An Investigation into the extent to which depositors exert market discipline

Abstract

This study explores whether depositors in the Kenyan banking sector observe risk and exert market discipline. The investigation assesses whether when risk levels are high based on bank fundamentals depositors react to the same by demanding higher interest on deposits or withdrawing their deposits. Using bank-specific panel data compiled from commercial banks' end of year financial results for the period 2008-2011, interest rates. paid on deposits and deposit growth are separately regressed against CAMEL ratings using panel regression techniques to establish if there is some statistical significance. The findings point towards the conclusion that the depositors exert market discipline through both price effects and quantity effects with the former being more pronounced. With respect to price effects depositors are particularly sensitive to capital adequacy, asset quality, return on assets and GOP growth indicators of bank risk. On the other hand with respect to quantity effects depositors are more sensitive to capital adequacy, asset quality, and management quality and return on assets. The evidence of market discipline by both quantity and price effects in this market, can be harnessed to achieve the goal of the primary regulator, Central Bank of Kenya (CBK) in promoting the oversight roles by stakeholders to complement regulatory discipline. The potential benefits of market discipline for the banking industry are reduced moral hazard brought about by the "too-big-to¬fail" attitude. Further, market discipline is likely to improve the efficiency of banks by pressurizing relatively inefficient banks to comply with acceptable levels of risk exposure or exit the industry. Finally, the overall supervisory process will be greatly enhanced by combining the intricate details that the regulators can access and market signals which could possibly eliminate bank failures.