Effects of the Central Bank of Kenya Regulations on the Financial Performance of Commercial Banks in Kenya

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Abstract

Bank regulation refers to the formulation and issuance by authorized agencies of specific rules and regulations, under governing law for the conduct and structure of banks (Harvey, 2012). This study, therefore, seeks to assess the effects of central bank regulatory requirements on the financial performance of commercial banks in Kenya. This study is aimed at establishing why despite the review of banking regulations by the CBK in 2013, some banks are still performing poorly while registering huge losses whilst others are performing well and making strides in the banking industry. This study shall specifically focus on the effects of: interest rate capping, liquidity management, credit risk management and a capital requirement on the financial performance of commercial banks. The study will employ a descriptive research design. Both primary data and secondary data shall be collected and analyzed. For primary data collection, the study shall target 30 key bank officials who will be randomly sampled and data collected by the use of a questionnaire. Secondary data shall be collected from the most recently published annual financial statements and banks supervision records at the Central Bank of Kenya. The data obtained will be cleaned; coded and statistical outputs generated using SPSS. Descriptive and inferential statistics will be employed to analyze the data. To determine the effects of central bank regulatory requirements on the financial performance of banks in Kenya, measures of central tendency, dispersion and multi-regression analysis model will be used.

Introduction

Background of the study

The current regulatory structure for banking services is not the result of any grand design or reasoned blueprint. Instead, it represents a set of accumulated responses to a long history of financial crises, scandals, happenstance, personalities and compromises among a broad and competing array of industry and governmental units (Markham, 2000). Regulations are aimed at ensuring the safe operation of financial institutions, set by both state and federal authorities.

Given the interconnectedness of the banking industry and its reliance on the national and global economy, it is important for regulatory agencies to maintain control over the standardized practice of these financial institutions. Well-established banking systems are important factors of functioning financial systems. These have been vividly proven by recent developments around the world. When banking or more generally, financial systems temporarily break down or operate ineffectively. The capacity of these firms to obtain funds necessary for ongoing existing projects and pursuing new endeavors is curtailed. Severe interferences in the intermediation process can even lead to a financial crisis and in some cases, undo years of economic and social development. Since 1980 more than 130 countries have experienced banking problems that have been costly to resolve and disruptive to economic development. This troublesome situation has led to calls for banking reform by national governments and such international organizations as the World Bank and the International Monetary Fund (Barth, Caprio & Levine,2001).

Central bank regulatory requirements for banking institutions refer to regulations and guidelines issued by the Central Banks that subject banks to certain requirements, restrictions and guidelines. Central bank regulatory requirements can also be defined as legal frameworks for financial operations. The regulations are a significant contributor to preventing or minimizing financial sector problems. The objectives of these regulations are: 1) to reduce the level of risk to which bank creditors are exposed (i.e. to protect depositors) 2) systemic risk reduction-to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures, 3) avoid misuse of banks to reduce the risk of banks being used for criminal purposes, such as laundering the proceeds of crime and to protect banking confidentiality credit allocation to direct credit to favored sectors hence to provide the best customer service in this competitive edge (CBK 2012).

In Kenya, commercial banks and mortgage finance institutions are licensed and regulated in accordance with the provisions of the Banking Act and the Regulations and Prudential Guidelines issued thereunder. As key players in the banking sector, commercial banks and mortgage finance companies are subject to regulatory requirements governing their prudential position and market conduct in order to safeguard the overall soundness and stability of the financial system. One of the statutory objects of the Central Bank of Kenya under the Central Bank Act (Cap 491) is the promotion of financial stability through the maintenance of a well-functioning banking system.

Banking institutions in Kenya are governed by two Acts; the Banking Act and the Central Bank of Kenya Act. According to Sonal, Anjarwalla and Khanna (2013), banking institutions in Kenya is governed under the Banking Act (Chapter 488, Laws of Kenya) and by the Central Bank of Kenya Act (Chapter 491, Laws of Kenya. CBK Act.). CBK is the main financial institution regulator in Kenya which came into operation since 1966 through the Act of Parliament, to carry out its functions free from any interference of individuals, groups of persons or politics. It is an independent body in its mandate (CBK, 2012).

Evidence shows that the absence of Central bank regulatory requirements in some key areas can lead to bank failures and systemic instability. Establishing sound, clear and easily monitored rules for financial activities both encourage managers to run their institutions better and facilitates the work of supervisors. A major weakness of some financial systems is the fact that various financial institutions, especially cooperatives and intermediaries in rural areas, operate completely outside prudential regulations. Some countries have one single general banking law, which tries to assemble all regulations, but in many countries, the operational issues are left to statutory notes, circulars or even simply the routine decisions of the supervisory institution. Various other laws can have an impact on the operation of financial institutions, e.g. company laws, securities laws, debt recovery laws and laws on liquidation and bankruptcy (Thumbi, 2014).

Kenya is currently using most aspects of Basel II; however, it is worth noting that the CBK has decided to incorporate certain features of Basel III in the Prudential Guidelines, particularly in relation to capital adequacy. Kenya is not a member of the Basel Committee on Banking Supervision, but the CBK does adopt and incorporate Basel standards when possible. The government of Kenya through its regulatory body, the Central Bank of Kenya, has introduced prudential regulations to guide commercial banks in conducting their business while cultivating a culture of fair competition in the industry. The introduction of prudential guidelines reflects Kenya’s continued efforts towards strengthening its banking environment so that she can achieve its goal under Vision 2030 to be an international financial stability country (Richard, Devinney, Yip & Johnson, 2009). However, despite the introduction of CBK prudential regulations 2006 governing commercial banks in Kenya, there are very few systematic studies that critically assess how regulations have affected the financial performance of commercial banks.

History of Central Bank Regulations

The term prudential regulation refers to central bank regulatory requirements that were first used in the 1970s in unpublished documents of Cooke committees (the precursor of Basel Committees on Banking Supervision) & the banking of England. But only in the early 2000s after two decades of the recurrent financial crisis in the banking industry in emerging markets, prudential approach to regulation and supervisory framework become increasingly promoted. This was done especially by authorities of the bank for International Settlement. A wider agreement on Central bank regulatory requirements relevance has been reached as a result of the late 2000s financial crisis( Clement,2010)

The history of U.S. banking regulation is written largely on the history of government and private response to banking panics. Implicitly or explicitly, each regulatory response is as result of a crisis which is presumed to be the model origin of banking panics. The founding father of US central bank strongly opposed to the formation of the central banking system,the fact that England tried to place the colonies under the monetary control of the bank of England. This was seen by many as the ‘last straw’ oppression which led to direct American Revolution war. The other who was strongly in favor of a central bank was Robert Morris a superintended of France who helped to open bank of Northern America in 1782. He has been called by Thomas Goddard as the father of the system of credit and paper circulation in the U.S. (Financial Stability Oversight Annual Report, 2003)

In the United Kingdom, the first UK Act to put banking regulation on a statutory footing was in 1979. Prior to 1977, there was no regulation of the sector. This was around the same time as EC Directive No 77/780 of 12 Dec 1977(1) intended to promote harmonization in financial services. This Act introduced the requirement for institutions to be licensed in order to accept deposits from the public. It made no attempt to define a bank or “banking business” and its provisions were applicable only to deposit-taking institutions. The 1987 Act significantly increased the BoE’s supervisory rule, including the power to vet shareholders of UK banks. There was an absolute prohibition on the accepting of deposits by a person in the course of carrying on a deposit-taking business, unless that person was an “authorized institution” in the words of the Act as per sec 67(2). Authorization could be revoked or restricted and the Bank had powers of investigation. It established a Deposit Protection Scheme, for the protection of customer accounts, into which the banks paid, which was replaced in 2001 by the Financial Services Compensation Scheme. It contained provisions for the controlled use of banking names and descriptions. An authorized institution was required to report to the Bank if it entered into a transaction relating to any one person as a result it was exposed to the risk of losses in excess of 10 percent of its capital. Regulation of overseas institutions based in the UK was also included in the Act (Clement, 2010).

Before US had a central bank, banks regulated themselves through established private clearing housing resembling the private central banks in other countries to provide both prudential supervision and prevent a local decline in the asset assisting that serves as bank reserve and money (Benston and Kaufman,1996). In the early 70s financial systems were characterized by important restrictions on market forces which included controls on the prices or quantities of business conducted by financial institutions, restrictions on market access and controls on the allocation of finance amongst alternative borrowers. However, in the mid-70s there has been a significant process of regulatory reform in the financial systems of most countries (Biggar & Heimler, 2005).

Prior to the 1980s, bank supervisors in the United States did not impose specific numerical capital adequacy standards. Instead, supervisors applied informal and subjective measures tailored to the circumstances of individual institutions. In assessing capital adequacy, regulators stressed factors such as managerial capability, and loan portfolio quality and largely downplayed capital ratios. Indeed, it is widely held that rigid adherence to fixed capital ratios would preclude the more comprehensive analysis of thoughts that was necessary to weigh the myriad of factors affecting a bank’s ability to sustain the losses. These statements exemplify a judgment-based, subjective; bank-by-bank approach to assessing capital adequacy. The convergence of macroeconomic weakness, more bank failures and diminishing bank capital triggered a regulatory response in 1981 when, for the first time, the federal banking agencies introduced explicit numerical regulatory capital requirements (Beatty & Liao, 2014).

Over the last thirty years, the mandate of central banks around the world has been progressively narrowed to the goal of price stability. This convergence was prompted by the chronic inflation that characterized most advanced economies in the 1970-80s and independent central banks anchored to an inflation target seemed to be the optimal institutional arrangement to the problem of inflation. However, the 2008-09 global financial crisis reopened the debate on central bank design (Alesina and Stella, 2010).

In Kenya, the first and most known milestone of CBK regulatory requirements was based on the Basel Accord of July 1988 which required the major international banks in a group of 12 countries to attain an 8% ratio between capital and risk-weighted assets from the beginning of 1992. Subsequently, the increasing range and sophistication of financial instruments made the limitations of the probably too simple design of the 1988 capital-adequacy framework become apparent. In 1997 the Basel Committee on Banking Supervision sought to enhance further banking supervision in both G10 countries and a number of emerging economies and it released a set of “Core Principles” which set out minimum requirements for banking (Thumbi, 2014).

In 1966, Kenya formed CBK under the Central Bank of Kenya Act. Since the amendment of the Central Bank of Kenya Act in April 1997, the Central Bank operations have been restructured to conform to ongoing economic reforms. There is now greater monetary autonomy. Section 4 of the Central Bank of Kenya Act states the core mandate of the bank as follows: the principal object of the Bank shall be to formulate and implement monetary policy directed to achieving and maintaining stability in the general level of prices; the Bank shall foster the liquidity, solvency and proper functioning of a stable market- based financial system; and the Bank shall support the economic policy of the Government, including its objectives for growth and employment. CBK prudential regulations 2006 for institutions licensed under the banking act were issued under Section 33(4) of the Banking Act, which empowers the CBK to issue guidelines to be adhered to by institutions in order to maintain a stable and efficient banking and financial system. The effective date for implementation of the regulations was 1st January 2006 (Njeule, 2013).

Financial performance of commercial banks in Kenya

Commercial banks propel the entire economy of any nation by transmitting monetary policy impulses to the economic system. During their operation, the banks face competition and other challenges that expose them to risks and therefore the need for bank supervision and regulations. Banking regulation plays a significant role in determining the cost of services of banks as if interests are unregulated it will create a great discrepancy from one bank to another. This aims at is for ensuring stability in the banking industry (Yona & Inanga, 2014).

Financial performance can be defined as how good is the organization performing at the end of the financial year results (Rutagi, 1997). Good financial performance is associated with an increase in profitability and growth. In banking sectors and other financial institutions, there are two important objectives; profit maximization and wealth maximization. In profit maximization, management uses all means available to them which can lead to an increase in firms’ profitability, while in wealth maximization management considers only decisions which will increase the value of the shareholders.

Performance measurement for commercial banks can be done by calculating ratios such as Return on Assets (ROA) and Return on Equity (ROE) as suggested by Murthy and Sree, (2003) and Alexandru et al., (2008). ROA indicates total profit from the bank assets after the deduction of all expenses and taxes. A higher ROA ratio indicates better performance and effective use of the assets while low ratio shows ineffective use of assets (Ross, Westerfield, Jaffe and 2005). 6

This study used ROE as a performance measurement since ROE is more important compared to another ratio because it shows the rate of return to the shareholders who are the owners of the business. ROE ratio is a good measure of performance efficiency because it discloses how much an organization has generated from the amount of money invested by the shareholders. The higher the ROE the better the performance and vice versa, Hassan (1999) and Samad (1999).

Statement of the problem

In recent decades, many countries have experienced banking problems requiring major reforms of the banking systems. The problems are largely due to domestic causes, such as weak banking supervision and inadequate capital. A key part of bank regulation is to make sure that firms operating in the industry are prudently managed(Berg, 2010) Thus, examining the effects of Central bank regulatory requirements in bank financial performance in countries is a critical area of inquiry.

Without sound measures of banking policies across countries and over time, researchers are constrained in assessing which policies work best to promote well-functioning banking systems and in proposing socially beneficial reforms to banking policies in need of improvement. This helps in explaining why the study of the effect of Central Bank regulatory requirements in bank financial performance in Kenya was needed. Various studies carried out on bank regulations across the globe have focused to mitigate the effects of economic crises and lead the stability of the banking system. Naceur and Kandil, (2009) studied the effects of capital regulations on the stability and performance of banks in Egypt for the period 1989-2004 in Egypt.

Despite the introduction of CBK prudential regulations in 2006 governing commercial banks in Kenya, there are very few systematic studies that critically assess how codes have affected the financial performance of commercial banks. These studies include The banking sector regulatory framework in Kenya: Its adequacy in reducing bank failure Obiero, (2002). Financial regulatory structure reform in Kenya and the perception of financial intermediaries in Kenya and Njeule (2013) studied the effects of Central Bank of Kenya Prudential Regulations on the financial performance of Commercial Banks in Kenya.

CBK 2006 regulation spelt out the guidelines and regulations to ensure that there is prudential management in the banking industry. Some of these guidelines relate to licensing of new institutions, corporate governance, capital adequacy requirements, liquidity management, risk classification and asset provisioning, foreign exchange exposure limits, and publication of financial statements among others. Neil’s (2013) study focused on CBK/PG/2 to CBK/PG/6(capital adequacy, liquidity management, risk classification of assets and provisioning, foreign exchange risk exposure and corporate governance) the study also analyzed one of the measures of performance referred to as the ROA. The study concentrated on CBK regulatory requirements two to five (corporate governance, capital adequacy, risk classification asset and provisioning and liquidity management) out of 22 in order to establish the effects of central bank regulatory requirements on commercial bank financial performance (ROA and ROE) in Kenya. The reason for the study to concentrate on these central bank regulatory requirements is that they are based on the CAMEL framework. CAMEL is a widely used framework for evaluating bank performance. The Central Bank of Kenya also uses the same to evaluate the performance of commercial banks in Kenya. Though some alternative bank performance evaluation models have been proposed, the CAMEL framework is the most widely used model and is recommended by Basel Committee on Bank Supervision and IMF also it. In all the studies cited, it was evident that the findings were conflicted with studies from different regions providing different conclusions. This study, therefore, sought to investigate the effects of central bank regulatory requirements on the financial performance of commercial banks in Kenya hence the research gap that the current study sought to fill. This study was built on the premise that the passage of time and the numerous and significant changes in the commercial banks’ operating environment have led to the different operating environments after the central bank regulatory requirements.

Objectives of the study

General Objective

The effects of central bank regulatory requirements on the financial performance of commercial banks in Kenya.

Specific objectives

To establish how interest rate capping affects the performance of Kenya Commercial Bank.
To establish the effects of capital requirements on the financial performance of commercial banks in Kenya.
To assess the effects of credit risk management on the financial performance of commercial banks in Kenya.
To determine the effects of liquidity management on the financial performance of commercial banks in Kenya.

Research Questions

How does interest rate capping affect the financial performance of listed commercial banks in Kenya?
What is the effect of liquidity management regulation on the financial performance of listed commercial banks in Kenya?
What is the effect of credit risk management regulation on the financial performance of listed commercial banks in Kenya?
Does capital requirement regulation affect the performance of commercial banks in Kenya?

Justification of the study

The findings of this study shall contribute more knowledge expansion concerning banks regulations and the performance of commercial banks in Kenya, after investigating the following three regulations, liquidity management, capital adequacy and credit risk management. The following among others will benefit more from the study:

Information is provided not only to the commercial bank’s management team only but also to financial institutions in general which offers almost similar services as banks. Management will use that information to know how regulations affect the operations of the organization and hence be able to identify the areas which are doing well or poorly then take appropriate action. Management of other financial institutions will find this research important and hence use it as a benchmark in performance improvement.

Central Bank of Kenya being a financial institution supervisor will be able to know how commercial banks are performing after the implementation of the new regulations and guidelines. That is, are they improving growth and the stability of the banks which is the main objective of formulation of those regulations or not. Other regulatory agencies such as Capital Markets Authority (CMA) and Kenya Bankers Association (KBA) will also asses the performance after the implementation of the new regulations.

A lot of government attention in the banking sector is on the vision 2030 achievement of Kenya being Centre of Finance in eastern and southern Africa. So, the Government of Kenya will benefit more from this study as it will know if the commercial banks in Kenya are performing towards that end.

Investors will also use this information to know how is their investments in banks being protected by the new regulations issued by the CBK, like in the case of capital requirement which can compensate them if the bank encounters performance problems. From that information, investors will be able to make right decision on whether to continue investing or leave that investment portfolio to another one.

This study will help academicians who want to know more about the effect of bank regulations on financial performance. Also, the information contained in this study will be used by other researchers who want to add more knowledge in this area.

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