kenya finance & banking system - 2000

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KENYA FINANCE AND BANKING SYSTEM:

AN INSTITUTIONAL ANALYSIS

by

John Thinguri Mukui

3 February 2000


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TABLE OF CONTENTS

ABBREVIATIONS AND ACRONYMS iiiEXECUTIVE SUMMARY ivCHAPTER 1: INTRODUCTION 1

TERMS OF REFERENCE 1INTERPRETATION OF THE TERMS OF REFERENCE 1OUTLINE OF THE REPORT 3

CHAPTER 2: THE FINANCIAL SYSTEM IN A HISTORICAL PERSPECTIVE 4THE EAST AFRICAN CURRENCY BOARD 4PRE-INDEPENDENCE COMMERCIAL BANKING 6NONBANK FINANCIAL INTERMEDIARIES 7DEVELOPMENTS IN BANKING LEGISLATION 8

CHAPTER 3: THE FINANCIAL SYSTEM AFTER INDEPENDENCE 9THE REGULATORY FRAMEWORK 9THE BANKING CRISIS OF THE MID-EIGHTIES 10REACTIONS TO THE BANKING CRISIS 11CHANGES IN MONETARY POLICY 11

CHAPTER 4: FINANCIAL SECTOR REFORMS 13FINANCIAL SECTOR REFORMS IN A MACROECONOMIC CONTEXT 13THE LEGAL AND SUPERVISORY REGIMES 14OUTCOME OF THE REFORM EFFORT 16

CHAPTER 5: CURRENT STRUCTURE OF THE BANKING AND FINANCIAL SYSTEM 18THE AGRICULTURAL FINANCE CORPORATION 19CONCENTRATION 19PERFORMANCE RATING 20RURAL TO URBAN RESOURCE TRANSFERS 21OWNERSHIP 22TRANSACTION COSTS AND ACCESS TO FINANCIAL SERVICES 22EMPLOYMENT 23SOURCES OF INCOME 23

CHAPTER 6: LITERATURE ON MONEY AND BANKING IN KENYA 24HISTORICAL PERSPECTIVES 24THE STRUCTURE OF THE FINANCIAL SYSTEM 25MONETARY POLICY 25SAVINGS AND DEVELOPMENT 26


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NONBANK FINANCIAL INTERMEDIARIES 28INFORMAL SOURCES OF FINANCE 28

CHAPTER 7: OTHER FINANCIAL ORGANIZATIONS 29SAVINGS AND CREDIT COOPERATIVES 29THE STOCK MARKET 30NATIONAL SOCIAL SECURITY FUND 31MICRO-FINANCE INSTITUTIONS 32SAVINGS AND CREDIT ORGANIZATIONS 34

CHAPTER 8: SUMMARY AND RECOMMENDATIONS 35SUMMARY OF THE MAIN FINDINGS 35PUBLIC EXPENDITURE SYSTEMS 36SUPERVISION OF THE FINANCIAL SYSTEM 36THE REGULATORY FRAMEWORK 36AUDIT AND DISCLOSURE RULES 37ACCESS BY THE POOR TO DEPOSIT-TAKING INSTITUTIONS 37

EMPLOYMENT CREATION 37MANAGEMENT OF SOCIAL DEVELOPMENT FUNDS 37RECOMMENDATIONS 38

REFERENCES 40TERMS OF REFERENCE 51


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ABBREVIATIONS AND ACRONYMS

ADF African Development FundAFC Agricultural Finance Corporation

AMFI Association of Micro-Finance InstitutionsASCA Accumulating Savings and Credit AssociationCBK Central Bank of KenyaCIC Capital Issues CommitteeCMA Capital Markets AuthorityDFCK Development Finance Company of KenyaDFI Development Finance InstitutionEACB East African Currency BoardHFCK Housing Finance Company of KenyaICDC Industrial and Commercial Development CorporationIDB Industrial Development BankIMF International Monetary FundJFA-PRESSA Jobs for Africa/ Poverty Reducing Employment Strategies for Sub-Saharan Africa

KIE Kenya Industrial EstatesK-REP Kenya Rural Enterprise ProgramKUSCCO Kenya Union of Savings and Credit CooperativesMFI Micro-Finance InstitutionMSEs Micro- and Small-EnterprisesNBFI Nonbank Financial InstitutionNGO Nongovernmental OrganizationNSSF National Social Security FundOMO Open Market OperationsPPA Participatory Poverty AssessmentROSCA Rotating Savings and Credit AssociationSACCO Savings and Credit CooperativeSAL Savings and LoanKenya LtdT-bill Treasury Bill


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KENYA FINANCE AND BANKING SYSTEM: AN

INSTITUTIONAL ANALYSIS1

EXECUTIVE SUMMARY

HISTORY OF MONEY AND BANKING

1.1. In pre-colonial Kenya, the predominant medium of exchange and store of wealth were commoditycurrencies, mainly livestock and cowries. The establishment of banking institutions at the turn of thecentury was the first instance of modern financial intermediation. The hut tax legislation of 1897 and 1902,introduced to create adequate labour supply for European settlers, enhanced the use of money since the taxwas payable in Indian rupees.

1.2. The East African Currency Board was constituted in 1919 and began operations in 1920. Thereserves of the Board were invested in Sterling securities as the Board was not allowed to hold securities ofthe governments within the currency board system. In 1959, the Board was authorized to acquire localTreasury Bills, and in 1960, the headquarters of the Board were transferred from London to Nairobi.

Tanzania set up its own central bank in January 1966, followed by Kenya and Uganda in May 1966, whichmarked the end of the East African Currency Board and the monetary union it presided.

1.3. Commercial banking was established in Kenya at the turn of the century immediately following theestablishment of a British presence in this part of the world. The banks concentrated their local lending toexpatriate industries operating in the territories, mainly in plantations (cultivation and export of primaryagricultural produce). In 1965, the government registered the Cooperative Bank of Kenya, while theNational Bank of Kenya was established in 1968 as a fully-owned Government entity. The National andGrindlays Bank was split into two entities in 1971: Kenya Commercial Bank (with 60% Governmentparticipation) and a new entity called Grindlays Bank International (with 40% Government participation).The foreign commercial banks operated a gentlemans club with respect to interest rates on deposits andloans/ advances, commissions and charges on various services offered, ledger fees, exchange ratecommissions, and guarantees. The emergence of state-owned and private indigenous banks which did not

subscribe to the cartel-like arrangements led to gradual erosion of the formal arrangements.

1.4. The idea of forming the Agricultural Finance Corporation (AFC) was first recommended by theWorld Bank country report to Kenya in 1963 to fill the gaps left by commercial organizations and providefunds on terms which are suitable for the average farmer (World Bank, 1963). Due to low repayment ratesoccasioned by lax loan recovery procedures and the fact that access to credit was largely politically-driven,new credit from AFC has been continuously declining in the nineties.

THE FINANCIAL SYSTEM AFTER INDEPENDENCE

1.5. Since the establishment of the Central Bank of Kenya in 1966, it became necessary to issue a newBanking Act in order to harmonise it with the Central Bank of Kenya Act. The Banking Act had moreliberal requirements for nonbank financial institutions than for banks, mainly lower minimum capital forfinancial institutions, liquidity ratio for banks and no minimum liquidity requirements for nonbanks until1974, a minimum cash ratio for banks, a higher maximum lending rate for nonbanks and a commonminimum savings rate for banks and nonbanks, administrative credit ceilings for banks and none fornonbanks, and restriction for banks in lending for long-term immovable property in order to protect theliquidity of the banks (term-structure risk as a result of the nature of funding through short-term deposits).

1Report prepared for ILOs Jobs for Africa/ Poverty Reducing Employment Strategies for Sub-SaharanAfrica (JFA-PRESSA)


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1.6. The less restrictive regulatory regime subjected to nonbanks led to substantial growth of thenonbank market segment in the seventies up to early eighties. The financial sector exhibited two types ofdualism: a complex financial system alongside a population hardly inside the monetary economy; andinternal dualism between banks and a relatively undercapitalized and unregulated nonbank market segment.However, new regulatory measures were introduced in the early eighties e.g. (a) high mandatory investmentin Treasury bills, (b) increase in liquidity requirements, (c) prohibition from charging fees or commissions

and to charge interest on a reducing balance basis, and (d) withdrawal of substantial parastatal deposits.

THE BANKING CRISIS OF THE MID-EIGHTIES

1.7. The more liberal legal regime and the spill-over effects of the 1976-79 coffee boom led toflourishing of private indigenous nonbanks as reflected in their large share of deposits before the bankingcrisis of the mid-eighties. The banking crisis caused a run on deposits of nonbanks and a flight to quality inthe form of deposits held at the large traditional commercial banks. The analysis of nonbanks covering theindex period also indicates that they were undercapitalized by international standards.

1.8. The minimum capital requirements were raised and the difference between minimum capital forbanks and financial institutions narrowed from a quarter to a half in 1982 due to increase in the players inthe finance industry. In 1984, provisions of the Banking Act were extended to building societies, mainlygiving Central Bank the powers to determine interest rates charged by building societies and to inspectthem.

1.9. The 1985 amendments to the Banking Act increased capital requirements for both banks andnonbanks; gearing ratio (capital and reserves to deposits) was increased from 5% to 7.5%; reintroduced aminimum statutory reserve fund equal to paid-up capital which was to be invested in Governmentsecurities; introduced a provision for establishment of a Deposit Protection Fund; and restricted the tradingactivities of nonbanks as well. The amendments also prohibited nonbanks from owning directly orindirectly shares in a bank. The introduction of 20% minimum liquidity requirement may have contributedto the collapse of two building societies after the legislation became effective. The strengthening of thefinancial sector was done at considerable cost to the domestic ownership of the financial market.

1.10. The late eighties saw great changes in the gradual liberalization of the financial sector.Traditionally, monetary policy was conducted through a rigid system of controls aimed at affecting theprice, allocation and size of credit to the private sector. As part of financial sector reform program, theGovernment reacted to the constraints that stifled the functioning of the financial system through anumber of measures. These included increasing the band between deposit and lending rates; strengtheningthe auction system for Treasury bills and developing a secondary market for T-bills; issuing a wider varietyof T-bill maturities; introducing more generalized monetary policy instruments e.g. open market operations(OMO), cash ratio and a discount window; and amending the regulations differentiating banks andnonbanks.

FINANCIAL SECTOR REFORMS

1.11. The Government has undertaken various measures to forestall further erosion in the confidence ofthe banking system, e.g. increased minimum capital requirements, Government divestiture from thebanking system, encouraging small banks to merge so as to enjoy economies of scale, tightening of bank

regulations, and improved supervision of the banking system. However, loans to politically-correctindividuals and their companies have made it difficult for banks, especially the two banks with governmentequity-participation, to recover nonperforming loans or to realise the assets (if any) pledged as lien. TheGovernment has protected some large defaulters in the two banks. Direct capital injection by Governmentand conversion of parastatal deposits to equity may have created laxity in lending operations in agovernment-owned bank.


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1.12. Kenya is a member of the Basle Committee on Banking Supervision. In addition to rules governingprudential supervision and disclosure requirements, the Basle Capital Accord sets two quantitativestandards: (a) capital adequacy ratio of 8% - capital and unimpaired reserves to assets (including their totalloans and advances) as per section 18 of the Banking Act, and (b) limit to which a bank or group may lendto any one customer and companies or persons connected with the bank or banking group itself. TheCentral Bank of Kenya has gradually upgraded the capital adequacy ratio to the Basle standards, and in1995 limited advances to any single customer from the previous 100% to 25% of an institutions paid-up

capital and unimpaired reserves.

1.13. Currently, banks are required to maintain specified minimum ratios of various balance sheet items.Specifically, section 7 of the Banking Act deals with minimum capital requirements in absolute terms;section 17 on the ratio of capital and unimpaired reserves to total deposit liabilities (gearing ratio); andsection 18 on the ratio of capital and unimpaired reserves to total assets - including loans and advances(capital adequacy ratio). Others include minimum holding of liquid assets in section 19 of the Banking Act(not liquidity ratio as it is applied in practice), and the ratio of minimum cash balance on deposit at CentralBank to deposit and other liabilities (cash ratio).

1.14. The disclosure requirements for both banks and nonbanks have been broadened to include:

(a) Publication of both the audited balance sheet and profit and loss statement in a nationalnewspaper;

(b) Beginning August 1997, declare specific base lending rates as a means to enhance transparency andcompetition;

(c) A requirement was introduced that loans to directors must be at commercial rates;

(d) Disclosure of the ultimate beneficial owners of shares held through nominees and othercompanies;

(e) Disclosure of all insider loans as well as nonperforming loans; and

(f) Imposition of cash penalties for noncompliance with mandatory cash and liquidity ratios.

1.15. Despite major changes in the enabling legislation covering the financial sector and the move tomarket-determined interest rate regime, the financial system continues to sag under the weight ofnonperforming loans. The first major disruption occurred during 1984-86 when several indigenous banksand nonbanks failed, mainly due to imprudent lending practices leading to high proportion ofnonperforming loans and the consequent inability to meet maturing obligations and statutory requirements.Other major disruptions occurred in 1989 when the Government amalgamated one bank and nine nonbankfinancial institutions to form the Consolidated Bank of Kenya in order to forestall their imminent collapse.During 1992/93, fourteen institutions were put under liquidation while another three came under CentralBank management in 1994.

1.16. As at the end of 1998, the total number of institutions under liquidation remained at 30 as in theprevious year, with 17 institutions remaining under Deposit Protection Fund, 7 under Consolidated Bankof Kenya, 4 under official receiver, 1 under voluntary liquidation, and 1 was wound up by the court. During

1998, 5 banks were placed under statutory management.

1.17. The accounting systems may have contributed to collapse of some financial institutions. Forexample, interest not collected was included in revenue, thereby giving a healthy income and loss statement,while the institution is facing a liquidity crisis. However, Central Bank has introduced stringent regulationsregarding the classification of debts as nonperforming. It has introduced a mandatory 10% generalprovision for bad and doubtful debts on all advances, over and above the specific provisions made by the


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bank.

1.18. However, economic liberalization has created competition from imports and interest rate andexchange rate volatility, which have effected various business establishments depending on (a) degree ofcompetition from imports, (b) the relative magnitudes of debt and equity, (c) import content of localproduction, and (d) share of production that is exported. Large banks may be able to absorb the shocks ofnonperforming loans due to their diverse clientele. However, small finance houses may experience shocks

depending on the sectoral concentration of their loans and advances e.g. building societies in the currentlydepressed housing market. The big banks which advanced funds to enterprises that rely on governmentcontracts have also experienced an increasing portfolio of nonperforming loans due to decline ingovernment spending.

1.19. Most of the formal financial institutions have put hurdles in the way for small depositors throughhigh minimum balances for both savings and checking accounts. For those with bank accounts, access tocredit is restricted by collateral requirements, the availability of marketable collateral (e.g. urban property),and the high and volatile interest rates spurred by Government deficit-financing through the bankingsystem.

CURRENT STRUCTURE OF THE BANKING AND FINANCIAL SYSTEM

1.20. In 1967 when the Central Bank of Kenya took over the management of the financial system, thebanking system consisted of eight branches of foreign banks. As of December 1998, the number oflicensed commercial banks was 53 (of which five were under statutory management), while the number ofnonbank financial institutions were 13, building societies (4), mortgage finance companies (2), and foreignexchange bureaux (44). In addition, there were 38 insurance companies and 2 reinsurance companies inoperation, while the capital market consisted of 58 listed companies in the Nairobi Stock Exchange.Following the foreign exchange liberalization and in order to increase competition in the foreign exchangemarket, foreign exchange bureaus were introduced in 1995 to serve the retail end of the market.

1.21. As at end of 1998, the top eight commercial banks held 71% of the deposits. To measure thedegree of concentration in the banking industry, the Herfindahl-Hirschman Index was computed. As forend-1991, the strength of competition in the banking industry was similar to that in a market characterizedby about 5 equally-sized banks rather than the 28 that actually existed, while the number equivalent fornonbank financial institutions was 13 equally-sized institutions rather than the 56 that actually existed. Asof December 1998, the number equivalent for banks was 11.7 rather than the 53 that actually existed.

1.22. Nairobi province has the highest number of bank branches (including head offices), while Centralprovince ranks second. However, the highest growth in branch network has been recorded in Nyanzaprovince. The branches are concentrated in Nairobi, Rift Valley and Central provinces. The nationalaverage population in thousands per branch was 46.8, with the lowest observed in Nairobi (12.3) followedby Coast (29.7) and Central province (40.8). The provinces with the highest population per branch wereWestern (129.3) and North Eastern province (141.8).

1.23. The overall performance index combines capital adequacy as measured by the gearing ratio, assetquality, earnings, and liquidity. The overall performance index combining strong and satisfactory forbanks declined from 94% in 1994 to 60% in 1998. Since the number of nonbanks has declined drasticallyduring the index period, their performance index does not merit serious inter-temporal comparison.

Nonbanks currently command about 8% of total deposits.

1.24. The structure of ownership between quoted, foreign and government equity was computed for1998. Among the four major banks, Kenya Commercial Bank had the highest percentage of quoted to totalequity at 40%, while the lowest was National Bank of Kenya (20%). Only Barclays Bank and Standard Bankhad significant foreign equity (excluding equity through the local stock exchange) at 68.5% and 74.5%,respectively. The distribution of ownership among the four banks was quoted (29.25%), foreign (35.75%),


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and government, including NSSF stake in National Bank of Kenya (35%). As at the end of 1998, the fourbanks held 57% of the total deposits of the banking system (excluding nonbank financial institutions).

1.25. The collateral for conventional lending mainly includes property (land and developments), quotedsecurities, T-bills and own-deposits. A typical network branch charges (a) annual renewal of facilities (about1.75%), (b) penalty fees (3% per year) for those falling in arrears, (c) provision fees (5%) for bad anddoubtful debts, and (d) interest rate of up to 7% above the base rate depending on the banks perception

about the riskiness of the borrower. Corporate customers normally pay about 3% above the base rate. Thebanks reported that the term structure of the deposit base has changed over the years, and one branchnetwork reported that its composition of deposits was fixed deposits (50%), savings accounts (30%) andcurrent accounts (20%). The high cost of funds has translated to higher lending rates. In the case ofcorporate banks, the cost of funds is higher compared with network banks, but the difference iscounterbalanced by the higher operating costs of the network banks.

1.26. The redistributive implications of the poors lack of access to banks (as depositors and borrowers)will create and sustain mass poverty, which in turn will be detrimental to the two main agents with access tobank credit: government (through decline in tax base) and big corporations (through lack of effectivedemand occasioned by general decline in the publics purchasing power). The high cost of domesticborrowing will ultimately force the government to reduce public expenditure, with unfavourableconsequences for the private sector and households (provision of infrastructure and public services) andbanks (income from government paper).

1.27. The income accounts of 47 out of 53 banks operational at the end of 1998 was split betweeninterest on loans and advances, income from government securities, and other income. The share of grossincome from interest on loans and advances was 63.5%; while that from Government securities was 15.2%or Shs 12.41 billion, which is roughly equivalent to 7% of government current revenue for the year 1998.One bank realized a high 47% of its gross income from interest in government securities. The distributionof sources of income in the entire banking sector was interest on loans and advances (63.5%), income fromgovernment securities (15.2%), interest on placements (4.3%), foreign exchange earnings (4.2%), fees andcommissions (10.4%), and other income (2.4%).

OTHER FINANCIAL ORGANIZATIONS

1.28. The growth of Savings and Credit Cooperatives (SACCOs) has been rapid since the early seventies.For example, there were only 129 in 1971, compared with 1,158 in 1984, 2,141 in 1989, and 3,408 in 1998.In the 1989-98 decade, their total membership increased from 821,039 to 3,509,000, while their total sharecapital increased from Shs 6.2 to 15 billion. In 1998, out of the total of 3,408 SACCOs, 1,668 were inNairobi, while only 32 were considered as rural. Although the distribution of societies was skewed in favourof urban areas especially Nairobi, some of the cooperatives based in Nairobi serve rural-based employeese.g. teachers and other public servants. The savings and credit societies have gradually been introducingfront-office banking facilities in some areas, especially producer cooperatives. This has assisted smallproducers who cannot afford the high payment processing costs associated with the formal banking andfinance system.

1.29. One of the constraints to the growth of savings and credit associations (and cooperatives ingeneral) is the punitive tax regime. Prior to the enactment of the Finance Act of 1984, taxation oncooperatives, if any, was limited to secondary activities which are not mutual trading between a society and

its members e.g. rental income on property, dealings with non-members, dividend and investment income,and interest income above a specified minimum computed per member per annum. In addition towithholding tax on interest on bank deposits, taxable income includes 85% of dividends and interest (otherthan interest from its members) and 70% of rental income. The tax is levied on each revenue categorywithout deducting operating expenses, which are presumably offset by the non-taxable categories ofincome. Depending on the structure of a SACCOs income statement, the tax may exceed that paid bycorporates net of allowable expenses.


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1.30. There are about 43 NGOs that provide credit to the poor. Out of these, over a dozen financialNGOs provide micro-credit as their main activity e.g. K-REP and PRIDE-Kenya, while others use creditas a complementary intervention. Most of these institutions use the Grameen model of group lendingwhere peer monitoring is largely responsible for the successful financial performance of the programs. Theprograms are largely characterised by high subsidies. For example, the Havers sustainability index for anurban savings and credit programme in a slum area of Nairobi showed that the breakeven annual interest

rate that would internalise all operating costs was 4.6 times the 15% charged, i.e. 69%.

1.31. The credit programs usually use primary and secondary groups for loan appraisal and enforcementof contracts. The groups are normally registered as welfare groups under the Ministry of Culture, and aretherefore not legal entities that can sue or be sued. Some NGOs have therefore been attempting totransform their credit programs to come under legal regulatory regimes e.g. as cooperatives, but withlimited success.

1.32. The Kenya Rural Enterprise Program (K-REP) has previously relied on donor grants to coverexpenses and provide loan capital. In 1995, K-REP decided to convert its financial services division to acommercial bank to serve low income groups. It will add deposit-taking function and other financialservices in an effort to meet the demand for micro-finance services in Kenya. However, there are justifiedfears that under traditional banking law and regulations, the K-REP bank may find itself drifting evenfurther away from poor people in future.


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CHAPTER 1: INTRODUCTION

TERMS OF REFERENCE

1.1. The terms of reference requires the consultant to:

(a) Critically review the functioning of the entire financial and banking systems with particularemphasis on key constraints such as collateral constraints, lender transaction costs, governanceand performance of social funds, savings mobilisation, inappropriate or non-existing regulatoryenvironment, etc that have had a direct or indirect bearing on the promotion of poverty-reducingemployment activities in each of the participating countries;

(b) Assess the role of membership-based financial organizations, social development funds andmicro-finance professional organizations, with a view to making policy-orientedrecommendations regarding their effective functioning and desirable impact on promotingemployment creation and poverty reduction activities in the Jobs for Africa/ Poverty Reducing

Employment Strategies for Sub-Saharan Africa (JFA-PRESSA) participating country;

(c) Make appropriate recommendations regarding the reform of the banking and financial systemswith a view to promoting and improving:

(i) Access by the poor to credit facilities so as to enable them create self-employmentactivities and micro-enterprises in urban and rural areas;

(ii) Incentives for the formal sector credit institutions to foster and enhance employment-intensive investment activities; and

(iii) Effective implementation of regulations and mechanisms which are designed to enhancemacroeconomic stability with regard to external capital inflows into Sub-Saharan Africa.

INTERPRETATION OF THE TERMS OF REFERENCE

1.2. Due to the declining capacity for employment creation in the formal sector, employment needsto be created through increased productivity in agriculture (through intensification of crop and livestockproduction), rural non-farm activity, a dynamic informal sector, and a restructured industrial sector.Employment and incomes would hence benefit a wide cross-section of the population, and each sectorwould find effective demand from the other sectors. The improvement in the livelihoods of small-scaleproducers (as entrepreneurs, farmers and herders) would also provide a market for goods and servicesproduced by the formal sector. The resulting economic structure would lead to improved distribution ofincomes and a dynamic basis for sustained economic growth. The role of the banking and financialsystem in promoting investment-led, poverty-reducing, employment creation is the purpose of this paper.

1.3. Following liberalization of the financial sector that started in the mid-eighties as a response tocollapse of a few indigenous financial institutions, substantial amount of research has been conducted onthe financial sector and the conduct of monetary policy. However, the existing body of research barelytouches on financial liberalization in the context of poverty reduction.

1.4. Due to difficulties in obtaining reliable and detailed data, say, on individual banks, the study is atbest casual empiricism. But the general impression created by the few people interviewed is that banks


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appear very busy milking a dying cow. This is reflected in little new lending, heavy bank investment inGovernment paper, hostility towards small savers (e.g. high minimum balances), concentration of lendingin urban areas (and therefore operating as a conduit of resource flows from rural to urban areas), and agradual change in earnings away from lending to non-funds based sources of revenue (e.g. commissionsand penalties). The latter enables the banks to post high profits without lending to the private sector,hence depressing capital formation and shortfalls in business funds that normally finance working capital.

1.5. Poverty reduction vis--vis the conduct of monetary policy and attitudes of Kenyas financehouses is supposed to address some basic issues, e.g.

(a) Bank outreach through the expansion of branches and increase in the mix of financial assets andservices provided;

(b) Sources of deposits by broad geographical coverage e.g. whether the financial sector drawsresources from rural areas for on-lending to urban areas;

(c) Lending by sector;

(d) Incentives to tap deposits e.g. minimum balances, charges (clearing checks, etc.) and penalties;

(e) Borrower transaction costs (appraisal, valuation, renewal fees);

(f) Government financing of fiscal deficits through the banking system, its implications forresources available to finance Government services, and the crowding out of the private sectorfrom investible funds;

(g) Central Banks conduct of monetary policy and supervision of the financial system;

(h) Adequacy of the enabling legislation (Acts of Parliament) covering the money (short-termsecurities) and capital (medium and long-term) markets;

(i) Disclosure rules to reduce information asymmetry between the financial sector (Central Bank,financial institutions) and the public;

(j) The degree of competition/concentration in the formal financial sector; and

(k) The role and performance of social development funds e.g. National Social Security Fund; and

(l) The size, outreach and performance of member-based financial organizations e.g. savings andcredit societies and various clones of Grameen bank operating under the umbrella ofnongovernmental organizations.

1.6. Most of the formal financial institutions have put hurdles in the way for small depositors throughhigh minimum balances for both savings and checking accounts. For those with bank accounts, access tocredit is restricted by collateral requirements, the availability of marketable collateral e.g. urban property,and the high and volatile interest rates spurred by Government deficit-financing through the banking

system. But this evidence is anecdotal. One is tempted to proclaim: Why call witnesses if it is true?2

2 In Aesops fable and Karl Marxs The Eighteenth Brumaire of Louis Bonaparte(1852), the expression meansthat people must be known by their deeds, not by their own claims for themselves; whereas here itimplies substantiating the obvious.


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OUTLINE OF THE REPORT

1.7. The report is a narrative of the major milestones in the development of finance and bankingsystem in Kenya. Since the majority of Kenyans are currently wallowing in poverty, the historicalapproach to the analysis of the financial sector might assist to answer two main questions, namely, whenthe money came and where it went.

1.8. The report is divided into seven chapters. The first two chapters cover the financial system inhistorical perspective. Chapter four covers the financial sector reforms, followed by the current structureof the formal banking and financial system. The review of the literature is contained in Chapter six, andChapter seven covers informal finance. Finally, the report ends with conclusions and recommendations.


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CHAPTER 2: THE FINANCIAL SYSTEM IN A HISTORICAL PERSPECTIVE

Let it be admitted at the outset that European brains, capital, and energy have not been, and neverwill be, expended in developing the resources of Africa from motives of pure philanthropy; that

Europe is in Africa for the mutual benefit of her own industrial classes, and of the native races intheir progress to a higher plane; that the benefit can be made reciprocal, and that it is the aim anddesire of civilized administration to fulfil this dual mandate. - F.D. Lugard, The Dual Mandate inBritish Tropical Africa(1922)

THE EAST AFRICAN CURRENCY BOARD

2.1. In pre-colonial Kenya, the predominant medium of exchange and store of wealth werecommodity currencies, mainly livestock and cowries. Early anthropologists described the attachment tolivestock as the cattle complex (Herskovits, 1926). Livestock had three main functions: source ofsubsistence, as capital, and medium of exchange. As a source of subsistence, livestock provided milk andother dairy products, meat and hides. In addition, livestock provided manure for communities engaged in

mixed farming. As capital, Lord Hailey in his An African Survey (1938) observed that herds and theirprogeny furnished the only form of interest-bearing investment (cited in Kaarisa, 1976). The use oflivestock as medium of exchange mainly used the cattle standard with the smaller animals acting as smallchange. Evidence of fixed price regimes between various types of livestock, grains and honey wererecorded by pioneer anthropologists to East Africa.

2.2. The first modern currency to circulate was the Indian rupee, mainly on account of Indianfinancing of trading with East African coast (mainly Zanzibar) and the Indian labourers working on theUganda railway. The Indian traders who opened trading posts along the railway route were instrumentalin the spread of rupee currency.For example, the Report of the Railway Committee for the year ended1899 recorded that so far as the rails have advanced, rupees are rapidly taking place of beads and wirewhich have hitherto occupied the place of money with the natives (cited in Memon, 1973). In 1906, therupee (rubia two shillings - in Kikuyu) became the official currency of British Possessions in East Africa.

Under the terms of the Versailles Treaty, Britain acquired the former German colony and renamed itTanganyika Territory3; and the status of Kenya also changed from an East African Protectorate to theColony and Protectorate of Kenya.

2.3. The establishment of banking institutions at the turn of the century was the first instance ofmodern financial intermediation. However, lack of effective demand for livestock meant that the capitalwas not translated into financial instruments. The hut tax legislation of 1897 and 1902 were the firstattempts to create adequate labour supply for European settlers as the tax was payable in Indian rupees(MacRae, 1937; Ojow, 1968; Berman and Lonsdale, 1980). When some people tried to evade it bycrowding into huts, a poll tax was introduced in 1903 making every male 16 years or older liable (the huttax if he owned a hut and poll tax if otherwise). The poll tax also served the additional purpose ofcapturing the warrior age set4. The collecting officers did not know whether a youth had attained the age

3The German East Africa coins consisted of rupie coins and multiples thereof, and subsidiary coinagewas given the name heller to distinguish it from the pfennig used in Germany. The heller was assignedthe equivalent value of 100 heller to one rupie, hence the common reference to hela to denote one cent.4The Report by the Financial Commissioner (Lord Moyne) On Certain Questions in Kenya, May 1932, statedthat The hut tax, unlike the poll tax, is a form of property tax, and, being levied according to the numberof huts owned by the taxpayer, varies to some extent with the ability to pay. Wives are still a very popularform of capital investment Women also yield a valuable income by working with their children in thefields, and they can therefore fairly be taken as a simple measure of the taxable capacity of the hut


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of 16, and one rough method was to check whether there was any growth of hair in the armpit, but insome cases an arbitrary decision was taken on who was liable to pay tax (Tarus, 2004). Income tax wasfirst introduced in Kenya in 1937 (Henry, 1963).

2.4 Lord Hindlip observed that one of the most important questions to be considered is that oflabour, without a sufficiency of which no development can take place; and if much encouragement isgiven to the natives to pay their taxes in grain, etc., the supply of labor will visibly decrease. I am sure that

as far as possible taxes should be paid entirely in labour and in cash. A demand for cash should be createdamong the natives, who would then have to obtain coin in order to pay their taxes (Hindlip, 1905).Taxation was introduced or increased, not only to raise revenue, but to drive Africans to serve theinterests of international capitalism. The guiding principle was stated vividly by the Governor of Kenya in1913: We consider that taxation is the only possible method of compelling the native to leave his reservefor the purpose of seeking work. Only in this way can the cost of living be increased for the native . . . itis on this that the supply of labour and the price of labour depend. To raise the rate of wages would notincrease, but would diminish the supply of labor (East African Standard, 8 February 1913; Padmore, 1931;Kaniki, 1985; Rothbard, 2011).However, to Lord Lugard (1922), among unorganised communities where native rulers cannot be said to exist, the tax affords a means of creating and enforcing nativeauthority, of curbing lawlessness, and assisting in tribal evolution, and hence it becomes a moral benefit,and is justified by the immunity from slave-raids which the people now enjoy.

2.5. The British Sterling was based on gold (until 1931) while the rupee was based on silver. Theinstability in the gold and silver markets that occurred after the First World War was mirrored in theexchange rate between Sterling and rupee. The appreciation of the rupee threatened European settlerswith bankruptcy5, which was further exacerbated by collapse of world commodity markets for Kenyasagricultural exports, e.g. coffee and sisal (Lomoro, 1964). To forestall further losses to the Europeanfarmers, the exchange rate between the Sterling and the rupee was fixed, the East African CurrencyBoard6 constituted, and a new currency established (East African florin in 19207, which was replaced bythe shilling in 1922). In 1931, the Land and Agricultural Bank of Kenya was established, principally toprovide credit to European farmers (Colony and Protectorate of Kenya, Colonial Reports No. 1562 for1930) due to freeze on agricultural lending by commercial banks as a result of the global depression,drought and locusts; while natives could not access credit due to the nature of the land tenure they weresubjected to (Report by the Financial Commissioner Lord Moyne On Certain Questions in Kenya, May1932)8. The agricultural commodity markets also came under administered pricing systems, and crop

marketing boards were established, which also enforced exclusion of African farmers from markets(Yoshida, 1966). Post Office Savings Banks were established in Kenya in 1910 and later in Tanganyika(1926) and Uganda (1927) Kamewe and Radcliffe (1999).

owners. The justification for taxing according to the number of huts owned is that a man with manyhuts will, generally speaking, have a proportionate number of people to work for him and contributetowards his taxable resources.5This is what Lugard (1922) probably meant when he said that East Africa is unfortunate in sharing thefluctuations of the Indian rupee.6 A currency board, which was essentially an invention of the British Empire (Williamson, 1995), is amonetary authority that issues and redeems domestic currency on demand against a specified foreigncurrency at a fixed exchange rate, while holding foreign reserves amounting to at least 100% of its issue of

domestic currency.7 His Majestys Stationery Office, Colonial Report No. 1122, Colony and Protectorate of Kenya, Reportfor 1920-21, London8As W.K. Horne, Speaker of the Legislative Council, said in 1948, I would take it that the Land BankOrdinance only works on the security of land tenure, and that it is not designed for Africans. That is thereal answer, is it not? J.F.G. Troughton, Financial Secretary and Member for Finance, answered, That iscorrect, sir Colony and Protectorate of Kenya, Legislative Council Debates, Volume 30, August 10, 1948,column 110; also cited in Kournossoff (1959).


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2.6. The East African Currency Board was constituted in 1919 and began operations in 1920. Thereserves of the Board were invested in Sterling securities, mainly in London, as it was not allowed to holdsecurities of the governments within the currency board system. The East African territories were part ofthe Sterling Area, and monetary or fiscal policies in UK having any bearing on the rate of exchange orinterest rate for the Sterling automatically affected the Shilling. The result was that the Board directlyfinanced the British public sector and the Bank of England, and indirectly the development of the Britisheconomy (Frediani, 1975). In 1955, the Board was authorised to hold up to 10m in long-term securities

issued or guaranteed by the constituent governments. The fiduciary limit (part of the local currency whichis not backed in full by Sterling assets) in government bonds were doubled in 1957.

2.7. In 1959, the Board was authorized to acquire local Treasury Bills, which Kenya barely utilisedsince it had least difficulties with raising tax revenues, compared with Tanganyika and Uganda which usedalmost all their allotment (King, 1973). In 1960, the headquarters of the Board were transferred fromLondon to Nairobi, while Treasury officials of the constituent governments were also appointed to theBoard. In order to facilitate orderly conduct of banking operations, the Board opened accounts forcommercial banks and provided clearing facilities beginning 1962.

2.8. The currency board maintained an equal cover for the currency it issued in Sterling, and couldnot therefore influence monetary conditions in the constituent economies. Participation in Treasury billsapproved in 1958 made it possible for the Board to become an agent of monetary expansion, similar in

principle to a central bank.

2.9. Tanganyika, Uganda, Kenya and Zanzibar achieved political independence in 1961, 1962, 1963and 1964, respectively. After independence, the member countries continued to support the regionalcurrency board. In February 1965, the government of Tanzania (comprising Tanganyika and Zanzibar)indicated its intention to establish a national central bank and to withdraw from the currency union. Sinceits independence, Tanzania had been examining its position in the Currency Board and had enlisted theservices of a leading German central banker, Erwin Blumenthal, to investigate the workings of the EastAfrican Currency Board, and to examine the possibility of establishing an East African Central Bank.Although Erwin Blumenthal recommended the creation of a Central Bank for the region which wouldtake over the assets and liabilities of the EACB, and four territorial state banks for Tanganyika, Kenya,Uganda and Zanzibar (Clark, 1964), it was clear that a workable regional central bank was not feasible inthe absence of a single authority to which it would be responsible to. The World Bank report on Kenya

(1963, p. 183) had expressed reservations about the workability of a regional monetary authority: Thedifficulty of evolving a single monetary authority in harmony with the individual economic objectives ofseparate governments would allow little scope for a central bank to function.

2.10. Tanzania set up its own central bank in January 1966, followed by Kenya and Uganda in May1966, which marked the end of the East African Currency Board and the monetary union it presided. The1965 Sessional Paper No 10 onAfrican Socialism and Its Application to Planning in Kenyastated that a centralbank, whether for Kenya or East Africa, will be established without delay. The euphoria of cooperationamong the three east African states and the possibility of forming a political and economic federationdelayed the initiation of central banks in each constituent country.

PRE-INDEPENDENCE COMMERCIAL BANKING

2.11. Commercial banking was established in Kenya at the turn of the century immediately followingthe establishment of a British presence in this part of the world. The National Bank of India (which laterbecame the National and Grindlays Bank) was the first to open an office in Mombasa in 1896, under theauthority of the Companies Act of 1862. It was followed by Standard Bank of South Africa in 1911 andthe National Bank of South Africa in 1916. The latter merged in 1926 with the Colonial Bank and theAnglo-Egyptian Bank to form Barclays Bank (Dominion, Colonial and Overseas (DCO)). These were theonly three banks in Kenya (two of which were branches of British banks) until after the end of the


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Second World War, except for Exchange Bank of India which was registered in 1928 and wound up in1949.

2.12. In 1951, the Nederlandsche Handel-Maatschappij, a German bank registered in the Netherlandsand later renamed Algemene Bank Nederland, opened a branch at Mombasa. Two Indian banks, Bank ofIndia and Bank of Baroda followed in 1953, and in 1956 Habib Bank (a Pakistan bank) established anoffice. Two years later, in 1958, the Ottoman Bank of Turkey and the Commercial Bank of Africa each

opened a branch in Kenya, and the African Banking Corporation, a member of the Standard Bank group,was granted a banking licence in 1963 although it did not carry out any banking business.

2.13. In 1965, the government registered the Cooperative Bank of Kenya initially under theCooperative Societies Act, which opened its doors in 1968. The National Bank of Kenya was establishedin 1968 as a fully-owned Government entity. In 1969, the business of Ottoman Bank was taken over bythe National and Grindlays Bank. The latter was split into two entities in 1971: Kenya Commercial Bank(with 60% Government participation) and a new entity called Grindlays Bank International (with 40%Government participation). In 1974, two American banks were established: First National Bank ofChicago and First National City Bank of New York.

2.14. The foreign commercial banks operated a gentlemans club with respect to interest rates ondeposits (by term structure) and loans/advances, commissions and charges on various services offered,

ledger fees, exchange rate commissions, and guarantees. In 1969, the gentlemans arrangement wasformalized into Summary of Banking Arrangements: Kenyawhich had the following subscribing banks: Bankof Baroda, Bank of India, Barclays Bank, Commercial Bank of Africa, General Bank of the Netherlands,Habib Bank, National and Grindlays Bank, Ottoman Bank and Standard Bank. The emergence of state-owned and private indigenous banks which did not subscribe to the cartel-like arrangements led togradual erosion of the formal arrangements. In other countries, the cartel would have attracted antitrustaction.

NONBANK FINANCIAL INTERMEDIARIES

2.15. The establishment of nonbank financial intermediaries came far much later. At the end of 1967,there were only three hire purchase houses: the Credit Finance Corporation (established in 1955), the

National Industrial Credit Corporation (established in 1959) and the United Dominions Corporation(East Africa). The Credit Finance Corporation was established in 1955; the National Industrial Credit in1959 and conducted banking business from 1960 to 1970 when it obtained a financial institution licence;and United Dominions opened in 1959. Most of the finance houses experienced a run on their depositsafter the financial panic unleashed by the Lancaster House Constitutional Conference of February 1960(Frediani, 1975). The finance houses were subject to the same regulations as banks under the MoneyLenders Ordinance and Banking Ordinance, except that they could not maintain checking accounts anddealt with specialised activities.

2.16. Before independence, there were only five building societies: Kenya Building Society, Savings andLoan Society, the First Permanent Building Society, the East African Building Society and the KentandaMutual Building Society9. Kenya Building Society was taken over by the Commonwealth DevelopmentCorporation in 1963; and Savings and Loan Society was taken over by Pearl Assurance in 1965 and

reconstituted as Savings and Loan Kenya Ltd. After independence, the Housing Finance Company ofKenya was set up in 1965 and was subscribed by the Commonwealth Development Corporation (60%)and the Kenya government (40%). Two financial intermediaries, Diamond Jubilee Investment Trust of

9 See, Colonial Office, Financial Difficulties of the Building Societies in East Africa: Memorandum bythe Secretary of State for the Colonies, 4th October, 1960, on the illiquid condition of banks and buildingsocieties due to repatriation of private capital as a result of lack of European and Asian confidence intheir future in independent Kenya.


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Kenya and Overseas Finance, served the Ismail and Asian communities, respectively.

DEVELOPMENTS IN BANKING LEGISLATION

2.17. Although the banks in pre-independence Kenya discharged monetary functions, they weresubject to virtually no institutional or monetary policy constraint. The first enabling legislation enacted to

regulate activities of banks was the 1910 Banking Ordinance, which covered licensing of banks, andorders for the Government to order a bank inspection if asked by a shareholder with more than 25%holding or a depositor holding more than 50% of deposits.

2.18. The nonbank financial institutions operated generally under the Money Lenders Ordinance of1932. In order to cope with the expansion of the banking industry, a new Banking Ordinance was enactedin 1956, together with a Building Societies Act. The revised legislation created an office of the Registrarfor Banks, introduced minimum capital requirements, and rules covering a banks reserve fund.

2.19. The only obligations under the Banking Ordinance of 1956 was the need for a licence and somelimited powers exercised by the Registrar of Banks which did not amount to bank supervision as iscurrently understood. The generous upper limit of 48% imposed upon the lending rates of all financialintermediaries by the Money Lenders Ordinance of 1932 cannot be regarded as a constraint at all, while

the exchange control regulations did not interfere with their freedom of action since all were agencies offoreign banks (Frediani, 1975). The banks concentrated their local lending to Europeans and Asianswhile Africans are unfavourably neglected (Lomoro, 1963). F.D. Lugards dual mandate ultimatelygave birth to economic dualism.


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CHAPTER 3: THE FINANCIAL SYSTEM AFTER INDEPENDENCE

Most things in life automobiles, mistresses, cancer are important only to those who have them.Money, in contrast, is equally important to those who have it and those who dont. - John KennethGalbraith,Money: Whence It Came, Where It Went(1975)

THE REGULATORY FRAMEWORK

3.1. Since the establishment of the Central Bank in 1966, it became necessary to issue a new BankingAct in order to harmonise it with the Central Bank of Kenya Act. The Banking Act, 1968, abolished theoffice of the Registrar of Banks and transferred the functions to Central Bank and Ministry of Finance;made a distinction between a bank and a financial institution; prohibited banks and financial institutionsfrom lending to any single person or institution more than 5% of its deposit liabilities or 100% of its paid-up capital and unimpaired reserves, whichever was greater; and required both banks and financial

institutions to maintain a minimum holding of liquid assets to be determined by Central Bank from timeto time. The Central Bank of Kenya Act was amended in 1972 to limit government borrowing from theCentral Bank to 25% of its gross recurrent revenue for the latest audited year. The latter provision wasnever consciously adhered to.

3.2. The Banking Act had more liberal requirements for financial institutions than for banks, mainlylower minimum capital for financial institutions (one quarter compared with banks); liquidity ratio of12.5% for banks beginning 1969 and no minimum liquidity requirements for nonbanks until 1974; aminimum cash ratio for banks beginning December 1971; a higher maximum lending rate for nonbanksand a common minimum savings rate for banks and nonbanks since 1980; administrative credit ceilingsfor banks since 1972 (abolished in December 1993) and none for nonbanks; and restriction for banks inlending on the security of immovable property (land) for the purpose of purchasing, improving or alteringthe property.

3.3. The less restrictive regulatory regime subjected to nonbanks compared to banks led to substantialgrowth of the nonbank market segment in the seventies up to early eighties. However, new regulatorymeasures were introduced in the early eighties, e.g.:

(a) In February 1983, nonbanks were instructed to invest not less than 50% of their liquid assets inT-bills which was relatively less profitable than other alternative investments;

(b) In 1983, their liquidity requirements were increased such that they were supposed to maintain aminimum of 24% of their total deposits in liquid assets, which constrained their ability to grantcredit facilities;

(c) In November 1983, nonbanks were prohibited from charging fees or commissions and required

to charge interest on a reducing balance basis (see, for example, extracts of a speech of theGovernor of the Central Bank to the Kenya Institute of Bankers in Economic and Financial Review,July-September 1984); and

(d) Substantial parastatal deposits were withdrawn.


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3.4. The Governor of the Central Bank, in reference to an IMF study conducted in 198410, statedthat the report argues that the present interest rate system may have distorted the nature of financialactivity by encouraging the growth of nonbanks compared with banks... Interest rate controls have led toshortages of long-term finance and venture capital from banks. In that connection, the report considersthat the tendency for nonbanks to make good the shortfall in this area of lending, together with theirrelatively high proportion of deposits from parastatals in some cases, may become a potential element ofinstability in the financial system (Central Bank of Kenya, Economic and Financial Review, July-September

1984). That was the beginning of the end of the NBFI era.

THE BANKING CRISIS OF THE MID-EIGHTIES

3.5. The more liberal legal regime and the spill-over effects of the 1976-79 coffee boom led to theflourishing of private indigenous nonbanks as reflected in their large share of deposits before the bankingcrisis of the mid-eighties. One of the large institutional investors in the collapsed banks was the NationalSocial Security Fund, which had huge deposits in the failed banks due to political influence and to takeadvantage of high interest rates on deposits placed with nonbanks compared to banks. The banking crisiscaused a run on deposits of nonbanks and a flight to quality in the form of deposits held at the largetraditional commercial banks.

3.6. The analysis of nonbanks covering the index period also indicates that they were undercapitalizedby international standards. The concentration of ownership of a financial institution among a fewindividuals also made it difficult for managers to exercise sufficient independence in decision-making,which led to proliferation of insider lending. The policy-makers had the options of instilling discipline andgradual introduction of a strict regulatory framework, or quick-fix that would lead to closure of weakinstitutions. Kenya opted for the latter, which led to substantial closures with heavy deadweight loss tothe economy (government revenue, depositors, and the general public through debt-financed costs ofrestructuring).

3.7. The minimum capital requirements were raised and difference between minimum capital forbanks and financial institutions narrowed from a quarter to a half in 1982 due to increase in the players inthe finance industry. In 1984, provisions of the Banking Act were extended to building societies, mainlygiving Central Bank the powers to determine interest rates charged by building societies and to inspect

them. At the same time, Central Bank run a spirited jawboning campaign to ensure that all banks andfinancial institutions charged interest on loans on a declining balance since a large number used fixedbalance method.

3.8. The 1985 amendments to the Banking Act were the most comprehensive since the Banking Actcame into force in 1969. The new measures increased capital requirements for both banks and financialinstitutions; gearing ratio (capital and reserves to deposits) was increased from 5% to 7.5%; reintroduceda minimum statutory reserve fund equal to paid-up capital which was to be invested in Governmentsecurities; introduced a provision for establishment of a Deposit Protection Fund; and restricted thetrading activities of financial institutions as well. The amendments also prohibited financial institutionsfrom owning directly or indirectly shares in a bank. The latter loophole had been used by financialinstitutions to open up banks so as to access interest-free current account deposits as nonbanks were notpermitted to operate checking accounts.

3.9. There were shivers among indigenous banks and financial institutions as the new capital-deposit(gearing) ratio took effect in May 1988. While the big banks either had the required capital or could meetthe shortfall from flotation of shares (Kenya Commercial Bank, National Bank, Barclays Bank, KenyaFinance Corporations private placement, and the Cooperative Banks injection of new capital from

10 IMF, The Financial System in Kenya, August 1984; and World Bank, The Development of Moneyand Capital Markets in Kenya, October 1984


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member cooperatives), the small indigenous financial institutions experienced difficulties as the onlyimmediate option would have been to restrict deposits. The introduction of 20% minimum liquidityrequirement may have contributed to the collapse of two building societies that collapsed after thelegislation became effective11.

3.10. The severity of regulations (especially those that were introduced for the first time) and the shortperiod allowed to conform to the regulations may have sealed the fate of some indigenous finance

houses, despite the long-term merit of the regulations in strengthening the financial sector. Thestrengthening of the financial sector was done at considerable cost to the domestic ownership of thefinance market.

REACTIONS TO THE BANKING CRISIS

3.11. In 1984, Central Bank of Kenya, with the support of the International Finance Corporation, theprivate sector investment affiliate of the World Bank, undertook a study of money and capital markets inKenya. The World Bank, on its part conducted four studies: (a) Agricultural Credit Policy Review 1985, (b)Industrial Finance, which was conducted in 1983 but published in 1985, probably to await the findings ofthe study on money and capital markets, (c) Kenya: Industrial Sector policies for Investment and Growth in 1987(which also covered the financial sector), and (d) Rural Finance Reviewin 1990.

3.12. Most of the changes in enabling legislation and supervision of the financial system have been as aresult of lessons after the event or external interventions introduced as part of economy-wide and sectoraladjustment operations. For example, the outcome of the above-mentioned studies conducted under theauspices of the World Bank and IMF were far-reaching changes in the money and capital markets.

3.13. The capital market remained fairly inactive and was controlled by the Capital Issues Committee(CIC), which was started in 1971 to regulate the size, timing and pricing of issues. The CIC process wasso slow that the Barclays Bank issue took about six years while others withdrew after starting the process(World Bank, 1987). As part of the World Banks 1988 Industrial Sector Adjustment Program, theGovernment agreed to establish a Capital Markets Development Authority by June 1989 and to strip CICof its power over timing and pricing of issues of domestically-owned firms, with the ultimate objective ofmoving toward market-determined prices for all equities. The far-reaching amendments to the Banking

Act in 1989 were a precondition for effectiveness of the World Banks Financial Sector AdjustmentOperation.

3.14. In 1996, the limit of advances to a single borrower was reduced to 25% of capital and unimpairedreserves, down from the previous 100% to reduce credit risk exposure; and minimum capital adequacyratio was raised from 7.5% to 8% in terms of total deposit liabilities. Beginning the mid-nineties, CentralBank started rating banks and financial institutions on the basis of their performance with respect tocapital adequacy/gearing ratio (capital and reserves to deposit liabilities), asset quality (the proportion ofloans and advance to total assets), earnings, and liquidity. The aggregate statistics for banks and nonbanksare published in the annual report of the Supervision Department of the Central Bank.

CHANGES IN MONETARY POLICY

3.15. The late eighties saw great changes in the gradual liberalization of the financial sector.Traditionally, monetary policy was conducted through a rigid system of controls aimed at affecting theprice, allocation and size of credit to the private sector. The major instruments of control were: (a)

11. Undoubtedly, other nonbanks may have suffered contagion effect. This is aptly summarised by

Hamada (1998) in discussing financial crises in Japan: If rumours create rumours, if panic psychologybecomes contagious, then the financial system collapses in a process of a self-fulfilling prophecy.


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maximum interest rates on loans and minimum rates on deposits, (b) a liquid assets ratio that requiredbanks and financial institutions to hold a specified proportion of their assets in liquid governmentinstruments (cash and T-bills), (c) guidelines on the maximum growth of private sector credit, and (d)guidelines on the allocation of credit (e.g. 17% of bank loans directed to the agricultural sector).

3.16. As part of financial sector reform program, the Government reacted to the constraints thatstifled the functioning of the financial system through a number of measures. These included increasing

the band between deposit and lending rates; strengthening the auction system for T-bills and developing asecondary market for T-bills; issuing a wider variety of T-bill maturities; introducing more generalizedmonetary policy instruments e.g. open market operations (OMO), cash ratio and a discount window; andamending the regulations differentiating banks and nonbanks.

3.17. In 1986, a 6% cash ratio was introduced for commercial banks based on a banks current reservesat Central Bank and deposits held at the end of the previous month, which did not apply to otherfinancial institutions. The government, however, continued to enforce the liquidity ratio, probably as awindow for forced lending to government through T-bills. The Government also introduced a discountwindow facility that allows banks having temporary difficulties meeting the minimum cash ratio torediscount their T-bills at the Central Bank. The Government introduced securities of longer maturities inthe form of Treasury Bonds. Initially, all the bonds were virtually held by banks, the National SocialSecurity Fund (about 50%), and life insurance companies who were required to invest at least 25% of

their assets in long-term Treasury securities under the Insurance Act.

3.18. The cash and liquidity reserve requirements use lagged reserve accounting, i.e. the reserves a bankhas to hold are based on deposits that were in the banks balance sheet at the end of the previous month(Saunders, 1988). This implies that there is no direct link between a banks current reserve position and itscurrent level of deposits - a direct link is called contemporaneous reserve accounting (Thornton, 1983).The lack of a contemporaneous reserve accounting is understandable due to the huge informationrequirements especially for network banks, and also avoids short-term monetary response based on short-term fluctuations in the level of deposits of major banks.

3.19. In a monetary regime based on open market operations and cash/reserve base control, the liquidassets ratio may be redundant as a monetary policy tool (Saunders, 1988). Saunders (1988) adds that itsonly purpose is forced lending to government through T-bills. In the absence of a liquidity ratio, banks

would still buy T-bills for liquidity, yield and portfolio diversification, especially as excess reserves andcash in vault have zero yield (the so-called reserve tax the interest they could have earned on thesebalances in the absence of reserve requirements). Financial institutions do not bear all of the costs butrather pass at least some of them on to their customers in the form of lower deposit rates and higher loanrates (Feinman, 1993;Demirguc-Kunt and Huizinga, 1998, 1999).


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CHAPTER 4: FINANCIAL SECTOR REFORMS

A peculiar arrangement existed in these early Irish banks, of which no trace is found elsewhere. Thedeposits of each subscriber were kept separately, and open to the inspection of the owner when hebrought any fresh deposit, on which occasion he might count his money if he chose. - WilliamLewins,A History of Banks for Savings in Great Britain and Ireland(1866)

FINANCIAL SECTOR REFORMS IN A MACROECONOMIC CONTEXT

4.1. In 1986, the Government released an economic reform programme, the Sessional Paper No. 1 of1986 onEconomic Management for Renewed Growth, as a blueprint of the envisaged structural adjustment andeconomic reform up to the year 2000. For renewed growth, the Sessional Paper recognized the dominantrole of the private sector in revitalizing the economy, the importance of efficient use of scarce resourcesand control of the budget deficit, the need for a market-based incentive system, and balanced

development of both the rural and urban areas. Since 1986, the Government has moved towards market-based incentive system in industrial, agricultural and financial sectors, supported by external loans andgrants from bilateral and multilateral sources.

4.2. One of the components of the reform efforts focused on the functioning of the financial andbanking sector. Prior to the reform, the financial sector was characterised by undercapitalization (due tolow entry requirements for nonbanks), high state ownership, ceilings on deposit and lending rates, andquantitative restrictions on credit allocation. The Government had also established Development FinanceInstitutions to alleviate perceived market failures in the provision of long-term credit, but theseinstitutions were weak and were vulnerable to political patronage and abuse. Repressed interest ratesenabled the Government to finance budget deficits at minimal cost. Measures to reform the sectorincluded removal of interest rate controls, minimizing taxation of financial instruments, managing bankinsolvencies, development of Central Banks capacity for supervision, and restructuring of the

Development Finance Institutions.

4.3. In 1991, the Government deregulated interest rates, allowing them to vary with demand andsupply of loanable funds. Currently, one of the constraints to investment is the high interest rates chargedby banks. High interest rates can be traced to both demand and supply sides of the loan market. On thesupply side, the banking sector exhibits an oligopolistic structure with the market dominated by fourmajor banks; and the cash and liquidity ratios imposed on banks reduce the funds available for tradingpurposes. On the demand side, the high Government borrowing from the banking sector, includinglending to state-owned enterprises, is a factor contributing to high interest rates.

4.4. In 1992, there was a massive increase in money supply (defined as currency outside banks,demand deposits, call and 7 days deposits, and savings and time deposits) estimated at 35%. The increasein money supply put pressure on the external account through (a) increased demand for imports and

domestically produced goods with an import content, and (b) capital outflow caused by increasedpreference for foreign assets as a result of the downward pressure on the real domestic interest rates.However, the most devastating effects of inflation fomented by the increase in money supply were mainlydistributional. Real income was shifted from people with fixed incomes and provident funds, and fromsavers to debtors and the recipients of the increased money supply since nominal interest rates did notadjust fully.

4.5. The Government overall reform effort was slow until 1993. Since 1993, the Government has


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eliminated exchange controls including the capital account, except for a short list of products controlledfor health, security and environmental reasons; while tariff rates on imports have been substantiallyreduced. The retail price controls on maize were abolished in December 1993, and the petroleum marketin October 1994. The monetary and exchange control regime created in response to the appreciation ofthe rupee (the East African Currency Board) and agricultural pricing and marketing controls following theGreat Depression were essentially dismantled in 1993 in the midst of another crisis as a result of policymisadventure revolving around export compensation, pre-shipment finance, retention accounts, foreign

exchange bearer certificates, and cheque kiting (crediting a customers account before a cheque or bill ofexchange has been cleared). Market liberalization has improved competition and reduced rent-seeking inGovernment. In addition, after the experience of the early nineties when funds were kite-flying from theCentral Bank to private bank accounts, the Central Bank has substantially improved bank supervision.However, corruption and a basketful of assorted financial scandals has affected the quality of publicservices (e.g. education, health and infrastructure) and increased the vulnerability of the poor due to cost-sharing in public service delivery.

4.6. Government borrowing from the Central Bank was the main source of monetary expansion inthe past. The Government had for many years flouted Section 18(3) of the Central Bank, which providesthat the total amount of advances outstanding shall not exceed 25% of the gross recurrent revenue ofthe Government as shown in the Appropriation Accounts for the latest year for which those Accountshave been audited by the Controller and Auditor General. Central Banks first policy statement to

Parliament (June 1997) promised that this provision of the law will not be infringed in future.

4.7. However, Central Banks efforts to mop up excess liquidity in the economy through open-marketoperations i.e. the sale of treasury bills, has had the effect of maintaining high interest rates. The increasein Treasury bill rate has made it profitable for banks to invest in treasury bills, thus boosting theirprofitability from tax revenue and crowding out Government expenditure on essential services. Inaddition, this has the effect of reducing the attractiveness of bank lending for long-term investment incapital formation.

4.8. The past fiscal deficits financed through domestic and external borrowing has led to large interestpayments as proportion of budgetary expenditures. The external debt, though about 70% of total debt, ismainly in the form of concessional, long-maturity debt. The domestic debt, though small, is high cost andof short maturity, and take up about 70% of interest payable. The management of domestic debt in

Treasury bills is a paradox in macroeconomic management. The high interest rates to mop up excessliquidity invite short-term capital inflows which have also to be sterilized through the sale of moreTreasury bills. Failure to address domestic debt burden in Kenya will continue to siphon tax revenue, thuscrowding out Government expenditure in, say, infrastructure, education and health.

4.9. Due to the macroeconomic instability that accompanied financial sector liberalization in the earlynineties, high fiscal deficits accompanied by a standoff with the donor community made domesticfinancing of the deficit the only available alternative. The high volume of domestic debt soared demandfor more government bills/bonds to retire maturing securities, while the high interest on domestic debtfurther increased the demand for more domestic financing. The feedback mechanism between fiscal andmonetary policies has not been broken due to the psychological overhang of the pre-liberalizationperiods cheap financing of fiscal deficits from the domestic financial market.

THE LEGAL AND SUPERVISORY REGIMES

4.10. The Government has undertaken various measures to forestall further erosion in the confidenceof the banking system, e.g. increased minimum capital requirements, Government divestiture from thebanking system, encouraging small banks to merge so as to enjoy economies of scale, tightening of bankregulations, and improved supervision of the banking system. However, loans to politically-correct


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individuals and their companies12 have made it difficult for banks, especially the two banks withgovernment equity-participation, to recover nonperforming loans or to realise the assets (if any werepledged as lien). The Government has protected some large defaulters in the two banks and has refusedto table their names and details of their outstanding debts in Parliament. Direct capital injection byGovernment and conversion of parastatal deposits to equity may have created laxity in lending operationsin a government-owned bank. The possibility of Government bailout in case of eventual instability mayexplain why state-owned banks have higher portfolios of nonperforming loans compared to foreign

banks.In the case of state-owned banks, the bad debts problem was attributable to moral hazard on bankowners (Government), and adverse selection of bank borrowers (including insider trading) in the case ofnonbank financial institutions, although the distinction between moral hazard and adverse selection israther thin for state-owned banks due to Governments obligation to bail out distressed banks.

4.11. According to Central Bank (Monthly Economic Review, June 1998), the uneven share in the industrycannot be broken by natural growth of the small players in the market. Central Bank thereforerecommended mergers to assist the small players offer more competition to the market leaders and as away of increasing their capital base to the statutory requirements by the end of 1999. Several nonbankshave converted to banks or merged with parent banks. Although all the operational banks and nonbanksmet the deadline, by September 1999, half of the banks and all the nonbanks had less than the minimumcapital base required by the end of 1999. The Darwinian theory of natural selection makes it relativelydifficult for weak financial institutions to effectively compete with large banks (with large foreign equity

or government ownership) within a common legal regime.

4.12. Kenya is a member of Basle Committee on Banking Supervision. In addition to rules governingprudential supervision and disclosure requirements, the Basle Accord sets two quantitative standards: (a)capital adequacy ratio of 8% - capital and unimpaired reserves to assets (including their total loans andadvances) as per section 18 of the Banking Act, and (b) limit to which a bank or group may lend to anyone customer and companies or persons connected with the bank or banking group itself. The CentralBank of Kenya has gradually upgraded the capital adequacy ratio to the Basle standards, and in 1995limited advances to any single customer from the previous 100% to 25% of an institutions paid-upcapital and unimpaired reserves.

4.13. Currently, banks are required to maintain specified minimum ratios of various balance sheetitems. Specifically, section 7 of the Banking Act deals with minimum capital requirements in absolute

terms; section 17 on the ratio of capital and unimpaired reserves to total deposit liabilities (gearing ratio);and section 18 on the ratio of capital and unimpaired reserves to total assets - including loans andadvances (capital adequacy ratio). Others include minimum holding of liquid assets in section 19 of theBanking Act (not liquidity ratio as it is applied in practice), while the ratio of minimum cash balance ondeposit at Central Bank to deposit and other liabilities (cash ratio) is in the Central Bank of Kenya Act butnot in the Banking Act, presumably because it is primarily understood to be a tool of monetary policy.Section 38 of the Central Bank of Kenya Act enacted in 1995 gives the Bank wide powers to imposeratios on different types of liabilities without further reference to Parliament, other than the routinetabling of subsidiary legislation (Legal Notices) in the National Assembly.

4.14. The disclosure requirements for both bank and nonbanks have been broadened to include:

(a) Publication of both the audited balance sheet and profit and loss statement in a national

newspaper;

(b) Beginning August 1997, declare specific base lending rates as a means to enhance transparencyand competition;

12. As stated in the Central Bank of Kenya Monthly Economic Review, February 1999, a large

proportion of nonperforming loans are loans improperly granted to influential persons.


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(c) A requirement was introduced that loans to directors must be at commercial rates;

(d) Disclosure of the ultimate beneficial owners of shares held through nominees and othercompanies;

(e) Disclosure of all insider loans as well as nonperforming loans; and

(f) Imposition of cash penalties for noncompliancewith mandatory cash and liquidity ratios.

OUTCOME OF THE REFORM EFFORT

4.15. Despite major changes in the enabling legislation covering the financial sector and the move tomarket-determined interest rate regime, the financial system continues to sag under the weight ofnonperforming loans. The first major disruption occurred during 1984-86 when several indigenous banksand financial institutions failed, mainly due to imprudent lending practices leading to high proportion ofnonperforming loans and the consequent inability to meet maturing obligations and statutoryrequirements. Other major disruptions occurred in 1989 when the Government amalgamated one bankand nine nonbank financial institutions to form the Consolidated Bank in order to forestall theirimminent collapse. During 1992/93, 14 institutions were put under liquidation while another three came

under Central Bank management in 1994.The banks that fell under the Consolidated Bank of Kenyawere Union Bank, Jimba Credit Corporation, Estate Finance, Estate Building Society, Business Finance,Nationwide Finance, Kenya Savings and Mortgages, Home Savings and Mortgages, and Citizens BuildingSociety.

4.16. As at the end of 1998, the total number of institutions under liquidation remained at 30 as in theprevious year while the same 17 institutions remained under Deposit Protection Fund, 7 underConsolidated Bank, 4 under official receiver, 1 under voluntary liquidation, and 1 was wound up by thecourt. During 1998, 5 banks were placed under statutory management. The 1998 annual report of CentralBanks Supervision Department gave the following major reasons for the bank failures during 1998:

(a) High level of nonperforming loans caused by poor lending practices which were compounded bymismanagement and outright frauds;

(b) Conflict of interest in those cases where shareholders participate in the day-to-day managementof their banks;

(c) Difficulties faced by banks in the recovery of nonperforming loans through the Judiciary;

(d) Some loans to nonviable projects appear to have been advanced on official influence;

(e) Insider lending to directors and their associates for nonviable investments;

(f) Undercapitalization for some banking institutions; and

(g) Overinvestment in the speculative property market which is currently experiencing dramatic drop

in prices.

4.17. The accounting systems may have contributed to collapse of some financial institutions. Forexample, interest not collected was included in revenue, thereby giving a healthy income and lossstatement, while the institution is facing a liquidity crisis. Unless there are transparent and uniformprocedures for computing provisions for bad and doubtful debts, a bank or financial institution maycontinue paying dividends while its underlying financial strength is dwindling. This would be equivalent topaying dividends out of shareholders capital.


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4.18. Central Bank has introduced stringent regulations regarding the classification of debts asnonperforming. It has introduced a mandatory 10% general provision for bad and doubtful debts on alladvances, over and above the specific provisions made by the bank. According toMarket Intelligence(May1999), the furore raised by the new requirements resulted in some banks [in 1998]... charging theirprovisions on retained earnings, instead of on their profit and loss accounts... The CBK finally ruled thatgeneral provisions should be charged on the profit and loss account.

4.19. The introduction of prudential guidelines and increased disclosure requirements has not beenmatched by improvement in the Central Banks performance ratings of the banking industry. Some of therules, e.g. minimum capital requirements and quantitative ratios, have been monitored more closely,probably because others players in the industry also have access to information on their competitors.Other disclosure rules (e.g. on ownership) can be selectively enforced.

4.20. Economic liberalization has created competition from imports and interest rate and exchangerate volatility, which have effected various business establishments depending on (a) degree ofcompetition from imports, (b) the relative magnitudes of debt and equity, (c) import content of localproduction, and (d) share of production that is exported. Large banks may be able to absorb the shocksof nonperforming loans due to their diverse clientele. However, small finance houses may experienceshocks depending on the sectoral concentration of their loans and advances e.g. building societies in the

currently depressed housing market. The big banks which advanced funds to enterprises that rely ongovernment contracts have also experienced an increasing portfolio of nonperforming loans due todecline in government expenditure. The complex feedback/feed-forward relationships between the realsector, structure of government spending, financing of fiscal deficits, politics (for politically-correctborrowers and state corporations), nonperforming loans, and financial sector performance is a web ofobscurities and organized confusion.


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CHAPTER 5: CURRENT STRUCTURE OF THE BANKING AND

FINANCIAL SYSTEM

Since man to man is so unjust it is hard to know what man to trust. I have trusted long to mysorrow. Pay today and I will trust tomorrow. The Nicolaus Heinrich Crist Account Book, 1778

Since man to man has been unjust,Show me the man that I can trust.I have trusted many to my sorrow,So for credit, my friend, come tomorrow Ngugi wa Thiongo,A Grain of Wheat, 1967

5.1. In 1967 when the Central Bank of Kenya took over the management of the financial system, thebanking system consisted of eight branches of foreign banks: Bank of Baroda, Bank of India, BarclaysBank, the General Bank of the Netherlands, Habib Bank, National and Grindlays Bank, Ottoman Bankand Standard Bank. As of December 1998, the number of licensed commercial banks was 53 (of whichfive were under Central Bank statutory management), while the number of nonbank financial institutions

were 13, building societies (4), mortgage finance companies (2), and foreign exchange bureaux (44). Inaddition, there were 38 insurance companies and 2 reinsurance companies in operation while the capitalmarket consisted of 58 listed companies in the Nairobi Stock Exchange. The development financeinstitutions include the Development Finance Company of Kenya (DFCK), Industrial and CommercialDevelopment Corporation (ICDC), Kenya Industrial Estates (KIE), and Industrial Development Bank(IDB).

5.2. Leading financial institutions that do not come under the Central Bank umbrella includedevelopment finance institutions that operate under their own charters, the Post Office Savings Bank,micro-finance institutions, and savings and credit cooperatives. In the mortgage segment, there are twomortgage finance companies: Housing Finance Company of Kenya (HFCK) and Savings and Loan(SAL). HFCK is a public company quoted in the Nairobi Stock Exchange, while majority shareholdersare the Kenya Government (30%) and the Commonwealth Development Corporation (30%). SAL is theoldest mortgage finance company in Kenya and is a wholly owned subsidiary of Kenya Commercial Bank.Out of the 40 building societies that have been registered since 1959 (when the first building society wasstarted), only four are still in operation: East African Building Society (the market leader), Equity BuildingSociety, Family Finance Building Society and Prudential Building Society.

5.3. The development finance institutions (DFIs) used to be the main source of long-term finance forindustry, using funds from government and donors. However, their impact has dwindled almost tovanishing point due to a high level of arrears built up over the years, overly c

kenya finance & banking system - 2000

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