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The Effect Of Monetary Policy On The Financial Performance Of Commercial Banks In Kenya




Monetary policy is one of the principal economic management tools that the government uses to shape economic performance. The government through the Central Bank uses monetary policy tools like open market operations, central bank rate and cash reserve ratio for commercial banks with the objective of managing multiple monetary targets among them price stability, promotion of growth, achieving full employment, smoothing the business cycle, preventing financial crises, stabilizing long-term interest rates and the real exchange rate. Commercial banks act as a mediator for the Central Bank in implementing these tools and hence the basis for this study. This study was carried out with the following objectives; to establish the effect of Central Bank‟s open market operations on the financial performance of Commercial Banks; to establish the effect of Central Bank Rate (CBR) on the financial performance of Commercial Banks and to establish the effect of Reserve Ratio Requirement on the financial performance of Commercial Banks. The study adopted descriptive research design. The target population of this study was commercial banks operating in Kenya and regulated by the Central Bank of Kenya as at 31st December 2014. For the purpose of this study, only secondary data was used. The secondary data was sourced from the Financial Statements of the commercial Banks that are available from their websites and Central Bank of Kenya Publications. Data was collected for a period of five years from 2010 to 2014. Data was analyzed using Statistical Package for Social Sciences (SPSS) version 16. The study then used descriptive statistics and inferential statistics to establish the relationship between monetary policies tools and the financial performance of commercial banks in Kenya. The study used Net Interest Margin as the measure for financial performance for the banks. The results showed that the model explained 17.7% of the variance in financial performance of commercial banks as given by the value of R2. The model was also fit to explain the relationship as the F-Statistic of 5.581 was significant at 5% level, p=0.000. The study established that monetary policy tools as represented by open market operation β=0.506, p=0.608, CBR, β=-0.221, p=0.687, and cash reserve ratio, β=-4.349, p=0.622, have no significant effect on the financial performance of commercial banks in Kenya. Bank size was however found to have a weak positive effect, β = 0.009, p <0.0, on financial performance of commercial banks in Kenya. The study concludes that monetary policy tools employed by the central bank of Kenya do not have a significant effect on the financial performance of commercial banks in Kenya. The study therefore recommends that commercial banks need to focus more on the internal factors that affect financial performance of commercial banks as have been identified in other studies. The study further recommends that commercial banks should focus on monetary policy changes to the extent of complying with the Central Bank guidelines and adjusting their variables accordingly. This is a matter of management efficiency.



1.1 Background of the Study

According to the Central Bank of Kenya, A commercial bank means a company which carries on, or proposes to carry on, banking business in Kenya and includes the Co-operative Bank of Kenya Limited but does not include the Central Bank of Kenya (CBK). Commercial banks in Kenya are licensed, supervised and regulated by the Central Bank of Kenya (CBK) as mandated under the Banking Act (Cap 488).

The environment in which commercial banks operate is constantly changing with different factors influencing their operations and hence performance. Since the turn of the millennium, the general business environment has become more volatile, unpredictable and very competitive, Pearce and Robinson (2005). Coping with the increasingly competitive environment has called on commercial banks to rethink their strategies. Commercial Banks must realize that their services and products, regardless of how good they are, will not simply guarantee good financial performance.

Recent trends in technology, financial innovations and globalization are certainly posing new challenges for market participants in the Kenyan financial sector. To this extent, advances in computer technology and telecommunications are expanding the frontiers of electronic banking and internet based financial services. In addition, local banks have continuously sought to establish branches in other East African countries. This leads to the banks been exposed to different environments in terms of regulations, market size, markets rates, etc which are country-specific. All those developments would surely have implications on the costs and revenues and hence the profitability of the commercial banks in the Kenyan banking industry.

During the 2015/16 Budget presentation by the Kenyan Cabinet Secretary to the National Treasury and the subsequent Finance Bill, Commercial Banks in Kenya have been given up to 2018 to increase their minimum core capital to KES 5 Billion from the current requirement of KES 2 billion. The Central Bank of Kenya through it Monetary Policy Committee has raised the Central Bank Rate in two consecutive meetings.

The understanding of the monetary policies in the home country and also the country of operation by the commercial bank would not only be useful for sustaining high profitability but would also be essential for the survival of these commercial banks by enabling them to hedge against the adversities of external shocks.

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1.1.1 Monetary Policy in Kenya

The first decade after independence can be characterized as passive in the conduct of monetary policy in Kenya, mainly because no intervention was necessary in an environment of 8% GDP growth and below 2% inflation rate (Kinyua, 2001). The first major macroeconomic imbalance arose in the second decade in the form of 1973 oil crisis and the coffee boom of 1977/78. This came at a time when the fixed exchange rate system had just collapsed with the Britton Woods System in 1971. In these first two decades, monetary policy was conducted through direct tools which were cash reserve ratio, liquidity ratio, credit ceilings for commercial banks, and interest rate controls.

The 1990s brought about the liberalization of the economy where interest rate controls were removed and exchange rate made flexible, ushering in a new era in monetary policy where open market operations (OMO) was the main tool. This was a period characterized by high interest rates and widening interest spread, which inhibited the benefits of flexible interest rate policy such as increasing financial savings and reducing cost of capital. Competing against double digit inflation rate spurred on by excessive money supply and accommodation of troubled banks, CBK used indirect tools to tame inflation in an atmosphere of instability and extreme uncertainty. In 1996, the CBK Act was amended and this allowed the CBK to shift from targeting broad money to targeting broader money as the principal concept of money stock, (Kinyua, 2001).

The CBK operates under a monetary policy programming framework that includes monetary aggregates (liquidity and credit) targets that are consistent with a given level of inflation and economic growth. According to the Monetary Policy Statement (2014), overall month-on-month inflation remained within the Government target bounds during the second half of 2014 except in July and August 2014. This reflected the success of the monetary policy stance adopted by the Monetary Policy Committee (MPC) in the period. Specifically, overall inflation rose from 7.39 percent in June 2014 to 8.36 percent in August 2014 mainly reflecting increases in the prices of energy and most foodstuffs. However, it declined gradually thereafter to 6.02 percent in December 2014 mainly reflecting the indulgence of the base effect attributed to the implementation of the VAT Act in September 2013 and decreases in prices of energy and some food items. The 12-month non-food-non-fuel inflation, which measures the impact of monetary policy, remained stable below the 5 percent target in the second half of 2014 indicating that there was no significant demand driven inflationary pressure or threat to the economy. The threat of imported inflation was dampened by the significant decline in international oil prices during the period.

Despite the temporary pressures on most international currencies reflecting the global strengthening of the US Dollar, the exchange rate of the Kenya Shilling against the US Dollar maintained its stable trend during the year 2014. The Kenya Shilling strengthened, on average, against the other major international currencies and regional currencies. The strengthening of the US Dollar partly reflects the strong performance of the US economy and changing expectations on the timing of the first US interest rate increase coupled with weak growth in the Eurozone. The Kenya Shilling continued to be supported by the resilient foreign exchange inflows through diaspora remittances, increased net purchases of equity by foreign investors in the Nairobi Securities Exchange (NSE), and sustained confidence in the economy reflected in the massive over-subscription of the Sovereign Bond that was re-opened on tap in December 2014. Interventions by the Central Bank of Kenya (CBK) through direct sales of foreign exchange to commercial banks stopped short-term volatility in the period.

The movements in short-term rates were generally aligned to the Central Bank Rate (CBR) while Open Market Operations continued to support liquidity management during the period. The MPC retained the CBR at 8.50 percent in the second half of 2014 to continue anchoring inflationary expectations and maintain the desired price stability objective.

1.1.2 Financial Performance

Financial performance measurement generally looks at firms‟ financial ratios (derived from their financial statements) such as liquidity ratios, activity ratios, profitability ratios, and debt ratios. The financial performance of commercial banks is measured through its profitability. There are various profitability measures that are used to measure the performance of commercial banks such as the Net Interest Margin (NIM), the Return on Assets (ROA) and the Return on Equity (ROE).

The Net Interest Margin is a measure of the difference between the interest income generated by banks from their loans and the amount of interest paid out to their lenders (for example, deposits), relative to the amount of their (interest-earning) assets. It is usually expressed as a percentage of what the financial institution earns on loans in a specific time period and other assets minus the interest paid on borrowed funds divided by the average amount of the assets on which it earned income in that time period (the average earning assets). The NIM variable is defined as the net interest income divided by total earnings assets (Gul et. al., 2011).

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Net interest margin measures the gap between the interest income the bank receives on loans and securities and interest cost of its borrowed funds. It reflects the cost of bank intermediation services and the efficiency of the bank. The higher the net interest margin, the higher the bank’s profit and the more stable the bank is. Thus, it is one of the key measures of bank profitability. However, a higher net interest margin could reflect riskier lending practices associated with substantial loan loss provisions (Khrawish, 2011).

The Return on Equity (ROE) is a financial ratio that refers to how much profit a company earned compared to the total amount of shareholder equity invested or found on the balance sheet. ROE is what the shareholders look in return for their investment. A business that has a high return on equity is more likely to be one that is capable of generating cash internally. Thus, the higher the ROE the better the company is in terms of profit generation. It is further explained by Khrawish (2011) that ROE is the ratio of Net Income after Taxes divided by Total Equity Capital. It represents the rate of return earned on the funds invested in the bank by its stockholders. ROE reflects how effectively a bank management is using shareholders‟ funds. Thus, it can be deduced from the above statement that the better the ROE the more effective the management in utilizing the shareholders capital.

The Return on Assets (ROA) is another financial ratio that refers to the profitability of a firm. It is a ratio of Income to its Total Assets (Khrawish, 2011). It measures the ability of the firm management to generate income by utilizing company assets at their disposal. In other words, it shows how efficiently the resources of the company are used to generate the income. It further indicates the efficiency of the management of a company in generating net income from all the resources of the institution (Khrawish, 2011). Wen (2010), state that a higher ROA shows that the company is more efficient in using its resources.

1.1.3 Effect of Monetary Policy on Financial Performance

The overall aim of the Monetary Policy is to set monetary policy targets that would ensure low and stable inflation, encourage growth, support long-term sustainability of public debt through stable interest rates and, by enhancing financial access within the economy, contribute to lowering the cost of doing business (MPS, 2014).

The CBK through, through Open Market Operations, purchases and sales of eligible securities to regulate the money supply and the credit conditions in the economy. OMO can also be used to stabilise short-term interest rates. When the Central Bank buys securities on the open market, it increases the reserves of Commercial banks, making it possible for them to expand their loans which increase the money supply. This thus means Commercial Banks can expand their loan book and thus increase in their profits.

The CBR is the lowest rate of interest charged on loans to commercial banks by the CBK. The level of the CBR is reviewed and announced by the Monetary Policy Committee (MPC) at least every two months and its movements, both in direction and magnitude, signal the monetary policy stance. An increase in the CBR signals an increase in the banks‟ lending rates hence a tightening of the banks‟ loan books. This is expected to reduce the banks‟ profitability.

The CRR is the proportion of a commercial bank‟s deposit liability which must be deposited at CBK. These deposits are held in the CRR Account at no interest. A reduction in the CRR releases liquidity thus enhancing the capacity of commercial banks to expand credit. This then is expected to increase interest income to the banks and hence increased profitability. An increase in the CRR tightens liquidity and could also dampen demand-driven inflationary pressures.

1.1.4 Commercial Banks in Kenya

The Companies Act, the Banking Act, the Central Bank of Kenya Act, the Kenya Bankers Association and the various guidelines issued by the Central Bank of Kenya (CBK), governs the Banking industry in Kenya. The banking sector in Kenya was liberalized in 1995 and exchange controls lifted. The CBK, which falls under the Cabinet Secretary to the National Treasury docket, is responsible for formulating and implementing monetary policy and fostering the liquidity, solvency and proper functioning of the financial system. The Central Bank of Kenya acts as the main regulator of commercial banks in Kenya (CBK Annual Report, 2014).

The banking industry in Kenya is composed of 43 Commercial Banks with 10 of them listed at the Nairobi Securities Exchange, 24 being locally owned and 4 being foreign owned. The banks have come together under the Kenya Bankers Association (KBA), which serves as a lobby for the banks‟ interests and addresses issues affecting member institutions. The commercial banks offer corporate and retail banking services with of late most of the banks starting to offer other services including investment banking and insurance products.

The banking sector plays a significant role in the implementation of government monetary policy. One of the key services rendered by banks is offering credit to the members of public. The rate at which members of the public are able to access loans and the amounts available for banks to lend, are highly guided by the CBK regulations. The banks also participate in purchase of government securities for example treasury bills and bonds which are aimed at raising funds for the government and maintaining low inflation levels. CBK also acts as a lender of last resort for commercial banks and hence the rate at which banks access credit influences the rate at which they offer credit to the members of the public.

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1.2 Research Problem

Monetary policy is one of the principal economic management tools that governments use to shape economic performance. Measured against fiscal policy, monetary policy is said to be quicker at resolving economic shocks. Monetary policy objectives are concerned with the management of multiple monetary targets among them price stability, promotion of growth, achieving full employment, smoothing the business cycle, preventing financial crises, stabilizing long-term interest rates and the real exchange rate. Experience shows that emphasis is usually placed on maintaining price stability or ensuring low inflation rates.

The Central Bank of Kenya is responsible for the recommendation and implementation of monetary policy tools in Kenya. The CBK recommends the CRR, CBR and Treasury bill rates. Those tools are implemented through commercial banks and they are aimed at stabilizing the price levels in the economy. The use of cash reserve ratio affects the level of liquidity in the commercial banks. When commercial banks are faced with limited liquidity, they turn to other commercial banks for inter-bank borrowing. Those funds are borrowed at the CBR and it is usually very high, which affects the interest expense for the borrowing bank and the interest income for the lending bank. The other way to increase liquidity in the bank will be to borrow by floating a debt instrument. The rate offered for the debt instrument is also tied to the treasury bills or treasury bonds issued by the government through the Central Bank. These effects of the monetary tools are expected to have an effect on the financial performance of commercial banks.

Several research studies have been done in relation to commercial banks in Kenya: Gitonga (2010) studied the relationship between interest rate risk management and profitability of commercial banks in Kenya; Kimoro (2010) did a survey of the foreign exchange reserves risk management strategies adopted by the Central Bank of Kenya and Mbotu (2010) did a study on the impact of the Central Bank of Kenya rate (CBR) on commercial banks‟ benchmark lending interest rates. Ongore and Kusa (2013) study examined the effects of bank specific factors and macroeconomic factors on the performance of commercial banks in Kenya during the period from 2001 to 2010. Kiganda (2014) carried out a study on effect of macroeconomic factors on the profitability of commercial banks in Kenya with a focus on Equity Bank.

This study has identified a gap in the current literature and research with respect to monetary policy and its effect on financial performance of commercial banks. The literature reveals that while there is much effort by the government to influence the money supply by instituting various policy tools, an analysis on the effects of those tools on Commercial Banks‟ financial performance, which are the most used channel of transmission of the policies, is inconclusive. This study will therefore be motivated to fill the knowledge gap on effects of the various monetary policy tools on financial performance of commercial banks in Kenya with firm size as the control variable. The following research question will therefore be explored: What is the effect of monetary policy on the financial performance of commercial banks in Kenya?

1.3 Objectives of the study

The general objective of the study is to determine the effect of monetary policy and the financial performance of Commercial Banks in Kenya.

The specific objectives are as follows:

  1. To establish the effect of Central Bank‟s open market operations on the financial performance of Commercial Banks.
  2. To establish the effect of Central Bank Rate (CBR) on the financial performance of Commercial Banks.
  3. To establish the effect of Reserve Ratio Requirement on the financial performance of Commercial Banks.

1.5        Value of the study

While this study may be of value to any person interested in monetary policies, it is anticipated that its findings will specifically benefit the following groups of people.

Investors will be in a position to utilize the research findings and recommendations from the study to forecast the financial performance of Commercial Banks and rebalance their portfolios accordingly given the changes in monetary policy tools.

The study is expected to contribute to the existing literature in the field of monetary policies. Future scholars can use this research as a basis for further research in the area of monetary policy theories.

The study will also enlighten management teams of commercial bank on the short-term and long-term effects of the monetary policy implementations by the Central Bank. This will greatly help them in designing the risk management measures to employ given anticipated changes in monetary policies.

Pages:  70

Category: Project

Format:  Word & PDF               

Chapters: 1-5                                          

Source: Imsuinfo                                     

Material contains Table of Content, Abstract and References.


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