BAHIRDAR UNIVERSITY

COLLEGE OF BUSSINES AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

THESIS PROPOSAL ON:

THE EFFECT OF CORPORATE GOVERNANCE ON THE FINANCIAL
PERFORMANCE OF MICRO FINANCE INSTITUTIONS IN ETHIOPIA

A Thesis Proposal Submitted To the Department Of Accounting & Finance

in Partial Fulfillment of the Requirement for MSc, in Accounting & Finance

BY
MULUSEW ABAWA

ADVISOR: TILAHUN A.

February, 2018
BahirDar, Ethiopia
Abstract
The general objective of the study is to investigate the effect of corporate governance on
financial performance of micro finance institutions in Ethiopian. In preparing this research both
primary and secondary information will be used. The primary data will be collected through
questionnaire and interview, while secondary data will be obtained from audited financial
statements of MFIs obtained from national bank of Ethiopia (NBE), organizations annual report,
published and unpublished materials that reports as impact of corporate governance on
financial performance of micro finance institutions, by owners and other responsible bodies.
Explanatory research design, with a mixed approach more of quantitative will be used to
establish the causal effect relationship between corporate governance variables and the control
variables. The financial performance measures will be Return on Asset and return on equity. For
this study the researcher will use a purposive sampling technique from which 11 (eleven) MFIs,
which are willing to provide and had complete ten year data, will be selected. The analysis
process will applies both qualitative and quantitative techniques of data presentation using
tables and percentages. In this study, to analyze the collected data, both correlation and
multiple panel linear regression data analysis method will be employed by using stata.

Key terms: - Corporate governance, MFIs, Financial Performance, ROA, ROE.

 List of Acronyms and Abbreviations

CG Corporate Governance

MFI Micro Finance Institutions

ROA Return on Asset

ROE Return on Equity

AEMFI Association of Ethiopian microfinance institutions

CEO Chief Executive Officer

OECD Organization for Economic Cooperation and Development

NGO Non-Governmental Organizations

NBE National Bank of Ethiopia

CHAPTER ONE

INTRODUCTION:

1.1. Background of the study

Most textbooks define corporate governance as “a process conducted by independent (outside)

board of directors to authorize, direct, and monitor management towards the achievement of the
organization’s objectives” (Reding et al 2007). Shleifer and Vishny, (1997) defines corporate
governance as the mechanisms by which “resource owners of corporations assure themselves of
getting a return on their investment.”

Rachana Vishwakarma (2011) defines corporate governance as controlling activities related to an

institution's internal operating and control procedures. Corporate governance plays a key role in
providing strategic direction which helps the institutions in creating transparency and trust for
investors and in attracting capital. In last few years, Microfinance Industries significantly
changes its shape, due to several reasons in which corporate governance also one of them which
plays a pivot role to enhance the performance of Microfinance institutions. Corporate
governance is therefore, about creating or building credibility, promoting transparency and
accountability as well as maintaining the effective way of information disclosure that will foster
good corporate performance. So for promoting effective corporate governance of micro finance
institutions it is recommendable to examine the effect of CG elements on financial performance
of firms.

Effective Governance of micro finance institutions is necessary due to its complex business as it
provides thrift, credit and other financial services and products of very small amounts mainly to
the poor in rural, semi urban or urban areas for enabling them to raise their income levels and
improve a living standard which leads to social and economic development of the country.
Majority of MFIs have a dual mission, i.e. a social mission (provide financial services to large
numbers of low-income persons to improve their welfare) and a commercial mission (to provide
those financial services in a financially viable manner). Maintaining and balancing both at the
same time is very challenging and complex task for the board of directors and senior
management who provides strategic vision to the institutions (Rachana Vishwakarma 2011).
Corporate governance has become a popular discussion topic in developed and developing
countries. The widely held view that corporate governance determines firm performance and
protects the interests of shareholders has led to increasing global attention. However, the way in
which corporate governance is organized differs between countries, depending on the economic,
political and social contexts. For example, firms in developed countries have dispersed
shareholders and operate within stable political and financial systems, well developed regulatory
frameworks and effective corporate governance practices. However, firms that operate in
developing countries such as Ethiopia may be affected by weak regulatory and institutional
framework (Tilahun and Kibre 2007). In order to promote good governance and assure
sustainability of firm’s performance it is recommendable to analyze how corporate governance
elements determine firm performance and how well the governance mechanism procedures are
followed.

To examine the relationship between corporate governance and firm’s financial performance first
it is better to define performance and its measurement. Performance can be defined as the
amount of utility or benefits derived from the firm or the organization by its stakeholders. The
continued viability of an institution depends on its ability to earn adequate return on its assets
and capital. Many institutions throughout the world have disappeared due to weaknesses in board
parameters of risk management functions. Institutions that must survive need Higher Return on
Assets (ROA). Companies, which use their assets efficiently, will tend to show a ratio higher
than the industry norm (Rashid I, and Anderson 2008). Therefore, good corporate governance
plays a key role in making efficient use of firms’ assets and generating profits or adequate return
from the invested assets as well as fulfilling the interest of shareholders.

Firms with independent boards have higher returns on assets, higher profit margins and larger
dividend yields, suggesting that board independence is associated with other important measures
of firm performance. Limiting board size also believed to improve firm performance because the
benefits by larger boards of increased monitoring are outweighed by the poorer communication
and decision-making of larger groups (Jensen, 1983). Therefore for firms to generate adequate
return on assets and equity corporate governance mechanism procedures should be followed for
financial sustainability of firms.
Black and Kim (2003) have identified Good corporate governance as a key bottleneck in making
effective or strengthening Microfinance Institutions’ financial performance. The relationship
between owners and board concerns how well the board is aligned to owner interests, how well
the board is informed, and how decisive the board is, and the higher is the score on these
dimensions of the board's characteristics, the better is financial performance.

Since the first Proclamation of 1996 that gave the legal background for the operation of the
micro-financing business, the industry has witnessed a major boom .Today, there are 35 MFIs
registered with the National Bank of Ethiopia serving clients. The Ethiopian micro finance
market is dominated by a few large MFIs, all of which are linked to regional state government
ownership. The three largest institutions account for 65% of the market share in terms of
borrowing clients, and 74% by loan provision. These are Amhara (ACSI), Dedebit (DECSI) and
Oromia (OCSSCO) Credit and Savings Institutions (Deribie et al., 2013).

Deribie et al., (2013) investigates in their study about challenges of micro finance institutions in
Ethiopia that, though the strengths of the Micro Financing Industry outweigh its weaknesses,
there are still big challenges facing the microfinance institutions. The first challenge is the
inaccessibility for foreign capitals which may foster their loan portfolio. As a result, many MFIs
are limited to certain category of services. Lack of clarity in ownership structures persist
specially in some MFIs where private investors are not the real owners of the MFIs though
they are shareholders. Therefore, this situation could be seen as a challenge due to
inefficiencies in the management. Therefore, to overcome those challenges effective corporate
governance mechanism procedures should be followed in the management system.

The Ethiopian government identified a number of priority areas of actions as part of the
government's poverty reduction and development programs. One of the priority areas
acknowledged is the provision of support to microfinance institutions. In this regard the
government is working hard to solicit funds from international donors for supporting the
microfinance (Meklit et al. 2005). Thus, results from empirical studies reviewed on the
relationship between financial performance and the various board characteristics were positive,
negative and mixed. In addition, the results that the researcher discussed all will not be generally
applicable enough to Ethiopia’s Microfinance Institutions as most of the research conducted
covering small period and the sample was small percentage of total taken from specific region.
This study will seek to investigate effect of corporate governance on financial performance of
Ethiopian MFIs.

1.2. Statement of the problem

The main challenge of micro finance is to create social benefits and encourage financial
inclusion by providing financial services to low-income households. This is often referred to as
the "double-bottom line" of Microfinance Institutions. The increasing emphasis in recent years
on financial sustainability rather than on social mission has led to allegations of mission drift
among Microfinance Institutions. It is in this context that the issue of corporate governance of
Microfinance institutions becomes increasingly relevant. Microfinance practitioners have
recognized that good governance is critical for the success of the MFIs (Campion, 1998).

According to Labie (2001) closer examination of the role of various governance mechanisms is
important because MFI managers control significant resources of the firm. The microfinance
community has experienced some major failures because of lacking quantity and quality in its
operation, including corporate governance. Given this, the future financial sustainability of firms
is depend on the effectiveness of those governance mechanisms and if those mechanisms are not
followed well it will result in loss to micro finance institutions.

MFIs often operate in unstable financial environments, which are causing stakeholders
(donors, lenders and owners) to require more transparency and communication of information
and only effective governance can assure the desired level of this accountability. In the Ethiopian
context, the establishment of sustainable MFI which could reach the large number of rural and
urban poor who are not being served by the conventional financial institutions (commercial
banks) has been a prime component of the new development strategy of the Country (Amaha,
2000).

Issues concerning financial reporting and auditing are seen by many investors as crucial because
of their central importance in ensuring management accountability. They have been the focus of
much debate and litigation. Whilst focusing the corporate governance debate solely on
accounting and reporting issue is inadequate, the greater regulation of practices such as off-
balance sheet financing has led to greater transparency and a reduction in risks faced by investors
(Eyob, 2016).
As the size of the outreach and saving mobilization from the public increases, there is a need to
ensure transparency, accountability and good governance in the micro finance sector. However
governance issues have not been given due attention by owners or shareholders, regulators, and
board members, (Amaha, 2008). Following this, addressing governance issues of Ethiopian MFIs
should be given due attention or importance for the following reasons:

 Ethiopian MFIs take deposits from the public and any misuse of assets and resources may
result in loss to the institution and the savings of the public.
 Though the strengths of the Micro Financing Industry outweigh its weaknesses, there are
still big challenges facing the microfinance institutions, such as the inaccessibility for
foreign capitals which may foster their loan portfolio, and Lack of clarity in ownership
structures persist specially in some MFIs where private investors are not the real owners
of the MFIs though they are shareholders.
 Since Ethiopia MFIs are under different categories; government supported, NGO
supported and privately owned, makes the CG more complex and suffering from
common legal framework and accountability which signifies that it is worth studying.
Keeping this in mind and the potential contribution of the Micro finance industry to the
economy of developing countries like Ethiopia, there is a need to conduct a study to
measure and analyze the effect of corporate governance on the financial performance of
MFIs by taking evidence from sample MFIs.

Even though many studies have been conducted to identify the relationship between corporate
governance practices and firm performance, there are limited scholarly studies conducted for the
microfinance industry in relation to corporate governance. Belete (2015) focused on impact of
CG on MFIs financial performance in Ethiopia by taking data over a period of seven years, and it
would be beneficial to extend observation of data to ten years by including more CG variables
focusing on board of directors which are not examined. Eyob (2016) also conducted research on
the same issue but considering only five limited number of MFIs, in the finance sector, and it
would be recommendable to extend the study by increasing the sample and number years of
observation. To add value to this study the researcher will select eleven microfinance institutions
by obtaining data over a period of ten years from 2007 to 2016.
The empirical analysis of good corporate governance practices in relation to MFIs is still at an
immature stage and as most of the researches conducted in Ethiopia covering small period and
the sample was small percentage of total taken from specific region, it is important to conduct
more studies in this field to enhance MFIs’ development. Therefore, to add a little value to the
literature of governance of micro finance institutions, it was found to be helpful to conduct a
study on the subject matter.

1.3. Objectives of the study

1.3.1. General objective of the study

The main objective of the study is to analyze the effect of corporate governance on financial
performance of micro finance institutions in Ethiopia.

1.3.2. Specific objectives of the study

The specific objectives of the study are as follows:

 To examine the impacts of board size on MFI financial performance.

 To investigate the effect of board gender diversity on MFI financial performance.
 To examine the influence of board independence on MFIs financial performance.
 To examine the effect of board business management experience in the Finance sector on
MFI financial performance.
 To ascertain whether size of audit committee has negative or positive effect on MFI
financial performance.
 To examine impact of board members educational qualification on financial performance
of MFIs.
 To examine Board members industry specific experience on financial performance of
MFIs.
1.4. Hypotheses of the Study

The following hypotheses will be developed for the study

Ha1: Board size has a significant relationship with the financial performance of Microfinance
Institutions.
Ha2: Gender Diversity of a Board has significant relationship with the financial performance of
MFIs.

Ha3: Educational qualification of the board members has significant relationship with the
financial performance of MFIs.

Ha4: Board members’ Industry specific experience has significant relationship with the financial
performance of MFIs

Ha5: Board members’ business management experience has significant relationship with the
financial performance of MFIs.

Ha6: Size of audit committee in a board has a significant relationship with the financial
performance of MFIs.

Ha7: Board independence has a significant relationship with the financial performance of MFIs.

1.5. Significance of the study

It is believed that the study will have extreme importance for different participants in the
Corporate Governance system as follows:

Boards of directors will use the study in benchmarking the financial performance of their
Institutions against that of their peers.

The regulator will be able to highlight the successes and challenges of corporate governance in
Microfinance Institutions and thereby helping policy makers such as Association of
Microfinance Institutions of Ethiopia (AMFIE) for making decisions.

In addition, this study will increase the experience of the researcher to do any other researches,
and finally, the result of this study will also serve as a reference for further researchers in this
field of research.
1.6. Scope and limitation of the study

The study will focus on 11 (eleven) selected Microfinance Institutions which are licensed and
supervised by National Bank of Ethiopia and willing to provide and had complete ten year data.
Other corporate governance variables may affect the financial performance of MFI; however the
variables the researcher selects to study will limited to Board size, Board gender diversity, Board
independence, Board management experience, Educational qualification of the board members,
Audit committee size, and board members industry specific experience.

1.7. Organization of the study

The study will organize in to five chapters. The first chapter will introduces what the study is
about and gives a brief introduction about the study, the problem statement, the objectives,
hypotheses, significance, scope and limitations of the study and organization of the study.
Chapter two will provide a highlight of theoretical and empirical reviews of the literature and
conceptual framework relevant to the study. The third chapter will provide description about the
methodology and the variables used in the study and the fourth chapter will present the results
and discussions of the study conducted based on data collected from secondary and primary
sources. The study will end up with chapter five with the conclusion and recommendations, in a
manner that relates to the topic, which is the impact of corporate governance on the financial
performance of Microfinance Institutions in Ethiopia.

1.8. Operational definitions

Corporate governance: the framework of rules and practices by which a board of directors
ensures accountability, fairness and transparency in a company’s relationship with its all
stakeholders.

Microfinance institutions: a financial institution specializing in banking services for low-

income groups or individuals.

Financial performance: the degree to which financial objectives being or has been
accomplished, or measuring the results of firms policies and operations reflected in firms return
on asset, return on equity and return on investment.
CHAPTER TWO

REVIEW OF RELATED LITERATURE

2.1. The concept of micro finance

Microfinance provides different basic financial services including small loans, savings, fund
transfers and insurance. Additionally MFIs provide non-financial services such as business
training, assisting peoples living in poverty who wouldn't usually qualify for regular banking
services because they have no form of collateral or formal identification. MFIs operate in a niche
market as they address the needs of those clients who are considered ‘high-risk’ by bigger banks.
High-risk groups or individuals are characterized as those with very few assets, requiring very
small loans, high degree of close follow-up, business appraisal and evaluation, as well as those
engaged in activities whose income is fluctuating such as small-holder farmers or petty traders
(Sunita, 2003).

The Ethiopian microfinance sector is characterized by its rapid growth, an aggressive drive to
achieve scale, a broad geographic coverage, and dominance of government backed MFIs, an
emphasis on rural households, the promotion of credit and savings products, a strong focus on
sustainability and by the fact that the sector is Ethiopian owned and driven like other financial
institutions (Deribie, et al. 2013). The industry has a strong focus on loans to the very poor, as
indicated by the relatively small loans when compared to neighboring countries. Sector outreach
is impressive and the financial performance of the sector is considered good, although the
operational margins and profitability are low. MFIs have also mobilized a significant amount of
savings, thereby improving financial as well as operational sustainability (MFT, 2011).

2.2. Corporate governance issues and the role of the board

Agents or managers may not always act in the best interest of shareholders when the control of a
company is separate from its ownership. In June 1959, Simon Herbert (cited in Baysinger and
Hoskisson, 1990) proclaimed that managers might be “satisfiers” rather than “maximisers,” that
is, they tend to play it safe and seek an acceptable level of growth because they are more
concerned with perpetuating their own existence than with maximizing the value of the firms to
its shareholders. But shareholders delegate decision-making authority to their agent (CEO) with
the expectation that the agent will act in their best interest.

Directors of poorly performing firms, who may be perceived to have done a poor job overseeing
management, are less likely to become directors at other firms. On the other hand, reputational
concerns do not correct all agency problems and can, in fact, create new ones (Kaplan and
Reishus, 1990).

Garrat (1997) defines the function of the board as a collective responsibility to:

 Determine the company’s purpose and “ethics”;

 Decide the direction, that is, the strategy;
 Plan;
 Monitor and control managers and CEO; and
 Report and make recommendations to shareholders.

2.3. Theoretical Literature

There are a number of theoretical perspectives which are used in explaining the impact of
corporate governance mechanisms on firms’ financial performance. The most important theories
are the agency theory, stakeholders’ theory and resource dependency theory (Maher & Anderson,
1999).

2.3.1. Agency theory

Agency theory is part of the bigger topic of corporate governance. It involves the problem of
directors controlling a company whilst shareholders own the company. In the past, a problem
was identified whereby the directors might not act in the shareholders (or other stakeholders)
best interests. Agency theory considers this problem and what could be done to prevent it.

Agency theory can be applied to the agency relationship deriving from the separation between
ownership and control. Shareholders delegate control to professional managers (the board of
directors) to run the company on their behalf. Agency theory can help to explain the actions of
the various interest groups in the corporate governance debate. Examination of theories behind
corporate governance provides a foundation for understanding the issue in greater depth and a
link between an historical perspective and its application in modern governance standards.
Historically, companies were owned and managed by the same people. For economies to grow it
was necessary to find a larger number of investors to provide finance to assist in corporate
expansion. This led to the concept of limited liability and the development of stock markets to
buy and sell shares. Limited liability: limited risk and so less interest in the firm (IBID).

2.3.2. Stakeholder theory

The basis for stakeholder theory is that companies are so large and their impact on society so
pervasive that they should discharge accountability to many more sectors of society than solely
their shareholders. Stakeholder theory may be the necessary outcome of agency theory given that
there is a business case in considering the needs of stakeholders through improved customer
perception, employee motivation, supplier stability, shareholder conscience investment. Agency
theory is a narrow form of stakeholder theory.

Stakeholder’s theory begins with the assumption that values are necessarily and explicitly a part
of doing business. It asks managers to articulate the shared sense of the value they create, and
what brings its core stakeholders together. It also pushes managers to be clear about how they
want to do business, specifically what kinds of relationships they want and need to create with
their stakeholders to deliver on their purpose. According to stakeholder theory the purpose of the
firm is to serve and coordinate the interests of its various stakeholders such as shareholders,
employees, creditors, customers, suppliers, government, and the community (Freeman et al
2004).

2.3.3. Resource Dependency Theory

In addition to monitoring, board members are also required to provide organizations with
resources (Hillman & Dalziel, 2003). The provision of resources is linked to the resource
dependence theory. Resource dependency theory concentrates on the role of board directors in
providing access to resources needed by the firm (Abdullah & Valentine, 2009) cited in Belete Z,
2015. According to this theory the primary function of the board of directors is to provide
resources to the firm. Directors are viewed as an important resource to the firm. When directors
are considered as resource providers, various dimensions of director diversity clearly become
important such as gender, experience, qualification and the like.

The resource based approach notes that the board of directors could support the management in
areas where in-firm knowledge is limited or lacking. The resource dependence model suggests
that the board of directors could be used as a mechanism to form links with the external
environment in order to support the management in the achievement of organizational goals
(Wang, 2009).

2.4. Empirical Literature

2.4.1. Corporate governance and Microfinance Institutions Performance

Governance in microfinance refers to the mechanisms which ensure donors, creditors and equity
investors, that their funds will be used according to the intended purposes. Good governance in
the Ethiopian deposit taking MFIs plays an important role in increasing outreach, improving
transparency, accountability, sustainability, profitability, efficiency, effectiveness, responsibility
and responsiveness to the changing environments (Amha, 2008).

The ultimate goal of microfinance industry is to contribute to development and alleviation of

poverty through reaching for low income productive poor people. To achieve this goal MFI in
Ethiopia should be financially strong enough. Therefore, MFI profitability is a paramount. There
are factors that lead MFI financial performance either weak or strong. Various researches have
been done on such factors. One of the focuses was corporate governance. Ms.S.Danoshana et al
(2013) documented that corporate governance practice of Board Size, Meeting Frequency and
Audit Committee Size have significant impact on firm performance and Board Size and Audit
Committee are positively related with firm’s performance but Meeting Frequency has negative
relation.

In MFI, board Members are the ultimate decision maker and stewards of the shareholders’
investment with fiduciary responsibility as well as the duty to balance the social mission and
financial objectives of MFIs. Effective governance depends primarily on the skills and
characteristics of the individual directors. Collectively, these attributes should represent a diverse
set of experiences, backgrounds, area of expertise, ethnicity and gender (Ayalew, 2007).

2.4.2. Board Size and MFI Performance

Board size is the number of directors in a given Microfinance. A microfinance board should be
large enough to incorporate the various skills, including audit skills, legal knowledge,
knowledge of the target market and social perspective in order to complete their work
effectively, to provide continuity, and to ensure quorums for meetings (council of Microfinance
Equity Fund, 2012) cited in Belete 2015. It was further stated by the Council of Microfinance
Equity Funds (2012) that it is important to have people in the board that are politically influential
so that they can assist with political issues, tap funding, and to enhance public image.

Whether large or small board help improve firm performance it is debatable issue and
researchers found mixed result about the relation between board size and firm performance. The
size of the board is measured by the number of board members as has been done by many
authors such as Hermalin and Weisbach (1999, 2002) and (Jensen & Meckling, 1976). In their
various studies, the size of the board has been seen to have an inverse relationship with firm
performance.

Jensen M. (1993) argues that a larger board leads to less effective monitoring due to coordination
and process problems inherent in large board size. Larger boards can be less participative, less
cohesive, and less able to reach consensus. Small board size was favored to promote critical,
genuine and intellectual deliberation and involvement among members which presumably might
led to effective corporate decision making, monitoring and improved performance.

In contrast, (Fridah Mukusya, 2016), have contended that larger boards have their benefits and
when board size increases firm performance also goes up as more board members provide
greater monitoring, advice and make available better linkages to the external environment.
Therefore, the result of its study shows that board size has a small positive relationship with MFI
financial performance.

2.4.3. Board gender Diversity and MFI Performance

Gender diversity is considered part of the broader conception of board diversity and many
scholars have shown that few women sit on corporate boards. When compared to men, most
women directors possess staff/support managerial skills, such as legal, public relations, human
resources and communications rather than operating and marketing skills. Based on the
indication given by many empirical studies, it is important to further explore the impact of
gender diversity of boards on MFI performance as it leads to better corporate governance
provides diverse viewpoints, values and new ideas to the boards and provokes lively boardroom
discussions (Daily & Dalton, 2003).

According to Letenah, (2015) research conducted on Board diversity, external governance,

ownership structure and MFIs performance in Ethiopia, investigated that the effect of some
government indicators on the sustainability and outreach performance of Ethiopian MFIs. And
the result shows that the boards of MFIs are not diversified as such despite MFIs having dual
mission of sustainability and outreach to the poor which may be contradictory objectives. This
may affect the performance of micro finance institutions.

2.4.4. Board Independence and MFI Performance

There are many different measurements on the composition of the governing board, and these are
varied as number of directors, number of outside directors, number of independent directors in
the board etc. The concept of board independence was grounded on agency theory. Independent
board members provide potentially greater oversight and accountability of operations, as they are
less likely to be subject to the principal-agent problem themselves. This is because as
independent members do not have inherent self interests per se and are instead guided by the
interests of the stakeholders who appointed them (La Porta et al. 1999). For this reason, a greater
percentage of independent members in the boards should promote positive performance.

According to the study conducted by Goeffrey (2015) and focused on the effects of corporate
governance on Microfinance Institutions financial performance in Kenya, corporate governance
practices plays an important role in the operation of Microfinance institutions for enhanced
financial sustainability and the findings of the study revealed that board independence has a
significant positive relationship with financial performance. This implied that Board
independence improved on financial performance. According the result of this study Board
diversity also proved to have a significant positive relationship with financial performance. So an
increase in both Board independence and Board diversity would lead to an increase in financial
performance of micro finance institutions.

2.4.5. Size of Board Audit committee and MFI Performance

An audit committee is an operating committee of the board of directors charged with oversight of
financial reporting and disclosure. Committee members are drawn from members of the
company's board of directors, with a Chairperson selected from among the committee members.
Its role includes choice and monitoring of accounting principles and policies, overseeing
appointment, dismissal of external auditors, monitoring internal control process, discussing risk
management policies and practice with management and overseeing the performance of internal
audit function

Empirical findings on the effect of size of audit committee and corporate performance show
mixed results. Ms.S.Danoshana et al (2013) found that increasing Audit Committee Size will
result high financial performance, because detailed discussion on the financial statement of the
companies will lead to get more ideas regarding the reports and it will guide to increase the
firm’s performance.

However, in Ethiopia banking industry, Ferede (2012) found that large number of audit
committee has a negative and significant effect on financial performance. He added that Limiting
audit committee size to reasonable number improves audit committee effectiveness. Thus, it is
expected that there is a significant Negative relationship between size of audit committee and
financial performance.

The presence of audit members with experience reduces the chances of financial misreporting
which in turn improves firm performance. The chances of fraud are also reduced as well as the
cost of debt. Further, vast wealth of experience of audit members is associated with quality
monitoring and greater audit knowledge which is instrumental to improved firm performance.
Finally, with increased size of the audit committee, firm performance is expected to decline
because of the problem of free riders and the pressure to follow other members’ opinion without
considering your argument. However, it can also be argued that large size audit committees can
protect and control the process of accounting and finance since there is increased expert advice
with increased size of the audit committee (Samoei Richard Kipkoech, 2016). Therefore, it is
utmost necessary for firms to elect audit committee members that have served for many years to
the board because of their vast experience. So for firms having experienced audit committee
members should be a key priority. The size of the audit committee should also be in a way that
the process of accounting and finance are protected and firm performance is increased.

2.4.6. Board members educational qualification and MFIs performance

According to Hambrick and Mason (1984) Educational background measures the cognitive
ability of the executive, which influences firm performance. The type and number of degree of
education one chooses serve as indicators of her or his values and cognitive preferences. Thus,
based on personal values, cognitive preferences and specialized education, we might expect
those with formal education in engineering to utilize different cognitive models in making
decisions than those with formal education in business or finance. Firms having top managers
with less formal education experience more variability in performance.

Firms with better educated board of director may come in to sight to have better performance in
the short-run, but that superiority will likely to reverse in the future. Even though intellectual
competence should appear to be one of the considerations in the appointment of board members,
the education qualification is not always a good proxy for superior advising or managerial
quality. Education degrees are usually obtained long before the director’s appointment, thus
other cognitive experience such as industry knowledge and network should be better parameters
of a director’s competency (Hung Phan, 2016).

2.4.7. Board members industry specific experience and MFIs performance

According to Wolfgang Drobetz et al. (2014) Board industry experience is one of the most
important determinants of a board’s ability to perform its role in a manner that enhances
shareholder value. In their study, they investigate that whether industry experience on corporate
boards is related to firm value and investment behavior, and they document that a robust positive
association between industry experience of corporate directors and firm value.

2.5. Summary of literature and research gap

Gadi Dung Paul, (2015) examined the relationship between Board composition and Board audit
committee and financial performance as measured by using EPS and ROA of micro finance
banks in north central Nigeria (2003) and fond that Board composition has a significant positive
relationship with ROA, and number of Board audit committee has a significant negative
relationship with financial performance. Goeffrey, (2015) conducts its research on effect of
corporate governance on financial performance of MFIs in Kenya argued that there was a
significant positive relationship between Board independence and financial performance and this
implied that Board independence improved on financial performance. Board diversity also has a
significant positive relationship with financial performance of micro finance institutions.

In contrast, Ahmad N, and Sana I, (2015) who conducts their research on financial performance
and corporate governance taking a sample of 173 MFIs an evidence from Asia, determines the
relationship between corporate governance and financial performance measured by return on
asset (ROA), return on equity (ROE), profitability yield (PY) and operating expense ratio (OER),
revealed that overall corporate governance system has no significant impact on the MFIs
financial performance. The results imply that profitability and sustainability of MFIs do not
improve with better governance practices. They link this insignificant result of financial
performance with corporate governance mechanism of MFIs to the fact that corporate
governance involves the monitoring and control of an institution by the executive and top
management levels. As profit generation and maximization is never a mission of MFIs this could
be the reason behind insignificant impact of corporate governance on financial performance of
micro finance institutions.

Ferede (2012) studied the impact of corporate governance Mechanism on Bank performance in
Ethiopia and concluded that large size board and audit committee negatively influences financial
performance; board members educational qualification positively associated with financial
performance; industry specific experience of director positively related with return on asset but it
has a negative effect on net interest margin; and the percentage of female directors and board
members business management experience does not have a significant effect.

Belete Z, (2015) studied the impact of corporate governance on MFIs financial performance in
Ethiopia by taking a sample of 10 micro finance institutions based on purposive cluster sampling
method. Panel data covering a Seven-year period from 2007/08– 2013/14 was used for the study.
It determines the relationship between corporate governance and financial performance of micro
finance institutions measured by ROA, and the result shows that independent variables; (board
size, board composition, board competency, board experience in the sector, meeting frequency
and audit committee size) are positively and significantly correlated with Return on Asset.
However, CEO gender and CEO duality are negatively and significantly correlated with return
on asset.

Thus, results from empirical studies reviewed on the relationship between financial performance
and the various board characteristics were positive, negative and mixed. In addition, the results
that the researcher discussed all will not be generally applicable enough to Ethiopia’s
Microfinance Institutions as most of the research conducted covering small period and the
sample was small percentage of total taken from specific region.

Control variables

Capital adequacy ratio

of MFI

Leverage of MFI

Growth of MFI

2.6. Conceptual framework

Based on empirical literature on corporate governance and MFI performance above the
researcher developed conceptual framework as shown below:

Corporate governance
elements
Board size
MFI
Board size
performance
Board gender diversity
ROA
Board educational
and
qualification

Board management ROE

experience

Board industry specific

experience

Size of audit committee

Source: researcher own design

Board independence

Figure 2.1: Conceptual Framework

CHAPTER THREE

METHODOLOGY

3.1. Introduction
Research methodology refers to the study of the general approach to inquiry in a given field. The
methodology part looks at the research design that will used, the population and sample size that
will be studied, the different sampling methods, types of data as well as the data collection
methods that will employed in conducting the study. It also presents how data analysis will be
conducted and report written.

3.2. Research Design

The primary objective of this study is examining the impact of corporate governance on the
financial performance of MFIs in Ethiopia. To achieve this objective, explanatory type of
research design with a mixed approach, more of quantitative will be employed. . The mixed
method of research provides stronger inferences. Therefore, by using a mixed approach it is able
to capitalize the strength of quantitative and qualitative approach and remove any biases that
exist in any single research method (Creswell, 2003). The explanatory type of research design
will be used to identify and evaluate the causal relationships between the different variables
under consideration and financial performance.

3.3. Sample size and sampling technique

According to Association of Ethiopian Micro Finance Intuitions (AEMFI), there are 35

microfinance institutions in the country, of which of nineteen are for profit MFIs while the rest
are not for profit (NFP) MFIs and they are in different stages of development and exhibit high
level of diversity in aspects such as ownership and leadership. For this study 11 MFIs, which will
provide and had complete ten year data, will be selected by using purposive sampling technique.
Due to the nature of the subject matter, Chief Executive Officers (CEOs) and other senior
managers will be selected for structured interview and questionnaire, since they are in a better
position to have all the information about CG in their organization.

3.4. Data sources and collection methods

For this study the data will be collected from both primary and secondary sources. The primary
data will be collected through questionnaires and interview. The questioner will be developed
and distributed to each CEO of the MFIs. The secondary source of data will be the audited
financial statements of MFIs which has been collected over a period of ten years (2007-2016)
from national bank of Ethiopia (NBE). In addition secondary data will be obtained from manuals
from organizations, annual report, published and unpublished materials that reports as impact of
corporate governance on financial performance of micro finance institutions, by owners and
other responsible bodies and the relevant document which are important for this research paper.

3.5. Methods of data analysis

The analysis process applies both qualitative and quantitative techniques of data presentation. It
will also use tables and percentages. In this study, to analyze the collected data, both correlation
and multiple panel linear regression data analysis method will be employed by using stata. The
correlation analysis will be used to identify the relationship between the independent, dependent
and control variables. Multiple panel linear regression analysis will be used to test the hypothesis
and to explain the relationship between corporate governance variables and financial
performance measures by controlling the influence of some selected variables.

3.6. Specification of research model

To estimate the impact of corporate governance on the financial performance of the micro
finance institution, the following general empirical research model will be developed:

Yit = β0 + ∑βKXit+ εit ROFINANC

Where:

Yit represents the mean value of dependent variables (ROA and ROE)

β0 is the intercept

βK represents the coefficients of the X variable

Xit represents the explanatory variables (BSIZE, BGD, BQUAL, BMEXP, INDUEXP, and
AUDITCSZ)

εit is the error term.

The above general empirical research model will be changed in to the study variables to find out
the impact of corporate governance mechanisms on firm’s financial performance as follows:

ROA = βo +β1 (MFIsize) + β2 (MFIGD) + β3 (MFIqual) + β4 (MFIBMExp) + β5

(MFIInduExp) +β6 (MFIAuditSize) + β7 (MFIBindit). + β8 (MFICARit) + β9 (MFILEVit) +
β10 (MFIGRTHit)

ROE = βo +β1 (MFIsize) + β2 (MFIGD) + β3 (MFIBqual) + β4 (MFIBMExp) + β5

(MFIInduExp) +β6 (MFIAuditSize) + β7 (MFIBindit). + β8 (MFICARit) + β9 (MFILEVit) +
β10 (MFIGRTHit)

Dependent variables:

ROA= Return on asset of the MFI

ROE= Return on equity of the MFI

Independent variables:

MFIBsize=board size of the MFI

MFIGD= Board gender diversity (presence of female directors)

MFIBqual=Educational qualification of board of directors

MFIBMExp=Board management’s business management experience of the MFI EFFECTS OF C

MFIInduExp= Industry specific experience of boards of the MFI

MFIAuditsize= Audit committee size of the MFI.

MFIBind = Board independence of MFI.

Control variables:

MFICAR = Capital Adequacy Ratio of the MFI

MFILEV = Leverage of the MFI

MFIGRTH = Growth of the MFI

3.7. Description of Variables and Measurements

3.7.1. Dependent Variables

The dependent variables considered in this study are variables that are used to measure the
financial performance of MFIs and are defined as follows:

 Return on Asset (ROA) - measures the overall efficiency of management. It gives an idea
how efficient management is at using its assets to generate earnings.

ROA = Net Profit after Tax/Total Asset.

 Return on Equity (ROE) - measures a firm’s financial performance by revealing how

much profit a company generates with the money shareholders have invested. It shows
how well the shareholders funds are managed and used to generate return.

ROE = Net Profit after Tax/Total Equity.

3.7.2. Independent Variables

The independent variables which are going to be considered for this study are variables that are
used as a determinant of corporate governance of MFIs. The definition and measurements of the
variables are as follows:

 Board Size

Board size can be defined as the number of directors sitting on the board.

 Gender Diversity of the Board

Ownership Gender diversity of the board is measured as the percentage of number of female
directors divided by the total number of board members.

 Educational qualification of board members

This is measured by the proportion of board members having college degree or higher to the total
number of board members. Educational qualification is an important determinant of board
effectiveness. According to Rose (2007) cited in Eyob 2016, as long as board members have a
university degree/or equivalent skills, it is possible to assume that the board have sufficient
human capital in order to understand information that is provided by management. The
monitoring role is also expected to be effectively implemented by the board if the board
members are qualified and experienced.

 Business Management experience of board members

This is measured as the percentage of directors who have business management experience
against the total number of board members. It is important for firms to have experienced
directors on board since it helps them in undertaking their duties of monitoring and controlling
the management in an effective and efficient way.

 Industry specific experience of the board members

It is measured as the percentage of directors who served in other MFIs earlier at the same
capacity divided by the total number of board members. It is important for MFIs to have skilled
and experienced board of directors in the same sector and position.

 Size of Audit committee in the board

Size of an audit committee in a board refers to the total number of MFIs’ audit committee
members out of the total number of board of directors.

 Board independence

Board independence is Percentage of external members to the total members in the board. The
concept of board independence was grounded on agency theory. Independent board members
provide potentially greater oversight and accountability of operations, as they are less likely to be
subject to the principal-agent problem themselves (La Porta et al. 1999).

3.7.3. Control Variables

Three microfinance specific control variables (capital adequacy ratio, leverage and growth of
MFIs) will be included for this study just to account their potential influence on financial
performance of MFIs’ and in order to know the effect of selected explanatory variables on MFI’s
financial performance.

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