Introduction

Background of the Study

In an effort to promote efficiency in the banking industry and after a period of worldwide liberalization and deregulation,
the Basel Capital Accord of 1988 (Basel I) which led to the endorsement of a new capital adequacy framework (Basel II)
in 2004 (operational from 2007) marked the beginning of a new phase of re-regulation with an attempt to bring about an
international harmonization of banking regulations (Bichsel and Blum, 2005). Kenyan banks are by and large yet to adopt
model based approaches to assessing their capital adequacy needs (Central Bank of Kenya, 2008a).
The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must
handle their capital. The categorization of assets and capital is highly standardized so that it can be risk weighted.
Internationally, the Basel Committee on Banking Supervision housed at the Bank for International Settlements influence
each country's banking capital requirements. In 1988, the Committee decided to introduce a capital measurement system
commonly referred to as the Basel Accord. This framework has been replaced by a significantly more complex capital
adequacy framework commonly known as Basel II. After 2012 it will be replaced by Basel III.
Capital adequacy has been the focus of many studies and regulator as it is considered to be one of the main drivers of any
financial institution’s profitability (Bourke, 1989; Berger, 1995; Navapan and Tripe, 2003; White and Morrison, 2001). In
contrast, other studies argue that in a world of perfect financial markets, capital structure and hence capital regulation is
irrelevant (Modigliani and Miller, 1958). However, White and Morrison (2001) posited that the regulator ensures that
banks have enough of their own capital at stake. Bichsel and Blum (2005) supported this proposition arguing that these
regulations help in reducing negative externalities (e.g., disruptions to the payments system and a general loss of
confidence in the banking system) in addition to boosting the slow economic growth hence the Gross Domestic Product
(GDP). These propositions leads to the question: what then do prudential capital requirements accomplish in thebanking
sector? This study suggests that these requirements have something to do with a bank’s performance. In Kenya, the
government, through the Central Bank of Kenya has put requirements that all commercial banks should gradually increase
their capital base to one billion Kenya shillings from the current 250 million Kenya shillings by 2012 (currently, 1US$ =
77.20 Kenya shillings) (Central Bank of Kenya, 2008b). This represents a 300% increase. This means that the level of
capital has some implication on the performance and bankruptcy of a bank, a subject which is being investigated by this
study.
Profitability is the primary goal of all business ventures. Without profitability the business will not survive in the long-run.
So measuring current and past profitability is very important. Profitability is measured with income and expenses. Income
is generated from the activities of the business. A business that is highly profitable has the ability to reward its owners with
a large return on the investment (Waweru and Kalani, 2009)
A profitable banking sector is better able to withstand negative shocks and contribute to the stability of the financial
system. Important changes in the operating environment particularly credit risk is likely to affect bank profitability.
Empirical analysis finds that both bank- specific as well as macroeconomic factors are important determinants in the
profitability of banks (Westerfield, 2008). Brealey and Myers (2003) argue that there are various important measures in
determining profitability of an organization. These include; Net Profit Margin, Return on Assets and Return on Equity. In
1972 David Cole introduced a procedure for evaluating bank performance via ratio analysis (MacDonald and Koch, 2006).
This procedure enables an analyst to evaluate the source and magnitude of banks profits relative to selected risks taken.
David Cole employed return on equity model to analyze bank profitability and identified specific measures of credit risk,
liquidity risk, interest rate risk, operational risk and capital risk (MacDonald and Koch, 2006).

Banking sector plays an important role in sustaining financial markets and has a significant impact on the success of the
economy. Sound financial health of a bank is the guarantee not only to its depositors but is equally significant for the
shareholders, employees and whole economy as well. As a sequel to this maxim, efforts have been made from time to time, to
measure the financial position of each bank and manage it efficiently and effectively (Din Sangm, 2010)

In Developing countries like Tanzania, banks play a major role in financial development. This is especially true since stock and
corporate bond markets are usually underdeveloped. Moreover, the development of the banking system and improving of its
financial performance is related to higher economic growth of a country. In Tanzania commercial banks contribute to
economic growth through their financial intermediation role. Better performance of commercial banks is pro foundation for
product innovation, diversification and efficiency of the commercial banks (Hempell, 2002). The stability of commercial banks
as whole in the economy depends on better financial performance. Better financial performance level has tendency to absorb
risks and shocks that commercial banks can face.

Commercial banks in Tanzania have undergone immense regulatory and technological changes since financial sector reforms in
1991. Tanzanian banks are faced with increasing competition and rising costs as a result of regulatory requirements, financial
and technological innovation, entry of large foreign banks in the retail banking environment and challenges of the recent
financial crisis. These changes had a dramatic effect on the performance of the commercial banks in Tanzania.

Studies on bank performance in Tanzania had focused on bank efficiency [see Aikaeli (2008); Gwaula (2012) using Data
Envelopment Analysis (DEA). This study compares and evaluates financial performance of small, medium and large Commercial
banks in Tanzania for the period from 2006-2012 using financial ratio analysis.

The present study is different from earlier studies in two ways: sample coverage and methodology. The study is motivated by
the fact that, the measurement of financial performance of the banking sector is important for several reasons. First, financial
performance is a vital factor for financial institutions wishing to carry out their business successfully, given the increasing
competition in the financial markets. Second, in a rapidly changing and more globalised financial marketplace, governments,
regulators, managers and investors are concerned about how efficiently banks transform their expensive inputs into various
financial products and services. Third, the financial performance measures are critical aspects of banking sector that enable us
to distinguish banks that has the capability to survive and prosper from those that may have problems with competitiveness.
Additionally, financial ratios enable us to identify unique bank strengths and weaknesses, which in itself inform bank
profitability, liquidity and credit quality.

1.2 Statement of the Problem

The relationship between Core Capital and Profitability is of considerable importance to all firms. Banks are especially
sensitive to changes in financial leverage due to their low level of equity capital to total assets. In addition, the capital
structure of banks is highly regulated, and the largest class of bank liabilities is retail deposits, which are insured by the
public. Various local studies conducted have failed to establish any relationship between Core Capital and profitability in
commercial banks in Kenya. The study by Mwega (2009) had sought to determine global crises and its effect on policy on
financial institutions in Kenya. Maina (2003) conducted a survey on risk based capital standards and the riskiness of bank
portfolio in Kenya. Ndung’u (2003) in a study on the determinants of profitability of quoted commercial banks in Kenya
finds that sound asset and liability management had a significant influence on profitability.
While the above research outcome provides valuable insights on Core capital, they have not induced a clear relationship
between Core Capital and profitability in Commercial banks in Kenya. Given the gaps poised by the above empirical
studies, this study poses the research question: “what is the relationship between Core Capitals and profitability in
commercial banks in Kenya?” The study hypothesizes that commercial Banks capital is negatively (positively) related to
ROE/profits. To answer the above question, the study seeks to establish a relationship between Core Capital and
profitability; this will be done by reviewing various profitability measures and in particular the ROE ratio. ROE has an
important indicator to measure the profitability of the banks has been discussed extensively. Foong (2008) indicated that
the efficiency of banks can be measured by using the ROE which illustrates to what extent banks use reinvested income to
generate future profits.
Navapan and Tripe (2003) asserted that the proposition that there should be a negative relationship between a bank’s ratio
of capital to assets and its return on equity may seem to be self-evident as to not need empirical verification. It is therefore
important to note that Berger (1995) found evidence for a positive relationship that is, the ratios of capital to assets and
returns on equity were positively related. Various studies have been carried out to ascertain various capital structure facets
in Kenyan firms. Kamere (1987) found out that stability of future cash flows, level of interest rates in an economy, asset
structure of a firm, the need for outside capital, lender attitudes towards a firm and attitudes of management towards risk
adjust towards some debt equity ratios. Omondi (1996) also found out that the mean debt equity ratios were not
significantly different for firms studied. He tested quite a number of factors (industry class, asset structure, profitability,
interest charges, size, and growth, changes in cash flows, age and ownership) and found out that the industrial class was
not statistically significant and that the capital structure of firms on sectoral basis was quite different.
Kiogora (2002) sought to find out whether capital structures of quoted companies were consistent over time and to
ascertain whether companies quoted on the Nairobi stock Exchange in the same industry had similar capital structures. He
found out that there were differences in capital structure among industry groups: there was a negative relationship between
returns of firms quoted on the Nairobi Stock Exchange and their level of leverage and that companies in the Agricultural
sector had consistent levels of equity from year to year. Firms within a given sector tended to cluster towards some target
Equity/Total Assets ratio implying that an optimal capital structure exists. He also found out that returns increased with
increased leverage hence supporting the traditionalists’ view of an optimal capital structure.
The local studies analyzed are biased towards the general capital structure in the NSE. The studies did not establish a
clear relationship between Capital Structure and profitability. In addition, the studies have not discussed measures of
profitability and Capital structure (Core Capital) in Banks. From the literature review it can be deduced that there is no
relationship between profitability and core capital in banks which are major parameters for stability thus necessitating
the study. The study investigated the relationship between Core Capital and profitability of commercial banks in Kenya.

1.4 Importance of the Study

The study was important to various stake holders as indicated here below:
 Banking Industry: The industry would obtain information on the relationship between Core Capital and
profitability. This information would be especially useful to future investors in the industry and Senior
Management.
 The Government: The government would obtain information on the importance of implementation of various
legal frameworks in relation to Capital management i.e. Basel Accords.
 Academicians: In addition to contributing to the body of knowledge, the research would also help and encourage
continuity as far as doing further research is concerned.
 Regulatory Body: Central Bank of Kenya would further acknowledge the importance of Capital Adequacy in
management in banks.

2.0 LITERATURE REVIEW

2.1 Introduction
In this chapter, previous studies related to the topic are reviewed. The chapter begins with theoretical orientation on
capital structure theories to inform the study further. In addition, the researcher will discuss various empirical studies
done in the same field. It further looks at determinants of commercial bank profitability and finally the relationship
between profitability and capital as a summary of the literature review.

2.2 Capital
Capital (equity and long-term debt) represents a source of funds to the bank along with deposits and borrowings. Pringle
(1971) observed that an undercapitalized bank will find itself subjected to high levels of short-term borrowing at potentially
high excess costs during periods of tight money. Flamini et al. (2009) postulated that bank returns are affected by
macroeconomic variables, suggesting that macroeconomic policies that promote low inflation and stable output growth do
boost credit expansion. According to Christian et al. (2008), capital adequacy measures provide significant information
regarding a firm's returns, while a few of the individual variables representing asset quality and earnings are informative. Size
and growth and loan exposure measures do not appear to have any significant explanatory power when examining returns.

Further in relation to the analysis, banks capital shall be deemed to be:

Core Capital (Tier 1) which refers to paid-up ordinary share capital/Assigned Capital. This is the nominal value of the ordinary
shares issued and fully paid, or capital assigned to Kenyan branch (es). Non-repayable share premium/ (discount) which is the
difference between the nominal price and purchase price of shares, which is not refundable/ recoverable. Retained earnings/
accumulated losses which represent retained earnings or accumulated losses from the profits/losses of the prior years. They
should however exclude reserves arising from revaluation of investment properties and cumulative unrealized gains and losses
on financial instruments.

Current year 50% un-audited after tax profits refers to a scenario of 50% of the current year to date un-audited after tax
profits. The institution must have made adequate provisions for loans and advances, depreciation, amortization and other
expenses. In arriving at the applicable figure, any proposed or interim dividends have to be taken into account. This should
however exclude reserves arising from revaluation of investment properties and cumulative unrealized gains and losses on
financial instruments. In case of a loss, full amount should be included.
Non-cumulative irredeemable preference shares are shares, which have a standing claim on the company every year, but the
claim is not carried forward in event of not being paid and they are not redeemable. Other reserves are all other reserves,
which have not been included above. Such reserves should be permanent, unencumbered, uncallable and thus able to absorb
losses. Further, the reserves should exclude cumulative unrealized gains and losses on available-for- sale-instruments.

To prevent multiple uses of the same capital resources in different banking institutions both in Kenya and abroad, the
institutions should deduct any investment in subsidiaries conducting Banking business and equity instruments of other banking
institutions.

2.4 Important Considerations in Capital Structure

2.4.1 Costs of Financial Distress
Emery (1988) defined financial distress as the disruption of normal operating and financial conditions as a result of
impending solvency. Such a situation can lead to bankruptcy. Excessive borrowing can lead to financial distress, which is
ordinarily reflected in the legal and administrative costs. Such costs can affect the cost of debt and equity. Altman (1984)
found out that distresses were peculiar to leveraged firms and they could be high especially in companies with fixed costs.
These companies become financially distressed when its cash flows are insufficient to cover its capital requirements. In
principal, as much as debt financing could present firms with tax shield benefits (debt is a tax deductible expense), there is
a limit to which firms can use debt financing. Excessive borrowing may lead to bankruptcy. Brighan and Gapenski (1990)
enumerate some events that may occur when a firm is faced with financial distress. These include: arguments that
claimants often delay the liquidations of assets thus leading to obsolescence of inventory and fixed assets, legal fees, court
costs, and administration expenses could absorb a large part of firm’s value. Employees of a firm generally loose their jobs
and when a firm fails and stake holders (line customers and suppliers) may take evasive action when they realize a firm is
facing financial difficulties. The higher the financial distress costs, the lower the value of the firm. Non-optimal
managerial actions associated with the financial distress as well as costs imposed by customers, suppliers and capital
providers are referred to as indirect costs of financial distress.
2.4.2 Agency Costs and Capital Structure
Stockholders, because of their rights, may take undue advantage over bond holders in an attempt to maximize their
fortunes in a firm. Bond holders are therefore compelled to protect themselves from such contingencies. Such covenants
adversely affect the corporate legitimate operations to some extent through the costs of lost efficiency and other costs.
Although Modigliani and Miller (1963) recommends that firms should maximize their debt financing opportunities, such a
situation does not hold in the long run due to such agency problems between stake holders. Therefore costs related to
protective covenants are substantial and rise with the increase in debt financing.
2.6 Profitability
Bessis (2005) defines profit as the surplus left over from revenue after covering expenses. Profitability is the measure of
profit generated on an ongoing basis. Profit is generally measured in shilling terms. Profitability ratios show a company's
overall efficiency and performance. Profitability can be measured using ratios of margins and returns. Ratios that show
margins represent the firm's ability to translate sales dollars into profits at various stages of measurement. Ratios that show
returns represent the firm's ability to measure the overall efficiency of the firm in generating returns for its shareholders
(Bessis, 2005).
2.6.1 Profitability Measure in Banks

The profitability in this case is presented and measured using ROE. In other words, the amount of net income (NI) returned
as a percentage of (Total Shareholders Equity) TSE. The ROE is defined as the company’s annual net income after tax
divided by shareholder’s equity. NI is the amount of earnings after paying all expenses and taxes. Equity represents the
capital invested in the company plus the retained earnings. Essentially, ROE indicates the amount of earnings generated
from equity. The researcher chose it as profitability indicator because ROE comprises aspects of performance, such as
profitability and financial leverage (Foong, 2008). The measurement of bank performance has been developed over time.
At the beginning, many banks used a purely accounting-driven approach and focused on the measurement of NI, for
example, the calculation of ROTA. However, this approach does not consider the risks related to the referred assets, for
instance, the underlying risks of the transactions, and also with the growth of off-balance sheet activities. Thus the
riskiness of underlying assets becomes more and more important. Gradually, the banks notice that equity has become the
scarce resource. Thereby, banks turn to focus on the ROE to measure the net profit to the book equity ratio in order to find
out the most profitable investments to put their money in. (Joetta, 2007).
ROE is commonly used to measure the profitability of banks. The efficiency of the banks can be evaluated by applying
ROE, since it shows that banks reinvest its earnings to generate future profits. The growth of ROE may also depend on the
capitalization of the banks and operating profit margin. If a bank is highly capitalized through the risk-weighted capital
adequacy ratio (RWCAR) or Tier 1 capital adequacy ratio (CAR), the expansion of ROE will be retarded. However, the
increase of the operating margin can smoothly enhance the ROE (Foong, 2008) ROE as an important indicator to measure
the profitability of the banks has been discussed extensively in the prior studies. Foong (2008) indicated that the efficiency
of banks can be measured by using the ROE which illustrates to what extent banks use reinvested income to generate
future profits. According to Risk bank’s Financial Report (2002), the measurement of connecting profit to shareholder’s
equity is normally used to define the profitability in the banks.
ROE also hinges on the capital management activities. If the banks use capital more efficiently, they will have a better
financial leverage and consequently a higher ROE. Because a higher financial leverage multiplier indicates that banks can
leverage on a smaller base of stakeholders fund and produce higher interest bearing assets leading to the optimization of
the earnings. On the contrary, a rise in ROE can also reflect increased risks because high risk might bring more profits.
This means ROE does not only go up by increasing returns or profit but also grows by taking more debt which brings more
risk.
Thus, positive ROE does not only represent the financial strength. Risk management becomes more and more significant
in order to ensure sustainable profits in banks (Sam and Magda, 2009).Furthermore, the paper “Why Return on Equity is a
Useful Criterion for Equity Selection” by Kee (2008) has mentioned that ROE provides a very useful gauge of profit
generating efficiency. Because it measures how much earnings a company can get on the equity capital. The increased
ROE may hint that the profit is growing without pouring new capital into the company. A steadily rising ROE also
indicates that the shareholders receive more each year for their investment. All in all, the higher ROE is better both for the
company and the shareholders. In addition, ROE takes the retained earnings from the previous periods into account and
informs the investors how efficiently the capital is reinvested (Kee, 2008).
In accordance with the study by Waymond (2007), profitability ratios are often used in a high esteem as the indicators of
credit analysis in banks, since profitability is associated with the results of management performance. ROE and ROA are
the most commonly used ratios, and the quality level of ROE is between 15% and 30%, for ROA is at least 1%. The study
of Joetta (2007) presented the purpose of ROE as the measurement of the amount of profit generated by the equity in the
firm. It is also mentioned that the ROE is an indicator of the efficiency to generate profit from equity. This capability is
connected to how well the assets are utilized to produce the profits as well. The effectiveness of assets utilization is
significantly tied to the amount of assets that the company generates for each shilling of equity.
2.7 The Relationship between Profitability and Capital
In banking as in any industry, it is common knowledge that higher leverage normally means higher returns (but also
greater risk). Yet, two recent studies actually find a negative relationship between leverage and returns in banking. Berger
(1995) reports a statistically significant positive relationship between return-on-equity (ROE) and the capital-asset ratio
(CAR, the inverse of leverage) among American banks in the 1980s. Likewise, Demirgüç Kunt and Huizinga (1999) study
80 countries in the years 1988–1995, and they also report a statistically significant positive relationship between capital
and returns. The fact that leverage increases returns seems to follow directly from the very nature of business. In its
strongest form, the “leverage formula” predicts that return-on-equity should increase linearly with the debt-equity ratio
(DER). How can this be reconciled with the empirical results? Berger (1995) suggests that more capitalized banks were
able to attract higher earnings because of lower expected bankruptcy costs, which enabled them to pay lower interest on
uninsured debt. In a similar vein, Flannery and Rangan (2002) also report a capital build-up among US banks in 1986–
2000, and they attribute this build-up to an increasingly competitive environment in the last two decades, promoting banks
to hold capital beyond legislative needs (market discipline). Another possibility is that the negative correlation between
leverage and profitability could reflect special circumstances of the 1980s and early [Link] 1980s was a decade of
financial liberalization, and the early 1990s was a time of financial turmoil. In one decade there is small variation in banks’
leverage. The difference in leverage among banks, at least in Europe and in North America, is small. Conceivably,
successful banks could tend to be both more capitalized and more profitable in the short run, which could obscure the
fundamental positive correlation between leverage and returns.
It is generally accepted (Berger, 1995; Barth et al., 1998) that the Capital Asset Ratio (hereafter CAR) is negatively
correlated with Return on Capital (hereafter ROC). According to this hypothesis, the negative relationship is obtained,
ceteris paribus, in a one-period model where deposit rates are not influenced by bank risks. However, assuming
information symmetry between the depositors and the bank i.e., ‘market discipline` exists and deposit and stock markets
are perfect, a rise in CAR due, for example, to the substitution of equity and debt, should entail a reduction of the bank's
risk to fail. In such a case, risk-averse depositors who regard capital as a cushion against unexpected losses will be
satisfied with a lower interest rate on deposits. This in turn, ceteris paribus, should increase Net Interest Margin (hereafter
NIM) and thus ROC. On the other hand, a rise in CAR increases capital, and therefore may reduce profitability either due
to the increase in the denominator of ROC or due to the perception that the bank is safer. Thus, an increase in CAR might
have an ambiguous effect on ROC. According to the Expected Bankruptcy Costs Hypothesis (henceforth EBCH), if a
bank’s capital is below its optimum level, a rise in capital should reduce the yield required on deposits. Consequently, the
increase in net income (the numerator in ROC) will have a greater effect than the rise in capital (the denominator in ROC),
ceteris paribus, and altogether one can expect a positive relationship between capital and profitability. On the other hand, if
capital is above its optimum level as perceived by depositors, the increase in capital reduces the interest rate required on
deposits, so that the relationship between capital and profitability is expected to be negative. In general, EBCH assumes
‘market discipline’ either for well-capitalized or under-capitalized banks and ROC influenced by loans and deposits but
not by operational activity e.g., commissions.
The concept of capital structure as used in Kenya refers not only to choices regarding capital structure (or the mix
debt/equity) but also to the kind of securities used to structure the equity and the debt that is influenced by the outside
context. In other words, it attempts to understand why certain choices regarding debt and equity are made (capital structure
in a strict sense), while observing the ownership structure and debt structures. For this reason, some authors do not believe
it is justifiable to analyze only capital structure as the mix of debt and equity, since it is strictly related to other aspects
concerning the structure of equity and debt (Fluck, 1998, Heinrich, 2000). Njoroge (2001) examined the relationship
between dividend payout and financial ratios. The results obtained were that the most significant variable in making
dividend decisions is return on assets while return on equity and growth in assets are not considered in making dividend
decisions. Maina (2000) carried out a study to establish whether there exists a relationship between dividend and
investment decisions since both compete for internally sourced funds and given that funds obtained by debt are very
expensive and not available to all firms.
According to the Signaling Hypothesis (Acharya, 1988), managers have ‘inside information’ regarding future
performance. If their compensation packages include stocks and/or stock options it will be cheaper for a safe bank than for
a risky bank to signal expected improved performance in the future by increasing capital today. Therefore, capital entails
profitability. Stiroh (2000) gives another argument for this causation. When banks overcome high entry barriers by
increasing their capital levels, they gain access to profitable activities such as issuing guarantees and subordinated notes,
and acting as intermediators in derivative markets.
2.8 Conclusion
Managers are better informed than investors. Investors might see an external equity issuance as bad news about the
company, assuming that managers want outside shareholders to share the loss, thus investors will react to this issuance
negatively, increasing the issuance cost of external equity. In principal, as much as debt financing could present firms with
tax shield benefits (debt is a tax deductible expense), there is a limit to which firms can use debt financing.
Titman and Wessels (1988) enumerated key attributes in determining capital structure. They include asset structure,
growth, uniqueness, industry classification, size earnings and volatility. Profit is generally measured in shilling terms.
Profitability ratios show a company's overall efficiency and performance. Determinants of commercial bank profitability
can be categorized into two categories, namely internal and external. In banking as in any industry, it is common
knowledge that higher leverage normally means higher returns (but also greater risk). It can be seen that there exist no
local literature on the effects of capital structure on performance. This is the gap the study seeks to address by
investigating the relationship between Core Capital and profitability of commercial banks in Kenya.