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THE EFFECTS OF OWNERSHIP STRUCTURE ON BANK PROFITABILITY IN
KENYA
Rokwaro Massimiliano Kiruri, Olkalou, Kenya
Cite this Paper: Kiruri, R. M. (2013). The effects of ownership structure on bank
profitability in Kenya. European Journal of Management Sciences and Economics, 1(2), 116-
127.
ABSTRACT
Recent years have seen increased research into the relationship between ownership structure
and bank profitability. It has been widely accepted that organizational form influences
operating behavior, as it defines the nature of residual claims and, thus, the motivations of
the firm’s owners. This study sought to investigate the effects of ownership structure on bank
profitability in Kenya. Primary data was obtained through a questionnaire that was
structured to meet the objectives of the study. The study used annual reports that are
available from their websites and in the Central bank of Kenya website. The study found that
ownership concentration and state ownership had negative and significant effects on bank
profitability while foreign ownership and domestic ownership had positive and significant
effects on bank profitability. The study concludes that higher ownership concentration and
state ownership lead to lower profitability in commercial banks while higher foreign and
domestic ownership lead to higher profitability in commercial banks.
Keywords: ownership structure, bank profitability, ownership concentration, foreign,
domestic, state.
INTRODUCTION
In a sense, ownership structure is a deep-seated problem for governance structure since it may
make big effects on business incentives, mergers and acquisitions, competition and oversight
of agency; and the concept is discussed by different views. The first view defined ownership
structure as different types of equity such as A share, B share, outstanding share or allotment
transfer, etc. (He, 1998, Zhou, 1999). A second view divided ownership structure according
to its “ownership”, i.e. state shares, state-owned legal person shares, legal person shares, etc.
This view sees ownership structure like the shareholder structure which refers to equity ratio
occupied by various shareholders (Wu, 2003).
Background of the study
The governance of corporations has attracted much attention in the past decade. The term
“corporate governance” derives from an analogy between the government of cities, nations or
states and the governance of corporations (Becht et al. 2005). In Shleifer & Vishny’s (1997)
survey on this topic, they pointed out that corporate governance relates to the ways in which
the suppliers of finance to corporations assure themselves of getting a return on their
investment. Ownership structure is like the hard core of corporate governance, a firm’s
“owners,” is those persons who share two formal rights: the right to control the firm and the
right to appropriate the firm’s profits, or residual earnings which in theory, could be separated
and held by different classes of persons Hansmann (2000).
The connection between ownership structure and performance has been the subject of an
important and ongoing debate in the corporate finance literature (Demsetz & Villalonga,
2001).The concept of ownership structure can be defined along two dimensions: ownership
concentration and ownership mix (Gursoy & Aydogan, 2002). The former refers to the share
of the largest owner and is influenced by absolute risk and monitoring costs (Pedersen &
Thomsen 1999), while the latter is related to the identity of the major shareholder.
The banking industry in Kenya
According to the Central Bank of Kenya, there are 43 licensed commercial banks in Kenya
(see list in appendix 1). Three of the banks are public financial institutions with majority
shareholding being the Government and state corporations. The rest are private financial
institutions. Of the private banks, 27 are local commercial banks while 13 are foreign
commercial banks (CBK, 2012).
Commercial banks in Kenya play a major role in Kenya. They contribute to economic growth
of the country by making funds available for investors to borrow as well as financial
deepening in the country. Commercial banks therefore have a key role in the financial sector
and to the whole economy.
Bank financial performance in the recent past has significantly improved since 2000. Data
from the Central Bank of Kenya shows a significant growth in the industry in all areas
including financial performance (CBK, 2012). While this is the case, some banks, especially
the foreign banks, have been performing better than others. The factors leading to this needs
an investigation as has been the focus of many studies in other countries such as China,
Nigeria, Singapore, UAE, UK, USA, among others.
The banking industry in Kenya has grown over the years since the Central Bank of Kenya put
up measures to regulate the banks in order to streamline the activities and more so to prevent
the collapse of the banking industry as had been before. Banks expand internationally by
establishing subsidiaries and branches or taking over established foreign banks. This
internationalization of banking systems has been encouraged by the liberalization of
international financial markets (Muthungu, 2003).
Statement of the Problem
Empirical studies that discusses the role of ownership structure in corporate governance
around the world include (Shleifer & Vishny, 1997; La Porta et al. 1999), with examples of
those specifically examining the relationship between ownership structure and firm
performance being (Bathala & Rao, 1995; Mitton, 2002; Ng, 2005; Vethanayagam et al.,
2006). The effect of ownership structure and concentration on a firm’s performance is an
important issue in the literature of finance theory (Zeitun & Tian, 2007). It is worth noting
that most research on ownership structure and firm performance has been dominated by
studies conducted in developed countries. However, there is an increasing awareness that
theories originating from developed countries such as the USA and the UK may have limited
applicability to emerging markets. Emerging markets have different characteristics such as
different political, economic and institutional conditions, which limit the application of
developed markets’ empirical models. Kenyan studies have been contradictory in theory
findings on the relationship between ownership structure, and firm performance (e.g.
Mbaabu, 2010; Muka, 2010; Ongore & K’obonyo, 2011 and Kihara, 2006). There is therefore
a gap in literature as far as an industry-wide study on the effects of ownership structure on
bank profitability in Kenya is concerned. This is the gap the present study seeks to bridge.
Research objectives
General Objectives
The main objective of this study was to determine the effects of ownership structure on bank
profitability in Kenya.
Specific Objectives
1. To determine the relationship between ownership concentration and bank profitability
in Kenya
2. To determine the relationship between domestic ownership and bank profitability in
Kenya
3. To determine the relationship between foreign ownership and bank profitability in
Kenya
4. To determine the relationship between state ownership and bank profitability in
Kenya
Research questions
1. What is the relationship between ownership concentration and bank profitability in
Kenya?
2. What is the relationship between domestic ownership and bank profitability in Kenya?
3. What is the relationship between foreign ownership and bank profitability in Kenya?
4. What is the relationship between state ownership and bank profitability in Kenya?
Importance of the study
Financial managers will be more sensitive to the influence that the various owners may have
to the decisions they make with regard to the various corporate decisions such as dividend
policy, investment policy and capital budgeting decisions of banks. Financial Managers will
further identify whether minority investors have a role to play. The government through the
regulators will be interested to know how the various owners may make decisions that may
affect some sectors of the economy and come up with regulations. Policy makers will pursue
economic reforms that will influence the corporate policies to be geared towards the welfare
of the nation at large and protection against minority investors. This study will also guide
policy makers in the banking sector especially the Central Bank of Kenya and the Treasury in
coming up with policies which will spur growth and profitability in this sector. Scholars will
have an insight of the relationship between various owners and corporate policies and
profitability of banks.
THEORETICAL REVIEW
Agency theory
Agency theory suggests that the firm can be viewed as a nexus of contracts between resource
holders. An agency relationship arises whenever one or more individuals, called principals,
hire one or more other individuals, called agents, to perform some service and then delegate
decision-making authority to the agents. The primary agency relationships in business are
those between stockholders and managers; and between debt holders and stockholders. These
relationships are not necessarily harmonious; indeed, agency theory is concerned with so-
called agency conflicts, or conflicts of interest between agents and principals. This has
implications for, among other things, corporate governance and business ethics. When agency
occurs it also tends to give rise to agency costs, which are expenses incurred in order to
sustain an effective agency relationship. Accordingly, agency theory has emerged as a
dominant model in the financial economics literature, and is widely discussed in business
ethics texts. Agency theory in a formal sense originated in the early 1970s, but the concepts
behind it have a long and varied history (Bowie & Edward, 1992).
The principal-agent model suggests that managers are less likely to engage in strictly profit
maximizing behavior in the absence of strict monitoring by shareholders (Prowse, 1992;
Agrawal & Knoeber, 1996). Therefore, if owner-controlled firms are more profitable than
manager controlled firms, it would seem that concentrated ownership provides better
monitoring which leads to better performance.
Resource Based View
Resource Based View (RBV) holds that firms can earn sustainable super-normal returns if
and only if they have superior intangible resources that are protected by some form of
isolating mechanism preventing their diffusion throughout industry. According to Wernerfelt
(1984) & Rumelt (1984), the fundamental principle of the RBV is that the basis for a
competitive advantage of a firm lies primarily in the application of the bundle of valuable
resources at the firm’s disposal. To transform a short-run competitive advantage into a
sustained competitive advantage requires that these resources are heterogeneous in nature and
not perfectly mobile (Barney, 1991; Peteraf, 1993).
Essentially, these valuable resources become a source of sustained competitive advantage
when they are neither perfectly imitable nor substitutable without great effort (Barney, 1991).
In a nutshell therefore, to achieve these sustainable above average returns, the firm’s bundle
of resources must be valuable, rare, imperfectly imitable and non-substitutable (Barney,
1991). The extent to which external and internal factors affect managerial discretion will
depend on, among other factors, the manager’s locus of control, perception of discretion and
the amount of power that people perceive the manager to possess.
Foreign shareholders are endowed with good monitoring capabilities, but their financial focus
and emphasis on liquidity results in them unwilling to commit to a long-term relationship
with the firm and to engage in a process of restructuring in case of poor performance. These
shareholders prefer strategies of exit rather than voice to monitor management (Aguilera
&Jackson, 2003). Consequently, foreign shareholders are postulated to have a moderate
impact on firm performance. Domestic shareholders possess characteristics that represent the
worst of both worlds. Their financial focus leads to short-term behavior and a preference for
liquid stocks while their domestic affiliation often results in a complex web of business
relationship with the firm and other domestic shareholders (Claessens et al., 2000;
Dharwadkar et al., 2000). Therefore, these shareholders are expected to have a negative
influence on firm performance.
Institutional Theory
Institutional theory emphasizes the influence of socio-cultural norms, beliefs and values,
regulatory and judicial systems on organizational structure and behavior. Institutions regulate
economic activities through formal and informal rules as a basis for production, exchange and
distribution (North, 1990). In addition to these features, emerging economies are
characterized by greater imperfections in the markets for capital, products and managerial
talent. These lead to so called institutional voids - a situation when specialized intermediaries
who typically provide these services in developed economies are absent (Khanna & Palepu,
2000). It presents an opportunity for some firms, which have the necessary resources and
capabilities to bridge these institutional voids.
Business groups are particularly well suited to provide the necessary welfare enhancing
functions to plug these institutional voids because of their superior ability to raise capital,
train and rotate managerial talent among group firms, and use common brand names in
marketing their products. On the downside, though, some of these institutional voids and
ineffective protection of minority shareholder and creditor rights lead to greater entrenchment
by controlling shareholders resulting in conditions ideally suited for expropriation of
disadvantaged stakeholders.
Conceptual framework
Independent variables Dependent Variable
Source: Author, 2012
Empirical Review
Ownership Concentration
The effect of ownership concentration on company profitability has been studied since Berle
& Means (1932). Other studies comparing profitability of manager–and owner–controlled
companies, often categorized by the share of the largest owner, generally found a higher rate
of return in companies with concentrated ownership (Cubbin & Leech, 1983). These studies,
however, were seriously lacking a theoretical foundation. They neither used nor provided a
theory of ownership structure and seemed to imply that shareholders could increase profit by
rearranging their portfolios. This point was emphasized by Demsetz (1983) who argued
theoretically that the ownership structure of the firm is an endogenous outcome of the
competitive selection in which various cost advantages and disadvantages are balanced to
arrive at an equilibrium organization of the firm.
Ownership Concentration
percentage of shares held
Domestic Ownership
Individual
Institutional
Foreign Ownership
Individual
Institutional
Bank profitability
ROE
State Ownership
Majority shareholding
Full Ownership
A study conducted in Kenya by Ongore & K’Obonyo (2011) on interrelations among
ownership, board and manager characteristics and firm performance in a sample of 54 firms
listed at the Nairobi Stock Exchange (NSE). Using PPMC, Logistic Regression and Stepwise
Regression, the paper presents evidence of significant positive relationship between foreign,
insider, institutional and diverse ownership forms, and firm performance. However, the
relationship between ownership concentration and government, and firm performance was
significantly negative. The role of boards was found to be of very little value, mainly due to
lack of adherence to board member selection criteria. The results also show significant
positive relationship between managerial discretion and performance. Collectively, these
results are consistent with pertinent literature with regard to the implications of government,
foreign, manager (insider) and institutional ownership forms, but significantly differ
concerning the effects of ownership concentration and diverse ownership on firm
performance.
Domestic Vs Foreign Ownership
Evidence across many countries indicates that foreign banks are on average less efficient than
domestic bank (Wahid & Rehman, 2009; Hasan & Hunter, 1996; Mahajan et.al, 1996; Chang
et. al, 1998). A more recent cross border empirical analysis of France, Germany, Spain, the
UK and the U.S. found that domestic banks have both higher cost efficiency and profit
efficiency than foreign banks (Berger et.al, 2000). It is important to note however, that
similar to other banking research, most of literature has focused primarily on developed
countries, particularly the United States (Clarke et.al, 2003). Studies that have not used the
U.S. as the host nation in the analysis, have found that foreign banks have almost the same
average efficiency as domestic banks (Vander, 1996; Hasan & Lozano - Vivas, 1998). And
studies that compared industrialized and developing countries have found that while foreign
banks have lower interest margins, overhead expenses, and profitability than domestic banks
in industrialized countries, the opposite is true in developing countries (Claessens, et al.,
2000; Demirgüç -Kunt & Huizinga, 1999). Claessens et al (2000) reported that in many
developing countries (for example Egypt, Indonesia, Argentina and Venezuela) foreign banks
in fact report significantly higher net interest margins than domestic banks and in Asia and in
Latin America foreign banks achieve significantly higher net profitability than domestic
banks.
There have been different lines of reasoning put forward for the relatively lower performance
of foreign banks compared with domestic in industrialized countries. These include different
market, competitive and regulatory conditions between industrialized and developing
countries (Claessens, et al., 2000); home field advantage of domestic banks (Clarke, et al.,
2001) and within the U.S. that foreign banks have been relatively less profitable because they
valued growth above profitability (DeYoung & Nolle, 1996). Within developing countries,
the reasoning suggested for the improved performance of foreign over domestic banks
included exemption from credit allocation regulation and other restriction, market
inefficiencies and outmoded banking practices that allow foreign banks better performance
(Claessens, Demirgüç- Kunt, & Huizinga 2000).
State Ownership
Following the 2002 World Development Report, Boubakri et.al (2002) suggested 3
arguments justifying state over private ownership of bank namely that private banks are more
prone to crisis; that excessive private ownership may limit access to credit to many parts of
society; and finally that the government is more fitted to allocate capital to certain investment
(Boubakri et.al, 2002)). Two additional theories have also been advanced for government
participation in the financial market, namely, the development view and the political view.
The development view suggests that in some countries where the economic institutions are
not well developed, government ownership of strategic economic sectors such as banks is
needed to jumpstart both financial and economic development and foster growth. The
political view suggests that governments acquire control of enterprises and banks in order to
provide employment and benefit to supporters in return for votes, contributions and bribes.
Such approach is greater in countries with underdeveloped financial system and poorly
developed property rights. Under the development view governments finance projects that are
socially desirable. In both views, the government finances projects that would not get
privately financed (La Porta, et.al, 2002).
While such arguments have some validity, recent evidence however point to the costs of
government ownership of banks, suggesting that state ownership have a depressing impact on
overall growth (La Porta, et.al, 2002). There is a strong negative correlation between the
share of sector assets in state banks and a country’s per capita income level. Greater state
ownership of banks tends to be associated with lower bank efficiency, less saving and
borrowing, lower productivity, and slower growth (Barth et.al, 2000). Even government
residual ownership is likely to have an effect on performance (Boubakri, et al, 2002).
Majority of research indicate that private ownership of banks is associated with superior
economic performance (Lang & So, 2002; Cornett et.al. 2000).
Theoretically this is consistent with the agency relationship hypothesized by Jensen &
Meckling (1976). State ownership would be deemed inefficient due to the lack of capital
market monitoring which according to the Agency theory would tempt manager to pursue
their own interest at the expense of the enterprise. Managers of private banks will have
greater intensity of environmental pressure and capital market monitoring which punishes
inefficiencies and makes private owned firms economically more efficient (Lang & So,
2002).
RESEARCH METHODOLOGY
The study used a descriptive study design. Data was drawn from all the registered banks by
the Central Bank of Kenya. According to the central bank of Kenya, there were 43 licensed
commercial banks in Kenya. The study also used annual reports that are available from their
websites and in the Central bank of Kenya website. Data was obtained for a five year period
from 2007 to 2011. Data was collected through the use of questionnaires. The findings of the
pilot study illustrates that all the instruments were reliable (CVI = 0.70)
The study used a form of the following simple linear regression equation
Y = a + b1X1 + b2X2 + b3X3 + b4X4 + €
Where:-
Y – Is the return on equity (ROE)
X1 – Ownership Concentration which is the sum of the holdings of the largest five block
holder shareholders.
X2 – Foreign Ownership which is the total value of the shares held by foreign owners
X3 – Domestic Ownership which is the total value of the shares held by the citizens of the
country
X4 – State ownership which is the total value of the shares held by the Government
a – is the constant
€ - Error term
The data collected was analyzed using regression and correlation analysis. Data was analyzed
to establish whether or not a relationship exists between the ownership structures of
commercial banks and their performance.
RESULTS AND DISCUSSION
Descriptive Analysis Results
The study found that Return on Equity ranged from 25% to 83% with a mean of 62% and a
standard deviation of 11%. Performance of banks as measured by ROE was therefore high as
they made an average of 62% return on their equity. Ownership concentration ranged from a
low of 43% to a high of 75% with a mean of 52% and a standard deviation of 12%. Thus, on
average banks had ownership concentration of 52% meaning that half of the shares were
owned by blockholders in most of the banks. The study found that the number of shares
owned by foreigners ranged from a low of 2,450,356 to a high of 27,125,450 with a mean of
15,475,025 and a standard deviation of 5,452,654. The study also found that the shares owned
by domestic investors ranged from a low of 13,452,147 to a high of 75,450,689 with a mean
of 48,632,450 and a standard deviation of 14,452,457. The study further found that state
ownership ranged from a low of 2,540,478 shares to a high of 85,456,812 shares with a mean
of 64,321,461 shares and a standard deviation of 10,458,610 shares.
Correlation and Regression Results
The results show that there were low correlation between the independent variables and
therefore no serial correlations between the variables. None of the correlations between the
independent variables was significant. On the other hand, the independent variables all had
significant effects on performance as measured by ROE. Ownership concentration and state
ownership had negative correlations with performance while foreign and domestic ownership
had positive correlations with performance.
Table 4.1 Effects of ownership structure on bank profitability
Return on Equity
Constant 1.192
Ownership Concentration -1.727 (.002)
Foreign ownership 1.947 (.001)
Domestic Ownership 1.175 (.021)
State Ownership -0.048 (.016)
R .976
R2 .953
F 2.536 (.002)
The study sought to determine the relationship between ownership concentration and bank
profitability in Kenya. Ownership concentration ranged from a low of 43% to a high of 75%
with a mean of 52% and a standard deviation of 12%. The results show that ownership
concentration had a negative and significant effect on bank profitability (β = -1.727). This
effect was significant at 5% level of confidence. What this means is that higher levels of
ownership concentration lead to lower profitability in commercial banks.
The study sought to determine the relationship between foreign ownership and bank
profitability in Kenya. The study found that the number of shares owned by foreigners ranged
from a low of 2,450,356 to a high of 27,125,450 with a mean of 15,475,025 and a standard
deviation of 5,452,654. The study found that foreign ownership had a positive and significant
effect on bank profitability (β = 1.947). This effect was significant at 5% level of confidence.
These results mean that higher levels of foreign ownership result in higher bank profitability.
The study sought to determine the relationship between domestic ownership and bank
profitability in Kenya. The study also found that the shares owned by domestic investors
ranged from a low of 13,452,147 to a high of 75,450,689 with a mean of 48,632,450 and a
standard deviation of 14,452,457 From the regression analysis, the results show that domestic
ownership had a positive and significant effect on bank profitability (β = 1.175). This effect
was significant at 5% level of confidence. These results mean that higher levels of domestic
ownership result in higher bank profitability.
The study sought to determine the relationship between state ownership and bank profitability
in Kenya. The study further found that state ownership ranged from a low of 2,540,478 shares
to a high of 85,456,812 shares with a mean of 64,321,461 shares and a standard deviation of
10,458,610 shares. The results show that state ownership had a negative and significant effect
on bank profitability (β = -0.048). This effect was significant at 5% level of confidence. What
this means is that higher levels of state ownership lead to lower profitability in commercial
banks.
The study found that the independent variables had a very high correlation with ROE (R =
0.976). The results also show that the variables accounted for 95.3% of the variance in ROE
(R2 = 0.953). ANOVA results show that the F statistic was significant at 5% level. Therefore,
the model was fit to explain the relationships.
CONCLUSIONS
The study found that ownership concentration is negatively correlated with bank profitability.
The study concludes that higher ownership concentration leads to lower profitability of
commercial banks in Kenya. Therefore, as the number of blockholders rise in a bank, the
performance of the bank falls while as the number falls, performance rises. The study found
that foreign ownership is positively correlated with bank profitability. The study therefore
concludes that higher foreign ownership in a commercial bank leads to higher profitability
while lower foreign ownership leads to lower performance in commercial banks in Kenya.
The study found that domestic ownership is positively correlated with bank profitability. The
study therefore concludes that higher domestic ownership in a commercial bank leads to
higher profitability while lower domestic ownership leads to lower performance in
commercial banks in Kenya. The study found that state ownership is negatively correlated
with bank profitability. The study concludes that higher state ownership leads to lower
profitability of commercial banks in Kenya. Therefore, as the ownership of the state rises in
commercial banks, the performance of the bank falls while as the ownership falls,
performance rises.
RECOMMENDATIONS
The study recommends that commercial banks should desist from higher levels of
blockholder owners in order to reduce ownership concentration. This will help improve the
profitability of commercial banks in Kenya. Secondly, the study recommends that
commercial banks should encourage foreign investors to invest in their firms as the higher
levels of foreign ownership would lead to better firm profitability. Thirdly, the study
recommends that commercial banks should encourage local investors to invest in their firms
as the higher levels of local ownership would also lead to better firm profitability. There is
need therefore to balance between local and foreign investors. Lastly, the study recommends
that state ownership in commercial banks in Kenya should be reduced. This is because higher
levels of state ownership are detrimental to the profitability of banks.
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