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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