The Impact of capital adequacy requirements on financial stability in the banking sector of Kenya

Abstract

This study examines the impact of capital adequacy requirements (CAR) on financial stability (FS) in Kenya's banking sector from 2000 to 2022, addressing both long-term and short-term dynamics. Grounded in theories such as the Modigliani-Miller Theorem, Capital Buffer Theory, and Signaling Theory; the research employs a positivism philosophy and a correlational design. The methodology integrates econometric techniques, including the Autoregressive Distributed Lag (ARDL) model and error correction mechanism (ECM), alongside diagnostic tests for model robustness. Quarterly data on CAR, FS (measured using Z-scores), exchange rates, and GDP were sourced from reliable financial databases. The findings reveal that CAR significantly enhances FS in both the short and long run, affirming its critical role in absorbing shocks and mitigating systemic risks. Economic growth (GDP) positively influences FS over time, highlighting the interplay between macroeconomic stability and financial resilience. Conversely, while exchange rate fluctuations exhibit short-term effects, their long-term impact on FS is negligible. Diagnostic tests confirm the validity of the model, with no evidence of multicollinearity, autocorrelation, or heteroscedasticity. The study concludes that stringent CAR regulations are essential for a stable banking environment, complemented by policies promoting economic growth. Recommendations include enhancing CAR compliance, aligning regulatory frameworks with Basel III standards, and fostering economic policies to stabilize the exchange rate and GDP growth. The research underscores the importance of robust risk management strategies and provides a foundation for policymakers to strengthen Kenya’s banking sector against future shocks.