The effect of capital adequacy requirements on credit creation by commercial banks in Kenya

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.