This selected issues paper assesses Kenya's revenue performance, the labor market, and the health of the banking sector. It analyzes Kenya's revenue potential, tax system, and economic activity while increasing revenues; assesses the labor market; and also notes the nonperforming loans (NPLs) in the Kenyan banking sector, especially in public sector banks, and suggests structural measures to reduce cost pressures in the banking sector, lower the NPLs, and reduce the spread between lending and deposit interest rates. It also provides the detailed statistical appendix of Kenya.

Abstract

This selected issues paper assesses Kenya's revenue performance, the labor market, and the health of the banking sector. It analyzes Kenya's revenue potential, tax system, and economic activity while increasing revenues; assesses the labor market; and also notes the nonperforming loans (NPLs) in the Kenyan banking sector, especially in public sector banks, and suggests structural measures to reduce cost pressures in the banking sector, lower the NPLs, and reduce the spread between lending and deposit interest rates. It also provides the detailed statistical appendix of Kenya.

IV. The Banking System and Interest Rate Spreads24

A. Introduction

44. This section describes the current health of the Kenyan banking sector. Subsection B describes the structure of the banking system and provides some standard indicators of banking system health. Subsection C discusses possible approaches to reducing spreads between lending and deposit rates in Kenya.

B. Banking System Structure and Performance Indicators

45. At end-December 2002, the Kenyan banking system included 44 banks and 3 nonbank financial institutions (NBFIs), 2 mortgage finance companies, and 4 building societies. In addition, there are 48 foreign exchange bureaus (Table 5).25 The banks, NBFIs, and building societies are supervised by the Central Bank of Kenya (CBK). The four largest banks hold over 50 percent of the gross assets in the system and a similar share of deposits, while the ten largest banks account for over three-fourths of both assets and deposits. 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. Government shareholding in the KCB is 35 percent; in NBK, direct government shareholding is 22.5 percent, while the government 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.

Table 5.

Kenya: Commercial Banks, NBFIs, and Foreign Exchange Bureaus, 2001–02

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Source: Central Bank of Kenya.

46. 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.

47. The overall share of nonperforming loans (NPLs) in the banking system increased from 30 percent of total advances in June 1999 to 40 percent by December 2002 (Table 6). 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 drawing out the recovery process. 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 6.

Kenya: Banking Industry Performance Indicators 1999–2002

(In millions of Kenyan shillings, unless otherwise indicated)

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Source: Central Bank of Kenya.

48. 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 have not always been effectively enforced.

49. Despite the difficult economic environment, preliminary numbers suggest that most banks appear to have remained profitable through December 2002 (Table 7). However, profitability indicators may decline after the audit of banks’ financial statements, which is due to be completed by March 31, 2003. It will be important for banks to make adequate provisions for NPLs. Actual provisioning expenses vary significantly among banks, reflecting in part the uneven application of provisioning standards by the institutions.26

Table 7.

Kenya: Trends in Profits (Losses), 2000–02

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Source: Central Bank of Kenya.

50. Spreads between deposit and lending rates have narrowed slightly since June 2000 but are still relatively wide (Figure 10). The spread between average 0- to 3-month deposit rates and average 0-to 1-year borrowing rates increased from about 9 percentage points in late 1998 to a peak of 14 percentage points 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 2002, the average lending rate was 17.4 percent, and the average deposit rate was 5.4 percent, implying a spread of about 12 percent.

Figure 10.
Figure 10.

Kenya: Commercial Bank Interest Rates, 1997–2002

(In percent)

Citation: IMF Staff Country Reports 2003, 200; 10.5089/9781451821093.002.A004

Source: Central Bank of Kenya.

C. Factors Contributing to Wide Interest Rate Spreads in Kenya

51. The Central Bank (Amendment) Act 2000 was passed by parliament as a means of limiting the margin (or spread) between commercial bank lending and deposit rates. The constitutionality of this law is currently the subject of court proceedings. The law, if implemented, would set a minimum deposit rate and a maximum lending rate, both linked to the level of the prevailing treasury bill interest rate. The IMF has advised against the implementation of the restrictive provisions of this act, which would likely exacerbate problems in the banking sector and further limit access to credit, especially for small and high-risk borrowers. This subsection explores the factors contributing to wide interest rate spreads and sets out an alternative approach to dealing with concerns about the wide spreads of commercial bank interest rates.

52. The wide margins between deposit and lending rates of Kenyan commercial banks reflect a number of factors:

  • High operating costs, including staff costs, the need for secure premises, equipment, telecommunications systems, contributions to the Deposit Protection Fund (DPF), and other costs contribute to the prevalence of wide interest rate spreads. High labor costs in the banking sector have reportedly been fueled by industrial court wage awards in excess of inflation.

  • Past failure to fully apply the regulatory and prudential supervisory framework has led to delays in the consolidation of the sector and thus to the preponderance of a large number of smaller commercial banks, which may also contribute to higher operating costs.

  • The high levels of NPLs, about 30 percent of total deposits, with much higher levels in public sector banks, result in high funding costs.

  • The holding of unremunerated cash deposits at the CBK to meet statutory reserve requirements acts effectively as a tax on the banking system.

  • Poor transport and telecommunications infrastructure leads banks to hold large cash balances in order to meet liquidity needs.

53. Structural measures are needed to reduce cost pressures in the sector and lower the level of NPLs, so that good borrowers do not subsidize bad borrowers. Specific measures to address these issues could include the following:

  • enforcing fully and in a timely fashion all prudential regulations and associated sanctions by the CBK, so that weak banks exit the sector (this will permit a timely rationalization of the sector);

  • improving borrower accountability by limiting the misuse of court injunctions and speeding up the turnover in commercial courts, in part through an increase in the number judges for commercial courts, which should help to lower risk premiums; and

  • divesting public sector interest from the banking system, which should limit the opportunities for directed lending that have been associated with high NPLs in the past.

54. Other measures to enhance competition in banking sector and improve public understanding of banking issues could include

  • encouraging regional integration and (pragmatic) harmonization of banking practices with other countries in the region;

  • improving public relations and education efforts by the banking sector, supported by the government, with a view to lessening debtor bias in public opinion and the courts; and

  • establishing an independent commission to review, among others, the cost structure of the commercial banks and the profitability of the sector, and to publicly report on the causes of large spreads.

STATISTICAL APPENDIX

Table 8.

Kenya: Gross Domestic Product by Origin at Constant Prices, 1996–2001

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.

Includes general government.

Table 9.

Kenya: Gross Domestic Product by Origin at Current Prices, 1996–2001

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.

Includes general government.

Table 10.

Kenya: Expenditure on Gross Domestic Product at Constant Prices, 1996–2001

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.
Table 11.

Kenya: Expenditure on Gross Domestic Product at Current Prices, 1996–2001

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.
Table 12.

Kenya: Gross Domestic Product, GDP Deflator, Population, and Real Per Capita GDP, 1987–2001

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Sources: Government of Kenya, Economic Survey, various issues; World Bank, World Development Indicators, various issues; and Fund staff estimates.
Table 13.

Kenya: Gross Fixed Capital Formation at Current Prices, 1996–2001

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.
Table 14.

Kenya: Sales of Agricultural Production to the Marketing Boards, 1996–2001

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.

Except pyrethrum, which is expressed in metric tons.

Table 15.

Kenya: Value of Agricultural Production Sold to the Marketing Boards, 1996–2001

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.
Table 16.

Kenya: Average Prices to Producers For Selected Commodities, 1996–20011

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.

These prices are for calendar-year deliveries and reflect actual payouts, although average prices for two seasons that overlap during a calendar year may have differed. For coffee and tea, the prices are processed coffee and made tea, respectively.

Table 17.

Kenya: Quantity Index of Manufacturing Output, 1996–2001

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.
Table 18.

Kenya: Selected Statistics on Construction Activity, 1996–2001

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.
Table 19.

Kenya: Energy Supply-and-Demand Balances, 1996–2001

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Sources: Government of Kenya, Statistical Abstract and Economic Survey, various issues.