THE EFFECT OF REGULATIONS ON FINANCIAL PERFORMANCE OF COMMERCIAL BANKS (A STUDY OF FORTY THREE COMMERCIAL BANKS IN KENYA)

The objective of this study was to determine if there is a relationship between regulations and financial performance. Regulations is the independent variable while financial performance is the dependent variable. Financial performance is measured using financial ratios such as return on capital, return on equity, return on assets, credit risk, liquidity ratio, interest coverage ratio, core capital to total risk weighted assets ratio, total capital to total risk weighted assets ratio and core capital to total deposit liabilities ratio. This study also analyses capital adequacy. The population of study is the 43 commercial banks in Kenya and the period of study is between 2010 and 2015. Three years before the reviewed prudential guidelines for banks of 2013 came into effect and three years after. Chi square test of independence was used to analyze the relationship between the two variables. The test was carried out on each of the ratios and the findings were that there is no relationship between regulations and financial performance of commercial banks.  Most of the banks have been able to comply with the minimum capital requirement and the government must continue to ensure that there is compliance of the stipulated guidelines in order to ensure the stability of the banking sector in Kenya. This will enable Kenya as an economy avoid financial crises. The CBK will also be able to discover struggling banks and provide remedial measures to manage them before they collapse and depositors lose their money. The finance ratios suggest a thriving banking sector that is profitable. This study did not factor in macroeconomic factors that may affect the financial performance of commercial banks and these may be helpful in a similar study in the future that also analyses a longer period of time.    

 

 

 

 

Table 1. Core capital to RWA ratio 

Table 2: Core capital to total deposit liabilities ratio 

Table 3: Total capital to RWA ratio 

Table 4: Return on assets ratio 

Table 5: Return on equity ratio 

Table 6: Return on capital ratio 

Table 7: Credit risk ratio 

Table 8: Liquidity ratio 

Table 9: Interest coverage ratio 

Table 10: Capital adequacy 

 

 

 

 

Fig 1. Core capital to RWA ratio 

Fig 2: Core capital to total deposit liabilities ratio 

Fig 3: Total capital to RWA ratio 

Fig 4: Return on assets ratio 

Fig 5: Return on equity ratio 

Fig 6: Return on capital ratio 

Fig 7: Credit risk ratio 

Fig 8: Liquidity ratio 

Fig 9: Interest coverage ratio 

Fig 10: Capital adequacy 

 

 

 

 

 

 

 

 

Since the 1980’s the financial sector in most western countries has been going through the process of deregulation, whereby their governments either removed or reduced state regulations that were governing financial institutions, (Kumbhakar, Lozano-Vivas, KnoxLovell & Hassan 2005). This is because policy makers are convinced that deregulation is the only way they can increase the efficiency and performance of these institutions. These policies aim at increasing banks competition on prices, products and territorial rivalry. This process of deregulation has however led to mixed consequences. Good for some countries and bad for others for instance the deregulation of Norwegian banks gave them the permission to set their own lending rates as well as the amount of money they could lend out. The results have been very favorable for them while in India and USA this has not been the case. 

 

Two theories were originated in 1979 by the Cooke committee namely micro prudential regulation and macro prudential regulation, Clement (2010). According to the micro prudential regulation, banks finance themselves using government insured deposits which while it helps to reduce bank runs, it creates a moral hazard problem because it leads to the management of banks taking too many risks because they know that the government will cover any losses they make. Micro prudential regulation requires banks to take prompt steps to restore their capital ratio if losses occur. This is referred to as Prompt Corrective Action, (Hanson, Kashyap, Stein 2011). Central banks enforce capital regulations. The macro prudential theory aims at reducing as much as possible the financial impact that is felt in the economy when many commercial banks decide to sell their assets at the same time in order to cover their losses especially when the assets are similar for example real estate, Hanson et al. (2011). The result would be a significant reduction in the market price of the assets. This was experienced in the United States of America during the global financial crisis of 2007 and 2008. Commercial banks will also cut back on lending which will increase the cost of borrowing. This theory is presumed to be applicable to all deposit takers, insured or not. Regulators are therefore required to monitor the activities of all financial institutions in order to eliminate any activities that can cause damage to the economy. 

 

There are 43 licensed commercial banks in Kenya according to the CBK. There is only one mortgage finance company namely Housing Finance Company of Kenya. The CBK has enforced strict regulations on financial institutions. However unlike in the American market, Kenya’s banks seem to be growing very fast over the past few years in spite of strict regulations.  According to the Monthly Economic Review of November 2015 by the CBK, the balance sheet saw an increase in terms of total assets from Ksh 3,168.7 billion in November 2014 to Ksh 3,626.9 billion in November 2015. This is a 14.5 percent increase.  

 

Financial regulations are the laws that have been put in place by the state to govern financial institutions, Agborndakaw (2010). The Financial Times (n.d.) have a similar definition and describe regulations as laws that govern the activities of all financial institutions. Agborndakaw (2010) says that these regulations aim at maintaining orderly markets, licensing the providers of financial services, enforcing applicable laws as well as prosecuting cases of market misconduct, protecting clients and investors and promoting the stability of the financial system. These regulations are promulgated by government regulators as well as international groups. The government regulator in 

Kenya is the CBK.  

 

According to a report by OXERA of September 2006, financial regulations can be measured by looking at the growth in the financial sector and this is done by comparing financial performance before new regulations came into effect and the performance after. They are also measured by using surveys that show growth in market outcomes which are as a result of regulation. International comparisons can also be used. These enable you analyze the outcomes in various countries that are comparable but that have different regulatory structures.  

 

The financial dictionary defines growth as the increase in the value of an investment over a period of time. According to the CBK, commercial banks have been doing well in terms of growth in revenue and assets over the past few years.  According to the monthly economic review of November 2015, the balance sheet for the banking sector grew from Ksh 3,168.7 billion to Ksh 3,626.9 billion in the period between November 2014 and November 2015. This is a 14.5 per cent growth. 

Financial performance of commercial banks is measured by evaluating its capital adequacy. This is done by ascertaining if the banks have complied to the minimum statutory capital requirement of one billion shillings. It is also evaluated by computing the core capital to total risk weighted assets (RWA) ratio, total capital to total RWA ratio and core capital to total deposit liabilities ratio. Financial performance is also measured by evaluating the liquidity ratio as well as the credit risk. The interest coverage ratio measures a bank's ability to meet its interest on debt obligations as and when they fall due. Investment ratios such as return on equity (ROE), return on capital and return on assets (ROA) are also used to establish the financial performance of a bank, 

(Understanding Financial Ratios, 2015).  

 

According to the micro prudential and the macro prudential theories there is a correlation between regulations and financial performance in financial institutions. These theories state that regulations must be put in place and enforced even though this may cause a bank to shrink its assets or seek fresh capital from the stock market. The theories aim at achieving economic stability and protecting tax payers’ interests. This may have the effect of slowing down the financial performance of commercial banks (Hanson et al., 2011). 

 

The global economic recession of 2008 has taught us that there is a need to regulate financial institutions, (Sherman, 2009). The case of USA brings forward the relationship between financial regulations and financial performance. Before 2007 USA had been deregulating their financial sector which saw tremendous growth of the financial institutions only that the growth could not be sustained and the whole industry crushed. Since the financial crisis they have introduced regulations to bring about economic stability and as a result the growth of financial institutions including banks has slowed down, KPMG (2014). Forbes Insights carried out a survey in the country between June and July 2013. Based on this, KPMG came up with a report that states that the new regulations have constrained revenue growth and profitability options. Another survey was carried out in Europe and it has been observed that new regulations on banking businesses have decreased profitability, below the 2007 peaks, (Chiarella, Harle, Neukirchen, Poppensieker & Raufuss, 2011). Therefore, surveys have confirmed the theory. 

 

As per the CBK, there are 43 licensed commercial banks in Kenya and 1 mortgage finance company. The Monthly Economic Review of November 2015 prepared by the CBK shows that the banking sector has grown in its financial performance. Gross loans grew from Ksh 1,948.4 to Ksh 2,260.2 billion between November 2014 and November 2015. This is a 16 percent growth. The deposit base increased from Ksh 2,279.8 billion to Ksh 2,553.8 billion in the same period of time, which is a 12 percent growth. Deposits were the main components of the balance sheet making up 70.4 percent of the total liabilities. Core capital increased from 402.5 billion to 460.3 billion while total capital increased from 473.2 billion to 552.1 billion in November 2015. Profitability grew by 14.4% in pretax profits from Ksh 20.1 billion to Ksh 23.0 billion in the period between February 2014 and February 2015. 

The CBK enforces regulations as per the Banking Act (cap 488). The objectives of these regulations according to the CBK are to protect the depositors and reduce the risk of disruption of the banks activities due to a harsh operating environment for the banks that can result in massive bank failures. The regulations also aim at avoiding banks being used for criminal purposes such as money laundering. Regulations also protect banking confidentiality credit allocation. This enables credit to be directed to favored sectors in order to provide the best customer service. 

 

Mwega (2014) states that there are four minimum capital requirements that all banks are expected to meet and they are a core capital to total risk weighted assets ratio of 8 percent, a core capital to total deposit liabilities ratio of 8 percent, a total capital to total risk weighted assets of 12 percent and a minimum core capital of Ksh 1 billion. 

 

As earlier discussed in the introduction, the monthly economic review of November 2015 by the CBK, shows that the balance sheet for the banking sector grew from Ksh 3,168.7 billion to Ksh 3,626.9 billion between November 2014 and November 2015. This is an increase of 14.5 percent. The NPL to assets ratio decreased from 22.6 percent in 2001 to 4.3 percent in 2007. As at December 2013 the ratio averages 5 per cent. This shows that the banks’ asset quality has improved through the years. The ROE and ROA have also increased since 2002, Mwega (2014). 

 

The research problem is to ascertain the effect of regulations on the financial performance of commercial banks in Kenya. Do regulations influence the growth of commercial banks or not. Implementing financial regulations is a major challenge for many countries especially the EMEs but in the long run they contribute to the strengthening of banking systems (Sinha, Kumar & Dhal 2011). Some aspects of regulation can be oriented towards these countries achieving their development objectives without having to sacrifice prudent regulation and financial sector stability considerations. Sinha et al. (2011) further state that there is a lack of unanimity among economists on how relevant finance is to the growth of an economy. However, the financial crisis of 2008 proved that it is necessary to have a stable financial system as it will have a positive impact on equity and growth. Typically, one would expect regulations to improve efficiency and lower any risk of a financial crisis. Many critics have argued that regulations interfere with the efficiency of the market while those advocating for regulation like Sinha et al (2011), have argued that if regulations are well designed and managed then they can make markets more efficient and equitable in terms of their outcomes. When we analyze the history of the banking sector in Kenya for example, we find that government interference has been present. This study will determine what effect it has had on the financial growth of the commercial banks. 

 

The context of this study is the commercial banks in Kenya. Regulation is costly and may impede the rapid growth of financial institutions. However, in the Kenyan market the 

CBK assures that there are strict regulations on commercial banks. At the same time, we have seen their rapid growth. For example, the profits before tax for equity bank for the last five years, as per the banks financial statement for the year ending 31st December 2015, have grown from 12.8 billion in 2011, 17.4 billion in 2012, 19 billion in 2013, 

22.36 billion in 2014 to 23.96 billion in 2015.This has been the trend for many banks and 

NBFIs.  

 

KPMG prepared a report in 2014 based on a survey that had been conducted by Forbes Insights between June and July 2013 in the United States after the financial crisis of 2008 and they observation that financial institutions were finding it very difficult to comply with new regulations that had been imposed. The survey showed that there was a reduction in profits as a result of regulations. Vianney (2013) carried out a study in Rwanda. He observed that there was no relationship between regulations and the financial performance of commercial banks in Rwanda. Chiarella et al. (2011) in a survey conducted by Mckinsey and Company observed that new regulation on corporate banking businesses in Europe had resulted in significant reductions in credit costs and profits had decreased remaining well below the 2007 peaks. Brownbridge (1996) conducted a study in Nigeria in which he investigated the effects of deregulation which had started in 1986. He concluded that it increased the financial fragility of even the most well managed banks. 

 

Mwega (2014) carried out a study in the Kenyan financial sector. He states that Kenya does not have very strict regulations. He concluded that regulations in the financial sector have strengthened the banking sector over the last ten years, in terms of customer service, products offered, profitability and stability. Gudmundsson, Kisinguh & Odongo (2013) conducted a survey to investigate the role capital requirements play on competition and stability of banks. They found that there is a positive relationship between capital regulation and the improved performance of banks and financial stability. Mureithi (2012) carried out a study on the effect of financial regulation on financial performance of Deposit-Taking Microfinance institutions in Kenya. She concluded that regulations on DTMs have led to the improvement in their financial performance. There was an increase in the value of loans outstanding, total assets, profit and shareholders’ equity of DTMs. Otieno (2012) carried out a study to evaluate the effect corporate governance has had on the financial performance of commercial banks in Kenya. He found that corporate governance does indeed play a role in the stability and good performance of a bank. 

 

As per the international studies, regulations have resulted in a decline in the financial performance of financial institutions except for Rwanda where there seems not to be any relationship between the two variables. In the local studies, regulations have resulted in an increase in the profitability of financial institutions even though the regulations are not as strict in Kenya as they are in the developed countries like USA. The various studies show that there is a lack of clarity on what the true impact of regulations is and this has led to the research question: What is the effect of regulations on the financial performance of commercial banks in Kenya? 

 

The objective of this study is to establish the effect of regulations on the financial performance of commercial banks in Kenya.  

 

This study will contribute to proving theory right or wrong. The findings will enable us to test the correctness of the micro prudential regulation theory and the macro prudential regulation theory. By establishing the effect regulation has had on the growth of commercial banks it will help policy makers in formulating new policies in that they will be informed about the effect their policies will have on the banking sector and the economy as a whole. They will be able to ascertain which aspects of regulation can be geared towards the accomplishment of development goals without compromising on prudent regulation and the stability of the financial sector, Sinha et al. (2011). They will also know how they can supplement development objectives with other well designed financial sector policies. In practice commercial banks will be well informed on the effect of regulations on their growth. It will inform their individual policy formulation in light of new regulations that will enable them to align the two in order to achieve their financial objectives.