Doctor of philosophy in commerce: Department of commerce and financial studies school of economics and commerce Bharathidasan university Tiruchirappalli-620 024 Tamil Nadu, India

The production of banks is an act of transforming inputs into outputs. The objective of production is to create value through transformation and the outputs are given in general desirable outcomes. Hence more output is better. At the same time, inputs are valuable resources, with alternative uses. Unspent quality of any input can be used for producing more of the same outputs or produce different outputs.

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Technical Efficiency of Kenyan Banks- A Data

Envelopment Analysis

Thesis submitted to the

BHARATHIDASAN UNIVERSITY, TIRUCHIRAPPALLI

for the Award of the Degree of

DOCTOR OF PHILOSOPHY IN COMMERCE

By ISAIAH ONSARIGO MIENCHA

Research Supervisor and Convener

Dr M.SELVAM ,

Professor and Head

DEPARTMENT OF COMMERCE AND FINANCIAL STUDIES

School of Economics and Commerce

BHARATHIDASAN UNIVERSITY TIRUCHIRAPPALLI-620 024 TAMIL NADU, INDIA

AUGUST 2015

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DEPARTMENT OF COMMERCE AND FINANCIAL STUDIES School of Economics and Commerce

BHARATHIDASAN UNIVERSITY TIRUCHIRAPPALLI – 620 024, TAMIL NADU, INDIA

Prof M SELVAM, M.Com., MBA., MADE., Ph.D Date:

Professor and Head

Email ID: drmselvam@yahoo.co.in

CERTIFICATE

The thesis entitled, TECHNICAL EFFICIENCY OF KENYAN BANKS - A DATA ENVELOPMENT ANALYSIS, is a bona fide record of

research work done for the award of Doctor of Philosophy in Commerce by

Mr ISAIAH ONSARIGO MIENCHA, Research Scholar (Full Time),

Department of Commerce and Financial Studies, Bharathidasan University, Tiruchirappalli, Tamil Nadu, India It is the original work of the candidate and it has not previously formed the basis for the award of any Degree, Diploma, Associateship, Fellowship or other similar titles The thesis represents independent work on the part of the candidate

SIGNATURE OF THE RESEARCH ADVISOR

AND CONVENER

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ii

ISAIAH ONSARIGO MIENCHA

Ph.D Research Scholar (Full Time)

Department of Commerce and Financial Studies

I hereby declare that the thesis entitled, TECHNICAL EFFICIENCY

OF KENYAN BANKS - A DATA ENVELOPMENT ANALYSIS, embodies

the result of my research work carried out under the guidance and supervision of

Professor M.SELVAM, Research Advisor and that I have not submitted the

above thesis to any University for any Degree, Diploma, Associateship,

Fellowship or other similar titles previously

(ISAIAH ONSARIGO MIENCHA)

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First, let me take this opportunity to thank God for everything that I have got in

my life, without which I would have been nothing

The individual to whom I owe the greatest debt for making this thesis possible is

my research supervisor Prof M Selvam Professor and Head, Department of

Commerce and Financial Studies, Bharathidasan University, Tiruchirappalli for his inspiring guidance He was the person who read every word in every draft, a task he volunteered with unflagging good cheer and enthusiasm and rearranged the text to create a more focused and usable document and invariably had excellent suggestions for improving the flow of ideas and sharpening throughout my work During this tenure, I always admired his incessant guidance, thought provoking ideas, valuable advice and constant encouragement towards my doctoral work

I avail this opportunity with great pleasure to ensure my unfathomable gratitude

and whole hearted thanks to my great Teachers, Dr M Babu, Dr S Vanitha and

Dr J Gayathri, Assistant Professors, Department of Commerce and Financial Studies,

Bharathidasan University, Tiruchirappalli for their support throughout my tenure of

my research I am thankful to them for all the motivation, encouragement and valuable suggestions that they have given me

I am extremely indebted to my Doctoral Committee Members, Dr Joseph

Anbarasu, Associate Professor in Commerce, Bishop Heber College, Tiruchirappalli

and Dr S Sekar, Principal, Urumu Dhanalakshmi College for their valuable

suggestions and constant inspiration which instilled in me an unquenchable thirst to my research work

I wish to record my sincere thanks to The Honourable Vice Chancellor, The

Registrar, The Controller of Examinations, The Finance Officer and the entire

Administration of Bharathidasan University, Tiruchirappalli for giving me the

opportunity to do my doctoral work

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iv

I would like to thank my seniors, Dr M Raja, Dr G Indhumathi,

Dr P Bhuvaneswari, Dr WRPK Fernando, Dr A Jeyachitra, Dr P Nageswari,

Dr E Bennet, Dr R Rajesh Ramkumar, Dr V Karpagam and fellow Research

Scholars, Ms M Gayathri, Mr V Vasanth, Mr K Lingaraja , Ms P Amrutha,

Ms S Amridha Vasani, Mrs S Vetrichelvi and Mr Marxia Oli Sigo, Department of

Commerce and Financial Studies, Bharathidasan University, Tiruchirappalli for their

contribution to the completion of this thesis

I would also like to thank Mr J Arokiam, Mr R Velmurugan,

Mrs D Shanthi Manjula and Mrs P Meena for their support and help

I am very much thankful to the Department Library, Department of Commerce and Financial Studies, Librarian, and other staff members of Central Library,

Informatics Centre, Bharathidasan University, for giving me necessary reference

materials and enabling me to successfully complete this thesis

My heartfelt gratitude to Prof Mohan Gnana Olivu, Academic Director, Annai

College, Kumbakonam, who helped me in shaping all my articles and my thesis work

Last, but certainly not the least, I must acknowledge, with deep thanks, the support from my family members and my dearest friends I thank my grandparents

Mr Gesicho Nyandumo (late) and Mrs Gechemba (late) who showered affection,

love and care on me I thank my father and mother, Mr Charles Minyencha Gesicho,

Mrs Rebeccah Moraa and Mrs Bethsheba Moraa for striving hard to provide a

good education for me They have instilled many admirable qualities in me and given

me a good foundation to face life with confidence They have taught me about hard work, self-respect, persistence, perseverance and they have set an example to be independent, Dad, especially, remained a great role model of resilience, strength and character They have always expressed how proud they are of me and how much they love me I am proud of them and love them very much I must thank my uncles

Mr Hezron Mageto (late), Mr David Mageto (late), Mr Zechariah Mageto,

Mr Moses Gesicho (late), Mr Samwel Gesicho (late), Mr Timothy Gesicho and

Mr Sanduki Gesicho (late), aunties Mrs Elzabeth, Mrs Jane Mosiori and Mrs Martha David for their invaluable love and affection I wish to thank my

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Brother-in-Laws Mr Peter King’oina, Mr Gerald Matara and Mr Zablon

Onyambu For their encouragement and support throughout my studies I also thank

my beloved sisters Mrs Teresa Stephen, Mrs Zipporah Monyenche, Mrs Alice

Bitutu, Mrs Mercy Moragwa, Mrs Florence Kemunto, Mrs Jane Nyaboke, Mrs Gladys Nyabonyi, Mrs Lilian and Mrs Linet my lovable brothers,

Mr Stephen Miencha (Late), Mr Joshua Morang’a, Mr Henry, Mr Richard Oigoro, Mr Peter Nyareru and (Dr.) Haron Miencha, nephew Erick Mose and Moses Gwaro for their love and support I always fall short of words and felt

impossible to describe their support in words and I am grateful for them who made my life enjoyable one

ISAIAH ONSARIGO MIENCHA Date:

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vi

This Thesis is dedicated to

my Brother Stephen Miencha (late)

who is missed deeply and my parents who had

a never-ending thirst for learning and imbued the same passion in me.

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LIST OF ABBREVIATIONS

AGM Annual General Meeting

BCC Bankers, Charnes and Coopers

CAMEL Capital, Asset, Earnings, Management, Earnings, Liquidity CBK Central Bank of Kenya

CCR Charnes, Cooper and Rhodes

CEO Chief Executive Officer

CMA Capital Markets Authority

CO-PRV Co-operative Bank of Kenya

CRS Constant Return to Scale

DEA Development Envelope Analysis

DEAOS Data Envelopment Analysis Online Software

DMU Decision Making Units

DPFB Deposit Protection Fund Board

FOB Foreign Owned Bank(s)

GOB Government Owned Bank(s)

GoK Government of Kenya

IFEM Interbank Foreign Exchange Market

I & M Industrial and Mortgage

IPO Initial Public Offering

KCB Kenya Commercial Bank

KShs Kenya Shillings

NBFIs Non-Bank Financial Institution (s)

NIDBK National Industrial Development Bank of Kenya

NH Null Hypothesis

NPL Non-Performing Loans

NSE Nairobi Stock Exchange

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viii

ROA Return on Assets

ROE Return on Equity

Sig Significant

SME Small and Medium sized enterprise SPSS Statistical Packages for Social Science STD Standard Deviation

T.A Total Assets

T.E Technical Efficiency

USD United States Dollar

VRS Variable Return to Scale

WWW World Wide Web

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II Review of Literature and Research Design 19

III Nature of Variables of Kenyan Sample Banks Using

IV Relationship Between Kenyan Sample Banks Using

V Technical Efficiency of Kenyan Sample Banks Using

VI Summary of Findings, Suggestions and

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6

1.4 Numbers of Financial Institutions in Kenya during the period from 1963 to

2012

9 1.5 List of Failures Banks and NBFIs in Kenya during 1984 – 2005 10 1.6 Regulatory Capital Ratios of Banks in Kenya 11

1.8 List of Organized Kenyan Commercial Banking Sector as on 31st

December 2013

17

3.1 Descriptive Statistics of Deposits for Large (Top and Lower) size Kenyan

Commercial Banks

46

3.2 Descriptive Statistics of Deposits for Medium (Top and Lower) size

Kenyan Commercial Banks

51

3.3 Descriptive Statistics of Deposits for Small (Top and Lower) size Kenyan

3.4 Descriptive Statistics of Total Assets for Large (Top and Lower) size

59

3.5 Descriptive Statistics of Total Assets for Medium (Top and Lower) size

63

3.6 Descriptive Statistics of Total Assets for Small (Top and Lower) size

67

3.7 Descriptive Statistics of Return on Assets (ROA) for Large (Top and

Lower) size Kenyan Commercial Banks

71

3.8 Descriptive Statistics of Return on Assets (ROA) for Medium (Top and

75

3.9 Descriptive Statistics of Return on Assets (ROA) for Small (Top and

79

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3.10 Descriptive Statistics of Return on Equity (ROE) for Large (Top and

3.11 Descriptive Statistics of Return on Equity (ROE) for Medium (Top and

3.12 Descriptive Statistics of Return on Equity (ROE) for Small (Top and

91

3.13 Descriptive Statistics of Deposits, Total Assets, Return on Assets and

Return on Equity in respect of Large, Medium and Small (Top and Lower)

Size Kenyan Commercial Banks

112

4.7 The Result of Correlation of RETURN ON ASSETS for (Top and Lower)

Kenyan Commercial Sample Banks under Large group

114

Kenyan Commercial Sample Banks under Medium group

116

Kenyan Commercial Sample Banks under Small group

118

4.10 The Result of Correlation of RETURN ON EQUITY for (Top and Lower)

Kenyan Commercial Sample Banks under Large group

120

Kenyan Commercial Sample Banks under Medium group

122

Kenyan Commercial Sample Banks under Small group

124 4.13 The Result of Consolidated Correlation Significance of Deposits, Total

Assets, Return on Assets and Return on Equity for Large, Medium and 126

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155

5.8 Results of Technical Efficiency Return on Assets (using CCR, BCC and T.E Models) for Kenyan Commercial Banks (three Top and three Lower banks in the Medium group) during the study period 2004 - 2013

159

5.9 Results of Technical Efficiency Return on Assets (using CCR, BCC and T.E Models) for Kenyan Commercial Banks (three Top and three Lower banks in the Small group) during the study period 2004 - 2013

163

5.10 Results of Technical Efficiency Return on Equity (using CCR, BCC and

T.E Models) for Kenyan Commercial Banks (three Top and three Lower banks in the Large group) during the study period 2004 - 2013

167

T.E Models) for Kenyan Commercial Banks (three Top and three Lower banks in the Medium group) during the study period 2004 - 2013

172

T.E Models) for Kenyan Commercial Banks (three Top and three Lower banks in the Small group) during the study period 2004 - 2013

176

5.13 Comparison ofTechnical Efficiency of Kenyan Sample Size Banks During

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3.1 The Results of DEPOSITS for Kenyan Commercial Sample (Large-

Top and Lower) Banks

49

3.2 The Results of DEPOSITS for Kenyan Commercial Sample

(Medium – Top and Lower) Banks

53

3.3 The Results of DEPOSITS for Kenyan Commercial Sample (Small

– Top and Lower) Banks

57

3.4 The Results of TOTAL ASSETS for Kenyan Commercial Sample

(Large – Top and Lower) Banks

61

3.7 The Results of RETURN ON ASSETS for Kenyan Commercial

Sample (Large – Top and Lower) Banks

73

Sample (Medium – Top and Lower) Banks

77

Sample (Small – Top and Lower) Banks

81

3.10 The Results of RETURN ON EQUITY for Kenyan Commercial

Sample (Large – Top and Lower) Banks

85

Sample (Medium – Top and Lower) Banks

89

5.1 Technical Efficiency of DEPOSITS (Top and Lower) for Kenyan

Commercial Banks under Large group during the study period

(2004 to 2013)

133

Commercial Banks under Medium group during the study period

(2004 to 2013)

137

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xiv

Commercial Banks under Small group during the study period (2004 to 2013)

141

5.4 Technical Efficiency of TOTAL ASSETS (Top and Lower) for

Kenyan Commercial Banks under Large group during the study period (2004 to 2013)

145

5.5 Technical Efficiency of TOTAL ASSETS (Top and Lower) for

Kenyan Commercial Banks under Medium group during the study period (2004 to 2013)

149

5.6 Technical Efficiency of RETURN ON ASSETS (Top and Lower)

for Kenyan Commercial Banks under Small group during the study period (2004 to 2013)

153

for Kenyan Commercial Banks under Large group during the study period (2004 to 2013)

157

for Kenyan Commercial Banks under Medium group during the study period (2004 to 2013)

161

165

5.10 Technical Efficiency of RETURN ON EQUITY (Top and Lower)

for Kenyan Commercial Banks under Large group during the study period (2004 to 2013)

170

for Kenyan Commercial Banks under Medium group during the study period (2004 to 2013)

174

178

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Chapter I

Introduction

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1

1.1 INTRODUCTION

The financial systems in Africa in general and Kenya specifically, are both shallow and fragile and therefore, cannot fulfill the real economic growth and poverty

eradication (Nissanke and Stein, 2003) The shallowness and fragility are reflected in

low lending levels, high interest rate spreads, high levels of nonperforming loans and several bank failures The financial institutions, particularly Commercial Banks, play a

vital role in the economy of a developing nation (King and Levine, 1993) As one of

the faster- growing economies in the world, Kenya experiences a slight increase in the expectations of the business partners The competitive service quality is important for survival and existence of any banking institution in the cut-throat competition The banking sector in Kenya faced serious functional problems during the past few decades Commercial Banks have been undergoing tremendous technological and managerial changes due to the globalization and dynamic environment Though the financial system in Kenya had an advantage in operating in closed and regulated environment, it went through a sea change during the nineties

The Central Bank of Kenya (CBK), besides initiating many reforms such as regulation, use of technology, de-licensing etc, created five banks on a national basis (National Banks) with a network throughout the country Besides, the computerization

de-in the bankde-ing operations got stepped up de-in Kenya Foreign Banks operatde-ing de-in Kenya were subjected to the same requirements as applicable to domestic banks These reforms created competitiveness and immense pressure in the Kenyan banking industry and it triggered greater use of information technology, consumer credit, more transparent balance sheet and product diversification The other reform was to reduce the number of banks in the system, consolidation imperative and introduce supportive measures of the banks.The reforms have also raised concerns about the performance of Kenyan banking system, especially due to the Non-Performing Assets (NPAs) In the current competitive atmosphere, the commercial banks are under pressure to make credit more affordable and expand their lending portfolio to reverse the slowdown and spur the growth It is greatly emphasized that the effectiveness of financial institution is

to be measured in terms of efficiency and competitive edge over others Therefore, an analysis of banks’ efficiency is crucial to the markets, the Government and the society

at large The commercial banks are constantly trying to reach international benchmarks, with their best practices Some research studies reported that the Private Banks in

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Kenya also performed well, with better liquidity assets, compared to Public Banks and

Foreign Banks The study by Miencha, Murugesan, Rajesh and Karpagam (2013),

found that the relative average efficiency score, for all sample banks, over the years was fair

1.2 Production and Technical Efficiency

The production of banks is an act of transforming inputs into outputs The objective of production is to create value through transformation and the outputs are given in general desirable outcomes Hence more output is better At the same time, inputs are valuable resources, with alternative uses Unspent quality of any input can be used for producing more of the same outputs or produce different outputs The main objectives of efficient resource utilization by banks are;

a) To produce as much output as possible from a specific quantity of inputs b) To produce a specific quantity of outputs using less inputs without affecting quality

An input-output combination is a feasible production plan if the output quantity can be produced from the associated input quantity The technology available to a firm

at a given point in time defines which input-output combinations are feasible Two concepts commonly characterize a firm’s resource utilization performance and they are;

Protectorate in 1895, under the sovereignty of the Sultan of Zanzibar (Mangat, 1968

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3

The origins of commercial banking in Kenya lay in these commercial connections between British East Africa and British India at the close of the 19th Century The first two British banks to be established were the National Bank of India

in 1896 and the Standard Bank of South Africa in 1910 The former became National and Grindlays Bank and later it became Standard Bank The National Bank of South Africa was established in 1916 but was later merged with the Colonial Bank and Anglo-Egyptian Bank formed the Barclays Bank (Dominion, Colonial and Overseas) in

1926 which was also based in London (Atieno Odhiambo et al 2000)

The most important point is that while commercial banks were relatively well established in Kenya during the colonial period, such banks showed little interest in the indigenous African population As the branches of metropolitan banks were designed to settle accounts of the colonial economy, they were not interested in encouraging

savings amongst Africans or financing African enterprise (Engberg, 1995 and Mkandawire, 1999) Further, the then commercial banks did little to help even their

main customer base (the white settler community that was dominated by farmers) These banks lent money to the farmers at interest rates from 8 to 10 per cent When crisis came after the First World War, they operated their traditional policy and shut down on credit at the moment when it was most required When European farmers were mortgaged and the wages of Africans were halved, these banks remained woefully prosperous Throughout the crisis, the Standard Bank of South Africa did not declare a dividend less than 10 per cent A good deal of property as well as money passed into their hands during these years It is to be noted that there was little evidence that the

banks proved adventurous in promoting industrial development in Kenya (Aaronovitch S., and Aaronovitch K 1997)

Interestingly, the restriction of credit by the three banks led to pressure on the government to relieve the heavily indebted white farmers The colonial government established The Land Bank in 1931 as a source of alternative credit However, it has been observed that the private banks benefited more than farmers, as 39 per cent of the funds of the Land Bank were used to discharge existing mortgages with the private bank and therefore, source of alternate credit did not increase the total availability of

credit (Aaronovitch S., and Aaronovitch K 1997) Furthermore, though the mandate

of The Land Bank included provision of credit to ‘native farms’, the skewed land

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tenure system where the lion’s share of African land was held under communal tenure, made it impossible to lend to ‘native farms’ and by 1945, only one African farmer had

benefited from The Land Bank (Maxon, 1992)

1.4 Pre-Independence Growth -1950 - 1963

It was not until the 1950s that other banks began to be established These banks were mainly single branch banks, with their headquarters in Nairobi and focus on trade

finance (Central Bank of Kenya, 1996 and Engberg, 1995)

There are other structural features to be noted

 First, there was no central bank fulfilling the function of lender of the last resort

In its place, there was the East African Currency Board (EACB), with the limited function of maintaining a strict parity between the East African shilling and the British Pound Therefore, the supply of credit was fully determined by commercial banks The commercial bank advances their own resources and funds borrowed from parent banks Funds moved freely from the parent bank to their branch as there were no capital account restrictions

 Secondly, prudential regulation was very lenient, with no statutory liquidity or

cash requirement ratios

 Thirdly, there was very little effort amongst the banks to compete for deposits

Interest rates on deposits and loans were determined by collective (cartel-type) bank arrangements, decided by the three major banks and subscribed to by the

other banks (Engberg, 1995)

Table – 1.1 shows that during the period from 1950 to 1963, the levels of

deposits, assets and loans held by commercial banks in East Africa (and therefore Kenya) grew substantially It has been documented that banks tended to be very conservative in applying credit standards, set by their head offices and these were not realistic in the extremely underdeveloped countries in which they were operating

(Engberg, 1995) The unwillingness of banks to extend credit led to a situation in the

1950s when there was export of capital from the underdeveloped region to the

developed metropolis (Maxon, 1992)

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5

East Africa but were linked to the capital and reserves of the parent banks overseas

Therefore, when large withdrawals of deposits took place in 1955, 1960 and 1963, the

banks were able to use the inter-bank borrowing facilities of their London Head Office

(Abdi, 1997)

Table -1.1 Monetization, Assets and Deposits held by Banks in East Africa from 1950 to 1963

Deposits Earning

Assets

Assets as % of Total Deposits Advances

Advances as % of Total Deposits

Source: Central Bank of Kenya (2000)

The foreign banks had already established a reputation as ‘safe banks’ before

independence On 30th June 1963, on the eve of independence, there were nine banks

operating in Kenya as given in Table – 1.2 The details of domestic banks (year of

incorporation and name of the banks) are given in Table 1.3

Table – 1.2 Foreign Banks Operating in Kenya before and after Independence till date

Nationality (Place of

Incorporation)

Date of Incorporation

Number of Offices in East Africa

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Table – 1.3 Domestic and Foreign Banks Operating in Kenya before and after Independence

S

Year of Incorporation

S

Year of Incorporation

1 African Banking Corporation Ltd 5/1/1984 22 Standard Chartered Bank Kenya Ltd 1/1/191

2 Bank of Africa Kenya Ltd 1980 23 Trans-National Bank Ltd 8/1/1985

3 Bank of Baroda (K) Ltd 7/1/1953 24 UBA Kenya Bank Limited 24/9/29

4 Bank of India 6/5/1953 25 Victoria Commercial Bank Ltd 6/1/1987

5 Barclays Bank of Kenya Ltd 6/5/1953 26 Gulf African Bank Limited 1/11/27

6 CFC Stanbic Bank Ltd 5/14/1955 27 Paramount Universal Bank Ltd 1/1/1993

7 Chase Bank (K) Ltd 4/1/1991 28 Giro Commercial Bank Ltd 12/17/1992

8 Citibank N.A Kenya 7/1/1974 29 Guardian Bank Ltd 12/17/1992

9 Commercial Bank of Africa Ltd 1/1/1967 30 Habib Bank A.G Zurich 1/7/1978

10 Consolidated Bank of Kenya Ltd 12/18/1989 31 Habib Bank Ltd 2/3/1956

11 Co-operative Bank of Kenya Ltd 1/1/1965 32 Imperial Bank Ltd 1/11/1992

12 Credit Bank Ltd 5/14/1986 33 I & M Bank Ltd 1/1/1974

13 Development Bank of Kenya Ltd 1/1/1973 34 Jamii Bora Bank Ltd 9/1/1984

14 Diamond Trust Bank Kenya Ltd 1/1/1946 35 Kenya Commercial Bank Ltd 1/1/1896

15 Dubai Bank Kenya Ltd 1/1/1982 36 K-Rep Bank Ltd 3/25/1999

16 Ecobank Kenya Ltd 1/11/25 37 Middle East Bank (K) Ltd 1/1/198

17 Equatorial Commercial Bank Ltd 12/2/1995 39 National Bank of Kenya Ltd 1/1/1968

18 Equity Bank Ltd 28/12/24 40 NIC Bank Ltd 9/17/1959

19 Family Bank Limited 1984 41 Oriental Commercial Bank Ltd 8/2/1991

20 Fidelity Commercial Bank Ltd 6/1/1992

21 Fina Bank Ltd 1/1/1986

Source: Central Bank of Kenya (2013)

Notes:

1 Includes banks and NBFIs and building societies placed under statutory

management by the Central Bank of Kenya (CBK)

2 Financial institutions, listed on the same line, share common ownership

3 Central Bank of Kenya Annual Reports, in the section on banking structure

developments, did not give the name of the financial institutions that have been placed under statutory management and liquidation but just the number of institutions Therefore, the author had to rely on newspaper articles to establish the names of failed banks

4 Glad-Ak Finance was not put under statutory management but undertook

voluntary liquidation

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7

1.5 Creation of Government Owned Banks – 1963 to 1980

During the period of post independence, bank developments started with the establishment of the Central Bank of Kenya (CBK) in 1966, after the dissolution of the EACB Kenya’s first national currency, the Kenya Shilling (KShs.), was introduced on

14th September of 1966 at the rate of KShs 20 to the pound (Central Bank of Kenya, 2012) At independence of Kenya in 1963, the prevalent understanding was that

development entailed massive resource mobilization and banks were seen as key instruments in this resource mobilization However, in Kenya, unlike most African countries, there was no wholesale nationalization of all banks This could be seen as part of the broader strategy by Kenyan leaders at independence to accommodate

colonial interests and prevent a wholesale migration of foreign capital (Leys, 1995) At

independence, the first President, Jomo Kenyatta, assured the white settler community

Therefore, the international banks now classified as foreign owned banks, including Barclays D.C.O and Standard Bank, continued to operate in Kenya Only the National and Grindlays Banks was bought out by the Government of Kenya (GoK) and

became the Kenya Commercial Bank (KCB) (Central Bank of Kenya, 1986) In 1974,

two American banks were established – the First National Bank of Chicago and the

First National City Bank of New York (Nasibi, 1992)

In the 1960s, Kenya experienced impressive economic growth, driven largely

by commercialization of African small holder agriculture In the first decade of independence, GDP, at constant prices, grew at an annual rate of 7.1 per cent

(Hazlewood, 1989) The GDP ratio increased from 19 per cent in 1963 to 30 per cent in

1970 (Central Bank of Kenya, 1986) However, there was government dissatisfaction

with the pace of adjustment, in particular with the very low loans to deposit ratio of

64.6 per cent in 1969 (Republic of Kenya, 1988)

1.6 The Rise of Indigenous and Political Banks – 1980 to 1990 (Nyayo)

The first President of Kenya, at his death is 1978, was succeeded by President Moi who was from the Kalenjin Community The watchword chosen by Moi for this

Presidency was Nyayo, meaning footsteps, emphasizing continuity with the economic

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policies of the first president era by remaining committed to a capitalist economy, with the focus on attracting foreign investment and maintaining policies of Africanization of

the economy (Maxon and Ndege, 1995)

The 1980s witnessed the growth of a large number of NBFIs which increased from 20 in 1980 to 53 in 1990 (a rise of 165 per cent) and the number of banks grew from 17 to 20 (a growth of 17 per cent) The majority of these new financial institutions

were owned by local entrepreneurs (Kariuki, 1993)

The banking system was considered repressed in the McKinnon-Shaw Report as

interest rates up to the early 1980s were low and negative in real terms (Mwega, Ngola, and Mwangi, 1990) It is worth noting that it had been the official policy in Kenya

since independence to follow a ‘low interest rate policy’ in order to encourage investment and to protect the small borrower, the Central Bank of Kenya (1986) The main structural adjustment policy relating to the financial sector was a gradual increase

in interest rates and real lending rates of banks increased from -2.5% in 1980 to 9% in

1990 (Brownbridge, 1998b)

1.7 Early Liberalization 1990 – 1994

The liberalization of the financial sector was financed by the World Bank’s Financial Sector Adjustment Credit (FSAC) which was approved by the board of the World Bank in June 1989 The theoretical basis of financial liberalization was based on the McKinnon-Shaw Report according to which the government control of interest rates was seen as a key constraint to financial sector development

The key step to full scale financial liberalization was the complete deregulation

of interest rates in 1991 (Brownbridge, 1998b) In 1992, the commercial banks were

authorized to deal in foreign exchange and in 1993, a market-determined flexible

exchange rate system was adopted for the Kenya Shilling (Brownbridge, 1998b)

The liberalization of interest rates and exchange rates provided further avenues for local banks to compete with more established banks and it was an added stimulus

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9

African (mainly Kikuyu) banks, the late 1980s and 1990s witnessed the rise of several African (Kalenjin) and Asian-African banks By the mid- 1990s, it is estimated that

local banks controlled about a quarter of the market (Brownbridge, 1998b)

Table – 1.4 shows the growth in the total number of financial institutions from

1990 up to 1993 The total number of banks grew by 67 per cent and the total number

of financial institutions grew by 13 per cent

Table – 1.4 Numbers of Financial Institutions in Kenya during the period from 1963 to 2012

Source: Brownbridge (1998b), Central Bank of Kenya (2000a, 2003, 2012)

Note: NBFIs - Non-Bank Financial Institution(s)

1.8 Bank Failures in Kenya

Table – 1.5 displays the names of banks that had failed in Kenya from 1984 to

2005 It is to be noted from the Table that the major failure banks could be grouped into

four periods, namely,1984 - 1989, 1993 - 1995, 1998 and 2000-2005

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Table – 1.5 List of Failure Banks and NBFIs in Kenya during 1984 – 2009

• Business Finance (African)

• Nationwide Finance (African)

• Kenya Savings and Mortgages (African)

• Home Savings and Mortgages (African)

• Citizens Building Society (African)

1993 -

1995

• International Finance Company

(African)

• Trade Bank, Trade Finance, Diners

Finance (Asian-African and African)

• Pan African Bank, Pan African

Credit Finance (Asian-African and

African)

• Exchange Bank (Asian-African and African)

• Post Bank Credit (Government owned)

• Thabiti Finance (African)

• Export Bank (African)

• Allied Credit (African

1998 • Bullion Bank, Fortune Finance

(independent Asian-African)

• Trust Bank (political Asian-African)

• City Finance Bank (political Asian-

• Daima Bank (political African)

• Prudential Building Society (political African)

• Euro Bank (political African) Source: Brownbridge (1998b), Central Bank of Kenya, 2010

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11

1.9 Consolidation and Changes in Regulation, 1994 – 2012

After 1994, there was a decline in the total number of institutions This was

partly due to the failure of fifteen financial institutions (Table 1.3 above) Hence in

1993, the Central Bank of Kenya adopted a universal banking policy and reduced the

regulatory advantages that were available to NBFIs This led to several NBFIs

converting themselves into banks or merging with their parent bank and led to a

consolidation of the banking sector (Ngugi, 2000) Throughout the late 1990s and up to

2012, the CBK Act and the Banking Act were amended to improve the regulation and

supervision of banks In October 1995, key amendments included the harmonization of

banks, accounting (financial) year, the approval of bank auditors by the CBK and

reduction of single borrower limit to core capital ratio from 100 per cent to 25 per cent

for banks in Kenya (Central Bank of Kenya, 1995, 1996)

In October 2000, the guidelines were issued, requiring banks to conform to the

Basel Capital Accord in terms of the composition of capital and the new regulatory

capital ratios were specified

The October 2000 Guidelines also reinforced the single borrower limits to 25

per cent of core capital, restricted lending to insiders to 20 per cent of core capital,

defined a large exposure as 10 per cent of core capital and further restricting the

lending to all large borrowers to five times the core capital (Central Bank of Kenya,

2000b) Table 1.6 reveals the regulatory capital ratios of banks in Kenya

Table - 1.6 Regulatory Capital Ratios of Banks in Kenya

Source: Central Bank of Kenya, 2000

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1.10 Financial Sector Reforms

The financial sector reforms in Kenya and elsewhere in Africa, have mainly

been motivated by the Financial Repression Paradigm, promoted by McKinnon and Shaw (1993) who emphasized the role of government failures in financial sector They

pointed out that misguided financial sector policies have damaged the economies of many developing countries by reducing savings and encouraging inefficient and unproductive activities in investment in Kenyan banking sector Particularly the administration fixed nominal interest rate that held the real rate below its equilibrium level and as a result, depressed returns to savers and so discouraged savings Also interest rate ceilings discouraged financial institutions from charging risk premiums,

which was to ration out a large number of potential borrowers with high-return projects

Further, they argued that selective or directed credit, associated with financial repression, would result in higher loan defaults, reduce flexibility and increase the fragility of the banking system Financial Repression was common in Kenya’s financial sectors before reforms Financial systems in the region were characterized by low or negative real interest rates, high reserve requirements, interest rate ceilings, directed credit allocations to priority sectors and heavy government ownership and management

The main objectives of Financial Sector Reforms in Kenya were to reduce direct government intervention and strengthen the role of market forces in the allocation of financial resources, improve the capacity of financial institutions to mobilize domestic savings, enhance the effectiveness of monetary policy instruments, promote competitions among banks, and strengthen their financial soundness Some of the major reform initiatives in the last decade, that changed the face of the country’s banking and financial sectors, are given below

1.11 Liberalization of Interest Rates and Credit Allocation

Initial steps towards liberalization of interest rates were introduced in 1989 when the interest rate ceilings on long term bank loans and non-bank financial institutions (NBFI) lending, were unified while the ceilings on deposit rates for both commercial banks and NBFI were progressively raised In 1990, the financial

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effective rates on loans could exceed the stipulated ceilings In November of the same year, Treasury Bill Rates were fully liberalized Both savings and lending interest rates were finally liberalized in July, 1991

In Kenya, the elimination of administrative credit allocation was an important component of the financial sector reforms The credit guidelines which were in existence since 1975 and in favor of agricultural sector, were abolished in December

1993

1.12 Deposit Protection Schemes

The introduction of Deposit Protection Schemes by the Government, was another important reform The Deposit Protection Fund Board (DPFB) was established

in 1986, under section 36 of the Banking Act The main purpose of establishing the deposit insurance scheme was to protect small depositors in case of bank failure and also to maintain confidence and stability in the financial systems This Scheme operates independently from the Central Bank and it is managed by an independent board of directors, chaired by the governors of the Central Bank The membership of the deposit insurance scheme is compulsory to all deposit taking financial institutions and terms and conditions of the scheme are explicitly stated in their respective statutes

In terms of coverage, the Government provided a limited coverage by which

deposit insurance is restricted up to a certain maximum amount, as given in Table 1.7,

and the limit is 100,000 Kenyan shilling (approximately USD 1,263) The Scheme covered all types of deposits inter-bank deposits, and deposits denominated in foreign currencies

Table- 1.7 Deposit Insurance Schemes in Kenya

Year of

establishment

Types of Deposits Covered

Coverage (National Currency)

Source: Central Banks of Kenya annual report 2013

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1.13 Other Reforms

The Government moved away from quantity rationing and direct controls and indirect and market-based instruments of monetary policy were developed As direct and discretionary forms of credit control were removed, the monetary authorities started to manage liquidity through a more active use of reserve requirements and a more market based allocation of refinancing This was done mainly through Open Market Operations (OMO), regular auctions of repurchase agreements and foreign exchange market operations The Government took measures to remove institutional constraints in the operation of Treasury Bill and bond markets, including the use of auction and issue of a broader range of Treasury Bills

In the course of financial sector reforms, the Government, particularly bank Foreign Exchange Market (IFEM) and stock markets, introduced new instruments and markets The introduction of Inter-bank Foreign Exchange Markets (IFEM) was an important move towards market-based allocation of foreign exchange, with the objective of replacing former regimes in which foreign exchange was administratively allocated The market-based exchange rate regimes were expected to provide a more efficient and reliable mechanism for the allocation of foreign exchange resources The Government introduced reforms like Inter-bank Foreign Exchange Markets in 1993

Inter-The development of capital markets was an important building block in the financial sector reforms in the country Stock exchange market existed in Kenya since

1954, though its scope of operation was limited A regulatory board called the Capital Market Authority (CMA) was formed in 1990, to assist the creation of an environment conducive to the growth and development of the country’s capital markets In 1991, the Nairobi Stock Exchange (NSE) was registered under the Companies Act and phased out the "Call Over" trading system in favor of the floor-based "Open Disagreement System" Subsequently, the stock exchange embarked on an extensive modernization exercise, including a modern information centre, computerization and electronic trading As part of reforms, the Government also had put in place several policy measures to encourage investments in the Nairobi Stock Exchange The above regulatory and technical improvements, along with the acceleration of privatization programs, had helped revitalize the stock exchange market in Kenya which is currently

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The other important component of reforms was the liberalization of banking industry to allow the entry of private and foreign banks the entry of Foreign banks, after the independence, were not banned but later they continued to dominate the banking system Although their dominance has been gradually eroded, however, they still accounted for substantial part of the banking system in Kenya

The main objective of liberalizing entry in the banking sector was to promote competition and in the process, efficiency in the banking system The liberalization of the banking sector and the subsequent enactment of the new banking laws in the country, appeared to have encouraged the emergence of new financial institutions, which added depth and diversity to the financial systems in the region Due to this, several banks and non-bank financial institutions have been established by private entrepreneurs, both local and foreigners The establishment of these financial institutions meant that financial services can be extended beyond the range typically provided by the financial institutions before reforms Although this has the potential to increase competition and enhance the efficiency in financial intermediation, the increase in the number of banks has not been translated into substantial increase in competition as most of the new banks operate in very limited geographical areas, mostly in urban areas As a result, interest rate spreads in the country have remained relatively high

1.14 Structure of the Organized Kenyan Banking Sector

The structure of the Banking Sector in Kenya, as on 31st match 2012, is given in

Chart - 1.1, which covers the public and private sector banks The list of organized Kenyan Commercial banks is given in Table-1.8 According to the Table, there are

three types of banks, namely, public sector banks, private domestic/local banks and

private foreign banks

1.15 Measuring Efficiency of Banks

The measurement of efficiency in respect of banks has two components: one is

purely technical or physical component which refers to the ability to avoid waste by

producing as much output as input usage allows or by using as little input as production demands Thus the analysis of technical efficiency can have an output augmenting

orientation or input conserving orientation The other is the allocative or price component which refers to the ability to combine inputs and outputs in an optimal proportion in the light of prevailing prices (Lovell, 1993)

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Chart - 1.1 Structure of Kenyan Banking Sector

Source: Central Bank of Kenya, 2013

Central Bank of Kenya

Public Financial Institutions Private Financial Institutions

Locals

Commercial Banks (27)

Foreign over 50% ownership

Commercial Banks (11)

1 Development Bank of Kenya

2 Consolidated Bank of Kenya

3 National Bank of Kenya

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Table – 1.8 List of Organized Kenyan Commercial Banking Sector as on 31 st December 2013

Public Sector

Banks Domestic Private Sector Banks Foreign Sector Banks

1 National Bank of

Chase Bank Bank of India

2 Development

Bank of Kenya K-Rep Bank Credit Bank of Kenya Bank of Baroda

3 Consolidated Bank

of Kenya Cooperative Bank of Kenya Prime bank Dubai Bank

4 Family Bank of Kenya Fina Bank Habib Bank

Bank

Equatorial Investment Bank

Imperial bank

Kenya

African Banking Cooperation

I & M Bank

Kenya African Development

Paramount Bank Ltd

Kenya

Consolidated Bank of Kenya

Barclays Bank of Kenya

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Technical efficiency and Allocative efficiency together, form the economic efficiency which is also called as X-efficiency The basic assumption underlying the measurement of technical efficiency, using the frontier method, is that a gap normally

exists between a firm’s actual and potential levels of technical performance The

potential level of performance is given by the frontier which is the locus of best performing firm(s) within the sample The technical efficiency of a particular firm is

measured as the ratio of actual performance to potential performance (Kalirajan and Shand, 1999)

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Chapter II

Review of Literature and

Research Design

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For the purpose of this study, this Chapter is divided into two sections as follows

Section A: Review of Literature and Section B: Design of the Study

SECTION – A 2.0 REVIEW OF LITERATURE

An attempt has been made in this section to review the earlier research works undertaken in the area of bank efficiency to understand the research gap, methodology adopted by researchers and findings of earlier studies

An article entitled, Report of the Banking Commission (1972), reviewed operating

methods and procedures of banks and made recommendations for improving and modernizing operating methods and procedures, particularly relating to customer services, credit procedures and internal control systems It also studied the cost structure and analyzed the profitability and finally, suggested measures to improve the banking system in Europe

Kulkarni (1976), in his paper entitled, Development, Responsibility and Profitability of Banks, pointed out that while studying the performance of banks, the

aspects of costs, profits and social benefits, arising out of banks, operations could not

be ignored The study recognized that while fulfilling the social responsibility, the banks may try to develop business and consider the steps to reduce costs, improve banking system and increase the overall productivity

According to Chames, Cooper and Rhodes (1978), in their article entitled, Some Models for Estimating Technical and Scale Inefficiencies in Data Envelopment Analysis, a nonlinear programming model was used to measure the relative efficiency

of Decision Making Units (DMUs) The study employed a CCR model to measure the technical efficiency which was based on the concept of the Pareto optimum The authors later revised the BCC Model to measure pure technical efficiency and scale efficiency However, the authors used basically the idea of Data Envelopment Analysis

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The paper entitled, Bank Productivity in Canada, by Bradford (1982), studied

the productivity of banks in Canada and found that the Canadian banks were ranked among the most efficient in the world The ratio of no-interest expenses to average total assets of the Canadian banks system as a whole, declined steadily

Berger, et al (1987), in the study entitled, Competitive Viability in Banking:

Scale, Scope, and Product Mix Economies, used two inputs (i.e., labor and capital)

and five outputs (i.e., demand deposits, time and saving deposits, real estate loans, commercial loans, installment loans) The study found that an average scale economies score was 0.96 (0.98) for units (branching) of state owned banks

An article entitled, Technical, Scale, and Allocative Efficiencies in U.S

banking: An Empirical Investigation, by Aly et al (1990), applied DEA to explore

various measures of efficiency for sample banks in 1986 The study employed three inputs (i.e., labor, capital, and loanable funds) and five outputs (i.e., commercial and industrial loans, consumer loans, real estate loans, other loans, and demand deposits) The study found that there was scale inefficiency

According to the paper entitled, Measuring Cost Efficiency in Banking: Econometric and linear programming Evidence, by Ferrier and Lovell (1990), both SFA and DEA models were used to evaluate the efficiency of 575 sample banks The study employed three inputs (i.e., total number of employees, occupancy costs and expenditure on furniture and equipment, and expenditure on materials) and five outputs (i.e., the number of demand deposit accounts, the number of the real estate loans, the number of installment loans, and the number of industrial loans) It was reported that there was overall inefficiency of 21.6 percent Further, it was found that unlike the other studies cited, small banks (i.e banks with under $25 million in assets) were the most efficient

Timme et al (1990), in the article entitled, An Examination of Cost

Sub-additivity and Multiproduct Production in Large U.S Commercial Banks,

analyzed the U.S bank production, using an intermediation approach and multi-cost production function The study found that there was no evidence of cost complementarity and no sub-additive cost functions

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A study entitled, Measurement and Efficiency Issues in Commercial Banking, Output Measurement in the Service Sector, by Berger and Humphrey (1992), used a

thick frontier approach to compare cost efficiency of banks and to study the shifts in the best practice of costs between 1980 – 1984 for all USA banks It was found that the thick frontier approach gave slightly higher estimates of inefficiencies, i.e sample banks were less efficient than the stochastic frontier approach

Fukuyama (1993), in the article entitled, Technical and Scale Efficiency of Japanese Commercial Banks: A Non-parametric Approach, applied DEA to examine the efficiency of 143 commercial banks in Japan The researcher used three inputs and two outputs (revenue from loans and revenue from other business activities)

It was found that the major cause for the overall technical inefficiency was pure technical inefficiency and not scale inefficiency The result also showed that the majority of sample banks were operating at the range of increasing return to scale

A paper entitled, Efficiency and Competition in O.E.C.D Financial Services, by

Fecher and Pestieu (1993), applied the stochastic production frontier approach to evaluate technical efficiency of the financial service sectors in eleven OECD countries

It is found that Japan was the most efficient country in providing financial services while Denmark was the least efficient

Berg et al (1993), in their study entitled, Bank efficiency Derived from the

Profit Function, studied the efficiency of banks in Norway, Sweden and Finland, using

data envelopment analysis The sample consisted of a number of 503 Finland banks,

150 Norwegian banks and 126 Swedish banks The study employed three outputs (total loans, total deposits and number of branches) and two inputs (labor measured in person-hours per year and capital measured in book values of machinery and equipment) The researchers found that the Swedish banks were 52-63 per cent more efficient than the banks in Finland, which was 40-60 percent more efficient than that of Norwegian It is to be noted that the largest Swedish banks were among the most efficient units in the pooled sample

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used a stochastic econometric cost frontier, to evaluate the efficiency of the sample banks, with total assets above $50 million The study employed four inputs (i.e deposits, labor, and capital and fixed assets) and four outputs (i.e consumer loans, real estate loans, commercial and industrial loans) It was found that there was a technical inefficiency of 9.8 percent

The study by Zaim (1995), in the paper entitled, The Effect of Financial Liberalization on the Efficiency of Turkish Commercial Banks, applied Data

Envelopment Analysis to estimate the bank efficiency of 56 commercial banks in Turkey during the post-liberalization era and 42 banks during the pre-liberalization era The study employed four inputs (i.e., labor, interest expenditures, depreciation expenditures, and material expenditures) and four outputs (demand deposits, time deposits, short-term loans, and long-term loans) It was found that on an average, the costs were 75 percent above the minimum in the pre-liberalization period and 38 per cent above the minimum in the post-liberalization period

Goldberg and Rai (1996), in their paper entitled, The Structure-Performance Relationship for European Banking, applied a stochastic cost frontier by using two

outputs (loans as the primary output and all other earning assets as the secondary output), and three inputs (price of fixed capital, defined as capital and occupancy expenses divided by fixed assets, price of labor defined as staff expenses divided by number of employees, and price of borrowed funds defined as total interest expenses divided by interest bearing liabilities) It was found that sample banks in Germany, Denmark, Belgium, and Spain were operating with the smallest deviation from the efficient cost frontier (X-efficient) while banks in Italy and France were operating in the optimal scale (scale-inefficient) The results also showed that sample banks in Germany, Switzerland, and Belgium were very competitive while banks in Spain and France were the least competitive

The paper entitled, Operational Efficiency in Banking: An International Comparison, by Allen and Rai (1996), applied both Data Envelopment Analysis and

Stochastic Frontier Analysis to compare input inefficiency (as measured by economies

of scale and scope) across 15 developed countries, distinguished by different regulatory

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environments The sample countries were classified into two groups as universal and separated banking countries Using two outputs (i.e., traditional banking assets such as loans, and investment assets) and three inputs (i.e., labor, capital and borrowed funds),

it was found that large banks in separated banking countries exhibited the largest measure of input inefficiency accounting for 27.5 percent of costs as well as significant levels of diseconomies of scale while other banks recorded significant lower input inefficiency measures, in the range of 15 percent of total costs

Lang and Welzel (1996), in the paper entitled, Efficiency and Technical Progress in Banking Empirical Results for a Panel of German Cooperative Banks,

assessed the performance of the UK Banking Sector It was found that all the sample banks enjoyed productivity, which was higher in small banks in the study sample

The study entitled The Technical Efficiency of Large Banks Production of USA Banks, by Miller and Noulas (1996), examined the technical efficiency of USA

large banks and found that larger and more profitable banks recorded higher levels of technical efficiency At the same time, larger banks were more likely to operate under decreasing returns of scale

Rim (1996), in his paper entitled, International comparison of Bank Efficiency: An Empirical Study of Large Commercial banking in the United States and Japan, applied a stochastic cost frontier to estimate bank efficiency in the USA

and Japan The study used two outputs (deposits and loans) and three inputs (price of labor, price of capital and price of funds) It was found from the study that the USA multinational banks and small and medium Japanese banks were operating at cost-efficient output levels The USA domestic banks enjoyed increasing returns to scale, implying that the average size of domestic USA banks were not optimal

An article entitled, An analysis of Efficiencies in Banking: A Stochastic Cost Frontier Approach, by Kwan and Eisenbeis (1996), examined the efficiency of 254

banks, using stochastic econometric cost frontier from 1986 to 1991 The study employed three inputs (labor, funds and capital) and five outputs (investment securities,

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