At the end of August, Kenyan President Uhuru Kenyatta shocked the domestic banking sector by signing legislation that imposes limits on bank lending and deposit rates. The amendments peg commercial lending rates at four percentage points above the benchmark Central Bank Rate (CBR), and set interest granted on deposits at a minimum 70% of the CBR. Lending at rates above those prescribed by the new legislation would be considered a criminal offence.
The new law has received fierce criticism from the Central Bank of Kenya (CBK) and the banking sector, with the former stating that these changes would create inefficiencies in the credit market, induce credit rationing, promote the use of informal lending channels and undermine the effectiveness of monetary policy transmission. In an attempt to prevent the implementation of the new law after lawmakers approved the legislation at the end of July, the Kenya Bankers Association (KBA, an umbrella body of lenders) stated that its members had agreed to reduce their interest charges by 100 basis points. The association added that its members had agreed to together set aside nearly $300m to improve access to capital for small- and medium-sized enterprises at concessionary rates. In addition, banks agreed that they would no longer charge customers who close their accounts in order to encourage competition in the sector. However, these concessions were clearly insufficient to encourage the finance ministry to look towards more market-based solutions to address the country’s issues related to the cost of credit.
A profitable yet fragile banking sector
Kenya has developed a vibrant and relatively sophisticated banking sector. The East African nation has established itself as a regional financial hub, boasting the largest banking system in East Africa. The sector has shown strong growth in recent years, increasing in both size and sophistication. The country is renowned for its financial innovation, particularly that of mobile banking. The adoption of technological developments, including the rapid expansion of money transfer through telephones and electronic mobile banking services, raised the quality of financial services in the country, and expanded financial access. The country also boasts one of the more profitable banking sectors on the continent. According to International Monetary Fund (IMF) figures, the estimated return on assets in the Kenyan banking sector was around 6.6% last year, which is notably higher than that of regional peers such as Rwanda (2.8%), Tanzania (2.9%), and Uganda (3.6%), as well as those of other more developed banking sectors such as South Africa (1.5%) and Mauritius (1.2%). These strong returns have in part been driven by considerable spreads between lending and deposit rates, reaching over 11 percentage points in some cases. The government has thus pointed out that these high returns have been at the expense of consumers and businesses.
The Kenyan banking sector has endured a tumultuous few quarters with three institutions being placed in receivership since June last year – when Patrick Njoroge took over as the central bank governor and introduced a much tighter, rules-based supervisory regime. The most recent of these, Chase Bank, was placed under receivership by the CBK in early April following a run on deposits after reports of malpractice by some of the bank’s directors. The Kenyan central bank’s hands-on approach to ensure financial sector stability will be beneficial over the medium to long term, even though short-term performances by some banks may suffer as a consequence. The CBK’s tighter supervisory regime includes requirements regarding provisions for non-performing loans (NPLs), which has resulted in the deterioration of some banks’ financial positions. Kenya faces the same problems that many other African countries face in that assessing credit worthiness is not that straight-forward, and consequently it is difficult to calculate what level of provision for NPLs is prudent and what level is overly conservative. The fact that Kenya has over 40 banks suggests that competition could encourage some banks to lean towards the less-prudent side of NPL provision. The key issue is that the banking sector is overpopulated (too many banks). In the context of too big to fail or too small to survive, the Kenyan banking system is certainly leaning towards the latter. Joshua Oigara, the chief executive officer of KCB, recently said that there were possibly 20 more banks than the domestic banking system required, and that he expected to see some voluntary consolidation in the industry. Some consolidation in the banking sector should support financial stability, and also allow for a regulatory framework that supports more autonomy in the banking sector while ensuring prudent practices.
The new legislation appears positive from a consumer and business perspective, but banks could be forced to remove high-risk borrowers from their loan books as the returns would not warrant the risk. That being said, the country does face the real problem of excessive credit costs, and it could be argued that the high cost of credit has sustained an over-populated banking sector with smaller banks dependent on these considerable interest spreads. Some potentially positive consequences stemming from the new law include the development of stronger credit information to assess credit risk, and increased competition in the banking sector, which encourages innovation and perhaps leads to some consolidation in the sector. In turn, negative ramifications include distorted credit markets, scope for rent-seeking, and a flow of capital away from private lending towards safer government securities. With regard to the latter, commercial banks’ weighted average lending rates were recorded at 18.18% in June, which, when adhering to the new legislation, would be decreased to a maximum of 14.5%. In turn, the yield on the 364-day Treasury bill trended just over 11% last month (most recently recorded at 11.9% in mid-August). This could thus encourage a significant increase in capital invested in government paper due to the limited risk, which would in turn reduce public debt yields until market conditions warrant a return to riskier lending. Furthermore, the central bank could be burdened in its mandate of maintaining price stability while fostering a stable financial system if policy decisions have a direct (and sometimes counterproductive) impact on banking operations. An expansionary monetary policy stance would imply a reduction in banking returns, assuming that operating costs remain sticky.
The Kenyan government has markedly increased its involvement in the banking sector over the past year, while the finance ministry is attempting to increase its involvement in the conduct of monetary policy. The potential gains from such a hands-on approach are easy to conceive, namely a more robust banking sector, lower borrowing costs and greater policy coordination. However, there are also considerable downside risks that are less tangible, including distorted markets, scope for rent-seeking, and the lack of central bank independence. The government is trying to address a salient issue while gaining some political capital in the process. However, it is impossible to accurately predict the overall impact of the new law, with a complex concoction of positive and negative repercussions filtering into a dynamic sector such as banking. Kenya is attempting to consolidate its position as a regional financial services hub, and the new law will have a profound impact on these efforts – whether positive or negative is yet to be determined.
This article has been written specifically for the NTU-SBF Centre for African Studies, a partnership between Nanyang Technological University and the Singapore Business Federation, Singapore.
It was first published by How we made it in Africa.
Published:5 September 2016