THE PEER MONITORING ROLE OF THE INTERBANK MARKET IN KENYA AND IMPLICATIONS FOR BANK REGULATION By Victor Murinde, Ye Bai, Christopher J. Green, Isaya Maana, Samuel Tiriongo, Kethi Ngoka-Kisinguh Murinde: University of Birmingham Bai: University of Nottingham Green: Loughborough University Maana: Central Bank of Kenya Tiriongo: Central Bank of Kenya Ngoka-Kisinguh: Central Bank of Kenya We acknowledge financial support by the Kenyan Ministry of Finance and the Central Bank of Kenya under contract Kenya/SPN/FS/CBK/05/2010-11 and without implication, research funding from DFID and ESRC under the DEGRP Call 3, Research Grant No. ES/NO13344/1.

The usual claimer applies.

Research focus 2. Research Motivations The peer monitoring implication of the participating banks in the Kenya interbank market 2. Research Motivations Lessons learnt from the 2007/08 financial crisis Necessary but insufficient government discipline Renewed interest in market discipline However, ineffective private monitoring due to… deposit insurance could weaken market discipline (Demirguc- Kunt and Detragiache, 2002) Hence another possible market discipline candidate: interbank market

2) The dark side of interbank market: contagion Continue… The interbank market: where individual banks transact with one another to meet their demand for and supply of short term funds. Interbank Market discipline: large, collateralized interbank loans … credit risk … motivated to monitor … amounts to a market peer monitoring mechanism 2) The dark side of interbank market: contagion interbank market: unsecured, based on lines of credit, the network of lending relationships direct credit exposures…network…domino effects

3) Research gap in emerging economies’ interbank market Continue… 3) Research gap in emerging economies’ interbank market ‘One size fits all’ type of official bank regulation…side-stepped (Murinde, 2010) Kenya banking sector: exemplary most developed in Africa credited for its size and diversification e.g. private credit to GDP in Kenya was 23.7% in 2008 vs. a median of 12.3% for Sub-Saharan Africa (Beck, Demirguc-Kunt and Levine, 2009) but largely bank-based with shallow capital market (Ngugi et al, 2006) entrenched interbank market (Green, et al., 2017)

3. Data and key variables 43 banks participating in Kenya interbank between 2003Q1 and 2011Q1

the interbank exposure measurements: Continue… Bank risks: the ratio of net charge-offs to equity in log form (lognco) Dinger and Von Hagen (2009) the interbank exposure measurements: the ratio of interbank liabilities to total assets (ibl_ta) the ratio of interbank assets to total assets (nia_ta) Important to consider interbank borrowing and lending separately (Huang and Ratnovski, 2009)…funding risk of equal importance

4. Empirical results Both interbank liability and asset positions are reversely linked with bank risk - support the ‘peer monitoring’ hypothesis However, if the interbank borrowing and lending position reaches a threshold, the impact reverses from risk reducing to risk increasing

Larger banks are exposed to smaller risks. Continue… Size matters Larger banks are exposed to smaller risks. however such advantage reverse to a disadvantage when its size reaches certain threshold.

As expected larger, foreign, listed and older banks are less risky. Continue… As expected larger, foreign, listed and older banks are less risky. When they are the borrowers, the risk reduction effect due to interbank peer monitoring becomes smaller. The usual bank risk determinants: capitalization, credit risk, liquid liability, managerial efficiency and macroeconomic variables can also be applied to Kenya banks.

5. Public policy implications The interbank market in Kenya provides a mechanism for peer monitoring and discipline Complements the regulatory oversight of the central bank and the usual private monitoring candidates Provides market signals to identify risky banks During the further transition to Basel III, Kenya should consider the option of exploiting interbank market discipline as a complementary regulatory tool

Empirical evidence support the role of capital adequacy Continue… Empirical evidence support the role of capital adequacy However, we do not recommend an over-reliance of capital adequacy ratio as a regulatory device official regulators have important roles to play…monitoring the contagion risk…overly connected interbank network Not only exemplary implications for the East African regional block But also for other countries at a relatively early stage of financial development

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