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Policy dilemma in the informal financial markets

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Central Bank of Kenya. The resilience of Kenya’s financial markets to weather a number of storms such as political shocks, droughts, war on terror, travel advisories baffles pundits. file photo | nmg

Summary

  • Notably, the resilience of Kenya’s financial markets to weather a number of storms such as political shocks, droughts, war on terror, travel advisories baffles pundits.
  • Nevertheless, the Central Bank of Kenya’s (CBK) regulatory attempts to lower the cost of credit has largely not achieved the desired results over the years.
  • It is evident that monetary policies such as interest rates regulation have not spurred growth in formal financial markets lending.

Kenya’s economy is the largest in East Africa. The country has one of the most sophisticated financial systems in Africa.

Notably, the resilience of Kenya’s financial markets to weather a number of storms such as political shocks, droughts, war on terror, travel advisories baffles pundits.

Nevertheless, the Central Bank of Kenya’s (CBK) regulatory attempts to lower the cost of credit has largely not achieved the desired results over the years.

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Nevertheless, it is evident that monetary policies such as interest rates regulation have not spurred growth in formal financial markets lending. So, what is the problem?

Monetary policy is a function of the CBK which simply entails the control of the price of money (interest rates) and the volume of money in circulation (money supply).

Among the many instruments of monetary policies employed by CBK, open market operations have been widely used. It entails the use of Treasury bills.

Treasury bill interest rates are considered risk-free since the government does not default on its obligations.

Any borrower other than the government is considered risky but the degree of risk varies depending on the borrower’s profile.

For instance, a TSC teacher is considered a lower risk than an employee of county government.

Suppose the Treasury bill rateis 10 per cent as is the current case, a bank may assign eight per cent interest rate as risk premium to TSC scheme and 12 per cent to a county government scheme.

What happens when interest rates are regulated? What if the risk premium is fixed at four per cent as is the current case? Since the demand for credit has always exceeded supply, formal lenders will shun risky borrowers and deny them credit, leaving them at the mercy of informal lenders.

Sadly, most countries omit data on informal financial markets in their official monetary data. The implication of this treatment is that the timing and effect of the monetary policies on economic activities is questionable.

Some studies show that, overall, formal and informal financial markets loans complement one another, implying that an increased use of formal financial markets credit produces additional productive capacity which requires more informal financial sector credit to maintain equilibrium.

Secondly, interest rates in the formal and informal financial sectors do not always change together in the same direction.

Thirdly, in some instances, interest rates in the two markets change in diametrically opposed directions with the implication that the informal financial sector may frustrate monetary policy.

Lastly, the larger the size of the informal financial sector the lower the likely impact of monetary policy on economic activity.

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