2.1.1 Agency theory

According to Habbash (2010) agency theory is the most popular and has received greater

attention from academics and practitioners. The agency theory is based on the principal-

agent relationships. The separation of ownership from management in modern

corporations provides the context for the functioning of the agency theory. In modern

corporations the shareholders (principals) are widely dispersed and they are not normally

involved in the day to day operations and management of their companies rather they hire

mangers (agent) to manage the corporation on behalf of them (Habbash, 2010). The

agents are appointed to manage the day to day operations of the corporation. The

separation of ownership and controlling rights results conflicts of interest between agent

and principal. To solve this problem or to align the conflicting interests of managers and

owners the company incurs controlling costs including incentives given for managers.

According to Bowrin and Navissi (n.d.) agency theory refers to a set of propositions in

governing a modern corporation which is typically characterized by large number of

shareholders who allow agents to control and manage their collective capital for future

returns. The agent, typically, may not always own shares but may possess relevant

professional skills and competence in managing the corporation. The theory offers many

useful ways to examine the relationship between owners and managers and verify how

the final objective of maximizing the returns to the owners is achieved, particularly when

the managers do not own the corporation’s resources. Agency theory identifies the role of

the monitoring mechanism of corporate governance to decrease agency costs and the

conflict of interest between managers and owners. It is clear that the principal-agent

10
theory is generally considered as the starting point for any debate on the issue of

corporate governance.

Agency theory having its roots in economic theory was exposited by Alchian and

Demsetz (1972) and further developed by Jensen and Meckling (1976). Jensen and

Meckling (1976) defined agency relationship as a contract under which the principal

engage another person or the agent to perform some service on their behalf which

involves delegating some decision making authority to the agent. If both parties to the

relationship are utility maximizes, there is good reason to believe that the agent will not

always act in the best interests of the principal. The principal can limit divergences from

his interest by establishing appropriate incentives for the agent and by incurring

monitoring costs designed to limit the irregular activities of the agent.

Control of agency problems in the decision process is important when

the decision managers who initiate and implement important decisions
are not the major residual claimants and therefore do not bear a major
share of the wealth effects of their decisions. Without effective control
procedures, such decision managers are more likely to take actions that
deviate from the interests of residual claimants. Individual decision
agents can be involved in the management of some decisions and the
control of others, but separation means that an individual agent does not
exercise exclusive management and control rights over the same
decisions (Fama & Jensen, 1983, p.304).
According to agency theory the agent strive to achieve his personal goals at the expense

of the principal. Mangers are mostly motivated by their own personal interests and

benefits, and work to maximize their own personal benefit rather than considering

shareholders interests and maximizing shareholders wealth. To reduce agency problem

there must be better monitoring and controlling mechanisms which helps to ensure that

managers pursue the interests of shareholders rather than only their own interests.

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 The agency problem can be set out in two different forms known as adverse
selection and moral hazard. Adverse selection can occur if the agent
misrepresents his ability to perform the functions assigned and gets chosen
as an agent. Moral hazard occurs if the chosen agent shirks the
responsibilities or underperforms due to lack of sufficient dedication to the
assigned duties. Such underperformance by an agent, even if acting in the
best interest of the principal, will lead to a residual cost to the principal.
These costs resulting from sub-optimal performance by agents are termed as
agency costs (Bathula, 2008, p.62).

The concept of corporate governance presumes a fundamental tension between

shareholders and corporate managers (Jensen & Meckling, 1976). While the objective of

a corporation’s shareholders is a return on their investment, managers are likely to have

other goals, such as the power and prestige of running a large and powerful organization,

or entertainment and other perquisites of their position. Managers’ superior access to

inside information and the relatively powerless position of the numerous and dispersed

shareholders, mean that managers are likely to have the upper hand (Fama & Jensen,

1983).

Therefore, shareholders monitor and controls managers through their representatives such

as board of directors. Boards of directors are considered as an important device to protect

shareholders from being exploited by managers and help to effectively control managers

when they try to maximize their self interest at the expense of the company’s

profitability. Fama and Jensen (1983) argues that in order to minimize agency problem

that emanates from the separation of ownership and control the corporations need to have

a mechanisms that enables to separate the authority of decision management from

decision control. This would reduce agency costs and ensures maximization of

shareholders wealth by effectively controlling the power and self-centered decisions of

management.

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The agency theory provides a basis for the governance of firms through various internal

and external mechanisms. Corporate governance mechanisms are designed to align the

interest of owners and managers, constrained the opportunistic behaviors of managers

and protect shareholder interests, generally to solve agency problem (Habbash, 2010).

Corporate governance is a mechanism through which shareholders are assured that

managers will act in their best interests and it limits agency problems. Agency theory

suggests that there are a number of mechanisms to reduce the agency problem in the

company such as choosing appropriate board composition (in terms of size, gender,

experience and competence), effective audit committee, and the threat of firing

(Tandelilin et al., 2007).

From agency theory view point, corporate governance improves corporate performance

by resolving agency problems through monitoring management activities, controlling

self-centered behaviors of management and inspecting the financial reporting process

(Habbash, 2010). Moreover, corporate governance is able to alleviate agency costs by

aligning the conflicting interests of management and shareholders through monitoring

management and using different corporate governance mechanisms. Therefore, corporate

governance mechanism such as boards of directors and audit committees enables

shareholders to closely monitor the activities of managers. Ineffective board and audit

committee may give confidence for managers to pursue their own interests but effective

board and audit committee can reduce deceptive behavior of managers by detecting

fraudulent financial report and actively monitoring.

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According to the assumptions of agency theory corporate governance mechanisms affect

financial performance. As a consequence, enhancing corporate governance mechanisms

should result in improved financial performance. Taking agency theory into

consideration, the study variables were identified with the aim of examining the

relationships between corporate governance mechanisms and financial performance.

Board structure has relied heavily on the concepts of agency theory, focusing on the

controlling function of the board (Habbash, 2010). The corporate governance

mechanisms considered in this research include board size, board gender diversity,

educational qualification of board members, general and industry specific experience of

board members and audit committee size.

2.1.2 Stakeholders theory

Stakeholder theory is an extension of the agency theory, where the agency theory expects

board of directors to protect only the interests of shareholders. However, stakeholder

theory extends the narrow focus of agency theory on shareholders interest to stakeholders

to take into account the interests of many different groups and individuals, including

interest groups related to social, environmental and ethical considerations (Freeman et al.,

2004).

According to Freeman et al. (2004), stakeholder theory begins with the assumption that

values are necessarily and explicitly a part of doing business. It asks managers to

articulate the shared sense of the value they create, and what brings its core stakeholders

together. It also pushes managers to be clear about how they want to do business,

specifically what kinds of relationships they want and need to create with their

14
stakeholders to deliver on their purpose. According to stakeholder theory the purpose of

the firm is to serve and coordinate the interests of its various stakeholders such as

shareholders, employees, creditors, customers, suppliers, government, and the

community.

According to Habbash (2010), stakeholder refers to any one whose goals have direct or

indirect connections with the firm and influenced by a firm or who exert influence on the

firms goal achievement. These include management, employees, clients, suppliers,

government, political parties and local community.

According to this theory, the stakeholders in corporate governance can create a favorable

external environment which is conducive to the realization of corporate social

responsibility. Moreover, the stakeholders in corporate governance will enable the

company to consider more about the customers, the community and social organizations

and can create a stable environment for long term development. The benefit of the

stakeholder model emphasis on overcoming problems of underinvestment associated with

opportunistic behavior and in encouraging active co-operation amongst stakeholders to

ensure the long-term profitability of the business firm (Maher & Andersson, 1999)

According to Kyereboah-Coleman (2007) management receive capital from shareholders,

they depend upon employees to accomplish the objective of the company. External

stakeholders such as customers, suppliers, and the community are equally important, and

also constrained by formal and informal rules that business must respect. According to

stakeholders theory the best firms are ones with committed suppliers, customers, and

employees and management. Recently, stakeholder theory has received attention than

15
earlier because researchers have recognized that the activities of a corporate entity impact

on the external environment requiring accountability of the organization to a wider

audience than simply its shareholders (Kyereboah-Coleman, 2007). Companies are no

longer the instrument of shareholders alone but exist within society. It has responsibilities

to the stakeholders. However, most researchers argue that it is unrealistic task for

managers (Sundaram & Inkpen, 2004b; Sanda et al., 2005). The stakeholder theory has

not been subjected to much empirical study. The common criticisms for stakeholder

theory is that how to align the stakeholders conflicting interests since the difficulties

result from how to administer different stakeholders with various needs and demands. It

is not possible to treat all stakeholders equally (Habbash, 2010). Moreover, it is not

practical for all stakeholders to be effectively represented in corporate governance

recommendations as this may undermine the welfare of company (Habbash). The other

critique of the stakeholder model is that managers or directors may use “stakeholder”

reasons to justify poor company performance (Maher & Andersson, 1999).

2.1.3 Resource dependency theory

Whilst the stakeholder theory focuses on relationships with many groups for individual

benefits, resource dependency theory concentrates on the role of board directors in

providing access to resources needed by the firm (Abdullah & Valentine, 2009).

According to this theory the primary function of the board of directors is to provide

resources to the firm. Directors are viewed as an important resource to the firm. When

directors are considered as resource providers, various dimensions of director diversity

clearly become important such as gender, experience, qualification and the like.

According to Abdullah and Valentine, directors bring resources to the firm, such as

16
information, skills, business expertise, access to key constituents such as suppliers,

buyers, public policy makers, social groups as well as legitimacy. Boards of directors

provide expertise, skills, information and potential linkage with environment for firms

(Ayuso & Argandona, 2007).

The resource based approach notes that the board of directors could support the

management in areas where in-firm knowledge is limited or lacking. The resource

dependence model suggests that the board of directors could be used as a mechanism to

form links with the external environment in order to support the management in the

achievement of organizational goals (Wang, 2009).

The agency theory concentrated on the monitoring and controlling role of board of

directors whereas the resource dependency theory focus on the advisory and counseling

role of directors to a firm management. Recently, both economists and management

scholars tend to assign to boards the dual role of monitors and advisers of management.

However, whether boards perform such functions effectively is still a controversial issue

(Ferreira, 2010). Within a corporate governance framework, the composition of corporate

boards is crucial to aligning the interest of management and shareholders, to providing

information for monitoring and counseling, and to ensuring effective decision-making

(Marinova et al., 2010). The dual role of boards is recognized. However, board structure

has relied heavily on agency theory concepts, focusing on the control function of the

board (Habbash, 2010).

Each of the three theories is useful in considering the efficiency and effectiveness of the

monitoring and control functions of corporate governance. But, many of these theoretical

17
perspectives are intended as complements to, not substitutes for, agency theory (Habbash,

2010).

Among the various theories discussed, agency theory is the most popular and has

received the most attention from academics and practitioners. According to Habbash

(2010), the influence of agency theory has been instrumental in the development of

corporate governance standards, principles and codes. Mallin (2007) provides a

comprehensive discussion of corporate governance theories and argues that the agency

approach is the most appropriate because it provides a better explanation for corporate

governance roles (as cited by Habash, 2010).

To sum up, this study will draw on agency theory to test whether hypothesized

relationships exist between corporate governance mechanisms and firms' financial

performance. The agency theory framework has the ability to explain corporate

governance mechanisms. It can also explain the expected association between corporate

governance mechanisms and financial performance as shown in figure 2.1 below in the

conceptual framework section.

18
 2.2 Conceptual framework of the study
Based on the agency theory the following diagrammatic framework is developed.

Figure 2.1

Separation of
Ownership & Control
(Agency Problem)

Minimize
Decrease

Corporate Governance
Mechanisms

Small board size I
Control variables
n Financial

Board gender diversity Performance  Bank Size
c  Return on asset

Board members  Bank Growth Rate
r
educational qualifications  Return on equity
e  Bank Leverage

Board members business a  Net interest margin
management experience
s

Board members industry e
specific experience

Small size audit

committee

Source: Researchers design

2.3 Corporate governance and the special nature of banks

According to Levine (2003) banks played a pivotal role for industrial expansion, the

corporate governance of firms, and capital allocation. When banks efficiently mobilize

and allocate funds, this lowers the cost of capital to firms, boosts capital formation, and

19
stimulates productivity and economic growth. Thus, the proper functioning of banks has

implications for the operations of firms and the prosperity of countries.

Given the importance of banks, the governance of banks themselves has been played a

central role (Levine, 2004). If banks designed sound corporate governance mechanisms,

the bank can allocate capital efficiently and improve its performance and effective

corporate governance protect the interests of shareholders as well as other stakeholders.

In contrast, if the banks face poor corporate governance mechanisms, it is less likely to

allocate capital efficiently. The bank manager will enjoy enormous discretion to act in

his/her own interest rather than in the interests of shareholders or other stakeholders. This

leads to banking failure. Banking crises dramatically advertise the enormous

consequences of poor governance of banks (Levine, 2004). Therefore, improving banking

sector corporate governance principles plays a decisive role to fostering improvement in a

business climate and the economy as a whole.

The multiplicity of stakeholders complicates financial sector corporate governance. In

addition to investors and depositors, organizers are directly concerned with the bank's

performance. At the macroeconomic level, organizers are concerned with the effect of

governance on financial institutions' performance, because the economy's health and

safety largely depends on their performance (Al-Hawary, 2011).

According to Levine (2003) banks have two related characteristics that induce a separate

analysis of the corporate governance of banks. First, banks are generally more opaque

than non financial firms. Even though information asymmetries exist in all sectors it is

larger in banking industry due to the opaqueness of their assets and activities. In banking,

20
loan quality is not readily observable and can be hidden for long periods. Furthermore,

banks can alter the risk composition of their assets more quickly than most non-financial

industries, and bank managers can hide problems by extending loans to clients that

cannot service previous debt obligations. The greater information asymmetry between

insiders and outsiders and relatively severe difficulties in acquiring information about

bank activities and monitor continuing bank activities intensifies the agency problem.

This makes the corporate governance mechanism of banks significant.

Second, banks are normally very heavily regulated. Governments impose heavy

regulation. The reason is banks are important for the economy of countries, banks assets

and activities are opaque this results difficulty of monitoring, and banks are a ready

source of fiscal revenue. At the extreme, governments own banks. Actually, banking is

not the only regulated industry and governments own other types of firms. However,

even countries that intervene little in other sectors tend to impose extensive regulations

on the banking industry.

Corporate governance broadly viewed as the methods by which suppliers of finance

control managers in order to ensure that their capital cannot be expropriated and to ensure

that they earn appropriate return on their investment (Shleifer & Vishny, 1997). The

special nature of banking requires not only a broader view of corporate governance, but

also government intervention in order to control the opportunistic behavior of bank

management (Arun & Turner, 2004). The unique nature of the banking firm, whether in

the developed or developing world, requires sound corporate governance, which

encapsulates both shareholders and depositors, be adopted for banks.

21
Corporate governance for banking industry is of even greater importance to the

international financial system and merits the stakeholders and countries due to the

important financial intermediation role of banks in an economy, and their high degree of

sensitivity to potential difficulties arising from ineffective corporate governance and the

need to safeguard depositors’ funds (Basel Committee on Banking Supervision, 2006).

Effective corporate governance practices are essential to achieving and maintaining

public trust and confidence in the banking system, which are critical to the proper

functioning of the banking sector and economy as a whole. Poor corporate governance

may contribute to bank failures, which can pose significant public costs and

consequences due to their potential impact on any applicable deposit insurance systems

and the possibility of broader macroeconomic implications (Basel Committee on Banking

Supervision, 2006).

2.4 Overview of Ethiopian banking industry

Services organizations in general and financial services in particular are considered to be

the key factor for growth and success of projects in both industrial and developing

countries (Tarawneh, 2006). However, the commercial banks take pride in offering

customers a full range of banking services inside and outside of Ethiopia.

The Ethiopian financial sector is dominated by the banking sector. Banks are the

important component of any financial system. They play important role of channeling the

savings of surplus sectors to deficit sectors. The efficiency and competitiveness of

banking system defines the strength of any economy. Like other developing countries in

Ethiopia banks plays a vital role in the process of economic growth and development.

22
The Ethiopian banking sector comprises one development bank, and fifteen commercial

banks out of which two banks are state owned.

The Ethiopian banking system has been regulated with its own key regulatory feature.

According to Mulugeteta (2010) the key regulatory features were interest rate regulation,

credit restrictions, equity market controls and foreign exchange controls. Although some

restrictions are still in operation regulations which are affecting banks are being relaxed

after implementing the financial liberalization (1992) measures. Consequently, the

private sector financial institutions are growing but major commercial banks and

specialized institutions still remain within the public sector.

The financial liberalization reform of 1992 allowed the participation of private financial

institutions in the economy. Private Banks’ participation has increased and hence the

share of their banking assets to total commercial banking assets increases. As in most

developing countries, financial sector policy in Ethiopia aims at achieving more effective

intermediation, and improving soundness and depth (Mulugeteta, 2010). According to

Mulugeteta the Ethiopian authorities have chosen to pursue these goals within a

distinctive strategic framework for the financial sector, and emphasize the importance of

further strengthening corporate governance and accountability of financial institutions,

and boosting the capacity of financial sector professionals. Ensuring better corporate

governance of corporations, financial institutions and markets is increasingly recognized

as a pre-condition for the countries development

The bank corporate governance process is a complex framework. This governance

framework encompasses a bank’s stockholders, its managers and other employees, and

23
the board of directors. Banks further operate under a unique system of public oversight in

the form of bank supervisors and a comprehensive body of banking laws and regulations.

The interaction between all of these elements determines how well the performance of a

bank will satisfy the desires of its stockholders, while also complying with public

objectives (Adusei, 2011).

In Ethiopia the corporate governance of banks is directed and supervised by the central

bank. The National Bank of Ethiopia monitors and controls the banking business and

functions as regulators of the country's money supply. Accordingly, national bank of

Ethiopia issued directives on the size, composition and competence of board of directors.

According to banking business Proclamation (No. 592/2008) the national bank is

responsible to issue directives on the qualification and competency to be fulfilled by

directors; the minimum number of directors in the membership of the board of a bank;

the duties, responsibilities and good corporate governance of the boards of directors of

bank; the maximum number of years a director may serve in any bank.

2.5 Corporate governance mechanisms and firms financial performance

Many studies revealed the effect of corporate governance mechanisms on firms’ financial

performance (See for example Sanda et al, 2005; Aljifri & Moustafa, 2007; Sunday O,

2008; Lupu & Nichitean, 2011; Al-Hawary, 2011; Khan et al., 2011; Al Manaseer et al.,

2012). Adopting better corporate governance mechanisms such as an enhanced board and

audit committee improves monitoring of management and reduces information

asymmetry problems (Aldamen et al., 2011). There is a significant literature that links

24
size, gender diversity, and other characteristics of the board of directors and audit

committees to improved firm performance (Klein, 1998; Aldamen et al, 2011).

Corporate governance mechanisms have been identified as an essential tools needed in

managing any corporation including banks. There are different mechanisms that reduce

agency cost whereby corporate governance can be measured in an organization. In the

corporate governance literature board characteristics (board size, board gender diversity

and educational qualification and experience) and audit committee size were used as

corporate governance mechanisms.

International organizations such as Organization for Economic Cooperation and

Development (OECD) and International Corporate Governance Network (ICGN) have

developed corporate governance principles which stressed on the role of boards.

According to Bathula (2008), corporate governance principles focus on the importance of

corporate governance for long-term economic performance and strengthening of

international financial system. A strong board can play a decisive role in improving firm

financial performance. The important role of boards is to act as an internal governance

mechanisms and monitoring of management (Shleifer & Vishny, 1997). An effective

board is likely to help the firm achieve better performance by effectively undertaking

their monitoring duties (Bathula, 2008).

Board of directors is an important corporate governance mechanism (Aljifri & Moustafa,

2007). Boards of directors are the agent of the shareholders and their primary task is to

monitor and control firm management on behalf of shareholders to reduce agency

problem. In modern corporations boards of directors are charged with the task of

25
monitoring the activities of top management to ensure that the managers act in the best

interests of shareholders (Jensen & Meckling, 1976). From the agency theory point of

view boards have play decisive role in alleviating agency problems that arising from the

separation of ownership and control of firms (O’Connell & Cramer, 2010). In doing so

the board of directors need to be effectively supervise the activities of top management.

The effectiveness of the board is influenced by factors such as board composition and

quality, size of board, , board diversity, board committee effectiveness such as audit

committee and information asymmetries ultimately this affects the board oversight

performance (Uadiale, 2010). When the board is effective it is expected to drive the

company towards better financial achievement (Andres & Vallelado, 2008).

When financial markets are not well developed as an efficient external control

mechanism and when the shareholders are not well protected due to weak legal system

and poor law enforcement the role of the board of director becomes highly significant as

an internal control mechanism (Gonz´alez & Garay, 2003). Boards of director are the

heart of corporate governance. However, the effectiveness of the board of directors as

shareholders’ monitoring mechanism can only be efficient if bounded with appropriate

size, composition and sub-committee (Lawal, 2012).

The audit committee is a sub-committee of the board of directors and its primary role is

to monitor and review financial statements (Yammeesri & Herath, 2010). An audit

committee has a particular role of ensuring that the interests of shareholders are properly

protected in relation to financial reporting and internal control (Habbash, 2010). The use

of an audit committee is an important part of the decision control system for internal

26
monitoring by boards of directors (Fama & Jensen, 1983). Monitoring is performed by

external audit and audit committees. The existence of an audit committee improves the

monitoring of corporate financial reporting and internal control and it helps to promote

good corporate governance in turn this improves firms’ financial performance by

reducing agency cost (Al –Sa’eed & Al-Mahamid, 2011). Size is vital characteristics of

audit committees (Habbash, 2010).

2.5.1 Board size

According to Kiel and Nicholson (2003) board size is crucial to achieving the board

effectiveness and improved firm performance. According to Lawal (2012), board size

affects the quality of deliberation among members and ability of board to arrived at an

optimal corporate decisions. Therefore, identifying the appropriate board size is essential

because size can be detrimental to corporate governance effectiveness beyond optimal

level. However, determining an ideal size of the board has being an ongoing and

controversial debate in corporate governance literature (Lawal, 2012). Whether large or

small board help improve firm performance it is debatable issue and researchers found

mixed result about the relation between board size and firm performance.

Jensen (1993) argues that a larger board leads to less effective monitoring due to

coordination and process problems inherent in large board size. Larger boards can be less

participative, less cohesive, and less able to reach consensus. Coordination,

communication and decision-making problems increasingly impede company

performance when the number of directors increases (Yermack, 1996 as cited by Uadiale,

2010). Al-Manaseer et al. (2012) also argues that boards with too many members lead to

27
problems of coordination in decision making. Small board size was favored to promote

critical, genuine and intellectual deliberation and involvement among members which

presumably might led to effective corporate decision making, monitoring and improved

performance (Lawal, 2012). In contrast Klein (2002) suggested that larger boards able to

promote effective monitoring due to their ability to distribute the work load over a greater

number of observers. Thus, board size can influence the financial performance of firms.

2.5.2 Board gender diversity

Gender diversity is part of the broader concept of board diversity. Boards are concerned

with having right composition to provide diverse perspectives. Greater female

representation on boards provides some additional skills and perspectives that may not be

possible with all-male boards (Boyle & Jane, 2011). Board diversity promotes more

effective monitoring and problem-solving. He suggests that female board members will

bring diverse viewpoints to the boardroom and will provoke lively boardroom

discussions.

Gender diversity in the boards is supported by different theoretical perspectives. Agency

theory is mainly concerned about monitoring role of directors. Representation from

diverse groups will provide a balanced board so that no individual or group of individuals

can dominate the decision-making of the board (Erhardt et al., 2003). The management

may be less able to manipulate a more heterogeneous board to achieve their personal

interests. Gender diversity is associated with effectiveness in the oversight function of

boards of directors. The oversight function may be more effective if there is gender

diversity in board which allows for a broader range of opinions to be considered.

28
According to Erhardt et al. (2003), diversity of the board of directors and the subsequent

conflict that is considered to commonly occur with diverse group dynamics is likely to

have a positive impact on the controlling function and could be one of several tools used

to minimize potential agency issues.

From stakeholders' theory, diversity also provides representation for different

stakeholders of the firm for equity and fairness (Keasey et al., 1997). From resource

dependency perspective, the board is a strategic resource, which provides a linkage to

various external resources (Walt & Ingley, 2003). This is facilitated by board diversity.

On the other hand, Rose (2007) revealed insignificant association between number of

women directors on the board and firm performance. However, many scholars now

believe that an increase in board diversity leads to better boards and governance on the

ground that diversity allows boards to tap on broader talent pools for the role of directors

(Bathula, 2008). However, as he stated in corporate world women representation on

boards is very limited.

2.5.3 Educational qualification

Director's educational qualifications are central to effectively interpret and utilize the

information generated by the management of particular types of business enterprise.

Educational qualification is potentially important since the ability to seek and interpret

appropriate information is essential for the efficient operation of the modern corporation

and the effective control or guidance of management by boards of directors. Educational

qualification affects the oversight and monitoring role of boards of directors (Gantenbein

& Volonte, 2011).

29
Board of directors is vested with the responsibility of ensuring that the shareholders’

money is not wasted, shareholders have a serious interest in ensuring that the board is

staffed with well educated and experienced directors (Gantenbein & Volonte, 2011). The

human capital provided by its board of directors is vital given the corporate board is one

of the mechanisms for overseeing the firm and it can arguably provide the knowledge

needed to function in the new environment. Personal profile factors of directors such as

education and experience is important for board efficiency.

2.5.4 Business management experience

Business management experience of directors enables them to have better knowledge and

understanding about business and enable to contribute effectively in the decision making

process as well as in effectively monitoring the activities of management (Saat et al.,

2011). Directors need to be competent and capable of understanding the business

operation. Kroll, et al (2008) found that boards rich in appropriate experience are

associated with superior returns. He argues that boards comprising directors with

appropriate knowledge gained through experience can be not only better monitors, but

also more useful advisors to top managers. According to Castanias et al. (2001)

differences between firms in the human capital of boards of directors are related to

differences in strategic actions and performance. However, empirical studies examining

the effect of business experience of board members on firm performance is scarce.

2.5.5 Industry specific experience

Appointing directors with related and relevant skills and knowledge to perform task

specific duties such as the firm's internal control and procedures will enhance the quality

30
of information gathered and the solution to problems and of the views held and

judgments made during the decision-making process (DeZoort, 1998 as cited by Saat, et

al, 2011). Directors' specialist knowledge will be valuable to the creation of a strong and

informed board (Saat et al., 2011). He claimed that experience of directors enables them

to guide, steer and monitor the firm more effectively. In other words, their knowledge of

the industry, its opportunities and threats and their connections to the industry

participants based on their experience enables them to contribute substantively in the firm

performance. However, empirical studies examining the effect of business management

and industry specific experience of board members on firm performance is scarce in the

literature.

2.5.6 Audit Committee Size

According to Jensen and Meckling (1976) the audit committee plays a significant role in

the monitoring process carried out by the directors of the firm and auditing is used by

firms to reduce agency costs. In addition to that they revealed that most essential board

decisions originate at the committee level, and this includes the audit committee. Audit

committees thus, represent another internal governance mechanism whose impact is to

improve the quality of financial management of a company and hence its performance.

Kyereboah-Coleman (2007) reported a significant positive relation between size of the

audit committee and firm performance (ROA and Tobin’s q) using the overall sample.

Kyereboah-Coleman (2007) describe that size of the audit committee could be an

indication of the seriousness attached to issues of transparency by the organization.

However, only using Ghanaian sample the size of the audit committee showed a negative

31
effect on performance. He explained as free-ridership and difficulty in consensus building

in large groups leads to low performance. In addition, Lin et al (2006) found significant

positive association between audit committee size and occurrence of earnings

restatement. It was explained that a certain minimum number of audit committee

members may be relevant to the quality of financial reporting. Aldamen et al. (2011)

reveals that smaller audit committees with more experience and better educational

qualifications are more likely to be associated with positive firm performance.

2.6 Review of previous empirical studies

This section of literature review concentrates on previous studies that have been

conducted in relation to this study. There were mixed results concluded by previous

studies pertaining to the relationship between corporate governance mechanisms and

firms’ financial performance. The important empirical studies are summarized below in

this section.

The study undertaken by (Erhardt et al., 2003), provide evidence on the relationship

between demographic diversity on boards of directors and firm financial performance.

The relationship was examined using two years financial performance data and

percentage of women and minorities on boards of directors for 127 US companies.

Correlation and regression analyses indicate board diversity was positively associated

with financial indicators of firm performance (return on asset and return on investment).

Sanda et al. (2005) examined the relationship between corporate governance mechanisms

and firm financial performance in Nigeria using pooled ordinary least squares regression

analysis for a sample of 93 firms quoted on the Nigerian Stock Exchange for the period

32
1996 to 1999. The researcher used return on asset, return on equity, price earnings ratio

and Tobin Q as performance measure and director shareholding, board size, outside

directors, ownership concentration, and role of chief executive officer as explanatory

variables and firm size and leverage as control variables of the study. The study points

out that leverage, director shareholding, ownership concentration and separation of chief

executive officer and board chairman works help promote firm performance. Board size

and firm size negatively influence performance. The results find no evidence to support

the idea that boards with a higher proportion of outside directors perform better than

other firms, he found evidence that firms run by expatriate chief executive officers tend

to achieve higher levels of performance than those run by indigenous chief executive

officers.

Abu-Tapanjeh (2006) analyze the association between good corporate governance

mechanism and firms' operating and financial performance by employing multiple

regression models with panel data set based on 39 industrial companies listed in Amman

Stock Exchange of Jordan, over the period of 1992 to 2004. The proportion of outside

directors, family member on board, general manager duality, gear ratio and firm size was

the independent variables of the study whereas the net sales to operating cost ratio and

dividend payout ratio were used as a measure of firms’ operating and financial

performance, respectively. The results showed that proportion of outside directors,

general manager duality and firm size positively and significantly influences firms’

performance both operating and financial. Moreover, gear ratio had significant positive

influence on operating performance but insignificant in case of financial performance. On

33
the other hand, family members on board have not significant effect on firms’ operating

as well as financial performance.

Aljifri and Moustafa (2007) provided evidence on the impact of corporate governance

mechanisms on firms’ performance using 51 United Arab Emirates listed firms by using

both accounting and market data for the year 2004. They have employed cross-sectional

regression analysis to test whether the selected corporate governance variables have an

impact on firms’ performance or not after controlling firm size. The results of the study

showed that the governmental ownership, the debt ratio, and the payout dividends ratio

have a significant impact on the firm performance (Tobin’s Q); whereas the institutional

investors, the board size, the firm size, and the audit type have insignificant effect on

firms’ performance. The study was concluded that three of the corporate governance

mechanisms; governmental ownership, debt ratio, and the payout dividends ratio were

strong enough to affect the performance of United Arab Emirates listed firms.

Rose (2007) examine whether female board representation influence firm performance

using all Danish firms listed on the Copenhagen Stock Exchange during 1998–2001

excluding banks and insurance companies with 443 firm-time observations. Its objective

was to explore the impact of board diversity on firm performance. Cross sectional data

analysis method has been used. Tobin's Q was used as a measure of performance and

board gender diversity were measured as percentage of female directors and using

dummy variable. In addition the proportion of foreign directors and educational

background of directors based on their field of study such as lawyers, economists and

engineers also included as an explanatory variables. Payment to the board, growth,

34
ownership concentration and firm size were the control variables of the study. The study

does not find any significant link between firm performance as measured by Tobin’s Q

and female board representation, members’ educational background as well as the

proportion of foreign directors. He argued that board members with an unconventional

background are socialized unconsciously adopting the ideas of the majority of

conventional board members, which entails that a potential performance effect does not

materialize.

Bathula (2008) studied the association between board characteristics and firm

performance. Board characteristics which were considered in the research include board

size, director ownership, chief executive officer duality, gender diversity, educational

qualification of board members and number of board meetings. Additionally, firm age

and firm size was used as control variables. Firm performance was measured by return on

assets. To test the hypothesis a sample of 156 firms over a four year period data from

2004 to 2007 was used. The sample includes all firms listed on New Zealand stock

exchange. Empirical analysis was undertaken using Generalized Least Squares analyses.

The findings of the study showed that board characteristics such as board size, chief

executive officer duality and gender diversity were positively related with firm

performance, whereas director ownership, board meetings and the number of board

members with PhD level education was found to be negatively related. Firm age and firm

size does not have significant influence.

Babatunde and Olaniran (2009) analyze the effects of internal and external governance

mechanism on performance of corporate firms in Nigeria. In the study panel data

35
regression analysis was used with a sample of 62 firms listed on the Nigerian Stock

Exchange for a period of five years from 2002 to 2006 to examine the relationship

between internal and external governance mechanisms and corporate firms’ performance.

The researchers found a positive and significant relationship between board size, block

shareholders and leverage and the dependent variable Tobin’s Q. However, the study

revealed an inverse relationship between director’s shareholdings, firm size,

independence of the audit committee and the numbers of outside directors on board.

When the return on asset was used as the dependent variable significant positive

relationship of board size, block holders and leverage with return on asset was found.

However, there was a negative relationship between the number of outside directors on

board, director’s shareholdings, independence of the audit committee, firm size and the

return on asset. In addition, the study found that the measure of performance matter for

analysis of corporate governance studies. In some cases different result were obtained

based on the measure used.

Ibrahim et al. (2010) examined the role of corporate governance in firm performance.

Their study was a comparative analysis between chemical and pharmaceutical sectors of

Pakistan using a sample of five companies from each sector from the year 2005 to 2009.

Multiple linear regression models with panel data methodology were used. Return on

asset and return on equity was used as a measure of performance and they used three

corporate governance variables; board size, board independence and ownership

concentration. They found that in both sectors, the impact of corporate governance on

return on equity is significant but there is no significant impact on return on asset. In case

of sector wise analysis, there is an insignificant impact of corporate governance on return

36
on asset for chemical and pharmaceutical. On the other hand, there is a significant impact

of corporate governance on return on equity in chemical sector, but in pharmaceutical the

impact is insignificant.

Amran (2011) empirically studied the association between Corporate Governance

Mechanisms and Company Performances. It was expected that corporate governance

mechanisms affect company performance. The hypothesis was tested on 424 public listed

Malaysian Companies (233 family controlled firms and 191 non-family controlled firms)

and the data about corporate governance mechanisms and company's performance was

collected from Sultanah Bahiyah Library database from the year 2003 to 2007. Board

size, board independence, director's qualification, director's professional qualification,

leadership structure were used as a corporate governance mechanisms, debt, firm age and

firm size were used as a control variable while Tobin's Q were used as a measure of

company performance. Panel data methodology with generalized least square estimation

method was used to test the hypothesis. The analysis has been done by classifying the

sample as family controlled firm and non-family controlled firm. The researcher revealed

that director’s qualification measured as the percentage of directors with degree and

above divided by total directors helps to enhance the performance of non-family

controlled firms but insignificant for family controlled firms. Board size and leadership

duality was a significant negative influence on family controlled firms performance but

insignificant for non-family controlled firms. Firm age was a significant negative and

positive association between the performance of family controlled and non-family

controlled firms respectively. On the other hand, there was a significant negative

relationship between firm size and performance of both family controlled and non-family

37
controlled firms. The other variables such as board independence and director's

professional qualification were insignificant for both classes of firms.

Yasser (2011) provide evidence on the effect of corporate governance on firm

performance using 792 companies listed on Karachi Stock Exchange from 2003 to 2008

in Pakistani. Tobin’s Q, return on assets, operating cash flow has been used as a measure

of firms' performance; dummy variable for family-controlled firm, Board composition,

director’s educational qualification, directors Professional qualification, leadership

structure and frequency of board meetings were the independent variables of the study.

Moreover, debt, firm age and firm size were the control variables of the study. The study

revealed that there are significant difference between family and non-family controlled

firms’ performance when measured by Tobin Q, return on asset and operating cash flow.

For non-family controlled companies, the board governance variables such as board

composition, director’s educational qualification, director's professional qualification,

leadership structure have improved the firm performance. In addition, debt, firm size and

firm age affect a firm’s performance. It was evidenced that corporate governance does

play a vital role in influencing Pakistani companies’ financial performance.

Khatab et al. (2011) investigated the relationship between corporate governance and

firms’ performance the case of twenty firms listed at Karachi Stock Exchange. The

researchers’ used Pooled Ordinary Least Square estimation method with panel data set

that covers five years period from the year 2005 to 2009, with a sample of twenty firms.

Tobin’s Q, return on asset and return on equity were the dependent variables of the study

and firm size, leverage and growth were the independent variables of the study. The study

38
revealed that leverage and growth has positive and significant impact on Tobin’s Q and

return on asset. Like Tobin’s Q and return on asset leverage positively and significantly

influence return on equity. However, growth has a negative and significant impact on

return on equity. Size of the firms has remained insignificant. The researchers’

recommended to extend the study period, increase simple size and to include more

profitability ratios for further study.

Aldamen et al. (2011) conducted a study on the effect of audit committee characteristics

and firm performance during the global financial crisis. The researchers used logit model

analysis with a sample of 120 firms listed on the S&P300 during the period of 2008 and

2009. The study revealed that smaller audit committees with more experience and

financial expertise are more likely to be associated with positive firm performance in the

market. It also found that longer serving chairs of audit committees negatively impacts

accounting performance. However, accounting performance is positively impacted where

audit committees include block holder representation, the chair of the board, whose

members have more external directorships and whose chair has more years of managerial

experience.

Adusei (2011) investigated the relationship between board structure and bank

performance with panel data from the banking industry in Ghana by implementing

estimation method of regression is pooled OLS. A total sample of 17 out of 26 universal

banks was used in the study in this study. The researcher used return on asset and cost

income ratio as dependent variable of the study and board size and board independence as

independent variable of the study. In addition to this the researcher incorporated bank

39
age, bank size, funds, and ownership structure and listing status as a control variable of

this study. The study found that as the size of a bank’s board of directors decreases its

profitability increases. In addition to this board independence has a negative, but

statistically insignificant correlation with bank profitability. No significant relationship

between the size of a bank and its financial performance has been found. He

recommended that banks seeking some improvement in their performance should

constitute small sized boards of directors composed of few independent directors.

Al-Hawary (2011) examined the effect of banks governance on banking performance by

taking all Jordanian commercial banks listed in Amman Stock Exchange i.e. 13 banks.

The researcher employed multiple regression models to measure the influence of

corporate governance variables on banks performance by controlling bank's size.

According to the study executive officer duality and percentage of non-executive

directors had statistically significant positive effect on Tobin’s Q. whereas leverage value

had statistically significant negative effect on Tobin’s Q, and capital adequacy, size of

board of directors, the largest shareholder, block holders’ equity ratio and bank's size had

no statistically significant effect on Tobin’s Q.

Al-Manaseer et al. (2012) empirically investigated the impact of corporate governance on

performance using 15 Jordanian banks listed at Amman Stock Exchange from the year

2007 to 2009 with a total of 45 bank-year observation. The study employed pooled data,

and OLS estimation method with panel methodology. Return on asset, return on equity,

profit margin (measured as net interest income divided by total asset) and earning per

share were the dependent variables of the study and board size, board composition

40
(independence), chief executive officer status, foreign ownership and bank size were the

independent variables of the study. The study revealed a significant negative relation

between board size and banks performance as measured by return on equity and earning

per share but insignificant negative association of board size with return on asset and

profit margin was found. Bank size was negatively related with return on asset, return on

equity and profit margin but only significant with profit margin. The study also reveals a

positive association between board composition and foreign ownership and bank

performance. In addition, chief executive officer status has a negative influence. Finally,

the researchers suggest extending the study period.

Finally, as far as the researcher's knowledge concerned there is no research that has been

conducted to provide empirical evidence particularly on the impact of corporate

governance mechanisms on financial performance of commercial banks in Ethiopia.

Given this lack of empirical studies, this study fills the gap and provides empirical

evidence on the impact of corporate governance mechanisms on financial performance of

selected commercial banks in Ethiopia by taking in to consideration the variables related

to the realities of the commercial banks governance mechanism in Ethiopia.

41
 Chapter Three
Methodology

3.1 Research design

The primary aim of this study is to examine the impact of corporate governance

mechanisms on firm's financial performance. To achieve this objective explanatory type

of research design with a mixed approach, more of quantitative, was employed. The

explanatory type of research design helps to identify and evaluate the causal relationships

between the different variables under consideration (Marczyk et al., 2005). So that, in this

study the explanatory research design was employed to examine the relationship of the

stated variables. Mixed methods research provides better (stronger) inferences. Therefore,

by using a mixed approach it is able to capitalize the strength of quantitative and

qualitative approach and remove any biases that exist in any single research method

(Creswell, 2003). A panel data study design which combines the attributes of cross-

sectional (inter-firm) and time series data (inter-period) was used. The advantage of panel

data analysis is that more reliable estimates of the parameters in the model can be

obtained (Gujarati, 2004).

3.2 Source of data and collection methods

The necessary data for this study were collected from both primary and secondary

sources. The secondary source of data is the audited financial statements of the sample

commercial banks over a period of five years (2007-2011). These data was obtained from

National Bank of Ethiopia. The primary data was collected through the use of

questionnaires. Data on corporate governance variables was collected by distributing

42
questionnaire to the board chairman of the sample commercial banks’ in each sample

banks head office, Addis Ababa. However, the board chairman of commercial bank of

Ethiopia was not available and the required data was obtained from assistant to president

office. Moreover, the qualitative data about corporate governance mechanisms were also

collected by using questionnaire to support the quantitative data.

3.3 Sampling design

The population of the study is all commercial banks operating in Ethiopia. To select

sample commercial banks purposive sampling technique was employed. In the sample

commercial banks that have complete financial statement for the study period were

included purposively i.e. based on the age and availability data for the study period.

According to the information obtained from National Bank of Ethiopia there are only 8

commercial banks that have complete financial statements for the study period out of the

total commercial banks operating in Ethiopia i.e. 15 banks as of November 2012. Thus,

these eight commercial banks were selected as a sample (See appendix III).

3.4 Description of variables and measurements

In this study, the variables were selected based on alternative theories and previous

empirical studies related to corporate governance and firm performance. In accordance

with the theory and empirical studies, the independent, dependent and control variables of

the study were identified in order to investigate the impact of corporate governance

mechanisms on firms’ financial performance.

43
3.4.1 Dependent variables

In this study, the dependent variables are variables that are used to measure the financial

performance of sample commercial banks. To measure the financial performance of

banks Tobin's Q and other market based measures were used by many researchers.

However, in Ethiopia there is no secondary market so that it is not possible to use Tobin's

Q as well as other market based measures. Therefore, the other most frequently used

profitability measures were used i.e. accounting measures of profitability (see for

example Erhardt et al., 2003; Abu-Tapajeh, 2006; Bathula, 2008; Ibrahim et al., 2010;

Adusei, 2011; Aldamen et al., 2011; Al-Manaseer et al., 2012). Those are;

1. Return on Asset (ROA) - measures the overall efficiency of management. It

gives an idea as to how efficient management is at using its assets to generate

earnings.

ROA = Profit after Tax

Total Asset

2. Return on Equity (ROE) - measures a firm’s financial performance by

revealing how much profit a company generates with the money shareholders

have invested. It shows how well the shareholders funds are managed and used

to generate return.

ROE = Profit after Tax

Total Equity
3. Net Interest Margin (NIM) - is a measure of the difference between

the interest income generated by banks and the amount of interest paid out to

44
 their lenders. It shows how successful a bank's investment decisions are

compared to its debt situations.

NIM = Net Interest Income

Average Asset

3.4.2 Independent variables

In this study, the independent variables are variables that are used as a determinant of

corporate governance of the sample Ethiopian commercial banks. The independent

variables of the study are board size, board gender diversity, board members educational

qualification, board members business management experience, board members industry

specific experience, and size of audit committee. The definition and measurements of the

variables are as follows:

1. Board size
It can be defined as the number of directors sitting on the board. According to agency

theory limiting board size to a particular level is generally believed to be improving

financial performance. The reason is that the benefit of larger boards is outweighed by

the poor communication and decision making when the board size is too large. Previous

studies found negative effect of board size on performance (Jensen, 2003; Sanda et al.,

2005; Aduesi, 2011; Al-Manaseer et al., 2012). In this study board size is expected to

negatively influence performance.

2. Board gender diversity

Board gender diversity is measured as the percentage of number of female directors

divided by the total number of board members. Due to the varying size of boards, a

45
percentage variable provides a more accurate and comparable measurement thus the

percentage was taken. Board gender diversity is considered to improve company

performance since it provides new insights and perspectives (Bathula, 2008; Erhardt et

al., 2003). Female board members will bring diverse viewpoints to the boardroom that is

not possible with all male directors.

3. Board members educational qualifications

It is measured by the proportion of board members who had college degree or higher to

the total number of board members. Educational qualification is an important determinant

of board effectiveness. According to Rose (2007) as long as board members have a

university degree/or equivalent skills, board members have sufficient human capital in

order to understand information that is provided by management. Educational

qualifications of individual board members are important for board decision making

(Amran 2011; Yasser; 2011). The monitoring role expected to be effectively

implemented if the board members are qualified and experienced. Competent board

members expected to reduce agency problem.

4. Board members business management experience

It is measured as the percentage of number of directors who had business management

experience divided by the total number of board members. Prior researchers measure

experience using proxy variables such as industry specific and generic experience

(Castanias et al., 2001; Kroll et al., 2008). It is important for firms to have experienced

directors on board since it helps them in undertaking their duties of monitoring and

controlling managers in effective and efficient way. Directors’ experience of managing

46
business increases their effectiveness since they fully understand the general business

situation (Saat et al., 2011). It would appear that if the directors are experienced, their

ability to provide effective monitoring increases.

5. Board members industry specific experiences

It is measured as the percentage of number of directors who served in other banks earlier

in the same capacity divided by the total number of board members. It is important for

banks to have skilled and experienced directors on board particularly prior experience in

the same sector and position. The effectiveness of board members monitoring role

depends on their expertise to fully comprehend a firm’s business situation (Kroll et al.,

2008). Thus, industry specific experience of board members expected to improve bank’s

performance by helping boards effectively reducing agency problem.

6. Audit committee size

Audit committee size refers to the total number of banks’ audit committee members. The

size of audit committee affects banks’ performance. Small size audit committee ensures

effective monitoring (Kyereboah-coleman, 2007; Aldamen et al., 2011). It is likely that

small size audit committees effectively communicate in the financial reporting process

and problems to be resolved easily.

3.4.3 Control variables

In this study three bank specific control variables are included to account their potential

influence on banks’ financial performance in order to know the selected explanatory

variables effect on banks’ financial performance. The selected control variables are bank

size, bank growth rate and banks’ leverage. The control variables are selected based on

47
previous studies. In most of the previous studies firm size, firm growth rate and firms’

leverage were used as control variables (Habbash, 2010; Aljifri & Moustafa, 2007; Al-

Hawary, 2011).

Bank size - measured as the natural logarithm of total assets at year-end.

Bank growth - calculated as [(revenuet−revenuet-1)/revenuet-1]

Bank leverage - calculated as the total amount of debt divided by total equity capital.

3.5 Specifications of empirical research model

To estimate the impact of corporate governance mechanisms on the financial
performance of sample commercial banks in Ethiopia the following general empirical
research model is developed.
Yit= β0 + ΣβKXit + εit

Where:

Yit represents the dependent variables (ROA, ROE, and NIM) of bank i for time
period t.

β0 is the intercept

βK represents the coefficients of the Xit variables

Xit represents the explanatory variables (BSIZE, FD, BQUAL, BMEXP,
INDUEXP, AUDSIZE, BS, BLEV and BG) of bank i for time period t.

εit is the error term

The above general empirical research model is changed into the study variables to find
out the impact of corporate governance mechanisms on firms financial performance as
follows:

ROAit = β0 + β1(BSIZEit) + β2(FDit) + β3(BQUALit) + β4(BMEXPit) +

β5(INDUEXPit) + β6(AUDSIZEit) + β7(BSit) + β8(BLEVit) + β9(BGit) +εit--(1)

ROEit =β0 + β1(BSIZEit) + β2(FDit) + β3(BQUALit) + β4(BMEXPit) +

β5(INDUEXPit) + β6(AUDSIZEit) + β7(BSit) + β8(BLEVit) + β9(BGit) +εit--(2)

48
NIMit = β0 + β1(BSIZEit) + β2(FDit) + β3(BQUALit) + β4(BMEXPit) +

β5(INDUEXPit) + β6(AUDSIZEit) + β7(BSit) + β8(BLEVit) + β9(BGit) +εit--(3)

Where:

i denote banks ranging from 1 to 8 (cross-sectional dimension).

t denote years ranging from 2007 to 2011 (time-series dimension).

Dependent Variables
th
ROAit Return on Asset for i bank and time period t

th
ROEit Return on Equity for i bank and time period t

th
NIMit Net Interest Margin for i bank and time period t

Independent variables
th
BSIZEit Board Size for i bank and time period t

th
FDit Female Directors on the board for i bank and time period t

th
BQUALit Board members Educational Qualification for i bank and time period t

th
BMEXPit Board members Business Management Experience for i bank and time

period t
th
INDUEXPit Board member's industry specific experience for i bank and time

period t
th
AUDSIZEit Audit committee size for i bank and time period t

Control variables
th
BSit Bank size for i bank and time period t

th
BLevit Banks leverage for i bank and time period t

th
BGit Bank growth rate for i bank and time period t

49
3.6 Operational definitions

Corporate governance mechanisms- are the methods employed at firm level to solve

corporate governance problems and to reduce the agency problem in the firm.

Financial performance -represents profitability which is measured by return on asset,

return on equity and net interest margin.

3.7 Methods of data analysis

In this study to analyze the collected data both descriptive, correlation and multiple panel

linear regression data analysis method were employed. The descriptive statistics was used

to quantitatively describe the important features of the variables using mean, maximum

minimum and standard deviations. The correlation analysis was used to identify the

relationship between the independent, dependent and control variables using Pearson

correlation analysis. The correlation analysis shows only the degree of association

between variables and does not permit the researcher to make causal inferences regarding

the relationship between variables (Marczyk et al., 2005). Therefore, multiple panel

linear regression analysis was also used to test the hypothesis and to explain the

relationship between corporate governance variables and financial performance measures

by controlling the influence of some selected variables. Qualitative analysis was used for

qualitative data collected through questionnaire. Eviews 6 software was used for analysis

and the results were presented through tables.

50
 Chapter Four
Results and Discussion

This chapter presents the descriptive statistics, correlation analysis and multiple panel

linear regression analysis of the study variables. It has three sections. The first section is

the descriptive statistics which summarizes the main features of the study variable such

as mean, maximum, minimum and standard deviation. The second section is the

correlation analysis which shows the degree of association between the study variables.

The third sections of the chapter, regression results report the OLS estimation output of

the three regression models.

4.1 Descriptive statistics of the study variables

This section discussed the summery statistics of each variables of the study. The variables

include the dependent, independent and control variables. The dependent variables used

in this study in order to measure the sample commercial banks financial performance are

return on asset, return on equity and net interest margin whereas the explanatory variables

are board size, board gender diversity, board members educational qualifications,

business management experience of directors, industry specific experience of directors

and size of audit committee. In addition to the explanatory variables control variables

were included those are bank size, banks leverage and banks growth. Accordingly, the

descriptive statistics for all variables are presented below in table 4.1.

51
Table 4.1: Descriptive Statistics of the study variables

Variables Mean Maximum Minimum Std. Dev. Observations

ROA 0.025750 0.040105 -0.018797 0.011553 40
ROE 0.221543 0.381040 -0.037037 0.095173 40
NIM 0.048590 0.082300 0.020800 0.015567 40
BSIZE 9.675 12 6 1.685344 40
FD 0.062662 0.166667 0 0.060096 40
BQUAL 0.965707 1 0.8 0.063659 40
BMEXP 0.934105 1 0.727273 0.080358 40
INDUEXP 0.139773 0.333333 0.000000 0.130451 40
AUDSIZE 3.1 6 0 1.498717 40
BS 8.690119 11.43644 5.583496 1.193717 40
BLEV 8.067199 15.58 0.97037 2.073216 40
BG 0.360322 1.5939762 0 1.229924 40
Source: Eviews summery statistics result

As presented in table 4.1, the average value of return on asset for the sample Ethiopian

commercial banks is 2.56 percent (mean=0.02575) with a maximum and minimum value

of 4.01 and -1.88 percent respectively. The standard deviation is 1.16 percent from the

average value. On the other hand, the average value of the sample banks return on equity

is 22.15 percent (mean=0.221543) and the maximum and minimum value of 38.1 and 3.7

percent respectively. It deviates by 9.52 percent from the mean value of the sample

commercial banks. The financial performance of the sample commercial banks on

average is 4.86 percent (mean=0.04859) as measured by net interest margin. The

maximum value of net interest margin among the sampled commercial banks is 8.23

percent and the minimum value is 2.08 percent. It shows a standard deviation of 1.57

percent from the mean value.

By comparing the three financial performance measures, it seems the sample commercial

banks are relatively doing better on the return on equity performance measure. While the

52
mean value of return on equity is 22.15 percent, whereas net interest margin and return

on asset is 4.86 and 2.56 respectively, indicating that the sample banks are better in

utilizing shareholders equity capital. From the three indicators of financial performance

in table 4.1 above, return on equity is first, net interest margin is second and return on

asset is the last, when they are ranked from the highest to the lowest value in terms of

their mean and maximum values. On the bases of standard deviation from the mean,

return on equity shows higher standard deviation i.e. 9.52 percent. However the deviation

of return on asset and net interest margin is 1.16 and 1.56 percent, which is low in

comparison with return on equity. Generally, the three financial performance indicators

have not the same value in different aspects of descriptive statistics indicators.

It is confirmed in the table above that the average board size for the sample commercial

banks is about 10 members (mean = 9.675) with a maximum of 12 and a minimum of 6

directors. The standard deviation indicates that for the sample commercial banks board

size varies by 1.69 from the average value of 9.68. The standard deviation of 1.69

suggests that there is no wide dispersion in the board size of the sample commercial

banks.

On average, 6.27 percent (mean=0.062662) of the sample commercial banks directors are

female as measured by percentage of female directors divided by total number of

directors, which is considerably a disappointing figure. It suggests that the diversity of

sample Ethiopian commercial bank boards, as measured by proportion of directorship

held by women, is low since its mean value is only 6.27 percent during the last five years.

The percentage of female directors in the sample commercial banks is range from 0;

53
banks do not have any representation for women on their boards to 16.67 percent

representation with a standard deviation of 6 percent.

It could also be seen that the mean value of board members educational qualifications, as

measured by proportions of directors holding college degree or higher, is about 96.57

percent which implies that directors of the sample commercial banks posses the necessary

educational qualifications. The proportions of board members educational qualifications

shows 6.34 percent standard deviation which is more or less low as evidenced by a

maximum and minimum values of 100 and 80 percent.

As it can be seen in the table above that the mean value of board of directors business

management experience, as measured by the proportions of directors who had business

management experience, is 93.41(mean=0.934105) with a maximum of 100 and a

minimum of 72.73 percent. So that, the board of the sample Ethiopian commercial bank

consist of directors with the majority of having general business management experience.

It varies from the mean value by 8.04 percent.

In terms of industry specific experience, the board of sample commercial banks has a

mean industry specific experience of 13.98 percent (mean=0.139773) as measured by the

proportion of directors who had industry specific experience. The percentage of directors

who had industry specific experience among the sample commercial banks is range from

0 to 33.33 percent with a standard deviation of 13.05 percent. The standard deviation of

13.05 percent indicates the existence of relatively high variation in industry specific

experience among the sample commercial banks as compared with business management

54
experience. The audit committee of the sample banks have a mean size of about 3

members (mean=3.1) and with a maximum of 6 members and a standard deviation of 1.5.

The mean value of bank size as measured by the natural logarithm of total asset is 8.69

(Birr 12747.45 in millions) with having a maximum value of 11.44 (Birr 92636.98 in

millions) and a minimum values of 5.58 (Birr 266 millions). The standard deviation of

bank size among the sample commercial bank is 1.19. On the other hand, the leverage of

selected commercial banks in Ethiopia is 807 percent on average as measured by debt to

equity with a range of 97 to 1558 percent. There is higher deviation, 207 percent, from

the mean value of financial leverage. Finally, the sample commercial banks growth has

36 percent average value for the study period. The standard deviation of bank growth rate

indicates a high variation among the sampled commercial banks. The maximum and

minimum values of bank growth rate are 159 and 0 percent respectively among the

sampled commercial banks.

4.2 Correlation analysis of the study variables

This section of the study presents the results and discussions of the Pearson correlation

analysis. To identify the relationship among the variables of corporate governance and

financial performance Pearson correlation coefficients were used. The correlation

coefficients show the extent and direction of the linear relationship between corporate

governance variables and financial performance measures of the sample Ethiopian

commercial banks. The correlation analysis has three sub-sections. The first sub-section

shows the relationship between return on asset and selected corporate governance

variables. The second sub-section is about the association between return on equity and

55
corporate governance variables. Finally, the relationship between net interest margin and

corporate governance variables were analyzed. The probability is shown in parenthesis

with the correlation coefficient for the three correlation matrix below. The significance

level also shown that is ***, ** and * for 1%, 5% and 10% level respectively. The

correlation coefficients are checked for the presence of high collinearity among

regressors. Since the correlation analysis shows only the degree of association, it is

followed by multiple regression analysis.

4.2.1 Correlation analysis of ROA and corporate governance

mechanisms

Below in table 4.2, the correlation matrix which shows the relationship of the return on

asset with board size, board gender diversity, board members educational qualifications,

board members business management experience, directors' industry specific experience,

audit committee size, bank size, banks financial leverage and bank growth. This table

also shows the linear relationships between each independent variables and control

variables used in this study.

56
Table 4.2: Correlation analysis of ROA and corporate governance mechanisms
Correlation
(Probability) ROA BSIZE FD BQUAL BMEXP INDUEXP AUDSIZE BS BLEV BG
ROA 1
-----
BSIZE -0.29994 1
(0.0601) -----

FD 0.261589 0.189792 1
(0.1030) (0.2408) -----

BQUAL 0.550994 -0.17414 0.027645 1

(0.0002) (0.2825) (0.8655) -----

BMEXP 0.654779 -0.28376 0.158058 0.657756 1

(0.0000) (0.076) (0.33) (0.00) -----

INDUEXP 0.438717 -0.47724 -0.36318 0.387851 0.393726 1

(0.0046) (0.0018) (0.0213) (0.0134) (0.0119) -----

AUDSIZE -0.0605 0.124863 -0.09034 0.55646 0.346995 0.058251 1

(0.7107) (0.4427) (0.5793) (0.0002) (0.0283) (0.7211) -----

BS 0.45769 -0.29371 0.300843 0.617894 0.606935 -0.054113 0.441417 1

(0.003) 0.0658) (0.0593) (0.000) (0.000) (0.7402) 0.0044) -----

BLEV 0.365299 0.100785 0.376521 0.151091 0.364292 -0.29163 0.075046 0.665724 1

(0.0205) (0.5361) (0.0166) (0.352) (0.0208) (0.0679) (0.6454) (0.000) -----

BG -0.28701 0.106691 -0.07605 -0.24226 -0.23869 -0.205308 -0.033567 0.004276 0.405913 1

(0.0726) (0.5123) (0.6409) (0.132) (0.138) (0.2038) (0.8371) (0.9791) (0.0094) ----
Source: Eviews correlation result based on the data obtained from sample commercial banks.

57
Table 4.2 point out that board members educational qualification, board members

business management experience and director's industry specific experience are

positively and significantly correlated at 1 percent significance level with return on asset.

On the other hand, board size is negatively and significantly correlated at 10 percent

significance level with return on asset. However, board gender diversity and audit

committee size shows insignificant correlation with return on asset. Even though they are

not significant board gender diversity shows a positive coefficient and audit committee

size shows a negative coefficient as expected.

As per the correlation result reported in table 4.2 , the Pearson correlation coefficients of

board size, board gender diversity, board members educational qualification, board

members business management experience, board members industry specific experience

and audit committee size are -30 percent, 26 percent, 55 percent, 65 percent, 43 percent, -

6 percent respectively. From this it can be understand that board members educational

qualification and board members business management experience are a strong

association with return on asset. In contrast with board gender diversity and audit

committee size, board size and industry specific experience also shows a strong

association with return on asset.

Moreover, as it is shown in the above correlation matrix both control variables are

significantly correlated with return on asset. Bank size and banks leverage has a

significant positive relation with return on asset at 1 and 5 percent significant level

respectively whereas bank growth is negatively correlated at 10 percent significant level.

As it is observed on the coefficients values, bank leverage and bank growth are weakly

58
correlated at 37 percent and -29 percent with return on asset in contrast with financial

leverage, which is relatively strong correlation, 47 percent.

4.2.2 Correlation analysis of ROE and corporate governance

mechanisms
Below table 4.3 presents the Pearson correlations among return on equity and corporate

governance mechanisms as well as control variables of the study. Here, also the

independent variables are board size, board gender diversity, board members educational

qualifications, board members business management experience, directors' industry

specific experience, audit committee size. The control variables are bank size, banks

financial leverage and bank growth.

As shown in table 4.3 below, board size is negatively related with return on equity at 1

percent significance level. While board members educational qualifications, board

members business management experience, and directors' industry specific experiences

are positively correlated with return on equity at 1 percent, 1 percent and 10 percent

significance level. But board gender diversity and audit committee size does not have a

significant relation with return on equity.

59
Table 4.3: Correlation analysis of return on equity and corporate governance mechanisms
Correlation
(Probability) ROE BSIZE FD BQUAL BMEXP INDUEXP AUDSIZE BS BLEV BG
ROE 1
-----
BSIZE -0.5813 1
(0.0001) -----

FD 0.213953 0.189792 1
(0.185) (0.2408) -----

BQUAL 0.620314 -0.17414 0.027645 1

(0.00) (0.2825) (0.8655) -----

BMEXP 0.657468 -0.28376 0.158058 0.657756 1

(0.00) (0.076) (0.33) (0.00) -----

INDUEXP 0.273813 -0.47724 -0.36318 0.387851 0.393726 1

(0.0873 (0.0018) (0.0213) (0.0134) (0.0119) -----

AUDSIZE 0.171303 0.124863 -0.09034 0.55646 0.346995 0.058251 1

(0.2906) (0.4427) (0.5793) (0.0002) (0.0283) (0.7211) -----

BS 0.780714 -0.29371 0.300843 0.617894 0.606935 -0.05411 0.441417 1

(0.00) (0.0658) (0.0593) (0.00) (0.00) (0.7402) (0.0044) -----

BLEV 0.432757 0.100785 0.376521 0.151091 0.364292 -0.29163 0.075046 0.665724 1

(0.0053) (0.5361) (0.0166) (0.352) (0.0208) (0.0679) (0.6454) (0.00) -----

BG -0.14764 0.106691 -0.07605 -0.24226 -0.23869 -0.20531 -0.03357 0.004276 0.405913 1

(0.3633) (0.5123) (0.6409) (0.132) (0.138) (0.2038) (0.8371) (0.9791) (0.0094) -----
Source: Eviews correlation result based on the data obtained from sample commercial bank

60
Furthermore, as shown in table 4.3, the Pearson correlation coefficients of board size is

-58 percent, board gender diversity is 21 percent, board members educational

qualification is 62 percent, board members business management experience is 66

percent, board members industry specific experience is 27 percent and audit committee

size is 17 percent with return on equity. This indicates that the association between board

members business management experience, board members educational qualification and

board size shows a strong correlation with return on equity.

In addition, as it is shown in the above correlation matrix the two control variables such

as bank size and bank leverages are positively correlated with return on equity at 1

percent level of significant with correlation coefficients of 78 percent and 43 percent

respectively. However, bank growth is insignificant. As it is observed on the coefficients

values, bank size is highly correlated with return on equity.

4.2.3 Correlation analysis of NIM and corporate governance

mechanisms

Below, Table 4.4 shows, the correlation matrix that predicts the likely relationship of the

net interest margin with board size, board gender diversity, board members educational

qualifications, board members business management experience, directors' industry

specific experience and audit committee size as independent variables and bank size,

banks leverage and bank growth as control variables of the study.

Based on the Pearson correlation independent variables; board members educational

qualifications and audit committee size are negatively and significantly correlated at 5

percent and 1 percent level of significance with net interest margin respectively.

61
Table 4.4: Correlation analysis of net interest margin and corporate governance mechanisms

Correlation
(Probability) NIM BSIZE FD BQUAL BMEXP INDUEXP AUDSIZE BS BLEV BG

NIM 1.000000
-----

BSIZE 0.135429 1.000000

(0.4047) -----

FD 0.119251 0.189792 1.000000

(0.4636) (0.2408) -----

BQUAL -0.360094 -0.174140 0.027645 1.00000

(0.0225) (0.2825) (0.8655) -----

BMEXP -0.194988 -0.283760 0.158058 0.657756 1.000000

(0.2279) (0.0760) (0.3300) (0.0000) -----

INDUEXP -0.214549 -0.477244 -0.363176 0.387851 0.393726 1.000000

(0.1837) (0.0018) (0.0213) (0.0134) (0.0119) -----

AUDSIZE -0.714546 0.124863 -0.090337 0.556460 0.346995 0.058251 1.000000

(0.0000) (0.4427) (0.5793) (0.0002) (0.0283) (0.7211) -----

BS -0.392088 -0.293712 0.300843 0.617894 0.606935 -0.054113 0.441417 1.000000

(0.0123) (0.0658) (0.0593) (0.0000) (0.0000) (0.7402) (0.0044) -----

BLEV -0.001048 0.100785 0.376521 0.151091 0.364292 -0.291630 0.075046 0.665724 1.000000
(0.9949) (0.5361) (0.0166) (0.3520) (0.0208) (0.0679) (0.6454) (0.0000) -----

BG -0.069978 0.106691 -0.076050 -0.242255 -0.238692 -0.205308 -0.033567 0.004276 0.405913 1.000000
(0.6679) (0.5123) (0.6409) (0.1320) (0.1380) (0.2038) (0.8371) (0.9791) (0.0094) -----
Source: Eviews correlation result based on the data obtained from sample commercial banks

62
On the other hand, board gender diversity, board members business management

experience, directors' industry specific experience shows statistically insignificant

correlation with net interest margin. Bank size is the only control variable which has a

significant association with net interest margin at 5 percent significance level with a

correlation coefficient of -39 percent. Bank leverage and bank growth are statistically not

significant. As it can be easily understand from the correlation coefficients of the

variables both independent and control variable of the study have a weak correlation with

net interest margin except audit committee size which shows a strong correlation of -71

percent.

From the correlation coefficients of the three model, shown in table 4.2, 4.3 and 4.4, no

high correlation is found among the independent as well as control variables. All the

independent and control variables included in the three models are not strongly correlated

with each other that results multicollinearity problem since all the coefficients are lower

than 0.8.

However, from the Pearson correlation coefficient the highest coefficient is 0.67 between

bank size and bank leverage. This result suggests that large banks have the possibility of

obtaining and using large amount of debt to finance their operations than small size

banks. Another significant and relatively high correlation is 0.66 between board members

educational qualifications and business management experience. This is suggesting that

qualified directors have business management experience.

Given these relatively high correlations the variance inflation factor (VIF) is checked. It

has been verified that there is no multicollinearity between independent factors by using

63
the variance inflation factor. Therefore, like earlier researchers all these variables are

included in the same model since the correlations are not strong (lower than 0.80 and VIF

values of not more than 10) as recommend by Gujarati (2004) and this multicollinearity

among variables is considered to be harmless. As a result, multicollinearity problem does

not exist to create a threat to the interpretation of regression coefficients of the

independent and control variables in the three models of this study.

Generally, the correlation analysis shows that the degree and directions of association of

some corporate governance mechanisms and financial performance differ depending on

the financial performance measure used. The correlation analysis shows only the

direction and degree of association between variables and it does not permit the

researcher to make causal inferences regarding the relationship between the identified

variables. Therefore, it is not possible to explain the relationship between corporate

governance variables and profitability measures by controlling the influence of some

selected variables using correlation analysis. As a result the main analysis is left for

regression analysis that overcomes the shortcomings of correlation analysis.

4.3 Regression Results and Discussion

This section of the study presents the results and discussions of the regression output. In

order to examine the impact of corporate governance mechanisms on sample Ethiopian

commercial banks financial performance three multiple panel linear regression models

were estimated. The regression analysis enables the researcher to empirically test the

proposed hypothesis and to achieve the research objective. The method of least squares

has some very attractive statistical properties that have made it one of the most powerful

64
and popular methods of regression analysis (Gujarati, 2004). Thus, by conducting the

appropriate diagnosis tests OLS estimation method was used in the three models.

4.3.1 Diagnostic tests of the data set

Before running the three models, the data sets were tested for the classical linear

regression model assumptions (See appendix II). Brooks (2008) suggests five critical

assumptions that must be met before utilizing OLS estimation in order to validly test the

hypothesis and estimate the coefficient. The classical linear regression model

assumptions and their diagnostic tests are discussed below.

1. The average value of the errors is zero. If a constant term is included in the

regression equation, this assumption will never be violated. So that in the three

models of this study a constant term is included. As a result this assumption was

not violated.

2. Normality assumption. This assumption requires the disturbances to be

normally distributed. Bera-Jarqu normality test which is the most commonly used

normality test was conducted for the three models after estimating the regression

(see appendix II). Based on the results shown in the appendix II, the p-values is

insignificant for the three models and the researcher failed to reject the null

hypothesis, which says the residual value is normally distributed. Therefore, there

is no normality problem on the data used for this study.

3. The assumption of homoskedasticity. This assumption requires that the variance

of the errors to be constant. To check this assumption White test was conducted

for the three models (See appendix II). In the first two models there was no

65
 problem of heteroskedasticity or the error variance is constant since the p-value is

not significant. This means the null hypothesis was not rejected which says that

the error variance is constant. But, in the third model, net interest margin as

financial performance measure, there exist a problem of heteroskedasticity since

the P-value is significant and the null hypothesis was rejected. Therefore,

heteroskedasticity-consistent standard error was used for the third model to

minimize the problem of heteroskedasticity.

4. No autocorrelation between the disturbances. It is assumed that the errors are

not correlated with one another. If the errors are correlated with one another, it

would be stated that they are ‘serially correlated’. A test of this assumption is

therefore conducted. The first test was Durbin-Watson which is shown in the

regression output of the three models separately. As per this test the values of

Durbin--Watson for the three models are 2.09, 1.96 and 2.34 all are near to two.

Thus, the null hypotheses were not rejected for the three models so there is no

problem of autocorrelation. However, Durbin-Watson is a test for first orders

autocorrelation. It tests only for a relationship between an error and its immediate

previous value. Therefore, in addition to DW test it is desirable to conduct

Breusch-Godfrey Serial Correlation LM test to examine a joint test for

autocorrelation that will allow examination of the relationship between error term

and several of its lagged values at the same time. Thus, Breusch-Godfrey test was

also conducted for the three models and found no problem of autocorrelation for

the three models (See appendix II).

66
 5. Model misspecification error. With regard to model misspecification error

Ramsey reset test was conducted for the three models (See appendix II). The

Ramsey regression specification error test results for the three models are

insignificant. The researcher fails to reject the null hypothesis. Thus, the results

indicate no model specification error in all the three models of the study.

Therefore, in this study appropriate functional form has been used.

In addition to the above diagnostic tests, the data set was checked for the problem of

multicollinearity. The presence of multicollinearity among explanatory and control

variables can be easily detected by looking the correlation coefficient in the correlation

matrix as discussed in the correlation analysis section. There is no high correlation among

the variables which results multicollinearity problem as it can be seen in the correlation

matrices. So there is no problem of multicollinearity.

Fixed effect Versus Random effect

It is also necessary to determine whether the fixed effect or random effect approach is

appropriate. A common practice in corporate governance research is to make the choice

between both approaches by running a Hausman test. To conduct a Hausman test the

number of cross section should be greater than the number of coefficients to be estimated.

But, in this study the numbers of coefficients are greater than the number of cross

sections so it is not possible to conduct a Hausman test. Therefore, a redundant fixed

effects test was conducted to determine whether the fixed effect is appropriate for the first

two models (see appendix II).

67
In the first model the p-value is insignificant in the case of time-fixed effects where only

the period fixed effects are allowed. As a result the time-fixed effect approach was used.

Hence, with time-fixed effects, the intercept is allowed to vary over time but assumed to

be the same across entities (banks) at each given point in time. The dummy variables

capture time variation rather than cross-sectional variation and it allow time specific

heterogeneity. In the case of the second model the cross section fixed is better so cross

section fixed approach was applied. Hence, with cross section fixed effects, the intercept

is allowed to vary across entities (banks). It captures bank specific heterogeneity. In the

case of the third model, net interest margin as a dependent variable, as stated before

heteroskedasticity problem was found and to minimize this problem heteroskedasticity-

consistent standard error is used. Therefore, simple pooled multiple regression

techniques is used on which fixed or random effect test is not allowed.

All the above tests of basic classical linear regression model assumptions for OLS

estimation prove that, the results obtained from the three regression models in this study

are consistent, free from bias and efficient since the assumption holds and the next step is

analyzing and discussing the outputs of the regressions.

The results of the three regression models that have been estimated to examine the impact

of corporate governance mechanisms on the financial performance of selected Ethiopian

commercial banks are shown below in table 4.5.

As it is summarized in the table below, the R2 for the three models is 81 percent, 88

percent, 69 percent for the first (ROA), the second (ROE) and the third model (NIM)

respectively. Which means that 81 percent of the variation in return on asset was

68
explained by the independent and control variables used in this study, only 19 percent of

variation in return on asset is due to other factor that are not included in this study. While,

88 percent of variation in return on equity was explained by the variables used in this

study where the remaining 12 percent was explained by other factors not included in this

study. The R2 of the third model implies that 69 percent of variation in net interest margin

was explained by the study variables and the remaining 31 percent was explained by

other factors. The selected variables best explained the variations of return on equity,

return on asset and net interest margin orderly. The R2 results indicate the overall

goodness-of-fit of the three models used in this study.

After modification the explanatory power of the three models, adjusted R2 values, is 71

percent, 80 percent and 60 percent respectively. This indicates that 71 percent, 80 percent

and 60 percent of the variation in the Ethiopian commercial banks return on asset, return

on equity and net interest margin respectively, was explained by the explanatory

variables in each model. The adjusted R2 measures how well the model fits the data by

taking into account the loss of degrees of freedom associated with adding extra variables.

Therefore, the three model best fits the data.

69
 Table 4.5 Summary of regression results of the three models

ROA (Model-1) ROE (Model-2) NIM (Model-3)

Variables Coefficient t-Statistic Coefficient t-Statistic Coefficient t-statistic
(Std. Error) (prob.) (Std. Error) (Prob.) (Std. Error) (Prob.)

-0.069555 -2.7642** -0.447678 -1.1393 0.020469 0.4532

Intercept (0.025163) (0.0103) (0.392957) (0.2663) (0.045168) (0.6537)
BSIZE -0.000865 -0.7042 -0.024154 -2.3772** -0.001086 -0.5311
(0.001228) (0.4876) (0.010161) (0.0261) (0.002045) (0.5993)
FD 0.033833 1.4644 0.234387 0.9821 -0.016228 -0.5025
(0.023104) (0.1551) (0.238665) (0.3363) (0.032296) (0.6190)
BQUAL 0.078718 2.3833** 0.988908 1.9439* 0.103607 2.0349*
(0.033030) (0.0248) (0.508711) (0.0642) (0.050916) (0.0508)
BMEXP 0.025304 1.0927 -0.032804 -0.1844 0.038018 1.3010
(0.023157) (0.2845) (0.177900) (0.8553) (0.029223) (0.2032)
INDUEXP 0.028913 1.8548* 0.151648 0.7092 -0.054166 -2.7402**
(0.015588) (0.0750) (0.213820) (0.4853) (0.019767) (0.0102)
AUDSIZE -0.002329 -1.9994* -0.004792 -0.2455 -0.006904 -3.7157***
(0.001165) (0.0561) (0.019520) (0.8083) (0.001858) (0.0008)
BS -0.002369 -0.7618 -0.017078 -0.5138 -0.010574 -2.1380**
(0.003110) (0.4530) (0.033236) (0.6123) (0.004946) (0.0408)
BLEV 0.003413 2.6298** 0.013630 1.2188 0.003293 1.6497
(0.001298) (0.0142) (0.011183) (0.2353) (0.001996) (0.1094)
BG -0.002970 -2.3660** -0.006371 -0.4680 -0.002566 -0.9098
(0.001255) (0.0257) (0.013614) (0.6442) (0.002821) (0.3702)
Observations 40 40 40
R2 0.806876 0.882163 0.689801
Adjusted-R2 0.710315 0.800189 0.596741
F-statistic 8.356063 10.76152 7.412447
Prob.(F-stat) 0.0000 0.0000 0.0000
Durbin- 2.089533 1.959458 2.344657
Watson stat
Effect Period-fixed Cross-section fixed Simple pooled reg.
specification
Source: Eviews regression results based on the data obtained from sample banks
Note: ***, **, * significant at 1%, 5%, and 10% level of significance respectively.
: Model three contains heteroskedasticity-consistent standard error

70
In addition, the F-statistic shows the overall significance of variables in other words the

significance of each models slope parameters jointly. The F-statistics of the three models

are 8.36, 10.76 and 7.41 respectively and the null hypotheses of the three models were

rejected at 1 percent significance level. Therefore, each model variables are jointly

significant. The three models adequately describe the data. Here one can infer from the

results of R-squared and F-statistics that the implemented models of this research are well

fitted that corporate governance mechanisms have a significant effect on banks’ financial

performance.

4.3.2 Corporate governance mechanisms: Results and Discussion

Board size

As shown above, table 4.5, this study found a negative and statistically significant

association between boards size (BSIZE) and return on equity at 5 percent level of

significance. It has also negative relation with return on asset and net interest margin

though insignificant. It implies that the numbers of board of directors' are negatively

related with commercial banks’ financial performance. In other words, the higher the

number of board members of commercial banks, the lower their financial performance

achievement is and vice versa. The result indicates that small boards are more effective in

monitoring and controlling banks management and it help to reduce agency costs.

The finding supports the argument of Jensen (1993) that an increase in board size leads to

less effective monitoring due to coordination and process problems inherent in large

board size. The result is also consistent with prior studies which argue that coordination,

communication and decision-making problems increasingly impede company

71
performance when the number of directors increases (Sanda et al., 2005; Adusei, 2011;

Yermack, 1996; Al-Manaseer et al., 2012). Recall the first hypothesis which states that

there is a negative association between board size and financial performance. The finding

supports this hypothesis when performance is measured by return on equity. Moreover, it

has a negative coefficient in all the three performance measures even if it is not

significant in the case of return on asset and net interest margin performance measures.

Subjective question was also asked to qualitatively check as to whether respondents

believe the number of board size affects banks performance (Q. No. 7, see appendix I).

All respondents said ‘‘yes’’ and they have justified that too large or too small board is not

appropriate to run the responsibility of the board. The best justification given is that, if

the number of board members is large, it creates conflict of interest between the board

members, which erodes the wealth of the bank. Banks need to have reasonable numbers

of directors in order to perform the board task effectively. National bank of Ethiopia set

the maximum number of director to be 12. The outcome of the analysis of both

quantitative and qualitative data indicates that there is a negative relationship between

board size and financial performance of sample commercial banks in Ethiopia. Therefore,

both the regression and qualitative result support the hypothesis.

Board gender diversity

The relationship between board gender diversity (FD) and all the three financial

performance measures are insignificant. However, it has a positive coefficient with return

on asset and return on equity. Hypothesis 2 predicts that the number of women directors

on the board is positively associated with financial performance. The insignificant

72
coefficient of the percentage of women directors does not support this hypothesis.

Therefore, this study does not support the view that gender diversity leads to superior

banks financial performance.

Some previous studies document a positive effect of the role of women on boards and

find that women enhance the quality of decision making and firm performance (Bathula,

2008; Erhardt et al., 2003). However, this study does not find a significant positive

association between percentage of women directors and banks financial performance.

This may be due to the relatively small proportion of board members who are women (as

shown in the descriptive analysis section), which does not permit them to be powerful

enough to make a difference to monitoring.

This result does not necessarily contradict the notion that women's presence on boards

may be useful and positive in general. Nevertheless, the low number of women on the

boards of sample Ethiopian commercial banks does not give them sufficient monitoring

power. The result is not surprising because other studies that examined the association

between proportion of women on boards and firm performance also found insignificant

result (for example see Rose, 2007; Habbash, 2010).

In the qualitative question (Q. No. 8 see appendix I) majority of respondents said 'yes'

and justified as board gender diversity is important since almost half of the country's

population is female, they can represent this significant potential customers and help

banks to have links with this potential customers. But, simply the presence of female

directors will not improve banks operation and performance unless they are qualified and

73
competent. Whether gender diversity help improve banks operation and performance it

depends on factors such as experience, education and assertiveness of female directors.

Board members educational qualification

Board members educational qualification (BQUAL) has a positive effect on both

measures of commercial banks financial performance. Board members educational

qualification explains the variations of the financial performance of commercial banks

with a coefficient of 0.078718, 0.988908 and 0.103607 and is statistically significant at 5

percent, 10 percent and 10 percent levels of significance for return on asset, return on

equity and net interest margin respectively. The result indicate that the increase in the

proportions of directors who had college degree or higher have a significant positive

influence on the financial performance of commercial banks and vice versa. In other

words the higher the number of directors who had college degree or above sitting on the

board the higher the financial performance of sample commercial banks in Ethiopia and

vice versa. This suggests that the presence of qualified directors on the board plays an

important role in carrying out the boards monitoring responsibility and in improving

financial performance.

Hypothesis 3 predicts that there is a significant positive relation between board members

educational qualification and banks financial performance. Since the null hypothesis is

rejected in all the three financial performance measures the result is in line with the

proposed alternate hypothesis. Thus, there is a significant positive relationship between

board members educational qualification and financial performance of commercial banks

in Ethiopia. This result supports the finding revealed by Amran (2011) and Yasser

74
(2011). They argues that directors with higher education are better in managing the

business operation and controlling agency problem than less educated counterparts this

reduce agency cost. Educational qualification affects the oversight and monitoring role

of boards of directors. The result support the view that educational qualification is

potentially important since the ability to seek and interpret appropriate information is

essential for the efficient operation of banks and the effective control or guidance of

management by boards of directors. The qualification of directors as measured by the

percentage of directors who had college degree or higher significantly influences bank

performance.

Respondents were asked to reflect their view as to whether they feel that educational

qualification of directors have any significant effect on their monitoring and controlling

efficiency (Qn. No. 9). All of the respondents said "yes". The best justification given is

that directors need to have a minimum of college degree in order to understand the

reports given by the banks management. Boards of directors make decision after

analyzing and carefully understanding the technical documents submitted by

management as a report. In addition, they stated that education plays a key role not only

in the banking sector but also in any other sector of the economy. Thus, educational

qualifications of directors play a great role in board decision making. Both the regression

result and the qualitative analysis indicate that educational qualification of directors is

important factor to improve financial performance of the sampled commercial banks in

Ethiopia. Thus, the hypothesis is supported.

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Business management experience of directors

Hypothesis 4 predicted that business management experience of directors (BMEXP)

positively influence banks financial performance. It has a positive coefficient when

financial performance is measured by return on asset and net interest margin but

insignificant in all the three models. It is therefore business management experience is

insignificant in explaining the variation in return on asset, return on equity and net

interest margin. The result is inconsistent with this study expectation. A possible

explanation of this result is that the nature of banking industry is different from other

industry and banks are generally more opaque than non-financial firms. Thus, the general

business management experience of directors may not be that much relevant (significant)

in improving financial performance due to the complex and special nature of banks

corporate governance. It means that it requires directors to deeply understand banking

business to influence the banks performance significantly rather than general business

understanding.

In the qualitative part (Q. No. 10), respondents was asked whether business management

experience of directors enables to promote better monitoring and good governance.

Respondents said ''yes'' and they have replied that, experienced directors will apply their

experience of managing business to the banking industry and this is believed to promote

better monitoring and good governance and help improve the performance of banks.

However, they should be assigned in committee based on their practical background to

make them to contribute more in promoting good governance. Otherwise the general

experience of directors may not be relevant for banks corporate governance since banks

are highly regulated and are somewhat sensitive and special than other sectors.

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Industry specific experience of directors

Hypothesis 5 expected that industry specific experience of directors (INDUEXP) is

positively associated with banks financial performance. As expected, a positive

association is found between industry specific experience and return on asset and return

on equity but only significant at 5 percent level with return on asset. However, contrary

to the hypothesis industry specific experience has a negative association with net interest

margin at 5 percent significance level. When the banks performance is measured by

return on asset industry specific experience of directors has a positive influence. It means

the higher the proportions of directors who had earlier working experience in the banking

industry the higher the financial performance (as measured by return on asset) of sample

commercial banks in Ethiopia and vice versa. On the other hand, industry specific

experience of directors has a negative influence on the financial performance of banks

when it is measured by net interest margin. Therefore, industry experience has a mixed

effect depending on the measure used. The result is somewhat inconclusive.

Respondents were asked a subjective question (Q. No. 11) about directors' prior

experience in banking industry. The respondents in which the board consists directors

who had prior experience in banking industry said ''yes'' and justified that directors who

had an experience in the banking industry is highly important because they knows what is

undertaken in the banking business and that play a great role in the board decision

making. The qualitative result and regression result based on return on asset performance

measures support this variable hypothesis.

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Audit committee size

The effect of audit committee size (AUDSIZE) on banks financial performance is

negative in all the three measures with a coefficient of -0.002329, -0.004792 and -

0.006904 for return on asset, return on equity and net interest margin respectively. The

negative effect is significant for return on asset and net interest margin with p-values of

0.05 and 0.01 respectively. Which means that the larger the audit committee is the lower

will be the financial performance of commercial banks as measured by return on asset

and net interest margin.

The result is consistent studies conducted previously (Jensen & Meckling, 1976);

Kyereboah-Coleman, 2007; Aldamen, et al., 2011). Kyereboah-Coleman (2007) point

out that the size of the audit committee negatively influence performance using Ghanaian

sample firms. This study result supports the notion that a certain minimum number of

audit committee members may be relevant to the quality of financial reporting and to

enhance financial performance. Free-riding and difficulty to reach in consensus in large

groups inversely affect financial performance. Therefore, the outcome of this variable is

in line with the proposed alternate hypothesis, when financial performance is measured

by return on asset and net interest margin.

For the subjective question (Q. No. 12) majority of the respondents said ''no''. They

justified that increasing the size of audit committee will not improve performance

because it is difficult to reach consensus and make timely decisions due to lack of

communications as audit committee size become large. Limiting audit committee size to

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reasonable number improves audit committee effectiveness. So the proposed hypothesis

is supported.

4.3.3 Control variables: Results and Discussion

In addition to what has been discussed above, table 4.5 depicts the result of the regression

analysis between the three control variables and financial performance indicators of

sample Ethiopian commercial banks, which are interpreted below.

Bank size

There is a negative relationship between the size of a bank (BS) and all the three financial

performance measures, yet this is statistically significant only with net interest margin

with p-value < 0.05. The finding support previous studies and arguments made in which

bank size negatively influences performance (Sanda et al, 2005; Babatunde & Olaniran,

2009); Amran, 2011; Al-Manaseer, et al, 2012). Al-Manaseer et al. (2012) found a

significant negative relation between bank size and net interest margin but insignificant

negative relation was found with return on asset and return on equity. It can be explained

as large banks have economies of scale and scope from this point it is supposed to

influence bank performance positively. However, at the same time agency problem

increase this may out weight the efficiencies of large banks efficiency achieved through

economies of scale and scope this may lead to bank inefficiencies. This may be also

because banks may not be able to fully control and monitor the business as the companies

become larger in size. The result implies size of a bank measured by its asset does not

necessarily enhance performance if this is not put to efficient use. Therefore, sample

Ethiopian banks are not utilizing their size to enhance their financial performance.

79
The insignificant negative relationship of return on asset and return on equity and size

also supported (Khatab et al., 2011; Al-Manaseer et al., 2012). They have found

insignificant negative association between size and return on asset and return on equity.

Bank leverage

The regression results also shows that bank leverage (BLEV) has significant positive

influence on bank performance measured by return on asset (p-value< 0.05) and it is only

marginally insignificant with net interest margin. In addition, although no statistically

significant relationship is detected, a positive directional sign of the coefficient is

observed in return on equity. It implies that an increase in the debt position is associated

with increase in performance. The result indicates that banks with higher levels of debt as

a proportion of equity is to perform better than those having lower proportion of debt.

According to the agency theory, the monitoring provided by debt financing reduces

management's incentive to misuse free cash flows, and consequently leads to a better firm

performance. The finding is consistent with the literature and with the study conducted

earlier (Khatab, et al, 2011; Sanda et al., 2005; Babatunde & Olaniran, 2009). Habbash

(2010) also argues that highly leveraged firms are found to be less involved in fraudulent

practices.

Bank growth

Finally, banks growth (BG) has a negative coefficient in all the three models but it is not

statistically significant when performance is measured by return on equity and net interest

margin. It is only significant with return on asset at p<0.05. The negative relation implies

that banks can grow without necessarily being profitable. This may be explained by

80
ineffective supervision of operations as a bank expands, giving room for resource

dissipation this will negatively influence performance. The result is not surprising

because Khatab et al. (2011) also found a significant negative association between

growth and return on asset.

In conclusion, results indicate that the direction and the extent of impact of some

corporate governance mechanisms are dependent on the performance measure being

examined. All corporate governance variables do not influence the three financial

performance indicators in the same direction and their degrees of association may also

differ. This is because financial performances indicators are not equally indicate the

performance of banks, because financial performance indicators used different formulas

with their limitations to indicate the banks performance. For example return on asset

indicates the overall efficiency of management and reflects whether the bank uses assets

effectively in order to produce its income. Return on equity provides information as to

how well managers are using the funds invested by the shareholders without considering

the effect of liability of the firm. Net interest margin shows how successful a bank's

investment decisions are compared to its debt situations. Due to this the direction and the

extent of relationship between corporate governance mechanisms and financial

performance are not the same for all performance measures.

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 Chapter Five

Conclusion and Recommendations

In the final chapter to this study conclusion of the study is made which is followed by

recommendations. Directions for future research also laid down.

5.1 Conclusion

This study investigates the impact of corporate governance mechanisms on firms'

financial performance using eight Ethiopian commercial banks with a data set covering

five years period from the year 2007 to 2011. Based on the results of the descriptive

statistics, correlation and regression analysis the researcher made the following

conclusions.

Based on the descriptive statistics the financial performance of sample commercial banks

are 2.56 percent, 22.15 percent and 4.86 percent as measured by return on asset, return on

equity and net interest margin respectively. It is therefore the sample commercial banks

are performing better in utilizing shareholders capital. The sample commercial banks

board is characterized by the presence of qualified directors and majority of directors

having business management experience. But, the board is dominated by male and

consists of low numbers of directors who had prior experience in the banking industry.

The correlation analysis indicates that most of the corporate governance mechanisms

significantly correlated with the financial performance of sample Ethiopian commercial

banks. But, the correlations of some corporate governance mechanisms differ depend on

the indicator used to measure financial performance.

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The regression result show that board size has a significant negative effect on return on

equity but its negative effect on return on asset and net interest margin was insignificant.

Board size does not have a significant effect on return on asset and net interest margin.

Accordingly, the researcher concludes that board size significantly and negatively

influence sample commercial banks financial performance as measured by return on

equity.

No statistically significant relation was found between percentage of female directors and

financial performance. However, this is due to very small numbers of female directors as

observed in the descriptive statistics which does not permit them to be powerful enough

to make a difference to monitoring. Moreover, the qualitative analysis revealed that

qualified and competent female directors help improve banks operation and monitoring

performance. Therefore, only the presence of qualified and competent female directors

helps improve banks performance.

Board members educational qualification significantly and positively influences the

financial performance of sample commercial banks. The presence of qualified directors

on the board plays an important role in carrying out the boards monitoring responsibility

and in improving financial performance. Thus, board members educational qualification

has a significant positive effect on banks financial performance.

Even though it has a positive coefficient with return on asset and net interest margin,

statistically insignificant relation was found between board members business

management experience and financial performance of sample commercial banks.

However, as per the qualitative result if directors are assigned in committee based on

83
their practical background they can contribute more in promoting good governance.

Otherwise the general experience of directors may not be relevant for banks corporate

governance since the banks are highly regulated and are somewhat sensitive and special

than other sectors.

Whereas industry specific experience of director positively and significantly influence

return on asset. Contrary to this negatively and significantly related with net interest

margin. But it has not significant relation with return on equity. The result is somewhat

inconclusive.

Audit committee size has a negative relation with all the three financial performance of

commercial banks but not statistically significant with return on equity. It implied that

audit committee size negatively and significantly influence commercial banks

performance as measured by return on asset and net interest margin. Thus, small size

audit committee is effective to improve financial performance of commercial banks.

In general, the findings suggest that banks with effective corporate governance

mechanisms improve financial performance depending on the financial performance

measure being used. Although not all corporate governance variables support the stated

hypotheses, the study has achieved its objective by identifying the attributes that help to

test the research hypothesis. This study, therefore, finds that agency theory offers a

generally good explanation of the associations between corporate governance

mechanisms with financial performance.

84
5.2 Recommendations

This study examined the impact of corporate governance mechanisms on firms’ financial

performance by taking evidence from selected commercial banks in Ethiopia. On the

basis of the findings and conclusions reached, the following recommendations were

forwarded.

 Attention should be given for the board size of banks to be small in number to

optimal level with better educational qualification since small board size with

better educational qualification is more effective in monitoring managers and help

to improve performance.

 This study revealed that the boards of banks are dominated by male and board

gender diversity is very limited in Ethiopian commercial banks. Thus, there is

much to be done to improve the gender balance of boards in Ethiopian banks with

a great care about their qualification and competency.

 Business management experienced directors should be assigned in committee

based on their practical background to make them to contribute more in

promoting good governance. Because the general experience of directors is only

relevant for banks corporate governance when they are assigned to committee

based on their prior experience as revealed in the qualitative analysis.

 Finally, the researcher recommends that Ethiopian commercial banks should

make their audit committee size small to improve their performance. Because, as

this study revealed large size audit committee negatively influences performance.

85
5.3 Avenue for future research

By taking this study as a standing point, it could be possible to come up with a better

insight and several extensions to this study are possible. Considering the available time

and resource the outcome of this study can be more robust, if future researchers conduct a

study on this area. First, by further increasing the study population and the sample size to

the whole financial sector. Second, by taking evidence from other industries and

increasing the number of observations through the use of large sample size and long years

data. The relationship between corporate governance mechanisms and firms' financial

performance can also be further explained if future researchers conduct study including

more corporate governance variables.

86
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APPENDICES

93
 Appendix I: Research Questionnaire
ADDIS ABABA UNIVERSITY
SCHOOL OF BUSINESS AND PUBLIC ADMINISTRATION
MBA PROGRAM
RESEARCH QUESTIONNAIRE
Dear respondents this questionnaire is designed to gather data for research to be
conducted on the impact of corporate governance mechanisms on firms’ financial
performance in Ethiopian banking industry. Its aim is only for educational value. So you
are highly requested to respond genuinely.

Thank you in advance for your cooperation!!!

Part: One
 For the table questions fill the number only for each period.
No Items Fiscal Year in Gregorian Calendar
2006/07 2007/08 2008/09 2009/10 2010/11
1 Total number of directors sitting on the board
2 Number of female board of directors

3 Number of board members who had college

degree or higher

4 Number of board members who had business

management experience

5 Number of board members who served in the

same capacity in other banks earlier

6 Total number of audit committee members

94
7. Do you believe that board size affects banks performance?
Yes No
How? Please justify it---------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------.
8. Does the presence of female board of directors’ (in terms of board diversity) helps
improve the banks operation and performances?
Yes No
Why? -------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------.
9. Does the educational qualification of directors have any significant effect on their
monitoring and controlling efficiency?
Yes No
Give your reasons--------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------.
10. Does business management experience of directors’ enables to promote better
monitoring and good governance?
Yes No
How?----------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------.

95
11. Are there any board members who had earlier working experience on banking
business now in your company?
Yes No
In what ways do these members contribute better than other directors?-------------------
-------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------.

12. Do you believe that increasing the size of audit committee improve their effectiveness?
Yes No
How?----------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------.

Thank You Once Again!!!

February, 2012

96
Appendix II: Diagnostic tests results for OLS Assumptions

1. Normality test
Ho: Residuals are normally distributed
Ha: Residuals are not normally distributed
Model-1: Return on Asset
10
Series: Standardized Residuals
Sample 2007 2011
8 Observations 40

Mean 1.30e-19
6 Median 0.000211
Maximum 0.009746
Minimum -0.012646
4 Std. Dev. 0.005077
Skewness -0.420611
Kurtosis 2.895026
2
Jarque-Bera 1.197788
Probability 0.549419
0
-0.015 -0.010 -0.005 0.000 0.005 0.010

Model- 2: Return on Equity

9
Series: Standardized Residuals
8 Sample 2007 2011
Observations 40
7

6 Mean 1.02e-18
Median 0.001556
5 Maximum 0.052928
Minimum -0.082130
4
Std. Dev. 0.032671
3 Skewness -0.464803
Kurtosis 2.862838
2
Jarque-Bera 1.471633
1 Probability 0.479114
0
-0.08 -0.06 -0.04 -0.02 0.00 0.02 0.04 0.06

Model-3: Net Interest Margin

8
Series: Residuals
7 Sample 1 40
Observations 40
6
Mean -1.73e-19
5 Median 0.000528
Maximum 0.017979
4 Minimum -0.017787
Std. Dev. 0.008670
3 Skewness -0.050491
Kurtosis 2.462096
2

Jarque-Bera 0.499229
1
Probability 0.779101
0
-0.02 -0.01 0.00 0.01 0.02

97
2. Heteroskedasticity test
Ho: The variance of the error is constant
Ha: The variance of the error is heteroscedastic
Model-1: Return on Asset
Heteroskedasticity Test: White

Statistic d.f. Prob.

F-statistic 1.599614 Prob. F(9,30) 0.1604

Obs*R-squared 12.97086 Prob. Chi-Square(9) 0.1639
Scaled explained SS 9.127422 Prob. Chi-Square(9) 0.4256

Model-2: Return on Equity

Heteroskedasticity Test: White

Statistic d.f. Prob.

F-statistic 0.963632 Prob. F(9,30) 0.4882

Obs*R-squared 8.970352 Prob. Chi-Square(9) 0.4400
Scaled explained SS 5.270031 Prob. Chi-Square(9) 0.8102

Model-3: Net Interest Margin

Heteroskedasticity Test: White

Statistic d.f. Prob.

F-statistic 3.781641 Prob. F(9,30) 0.0028

Obs*R-squared 21.26018 Prob. Chi-Square(9) 0.0115
Scaled explained SS 8.742496 Prob. Chi-Square(9) 0.4614

There is problem of heteroskedasticity

3. Autocorrelation test
Ho: The errors are uncorrelated with one another
Ha: The errors are correlated with one another
Model-1: Return on Asset
Breusch-Godfrey Serial Correlation LM Test:

Statistic d.f. Prob.

F-statistic 0.100942 Prob. F(2,28) 0.9043

Obs*R-squared 0.286341 Prob. Chi-Square(2) 0.8666

98
Model-2: Return on Equity

Breusch-Godfrey Serial Correlation LM Test:

Statistic d.f. Prob.

F-statistic 0.153445 Prob. F(2,28) 0.8585

Obs*R-squared 0.433662 Prob. Chi-Square(2) 0.8051

Model-3: Net Interest Margin

Breusch-Godfrey Serial Correlation LM Test:

Statistic d.f. Prob.

F-statistic 0.713630 Prob. F(2,28) 0.4986

Obs*R-squared 1.940051 Prob. Chi-Square(2) 0.3791

4. Model specification error (linearity) test

Ho: The models functional form is appropriate
Ha: The models functional form is inappropriate

Model-1: Return on Asset

Ramsey RESET Test
Statistic d.f Prob.

F-statistic 0.529324 Prob. F(1,29) 0.4727

Log likelihood ratio 0.723519 Prob. Chi-Square(1) 0.3950

Model-2: Return on Equity

Ramsey RESET Test:

Statistic d.f. Prob.

F-statistic 0.211863 Prob. F(1,29) 0.6487
Log likelihood ratio 0.291163 Prob. Chi-Square(1) 0.5895

99
Model-3: Net Interest Margin
Ramsey RESET Test
Statistic d.f Prob.

F-statistic 0.547128 Prob. F(1,29) 0.4654

Log likelihood ratio 0.747629 Prob. Chi-Square(1) 0.3872

5. A redundant fixed effects test

Ho: Fixed effect is appropriate
Model-1: Return on Asset
Redundant Fixed Effects Tests
Test period fixed effects

Effects Test Statistic d.f. Prob.

Period F 0.996973 (4,26) 0.4269

Period Chi-square 5.707886 4 0.2221

Model-2: Return on Equity

Redundant Fixed Effects Tests
Test cross-section fixed effects

Effects Test Statistic d.f. Prob.

Cross-section F 1.301986 (7,23) 0.2935

Cross-section Chi-square 13.351794 7 0.0640

100
Appendix III: List of sample commercial banks

1. Awash international bank

2. Dashen bank

3. Bank of Abyssinia

4. Wegagen bank

5. United bank

6. Commercial bank of Ethiopia

7. Nib international bank

8. Lion international bank

101