Effects of Interest Rate on Bank Sector Asset Quality in Kenya

Abstract

In the Kenya vision 2030, financial services were designated as one of the six key priority sectors within the plan framework. The plan framework was introduced in 2008 to be implemented through a series of medium-term plans. The Medium-Term Plan 1 identifies the promotion of private sector credit and improvement of financial sector performance as the major actions to stimulate economic growth for the attainment of an annual target rate of 10 per cent. Commercial banks occupy the largest proportion accounting for 49.5 per cent of the financial sector. This makes the performance of the bank sector to be a key element in driving investment through mobilization of both domestic and international resources. Loans are not only the major income-generating but also the major asset in the banking industry, accounting for an ordinary 50 per cent of the bank total assets (CBK,2019). The quality of the stock of bank loans is a pointer of bank sector credit risk and asset quality. This research aimed at establishing how the bank sector asset quality is affected by the rate of interest. Bank sector loan assets served as a proxy to bank sector assets. Specifically, this paper sought to examine the nature of causality and to determine the relationship on interest rate and the bank asset quality. The study also examined the effect in short and long term. To achieve the study objective, the study utilized monthly data over the period January 2015 to February 2020. The study adopted Granger causality and ARDL F bound test to establish the nature of causality and the correlation between the interest rate and bank sector asset quality. The long- and short-run impact of the rate of interest was examined using the ARDL model. The findings suggested bi-directional causality between bank asset quality and interest rate in Kenya. In addition, a relationship was established between bank asset quality and interest rate in the long-run. In the short-run, asset quality was significantly and negatively affected by interest rate. This effect turned positive in the long-run suggesting a deterioration of asset quality an increase in the rate of interest. To achieve the targeted level of bank asset quality of 5%, the study recommends for lower interest rate in the banking sector.