This Selected Issues paper and Statistical Appendix addresses the question of how to interpret recent developments in the Kenyan consumer price index (CPI) properly to assess the current inflation pressure and extract signals about possible future CPI inflation trends. The paper discusses why Kenya’s exports have performed poorly over the past five years in spite of a more liberalized trade and exchange rate regime. The analysis shows that Kenya faces both price and nonprice constraints on export performance.


This Selected Issues paper and Statistical Appendix addresses the question of how to interpret recent developments in the Kenyan consumer price index (CPI) properly to assess the current inflation pressure and extract signals about possible future CPI inflation trends. The paper discusses why Kenya’s exports have performed poorly over the past five years in spite of a more liberalized trade and exchange rate regime. The analysis shows that Kenya faces both price and nonprice constraints on export performance.

V. The Health of the Banking Sector52

A. Introduction

132. Kenya’s banking system has been in a fragile and deteriorating state for some years. This largely reflects the belated recognition of nonperforming loans (NPLs) in government-owned and other small banks, mainly resulting from political interference with licensing and lending decisions. This section53 summarizes the current health and prospects for the Kenyan banking sector. Subsection B describes the structure of the banking system and provides some standard indicators of banking system health. Subsection C describes the recently passed amendment to the Central Banking Act (the so-called Donde Act) and the potential implications of implementing the main elements of this act for banking sector performance.54 Subsection D concludes by briefly discussing prudential regulations and the legal and judiciary system and the current policy challenges facing the Kenyan banking system.

B. Banking System Structure and Performance Indicators

133. The Kenyan banking system includes 47 banks and 5 nonbank financial institutions (NBFIs), including two mortgage finance companies. In addition, there are 4 building societies, and 47 foreign exchange bureaus.55 The banks, NBFIs and building societies are supervised by the Central Bank of Kenya (CBK). The four largest banks hold over 55 percent of the gross assets in the system and a similar share of deposits, while the ten largest banks account for over 74 percent of both assets and deposits.56

134. The NBFIs operate like banks, except that they are not allowed to accept demand deposits. Many of the NBFIs were created as subsidiaries of banks during the era of interest rate controls, in order to circumvent caps on bank lending rates. After interest rate liberalization in the early 1990s and the introduction of cash ratios for both banks and the NBFIs, many of the NBFIs were converted to, or merged with, banks.

135. The interbank market, with an average daily (gross) volume of about KSh 3 billion, or US$38 million, of mainly overnight lending, is dominated by a number of the larger banks. These banks, however, are normally reluctant to deal with more than a handful of reliable counterparties.

136. The overall share of NPLs in the banking system increased from 30 percent of total advances in June 1999 to 41 percent by June 2001 (Table 16).57 NPLs net of suspended interest amount to about 30 percent of total loans, or 8.8 percent of GDP. About two thirds of the NPLs are concentrated in the public sector banks. Recovery of NPLs and liquidation of collateral are extremely difficult in Kenya. Courts routinely issue last-minute injunctions against such actions, thereby allowing the recovery process to be drawn out. Assets, meanwhile, are stripped or decline in value. A large and increasing backlog of cases in commercial courts also contributes to delays in their finalization.

Table 16.

Kenya: Banking Industry Performance indicators, 1999–2001

(Millions of Kenyan shillings, unless otherwise indicated)

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Source: Annual Report of the Central Bank of Kenya.

137. The largest foreign-owned banks have relatively high-quality assets and thus provide an element of needed stability in a fragile banking sector. In some smaller banks however, insider loans, many of them nonperforming, amount to a substantial share of capital, suggesting that CBK regulations on large exposures and insider lending are not always effectively enforced.

138. Despite the difficult economic environment, preliminary numbers suggest that most banks appear to have remained profitable through December 2001 (Table 17). However, profitability indicators may decline after the audit of banks’ financial statements due to be completed by March 31,2002. It will be important for banks to make adequate provisions for NPLs. At end-2000, most banks and the NBFIs were generating gross interest income of about 15 percent of interest-earning assets, with lower returns of about 4-5 percent for the weaker banks. Whereas most of the foreign banks can raise funds at low rates (interest expense to deposit ratios of 3-5 percent), domestic banks face substantially higher funding costs of between 7 percent and 12 percent.58 Actual provisioning expenses vary significantly among banks, reflecting in part the uneven application of provisioning standards by the institutions.59

Table 17.

Trends in Profits/(Losses), 2000–01

(In millions of Kenyan Shillings)

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Source: Central Bank of Kenya.

139. Spreads between deposit and lending rates have declined since June 2000, but are still relatively wide (Figure 13). The spread between average 0-3-month deposit rates and average 0-1-year lending rates increased from about 9 percent in late 1998 to reach a peak of 14 percent in June 2000. The wide spreads are in part a reflection of the very high level of NPLs and the need for banks to make provisions for past losses. At end-December 2001, the average lending rate was 18.8 percent, and the average deposit rate was 6.9 percent, implying a spread of about 12 percent.

Figure 13.
Figure 13.

Kenya: Commercial Bank Interest Rates, 1997–2001

(In percent)

Citation: IMF Staff Country Reports 2002, 084; 10.5089/9781451821062.002.A005

Source: Central Bank of Kenya

140. Most banks comply with the minimum required liquidity ratio of 20 percent. The liquidity ratios (as measured by the average monthly ratio of liquid assets over net deposit liabilities) vary substantially among institutions, but the average for both banks and the NBFIs was about 45 percent at December 2001, reflecting the weak economy and high credit risks.

141. The net foreign assets of the commercial banking sector increased to almost US$390 million at the end of January 2001, before falling to about US$230 million by December 2001. Foreign currency deposits account for 16 percent of total deposits, and credit denominated in foreign currency amounted to 9 percent of total domestic credit.

C. The Amendment to the Central Bank Act60

142. In July 2001, the National Assembly passed a revised version of the Central Bank of Kenya (Amendment) Act (the so called “Donde Act"). The act reintroduced controls on lending and deposit rates. It was to have retroactive effect from January 1, 2001, thereby creating a potential liability for banks to both borrowers and depositors from that date. On January 24, 2002, the High Court ruled that the retroactive application of the act was unconstitutional.

143. Contents of the law

The Donde Act contains the following five main provisions:

  • The maximum rate of interest on loans must not exceed 4 percent over the (91-day) treasury bill rate, and the minimum rate of interest-earning deposits must be 70 percent of the treasury bill rate.

  • Total interest charged on a loan may not exceed the principal sum loaned or advanced.

  • No loan or advance made by a bank can be guaranteed by a director of the borrower.

  • No fees can be charged except for legal fees, valuation fees, and charges on securities.

  • The Minister of Finance will establish a Monetary Policy Advisory Committee, which will be responsible for advising on monetary policy, including the level of interest rates.

Potential effects of the Donde Act, if implemented

144. Implementation of this law would likely have a number of adverse implications, especially for the small domestic banks and their depositors. It will exacerbate credit constraints for individuals, and small and medium-sized enterprises, and it is ultimately likely to affect the long-term growth of the economy, increasing unemployment and poverty:

  • The cap on loan interest rates is likely to induce banks to be much more selective in their lending policies. Potential borrowers may be forced to turn to informal lenders that charge much higher rates and are not subject to supervision, causing bank dis intermediation.

  • The floor on deposit interest rates is unlikely to increase the rates that the largest deposit-taking banks pay, since these banks are able to redenominate the accounts of smaller depositors as non-interest bearing, without losing many of their deposits. For smaller banks, however, interest rates play a much larger role in attracting deposits; therefore the setting of a floor will force them to either lose deposits or pay the higher rate, because of the quality of bank services provided, and thus endanger their profitability.61

  • The cap on the total absolute amount of interest will make it more difficult for companies to obtain predictable and stable financing for medium- and longer-term investments.

  • The ban on directors’ guarantees will likewise cut off financing from smaller companies. In light of the difficulties associated with obtaining reliable accounts and liquidating collateral, banks in Kenya rely heavily on such guarantees in their lending to small companies. If guarantees are banned, banks may no longer lend to those firms.

  • All these provisions would affect the smaller domestic banks much more severely than the larger banks, since the former are more dependent on interest income, and on deposit funding at moderate rates. Smaller banks will likely be forced out of the market, while larger banks may close more marginal branches; both factors will reduce competition and the provision of banking services to the population.

  • To the extent that lower profitability and levels of bank intermediation will reduce the franchise value of banks, privatization efforts could be hampered, through reduced investor interest and depreciating bank stock prices. Thus, implementing the new law will likely reduce competition in banking, which is key to fostering efficiency and lower interest rate spreads.

  • Finally, linking commercial bank interest rates to prevailing treasury bill rates raises the prospect of banks’ attempting to influence the treasury bill rate.

D. Prudential Regulations, Legal System, and Policy Challenges

145. The CBK has made a considerable effort over the past few years to strengthen its supervisory capacity. Several revised and/or new prudential regulations were issued during 2000 covering most of the major risk activities in banks. The minimum capital level was increased to KSh 300 million with effect from January 2002 and will be increased by an additional KSh 50 million annually to KSh 500 million by end-2005. A revision of provisioning requirements for loan losses is also being considered; if adopted it will require banks to set aside more realistic amounts for potential loan losses.

146. The CBK is relatively proficient at anticipating problem areas or banks and also at identifying problems through a combination of on-site inspections and off-site surveillance. However, prompt regulatory responses and, especially, the use of defined corrective programs and regulatory enforcement actions are often lacking or not timely. As a result, the problems in banks have worsened.

147. Continued inefficiencies and political interference in the commercial court system hinder the efforts of banks, creditors, and liquidators (such as the Deposit Protection Fund) in enforcing contracts, collecting on loans, and realizing collateral. The commercial courts have a backlog of 4,000 cases and this is increasing by about 300-400 monthly. Borrowers are able to obtain injunctions for little or no cost and thus are able to considerably delay debt recovery efforts. Furthermore, it is reported that it may take from nine months to ten years to settle a case; only one in ten cases is successfully settled; and the recovery rate on security is only about 50 percent of appraised value. Moreover, this rate declines significantly if the settlement time is delayed. Clearly there is a need to change the currently poor credit culture to one of accountability for incurred debts, and a need for public policy to actively promote responsible behavior among borrowers.

148. In conclusion, the main policy challenges facing the authorities include removing the uncertainty currently surrounding the potentially damaging reintroduction of interest rate controls. The authorities need to begin creating a fairer environment for the protection of both creditors and debtors through judicial reforms, and to facilitate the closure of irredeemably weak financial institutions. They should avoid interfering in this process through providing support with CBK liquidity, parastatal deposits, or other means. Finally, there is a need to strengthen the regulatory and safety net institutions to ensure that they are able to effectively carry out their mandates.


Prepared by Robert Powell.


This section draws on the reports of MAE technical assistance missions in March and October 2001.


On January 24, 2002 the High Court ruled that one element of the Donde Act was unconstitutional. The full implications of this ruling for the immediate applicability of the remainder of this act are unclear and the government is expected to issue guidance on this issue. In the circumstances, the eventual implementation of this law is still possible.


Foreign exchange bureaus may buy or sell foreign exchange in cash, travelers checks, personal checks, and bank drafts. The sale of instruments other than cash is allowed only with explicit approval of the Central Bank of Kenya, which also acts as the licensing authority.


Two of the four largest banks, the Kenya Commercial Bank (KCB) and the National Bank of Kenya (NBK), are partially government owned, and the other two are majority foreign owned. The government shareholdings in the KCB is 35 percent; in NBK direct government shareholding is 22.5 percent, while it indirectly holds 47.5 percent through the National Social Security Fund. Four more banks and one NBFI also have government shareholdings, while most of the numerous smaller banks are family owned and operated.


Provisional data for end December 2001 indicate that the share of NPLs has increased to 42 percent.


For some of the smaller banks, low ratios may be primarily due to smaller deposit-taking operations.


Underprovisioning also distorts the profitability figures and capital asset ratios for some institutions.


The Act is also known as the “Donde” Act, named after the member of parliament who initiated it.


The mandatory reference to the 91-day treasury bill rate also complicates the setting of rates for deposits with other maturities.