Kenyan banks are known to make super normal profits with the industry generally characterised as healthy. Many have asked why these banks hold high liquidity levels and avoid lending to the public.
Treasury Principal Secretary is the latest entrant in this conversation, accusing banks of holding liquidity more than the statutory requirement, saying their liquidity ratio stands at 51 percent against the 20 percent statutory requirement.
He is asking: Is financing to micro business the problem or lack of financing a manifestation of an underlying problem?
Unfortunately, this discussion never goes beyond the concern that banks are holding onto liquidity above statutory requirement.
A research paper published in February 2022 titled “Banking System Adjustment to shock; The Kenyan Case of Liquidity-Profitability Trade Offs” written by Jared Osoro and Josea Kiplangat talks in detail about this topic. The research used bank level data from 2002 to 2020 and found reasons banks hold high liquidity.
They note that the extent to which banks are willing to hold liquidity above regulatory requirements is potentially size-sensitive and a reflection of the segmentation in the inter-bank market that is a binding constraint to liquidity distribution.
To start with, liquidity is created on both sides of the bank’s balance sheets. Banks provide liquidity on demand to depositors on the liability side, while loans to households and businesses are made on the asset side.
First, the size of the bank is positively related to excess liquidity. Second, listing status is also an important predictor of excess liquidity holding; publicly listed banks tend to hold less liquidity. Third, listing status confers banks with better access to capital markets and, therefore, less incentive to hold excess liquidity.
Fourth, capital buffers are associated with an increase in excess liquidity holding. The higher capital ratio a bank holds is associated with stable liability structure and, therefore, there is a need to hold more liquidity.
Lastly, bank liquidity and profitability are inversely and statistically related, meaning there is a trade-off between bank profitability and liquidity. Higher profitability is often associated with higher illiquidity; profitable banks opt for optimality in their balance sheet structure by shifting their asset allocation towards high-yielding assets and in turn achieve higher profitability.
The more a bank leans towards liquid assets the less profitable they are.
In Kenya, the loan-to-deposit ratio, a proxy for liquidity, has been on a declining trend between 2006-2010 and 2016-2020, reflecting a general increase in overall market liquidity that coincided with declining profitability.
So, with banks choosing to remain on optimal profitability path, they resort to liquid but safe investments like government securities over loans and advances.
Government securities is one of the policies that has led to this trend. Banks are investing in government securities as a share of total assets. It’s noted that government securities as a share of total assets have increased among medium-sized banks where it is ahead of the industry average.
Banks invest in government securities for precautionary reasons where at a time non-performing loans as a share of total gross loans banks increase investment in government securities which is seen as a safe haven.
Prior to Covid-19 pandemic, banks were adjusting to the regime interest rate control and there was a steady increase in the share of government securities at the expense of loans and advances while at the same time government was having an expansionary fiscal policy, running high budget deficits plugged by high borrowing. This led to banks choosing profitability over liquidity.
With the pandemic happening and a slow recovery out of its ravaging economic effects, banks will give priority to capital management and avoid lending risks.
PAYE Tax Calculator
Note: The results are not exact but very close to the actual.
