CHAPTER ONE

INTRODUCTION

1.0 Background to the study

Banks are the backbones of any economy; therefore it is of immense importance for economies
to possess a healthy and buoyant banking system with effective corporate governance practices.
It has become a worldwide dictum that the quality of corporate governance makes an important
difference to the soundness and unsoundness of banks. Broadly speaking, corporate governance
refers to the extent to which companies are run in an open and honest manner. Sanusi (2003).
Thus, effective corporate governance practice incorporates transparency, openness, accurate
reporting and compliance with statutory regulations among others. For the financial institutions,
the retention of public confidence through the enthronement of good corporate governance
remains of almost importance given the role of the industry in the mobilization of fund, the
allocation of credit to the deficit sectors of the economy, the payment and settlement system and
the implementation of monetary policy.
There are many ways of defining corporate governance, ranging from narrow definitions that
focus on companies and their shareholders, to broader definitions that incorporate the
accountability of companies to many other groups of people, or stakeholders. The Cadbury
Report (1992) was set up by the Committee on the Financial Aspects of Corporate Governance,
known as the Cadbury Committee in May 1991 by the Financial Reporting Council, the London
Stock Exchange, and the accountancy profession. The report made far reaching
recommendations on corporate governance concerning the way in which companies are directed
and controlled. Corporate Governance is a mechanism to structure, operate and control a
company with the objective to achieve long-term strategic goals of safeguarding the interests of
shareholders and different stakeholders.
In the banking industry, corporate governance involves the way banking institutions' business
and affairs are managed by the board of administration and the top management, which affects
how the bank works out the bank's objectives, plans and policies, taking into consideration
making appropriate economic returns for founders and other shareholders, day-to-day work
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management, protection of the rights and interests of recognized stakeholders (shareholders and
depositors), companies' commitment to sound and safe professional behaviors and practices
which are in conformity with regulations and legislations, (Linyiru, 2006).
Financial scandals around the world and the recent collapse of major corporate institution in the
USA has brought to the fore, once again the need for the practice of good corporate governance,
which is a system of managing the affairs of corporations with a view to increasing shareholders
value and meeting the expectations of other stake - holders. Particularly, the need to implement
good corporate governance in the banking sector becomes more apparent after the Asian
financial crisis. This has been largely event- driven in the sense that it is in response to scandals
and unexpected crisis, which in some cases abruptly terminated the existence of large corporate
entities. The failure of Johnson Matheys Bank, Bank of Credit and Commerce International,
Polly Peck, world com and Enron Incorporation are cases in point. The failure of these
institutions has been traced to several lapses associated with poor corporate governance
including conflicts of interest of corporate governors. Corporate governance has in recent times
assumed heightened importance requiring that boards and management of companies exhibit
greater transparency and accountability in their business conduct. Indian authorities took the first
initiative in 1996 when the Confederation of Indian Industries developed a code for corporate
governance to be adopted by Indian Companies. But still there was need for further strict
regulations to be imposed on Indian companies. So SEBI came up the regulations for listing
companies in 1999, which included mandatory and non-mandatory recommendations. These
guidelines played a prominent role in the Indian corporations. Followed by CII and SEBI other
regulatory authorities also actively participated in strengthening the corporate governance system
of India.
Several empirical studies have provided the nexus between corporate governance and firm
performance. Bebchuk, Cohen and Ferrell (2004) postulates that a well governed firm have
higher firm performance; Gompers, Ishii & Metrick (2003) demonstrate through their study that
firms with poor corporate governance quality enjoy lower stock returns than those with a higher
level of governance quality. Financial devastation of many corporations such as those of USA,
South East Asia and Europe have been premised on the failure of corporate governance; high
profile scandals throughput the world such as Enron and World.Com in the United States,
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Transmile, Megan Media and Nasioncom in Malaysia brought about the importance of good
corporate governance to limelight. Each of these corporate cases was directly linked to corporate
governance failures (Hussin & Othman 2012; Abdul-Qadir & Kwambo, 2012). Jensen and
Meckling (1976) acknowledged that the principal-agent theory which was also adopted in this
study is generally considered as the starting point for any debate on the issue of corporate
governance. A number of corporate governance mechanisms have been proposed to ameliorate
the principal-agent problem between managers and their shareholders. These governance
mechanisms as identified in agency theory include board size, board composition, CEO pay
performance sensitivity, directors ownership and share holder right (Gomper, Ishii and Metrick,
2003) . They further suggest that changing these governance mechanisms would cause managers
to better align their interests with that of the shareholders thereby resulting in higher firm value.
The idea of corporate governance is mostly common to banks and multinational firms. Corporate
governance has been an item of great importance on the policy agenda in most developed
countries for many years now. Although corporate governance in developing economies has
recently received a lot of attention in the literature (Lin (2000); Goswami (2001); Oman (2001);
Malherbe and Segal (2001); Carter, Colin and Lorsch (2004); Staikouras, Maria-Eleni, Agoraki,
Manthos and Panagiotis (2007); McConnell, Servaes and Lins (2008) and Bebchuk, Cohen and
Ferrell (2009), yet corporate governance of banks in developing economies as it relates to their
financial performance has almost been ignored by researchers (Caprio and Levine (2002); Ntim
(2009) . Even in developed economies, the corporate governance of banks and their financial
performance has only been discussed recently in the literature (Macey and OHara, 2001).
The few studies on bank corporate governance narrowly focused on a single aspect of
governance, such as the role of directors or that of stock holders, while omitting other factors and
interactions that may be important within the governance framework. Feasible among these few
studies is the one by Adams and Mehran (2002)for a sample of US companies, where they
examined the effects of board size and composition on value. Another weakness is that such
research is often limited to the largest, actively traded organizations- many of which show little
variation in their ownership, management and board structure and also measure performance as
market value.
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In the African continent the idea of corporate governance is steadily gaining huge recognition.
Several recent activities have led to the increased pursuit in effective corporate governance
policies in all nations. The case of having effective governance policies gained universal
recognition from a period of absolute ambiguity after series of high profile collapses led to
significant interest. In Nigeria the upsurge in the number of financial intermediaries following
deregulation and the failure of a significant number of the institutions with attendant agony
suffered by many Depositors/Customers and the systemic threat to the economy, all underscore
the imperative for greater concern for corporate governance in financial intermediaries especially
mainstream banks. For instance, between 1994 and 1995, five banks failed and had their licenses
revoked by the Central Bank of Nigeria (CBN) due to distress. This was to be a tip of the iceberg
as the distress situation worsened and later resulted in the closure of thirty other licensed banks
between 1998 and 2002.
The banking industry in Kenya is one of the most dynamic and important industries to the
economy. The industry has recently experienced phenomenal growth and is one of the fastest
growing industries in Africa. The growth has mainly been supported by the expansion of banks
into new market segments and especially in East Africa, prudent risk management and enhanced
economic prospects. The Central Bank of Kenya (CBK) expects the banking sector to continue
on this growth and especially due to ongoing reforms and initiatives by the Government and
itself that will serve to further propel the banking sector to new frontiers. The Kenyan banking
industry being the nerve centre of the economy is invariably affected by economic and political
environment/condition of the country.
The subject of corporate governance in Kenya has been top of the agenda for many years.
Despite tight regulatory framework, corporate governance continues to weaken in Kenya to some
extent. Kenya in particular, concern was raised specifically on the way in which organizations
were managed and controlled. According to Centre for Corporate Governance of Kenya (CCG)
(2004) , focus on corporate governance in the financial sector is crucial mostly because the
banking industry became highly exposed to scrutiny by the public and many lessons were learnt
because of the risks involved including adverse publicity brought about by failings in governance
and stakeholder relations for instance, the collapse of banks such as Euro bank, Trust bank and
Daima bank just to mention a few cases (CCG, 2004).
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Kenyas corporate governance system was highly influenced by two factors: after the
government relaxed rules that governed issuance of licenses to banks in 1982 and by the
privatization process that began in the 1980s and gained momentum in the 90s. This led to the
growth of many banks that did not put into practice proper corporate governance structures
resulting into poor governance and management culture in the industry (Mwangi, 2002). A case
in point was it the year 1984 when the Rural Urban
Credit Finance was placed in interim liquidation. The Government of Kenya through the Central
Bank made changes in the Central Bank act and the banking act to curb instability in the banking
industry. This was for example, through raising the capital requirements and the creation of the
Depositors Protection Fund. Regardless of efforts made to streamline the banking sector, many
banks have been liquidated or put under receivership. The collapse was due to weak internal
controls, poor governance and management practices. For example, Continental Bank of Kenya
and Continental Credit Finance Ltd collapsed in 1986. In 1987 Capital Finance went under.
The Government then formed Consolidated Bank by merging seven banks that had collapsed
( Nambiro, 2007). Various reasons were given that may have contributed to the collapse of
banking institutions in Kenya. The Centre for Corporate Governance, (2004) outlined the
following reasons as being major contributors to this phenomenon; insider lending and conflict
of interest, weaknesses in regulatory and supervisory systems, poor risk management strategies,
lack of internal controls and weak corporate governance practices. This followed by the Central
Bank of Kenya to outline more bold and elaborate measures to curb these problems and also to
strengthen its arm of supervisory role it plays in the industry.
In 2002, the Capital Markets Authority (CMA) developed a set of Guidelines on corporate
governance to guide Kenyan listed companies in streamlining their corporate governance
practices. The Guidelines were formulated in accordance with the provisions of sections 11(3)
( v) and 12 of the Capital Markets Act (Cap. 485A). The Guidelines were also developed in
response to the growing importance of corporate governance in promoting the growth of
domestic and regional capital markets through better financial performance, capital formation
and maximisation of shareholders value (CMA, 2002; Matama, 2008).

According to the CMA Guidelines, corporate governance is the process of managing business
affairs of an institution to achieve financial prosperity, accountability and improve shareholders
long-term value (CMA, 2002). The overall objective of the CMA Guidelines is to strengthen
corporate governance practices among listed companies in Kenya. In this regard, the directors of
such institutions should comply with good corporate governance practices, as part of their
obligations to sustain their listing at the Nairobi Stock Exchange (NSE) market. The Guidelines
outline various corporate governance principles, touching on structure and functions of the board
of directors; the rights and responsibilities of shareholders; auditing and accountability, as well as
public disclosure. The CMA Guidelines should enhance sound economic growth through higher
financial performance and capital formation to enhance the long-term value of shareholders
( CMA, 2002). All listed corporate entities in Kenya should embrace good governance practices
in line with provisions of the Guidelines, as a pre-requisite for their continued listing at the NSE.
However, unlisted firms are encouraged to practice good corporate governance (CMA, 2002).
This implies that listed and unlisted corporate entities in Kenya operate under different
governance policy environments, which is likely to create variation in their financial
performance and stability.
The collapse of a number of locally owned commercial banks in the 1990s was closely associated
with a high portfolio of non-performing loans (NPLs) a situation that ties to poor corporate
governance practices Murugu (2002). As at December 2001, prior to the launch of the CMA
Guidelines, the banking sector had registered up to KES 215 billion in terms of NPLs, which
accounted for up to 51 percent of the sectors net assets. Besides, the proportion of NPLs to the
total loans in Kenya was at a high of 33 percent [Central Bank of Kenya (CBK), 2001]. As a
result, the period between 1990 and 2005 saw the insolvency of a number of banks, including
Euro Bank Limited, Trade Bank Limited, Daima Bank Limited, Transnational Bank Limited,
Trust Bank Limited, Delphis Bank Limited, among others. It also marks the period when a
number of state-owned banks such as Kenya Commercial Bank Limited and the National Bank
Limited experienced serious financial performance challenges. Comparing the ratio of NPLs to
total loans in Kenya of 33 percent to similar African economies at the end of 2001 the CBK
supervision report notes that Zimbabwe had 24 percent, Nigeria registered 11 percent and South
Africa 3 percent (CBK, 2001). This trend necessitated the formulation of appropriate regulatory
measures, including the CMA guidelines to safeguard the interest of investors.
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The CBKs annual supervision report of 2009 indicated that the NPLs portfolio had reduced from
by 65.6 percent from KES 215 billion in 2001 to about KES 74 billion (CBK, 2009). Although
these statistics suggest that the banking sector has improved since the Guidelines came into
existence, there is limited or no documentation regarding the role of the Guidelines in the
improvement of financial performance in the banking sector. The few most recent studies
focusing on the application of CMA Guidelines have targeted the manufacturing and utility
industries (Mutuku, 2005; Kiplangat, 2005; Gitari, 2005). The dearth of academic literature
regarding the subject inspired the conduct of this study. To achieve its objectives, the study will
examine listed commercial banks in terms of selected indicators of good corporate governance,
including board size, proportion of non-executive directors, board maintenance cost and gender
composition of the board. Additional indicators included the proportion of non-executive
directors as well as the number of public disclosures in the immediate financial year. The study
will also determine the effect of each indicator of good corporate governance on the financial
performance of commercial banks.

1.2 Research Problem

Corporate governance in the banking sector in Kenya largely relates to the responsibility
conferred to and discharged by the various entities and persons responsible for and concerned
with the prudent management of the financial sector (Central Bank of Kenya, 2006). The
corporate governance stakeholders in the banking sector include the board of directors,
management, shareholders, Central Bank of Kenya, external auditors and Capital Markets
Authority (CCG, 2004). It is believed that good governance generates investor goodwill and
confidence. Again, poorly governed firms are expected to be less profitable. Poor corporate
governance could have a significant impact on any economy, it can lead to bank failures while on
the long run impact on the publics trust on an economys banking system efficiently manage its
assets and liabilities. A banks assets and liabilities involve its customers deposits and if these
funds are not efficiently managed could lead to a liquidity crisis. Historically, antecedents
indicate that financial crisis is a direct consequence of lack of good corporate governance in
banks; invariably one of the sources of instability in the banking sector is lack or inadequate
practice of corporate governance. The Kenyan Structural Adjustment Programme ( SAP )
introduced in 1986 led to a wide range of economic reforms that affected the banking system.
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Also political situation like the political crisis like the disputed election in 2008, led to massive
withdrawal of funds that affected banks (especially) those around affected regions, (CBK, 2008).
The regulatory and supervisory measures of the CBK are unable to keep pace with the rapid
changes in the banking industry. The CBK brief (2007) noted that the ability of the CBK to
perform its regulatory role had in the past been affected by political leadership and corruption in
the former regime. There is a yawning gap that exists since none of them covers effects of
corporate governance and financial performance specifically listed banks in Kenya. The only
study done in Kenya by the Centre for Corporate Governance focused on governance practices in
the commercial banking sector in Kenya. Ogumu, (2006) in discussing the challenges of bank
liquidation and deposit payoff, noted that closing a bank is a specialized job requiring services of
technically skilled people in banking, accounting, legal, quantity surveying, estate management,
information management and technology as well as facility support and also noted that political
instability constituted a problem to its supervisory function. More so, the many unpublished
work done in Kenya followed suit by focusing corporate governance in general with only one
study among them focusing on the relationship between implementation level of Capital Markets
Authority guidelines on corporate governance and profitability of companies listed at the Nairobi
Stock Exchange (NSE). Locally, there are a few studies in corporate governance though none has
focused on commercial Banks. For instance, Jebet (2001) focuses on the listed companies;
Macuvi, (2002) focuses on the motor vehicle industry while Mwangi, (2002) focuses on
insurance companies. From the published annual financial reports, commercial banks in Kenya
recorded unpleasant performance in the early 2000 but there has been significant improvement
since 2007 and this study is therefore, is designed to establish the effect if any of corporate
governance on financial performance of Commercial Banks in Kenya. Many other researchers
have examined the relationship between variety of governance mechanisms and firm
performance. However, the results are mixed. Some examine only the impact of one governance
mechanism on performance, while others investigate the influence of several mechanisms
together on performance. A number of studies have also been carried out in the area of corporate
governance and financial performance in state corporations, in cooperative societies, in
companies listed in the Nairobi Stock Exchange in Kenya, examples; Njoka, (2010); Linyiru,
(2006); Maina, (2006); Awino, (2011); Muriiti, (2011) and Ooko, (2011).

1.3 Research Objectives

Generally, this study seeks to explore the relationship between internal corporate governance
structures and firm financial performance in the Kenyan banking industry. However, it is set to
achieve the following specific objectives:
1) To examine the relationship between board size and financial performance of banks in Kenya.
2) To find out if there is a significant difference in the financial performance of banks with foreign
directors and banks without foreign directors in Kenya
3) To appraise the effect of the proportion of non- executive directors on the financial performance
of banks in Kenya
4) To investigate if there is any significant relationship between directors equity interest and the
financial performance of banks in Kenya
5) To empirically determine if there is any significant relationship between the level of corporate
governance disclosure and the financial performance of banks in Kenya
6) To investigate if there is any significant difference between the profitability of the healthy banks
and the rescued banks in Kenya
1.4 Research Questions
This study seeks to address issues relating to the following pertinent questions emerging within
the domain of study problem:
1) To what extent (if any) does board size affect and the financial performance of banks in Kenya?
2) Is there a significant difference in the financial performance of banks with foreign directors and
banks without foreign directors in Kenya?
3) Is the relationship between the proportion of non-executive directors and the financial
performance of listed banks in Kenya statistically significant?
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4) Is there a significant relationship between directors equity holdings and the financial
performance of banks in Kenya?
5) To what extent does the level of corporate governance disclosure affect the performance of banks
in Kenya?
6) To what extent (if any) does the profitability of healthy banks differ from that of the rescued
banks in Kenya?
1.5 Hypotheses
To proffer useful answers to the research questions and realize the study objectives, the following
hypotheses stated in their null forms will be tested;
Hypothesis 1a:
H0: There is no significant relationship between board size and financial performance of banks
in Kenya
Hypothesis 1b:
H0: There is no significant difference in the financial performance of banks with foreign
directors and banks without foreign directors in Kenya
Hypothesis 2:
H0:

The relationship between the proportion of non executive directors and the financial

performance of Kenya banks is statistically not significant

Hypothesis 3:
H0: There is no significant relationship between directors equity holding and the financial
performance of banks in Kenya

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Hypothesis 4:
H0: There is no significant relationship between the governance disclosures of banks in Kenya
and their performance
Hypothesis 5:
H0: There is no significant difference between the profitability of the healthy and the rescued
banks in Kenya
1.6 Significance of the Study
The findings of this research project would contribute to improving understanding about
corporate governance practices in Kenyan banking, and in what ways the banks can implement
good corporate governance that aligns with bank performance. Many Commercial Banks in
Kenya will find the study very valuable to their operations and more so a benchmark to decisions
to improve on corporate governance in the banking industry.
This study will further provide an insight into understanding the degree to which the banks that
are reporting on their corporate governance have been compliant with different sections of the
codes of best practice and where they are experiencing difficulties. Boards of directors will find
the information of value in benchmarking the performance of their banks, against that of their
peers. The result of this study will also serve as a data base for further researchers in this field of
research.
1.7 Justification of Study
Generally, banks occupy an important position in the economic equation of any country such that
its (good or poor) performance invariably affects the economy of the country. Poor corporate
governance may contribute to bank failures, which can increase public costs significantly and
consequences due to their potential impact on any applicable system. Poor corporate governance
can also lead markets to lose confidence in the ability of a bank to properly manage its assets and
liabilities, including deposits, which could in turn trigger liquidity crisis.

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From the preceding discussions, it is evident that the question of ideal governance mechanism
(board size, board composition and directors equity interest) is highly debatable. Since
performance of a firm, as identified by Das and Gosh (2004), depends on the effectiveness of
these mechanisms, there is a need to further explore this area. Although researchers have tried to
find out the effects of board size and other variables on the performance of firms, they are mostly
in context of developed markets. To the best of the researchers knowledge based on the
literatures reviewed, only few studies were found in the context of Kenyan banks. Due to
neglect of banking sector by other studies and with radical changes in Kenya banking sector in
the last few years, present study aims to fill the existing gap in corporate governance literatures.
The empirical results would also provide general indicators of corporate governance useful for
both regulator and business people in making policies and decisions as well as in rewarding or
punishing the banks that have great or little intention to improve their corporate governance
aligning with managers-owners risk-taking behaviour and bank performance. Other researchers
and academic community will use this study as a basis for further studies on corporate
governance in Kenyan banks.
Studies on bank governance are therefore important because banks play important monitoring
and governance roles for their corporate clients to safeguard their credit against corporate
financial distress and bankruptcy. An expose by Prowse (1997) shows that research on corporate
governance applied to financial intermediaries especially banks, is indeed scarce. This shortage is
confirmed in Oman (2001); Goswami (2001); Lin (2001); Malherbe and Segal (2001) and Arun
and Turner (2002). They held a consensus that although the subject of corporate governance in
developing economies has recently received a lot of attention in the literature, however, the
corporate governance of banks in developing economies has been almost ignored by researchers.
The idea was also shared by Caprio and Levine (2001). Macey and OHara (2002) shared the
same opinion and noted that even in developed economies; the corporate governance of banks
has only recently been discussed in the literature. To the best of the researchers knowledge, apart
from the few studies by Caprio and Levine (2002), Peek and Rosengren (2000) on corporate
governance and bank performance, very little or no empirical studies have been carried out
specifically on this subject especially in developing economies like Kenya.

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This scarcity of research effort demands urgent intervention, which therefore justifies the
importance of this study, which intends to provide guidance in corporate governance of banks.
Furthermore, banks are very opaque, which makes the information asymmetry and the agency
problem particularly serious (Biserka, 2007).
1.8 Scope and Limitation of Study
This study investigates the relationship between corporate governance and financial performance
of banks. The choice of this sector is based on the fact that the banking sector s stability has a
large positive externality and banks are the key institutions maintaining the payment system of an
economy that is essential for the stability of the financial sector. Financial sector stability, in turn
has a profound externality on the economy as a whole. To this end, the study basically covers all
the listed banks operating in Kenya. However it is not possible to obtain the annual reports of
2014/2015 since they are yet to be published by many of the banks as at the time of this research.
The study focuses only on banking industry because corporate governance problems and
transparency issues are important in the banking sector due to the crucial role in providing loans
to non-financial firms, in transmitting the effects of monetary policy and in providing stability to
the economy as a whole. The study therefore covers four key governance variables which are
board size, board composition, directors equity interest and governance disclosure level.

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