Discussion Paper No. 40 of 2004 on Understanding Interest Rates Structure in Kenya.

Abstract

This study looks at the structure of interest rates in the banking sector in Kenya. It covers interest rates in the money market and the banking institutions in the post-reform period. Results show a significant relationship among interest rates, especially in their response to liquidity management efforts by the monetary authority. Except for the inter-bank and Treasury bill rate that are market determined, other money market interest rates are benchmarked to the Treasury bill rate giving it a vital position in liquidity management. There is a deliberate effort to enhance growth of the inter-bank market and the secondary market for government securities especially with the high penalties charged for the discount window and overnight lending facility. A positive and significant relationship is observed between monetary policy instruments, money market interest rate and the inter-bank rate, while causality test confirms unidirectional relationship from monetary policy instruments to the inter-bank rate. Inter-bank rate, however, appears to be more stable compared to other money market interest rates as indicated by lower volatility. Commercial banks lending rates are much noisier than the deposit rate, while the study confirms the hypothesis that deposit rate changes to maintain the spread; the spread is sustained by low deposit rate. The spread between the lending and deposit rate is composed of 89 per cent credit risk and 11 per cent prime risk. This implies that making the credit market more competitive would reduce the lending rate. There is a consistent downward trend indicated by all interest rates especially from June 2001. However, with inflationary tendency, a major challenge is how to maintain the deposit rates positive in real terms; lending rates are maintaining a positive real value...