Rigid financial rules can stifle innovation

The microfinance banks in Kenya are not doing well. A report by the Central Bank of Kenya (CBK) reveals their gradual decline in profits from Sh549 million in 2015 to a loss of Sh731 million in 2017.

The CBK, in a consultative note, has formulated regulatory proposals to redeem the sector. These include enhancing corporate governance, increasing capital and liquidity requirements and reducing reliance on deposits and borrowed funds.

In summary, the CBK solution is more and more regulations. This regulatory philosophy needs to be revisited. For excessive, prescriptive, regulatory interventions in financial sector do cause market distortions and stifle innovations. Regulatory enthusiasm in addressing market failures often trigger government failures.

The goal of financial regulation is to ensure the triple objects of financial stability, consumer protection and market integrity. Each of these objects ought to be pursued on structure of a bigger picture as this essay illustrates.

Ensuring financial stability is an essential goal. However, when regulators pursue financial stability as the only overarching goal, financial institutions may become overly risk averse and refrain from discharging their intermediation functions, restraining economic growth.

Prescriptive regulations may make financial institutions consider that compliance with rules is all that is expected of them. In such a case, they may not make efforts to improve their products or services to best suit the interests of customers, limiting the financial industry’s contribution to the growth in national wealth.

The rules must allow flexibility on banks to periodically improve their services. As regulators pursue triple objects, they should not sacrifice bid for better services by market players, effective intermediation and normal market vigour and innovation.

A cursory look at the Kenya’s banking industry reveals a sector with multiple equilibria. We have some banks making huge profits while others are struggling. A sector with multiple equilibria is ripe for disruption as the market strives for efficiency gain to a better equilibrium.

However, an efficiency shift requires change in strategy. Where prescriptive rules overhang, like in Kenya, they hinder operational flexibility. The effect is that no institution is willing to change their strategy, as the first mover from inefficient models can become disadvantaged and often becomes a prey to dominant firms, creating the prisoner’s dilemma scenario.

The result is that no bank exits from the strategy. Smaller banks are more disadvantaged as they hold on into inefficient business models. That is why supervisory approaches have to be consistent with the ultimate goal of regulation. A way the CBK can create financial stability in banks is addressing vulnerabilities in the financial system.

As successive collapse of Dubai Bank, Imperial Bank and near collapse of Chase bank illustrates, a bank’s failure has domino effects on other lenders due to the inter-connectedness. But the management of the bank may not take this potential spill-over into consideration due to information asymmetries.

Depositors may not have enough information to distinguish good banks from bad ones, yet bad lenders may cause runs on good ones. This is the danger of information asymmetries.

In promoting better services, market forces may not necessarily foster competition towards better services. This is because financial institutions have varying asset management capabilities or their dedication to customers’ interests may not be properly appreciated by customers due to, again, information asymmetries and bounded rationality, limiting differentiated growth of firms.

The question which may arise from this narrative is how the CBK can minimise government failures while addressing market failures. Sadly, the current supervisory approach by CBK on banks, as espoused in among others, prudential regulations, majorly based on compliance checks and asset quality reviews, may no longer be effective.

Mechanical and repetitive application of rules makes the industry to be obsessed with compliance with the letters of the rules (focus on form), backward-looking review of the evidence of the past (focus on the past) and analysis of details and elements (focus on elements).

Focus on forms, rather than substance, makes it easier for bankers to defend their lending decisions by referring to collaterals and guarantees than by presenting bankers’ own views on borrowers’ future business prospects. This promotes complacency on the sustainability of banks’ business models.

Where a banks regulator spends much time criticising specific past incidents of misconduct, they may fail to discuss whether firms meet the changing needs of the customers. The CBK should expand its supervisory approaches from a backward-looking, element-by-element compliance check with formal requirements to substantive, forward-looking and holistic analysis and judgment. This would ensure banks better contribute to the ultimate goal of regulation. To this extent, CBK can adopt a supervisory approach with three pillars.

The first pillar is the enforcement of minimum standards. Such includes accounting standards on loan classification, loan write-offs and loan loss provisioning, capital adequacy requirements, rules on consumer protection and market integrity, internal controls, all as a precondition for adequate business management.

The second pillar is the dynamic supervision. On this, the CBK would avoid imposing a one-size-fits-all solution across the industry by developing approaches to engage in constructive two-way dialogue with an individual financial institution and explore solutions tailored circumstances.

The third pillar is promotion of disclosure and engagement with financial institutions to encourage them to adopt best practices. Basel III, the international framework for prudential supervision of banks, recommends these three pillar approach.