Regulator should commit to fully reforming horizontal repo market

Patrick Njoroge

Central Bank of Kenya (CBK) Governor Patrick Njoroge. PHOTO | DIANA NGILA | NMG

From the feedback on last week’s article about the comeback of the repo market, the emerging concern has been whether it will translate to liquidity distribution in the interbank.

Let’s start with what is an interbank market. This is a market critical to the economy because it helps allocate liquidity from banks with a surplus to the banks facing a liquidity deficit.

Many times small banks that don’t have a foreign principal find themselves in liquidity distress, so in the interbank market, they are able to borrow from big banks that have a liquidity surplus.

So where do the repo and reverse repo markets come in? When banks experience a liquidity shortage they can borrow money from either the CBK or other banks against the collateral of government securities.

If they borrow from the CBK against the collateralised government securities that are the vertical repo market and if they borrow from other banks that are the horizontal repo market.

So, what is being brought back is the horizontal repo market.

Now, the repo and reverse repo markets provide system-wide stability in the interbank market. An example is when in 2016 small banks experienced capital flight following the placement of Chase Bank under receivership.

As a reaction to this circumstance, big banks which would have lent money to these small banks chose to cut them off and instead bought Treasury bills.

If we had a functioning repo market, the big banks would not have cut off the small banks but lent to them against the Treasury securities the small banks hold.

So, there is no doubt that the repo market will increase overall liquidity conditions in the market.

But the fundamental question is, will the return of the repo market positively affect the distribution of this liquidity it will bring in the interbank market which is the main problem with our interbank?

What we have failed to admit for a period of time now is that our interbank market despite showing normal market behaviour has a network structure of asymmetrical nature.

In a research paper 'The Interbank Market in Kenya: A Event-Based Stress Analysis Based on Treasury Bill Market', Osoro Jared and Muriithi David observed that Kenya’s interbank market is asymmetrical in the sense that big banks often have the opportunity to access relationships across the industry while the small banks don't.

In short, the interbank is segmented and therefore carries limited information content about the market liquidity situation.

So, if we have a segmented interbank, will the horizontal repo market function efficiently?

Osoro and Muriithi also observed that the reverse repo rate – the rate at which the banks maintain surplus funds with the CBK signalling the level of liquidity surplus in the market – has perpetually been zero.

This suggests the limitations of using repo and reverse repo rates as a signal of liquidity distress or abundance. The horizontal repo market can correct the liquidity distribution problem in the interbank only if the regulator is committed to it.