RELATIONSHIP BETWEEN CORPORATE GOVERNANCE AND FINANCIAL PERFORMANCE (A CASE STUDY OF SELECT BANKS IN KENYA)

CHAPTER ONE

                                     INTRODUCTION

1.1      Background to the Study

Corporate governance reform has emerged as a critical business issue, thrust on the world stage by a number of high profile corporate failures (Strandberg, 2001). The prominent corporate accounting scandals of Enron Corporation, World Com, Tyco, and Parmalat have led to contemporary discussion on the best mechanisms for protecting stakeholder’s interest and ensuring shareholders wealth maximisation. Also, in Kenya the emphasis on the need for corporate governance reform sprung up swift actions by some banks like ABC Capital, African Alliance Kenya Investment Bank, Afrika Investment Bank, ApexAfrica Capital, CBA Capital and the likes in Kenya to enhance their financial performances and also enable them to gain competitive advantage over their counterparts in the country.

Abor & Biekpe (2005) intricately define corporate governance as the process and structure used to enhance business prosperity and corporate accountability with the ultimate objective of realizing long- term shareholder value, whilst taking into account the interest of other stakeholders. Kyereboah-Coleman (2007) argues that corporate governance is represented by the structures and processes lay down by a corporate entity to minimize the extent of agency problems as a result of separation between ownership and control. Simply put, corporate governance in an organizational context is the totality of the control, monitoring and directing mechanism utilized by strategic management in the best interests of its stakeholders.

Firm performance is a concept that supports the effective and efficient use of financial resources to achieve overall company objectives which include both shareholders wealth maximisation and profit maximisation objectives. It can be measured using long term market performance measures and other performance measures that are non-market-oriented measures or short term measures (Zubaidah et al, 2009). The measure of firm performance employed in this study is from a non-market oriented perspective which is most common and requires the use of accounting ratios which are the profitability and investor ratios. 

1.2 Statement of Research Problem

The problem areas that spurred the interest in researching on this topic are specifically the loss of confidence by the investors on the capital market, the persistent agency problem and the insolvency of large companies as a result of financial improprieties. These issues are discussed more explicitly below.

Kajola (2008) asserts that financial scandals around the world and the recent collapse of major corporate institutions in the USA, South East Asia, Europe and Nigeria have shaken investors’ faith in the capital markets and the efficacy of existing corporate governance practices in promoting transparency and accountability. Good corporate governance is an important step in building market confidence and encouraging more stable, long-term international investment flows (Bocean & Barbu, 2007). The loss of confidence by investors in the capital market is therefore an indicator of poor corporate governance practice in quoted companies (Oyebode, 2009). The shares of the listed companies on the Nigerian stock exchange are gradually declining from a bullish state to a bearish status. Shareholders have lost interest in trading on the stock exchange because of the crash in share prices just as in the Cadbury Nigeria Plc. case when it overstated its earnings and its shares were dealt a heavy blow on the Nigerian Stock Exchange Market. 

Also, the existence of the agency problem which arises in a bid to intermediate between the interests of the managers and that of the shareholders typically influences firm performance. It is for this reason that Sanda, Mikailu, & Garba (2005) posits that for example, the managers might take steps to increase the size of the company and, often, their pay, although they may not necessarily raise the company’s profit, the major concern of the shareholder. The insolvency of large companies as a result of financial improprieties has awakened discuss on the effect of corporate governance on firm performance (Claessens, 2003; MENA-OECD Investment Programme- Working Group 5, n.d). In the same vein, the predominance of sharp practices by management and insider trading for the purpose of defrauding such companies as a result of the need to satisfy some personal interest may also a contributory factor to poor firm performance.

It is therefore believed that examining the relationship between corporate governance mechanisms and firm performance would attempt to address the problems as stated.

1.3   Objectives of Study

The objective of this study is to measure the relationship between corporate governance and financial performance by using selected banking firms in Kenya as a case study. The specific objectives of this study are thus as follows:

i)             Ascertain whether there is a negative relationship between board size and firm performance.

ii)           Ascertain whether or not the combination of the posts of the CEO and Chairman of the board significantly enhances firm performance.

iii)         Investigate whether there is a positive relationship between ownership concentration and firm performance.

iv)         Examine whether the independence of the audit committee affects firm performance positively.

1.4   Research Questions

The study provides answers to the following questions:

i)             What is the relationship between board size and firm performance?

ii)           To what extent does the combination of the posts of the CEO and Chairman of the Board affect performance?

iii)         How does concentration of ownership affect firm performance?

iv)         What relationship exists between the independence of the audit committee and firm performance?

1.5   Hypotheses

The hypotheses that provide greater insight into the research work are as follows:

i)             There is a significant relationship  between board size and firm performance

ii)           There is no significant correlation betweenCEO duality and increase in firm performance

1.6   Scope of Study

The focus of this study is to employ panel data methodology to provide evidence on the relationship between firm performance measures and corporate governance in Kenya. The study observes the most recent financial periods of some of the financial companies listed on the Kenyan Stock Exchange. This includes twenty one selected listed financial companies.  Information is elicited from Annual Reports and Accounts for a period of 6 years from 2003 to 2008.

1.7   Significance of Study

The indispensability of this study lies in its ability to fill an identified gap and contribute to existing researches in the subject area. 

The previous empirical studies conducted on the Nigerian environment do not cover information elicited from the most recent periods. The studies provide evidence from the period of 1996 to 2006 (Kajola, 2008; Sanda, Mikailu, & Garba, 2005), whereas this study provides evidence from 2003 to 2008.  

Most importantly, this study advances on Kajola (2008) which is the most recent study in this area on the Nigerian Stock Exchange known to the researcher. Kajola (2008) undergoes a limitation borne from examining the relationship between only two performance measures – Return on Equity and Profit margin on the corporate governance variables on twenty (20) companies listed on the Stock Exchange. Whereas, this study makes use of a larger sample size of twenty one and examines the relationship between three performance measures (Return on Equity, Return on Assets, and Profit Margin) and four corporate governance variables .

As a result of the selection of sample companies from different industries, an industry dummy variable is created so as to determine whether or not peculiarity exists in the results of companies in same industry. Also, company size and leverage are introduced as control variables in order to determine their relationship with firm performance. 

The intended purpose of bridging the discussed gaps would not be achieved without this research lending its solutions and methodologies to resolving the lasting conflict of interest between managers and shareholders which has been tagged as the agency problem. 

This study is beneficial to the following categories of people:

Top executives: this includes the CEO, Chairman and members of the board. It would aid them in managing the issues arising from agency relationships. It would also broaden their perspective on the aspects of corporate governance that need to be enhanced that will result in improved firm performance.

Shareholders/ Investors: it would assist existing shareholders and potential investors to make appropriate judgment as regards their investments and performance of the companies in which they are stakeholders. 

Regulators: it would assist the regulators in promulgating better corporate governance regulations that will be more encompassing and contribute effectively to enhancing firm performance and resolving agency conflict. 

Future Researchers: they will be able to apply this research to carry out further studies in the same area or related area by serving as a theoretical base for the research to be carried out.

1.8   Limitations of Study

The constraints experienced in carrying out this research are

Availability of data: the inability to obtain data from a very large sample of the population impairs the generalization of the findings to a certain extent. 

Time constraint: based on the fact that the researcher has to cope with other academic activities and official assignments, there is insufficient time for project work.

1.9 Definition of Terms

Accounting scandals: an event of an accounting nature that causes public outrage or censure such as the understatement of profit, overstatement of assets.

Agency: fiduciary relationship between two parties in which one (the “agent”) is obligated to the other (the “principal”).

Audit Committee: it is a body formed by a company's board of directors to oversee audit operations and circumstances. Besides evaluating external audit reports, the Committee may evaluate internal audit reports as well.

Bearish: a stock market situation characterized by falling stock-market prices.

Board of Directors:  A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. The body sometimes has a different name, such as board of trustees, board of governors, board of managers, or executive board.  

Bullish: a stock market situation characterized by rising stock market prices.

Corporate Governance: Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a company is directed, administered or controlled.

Financial Reporting: the presentation of financial information about an entity to potential users of such information. The term usually refers to reporting to users outside of the entity.

Insolvency: the situation where entities cannot raise enough cash to meet its obligations, or to pay its debt as they become due for payment.

Profit Margin: It is a measure of operating efficiency and pricing strategy, the ratio is usually computed using net profit before extraordinary items and taxes-that is, net sales less cost of goods soldand Selling, General, and Administrative (SG&A) Expenses. It is expressed as a percentage and calculated as Net profit divided by Sales.  

Return on Assets (ROA): ROA gives an idea as to how efficient management is at using its assets to generate earnings. It is displayed as a percentage and calculated as Profit after Tax/ Total Assets.

Return on Equity: Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.  

ROE is expressed as a percentage and calculated as: Profit after tax /Shareholder's Equity. Stakeholders: persons with interest in an organisation such as its owner, employees and creditors.

Shareholder: an individual or group who holds one or more shares in an organisation, and in whose name the share certificate is issued.

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