Corporate Governance and Banking Performance: Mediating role of

Financial Risk in Pakistan

Empirical results indicate that ownership structure of banks significantly influence their financial
performance. In particular, board and government ownership are significantly and negatively
associated with bank performance, whereas foreign ownership is strongly positively associated
with bank performance, and institutional shareholders have no impact on the performance of
financial institutions in Kenya. The study makes a significant contribution to financial research
by extending examination of banks performance to a developing country context beyond the
usual confines of the developed western economies, and adds to the small number of similar
studies in the African context. The results are consistent with prior research findings, and more
importantly, presents statistical justification for pursuing further corporate governance reforms
with respect to banks’ ownership structure to enhance the financial stability of the sector,(Dulacha
G. Barako, Winter 2006-2007 ).

Nada (2004) and (Myoung-Ho, 2002, p 1).

Corporate Governance and Ownership structure

Financial institutions as intermediaries between savers and borrowers plays pivotal role in the economic development of a country. As cited in Nada
(2004), a growing body of research literature emphasis the crucial importance of the financial sector to economic growth, and analogous to the empirical
evidence, The Vice President of Asian Development Bank, presenting a paper on financial sector development and economic growth in the wake of the
Asian financial crisis states, “the better the financial sector can perform… the better the economy will perform in the long run” (Myoung-Ho, 2002, p 1).

This paper examines the relationship between bank performance and an important governance variable: ownership structure. Ownership is an important
aspect of the internal corporate governance mechanism in that owners (shareholders) have direct influence on the board composition, a vital corporate
governance mechanism

Dulacha G. Barako, G. T. (Winter 2006-2007 ). CORPORATE GOVERNANCE AND BANK PERFORMANCE:

DOES OWNERSHIP MATTER? EVIDENCE FROM THE KENYAN BANKING SECTOR. Corporate
Ownership & Control / Volume 4, Issue 2, , 133-144.

Barako, D. G., & Tower, G. (2007). Corporate governance and bank performance: Does ownership
matter? Evidence from Kenyan banking sector. Corporate Ownership and Control, 4(2), 133-144.

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Borako, D. G. (2007). Corporate Governance and Bank Performance: Does Ownership matter. Evidence
from the Kenyan Banking Sector. Corporate Ownership and control, 4(2).

Literature Review:
Literature on corporate governance is dominated by agency theory. Agency theory elaborates the
agency problems which arise due to the conflict between principal and agent. Agency theory
represents a relationship between principal and agent who have different interests which can be
aligned through proper monitoring and a well planned compensation system [Davis, Schoorman,
& Donaldson, (1997)]. Due to agency problems, corporate governance is needed to align the
interests of shareholders and managers. Corporate governance is a system of managing and
controlling the management to work in the best interest of corporations as well as its
shareholders [Oso, L., & Semiu, B. (2012)]. Through proper implementation of corporate
governance, financial risk can be managed effectively and efficiently which in turn improves
performance. In literature review, the focus is on the following three relationships:
Corporate governance and Bank Performance:
Many studies have been conducted to examine the relationship between corporate governance
and financial performance of banks. Afolabi, B. et al. (2017) conducted a study on the
relationship between corporate governance, bank performance and bank crises in Nigeria. In this
study board size and board composition were used as proxies for measuring corporate
governance and profit after tax was used as proxcy to measure bank performance. The results of
regression analysis showed a positive relationship between corporate governance and Bank
performance. Another similar study in Nigeria was conducted by Samson, O. and Tarila, B.
(2014). In this study board size, board composition and corporate governance disclosure index
were used as key variables of corporate governance and ROE and ROA as key variables to
measure performance. This study also found positive relationship between variables of corporate
governance and bank performance in both perspectives. Staikouras et al. (2014) examined the
impact of board size and board composition on European bank performance. They found a

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negative relationship between board size and bank performance and positive relationship
between board composition and bank performance. Changezi, N. I., & Saeed, A. (2014) studied
the effect of corporate governance on bank performance. This study used director’s
remuneration, communication strategies, code of conduct and governance mechanisms as
corporate governance indicators. On the basis of regression analysis, it was found that director’s
remuneration, communication strategies and governance mechanisms significantly influence
bank performance but code of conduct has no influence on bank performance.

Achchuthan, S. and Kajananthan, R. (2013) studied the impact of corporate governance practices
on firm performance in Sri Lanka. In this study, borad leadership structure, board committees,
board meetings and proportion of non-executive directors on board were used as key corporate
governance variables and return on equity (ROE) as firm performance variable. This study found
no significant impact of corporate governance practices on firm performance in Sri Lanka.

Shahid, M. N. et al. (2018) analyzed the impact of corporate governance elements on firm
performance in cement industry in Pakistan. In this study, board size and financial leverage were
used as independent variables and CEO duality as control variable while ROE as dependent
variable to measure performance. This study found positive but insignificant relationship
between firm’s board size and ROE. This study also found negative but significant relationship
between financial leverage and ROE. With CEO duality as control variable, it was found that
both independent variables has crucial influences on firm performance in cement industry in
Pakistan.

Thi Thanh Binh, D., & Thi Huong Giang, H. (2012) explored the relationship between corporate
governance and bank performance in Vietnam. They used risk management(CAR), foreign
ownership, board size and board composition as their independent variables to measure corporate
governance and ROE as dependent variable to measure bank performance. They found through
regression analysis that board size and capital adequacy ratio (CAR) significantly effect bank
performance while board composition and foreign ownership insignificantly effect bank
performance.

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Financial Risk and Bank Performance:

Banks play a pivotable role in the success of financial sector of any country. The performance of
banking sector depends on the public confidence which can be gained through good corporate
governance and well established risk management system. Financial risks are the major threats
faced by the banking sector. A number of studies have been conducted to analyze various
financial risks and to understand their impact on performance of the banking institutions. .
Ofosu-Hene & Amoh (2016) examined the risk levels of banks and the relationship between risk
management and the performance of banks listed on the Ghana Stock Exchange (GSE) as well.
They concluded that banks listed on GSE have declining risk indexes. They also concluded that
risk management is positively related to performance of GSE listed banks. Hussain, Ihsan &
Hussain (2016) studied the relationship between risk management and bank performance in
Pakistan. They analysed various risks that affect banking operations in Pakistan and assessed the
effect of risk management on the performance of both large and small banking institutions. They
concluded in their study that better risk management system of banks leads to better
performance. They also concluded that capital adequacy ratio, nonperforming loans, operational
risk, liquidity risk and interest rate risk all significantly affect the performance of large
commercial banks while only non performing loans and capital adequacy ratio affects
performance of small commercial banks in Pakistan. Olamide, O. et al, (2015) examined the
relationship between risk management and financial performance of banks in Nigeria. This study
revealed results that were opposite to the above mention studies. Findings show that risk
management proxies have negative, non significant impact on the financial performance of
Nigerian banks as measured by return on equity.

Museiga et al. (2017) studied the influence of credit risk on the performance of commercial
banks in Kenya. They used capital adequacy, non performing loans ratio and loans to total
deposite ratio to measure credit risk. They found a negative and significant relationship between
credit risk and performance of commercial banks in Kenya. Mendoza, R. & Rivera, J.P,R.
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(2017) conducted the same study on the rural banks in Philippines. They studied the effect of
credit risk and capital adequacy on the profitability of rural banks in Philippines. They also
found a negative and significant relationship between credit risk and profitability of rural banks
in Philippines. However, empirical analysis showed that capital adequacy has no significant
impact on the profitability of rural banks in Philippines. Abbas, et al., (2014) studied the of credit
risk exposure on the performance of banking sector of Pakistan. Fixed effect regression analysis
was used in this study which revealed that credit risk measured by ratio of non performing loans
to total loan and loan loss provision to non performing loan negatively affect performance
variables of ROA and ROE. Iftikhar, M. (2016) conducted a study to test the relationship
between credit risk management and financial performance of commercial banks of Pakistan. It
was concluded from this study that factor of credit risk management have significant impact on
the financial performance of commercial banks in Pakistan. He recommanded banks to develop
their effective credit management to achieve higher profits. Alshatti, A.S. (2015) explored the
effect of credit risk management on the financial performance of the banking sector of Jordan.
This study used capital adequacy ratio, credit interest/credit facilities ratio, provision for facilities
loss/net facilities ratio, non performance loans ratio and leverage ratio as credit risk management
indicators. This research revealed that credit risk management effects on the financial
performance of commercial banks of Jordan as measured by ROE and ROA. This research
further revealed that Non performing loans ratio has a positive impact on bank performance and
the capital adequacy and leverage ratio have no significant impact on bank profitability. Olausi,
A.S. & Abiola, I. (2014) supported the results of Alshatti, A.S. (2015) as they conducted the
study to investigate the impact of credit risk management on the performance of commercial
banks in Nigeria. They used non performing loans and capital adequacy ratio as credit risk
management indicators and ROE & ROA as performance indicators. They found a significant
impact of credit risk management on the bank performance in Nigeria. They also found a
positive relationship between NPL ratio and bank profitability and no significant relationship
between CAR and bank profitability.

Arif, A. & Anees, A.N. (2012) examined the relationship between liquidity risk and performance
of banking system in Pakistan. They used liquidity gap and non performing loans as proxies to
measure liquidity risk. They concluded that these two factors have a negative relationship with
bank’s profitability.

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Kamau, P., Inanga, E.L. & Rwegasira, K. (2015) studied the impact of currency(FX) risk on the
financial performance of multilateral banks. They concluded in their study as suggested by the
two tailed t test on the b regression coefficient that the relationship between currency risk and
financial performance is statistically insignificant which means that there is no significant
impact of currency risk on the financial performance of multilateral banks during the period of
1998-2006.
Muriithi, J.G. et al. (2016) studied the effect of market risk on the financial performance of
commercial banks in Kenya. This study used degree of financial leverage, interest rate risk, and
foreign exchange exposure as proxies to measure market risk and return on equity(ROE) as
proxy to measure financial performance. It was concluded from their results that financial
leverage, interest rate risk and foreign exchange exposure have negative and significant
relationship with bank profitability which means that market risk has a negative and significant
effect on the financial performance of banks in Kenya.

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