THE RELATIONSHIP BETWEEN FINANCIAL INNOVATION AND GROWTH IN PROFITABILITY OF ISLAMIC BANKING IN KENYA BY ALFRED MASIKA MUIA D61/64345/2011 A RESEARCH PROJECT REPORT SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF MASTER OF BUSINESS ADMINISTRATION DEGREE, UNIVERSITY OF NAIROBI NOVEMBER, 2013 DECLARATION This management research project is my original work and has not been submitted for a degree in any other University. SIGNED…………………………....... DATE …...………………………….. ALFRED MASIKA MUIA D61/64345/2011 This management research project has been submitted for examination with my approval as the University supervisor. SIGNED …………………………....... DATE …...………………………….. MR. JAMES NG’ANG’A School of Business University of Nairobi ii ACKNOWLEDGEMENTS I acknowledge my parents, my brother and friends for their constant support and encouragement throughout my study period. I acknowledge my fellow students amongst Esther Watakah and lecturers at the University of Nairobi whose wells of knowledge I drew from through the academic period, and have made me a better professional. I would also like to specially acknowledge my supervisor, Mr. James Ng’ang’a, who has guided me tirelessly through the research project. His guidance is invaluable. iii DEDICATION I would like to take this opportunity to thank God for making this study possible. I dedicate this work to my parents and brother, Paul Muuo, who supported and encouraged me to complete this project and to my friends especially Grace Gacheru who has been my best cheerleader. iv ABSTRACT The objective of this research study was to assess the relationship between financial innovation in Shariah compliant financial products and services and profitability of Islamic banking in Kenya. This study targeted eight (8) commercial banks that operate Islamic banking in Kenya. It covered the period between 2009 and 2012. Specifically, the study sought to establish the relationship between Islamic financial innovations and banking profitability. The return on Assets (ROA) was used to measure profitability and was calculated by dividing the banks’ net profit before taxation by the total assets held by the bank over the study period. Financial innovation was measured by; Number of Islamic debit and credit cards issued by Islamic banks, Contribution of agency banking, internet banking and mobile banking to income generated from Islamic banking, Number of new Shariah compliant financing facilities, Maintenance cost of Islamic debit and credit cards and Margin generated from Islamic debit and credit cards. The data for this study was collected using questionnaires for primary data study and secondary data was obtained from the Central Bank of Kenya annual reports. Out of the eight banks targeted, six responded which represented a response rate of 75%. A regression analysis on each of the Islamic banking innovations above individually against the bank’s profitability (ROA) revealed that there is a very weak relationship between individual innovations and profitability. The study results showed that bank innovations have a moderate influence on profitability of Islamic banks in Kenya. The analysis on combined effect of bank innovations produced a coefficient of determination of 56.8% which shows the percentage of variations in profitability which is explained by bank innovations. Based on the summary of the findings the study concluded that if Islamic banking is to have meaningful contribution to profits such banks should adopt a composite of financial innovations. Given that the relationship of the model is positive, increasing financial innovations would affect a bank’s profitability positively. Similarly, a decline in financial innovations would decrease a bank’s profitability. The moderate relationship (moderate correlation) between financial innovations and profitability implies that there are more other factors which affect a bank’s profitability and not only financial innovations. The study recommended that banks offering Shariah compliant financial services should focus their efforts on financial innovations. The more the financial innovations a bank is able to adopt, the more its chances of enhancing its profitability. v TABLE OF CONTENTS DECLARATION ................................................................................................................ ii ACKNOWLEDGEMENTS ............................................................................................... iii DEDICATION .................................................................................................................... iv ABSTRACT ......................................................................................................................... v TABLE OF CONTENTS .................................................................................................... vi LIST OF TABLES .............................................................................................................. ix LIST OF FIGURES ............................................................................................................. x LIST OF ABBREVIATIONS ............................................................................................. xi CHAPTER ONE .................................................................................................................. 1 INTRODUCTION ............................................................................................................... 1 1.1 Background of the Study ............................................................................................... 1 1.1.1 Financial Innovation ................................................................................................ 2 1.1.2 Growth in Profitability ............................................................................................. 3 1.1.3 Financial Innovation and Growth ............................................................................ 4 1.1.4 Islamic Banking in Kenya ....................................................................................... 6 1.2 Research Problem .......................................................................................................... 7 1.3 Objective of the Study ................................................................................................... 9 1.4 Value of the Study ......................................................................................................... 9 CHAPTER TWO ............................................................................................................... 11 LITERATURE REVIEW .................................................................................................. 11 2.1 Introduction .................................................................................................................. 11 2.2 Theoretical Framework ................................................................................................ 11 2.2.1 Models of Innovation............................................................................................. 11 2.2.2 Drivers of Financial Innovation ............................................................................. 13 2.2.2.1 Constraint-Induced Financial Innovation Theory........................................... 13 2.2.2.2 Transaction Cost Innovation Theory .............................................................. 14 2.3 Empirical Evidence on Islamic Banking Innovation ................................................... 15 vi 2.3.1 Review of Studies on Islamic Banking Innovation ............................................... 15 2.4 Conclusion ................................................................................................................... 18 CHAPTER THREE ........................................................................................................... 19 RESEARCH METHODOLOGY....................................................................................... 19 3.1 Introduction .................................................................................................................. 19 3.2 Research Design........................................................................................................... 19 3.3 Population and Sample Design .................................................................................... 19 3.4 Data Collection Methods ............................................................................................. 20 3.5 Data Analysis Methods ................................................................................................ 20 CHAPTER FOUR .............................................................................................................. 22 DATA ANALYSIS, RESULTS AND DISCUSSIONS .................................................... 22 4.1 Introduction .................................................................................................................. 22 4.2 Results of Research ...................................................................................................... 22 4.2.1 Effect of Islamic debit Cards Issued on ROA ....................................................... 23 4.2.2 Effect of Agency, Internet and Mobile banking on ROA ...................................... 24 4.2.3 Shariah Compliant Financing Facilities and ROA ................................................ 26 4.2.4 Relationship between Maintenance Costs of Cards and Profitability ................... 27 4.2.5 Relationship between Margins from Islamic Debit Cards and Profitability ......... 28 4.3 The Multiple Regression Model .................................................................................. 30 4.4 Discussion .................................................................................................................... 31 CHAPTER FIVE ............................................................................................................... 32 SUMMARY, CONCLUSION AND RECOMMENDATIONS ........................................ 32 5.1 Introduction .................................................................................................................. 32 5.2 Summary of Findings ................................................................................................... 32 5.3 Conclusions .................................................................................................................. 33 5.4 Recommendations ........................................................................................................ 34 5.5 Limitations of the Study............................................................................................... 34 5.6 Suggestion for Further Studies..................................................................................... 35 vii REFERENCES .................................................................................................................. 36 APPENDICES ................................................................................................................... 40 viii LIST OF TABLES Table 4.1: Effect of Debit and Credit Cards Issued on ROA ............................................. 24 Table 4.2: Relationship between Agency, Internet & Mobile banking and ROA ............ 25 Table 4.3: Relationship between Shariah Compliant Financing Facilities and ROA ........ 26 Table 4.4: Relationship between Maintenance Costs of Islamic Debit Cards and ROA ... 27 Table 4.5: Relationship between Margin from Cards and ROA ........................................ 29 Table 4.6: Multiple Linear Regression Coefficients .......................................................... 30 Table 4.7: Statistics of Linear Relationship of the Multiple Linear Regression Model .... 31 ix LIST OF FIGURES Figure 4.1: Test for Normality ........................................................................................... 23 Figure 4.2: Effect of Debit and Credit Cards Issued on ROA ........................................... 24 Figure 4.3: Relationship between Agency, Internet & Mobile banking and ROA ............ 25 Figure 4.4: Shariah Compliant Financing Facilities and ROA .......................................... 26 Figure 4.5: Maintenance Costs of Islamic Debit Cards and ROA ..................................... 28 Figure 4.6: Margin from Cards and ROA .......................................................................... 29 x