Volume 7, Issue 8, August – 2022 International Journal of Innovative Science and Research Technology

ISSN No:-2456-2165

Supervisory Review and Financial Performance of

Commercial Banks in Kenya
Mathina Ruth Wanjiru Dr. Ruth Mathina
(Corresponding Author) Kenyatta University, Nairobi, Kenya

Dr. Ambrose Jagongo Dr. Lucy Wamugo

Kenyatta University, Nairobi, Kenya Kenyatta University, Nairobi, Kenya

Abstract:- The purpose of the study was to establish the bank to employ available resources to increase shareholders’
effect of supervisory review on financial performance of wealth and generate sustainable profits. The current study thus,
commercial banks in Kenya. The study was founded on defined financial performance as the use of the resources
asymmetry information theory. Positivism research invested by the shareholders efficiently and effectively to
philosophy and casual research design were employed. The generate revenue. From literature, there are two types of
target population comprised of forty-three commercial financial performance measures, namely, traditional and market
banks from which a sample of thirty-eight commercial based measures. Traditional financial measures include; cost to
banks was selected using purposive sampling technique. income (CI) return on equity (ROE), return on assets (ROA),
Commercial banks which were actively operating and not non-performing loans ratio (NPLR), percentage change of pre-
under statutory management during the period of study tax profits (%GPBT) and net interest margin (NIM). Market
were selected. Data for the period between 2013-2020 was based financial measures include; total shareholders returns,
extracted from the bank supervision annual reports and price to book value and P/E ratio (Muriithi et al., 2016;
individual bank’s published annual reports using document Mwangi, Makau & Kosimbei, 2014; Odonkor & Barmor,
review guide. Data analysis involved descriptive statistics 2012). The commercial banks financial performance was
and inferential analysis. The study conducted panel unit mainly arrived using ROA since it considers all the assets
root test, multicollinearity test, normality test, utilized to generate revenue for the firm, in addition, the banks
heteroscedasticity test and autocorrelation test to avoid largest assets consists of bank loans and they are the largest
spurious results. The 5% significance level was used to test source of earnings. Thus the per Kenyan shilling return on
the research hypothesis. The panel regression findings assets is key to the commercial banks management (Muriithi et
showed that supervisory review had a positive significant al., 2016). Moreover, CBK employs return on assets to assess
effect on financial performance of commercial banks in the financial performance of commercial banks in Kenya (CBK,
Kenya. The conclusion of the study was that supervisory 2015). The present study therefore used return on assets to
review explains the variation in financial performance of measure financial performance of commercial banks in Kenya.
commercial banks in Kenya. Further, increase in
supervisory review enhances financial performance. The Commercial banks of European member countries have
study thus, recommends that commercial banks in Kenya been struggling to return to profitability after the 2008-2009
should adhere to the prudential guidelines on supervisory global financial crisis. For instance, European union banks
review so as to enhance financial performance in the long (EUB) profitability remained lower than before the crisis time
run. with the return on equity (ROE) declining from 4.4% in 2015
to 3.5% in 2016 and from 6.1% in 2018 to 5.4% in 2019
Keywords:- Supervisory Review, Financial Performance, (KPMG, 2019; Ernst & Young, 2019). The ROE seem to be
Commercial Banks. very low since the cost of capital was about 10% for most EUB
after the global financial crisis. Non-performing loans ratio
I. INTRODUCTION (NPLR) are still high in some of EU member countries after the
crisis. For example, Greece NPLR in 2016 was 46.9% and in
Financial performance is the ability of a firm to employ 2017 was 46.5% while Cyprus NPLR in 2016 was 47.4% and
the available resources efficiently in order to generate revenue. in 2017 was 42.7% (KPMG, 2017). Financial performance of
Shukla (2014) defined financial performance as the bank commercial banks in Kenya declined as noted by return on
capability to create maintainable profits or it’s the ability of a assets over the study period as shown in table 1 and figure 1.

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Volume 7, Issue 8, August – 2022 International Journal of Innovative Science and Research Technology
ISSN No:-2456-2165
Table 1: Return on assets (ROA)
Year 2013 2014 2015 2016 2017 2018 2019 2020
ROA(%) 4.7 3.4 2.9 3.3 2.7 2.7 2.6 1.7
Source: Central bank of Kenya (2013-2020)

ROA
5
4
3
ROA

2
1
0
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
Year

Fig 1: Return on assets (ROA)

Source: Central bank of Kenya (2013-2020)

Table 1 and Figure 1 indicate that return on assets on 2013 Demirguc-Kunt & Ross, 2006; Barth et al., 2013). In December
was at 4.7% which reduced to 3.4% in 2014 and further to 2.9% 2020, 40.46% commercial banks were ranked strong, 54.05%
in 2015. In 2016 return on assets raised to 3.2% a time when ranked satisfactory, 4.15% ranked fair, 1.25% ranked marginal
interest capping was introduced by the government of Kenya. while 0.09% ranked unsatisfactory. Supervisory review was
But in 2017, return on assets dropped to 2.7%, remained measured using the natural logarithm of the number of audits
constant in 2018 at 2.7% while in 2019 return on assets, further made by central bank of Kenya in an individual bank. Delis and
reduced to 2.6% a time when the government of Kenya Staikouras (2011) noted that improved supervision enhanced
abolished the interest capping. In 2020, return on assets reduced financial performance of banks while reducing financial crisis.
further to 1.7%. In addition, Rezende and Wu (2014) argues that frequent
examination of banks by the regulators made the banks to
Supervisory review is the standard adopted by commercial adhere to the regulations set by the regulatory authority and
banks to evaluate the extent to which commercial banks are therefore, reducing loan losses and increasing financial
adhering to stipulated rules guiding banking operations in their performance. Faten, Hachmi, Cheffon and Fredji (2014) noted
respective countries (Fapetu & Kolapo, 2015). Supervisory that onsite and off-site examination of commercial banks
review ought to be implemented by both regulatory agencies improved their financial performance hence reducing the
and respective commercial banks. Internally, banks ought to chances of failure.
develop their own assessment criterion on adherence to capital
adequacy and information disclosure strategies adopted. A. Statement of the Problem
Supervisory review call for adoption of recommended Commercial banks major role is for directing funds from
accounting standards and policies. Recently, commercial banks surplus units to deficit units. Therefore, through this role
have adopted varied risk management models through asset commercial banks contribute directly to the economic growth
liability matching strategies. This has amplified levels of and development of any country, thereby improving the lives of
accounting data transparency (David & Muendo, 2018). To the citizens. Since the global financial crisis of 2008- 2009,
achieve supervisory review standards, commercial banks financial performance of commercial banks in Kenya have
should invest in reasonable risk levels. From literature recorded a downward trend (Ernst & Young, 2019). Therefore,
reviewed, it was noted that supervisory review increased the central bank of Kenya introduced supervisory review
financial performance of commercial banks (Beck, Demirguc- regulations for adoption by all commercial banks actively
Kunt & Ross, 2006; Barth, Lin, Ma, Seade & Song, 2013). The trading in Kenya so as to enhance their financial performance
present study operationalized supervisory review as the (CBK, 2013). Nonetheless, despite the momentous efforts by
oversight of banks in order to identify insecure practices which the central bank of Kenya, there have been a reduction in
can be risky to economy or banks. Previous studies measured financial performance of commercial banks in Kenya between
supervisory review by interventionist supervisory (Chortareas 2013 to 2020 as shown by return on assets; 4.7% in 2013, 3.4%
et al., 2012), onsite examination by supervisors (Beverly, Anna in 2014, 2.9% in 2015, 3.3% in 2016, 2.7% in 2017, 2.7% in
& Matthew, 2016), minimum frequency of examination 2018, 2.6% in 2019 and 1.7% in 2020 (CBK, 2020). In addition,
(Rezende & Wu, 2014), Basel core principles index (Beck, charter house bank, imperial bank and chase bank were put

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Volume 7, Issue 8, August – 2022 International Journal of Innovative Science and Research Technology
ISSN No:-2456-2165
under statutory management in 2006, 2015 and 2016 them loans, information disclosure by banks to the public
respectively (CBK, 2015; CBK, 2016). The reduction in (David & Muendo, 2018).
financial performance of commercial banks in Kenya may be
linked to poor execution of supervisory review policies. This theory was applicable in the study in that, in a
financial contract, commercial bank depends on the information
In view of this, the researcher sought to establish the effect provided by the borrower to make credit decision, when the
of supervisory review on financial performance of commercial borrower conceals relevant information to the loan agreement,
banks in Kenya. Previous studies have produced contradicting commercial bank (lender) may either make right or wrong
results on the effect of supervisory review on financial credit decision, since it may be hard to differentiate a bad
performance. For instance, Faten et al. (2014) documented a borrower from a good borrower. Hence, this might lead to
positive and significant effect of supervisory review on moral hazard and adverse selection which in turn may affects
financial performance whereas Khamees (2018) established a the financial performance of commercial banks through non-
negative and significant influence of supervisory review on payment of interest on loans. This theory anchors on financial
financial performance. The contradiction in findings may be performance as the dependent variable. Further the theory
attributed to contextual differences. Further, most of the anchors on supervisory review since the commercial banks may
previous studies are cross-country level analysis and not bank conceal information about their operations to the central bank
level analysis (Faten et al., 2014; Barth et al., 2013). Moreover, (regulator). To mitigate the information asymmetry problems,
locally, there are few studies if any on the effect of supervisory the CBK should conduct regular audits to supervise if
review on financial performance of commercial banks in commercial banks have complied with the Basel accord
Kenya. It is against this background that the study sought to fill requirements (David & Muendo, 2018; Khamees, 2018; Sudesh
in the existing gap and established the effect of supervisory & Kumar, 2016). Hence, the study conceptualized supervisory
review on financial performance of commercial banks in review as the number of CBK audits in an individual bank and
Kenya. established its effect on financial performance of commercial
banks in Kenya.
II. THEORETICAL REVIEW
A. Empirical review: Supervisory review and financial
Asymmetry information theory proponents were Akerlof performance
(1970), Spence (1973) and Stiglitz (1961). Asymmetry Hirtle, Kovner and Plosser (2016) did a research on
information is a problem in borrowing and lending of money supervisory review and bank financial performance in United
where the party borrowing has more information about his/her States. Supervisory review was measured using supervisory
credit worthiness than the party lending. The disparity in hours while financial performance was measured using
information held by the borrower and the lender may result in volatility in earnings. The findings informed that supervisors of
market failure. In a banking context, information asymmetry large banks in a district recorded more hours as compared to
may arise when the banks have more information about their small banks. Additionally, increased supervision lead to less
operations than the regulator or where the borrower has relevant volatility in earnings and less risky lending. The study by Delis
information than the lender when contracting. Difference in the and Staikouras (2011) also identified supervisory review as a
information held by the parties to a contract may lead to a bank vital factor in improving the financial performance and
being rated as performing well by the regulator which may not reducing the riskiness of a bank. However, the study by Hirtle
be the case or a lender granting loan at a lower interest rate to a et al. (2016) was done in a developed country with different
risky borrower which may not be the case. Thus sharing of economic, political and social conditions than those present in
information among the borrower and lender may reduce Kenya. Rezende and Wu (2014) studied on the influence of
adverse selection (Karim, Chan & Hassan, 2010). Richard bank supervisory review on bank financial performance in
(2011) observes that information asymmetry may cause both United States. Supervisory review was measured by onsite
moral hazard and adverse selection as may be hard to examination (frequency of examinations) while bank financial
distinguish between bad and good borrowers. Guidara, performance was measured by ROE, net interest margin/total
Soumare and Tchana (2013) established that moral hazard and loans, charge offs/total loans, provision for loans and
adverse selection has contributed to non-repayment of loans in leases/total loans. The study reported that frequent examination
commercial banks since the lender can make either right or of banks by the regulators made the banks to hold safer assets
wrong credit decision when granting loans due to the borrower and therefore reducing loan losses and increasing financial
failure to disclose all relevant information to the bank. Moral performance. The results of the study supported the results by
hazard arises when a party to a contract gives false information Chortareas et al. (2012). However, the study of Rezende and
about its credit ability, liabilities and assets. While adverse Wu (2014) was done in an advanced country where the
selection arises when the lender cannot distinguish between conditions are different from those dominant in Kenya. Faten et
higher and lower risk borrowers so as to know the risk premium al. (2014) investigated regulations influence on supervisory
to charge on loans. These information asymmetry problems review on European banks profitability. Profitability measures
may be reduced by screening the borrowers before granting were ROE and ROA while supervisory review measurement
was four components of six graded dimensions of banking

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Volume 7, Issue 8, August – 2022 International Journal of Innovative Science and Research Technology
ISSN No:-2456-2165
supervision. The study applied Generalized Method of supervisory agent and onsite examinations while financial
Moments (GMM) estimator. Banking regulations had performance was proxied by aggregate income, operating costs
significant positive effect on profitability. Also, there was to assets ratio and NPL ratio. Vighneswara (2014) study
significant positive effect of deposit insurance, capital reported that regulation, supervisory review and efficiency
adequacy on profitability. Thirdly, increased banking related significantly. The results of the study corroborated with
regulations enhanced commercial banks financial performance. Rezende and Wu (2014) findings. However, the study by
The study by Faten et al. (2014) however, was a cross-country Vighneswara (2014) was a cross country analysis and not bank
level analysis and not bank level analysis. Vighneswara (2014) level analysis.
carried out a study in the course of universal financial crisis on
the effect of supervisory review, regulation on efficiency in B. Conceptual Framework
BRICS countries. Supervisory review was proxied by power of

Fig 2:- Conceptual framework

Source: Researcher (2021)

C. Research Hypothesis consists of how the research objective was achieved. That is, it
H01: Supervisory review has no significant effect on financial shows how the data was collected, measured and analyzed
performance of commercial banks in Kenya. (Saunders, Lewis & Thornhill, 2012).

III. RESEARCH METHODOLOGY B. Empirical Model

𝑅𝑂𝐴𝑖𝑡 = 𝛽0 + 𝛽1 𝑆𝑅𝑖𝑡 +
A. Research Design 𝜀𝑖𝑡 … … … … … … … … … … … … … … … … … … … … … … … … … … … … (1)
Casual research design was used to find the extent and the Where;
nature of cause-and-effect relationships prevailing between 𝑅𝑂𝐴𝑖𝑡 = Financial performance of commercial banks.
supervisory review and financial performance. According to 𝛽0 = Constant.
Zikmund, Babin, Carr and Griffin (2013) causal research design 𝑆𝑅𝑖𝑡 = Supervisory review.
is used to assess what effect a specific change will have on 𝛽1 =Coefficient of supervisory review.
prevailing norms and assumptions. Thus, supervisory review as 𝜀𝑖𝑡 = Error term.
a regressor variable was varied to establish the change in the
criterion variable, financial performance. Research design

Table 1: Operationalization and measurement of study variables Measurement scale

Operationalization

Measurement
Variable
Type

Dependent Financial Profitability ROA=Earnings before Ratio

performance interest and tax/Total assets
Independent Supervisory review Oversight of banks in order to Natural logarithm of Ratio
detect unsound practices that number of central bank of
can affect a bank as well as Kenya audits to an
whole economy. individual bank.

Source: Researcher (2020)

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Volume 7, Issue 8, August – 2022 International Journal of Innovative Science and Research Technology
ISSN No:-2456-2165
C. Target Population secondary data can be achieved through the literatures
The target population for the study consisted of forty-three reviewed. Therefore, various literatures reviewed informed the
commercial banks operating in Kenya over the period of study development of document review, operationalization and
(2013-2020). However, the unit of analysis involved measurement of the study variables.
commercial banks which were not placed under statutory
management and were actively trading during the time of the F. Data Analysis and Presentation
study. The individual commercial banks and banking Panel regression analysis, correlation analysis and
supervisory annual financial reports from year 2013-2020 were descriptive statistics were employed to analyze the data.
the unit of observation. Analysis of data involved the following steps as suggested by
(Zikmund et al., 2013). First, panel data was revised for
D. Sampling design and Sample size completeness, consistency and accuracy. Relevant ratios for
Purposive sampling design was applied by the researcher each bank across time were calculated by the help of Ms- Excel.
in order to choose a sample that represents the population of the Stata software was then used for data analysis after importing it
study (Mugenda & Mugenda, 2013). Commercial banks that from excel. Descriptive statistics values (minimum, maximum,
were under statutory management or not actively trading over standard deviation, mean) for the variables in the study were
the eight years of study (2013-2020) were excluded from the computed to explain the patterns of the data and presented using
sample. The commercial banks carrying out banking activities a table. Inferential analysis involved both correlation and
in Kenya in year 2020 were forty-three. However, five banks multiple regression analysis. Diagnostic tests were done to
were dropped, since Charter house bank, Chase bank and check the violations of classical linear regression (CLR)
Imperial bank were under statutory management while Mayfair assumptions in the panel data. According to Greene (2011)
bank and Dubai Islamic bank (K) limited were opened in 2017 running regression models without checking for the violation of
and therefore were in operation for less than eight years. Hence, CLR assumptions first, might lead to spurious results. The
the remainder of thirty-eight commercial banks formed the existence of the effect of Basel accord requirements and
sample of the study. financial performance measures were tested using correlation
analysis. Association among dependent and independent
E. Data Collection Procedure variable for strength and direction was aided by Pearson’s
The nature of data in the present study was secondary and correlation analysis. Finally, panel regression analysis was done
quantitative. Panel data sources were individual banks’ audited so as to test the null hypotheses of the study. Hypotheses testing
financial reports and banking supervision annual reports was done at 0.05 significance level which is the level mostly
between 2013 and 2020. The study used data collection used in social and business research (Mugenda & Mugenda,
schedules to extract the data specifically from profit and loss 2013). Application of inferential and descriptive statistical
account, statement of financial position and disclosures to the analysis improved the study results (Rajkumar, 2014).
reports. Faten et al. (2014) proposed that construct validity in Information was presented using tables.

IV. EMPIRICAL RESULTS AND DISCUSSION

Table 2: Descriptive Statistics

Variable Observations Mean Standard Deviation Minimum Maximum
Financial Performance 284 .0261067 .0381216 -.1980881 .4938343
Supervisory Review 282 0.4447629 0.4709894 0 1.098612
Source: Study Data (2020)

The results in table 2 show that financial performance in From the results in table 2 supervisory review as measured
terms of return on assets for 284 observations had a mean value by the natural logarithm of the number of central bank of Kenya
of 0.0261067, a standard deviation of 0.0381216 with minimum audit for 282 observations had a standard deviation of
and maximum values of -0.1980881and 0.4938343 0.4709894 with a mean value of 0.4447629. The mean value
respectively. The standard deviation value was higher than the indicates that central bank of Kenya was playing its critical role
mean value, indicating that during the period of study (2013- of conducting audits in each of the commercial banks
2020) there was greater variability in return on assets across consequently instilling discipline in the banking industry.
commercial banks, which was corroborated by the difference Further, there was a higher variability in supervisory review
between maximum (0.4938343) and minimum (-0.1980881) since the mean value was lower than standard deviation value
values. The positive value of financial performance means that, that was confirmed by the minimum value of zero and
commercial banks were on average profitable but a negative maximum value of 1.098612. A positive value of supervisory
minimum value of -0.1980881 indicates that some commercial review indicates that improvement in the quality of audit by
banks were operating at a loss over the same time of study. central bank of Kenya increases financial performance of
commercial banks in Kenya.

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Volume 7, Issue 8, August – 2022 International Journal of Innovative Science and Research Technology
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A. Diagnostic Test Breusch and Pagan Lagrangian multiplier test for random
The study conducted the following diagnostic tests; panel effects. The null hypothesis stated that ordinary least square
unit root, normality, heteroscedasticity, autocorrelation to model was preferred to fixed effect model. The chibar2 value
prevent spurious results. was zero with a p-value of 1.0000 hence the null hypothesis that
pooled regression model was preferred to fixed effect model
B. Model Specification Test was not rejected. The researcher concluded that the data did not
The researcher had to apply either random or fixed effects have panel effects and thus employed pooled effect model
model hence the decision was made using Hausman (Greene, 2011).
specification test (Baltagi, 2013). The null hypothesis stated
that random model was preferred to fixed model. Model C. Inferential statistics: Regression analysis and Hypothesis
specification test reported a chi square of 12.35 with a p-value testing
of 0.0063<0.05. The results indicated that the chi square value The following hypothesis was tested by the study.
was statistically significant at 5%. Hence the null hypothesis
that random model was preferred to fixed model was rejected. H01: Supervisory review has no significant effect on
The study concluded that fixed effect model was consistent. financial performance of commercial banks in Kenya.
The researcher then tested for panel effects in the data by using

Table 3: Effect of supervisory review on financial performance

Coefficient Robust Std. Err. t P>t
Supervisory Review 0.0297212 0.0055910 5.32 0.000
Constant .0044411 .0056281 0.79 0.31
Dependent variable= Financial performance (ROA)
Source: Study Data (2021)

The following model was formulated based on the V. CONCLUSION AND RECOMMENDATIONS
analysis in table 3.
𝑅𝑂𝐴𝑖𝑡 This study analyzed the effect of supervisory review on
= 0.0044411 + 0.0297212𝑆𝑅𝑖𝑡 financial performance of commercial banks in Kenya using
+ 𝜀𝑖𝑡 … … … … … … … … … … … … … … … … … … … … . (2) positivism research philosophy and causal research design. The
study found that supervisory review has positive and significant
In table 3 supervisory review coefficient (β=0.0297212, p- effect on return on assets. The finding of the current study is
value of 0.000<0.05) indicates supervisory review has a supported by several empirical studies though it also contradicts
positive and significant effect on financial performance (ROA) other studies. The study therefore concludes that as the quality
of commercial banks in Kenya hence the null hypothesis that of supervisory review of commercial banks is improved, it may
supervisory review has no significant effect on financial enhance the return on assets as commercial banks will not
performance of commercial banks in Kenya was rejected at five carryout activities restricted by central bank of Kenya. The
percent level of significance. The positive coefficient study thus recommends that central bank of Kenya should
(β=0.0297212) in the findings suggest that one percent increase design banking financial policies that increase the number and
in the frequency and quality of supervisory review of quality of audit reviews thus preventing commercial banks from
commercial banks by central bank of Kenya would increase engaging in activities restricted by central bank of Kenya. The
financial performance of commercial banks in Kenya by study also recommends that commercial banks in Kenya should
(0.0297212 divided by 100) units while holding other factors adhere to the prudential guidelines on supervisory review so as
constant. The finding was consistent with those by Faten et al. to enhance financial performance.
(2014), Rezende and Wu (2014), Vighneswara (2014) who
found a positive and significant effect of supervisory review on  Suggestion for Further Research
financial performance of commercial banks. However, The scope of this study was commercial banks licensed
Chortareas et al. (2012) found that official supervisory powers and operating in Kenya between the period 2013-2020. A
improved operations of the banks while interventionist similar study can be conducted to investigate the effect of
supervisory and regulatory policies lead to higher bank supervisory review on financial performance of other financial
inefficiency levels. The inconsistency with Chortareas et al. and non-financial institutions.
(2012) study may be due to market differences.

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Volume 7, Issue 8, August – 2022 International Journal of Innovative Science and Research Technology
ISSN No:-2456-2165
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