Effect of interest rate capping on interest earnings among Commercial Banks in Kenya (2013-2018)

Abstract

Interest rate earnings is one of the critical components in lending decision process of commercial banks. Capping on interest rates have been declining over the past several decades as most developed states and more of upcoming states continue relaxing their fiscal policies. The general objective of this study was to analyse effect of interest rate capping on interest earnings among commercial banks in Kenya. The specific objectives were to analyse the influence of: credit risk, capital adequacy, operation efficiency, and liquidity risk and bank size on interest rate earnings. The study adopted explanatory research design. Panel data was employed using annual data over the period before interest rate, covering 2013-2015, and after capping of interest rate, covering 2016 to 2018. Thirty-eight commercial banks in Kenya in normal operation as at 31st December 2018 were used giving 228 firm observations. Interest rate earnings was informed by Dealership Model. Dynamic Stochastic General Equilibrium modelling-Generalized Method of Moments approach was used in analysis. Results for the period before interest rate capping in Kenya indicated that before interest rate capping in Kenya, coefficients of lagged interest rate and capital adequacy p  0.000 0.05 and p  0.000 0.05 respectively, were positive and statistically significant at 5% level of significance. This implied that increasing one unit of previous year’s interest rate earnings and capital adequacy had a positive effect of 0.7998 and 0.0197 units respectively. Coefficients of operation efficiency and liquidity risk were negative and significant, p  0.036 0.05 and p  0.000 0.05 respectively, at 5% level. This implied that as operation efficiency and liquidity risk increased by one unit, interest rate earnings reduced by 0.0165 units and 0.0375 units respectively. Higher amounts of operating expenses could be associated with higher volume of banking activities and therefore higher revenues necessitating the commercial bank in Kenya to reduce interest rate earnings. Coefficient of liquidity risk indicated that as one unit of liquidity risk increased, interest rate earnings reduced by 0.0375 units which implied that interest rate earnings for commercial banks in Kenya which were highly liquid were associated with lower interest rate earnings. Coefficient of bank size p  0.087  0.1was negative and significant at 10% level of significance. For every unit increase in bank size, interest rate earnings reduced by 0.1576 units. Results for the period after interest rate capping was relaxed showed that coefficient of lagged interest rate was p  0.009 0.05which implied that increasing one unit of previous year’s interest rate earnings had a positive effect of 0.4246 units implying that one unit of the previous interest rate increased interest rate earnings by 0.426 units. Coefficient of capital adequacy was 0.0479 which was positive and significant at 10% level of significance which implied that for every unit coefficient of capital adequacy, interest rate earnings increased by 0.0479 units. Coefficient of bank size was 0.0304 which was negative and significant at 10% level which implied that for every coefficient of bank size, interest rate earnings increased by 0.0479 units. Government could consider relaxing now and in future interest rate capping in order to avoid effect of capital adequacy, operation efficiency, liquidity risk and bank size on interest rate earnings. Commercial banks could improve their operation efficient so that the cost of funds can be reduced leading to improvement of commercial bank performance. Commercial banks be encouraged to expand their market sizes in order to increase collection of deposits and consequently performance.