Revisiting Regulatory Models of Banking Sector in Kenya: From Njuguna’s Restraint to Njoroge’s Missiles

Former CBK governor Njuguga Ndung’u exercised regulatory restraint in regulating the banking sector and payment systems. This hands off approach led to growth of Fintech in the country making Kenya to be among the leaders. But it also led to accumulation of risk and unsafe banking practices. Governor Njoroge has taken a prescriptive regulatory approach, in its wake leading to collapse of three banks. Even though this may have led to stability in banking sector, such cautious regulatory approach  is stifling innovation. There is need to urgently create a regulatory balance. 

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CBK Governor Patrick Njoroge in a media briefing. Photo: courtesy

By gatuyu t.j

The Kenyan Microfinance banks are doing badly. A report by the Central Bank of Kenya (CBK) reveals microfinance banks gradual decline in profits from KES 549M in 2015 to a loss of KES 731M for the year 2017.

The poor performance has been attributed to the low mobilization of deposits, emerging financial technology (Fintech) and imposition of interest rate caps that has contributed non-performing loan portfolios.

To address these issues, the CBK, in a consultative note, has proposed regulatory measures to enhance corporate governance structures, increase adequacy of capital and liquidity and reduce reliance on deposits and borrowed funds.

The CBK desire to ensure financial stability, promote consumer protection, and maintaining market integrity and transparency, create resilient and viable business models in the financial sector is appreciated.

However, there is need for moderation on the methods employed. The CBK proposals are excessive intervention and overly prescriptive. The implication of such actions is they may cause undue market distortions and stifle innovations.

Most often, the regulatory enthusiasm can trigger government failures in trying to address market failures. It may increase the risk of unintended consequences such as unduly increasing compliance costs to financial institutions.

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

This calls for the need to strike the right balance between ensuring financial stability and securing effective financial intermediation. This results to a virtuous cycle where sound banks support economy and sound economy makes banks sound.

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

There is thus need to ensure that financial institutions abide by rules as a matter of course but equally strive for better services.

Indeed, market integrity and transparency is a precondition for the proper functioning of the market. However, should the Kenyan market stay stagnant while markets across the world compete with each other vigorously, it cannot make enough contributions to efficient corporate financing or growth in house held assets.

Balance need to be created for a market which attracts critical information and players from around the world and provides a variety of opportunities for financing and investment. Bid for transparency should not sacrifice market vigour.

Therefore, financial regulation goals of financial stability, consumer protection and market integrity should be balanced with the outcomes of effective intermediation, better services and market vigor. To achieve the ultimate goal of enhancing national welfare, the CBK proposals should seek to attain both outcomes.

A look at the Kenya’s banking industry, there exist multiple equilibria, where some institutions are making huge profits while others are not doing so well. A sector with multiple equilibria is always ripe for disruption to attain an efficiency gain by shifting to a better equilibrium.

Nevertheless, such a shift may require a strategy change. Sometimes, prescriptive laws hinder operational flexibility.  It becomes that no financial institutions is willing to change their strategies as the first mover may become prey to other firms, presenting the prisoner’s dilemma scenario.

For instance, no bank exits from the strategy focusing on lending volume as the first mover may lose market share. That is why it is necessary to make supervisory approaches to be consistent with the ultimate goal of regulation. The first mover breaking away from the prevalent inefficient business model can become disadvantaged against its competitors at least for certain period of time.

One of the ways for the CBK to create financial stability in banks is by addressing vulnerabilities in the financial system arising from negative externalities.

As was witnesses in the successive collapse of Dubai Bank, Imperial Bank and near collapse of Chase bank, a bank’s failure has domino effects on other banks due to the inter connectedness, but the management of the bank may not take the potential spillover into their consideration due to  information asymmetries.

Depositors who do not have enough information to distinguish good banks from bad banks may cause runs on good banks. Regulators must protect consumers of financial services against disadvantages stemming from information asymmetry and from limited means available for them to handle stress events.

In promoting better services, market force may not necessarily foster competition towards better services. This because financial institution have varying asset management capabilities or in their dedication to customers’ best interest may not be properly appreciated by customers due to information asymmetries and bounded rationality, and thus may not lead to differentiated growth of firms.

The CBK and other regulators can address this by promoting disclosure by financial institutions and enhancing customers’ financial literacy.

Lastly, to promote market vigor, regulators should work to eliminate obstacles and provide necessary conditions for market agglomeration to happen, as the benefit of agglomeration might not be fully reflected in individual market participants’ decisions (positive externality). In view of the foregoing narrative, the question is how best can the CBK minimize government failures while addressing market failures?

The current CBK supervisory approach outlined in prudential regulations, 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).

Examination in the light of forms, not substance,would for instance make bankers find it easier to defend lending decisions by referring to collaterals and guarantees than by presenting bankers’ own views on borrowers’ future business prospects.

It promotes complacency on the sustainability of banks’ business models in the future. CBK or any regulator may spend most of their time criticizing specific past incidents of misconduct but may fail to discuss whether firms meet the changing needs of the customers.

The CBK should expand the scope of its supervisory approaches from a backward-looking, element-by-element compliance check with formal requirements to substantive, forward-looking and holistic analysis and judgment so that the banks will better contribute to the ultimate goal of regulation by attaining basic goals in a balanced manner. The new supervisory approaches have the following three pillars.

The first pillar is the enforcement of minimum standards. Examples of the minimum standards include accounting standards on loan classification, loan write-offs and loan loss provisioning, capital adequacy requirements, rules and regulations on consumer protection and market integrity, as well as the minimum levels of internal control as a precondition for adequate business management, customer protection and risk management.

The second pillar is the dynamic supervision. It will also avoid imposing a one-size-fits-all solution across the industry and continue its efforts to develop approaches to engage in constructive two-way dialogue with an individual financial institution to explore possible solutions tailored to its own circumstances.

The third pillar is the promotion of disclosure and engagement with financial institutions aimed to encourage financial institutions’ pursuit of best practices.

Given the rapid evolution of financial businesses, financial institutions’ practices will quickly become outdated if they are designed just to satisfy minimum standards. Their business models and risk management practices should be renovated day by day.

Equally, better financial intermediation, better services and more vibrant markets can be attained only through firms’ diverse initiatives to innovate themselves. Basel III, the international framework for prudential supervision of banks, also adopts this three pillar approach.

A key to establishing this virtuous cycle is the creation of shared value between financial institutions and customers. In their 2011 article Creating Shared Value, Michael E. Porter and Mark R. Kramer argued that companies can find new markets and achieve a competitive advantage by creating shared value with customers, the community, and the society in their core businesses.

By providing high-quality products and services that meet customer needs and contribute to customers’ growth, companies can solidify the foundations of their businesses and increase their corporate value, according to their argument.

The author is the managing editor of the Gatuyuriana and a financial markets specialist. 

Kenya Public Pension Scheme Require Overhaul

In Kenya, pension expense take a huge percentage of public expenditures. Yet, the government is making payments to people who are able bodied, but not contributing to public coffers. Such regime of social security is outdated. Public pension schemes require immediate overhaul
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Photo: Courtesy
It is the German Chancellor Otto von Bismarck who introduced the world’s first public pension system in 1870. At the time, the retirement age was 70, and the average life expectancy was 45.
 
Today, in case of Europe, the average European retires at 65 and lives until he or she is at least 80. In Kenya, retirement age is 60 and average life expectancy is 65 years.
 
At the time Otto Von was introducing pensions as social security forms, expectation was very few workers would live to enjoy it. It is no longer the case, as people live longer. This where the problem lies.
 
Having overly generous pension benefits are destabilizing public finances, compromising the inter-generational social contract, and creating discontent. This problem has to be fixed.
 
The standard way to fix it is is by way of raising the retirement age or cut pension benefits. Each of these measures comes at a cost. The longer that older workers remain in the labor force, the more exposed they are to technological unemployment.
 
Cutting benefits, as Greece’s experience during the euro crisis showed such can force retirees to reduce their consumption, causing recessionary pressures.
 
In stagnant economies, where youth wait for attrition or retirement to be absorbed into the workforce, raising retirement age may fuel further discontent. There are two ways out.
 
One, everybody should contribute for their pension benefits, and this should no longer be a government role. This could be actualized by scrapping the defined benefit schemes in public service and replacing it with defined contribution benefit schemes.
 
Second, even though most seniors are ill-suited for today’s fast-changing labor market, they still have the skills, wisdom, and experience to contribute to society.
 
As such, governments should start treating them as a segment of the workforce, rather than as a burden on public spending and economic growth.In such case, eligibility for pension benefits should be pegged on performing some community work.
 
Such community work would have benefits for pensioners, too. Typically, idle retirement leads to a sharp decline in one’s cognitive skills, whereas a policy of active retirement would encourage older people to pursue fulfilling new challenges.
 
The government should not continue paying people who are able bodied free money. They should equally work and deliver something for it. For this, public pension has to be overhauled.

End of Dollar Dominance and Its Malcontents

Dollar dominance may have reached its end. Evidence portray a trend of massive de-dollarisation by world economies. It is time emerging economies such as Kenya adjusted accordingly.
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Photo: Courtesy
A random invoice will demand that payment to be made through SWIFT. This is an international payment system by the Society for Worldwide Inter-bank Financial Telecommunication (SWIFT), which is a dominant wire transfer.
 
Recently, on recent days, if the invoice originates from a Chinese, they have omitted SWIFT and replaced it with CIPS. The cause is China has abandoned SWIFT in favour of its own China International Payments System (CIPS), which they launched 2015.
 
In addition, the Chinese Renminbi has been admitted into the IMFs Special Drawing Rights (SDRs) basket, making it one of the top-tier international currencies.
 
The casualty of these Chinese overtures has been the US dollar. President Donald Trump has escalated the dollar slaughter through his confrontational foreign trade policy targeting China and and trade agreements.
 
In the aftermath of the World War II, the US Dollar, Euro, Yen and British Pound become the four main base currencies for settling international transactions. But the Dollar become dominant of theme to form the main base currency.
 
The trend that followed was a massive dollarisation of the world economies. Dollarisation is the use of the US Dollar in addition to or instead of the domestic currency as legal tender.
 
In fact, some countries, such as Ecuador, East Timor, El Salvador, Marshall Islands, Micronesia, Palau, and Zimbabwe use the US Dollar as the only currency include.
 
However, countries have been abandoning the dollar. This is a phenomena of de-Dollarization, where there is a deliberate action by a nation to cut down on the use of the U.S. Dollar.
 
The New Development Bank, earlier known as the BRICS evidenced the scenario of weakened Dollar when they announced the issuance of 3 billion yuan worth of five-year “green bonds” denominated in the Renminbi, to raise funds for clean energy and infrastructure projects.
 
These de-Dollarization efforts have implications for Kenya. Currently, the Central Bank of Kenya has foreign exchange reserve of USD 8000M (approx Ksh 800B) 5 months of cover. The CBK should diversify this reserve with other base currencies.
 
This would reduce the impact of USD fluctuations on the Kenyan currency. Lastly, as a country that has a substantial portion of its debt obligations to China, Kenya should do a currency swap relations with China.
 
The days of dollar dominance are all over and requisite adjusting are immediately required.