Effect of financial regulatory requirements on profitability of micro-finance institutions in Kenya

Abstract

The Micro-finance industry has shifted from the purely social mission orientation to commercial enterprises with profit motive and regulation emphasises sustainability which can be achieved through profitability. The purpose of the study was to establish the effect of financial regulatory requirements on profitability of micro-finance institutions in Kenya. Specific research objectives were to determine the effect of quality of loan portfolio on profitability of MFIs, to examine the effect of capital adequacy on profitability of MFIs, to determine the effect of liquidity risk on profitability of MFIs and to examine the effect of number of branches on profitability of MFIs. The study adopted an explanatory research design. The target population were Thirteen (13) Deposit taking Micro-finance Institutions (DTMI) licensed by the Central Bank of Kenya. The study was premised on the Agency Theory as well as Public Interest Theory of regulation. Secondary data obtained from published financial statements for the periods 2010 to 2018 for all the thirteen Micro-finance Institutions was used. Data analysis was done using R software and panel data regression was done using ordinary least square method and tested using Lagrange Multiplier test. One-way fixed effect model was the most suitable model hence used for data analysis due to the unbalanced data. The results indicated that Capital adequacy had a negative impact of profitability with β=0.005; p<.6.70e-05 and β=0.004; p<.0.035 under individual specific and time effects respectively hence rejected the null hypothesis that capital adequacy has no effect of profitability of MFIs. Quality of loan portfolio had a negative impact on profitability with β=0.001; p<.0.002 and β=0.001; p<.0.0002 under individual specific and time effects respectively implying increase in PAR led to decrease on profitability. This too rejected the null hypothesis. Liquidity risk had a positive impact on profitability with β=0.11; p<.0.031 and β=0.183; p<.5.77e-06 under individual specific and time effects respectively which implied that a higher financing gap ratio resulted in higher profitability. The number of branches was insignificant under individual specific effects hence had no effect on profitability but significant under time effects with a β=0.002; p<.0.001. Inclusion of the control variables did not change significant variables both under individual specific and time effects models; and were observed not to be significant in explaining the relationship with profitability. In conclusion, the study established that the Micro-finance regulatory requirements have an impact on profitability. Based on the findings it is recommended that regulation be extended to credit only and other unregulated MFIs for them to benefit from regulatory requirements alongside installing financial discipline. The regulated MFIs should work towards implementing recommendations on variables under study to maximize profitability. The study recommends studies to be carried out with the inclusion of the non-regulated MFIs who represent a large market share of the industry. Given the high variability of liquidity risk on profitability, it is recommended that more studies be undertaken to cover other aspects of risk management on profitability of Micro-finance institutions.