How central bank can infuse stability in the financial sector

My article on interest rates published in the Business Daily of Monday April 4, 2016 looked at the state of the country’s economy as a result of the ongoing monetary intervention by the Central Bank of Kenya (CBK) in an effort to maintain monetary stability.

In it, I argued that the high interest rates will kill business in this country as banks continue to retain huge spreads - the difference between loans and deposit interest rates - as they compete to report high profits.

CBK, as the financial sector regulator, should shoulder part of the blame for the failures in the banking system due to its market intervention in a quest to stabilise the shilling and tame inflation without looking at the negative implication of this policy intervention instrument, particularly when held for a long time.

I repeat that the government should do what retired President Kibaki’s regime did –borrow foreign exchange reserves via loans and grants from development partners to enhance liquidity in the market, stabilise the shilling and reduce inflation in the economy.

Such a measure does not impose punitive and negative implications to the banking sector.

The Central Bank and the Treasury have refused to adopt the two-prong approach in dealing with the shilling instability and inflation resulting in the troubles the banking sector is finding itself in today.

High returns by commercial banks and high growth in reported profits occasioned by high interest margins and other costs, are what is killing borrowers resulting in business failures.

Their failure impacts negatively on the performance of banks as their bad debts must be provided for in the profit and loss accounts.

Competition to make higher profits in order also to meet the prescribed minimum capital, which has been projected to rise from Sh1 billion to Sh5 billion, is the other cause of the troubled banking sector.

If the government had maintained the exchange rate at Sh60 to the dollar, there would not have been any need for the revision of the minimum capital to Sh5 billion.

The cutthroat competition forces banks to take on very high risk loans, which are not properly structured, leading to huge provisions in bad and doubtful debts, which is the reason behind the troubles both the National Bank of Kenya and Chase Bank, among others, are grappling with.

The other problem is that most of the regulators and auditors as well as commercial banks in this country either do not understand, appreciate or both the concept of structured finance as practised in the global market place.

As a result, when a regulator or an auditor comes across such a transaction, the natural thing for him is to recommend a full (100 per cent) provision for bad and doubtful debt.

This wrong application of the Basle Accords on Capital Ratios and Provisions for Bad and Doubtful Debts is what is destabilising the banking industry among others.

So, the natural decision model by the regulator is that banks must provide for 100 per cent bad and doubtful debts if no tangible collateral is used to secure loans.

This immediate provision is what has caused financial instability at the National Bank of Kenya, the Chase Bank and many others at the moment.

As we all know, when a bank is troubled, it is only the insiders and regulators who are privy to the whole issue.

And like it has happened in many countries, including the US, laxity in taking the corrective decision at the right moment is what is killing the banking sector and CBK must take responsibility for this as the regulator.

The current prudential banking regulation and governance practices call for the regulator to be online with commercial banks 24/7.

That is also why commercial banks are required by the same prudential governance structures and guidelines, to have a compliance officer who reports to the regulator throughout.

On the same token, that is why commercial banks and financial institutions must have statutory committees of their boards comprising mainly of outside directors and nominated professionals to sit on the credit panels, asset liability management committees, audit committees, etc, and, which must meet regularly so that they can identify a problem in good time before it becomes cancerous.

This is also the reason why shareholders owning 5 per cent or more equity in a banking institution are prohibited from being executive directors in commercial banks and financial institutions.

Whether this guideline is being followed in the appointment of executives and directors is a story for another day and you can rest assured it is one of the reasons leading to huge insider loans and reckless loans for that matter.

In order to save the banking sector from an imminent collapse due to instantaneous application of the Basle Accords, the regulator should engage commercial banks on policy dialogue on how to apply the Accords on a gradual basis without causing the instability we are witnessing today in the sector and the entire financial market.

CBK should at this point in time look for funds to infuse into these troubled institutions quietly without letting the cat out of the bag in order to avert a looming financial crisis.

Mr Munyaka is an independent financial consultant.