The impact of Governance Factors in the Financial Sector: An investigation of UK Banks listed in FTSE 100
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CHAPTER ONE: INTRODUCTION
Background
This study aims at examining the impacts of corporate governance factors on the financial performance of financial firms. Anwaar (2016) defines corporate governance as the factors that affect the institutional processes, including those that control and regulates the organization of the production and sales of goods and services. According to Mahrani and Soewarno (2018), corporate governance deals with the structures and processes through which firm members actively protect the shareholder’s interests.
The expansion of companies in both the merging and developed nations has increased corporate governance relevance. As the companies grow and expand, they employ the local people, use local raw materials, pay taxes, offer goods and services, and provide other services that benefit society. However, BAYERO (2019) shows that there has been a rise in corporation scandals. These scandals are attributed to “bad” corporate governance. According to Kabir and Thai (2017), corporate scandals results incorporate a failure, which consequences can be felt in every aspect of society. For instance, corporate failure leads to job losses and loss of investors’ capital.
Moreover, corporate governance affects influence the interest of other stakeholders, affecting the corporation’s performance. For instance, society may boycott a firm’s products if it is discontented with the firm’s operations. Consequently, Kabir and Thai (2017) show that companies modify their “usual governance and adopt social social-friendly geared towards satisfying different shareholders.” Besides, studies have shown that investors are more willing to invest in companies with good governance structure (Anwaar, 2016). This proves that corporate governance mechanisms affect the financial performance of the organizations.
Companies require investor’s funding to expand their projects. Ahmed and Che-Ahmad (2016) indicate that organizations with suitable corporate governance mechanisms can improve their firm’s value by 10% t0 12%. This results from investors’ investigation of corporate governance mechanisms before committing their funds to the companies. Firms with “undesirable” corporate governance mechanisms struggle to acquire loans. For instance, before financiers extend loans to the firms, they look at the indicators like audit committees, shareholders, the board size, board duality, and board independence, among other factors related to an organization’s corporate structure. Consequently, organizations are adopting corporate governance mechanisms that are attractive to financiers and investors.
The financial success of organizations relies not only on the innovation, quality of management, and efficiency but also on compliance with corporate governance principles. Ochieng (2017) shows that conformity with corporate governance standards increases the firm’s internal efficiency and improves its financial performance. However, insufficient disclosure of the firm’s practices and lack of transparency reduces corporate governance mechanisms’ efficiency. Palaniappan (2017) shows that major corporate scandals and the worldwide financial crises have reinforced the importance of good corporate governance in improving the firms’ financial performance and sustainability. The primary role of the administration is to facilitate efficient monitoring and the effective control of the businesses. Palaniappan (2017) shows that the essence of corporate governance lies in transparency and fairness in the firm’s operations and the enhancement of disclosures aimed at protecting all shareholders’ interests. According to Murwaningsari (2019), the corporate governance structures should enable the firm to make better decisions, hence improving its financial performance. A broader definition by Dzingai and Fakoya (2017) states that corporate governance outlines the relationships between the organization’s management, its board, its stakeholders, and its shareholders. Efficient corporate governance “ensures that corporations take into account the interests of a wide range of constituencies, as well as of the communities within which they operate and that their boards are accountable to the company and the shareholders (Wahudin and Solikhah, 2017)”
Corporate governance outlines the responsibilities of the auditors and the directors towards all the stakeholders. Wahyudin and Solikhah (2017) show that corporate governance is crucial as it increases shareholders’ confidence with the firm, therefore improving the later’s financial performance. Moreover, Corporate governance improves the firms’ relationship with other stakeholders, including the employees, suppliers, consumers, environment, and the community by ensuring that the company behaves responsibly towards the environment and the community. Therefore, safe for ensuring accountability, corporate governance also includes aspects of environmental and social responsibility.
Earlier, good corporate governance was not a compulsory legal requirement, and the adherence to good rule was voluntary. However, Fiori et al., (2016) show that due to corporate failures resulting from unethical acts corporate managers, most countries have outlined compulsory guidelines and norms to strengthen the framework of corporate governance. For instance, the United Kingdom outlined the Cadbury Committee Report in 1992. The report was followed by the Sarbanes Oxley Act of 2002 initiated by the united states. These acts acted as the initial development in the development of corporate governance regulations. The Acts were followed by the development of similar laws by other countries.
After the Enron financial crisis in Asia and WorldCom in the USA, Mansur and Tangl (2018) show that the corporate governance focus shifted from the traditional ground, which had agency conflicts to ethical issues like transparency, reporting, accountability, and disclosure. Following high-profile corporate scandals, there has been a public demand for corporate responsibility, triggering the academics, policymakers, and public and private sectors to ensure good corporate governance. For instance, WAMAITHA (2017) illustrates that the Sarbanes-Oxley Act was enacted in the united states to ensure that to ensures that the board of directors adhere to the best practices of corporate governance like honesty reporting and disclosure. Good corporate governance upholds the principles of transparency, accountability, responsible management, and fairness. Addressing ethical corporate governance concerns through decision-making benefits the investors, consumers, employees, and the community.
However, the 2008 financial crisis triggered a debate on whether corporate governance affects (positively or negatively) the organization’s economic performance. This paper studies the corporate governance mechanisms of the banks listed in FTSE100 companies.
A theoretical framework based on stewardship and stewardship theories will help in answering the research questions. The study will use corporate governance mechanisms like board independence, board size, insider shareholder, CEO duality, audit committee meetings, and independence. The research will use the firms’ return on capital and Tobin’s Q to capture its financial performance.
Problem statement
Although numerous studies have attempted to find the importance of corporate governance on the organizations’ financial performance, only a few studies have addressed the case of companies in the London stock exchange market, especially the banks listed in the FTSE 100 companies. There is an existing gap in the study of the effects of corporate governance on UK banks’ financial performance. This study aims to cover the gap and advise the banks on the advantage of corporate governance factors.
Research Justification
This study seeks to investigate the impacts of corporate governance practices on the banks’ financial performance listed in the FTSE100 companies. The study overviews the corporate governance practices and mechanisms and the financial performance of the organizations. The investigations also review the theories and the empirical frameworks affecting the companies’ financial performance mentioned above.
Study objectives
- To assess the effects of shareholders rights, board independence, and board composition on the performance of UK banks listed in FTSE 100
- To establish whether there is an association between the disclosure, transparency, and policies on the financial performance of UK banks listed in FTSE
Research questions
- What are the effects of shareholders’ rights, board independence, and board composition on UK banks’ performance listed in FTSE 100?
- Is there an association between the disclosure, transparency, and policies on UK banks’ financial performance listed in FTSE 100?
Research rational
Corporate governance practices are crucial tools in the management of big organizations. Corporate governance includes constitutes of the different mechanisms aimed at improving the efficiency of the firm’s financial performance, including the structure of the ownership, size of the board of directors, the number of shares that can be owned by the largest shareholders, and CEO’s terms of work and remuneration. Therefore, it is necessary to comprehend the particular mechanisms and tools of corporate governance to ensure that the companies attain considerable financial performance results. Moreover, Anwaar (2016) shows that there has been a controversy on whether controlling the incentives and the corporate governance mechanisms improve financial performance. Further, there is a question on whether the parameters of corporate governance enhance an organization’s profitability when combined with other factors represented by the control variables.
According to WAMAITHA (2017), numerous studies attempted to answer the above questions, but the evidence presented was controversial. All studies showed that all the parameters had different influences on the organizations’ financial performance depending on the periods, explored samples, applied analytical method, and the employed variables. Therefore, this study attempts to elucidate the significance of the factors mentioned above in the UK banks where corporate governance practices have been widely distributed. Furthermore, the study employs the most recent data to explore the latest impacts of various corporate governance mechanisms on its profitability. Lastly, the research sample includes banks from the FTSE100 index. In the author’s opinion, the United Kingdom’s largest companies (FTSE100) mostly reflect the regulatory power of corporate governance due to the volume of assets and the size of the companies mentioned above and their immense influence on the performance of the financial sector in the United Kingdom.
Structure of the research
The study is based on the investigation of corporate governance practices and their impacts on the financial performance of the banks listed under FTSE100 companies. Chapter one of the research covers the introduction of the study’s background, problem statement, the rationale of the study, the purpose of the study, study objectives, and the study questions. Chapter two includes the literature review. It explores the theoretical and conceptual frameworks of corporate governance and their effects on the organizations’ financial performance—chapter three outlines the research methodology, data collection, and analysis techniques. Chapter four includes the data analysis, results, and discussion of the collected data—lastly, chapter five consists of the research findings, conclusions, recommendations, and other research areas.
CHAPTER TWO: LITERATURE REVIEW
Introduction
This section reviews various literature connected to the area of the study. It covers board composition, ownership structure, and other corporate governance factors and their impact on banks’ financial performance in the United Kingdom.
Theoretical Framework
Several theories form the basis of corporate governance. These theories are outlined in the subsequent sections.
Agency theory
Suteja et al. (2017) observed that the principle-agent theory is usually the starting point of controversies on corporate governance. According to Nuryana and Surjandari (2019), the modern firm’s main challenge primarily lies in the separation between management and finance. Studies have uncovered that modern firms suffer from the separation of control and ownership, and they are led by agents (professional managers) who are not accountable to the dispersed shareholders.
Agency theory outline mechanism to eradicate agency problems in the organizations. For instance, Lamichhane (2018) illustrates that the dividends mechanism limits the managerial intention of making overinvestment decisions that are usually financed by the internal cash flow. The executive incentive mechanism remunerates managers for serving the owners’ interests; the bonding mechanism minimizes the managerial moral hazard. This usually occurs when the managers are not restricted by the bankruptcy risk and the bond contract. According to Omware et al., (2020), the agency theory also outlines other owner’s efforts to reduce the agency cost of equity that usually arises from the moral hazard managers. These efforts include the owners’ intention to select competent and reputable board managers, the threat of firing, the risk of takeover, and direct intervention by the shareholders.
Stakeholder theory
The agency theory is limited in addressing the corporate governance issues due to its narrowness as it identifies shareholders as the only interest groups of the organizations. The stakeholder theory has become more prominent as many researchers have acknowledged that corporate activities affect the external environment, necessitating the firm’s accountability to a wider audience apart from shareholders only. For instance, Li et al., (2017) illustrated that companies are not the interests of shareholders only as they exist within the society; therefore, the companies are responsible to the community. Furthermore, Li et al. (2017) recognized that economic value arises from people who come together and work together to improve everyone’s position.
However, Sathyamoorthi et al. (2017) critique the theory for its assumption of a single-valued objective. Felício et al. (2016) argue that stakeholder’s gains should only measure the organizations’ performance. There is a need to consider other critical issues, including interpersonal relationships, information flow from the management to its subordinates, and working environment, among other topics.
Corporate governance from the theoretical perspective
The Board of Directors (BODs) has a crucial role in the organizations’ management. Due to the significance of the BODs in the governance mechanisms, BODs have increasingly become responsible for the organization’s performance. Consequently. Most studies from diverse fields such as finance, economics, sociology, strategic management, law, and organizational theory focus (Bods Mandivhei 2019). According to Irawati et al. (2019), a firm’s performance depends on the realization of the roles of the BODs. Bansal and Sharma (2016) assert that these roles are numerous and essential.
Jemal (2019) shows that the most emphasized duties of the BODs in literature are service, resource dependence, and control roles. The service roles involve formulating initiating strategies and advising the executives on the administrative and other managerial issues. On the other hand, the resource dependence roles view the BODs as the facilitators of the acquisition of materials crucial for the organization’s success. Finally, the control role involves BODs monitoring managers, determining the executive’s remuneration, and hiring and firing executives.
Researchers have employed various theories, mostly the agency theory, to study the BODs. The Agency theory assumes that the BODs influence the opportunistic traits of the managers. Therefore, the BODs primarily controls the systems that fit the interests of the shareholders and the managers. According to Bansal and Sharma (2016), board composition is critical for monitoring the managers and minimizing agency costs. Bansal and Sharma (2016) show that despite the executive directors having expertise, valuable knowledge, and specialized skills, independent directors need to have independent directors to contribute new ideas, objectivity, independence, and expertise acquired from their fields. Therefore, agency theory recommends involving non-executive directors to oversee any self-centered manager’s interests and reduce agency costs (Esteban et al., 2017).
According to Suttipun (2018), BODs with more than eight members are unlikely to be effective. Large boards reduce the effectiveness of coordination, decision making, and communication, and they are most likely to have the CEO’s influence. Esteban et al. (2017) also assert that large boards are less cohesive and challenging incoordination, as there might numerous interactions and conflicts among members. Additionally, Esteban et al. (2017) show that CEOs usually make large BODs as the large boards enhance the dispersion of members’ power in the boardroom, reducing the directors’ potential for coordinated actions and leaving the CEO as the predominant figure.
The inherent focus of the resource dependence framework is the maximum interaction between the organizations and the environment. Bansal and Sharma (2016) show that organizations need to get access to environmental resources as the vital issue of survival under the resource development theory’s scope. The resource development theory views organizations as open systems that are dependent on the other firms to provide necessary resources Li et al., (2017). According to Fiori et al. (2016), the assumption holds that an organization’s financial success depends on the firm’s ability to provide and control the external resources. BODs are the main mechanisms that administer these external dependencies (Felício et al., 2016).
Corporate governance framework
Li et al., (2017) described corporate governance as systems that provide principles and guidelines to enhance appropriate execution of the executive responsibilities, satisfy the shareholders and eliminate the challenges emanating from the moral hazard. It is worth noting that a unified and global corporate governance standard is not applicable as it could not be responsive to the local economies. Bansal and Sharma (2016) show that institutional diversity characterizes corporate governance in European countries, including the United Kingdom.
The Board size
The BODs of a firm is a crucial mechanism for monitoring manager’s behaviors and advising them accordingly. The common belief is that the board’s efficiency reduces with the increase in the number of board members. According to Esteban et al. (2017), the reduction in the efficiency emanates from the increased cost and difficulties in decision making, communication, and coordination on large groups.
They are limiting the board size to the optimum increase in the performance of an organization. Ahmed and Che-Ahmad (2016) show that the benefits emanating from the increased monitoring in large boards are outweighed by cumbersome decision-making and poor communication. Studies on the board size seem to have a similar conclusion; a giant board is likely to be less effective in decision making and more exposed to the CEO’s control.
Board composition
According to Outa and Waweru (2016), liberalization and globalization of the financial markets, corporate scandals, transparency of the organizations, and the increased demand of accountability by the stakeholders made the tasks and the roles of BODs the central aspect of the corporate governance debate. Suteja et al. (2017) show that BODs have various essential functions, including controlling the organization, ensuring service delivery, and devising a corporate strategy. The realization of the roles mentioned above relies on the boards’ features, which influences the performance of a firm.
This study concentrates on investigating the effects of the board composition, measured in terms of outsider director, affiliated director presentation, and insider director on the firm’s performance of the banks listed under FTSE 100 companies. BOD is undoubtedly the major decision-making organ of the firms listed in FTSE 100, and they are responsible for the performance of the respective organizations.
Transparency and disclosure
Transparency is a crucial aspect of corporate governance. Nuryana and Surjandari (2019) show that transparency minimizes the information asymmetry between the financial stakeholders and the organizations’ management, thereby reducing the agency challenge in corporate governance. According to Sathyamoorthi et al. (2017), transparency in the banking context is broad. It refers to the quantity and the quality of information concerning the bank’s risks and its previous, current, and plans, actions, and decisions.
Insider shareholding and firm value
The primary argument to solve the challenge of the agency involves the use of insider shareholders. Several studies (Esteban et al., (2017), Li et al. (2017), and Mansur and Tangl (2018)) have explored the influence of the insider shareholder on the reduction of the agency problem. However, the studies reported very conflicting results. For instance, Fiori et al., (2016) found a significant relationship between the insider shareholder and the firm performance; Suttipun (2018) reported that there is a meaningful relationship between performance and ownership while Felício et al., (2016) did not find any linear relationship between the variables mentioned above.
The role of debt
Studies have linked debt owed to large creditors with the reduction of the agency problem. Anwaar (2016) shows that large creditors, just like the stakeholders, are interested in seeing the corporate management take performance improvement measures. For instance, Outa and Waweru (2016) found higher incidences of management turnover in Japanese firms in response to low performance in organizations with a principal bank relationship compared to those that do not. However, Mansur and Tangl (2018) show that another debt agency, another type of agency problem, arises when the conflict of interest emerges between the debt holders and the stockholders.
Financial performance in financial institutions
Financial soundness occurs when the banking system is stable, securing the depositor’s funds. Ahmed and Che-Ahmad (2016) show that whether a financial institution’s financial stability is unsatisfactory or strong varies from a bank to another. The external factors, including homogeneity of the bank businesses, lack of information by customers, the connection among financial institutions, and deregulation lead to bank failure. The camel framework constitutes of some useful measures to ensure financial performance as outlined below:
Capital Adequacy: Murwaningsari (2019) shows that capital adequacy influences how well an institution can cope with shocks to their balance sheet. The banks monitor their capital adequacy using the ration set by the banks for the global settlement. According to Nuryana and Surjandari (2019), banks measure their capital adequacy based on the relative risks weights assigned to the various sets of assets held off and on the balance of the balance sheet items.
Asset quality: when the assets of a bank become impaired, they expose the bank’s solvency at risk. In response, banks are required to monitor the indicators of the quality of their assets in terms of exposure to certain risks. Mansur and Tangl (2018) show that credit risk is inherent in lending – which is the primary banking activity- and it arises when the borrowers fail to meet their obligations. Banks should monitor such risks to enhance their positive financial performance.
Earnings: Banks and other financial institutions’ sustainability depends on their abilities to earn adequate returns from their capital and assets. Nuryana and Surjandari (2019) indicate that good earnings performance enables a bank to remain competitive, expand its operations, and increase its capital base.
Liquidity: according to Sathyamoorthi et al., (2017), initially performing banks and other financial institutions may close due to poor management of short-term liquidity. Liquidity indicators need to contain funding sources and capture significant maturity mismatches. Bansal and Sharma (2016) indicate that an unmatched position may increase profits, but it also magnifies the risk of losses.
Measurement of financial support variables
Most studies acclaim that effective corporate governance improves a firm’s financial performance. Despite the widely accepted belief that good corporate governance improves a firm’s financial performance, some studies have established negative relationships between organizations’ financial performance and corporate governance. Bansal and Sharma (2016) have not found any connection between the two variables Mahrani and Soewarno (2018). Researchers have given several explanations to account for these inconsistencies. Some researchers have argued that these inconsistencies emanate from the use of surveys or publicly available data as these sources are usually limited in their scope. Moreover, some have argued that the nature of performance measures could contribute to these inconsistencies.
Furthermore, BAYERO (2019) observes that “theoretical and empirical literature in corporate governance considers the relationship between corporate performance and ownership or structure of boards of directors mostly using only two of these variables at a time.” For instance, Dzingai and Fakoya (2017) studied the relationship between board composition and financial performance while Wahyudin and Solikhah (2017) studied the correlation between managerial ownership and the organization’s performance.
To address the problems mentioned above, Omware et al. (2020) recommend that studies take a multivariate approach when testing the correlation between the firm’s governance and financial performance. This study adds to the literature body by applying both accounting-based and market-based performance measures like Tobin’s q and return on assets to test the correlation between the selected governance variables. Besides the board characteristics, the study will incorporate the intensity of the board activity, the audit committee activities, and the institutional shareholding features to explore governance. The study will combine the publicly available data and a survey to widen the governance variables’ scope.
Empirical studies on the effects of corporate governance on bank performance
studies have established causalities between the corporate governance factors and the organizations’ financial performance. However, some studies have shown a strong relationship, while others have found very weak connections between the variables mentioned above. Similarly, Li et al., (2017) account that empirical evidence supports the hypothesis that large shareholders actively monitor the firms, and direct monitoring by the shareholders boosts firm performance.
Additionally, surveys of corporate governance by Esteban et al., (2017) and Fiori et al., (2016) found that the empirical evidence suggests that control is valued, which would not be the case if the large shareholders or block holders received similar benefits with the investors. Therefore, despite direct shareholder being an adequate substitute for compensation incentives, the institutional investors and the board’s monitoring is weak monitoring devices that should not be used as substitutes for direct monitoring.
In investigating the relationship between corporate governance, ownership, and banks’ financial performance, Dzingai and Fakoya (2017) reported that the regression results demonstrated some significant but economically irrelevant connection between corporate governance and operating performance. Another study by Felício et al. (2016) examined the relationship between risk management, corporate governance, and Indonesian banks’ financial performance. The study found that bank ownership influences corporate governance and risk management. However, the study did not establish any linear relationship between corporate governance and bank financial performance.
Reliability of financial reporting
The reliability and accuracy of the management’s financial reports affect the investors’ and other stakeholders’ perceptions of the organizations. Safe for the experience of banks listed in FTSE 100 in the London Stock Exchange Market. Irawati et al. (2019) show that the stakeholders perceive the public listed financial firms’ financial reporting as more credible and transparent due to their subjection to more rigorous and stiffer scrutiny than the private companies. Due to inadequate scrutiny, Sathyamoorthi et al. (2017) argue that it is difficult to assure corporate governance’s financial reporting role in private organizations. External auditors and audit committees are the critical tools for ensuring the financial reporting corporate governance variable. However, there is limited empirical evidence around the variable, as mentioned above.
Existence of code of corporate governance
Ahmed and Che (2016) show that the increasing concerns over institutionalizing corporate governance mechanisms in banks and other financial institutions have led to the formulation of governance codes by voluntary industry associations and the regulatory agencies. However, clear evidence of what extent these UK banks listed have adopted the regulations mentioned above is or developed their firm-specific governance polices is still unknown due to the available data limitation.
Audit committee
The results of Kabir and Thai (2017) and Mansur and Tangl (2018) demonstrated the presence of a strong connection between the audit committees and the performance of the financial institutions. However, a study by Nuryana and Surjandari (2019) found no significant association between the variables mentioned above. There is a need for more profound research to establish consensus on the relationship between audit committees and performance.
Board size
Research findings have agreed on the argument that there is an association between board size and financial performance. However, they are conflicts on whether it is a large or small board that is more efficient. For instance, Sathyamoorthi et al. (2017) found the Tobin’s Q reduces with a decline in board size while Bansal and Sharma (2016) and Mansur and Tangl (2018) showed that small boards were associated with higher performance. Besides, Outa and Waweru (2016) indicate that large panels are related to a positive influence on the shareholders’ wealth compared to smaller boards.
Separation of office of CEO and board chair
Separation of the CEO’s office and the board chair aims at reducing the agency costs of a firm. Anwaar (2016) found a significant positive relationship between financial performance and the separation of the CEO and the board chair’s office. Kabir and Thai (2017) also reported that the firms were more valuable when they disintegrated the offices mentioned above. Furthermore, Ahmed and Che (2016) found that large independent boards improve the firm’s performance. The fusion of the CEO and the board chair’s office reduces the organization’s performance as the firm gets less access to debt finance. According to Ahmed and Che (2016), boards independent from the CEO’s influence are more reliable for monitoring the organizations’ financial process, therefore improving the firms’ value.
Conclusion
In summary, studies have not consented to a general relationship between corporate governance and financial performance. However, empirical evidence demonstrates that, generally, corporate ownership structure significantly influences financial performance. Moreover, weak corporate governance reduces the organizations’ financial performance (Li et al., 2017)
In general, corporate governance literature constitutes attributes like disclosure, trust, and transparency, among others. Further, disclosure and financial transparency enhance trust between the organization and the stakeholders, hence improving its economic performance. Capital adequacy, liquidity, and earnings are critical dimensions for assessing the financial performance of the banks. In conclusion, this literature forms the foundation for establishing the relationship between economic performance and corporate governance.
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