Essays on the impact of changes in interest rate regulation in Kenya

Abstract

Globally, banking regulation has led to a closer focus on loan pricing and its impact on bank performance and other stakeholders such as investors. The aim of the study was to examine the effect of changes in interest rate regulation on the financial performance of banks, equity market performance, and bank lending behaviour. There is still an ongoing empirical question and a policy dilemma regarding the economic benefit of interest rate controls and why they are commonly used. Interest rate controls are intended to protect consumers but sometimes result in unintended negative consequences. The study adopted descriptive research approach and positivism as the research philosophy. Multivariate regression analysis was applied. First, using a balanced panel dataset of 83 banks comprising 1,494 observations from 2004-2021, the difference-in-differences (DiD) methodology was applied to accounting and market value measures of financial performance. A two-step generalised method of moments (GMM) in panel data regression was used as the estimation technique to address the problem of endogeneity commonly found in panel data. The findings reveal that introducing interest rate caps in Kenya significantly increased banks' profitability. This increase is likely attributed to a rise in non-interest income and reduced operating expenses. On the contrary, the impact on the firm value of listed banks was insignificant. Next, an event study was employed to explore any impact of changes in interest rate regulation on equity market performance. An exponential generalised autoregressive conditional heteroscedasticity (EGARCH) model was used to supplement the event study methodology. The results reveal that the market reaction to the announcement of the imposition of interest rate restriction was negative and statistically significant. This is contrary to the expectation that controls would increase stock valuation since investors would, as a result, enjoy a reduced cost of credit. The EGARCH results revealed that volatility persistence was high, the changes in interest rate regulation had lasting effects on the stock market. The findings support monetary policy that welcomes financial liberalisation. The theory of rational expectations was applicable as investors in the stock market reacted to the changes in interest regulation. The third aspect of the study entailed determining bank lending behaviour. Using a panel dataset of 35 banks in Kenya comprising 630 observations over the period 2004-2021, multivariate regression analysis was applied. A two-step generalised method of moments was used as the estimation technique to address the endogeneity problem commonly found in panel data. The findings reveal that the composition of the government loan portfolio reaction to changes in interest rate regulation was positive and significant. There is no statistical evidence of a similar impact in the private and interbank loan compositions. This implies that the implementation of lending interest rate controls was ineffective in increasing access to credit. The financial market intermediation theory explains the role of commercial banks as bridging the gap between lenders and borrowers. If the financial market is perfect, the price charged would be at equilibrium, while if an imperfect market, the fee charged is higher or lower. Current theorists argue imposition of interest rate caps distorts the market. From the findings, interest rate caps had a negative impact especially to the small medium enterprises (SMEs). The study can potentially inform policymakers in the East Africa region on the effects of interest rate regulation. High lending interest rates have seen some countries, such as Kenya, impose interest rate caps and subsequently repeal them. Other countries, such as Uganda, were in the process of considering interest rate caps but have deferred the decision. Kenya has now adopted risk-based loan pricing as an alternative measure to improving access to credit. This is perhaps the first study to utilise a multi-pronged focus on the effects of changes in interest rate regulation in a developing economy. Key words: Bank financial performance; Bank lending behaviour; Equity market performance; Interest rate caps; Interest rate regulation.