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# DETERMINANTS OF INTEREST RATE VOLATILITY IN COMMERCIAL BANKS IN KENYA

DETERMINANTS OF INTEREST RATE VOLATILITY IN COMMERCIAL BANKS IN KENYA

TOC o “1-3” h z u HYPERLINK l “_Toc340159629” CHAPTER ONE: INTRODUCTION PAGEREF _Toc340159629 h 3

HYPERLINK l “_Toc340159630” 1.1 Background of the Problem PAGEREF _Toc340159630 h 3

HYPERLINK l “_Toc340159631” 1.1.1 Commercial Banks in Kenya PAGEREF _Toc340159631 h 4

HYPERLINK l “_Toc340159632” 1.2 Statement of the Problem PAGEREF _Toc340159632 h 5

HYPERLINK l “_Toc340159633” 1.3 General Objective PAGEREF _Toc340159633 h 6

HYPERLINK l “_Toc340159634” 1.3.1 Specific Objectives PAGEREF _Toc340159634 h 6

HYPERLINK l “_Toc340159635” 1.4 Research Questions PAGEREF _Toc340159635 h 6

HYPERLINK l “_Toc340159636” 1.5 Significance of the Study PAGEREF _Toc340159636 h 7

HYPERLINK l “_Toc340159637” 1.6 Scope of the Study PAGEREF _Toc340159637 h 7

HYPERLINK l “_Toc340159638” 1.7 Definition of Terms PAGEREF _Toc340159638 h 7

HYPERLINK l “_Toc340159639” REFERENCES PAGEREF _Toc340159639 h 8

CHAPTER ONE

INTRODUCTION

Background of the ProblemInterest rate is a common word in the financial world and always refers to the cost of borrowing money; it always sums up to the price that a borrower pays in exchange for borrowed financial asset to the lender which may be an individual, financial institution. The borrower must compensate the lender for the opportunity cost of their financial assets which may include their own consumption. In financial terms, the initial amount borrowed is referred to as principal and the additional amount which may be calculated as a percentage of the principal and is payable over a period of time is called interest. The percentage rate of estimating interest over stipulated time period is termed as interest rate (Thygersa, 1995). Interest rate is a price similar to the price of any other commodity and it involves transactions (Saunders, 1999). The only special thing about this type of price is that it deals with credit transactions or deposits, loan transactions and involves lender or saver relationship in which case there is supply of surplus funds (Bikbov & Chernov, 2004).

According to Saunders (1999), interest rate is a price, and like any other price, it relates to a transaction or the transfer of a good or service between a buyer and a seller. This special type of transaction is a loan, credit transaction or deposit, involving a supplier of surplus funds, that is, a lender or saver, and a demander of surplus funds, that is, a borrower (Bikbov & Chernov, 2004). Interest rate enhances saving on one side due to expected return while on one side it help in defraying the lending cost.

A number of reasons lead to the use of interest rate in acquisition of financial assets. Top in the list is the issue of deferred payment. In regard to the time preference theory, people tend to exhibit preference on present consumption to future and this explains the positive rate of interest in a free market. This therefore means that interest rate is the price gained from deferred consumption. The effect of inflation expected by individuals will initiate an action of charging interest due to the loss in purchasing power of money with time. To compensate for this, the lender imposes an interest charge to the borrower. The opportunity cost incurred by the lender on the other alternative investments (Weth, 2002) on which the finances can be directed makes the financial assets owners to charge some interest as the return from lending. Chances are there that the borrower may default in repayment or bankrupt and for the lender to cushion his/her risk interest must be charged on the borrowed asset. The monetary and fiscal policies of the state may push financial asset owners to pay taxes and this they may take care of through transfer to the borrowers in the form of raised interest rates (Buiter, 2009).Last but not least, the theory of liquidity preferences tend to compel people to convert their resources to items that can easily be cashed and this is where role of interest on borrowed money comes in.

Rate of interest is important in explaining expected market trend in respect to the expected changes in the future inflation or purchasing power of money. It gives information about the risks of fall and rise in economic activities, changes in maturity preferences of bondholders, financial credit ratings, and the trend in stock market (DeBondt, 2002).Changes in the interest rates results from various economic activities occasioned by local and global financial market crises, inflation, government policy and the long term economic growth prospects. It is worth note that economic cycles are irregular. Due to such factors, interest rates are fairly sensitive to economic cycle’s stages, contractionary and expansionary economic phases over time (Bikbov & Chernov, 2004).It should be noted commercial banks play a vital in minimizing the problems of moral hazards and adverse selection which tends to be very rampant in the financial transactions executed directly.

These banks help in assessment and evaluation of loans which their prices may not be gauged accurately by financial market players (DeBondt, 2002). This they can achieve due to wealth of skilled manpower that has wide knowledge on financial assets liquidity and maturity. Economic growth hinges on savings and this role is played well by commercial banks and other non-banking financial institutions that mobilize, diversify and help in pooling of risks and resources allocations. Due to lack of synchronization of the loans and deposits receipts by the financial institutions, they impose some interest on the deposits and loans due to the associated uncertainties and risks. The interest charged is the cost incurred by the financial institution and they entails operational costs, default costs, administrative, transactional and information costs (Ghazali & Ali, 2002). This explains why commercial banks are the common casualties of interest rate fluctuations. It is important to understand that the rise in interest rates raises the cost of borrowing and this discourages applications for loans and a fall in mortgage demands. Besides, rising interest rates may trap some borrowers in default and this incurred by the financial institutions (Ghazali & Ali, 2002).According to Flannery (1981) banks risk market interest rate fluctuation in two ways. One of them is the imbalanced lending and borrowing balances experienced by the banks which tend to dump them in expensive transactional costs when the interest rates hikes. Rise in rate of interest creates inflationary pressure in the economy characterized by increased cost of production which translates to reduction in earnings before interest and taxes. In some occasions EBIT may not cover the interest expenses and this means zero repayment; this may also lead to liabilities outweighing assets with the effect of debt default occurrence (Merton, 1974). The inflationary upward push of both nominal and asset market value may not be sufficient to overcome the rising interest rates. According to Hoque and Hossain (2008), in the event that EBIT is not sufficient to create any net profit that is after taxes and interest rate payments. On the other side of the coin, lower interest rates discourages savings as people tend to engaging in present consumption and this discourages investment in the economy. This is a simple economic concept that is easily observable in the sense that expected future return will seem worthy today than a future date hence preferred present consumption and less saving (Weth, 2002).

Information asymmetry that prevails between the lender and borrower has significantly influenced the interest rate charged by banks across the globe. The major cause of this is market imperfections in the developing countries. Questionable credit worthiness of most borrowers leads to demand for collateral back up by banks which in most cases is always overstated explains the inefficiency experienced at the financial institution. In this regard, most of these banks are used to high interest rates which is quite counterproductive as it necessitates failure to honor loan repayment obligation by the borrowers (Bikbov & Chernov, 2004).

1.1.1 Commercial Banks in Kenya

In Kenya, the banking industry is constituted of the Central Bank of Kenya (CBK), as the main regulatory authority and the regulated; commercial banks, non-bank financial institutions and foreign exchange bureaus. By the year 2011 this banking sector comprised 44 institutions, 43 of these were licensed commercial banks with a lone mortgage finance company. Out of the 44 commercial bank institutions, 31 were domestically owned and the rest 13 were owned by foreigners. The financial institutions owned locally comprised 3 banks with substantial government shareholding, 27 commercial banks are in private ownership and 1 mortgage finance companies (MFCs). The financial institutions under foreign ownership comprised 8 locally incorporated foreign banks and incorporated banks which are 4 (CBK, 2012).

In Kenya, CBK is the lender to commercial banks as the banks’ lender of last resort and as such is a principal determinant of the final rates of interest on borrowing and mortgages. Interest rates formulation is managed by by Monetary Policy Committee (MPC) of the CBK (Kiragu, 2012). The Kenyan government through central bank has reformed banking to ensure it is internationally competitive from a suppressive control policy intervention to a liberated industry in 1992 and comprehensive reforms in 2003. In mid-2007, the government raised minimal bank capital from Sh250 million (\$3.1 million) to the tune of Sh1 billion (\$12.5 million) by early 2010. In addition, two Sharia-compliant commercial banks, that are First Community and Gulf African, were issued with license in 2007. Historically, from 1992 until early 2012, average interest rate hit 15.1% reaching an all time high of 84.7% in the financial year of 1993 and a record lowest average interest of 0.8% in September of 2003 (CBK, 2012).

The Kenyan economy has survived through steep inflationary pressures foreign exchange depreciation for about 9 months in the year 2011. This was ne by buildup in inflationary pressures in 2011, then the onset of exchange rate depreciation in April 2011 and the corresponding rise in interest rates. Inflation jumped from around 4.51% in January to 19.7% by later 2011. Kenya’s shilling depreciated from about Ksh. 80s to over Ksh. 107 to the US dollar in October 2011. To solve these monetary problems, the CB increased the Central Bank Rate (CBR) to 11% in October 2011 and further to 16.5% in December. Commercial Banks increased their lending rates between >20% and <25% which set rate of interest on a ‘roller coaster’ (Parliamentary Service Commission, 2011).

1.2 Statement of the Problem

It is worth to not that efficiency in financial intermediation is a significant factor in economic development process since it has implication for effective mobilization of investment resources (Bordo, 2008). A stifled financial system in a country is viewed as a deterrent to economic growth as it promotes inefficient allocation of resources (with credit controls and distorted price indicators); this curtails local resource mobilization (with interest rates set at low levels). It, hence, makes the economy to depend on foreign savings and supports fiscal and monetary indiscipline as the government obtains nearly zero-interest-denominated economic resources to finance its deficit. Therefore, with financial liberalization policy, greater efficiency in the financial industry stimulates savings, investment (hence economic growth) and enhances commercial bank lending to the people (Ghazali & Ali, 2002).

However, financial liberalization will bring with it interest rate spread and volatility which indicates the underlying weak institutional and policy set-up of the financial sector (Kiragu, 2012). When ceilings on lending rates is not there, it is easier for banks to charge a higher risk premium and therefore to award loans to more risky projects. This raises the rate of bank insolvency the volume of non-performing assets increase (Weth, 2002). As a result, banks attempting to cushion their profit margins by charging high interest rates on the performing loans (Bordo, 2008). While rate of interest and volatility have been used to evaluate its impact on economic growth and development, very little research have sought to establish what factors influence this interest rate sensitivity.

Kenya has had one of the erratic increases in the interest rates. In 2011, CBK increased its base lending rates from 5% in January to 11% in October and 16.5% in December; effectively increasing banks’ lending rates to between 20-25%. While this was meant to curb the inflation, which increased to 19.7% in November from 4.51% in January, it had implications on the consumer and company borrowing and savings (Parliamentary Service Commission, 2011 and Okoth, 2011). Nonetheless, interest rate is an important monetary policy tool in modern economies. Their roles in savings mobilization and investment expansion are robustly documented especially in developed world (Weth, 2002). However, the dearth of studies on the determinants of interest rate volatility in Kenya provides the justification for this study.

A study on the impact of interest rate spread (Ngetich, 2010) on non-performing loans established a positive relationship between the two variables. According to Mukami (2012), the impact of interest rate sensitivity on credit borrowing does adversely affect borrowing. However, no study has been carried out, in Kenya, to establish the determinants of interest rates sensitivity in commercial banks. This study seeks to fill-in this knowledge gap.

1.3 General ObjectiveThe research study seeks to establish the determinants of interest rate volatility in Commercial banks in Kenya

1.3.1 Specific Objectives

The objectives of the proposed study are:

To determine the effect of government policies and regulations on commercial banks’ interest rate volatility in Kenya

To investigate the effect of customer attributes on commercial banks’ interest rate volatility in Kenya

To evaluate the effect of commercial banks’ policies on their interest rate volatility in Kenya

1.4 Research Questions

The study will answer the following research questions:

How do government regulations and policies affect commercial banks’ interest rate volatility in Kenya?

What is the effect of customer attributes on commercial banks’ interest rate volatility in Kenya?

How do commercial banks’ policies affect their interest rate volatility in Kenya?

1.5 Importance of the StudyThe results of this research study will be useful to the students and researchers by contributing to the existing body of knowledge in the area of finance and economics especially interest rate volatility. Academic scholars may use findings from this experiment for further research as a reference point and for literature and even empirical purposes. In that respect, the study will provide a ground for further research in the area of commercial banks’ interest rate volatility issue.

The study will be of great help to commercial banks’ management and other non-bank financial institutions in Kenya and elsewhere as it will assist them in pointing out the causes of interest rate increments or decrease. By extension, the research study’s findings might help the management in formulation of interest rates policies and in solving cases related to external or exogenous factors affecting rate of interest. The study will be of great value to the government (CB) in setting up their central bank rate (CBR) and other macro-economic policies (both fiscal and monetary) that may be instrumental in helping stabilize interest rates and spur macro-economic growth. This would help boost commercial banks’ performance.

The interest of the general public and the various financial institutions will be taken care of the research study and this will have a trickledown effect on the general public and specifically commercial banks’ customers as the study seeks to illuminate causes of interest rate volatility, hence, recommend on ways of ensuring that such fluctuations do not occur at the expense of consumers nor have adverse effects on the country’s economic growth. Stabilized interest rates would also change the bad perception that the public have on commercial banks thus lead to financial deepening and subsequent access to financial services. Interest rate is the cardinal revenue sector for commercial banks in any country. The findings of this investigation will provide in-depth information on the factors determining the interest rates volatility. Thus, prospective and current investors can use the findings and recommendations there-to to improve banks’ performance. Consequently, if the research findings are properly utilized, commercial banks investors and or shareholders stand a chance to gain value for their investments.

1.6 Research Design/ScopeThe research study investigates the determinants of interest rate volatility. The study will focus on government regulations, customer factors and financial institutions’ policies in establishing the causes on interest rate volatility. The study will target all the available commercial banks in Kenya which are 42 and 2 Islamic owned commercial banks; That is, First Community and Gulf African Bank. Finance officer or equivalent will be randomly selected per commercial bank and questionnaires administered to them. The researcher has faith in that this will provide an adequate and representative sample and would give reliable results/findings for the experiment.

1.7 Definition of Terms

Interest Rate Volatility – It is the degree by which the rate of interest changes over time. High volatility means rapid and huge upward and downward movements over a relatively short time period; on the other hand low volatility implies much smaller and less frequent changes in value (Bester, 2004).

Loan Default – It is the deliberate or unavoidable failure by a borrower to honor loan repayment obligation on a timely basis or to comply with other conditions of the contract (Ghazali & Ali, 2002).

Monetary Policy – It is the constitutionally defined process by which the monetary authority of a country controls the supply of money, often targeting a given interest rate for the purpose of promoting economic growth and stability (Bordo, 2008).

REFERENCES

Bester, C.A. (2004). Random field and affine models for interest rates: An empirical comparison. Working Paper, 2004

Bikbov, R., & Chernov, M. (2004). Term structure and volatility: Lessons from the eurodollar market. Working Paper.

Bordo, M. D. (2008). Monetary Policy, History Of. The New Palgrave Dictionary of Economics, 2nd Edition.

Buiter, W. (2009). Negative interest rates: when are they coming to a central bank near you?. Financial Times, May 7, 2009.

CBK (2012). Banking Survey Report 2011. Annual Report, Central Bank of Kenya (CBK)

DeBondt, G. (2002). Retail Bank Interest Rate Pass-Through: New Evidence at the Euro Area Level. ECB Working Paper 136, Frankfurt, Germany: European Central Bank.

Flannery, M.J. (1981). Market Interest Rates and Commercial Bank Profitability: An Empirical Investigation. Journal of Finance 36: 1085-101

Ghazali, N.A., & Ali, K.A.M. (2002). The Effect of Open Market Interest Rates on Malaysian Commercial Banks’ Interest Rate Spread: An Empirical Analysis. IIUM Journal of Economics and Management 10(1)

Hoque, M.Z., & Hossain, M.Z. (2008). Flawed Interest Rate Policy and Loan Default: Experience from a developing country. International Review of Business Research Papers, 4(5) October –November, Pp. 235-246

Kiragu, P. (2012). CBK cuts lending rate to 13%. The Star, September 6, 2012

Okoth, J. (2011). New CBK rate puts borrowers on notice. Standard Newspaper, December 03, 2011.

Parliamentary Service Commission (2011). High Interest Rates and the Risks to Economic Growth. Discussion Paper, December 2011, Parliamentary Budget Office Nairobi, Kenya

Saunders, A. (1999). Financial Institutions Management: Modern Perspective., 3rd Edition. Irwin McGraw Hill

Thygersa, K.J. (1995). Management of Financial Institutions, 1st Ed. Harpe Collins, College Publishers

Weth, M.A. (2002). The Pass-Through from Market Interest Rates to Bank Lending Rates in Germany. Discussion Paper No 11, Economic Research Center of the Deutsche Bundesbank.

2.0 LITERATURE REVIEW

2.1 Introduction (0.25 -0.33 of a page)

2.2 Subheading -Based on Research Question or Specific Objective #1(at least 4-5 pages) (To determine the effect of government regulations on commercial banks’ interest rate volatility in Kenya)

2.2.1

2.2.2

2.2.3

2.3 Subheading -Based on Research Question Specific Objective #2 (at least 4-5 pages) (To assess the effect of customer attributes on commercial banks’ interest rate volatility in Kenya)

2.3.1

2.3.2

2.4 Subheading -Based on Research Question Specific Objective # (at least 4-5 pages) (To evaluate the effect of banks’ policies on their interest rate volatility in Kenya)

2.4.1

2.4.2

2.5 Chapter Summary

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