More regulation needed in the banking sector

People queue at a banking hall in Mombasa.Photo/FILE
People queue at a banking hall in Mombasa.Photo/FILE

The prospects of bank consolidation, following the distress of three lower-tier banks in the last nine months is real. The present-day crisis in the banking industry has created the perception that large banks are safer because they are 'too-big-to fail'. Fortunately, the liquidity support programme by the Central Bank of Kenya to provide liquidity to any bank that comes under distress, for as long as is necessary, has temporarily reduced panic in the market. However, this needs to be a precursor to much wider reforms in regulation to ensure depositors are secure. Besides, it is unlikely this facility will run indefinitely. Ultimately, small banks will need to re-evaluate whether they are 'too small to succeed', and whether consolidation is the better option. More importantly, lessons learnt from the crisis ought to inform future regulation and supervision in order to prevent a recurrence of the current crisis.

Effective regulation and supervision is necessary to ensure banks put in place structures and robust processes that ensure sound management and quality control. It becomes more serious when fraud is involved, and the actions of the regulator at such times will signal the market's level of tolerance to fraudulent activities.

The too-big-to-fail idea is the expectation that a business has become so large and ingrained in the economy that a government, and hence the taxpayer, will provide assistance to prevent its failure. This has the potential to be a form of subsidy, which runs against the tenets of free market, and also diverts scarce resources from public goods such as health, education and security. It could also encourage management to take in more risk that is outside the capacity of the institution to effectively manage. Like any other businesses, banks get the upside in good times, which should go along with the burden of bad times in a free market economy. To avoid the subsidy, banks may need to build resilience to withstand the risks of bad times. This may call for regulatory requirement to build up a buffer of reserves during good times that can absorb future shocks.

Perhaps the regulator also needs to assess the adequacy of placing all institutions, regardless of their size and client profile, under the same regulatory regime. Systemically important financial institutions, whose collapse would pose a serious risk to the economy, may require higher levels of capital standards and contingency plans for potential future failures. While size is one factor that makes an institution systemically important, sector concentration to a priority sector such as SME has also emerged as another factor in the local market.

Granted, from the depositor’s perspective, the regulator holds the ultimate mandate to ensure licensed banks do not collapse with their deposits. Going forward, this may require tighter regulation, higher capital requirements and closer supervision.