EFFECTS OF CENTRAL BANK MONETARY POLICIES ON FINANCIAL PERFORMANCE OF COMMERCIAL BANKS

18

CHAPTER ONE
INTRODUCTION

1.1 Background of the Study
Monetary policy has developed considerably in recent years due to the governments urge to control inflation and to promote economic growth. In the fifties and sixties, monetary policy relied mainly on direct controls. The government often set limits on the amount that financial institutions could lend, and mortgages were effectively rationed. In those days the Bank could exert some control on financial institutions by what was known as 'moral suasion'. Banks and individuals had strict limits on the amounts they could change into other currencies.
The purpose of monetary policy includes macro-economic goals of full employment, economic growth, price stability, wealth distribution, efficient resource allocation, favourable balance of payment and industrial development (Ojo, 2002). A key function of Central Bank of Kenya (CBK) is to promote and maintain monetary stability and sound financial system (CBK Act, 2006). This function has facilitated long term planning, aid infrastructural development, attract foreign investments and engender economic growth (Adekunle, 2002). In Kenya the Central Bank is responsible for the promulgation of sound monetary policies in order to aid the attainment of the set objectives.
The first decade after independence can be characterized as passive in the conduct of monetary policy in Kenya, mainly because no intervention was necessary in an environment of 8% GDP growth and below 2% inflation rate (Kinyua, 2001). The first major macroeconomic imbalance arose in the second decade in the form of 1973 oil crisis and the coffee boom of 1977/78. This came at a time when the fixed exchange rate system had just collapsed with the Britton Woods System in 1971. In these first two decades, monetary policy was conducted through direct tools which were cash reserve ratio, liquidity ratio, credit ceilings for commercial banks, and interest rate controls. The 1990s brought about the liberalization of the economy where interest rate controls were removed and exchange rate made flexible, ushering in a new era in monetary policy where open market operations (OMO) was the main tool. This was a period characterized by high interest rates and widening interest spread, which inhibited the benefits of flexible interest rate policy such as increasing financial savings and reducing cost of capital. Competing against double digit inflation rate spurred on by excessive money supply and accommodation of troubled banks, CBK used indirect tools to tame inflation in an atmosphere of instability and extreme uncertainty. In 1996, the CBK Act was amended and this allowed the CBK to shift from targeting broad money to targeting broader money as the principal concept of money stock, Kinyua (2001).
The CBK operates under a monetary policy programming framework that includes monetary aggregates (liquidity and credit) targets that are consistent with a given level of inflation and economic growth, KIPPRA (2006). For instance, the banks objective for the fiscal year 2005/2006 was to achieve inflation rate below 5% using quarterly reserve targets. To this end, the CBK set a ceiling for reserve money and a floor for the net foreign assets (NFA). This was the mainstay of monetary policy at least until the introduction of the Central Bank rate CBR. The use of monetary targeting as currently used by the CBK has also been criticized. Monetary aggregate targeting policy is more effective where there exists a stable demand for money relationship dependent on overall economic activity and price level, but this may not be the case in Kenya which has a financial sector which is at a period of growth, making demand for money unstable according to KIPPRA(2006).

Recently Financial sector reform (FSR) has become a major component of the structural adjustment programme in Kenya with the deregulation of interest rates. However, in terms of attention, research efforts in this regard have been minimal, when compared to the efforts into the other components of the programme such as trade liberalization and exchange rate reforms. Even where research is available, emphasis has tended to be placed on the institutional aspects of the programme and here too the focus has been on the banking sub-sector (Ikhide and Alawode 1994). The reasons for this are not far-fetched. Stabilization issues tend to have more far reaching implications, given the structures of most Sub-Saharan African countries and given the nature of imbalances that necessitated the implementation of economic reforms in these countries in the seventies and early eighties. Efforts were geared towards the investigation of current account and government deficits as well as their implications for saving/investment imbalances. The financial sector in some of these countries is coterminous with the banking system and an examination of the role of the banks in the mobilization of savings for the purpose of bridging the savings/investment gap come naturally with the aforementioned concerns. The central bank has a great role in regulating the financial sector to achieve accelerated economic growth. The principle objective of the Central Bank of Kenya (CBK) is to formulate and implement monetary policy directed to achieving and maintaining stability in the general level of prices in the economy. To achieve these objectives monetary policy must directly affects bank lending.

1.2 Statement of the problem
A couple of studies have been done in relation to commercial banks in Kenya: Jackline (2013) did a study on assessment of effects of monetary policies on lending behavior of commercial banks; Edwin (2010) did a study on challenges faced by the central bank of Kenya in combating money laundering; Gitonga (2010) studied the relationship between interest rate risk management and profitability of commercial banks in Kenya; Kimoro (2010) did a survey of the foreign exchange reserves risk management strategies adopted by the central bank of Kenya and Mbotu (2010) did a study on the impact of the central bank of Kenya rate (CBR) on commercial banks' benchmark lending interest rates.
Despite several studies carried out with respect to monetary policies, the literature reveals while there is much effort by the government to influence the money supply by invoking various policies, much has not been done to ascertain the effects of monetary and fiscal policy of the Central Bank on the profitability of commercial banks in Kenya. A strong and healthy bank undoubtably mean a strong and healthy economy. In view of this, there is a need to evaluate the effect of monetary policies on profitability of commercial banks in Kenya.
1.3 Objectives of the study
1.3.1 General objective
The general objective of the study was to determine the effects of monetary policy on performance of commercial banks in Kenya.
1.3.2 Specific objectives
To establish the effects of Central Bank Rate (CBR) policy on commercial bank's performance
1.4 Research questions
The study sought to answer the following questions;
How does the Central Bank Rate (CBR) policy affect performance of commercial banks in Kenya?
1.5 Significance of the study
To commercial banks
The findings of the study would be important to commercial banks, as they would be able to establish the effects of the various monetary policy tools on their financial performance and hence understand their role in attainment of desired economic growth for the country.
To bank customers
The study would also be of importance to various stakeholders in the banking sector among them bank's customers who are keen to know why the cost of borrowing has suddenly increased in the recent past. Understanding the effect of monetary policy on cost of borrowing would help the consumers to make borrowing decisions.
To the government
The study would also benefit the government as it would provide an insight to the effect of monetary policies on performance of commercial banks. The government partners with banks to ensure price, interest rates and exchange rates stability and enhance economic development through provision of affordable credit.
To scholars and other researchers
Also, the results of this study would also be valuable to researchers and scholars, as it would form a basis for further research. Further, this study would contribute to the pool of knowledge into the relationship between of monetary policies and financial performance of commercial banks in Kenya and therefore contribute to academic reference materials.
1.6 Scope of the study
The study focused on the senior employees of NIC bank Mombasa branch. This study was limited to determine the effects of monetary policies on financial performance of commercial banks in Kenya. The study took approximately 15 weeks to write project, collect and analyze data and present research findings.

1.7 Limitations of the study
Lack of sufficient published materials such as books and journals in the library relevant to the research topic. This forced the researcher to rely on e-books which are time consuming in terms of ease of access. Lack of cooperation from respondents due to their busy schedules is expected to be another major limitation. Besides, respondents might be privy to diverting confidential information of the target organization for fear of reprimand. Lastly, time constraints might be another major limitation to the study given that the researcher is in a full time job.
















CHAPTER TWO
LITERATURE REVIEW

2.1 Introduction
This chapter provides a review of the existing literatures on effects of monetary policies on performance of commercial banks. The main sections included therein are: theoretical framework, conceptual framework, and empirical review, critique of existing literature relevant to the study, summary and research gaps.
2.2 Theoretical review
2.2.1 Loanable Funds Theory
Under the loanable Funds theory of interest, the rate of interest is calculated on the basis of demand and supply of loanable funds present in the capital market. The loanable funds theory of interest advocates that both savings and investments are responsible for the determination of the rates of interest in the long run while short-term interest rates are calculated on the basis of the financial conditions prevailing in an economy. The determination of the interest rates in case of the loanable funds theory of the rate of interest depends on the availability of loan amounts. The availability of such loan amounts is based on factors like the net increase in currency deposits, the amount of savings made, willingness to enhance cash balances and opportunities for the formation of fresh capitals (Bibow, 2000).
The nominal rate of interest is determined by the interaction between the demand and supply of loanable funds. Keeping the same level of supply, an increase in the demand for loanable funds would lead to an increase in the interest rate and the vice versa. An increase in the supply of loanable funds would result in fall in the rate of interest. If both the demand and supply of the loanable funds change, the resultant interest rate would depend much on the magnitude and direction of movement of the demand and supply of the loanable funds. The demand for loanable funds is derived from the demand from the final goods and services which are again generated from the use of capital that is financed by the loanable funds. The demand for loanable funds is also generated from the government (Bernake, 2000).

The Loanable Funds Theory of the Rate of Interest has similarity with the Liquidity-Preference Theory of Interest in the sense that both of them identify the significance of the cash balance preferences and the role played by the banking sector to ensure security of the investment funds. Wray (1992) in his work titled alternative theories of the Rate of Interest criticizes the liquidity preference theory by pointing out that the rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving by the people also play an important role in the determination of the rate of interest which is ignored by the Keynes liquidity preference theory. Wray adds that liquidity preference is not the only factor governing the rate of interest.

2.2.2 Keynesian Theory
The Keynesian theory stated that some microeconomic-level actions if taken collectively by a large proportion of individuals and firms can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate. Most Keynesians advocate an activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most serious of economic problems. Keynes argued that the solution to the Great Depression was to stimulate the economy ("inducement to invest") through some combination of two approaches: a reduction in interest rates and government investment in infrastructure. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment. A central conclusion of Keynesian economics is that, in some situations, no strong automatic mechanism moves output and employment towards full employment levels. This conclusion conflicts with economic approaches that assume a strong general tendency towards equilibrium. In the 'neoclassical synthesis', which combines Keynesian macro concepts with a micro foundation, the conditions of general equilibrium allow for price adjustment to eventually achieve this goal.
2.3 Conceptual framework
This study was guided by the following conceptual framework which indicates the relationship between the variables;
Central Bank Rate (CBR)Central Bank Rate (CBR)
Central Bank Rate (CBR)
Central Bank Rate (CBR)

Commercial banks' performanceCommercial banks' performanceCash reserves ratioCash reserves ratio
Commercial banks' performance
Commercial banks' performance
Cash reserves ratio
Cash reserves ratio


Open market operations (OMO)Open market operations (OMO)
Open market operations (OMO)
Open market operations (OMO)


Independent variables Dependent variables
Figure 2.1: Conceptual frame work
2.3.1 Central Bank Rate (CBR)
There is general agreement among economists and policymakers that monetary policy works mainly through interest rates. When the central bank policy is tightened through a decrease in reserve provision, for instance, interest rates rise. Interest rate rise means that the banks have to adjust their lending rates upwards. The rise in interest rates leads to a reduction in spending by interest sensitive sectors of the economy, such as housing and consumer purchases of durable goods. Therefore, the cost of credit becomes high and in most cases becomes unaffordable reducing demand for credit.

Some economists and policymakers have argued that an additional policy channel works through bank credit (Keeton, 2001; Stiglitz and Weiss, 2001). In this view, monetary policy directly constrains the ability of banks to make new loans, making credit less available to borrowers who depend on bank financing. Thus, in the credit channel, restrictive monetary policy works not only by raising interest rates, but also by directly restricting bank credit.

2.4 Empirical review
Abdurrahman (2010) empirically examined the role of monetary policy on economic activity in Sudan for the period which spanned between 1990 and 2004 and found that monetary policy had little impact on economic activity during the period under consideration. Mangani (2011) assessed the effects of monetary policy in Malawi by tracing the channels of its transmission mechanism, while recognising several factors that characterise the economy such as market imperfections, fiscal dominance and vulnerability to external shocks. Using vector autoregressive modelling, Granger causality, block exogeneity and innovation accounting analyses to describe the dynamic interrelationships among monetary policy, financial variables and prices. The study established the lack of unequivocal evidence in support of a conventional channel of the monetary policy transmission mechanism, and found that the exchange rate was the most important variable in predicting prices.

Karimi and Khosravi (2010) investigated the impact of monetary and fiscal policies on economic growth in Iran using autoregressive distributed approach to co-integration between 1960 and 2006. The empirical results indicated existence of long-run relationship between economic growth, monetary policy and fiscal policy. The results further showed exchange rate and inflation as proxies for monetary policy have inverse impact on economic growth.

Olweny and Chiluwe (2012)explores the relationship between monetary policy and private sector investment in Kenya by tracing the effects of monetary policy through the transmission mechanism to explain how investment responded to changes in monetary. The study utilises quarterly macroeconomic data from 1996 to 2009 and the methodology draws upon unit roots and cointegration testing using a vector error correction model to explore the dynamic relationship of short run and long run effects of the variables due to an exogenous shock. The study showed that monetary policy variables of government domestic debt and Treasury bill rate are inversely related to private sector investment, while money supply and domestic savings have positive relationship with private sector investment consistent with the IS-LM model. Based on the empirical results the study suggests that tightening of monetary policy by 1 % has the effect of reducing investment by 2.63% while the opposite loose monetary policy tends to increase investment by 2.63%.


In Nigeria contest, Sanusi (2002) noted that the role of the Central bank in regulating the liquidity of the economy which affects some macroeconomic variables such as the output, employment and prices cannot be over-emphasised. The Central Bank of Nigeria over the years has adopted different monetary policy management techniques to keep the economy in a stable state. Before the structural adjustment of 1986 which ushered in a period of financial deregulation, it adopted a system of direct control through the issue of credit guidelines and interest rate fixation but from the later part of the 1980s, it adopted indirect control system of management by resorting to open market operations, adjustment of legal reserves requirement and the rediscount rate. But in all these, the attainment of the desired objectives of monetary policy has been affected by domestic and external environments which include fiscal dominance, underdeveloped nature of the financial markets, external debt overhang and volatility in oil price.

Onyeiwu (2012) studied the effect of Central Bank of Nigeria's (CBN) monetary policies on selected macroeconomic variables – gross domestic product, inflation rate and balance of payment between 1981 and 2008. Using the Ordinary Least Squares Method (OLS) to analyse data, the result shows that monetary policy proxy by money supply exerts a positive impact on GDP growth and Balance of Payment but negative impact on rate of inflation. He recommended that monetary policy should facilitate a favourable investment climate through appropriate interest rates, exchange rate and liquidity management mechanism.


2.5 Critique of existing literature
Monetary policy covers the monetary aspect of the general economic policy which requires a high level of co-ordination between monetary policy and other instruments of economic policy of the country. The effectiveness of monetary policy and its relative importance as a tool of economic stabilization varies from one economy to another, due to differences among economic structures, divergence in degrees of development in money and capital markets resulting in differing degree of economic progress, and differences in prevailing economic conditions (Faure, 2007). To achieve the desired stabilization in an economy, central banks use various monetary policy instruments which may differ from one country to another according to differences in political systems, economic structures, statutory and institutional procedures, development of money and capital markets and other considerations. Some of the commonly used monetary policies include: changes in the legal reserve ratio, changes in the discount rate or the official key bank rate (Central bank Rate), exchange rates and open market operations. In order to investigate the effect of monetary policy on commercial banks' performance a holistic approach is required rather than emphasizing on a single monetary tool an integrative approach is imperative in this regard.

2.6 Summary
This chapter focused on review of literature related to studies undertaken by other scholars in relation to effects of monetary policies on commercial bank's performance. It was divided into three sections. Section one gives an introduction of the topic. Section two covers the theoretical literature review on commercial banks' performance. The chapter ends by looking at each of the specific aspects: Central Bank Rate, Cash reserve ration, Open market operations and how they would affect the performance of commercial banks.

2.7 Research gaps
Despite many studies having been undertaken both within as well as without Kenya, none of the above studies focused on the effects of monetary policies on banks' performance in Kenya. This research project, therefore, sought to fill the literature gap by examining the effects of monetary policies on commercial banks' performance.
















CHAPTER THREE

RESEARCH DESIGN AND METHODOLOGY

3.1 Introduction
This chapter describes the method that was used in collection of data pertinent to answering the research questions. The chapter comprises the following sub-topics; research design, target population, research instruments, the sampling procedure, data collection procedures and data analysis procedures.
3.2 Research design
The research adopted a cross sectional descriptive research design. According to Sila, (2007) a simple descriptive research design is used when data is collected to describe persons, organizations, settings or phenomena. Advantages of this design are that it is relatively inexpensive and takes up little time to conduct, can estimate prevalence of outcome of interest because sample is usually taken from the whole population, many outcomes and risk factors can be assessed and there is no loss to follow-up (Sila, 2007).
3.3 Target population






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APPENDIX I

Letter of introduction

JOMO KENYATTA UNIVERSITY OF AGRICULTURE AND TECHNOLOGY,
SCHOOL OF HUMAN RESOURCE DEVELOPMENT,
P.O BOX 81310-80100,
MOMBASA.
17TH MARCH 2015

Dear Respondent,

RE: Research Project Questionnaire
I am a student at Jomo Kenyatta University of Agriculture and Technology, Mombasa Campus pursuing an undergraduate degree course in Bachelor of Commerce. In partial fulfillment of the requirement for the award of the above mentioned Degree, I am required to carry out and submit