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TOOTHLESS DOG: CBK monetary policies ineffective in downing commercial banks lending interest rates

The Central Bank of Kenya (CBK) principal objective is the formulation and implementation of monetary policy which is directed at achieving and maintaining stability in the general level of prices. CBK has been on the forefront in formulation of monetary policies but has utterly lagged behind in the implementation of those policies.

The Monetary Policy Committee (MPC) met on May 23, 2016, to review recent economic developments, and the outlook for the domestic and global economies. Their analysis concluded that there was policy space for an easing of monetary policy and therefore decided to lower the Central Bank Rate (CBR) by 100 basis points to 10.50% from 11.50%.

Bravo to the MPC for taking such a strategic move in the wake of falling local inflation figures – month on month inflation fell from 6.5% in March to 5.3% in April 2016. Though the move to lower CBR will be welcomed by economists, its ability to feed into the local economy and spur economic growth may be questioned by critical economic analysts.

Also Read: Kenya Financial Status: Has Jubilee Government Made us Poorer or Richer?

To understand the critical analyst perspective, we have to look at the expected implication of such a move in the local market. The essence of lowering the CBR rate is to create a chain effect that would eventually end with the consumer getting lower interest rates on loans from local commercial banks. The converse is also true; increasing the CBR rate would have an overall effect of increased interest rates on bank loans in the local economy.

Section 36 (4) of the Central Bank of Kenya Act stipulates that the central bank shall publish the lowest rate of interest it charges on loans to banks and that rate is the CBR rate. Therefore, lowering the CBR rate clearly indicates that commercial banks can get cheaper loans from the regulator.

The lower borrowing costs for commercial banks should feed into the local market through lowered interest rates on loans but this may not be the case. CBR rate was ineffective in the past in feeding monetary policy stance into the market hence Kenya Banks’ Reference Rate (KBRR) was formulated. KBRR was to compose of the CBR rate and 91 day Treasury bill six month moving average and was to be the benchmark which commercial banks used to price their loans. KBRR was formulated to tighten the lag between CBK monetary policy changes and its desired effect in the market but it has also had questionable effectiveness in the market.

Ineffectiveness of CBK monetary policy arises from how commercial banks price interest on loans rather than from CBK’s actual monetary policy move on interest rates. Commercial banks add overhead costs as a percentage to the KBRR or CBR to arrive at the commercial bank lending rate. This is a black box that CBK cannot regulate since overhead costs vary from bank to bank.

Commercial banks exploit the overhead costs opportunity to manipulate interest rates in their favor. This exploitation can be observed in the divergence of the CBR rate and commercial bank lending rates in the graph below.


CBR Vs Commercial Banks Average Lending Rates

From July 2015 (black vertical line on graph) to February 2016, CBR rate was held steady at 11.50% but commercial banks weighted average lending rate fluctuated between 15.00% and 18.00%. The graph highlights the concern that the desired effect by CBK monetary policy may not be transmitted to the local economy.

CBK can do more than just barking by implementing policies that will increase effectiveness of its influence in the local market. One of the solutions is to increase monitoring of commercial banks lending activities. One can note that banks are notorious for increasing rates when CBR moves up but are very reluctant to lower their rates when the CBR moves downwards. Penalties for violations on CBR compliance can also be an effective means to tame the rates manipulation malady.

The other option for the regulator may be to put a periodic cap on the commercial banks lending rates. The periodic cap would allow the regulator to maximize on the advantages of an interest rate cap and minimize on the drawbacks of an interest rate cap.

Faster transmission of CBK monetary policies may be actualized by the implementation of some of the above stated policies. This will spur economic growth as the local market would be in tandem with shifting dynamics of local, regional and international markets.

Also Read: Expected Impact of US Rate Hike On Emerging Markets

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Posted by Timothy II Aperit

True believer in numbers. Statistics never lie. Bsc Financial Engineering MBA Finance ACCA