The Effect Of Capital Adequacy Requirements On

68 Pages·2016·2.07 MB·English

THE EFFECT OF CAPITAL ADEQUACY REQUIREMENTS ON-
CREDIT CREATION BY COMMERCLAL BANKS IN KENYA
BY
WACHIURI MARY WANGUI
D61/60011/2011
Li
gRARy
A RESEARCH PROJECT SUBMITTED IN PARTIAL
FULFILLMENT OF THE REQUIREMENT FOR THE AWARD OF
THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION
SCHOOL OF BUSINESS, UNIVERSITY OF NAIROBI
OCTOBER, 2012
DECLARATION
This is my original work and has not been presented in any other university or college for
examination purpose.
Signature................................ Date....3^..Y?.Y.I^ ^ ^ ^ ..? Y ,z-
MARY WANGUIWACHIURI
D61/60011/2011
This Project has been submitted for examination with my approval as university
supervisor.
DR ADUDA J.O
SENIOR LECTURER SCHOOL OF BUSINESS
UNIVERSITY OF NAIROBI
ii
DEDICATION
I dedicate this project to my husband Gilbert, son Xidas, daughter Becky and friends who
have tirelessly supported me and contributed towards completion of this study.
iii
ACKNOWLEDGEMENT
Many thanks to the almighty- God who has made me complete this research project in
time.
Special thanks to my husband Gilbert, son Xidas and daughter Becky who have offered
tremendous support towards completion of this project.
My sincere appreciation goes to my parents Mr & Mrs Wachiuri who have been of great
encouragement and inspiration towards my further studies.
Much appreciation goes to my friends and colleagues who have stood by me throughout
the period of this study including my lecturers.
Finally, I specifically thank my project supervisor Mr Josiah O. Aduda for the tireless
commitment and guidance offered throughout the study.
IV
ABSTRACT
Capital provides buffer against losses and thus it ensures safety and soundness of the
financial institutions. It is necessary to ensure that the banks have sufficient capital.
Capital regulations are therefore put in place to ensure that the banks meet the minimum
capital requirements expected of them.
This research project aimed at assessing the effect of capital adequacy requirements on
credit creation by commercial banks in Kenya. Data for a period of 11 years from 2001 to
2011 was studied where an econometric model was used. For this purpose, data from 43
commercial banks in Kenya was extracted from CBK annual bank supervision reports.
The study revealed that capital adequacy requirements introduced by Basel 1 had a
negative impact on credit creation by banks in Kenya. This was evident especially in
2000 when the requirements were introduced in Kenya and in 2009 when further
enhancement of minimum statutory capital requirements from Kshs. 250 million to 350
million (all the way to 1 billion by December 2012) was introduced. The trend in credit
created has been changing direction every four years a fact that can be attributed to
shocks emanating from the piecemeal enhancement of capital adequacy requirements by
the Central Bank of Kenya. The study generally shows that the volume of existing bank
capital may act as binding constraint on liquidity and credit creation.
It is worth noting that there could have been other factors accounting for variations in
credit created trends other than the capital adequacy requirements as experienced in 2005,
a fact that could be attributed to factors such as high interest rate and reduced demand for
credit as observed by opponents such as Sharpe, (1995).
Policy makers should ensure commercial banks have adequate capital to strengthen
confidence of depositors, but capital adequacy requirements should not be very punitive
as to suppress bank activities and the performance of the overall economy.
TABLE OF CONTENTS
PAGE
DECLARATION........................................................................................................................ii
DEDICATION..........................................................................................................................iii
ACKNOWLEDGEMENT........................................................................................................iv
ABSTRACT................................................................................................................................v
LIST OF ABBREVIATIONS..................................................................................................ix
CHAPTER ONE.........................................................................................................................1
INTRODUCTION......................................................................................................................1
1.1 Background to the Study......................................................................................................1
1.2 Statement of the Problem.....................................................................................................6
1.3 Research Objective............................................................... 8
1.4 Importance of the Study.......................................................................................................8
1.4.1 Commercial Banks........................................................................................................8
1.4.2 The Govemment/Regulators/ Policy makers.............................................................9
1.4.3 Academicians.................................................................................................................9
CHAPTER TWO......................................................................................................................10
LITERATURE REVIEW........................................................................................................10
2.1 Introduction.........................................................................................................................10
2.2 Theoretical Review.............................................................................................................10
2.2.1 Agency theory...................................................................................................................10
2.2.2 Credit Theory of Money.................................................................................................11
2.2.3 Capital Structure Theories..............................................................................................12
2.3 Conceptualization.............................................................................................................13
2.3.1 Capital Adequacy and Credit Creation.........................................................................13
2.3.2 Capital Adequacy Ratios................................................................................................14
2.3.3 Core Capital.....................................................................................................................15
2.4 Empirical Literature Review..............................................................................................16
2.5 Summary.............................................................................................................................22
CHAPTER THREE.................................................................................................................24
VI
RESEARCH METHODOLOGY...........................................................................................24
3.1 Introduction.........................................................................................................................24
3.2 Research design.................................................................................................................24
3.3 Study Population................................................................................................................24
3.4 Sample................................................................................................................................24
3.5 Data Collection..................................................................................................................25
3.6 Data Analysis and Reporting...........................................................................................25
CHAPTER FOUR....................................................................................................................27
DATA ANALYSIS, FINDINGS AND DISCUSSIONS....................................................27
4.1 Introduction........................................................................................................................27
4.2 The relationship between Capital Adequacy Ratios and credit creation by commercial
banks in Kenya...................................................................................................................27
4.3 Summary7 and interpretation of findings..........................................................................37
4.3.1 Core Capital to Total Risk Weighted Assets and credit created................................37
4.3.2 Total capital/ TRWA and credit created.......................................................................38
4.3.3 Core capital/ Deposits and credit created......................................................................38
4.3.4 Core capital and credit created.......................................................................................39
4.3.5 Credit created...................................................................................................................40
4.4 Findings of this study with reference to similar studies................................................40
CHAPTER FIVE......................................................................................................................42
SUMMARY, CONCLUSION AND RECOMMENDATION............................................42
5.1 Summary.............................................................................................................................42
5.2 Conclusion..........................................................................................................................43
5.3 Policy Recommendations.................................................................................................43
5.4 Limitations of the study.....................................................................................................44
5.5 Suggestion for further studies..........................................................................................45
REFERENCES....................................................... 47
APPENDICES.........................................................................................................................57
List of Commercial Banks in Kenya by December, 2011...................................................57
Data Extract- CBK Bank Supervision .Annual Reports........................................................59
vii
LIST OF FIGURES AND TABLES
Figure 2.0 Conceptual Framework.......................................................................................15
Table 4.1 Model summary.......................................................................................................28
Table 4.2 Coefficients* of Capital Adequacy Requirements on credit created.................29
Table 4.3 Summary data for period 2001 to 2011...............................................................30
Table 4.4 Correlation between variables...............................................................................31
Figure 4.1 Trends of Core capital/ TRWA and credit created.............................................32
Figure 4.2 Trends of Total capital/ TRWA and credit created............................................33
Figure 4.3 Trends of Core Capital/Deposits Ratio and credit created................................34
Figure 4.4 Trends of the Core Capital and credit created....................................................35
Figure 4.5 Trends of Credit Created from 2001 to 2011.....................................................36
viii
LIST OF ABBREVIATIONS
ASEAN+3 region- People’s Republic of China (PRC), Indonesia, Japan, Republic of
Korea. Malaysia, the Philippines, Singapore, Thailand, and Viet Nam.
C.AMEL- Capital adequacy, Asset quality, Management quality, Earnings performance
and Liquidity
CAR- Capital Adequacy Ratio
CBK-Central Bank of Kenya
CBR- Central Bank Rate
DPFB- Deposit Protection Fund Board
ERS- Economic Recovery Strategy
GDP- Gross Domestic Product
GOK- Government of Kenya
RWA-Risk Weighted Assets
SME’s- Small and Medium Enterprises
TRWA-Total Risk-Weighted Assets
US- United States
USA-United States of America
IX
CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Kenyan economy is largely driven by various financial intermediaries comprising of
Banks and Non-Bank institutions who pool resources from various savers/ investors with
a view of onward lending of such funds through the credit creation process.
Banks are those deposit financial institutions that advance loans directly to borrowers and
include commercial banks, savings banks and credit unions among others. It is evident
that financial intermediaries play a key role in improving the performance of an economy
and are therefore successful elements of the financial system. Financial markets and
institutions embody a mixture of specific elements that are brought together with the sole
purpose of controlling and coping with the enormous amount of assets available and the
income generated by them. However, (Merton, 1990) said that it is important to note that
there are emerging trends that are complicating their position and which can lead to
instability of the financial system.
A commercial bank is a financial institution that provides services, such as accepting
deposits, giving business loans and auto loans, mortgage lending, and basic investment
products like savings accounts and certificates of deposit. Commercial banking activities
are different than those of investment banking, which include underwriting, acting as an
intermediary between an issuer of securities and the investing public, facilitating mergers
and other corporate reorganizations, and also acting as a broker for institutional clients
(Investopedia, 2012).
One of the important functions of commercial banks is the creation of credit. Banks are
the only financial institutions that can create credit through expansion of demand deposits
as a multiple of their cash reserves, a process called ‘‘Credit creation”. Vaish (1997) calls
it a process under which commercial banks advance loans many times greater as
compared to the legal money at the disposal of these banks. A bank credit is made up of
1