Ills that make it hard to police banking industry

Mortgage loan application form, the pen and a calculator. [Courtesy]
Kenya has been listed as falling under a systematic banking crisis.

This is as indicated by losses in the banking system and significant banking policy intervention measures implemented by the authorities in response losses among the individual components of the banking system.

An example was found in Chase Bank.

Kenya needs an extensive regulatory regime because of weak market discipline. Then why are banks heavily regulated in most economies?

Why is it that even with heavy regulation, financial crises occur in both developed and emerging economies?

Banks provide special and critical services to the economy, including money transmission, credit allocation and payment.

Individuals and the economy suffer when banks fail in these activities.

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We need stiffer regulations to protect borrowers, lenders and investors, prevent unfair practices and to stabilise the economy.

For example, if in a day banks fail to provide payment services, there will be catastrophic disruption in the entire economy.

Banks are tricky entities to manage and more difficult to supervise.

Central Banks would expect commercial banks to create advances (loans) from existing deposits.

But it will be difficult monitoring how banks create loans out of deposits, more so in an environment where daily, if not hourly loans can be available.

The intermediary role of banks is being challenged, and the idea that more banks create credit than being an intermediary is gaining ground.

Banks are delicate entities to manage because they deal with customers who need finances but are unwilling to disclose much about themselves.

This problem, also known as adverse selection exists when banks approve a loan with incomplete information. Furthermore, banks must make sure that the amount loaned is invested for the purpose or project disclosed to them during application.

Thus banks face a moral hazard when borrowers without the knowledge of the lender decide to invest in too risky ventures.

Regulations pre-empt moral hazard and adverse selection problems.

Depositors and borrowers might lack the sophistication to evaluate and monitor banks to transact with. This explains why regulations exist to protect depositors and borrowers.

Regulations can be good or bad.

For example, deposit insurance has been found to dampen banks’ performance.

Insurance cultivates laxity in the form of increased risk taken by the insured.

Insurance can retard financial development because financial market players lose interest in developing risk management products.

This is evident in emerging countries that shy away from using options and futures to manage risk.

Regulations do not always work.

For example, banks are not allowed to invest in the shares of other companies and are closely watched by relevant authorities but still collapse.

Banks must hold a certain level of capital set by Central Bank of Kenya because undercapitalised banks will take a higher risk thus exposing depositors’ money to unpriced risk.

This rule is vague because no one appears to be sure about the amount of capital that a bank must hold relative to the risk profile of its asset.

A well-managed bank can be financially sound even with low capital.

The link between capital and risk inherent in the bank’s asset is not determinate or too fluid, making it difficult to supervise banks. 

Effective regulations should address banks’ liquidity problems. Excessive risk-taking is real.

Senior managers

This explains why central banks continuously review capital requirements.

The evidence of excessive risk-taking is the increasing non-performing assets in our banks.

Excessive risk-taking is explained by a lack of capacity to credit evaluation or ownership of banks by crooks.

The Central Bank can solve this through effective supervision.

On risk management and control, the apex bank has made attempts to address the issues relating to the quality of the board and senior managers.

This can improve on policies limiting risk-taking activities and fraud.

Banks have a tendency of calling customers to take loans.

This should be controlled because many customers end up taking loans even when they do not clearly understand the terms.

We might be having too many banks with huge branches.

This has introduced unhealthy bank competition in the banking industry as well as lending, leading to marginal borrowers.

The result is an increase in asset prices that create asset bubbles.

The next phase of regulation must focus on electronic banking, particularly on security and privacy.

The new Central Bank supervisor must also have the skills to monitor electronic transactions.

To quote Mishkin, “financial liberalisation leads to bad loans, and deposit insurance is not big enough to cover losses.” States that bail out banks distort financial markets and undermine market discipline.

-The writer teaches at the University of Nairobi

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Chase BankBanking policyCentral Bank of Kenya