At the end of August, Kenyan President Uhuru Kenyatta shocked the domestic banking sector by signing into law a bill 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 will now 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 will 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 US$300m to improve access to capital for small- and medium-sized enterprises at concessionary rates.

In addition, banks agreed that, in order to encourage competition in the sector, they would no longer charge customers who close their accounts. These concessions were insufficient to encourage the finance ministry to investigate market-based solutions to Kenya’s high credit costs.

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 sees these high returns as having been at the expense of consumers and businesses.

The Kenyan banking sector has endured a tumultuous few quarters. In June last year, when Patrick Njoroge took over as the central bank governor and introduced a much tighter, rules-based supervisory regime, three institutions were placed in receivership. 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 have resulted in the deterioration of some banks’ financial positions.

Kenya faces some of the same problems as many African countries. Because assessing credit worthiness is not straight-forward, it is difficult to calculate what level of provision for NPLs is prudent, and what 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 NPLs provision. The key issue is that the banking sector is overpopulated. There are simply 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. A degree of consolidation in the banking sector should support financial stability, and also allow for a regulatory framework that encourages more autonomy in the banking sector while ensuring prudent practices.

Unforeseen consequences

The new legislation appears positive from a consumer and business perspective, but, because returns are less likely to warrant the risks, banks could be forced to remove high-risk borrowers from their loan books. That said, the country faces the very real problem of excessive credit costs. 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 and 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 encourage a significant increase in capital invested in government paper due to the limited risk, reducing public debt yields until market conditions warrant a return to riskier lending.

Furthermore, if policy decisions have a direct (and sometimes counterproductive) impact on banking operations, the central bank could be burdened in its mandate of maintaining price stability while fostering a stable financial system. 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 considerable, if less tangible, downside risks. These include 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.

Jacques Nel is the head analyst for the East Africa region for NKC African Economics. 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.