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October 21, 2017

Innovation and effi ciency only way for banks

Central bank of Kenya
Central bank of Kenya

The Central Bank of Kenya this week announced its intention to finalise the license applications for two more banks. This is a notable step for several reasons. One, it signals the lifting of the existing moratorium on licensing of more banks in the market. The CBK started the moratorium in November 2015, shortly after placing two banks under statutory management. One more bank was placed under statutory management thereafter. The moratorium was possibly a response to too many and inefficient banks in the market. Since then, two bank acquisitions have taken place. Although this is a step towards fewer banks, it is hardly significant to the industry.

With about 43 institutions licensed as commercial banks and mortgage finance institutions, possibly the market has too many banks. Add to this another 164 deposit-taking Saccos and 13 microfinance banks. It is hard to sustain this number of players in an efficient market for the size of the economy.

Granted, more players increase market competition, which is good, but only to an extent. As competition increases, innovation and efficiency becomes the only way to survive and make profits. It also means not all players will survive the competition and some will need to exit the market. It is important that CBK allows a smooth exit.

This is where the role of policy makers in managing competition comes in. This is because the ease of entry and exit is a major factor in competition. When it is easier for a new bank to enter the market, existing banks are pressured to be more efficient and to lower interest rates on loans. When exit is smooth, then uncompetitive banks will either exit through closure or merge with bigger banks.

However, due to its role and functions in an economy, competition and efficiency in the banking industry must balance with stability. As we have recently witnessed in the market, the closure of a bank is anything but smooth. The consequences for individuals, businesses and the economy are disastrous.

In fact, to avoid the negative consequences, CBK has faced pressure to provide safety net for troubled banks. And yet, it is neither sustainable nor realistic to create the expectation that no institution will be allowed to close. This amounts to CBK interfering with competition, but more critically, subsidising risk-taking. Investors and depositors that feel protected will be less likely to evaluate and monitor banks that hold their funds. On the other hand, banks will have the incentive to take excessive risk in the expectation and comfort of a CBK safety net. If this happens often, it can result to a self-reinforcing cycle that requires an increasing safety net over time. Eventually, this erodes market discipline with more banks likely to take excessive risks that threatens the stability of the industry.

Karen Kandie is a financial and risk consultant with First Trident Bank

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