Understanding Interest Rates Structure
in Kenya
Rose W. Ngugi
Joseph Wambua
Private Sector Development Division
Kenya Institute for Public Policy
Research and Analysis
KIPPRA Discussion Paper No. 40
June 2004
Understanding interest rates structure in Kenya
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Published 2004
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Government of Kenya (GoK).
2
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.
The commercial banks deposit and lending maturities indicate higher short-
term interest rates compared to longer-term maturities. However, the curvature
of the yield spread across the maturities does not show a clear picture of the
motivation behind setting of interest rates. For example, short-term deposit
rates may be higher to reflect the competition from short-term government
securities, while short-term lending rates may be high due to high competition
from the overdraft facility whose demand is driven by the minimal requirements
in acquiring such loan facilities. There is also notable change in the structure of
the maturities over time.
There seems to be a convergence in the institutional interest rates (i.e. the
commercial banks and the NBFIs). However, NBFIs have generally higher
interest rates compared to the commercial banks. They also have wider interest
spread and more so for building societies.
All the money market interest rates are positively related to the commercial
banks deposit and lending rates. Further, there is a clear unidirectional
relationship from the money market interest rates to the commercial banks’
interest rates, which implies that these interest rates respond to monetary policy
actions.
3
Understanding interest rates structure in Kenya
This Discussion Paper is produced under the Umbrella Project for Improving
the Enabling Environment for Businesses in Kenya. The aim of the Project is to
improve the policy, legal, and regulatory environment for businesses. The
Project has three components. The Simplifying the Regulatory
Environment for Business (SREB) component involves research on
constraints to operation of business by the private sector in Kenya. The
Private Sector Advocacy component assists the private sector in advocating
for reforms that create a favourable environment for business and
investment. The Capacity Building component aims to build capacity in
line ministries and regulatory agencies to respond to reform proposals
made by the private sector and other stakeholders. KIPPRA implements
the first and third components while the Kenya Private Sector Alliance
implements the advocacy component. The Project is funded by the British
Department for International Development (DfID).
4
Contents
Abstract ........................................................................................... iii
List of Tables ........................................................................................... vi
List of Figures ........................................................................................... vi
List of Acronyms .................................................................................... viii
1. Introduction ................................................................................. 1
2. The Conceptual Framework for Interest Rate Structure ........ 3
3. Methodology ................................................................................ 7
4. What Characterises Interest Rates ............................................ 9
4.1   The money market rates ..................................................... 9
4.2    Interest rates for banking institutions ........................... 22
4.3    Interest rates for non-banking financial institutions ... 39
5. Conclusions ................................................................................ 42
6. Policy Implications .................................................................... 45
References ................................................................................... 47
5
Understanding interest rates structure in Kenya
List of Tables
Table 1: Summary statistics of money market interest rates .............. 10
Table 2: The relationship among the money market interest rates ... 20
Table 3: Summary statistics of commercial banks interest rates ....... 21
Table 4: The relationship among the money market and banks
interest rates ............................................................................... 26
Table 5: Correlation between the interest rates and the overall (Over)
and under (Under) inflation ...................................................... 28
Table 6: Summary statistics of the spread and its components ......... 31
Table 7: Summary statistics of the deposit rates by maturities ......... 32
Table 8: Summary statistics of the deposit rates by maturity
volatilities .................................................................................... 35
Table 9: Correlation between the money market rate and the
maturities of deposit rate .......................................................... 35
Table 10: Summary statistics of the lending rates by maturities ......... 36
Table 11: Summary statistics of the lending rate volatilities by
maturities and correlations with interest levels .................... 38
List of Figures
Figure 1: The interest rate structure ......................................................... 4
Figure 2: Trends in money market interest rates and liquidity of
banking institutions ................................................................. 10
Figure 3: Volatility in interbank rate (interv), repo rate (repov) and
treasury bill rate (tbillv) ........................................................... 21
Figure 4: Trends in deposit and lending rates and the
interest spread ........................................................................... 23
Figure 5: Real interest rate and inflation................................................ 27
Figure 6:  The relationship between the spread, the components and
the interest rates ...................................................................... 30
Figure 7: Deposits maturities interest rates ........................................... 33
Figure 8: Relating the difference between the M03 and M12v
with the Treasury bill rate ....................................................... 34
Figure 9: Trends in lending maturities interest rates ........................... 37
Figure 10: Relationship between money market interest rate and the
base lending rate ....................................................................... 38
Figure 11: Trends in the hire purchase (HP) and the building
societies (BS) lending and deposit rates ................................ 39
6
Figure 12: The spread between commercial banks and both
building societies and hire-purchase lending and deposit
rates ............................................................................................ 40
Figure 13: Relationship between commercial banks interest
spread (Spread) and the interest spread for hire purchase
and building societies .............................................................. 41
7
Understanding interest rates structure in Kenya
List of Acronyms
CBK - Central Bank of Kenya
FCTB - fixed coupon rate Treasury bond
FRTB - floating rate Treasury bond
NBFIs - non-banking financial institutions
OMO - open market operations
OMTO - open market type operations
REPOs - repurchase agreements
8
1. Introduction
Financial sector plays a significant role in the development process,
especially in mobilising and allocating financial resources. However, for
it to play its role effectively, the interest rate structure must capture the
diverse investors risk preferences and reflect the true cost of capital. In a
substantially diversified financial sector, interest rate structure mirrors
the diverse products offered, the financial structure and the level of
market competition. Therefore, interest rate structure enhances our
understanding of the operations of banking institutions and the market
microstructure of banking sector while at the same time giving a clear
guide on interest rate management.
In a system where interest rates are administratively set, the structure of
interest rates is easily understood. For example, in the pre-reform period,
the Government of Kenya fixed minimum savings rates for all the
deposit-taking institutions and maximum lending rates for commercial
banks, NBFIs and building societies, defining the maximum possible
interest spread. Interest rates were adjusted to maintain them positive
in real terms so as to encourage savings and allow for more efficient
allocation of capital stock, especially by ensuring that funds flowed to
the most productive areas. However, the interest structure, defined by
the control regime, seemed to restrain the financial sector from achieving
its role in development process especially with the experienced slow
growth in savings and investment. At the same time, it curtailed creation
of a competitive financial market. There was also a feeling that the
administratively set interest rates were inefficient and unfair in the
conduct of monetary policy. For example, deposit rates were kept low
and not negotiable except for favoured customers. Furthermore, with
uniform rates fixed administratively, depositors could not benefit from
higher rates offered by banks competing for deposits, especially when
the deposits are large. As a result there was a growing need to review
9
Understanding interest rates structure in Kenya
the interest rates policy in order to encourage savings through the banks
and to create a disincentive to forestall speculation and uneconomic use
of savings by borrowers (Government of Kenya, 1974).
In a liberalised era, effective and efficient management of interest rates
is important to allow for a desirable interest rates structure. It is also
important to realise that when interest rates are defined by market forces,
their structure is more complex. However, it is expected that a flexible
interest rates policy would allow for genuine competition in the financial
sector as savers get the best returns on their savings and borrowers the
most appropriate rate to their circumstances. It is also expected that the
policy would allow for more diversity in the interest rate structure as
banking institutions match their interest rate levels with the risk profiles
and enhance competition in the banking sector.
This paper attempts to shed some light on the interest rate structure in a
liberalised market and therefore contribute in interest rates management
efforts. The paper covers the segment of financial sector under the
monetary authority, including the money market interest rates (the
discount rates, repurchase agreements – REPOs – and inter-bank rates)
and banking institutions lending and deposit rates.
The rest of the paper is organised as follows. Section 2 captures the
conceptual framework of interest rate structure, section 3 the
methodology, section 4 the analysis, while section 5 concludes the paper.
10
2. The Conceptual Framework for Interest
Rate Structure
The banking sector in Kenya has at its apex the Central Bank of Kenya
(CBK), which is the monetary authority with the main responsibility of
ensuring the creation of a financial sector that meets the developmental
goals of the economy. The Bank also has the responsibility to manage
interest rates through its monetary policy operations. In a liberalised
market, interest rates are managed using indirect monetary policy tools;
the tools of monetary policy depend on the level of development of the
market. Among the tools used for management of interest rates include
discount rate, overnight lending rate, REPO rate and the bank rate (inter-
bank rate). Depending on the monetary policy rule adopted, central
banks across various economies exercise different liquidity management
styles. Figure 1 summarises the relationship between interest rates.
In the Kenya context, where indirect monetary policy is based on the open-
market-type operation, Treasury bill rate has been core in the management
of short-term interest rates; it has been used as the benchmark for most of
the interest rates, including the discount rate, overnight lending, REPO
rate, and Treasury bonds. With the open market operation, CBK engages
in buying and selling of government securities to reflect the desired change
in liquidity of the banking sector. As long as the operations of the Treasury
bill market reflect on the monetary policy objectives, Treasury bill rate to
a large extent performs the role of signalling interest rate especially when
the money market is at its infant stage. It is therefore expected that changes
in the signalling interest rate will result to changes in other wholesale
interest rates and banking institutions deposit and lending rates. For
example, by making sales or purchases in the open market operations the
CBK exerts or eases pressure on the inter-bank market. Similarly, tightening
the discount window exerts pressure on the inter-bank market, therefore
increasing the interest rate that banks face as they participate in the market.
The relationship between the signalling rate and the commercial banks
11
Understanding interest rates structure in Kenya
12
Figure 1: The interest rate structure
Open market Money market for Banking institutions
operations (OMO) liquidity management
Overnight lending Lending rate
(Treasury bill rate +
premium)
Interest spread
Inter-bank rate between the
(Transactions lending and
Rediscount rate among the banks) deposit rate
(Treasury bill rate +
premium)
Deposit rate
Treasury bill
rate
REPO
 (Treasury bill rate +
premium)
The conceptual framework for interest rate structure
interest rates is defined by the efficiency of the transmission mechanism
and competitiveness of the banking sector.
In managing their liquidity, banks have the option to mobilise deposits,
use the rediscounting window, overnight lending facility, and the inter-
bank market. The choice between the various options depends on the
accessibility to the facility, availability of liquidity, and the interest rate
charged. A positive relationship is expected between the discount rate
and the inter-bank rate. Further, since banks pay an interest rate when
they borrow at the inter-bank market, this should see an increase in the
lending rate charged to the non-financial sector. Depending on the
sensitivity of loans to interest rates, banks shift a proportion of the
liquidity management costs to investors and depositors as banks
maintain the profit margin. Therefore, a direct relationship is expected
between the inter-bank rate and banking institutions interest rates.
Treasury bills form part of the financial asset portfolio for investors;
therefore, a direct relationship is expected between deposits and Treasury
bill rate. A rise in Treasury bill rate would exert pressure on commercial
banks to compete for deposits from the non-financial sector resulting to
an increase in deposit rate. And given that the deposit rate forms part of
the lending rate then lending rates, will also be pushed upwards.
Commercial banks deposits and lending rates have wide range
maturities. The interest rates set for the various maturities could reflect
on the liquidity preference of the consumers, risk preferences,
competition from other financial assets with similar maturities, or the
bank motivation (profit maximisation or cost minimisation). For example,
a high preference for short-term maturities may push the short-term
interest rate high compared to the long-term interest rates. Similarly,
having less competition for specific maturities in the financial asset
portfolio implies no pressure on the interest rate levels. For example,
banks may be under pressure to keep the short-term maturities deposit
13
Understanding interest rates structure in Kenya
rate high to compete with the short-term government securities. Further,
a monopoly bank that is out to maximise its profit will aim to capture
the entire consumer surplus.
In the analysis of the interest structure, it is important to note that interest
rates are composed of various components including the credit/default
risk premium, the interest risk premium, inflation risk premium, implicit
and explicit taxes, liquidity risk premium and the interest costs. The
macroeconomic environment, the monetary policy operations and the
banks operations define these components; they are important in
understanding the link between the various interest rates.
14
3. Methodology
The study borrows heavily from the monetary transmission mechanism
framework to understand the structure of interest rate in the banking
sector. The study looks at the trends in levels of interest rates, volatility
and spreads. It also uses various statistics to test for the relationships
including correlation, granger causality test and co-integration test in
analysing the interest rate structure. For example, with the indicated
links between various interest rates, it is important to find out the
direction of relationship, causality and long-run relationship.
Definitions
Real interest rate: Real rate of interest is defined as the difference between
the nominal rate of interest and the expected rate of inflation. Using the
Fisher equation, real interest rate is defined as:
⎡i−π ⎤
r =
⎣⎢
1
1+π ⎥⎦
where r is real interest rate, i is th nominal interest rate and π is the
inflation rate.
Interest rate volatility: To capture interest rate volatility, the study uses
the standard deviation and squared standard deviation (variance) as
proxies of historical volatility and the GARCH volatility for the ex-ante
volatility.  The historical volatility is measured as follows:
−
HV = (i − i)2i
− 12
i =∑ (ii / n) 2
i=1
where i is interest rate and i-bar is mean interest rate.
Interest spread: The spread can be decomposed into prime rate spread
and the credit risk spread as follows (Brock, 1996).
15
Understanding interest rates structure in Kenya
i − i = (i − i prime ) + (i prime − i )
l d l l l d
where the first term on the right-hand side is the credit risk spread and
the second term is the prime rate spread. The prime (base) interest rate
reflects on the minimum interest charged by the banks without
considering the credit risk.
16
4. What Characterises Interest Rates
4.1 The money market rates
Money market interest rates are in the category of wholesale interest
rates. These rates play a major role in liquidity and interest rate
management in the banking sector. Among the money market interest
rates includes the rediscount rate, overnight borrowing rate (Lombard
facility), REPO rate and the inter-bank rate. The first three rates are set
by the CBK to reflect the monetary policy stance, while the inter-bank
rate is determined by market forces reflecting on the liquidity in the
banking sector. It is, however, important to note that in some markets,
like the United States, inter-bank rate is used as a monetary policy
signalling interest rate. To affect the inter-bank rate, the Federal Reserve
Bank participates in the open market operations by selling or buying
government securities. To ease pressure on the inter-bank rate, the
Federal Bank sells government securities, therefore increasing liquidity
in the market.
Figure 2 traces the movement in the money market interest rates.
Generally, it shows that all interest rates move together and have taken
a consistent downward trend since July 2001, coupled with a rising
liquidity in both the commercial banks and the non-bank financial
institutions. To a large extent, the trends reflect on the various
monetary policy actions undertaken during the period, including tight
monetary policy adopted in the early 1990s to ease liquidity in the
market.
Table 1 provides summary statistics of the money market interest rates.
The normality test results imply that normal distribution cannot be
rejected for the various interest rates. Inter-bank rate is lower than the
other rates, which allow it to attract the participation of the banking
institutions in their liquidity management efforts.
17
Understanding interest rates structure in Kenya
Figure 2: Trends in money market interest rates and liquidity of banking
institutions
Figure 2 Trends in money market interest rates and liquidity of banking institution
80.00 0.80
70.00 0.70
60.00 0.60
50.00 0.50
40.00 0.40
30.00 0.30
20.00 0.20
10.00 0.10
0.00 0.00
period
tbillrate interbank repo avliqb avliqn
Table 1: Summary statistics of money market interest rates

Inter Repo Tbill
Mean 9.9186 11.4090 12.6882
Median 9.6432 10.6544 11.2780
Maximum 24.1765 24.5000 26.7350
Minimum 0.4302 0.4710 0.8300
Std. Dev. 4.7254 5.6426 6.3484
Skewness 0.3185 0.2730 0.2690
Kurtosis 3.7105 3.2015 2.5047
Jarque-Bera 2.9212 1.0870 1.7161
Probability 0.2321 0.5807 0.4240
Note: Inter = inter-bank rate; Repo = Repo rate; Tbill = Treasury bill rate
The Treasury bill rate
The Treasury bill rate is the rate at which government securities are traded
in the open market operation (primary market). The rediscount rate is
the rate at which CBK accepts existing government securities in exchange
for cash at the initiative of investors, especially the commercial banks
18
percentages
Jul-91
Jul-92
Jul-93
Jul-94
Jul-95
Jul-96
Jul-97
Jul-98
Jul-99
Jul-00
Jul-01
Jul-02
Jul-03
What characterises interest rates
and NBFIs facing liquidity shortfall; individuals also en-cash their
holdings of government securities whenever need arises. The premium
on discounting rate is set by the CBK and varied according to the
monetary policy stance. The CBK is legally bound to rediscount
government securities, but it does so at punitive rates in order to
discourage misuse of the facility as a source of reserves for the banking
sector; the penalty charged is meant to safeguard against the risk of
making CBK a cheap source of liquidity while at the same time retaining
its crucial role as a lender of last resort.
The rediscount window was opened in 1988 on demand to allow
rediscounting by any holder of Treasury bills and any other government
security with three months or less to final maturity.1  The establishment
of the rediscount window was aimed at making the Treasury bill market
more liquid and therefore attractive to investors, creating a ready market
for government securities. Rediscount rate was fixed at 1.5 per cent points
1. Treasury bills were first issued in 1969. However, it was not until 1990 that the open
market operation was introduced. This saw a shift away from the use of quantitative
credit controls to the use of more indirect instruments of monetary policy. Treasury bills
are issued by the CBK on behalf of the government and constitute a large proportion of
the government domestic debt. The bills are purchased by a wide variety of investors
including commercial banks, NBFIs, insurance companies, pension schemes, parastatals,
corporate entities and individuals. The banking sector dominates in holding the bulk of
the bills. Treasury bills are currently sold in maturities of 91 and 182 days through weekly
tenders. Treasury bill is a discount instrument where purchasers pay an amount below
the face value at the time of issue while at maturity the repayment is made at face value.
The difference represents a discount, which is the interest earned. With the applications
made, the bank accepts tenders starting with those at the lowest rate until the pre-
announced tender amounts are realised. In case there are several bidders at the cut-off
rate, CBK has the right to allot the bills on a pro-rata basis. The bills are issued as paperless
securities through a book entry central depository system (CDS). Under the CDS, the
CBK opens a Treasury bill account for the investor into which the value of the purchased
bills is credited. Investors retain a copy of the bank’s credit voucher as evidence of
payment. They are also required to furnish the CBK with their bank account numbers
so that as the bills are due for redemption; the proceeds are credited directly to their
account. The CBK acts as an agent in sale of Treasury bills in the primary market with a
minimum purchase of one million. Investors not qualifying for the minimum amount
in the primary market are expected to purchase securities in the secondary market where
minimum investment remains 50,000.
19
Understanding interest rates structure in Kenya
above the latest Treasury bill rate, an increase from the previous 0.125
per cent points. The premium loaded above the Treasury bill was meant
to preserve the CBK role as a lender of last resort while at the same time
ensuring that banks observe their liquidity and use. For example, the
inter-bank market as a priority instead of borrowing from the CBK. It is
important to note that during the period, efforts to establish the Treasury
bonds market were not bearing fruits and therefore Treasury bills were
a major source of budget deficit financing.2
Penalty charges were increased by 1.0 per cent in April 1990 so that the
rediscount rate of Treasury bills, and other eligible government securities
was set at 2.5 per cent above the latest Treasury bill rate while the
2. Treasury bonds (bearer bonds) were first introduced in August 1986 with the aim of
lengthening government debt structure and finance the budget deficit. In less than a
year of trading the market was inactive and in 1987, CBK resumed trading in Treasury
bonds after eight months period of no trading. The first two issues were held in
September and December 1987 during which time Treasury bonds of 6 months and 1-
year maturities were introduced. During auctioning, sales were concentrated on 1
year and 2 year maturity bonds, and a few on 5-year maturity bonds. The bids rate for
the 6 months maturity bonds was about 18 per cent. If the bids were accepted it would
have meant a negatively sloped yield curve or anticipated rise in long-term interest
rates given that the prevailing Treasury bill rate was low (13 %) together with the
average yield on 1-year bonds (14 %). In February 1988, the Government launched a
new issue of Treasury bonds with new rates set at 14.5 per cent for the 1 year, 15.5 per
cent for 2 year and 16.5 percent for the 5 year bond reflecting a positively sloped yield
curve. To enhance the attractiveness of the Treasury bonds, CBK revised the coupon
rates in March 1990 so that the rate for 1 year Treasury bond was raised from 14.5
percent to 15 percent while the rates for 2 and 5 year bonds was raised from 15.5
percent and 16.5 per cent to 16.5 per cent and 17 per cent. The Government introduced
bearer Treasury bonds in December 1990 to diversify the range of securities available
to savers and investors. However, these bearer bonds were not different from registered
bonds in terms of coupon rates and maturity. Registered bonds are issued and allocated
based on a monthly tender process, while bearer bonds are floated bonds, which remain
on tap for unspecified period. Therefore, the remaining time to maturity determines
the prices of bearer bonds. The interest paid on floating bonds is tied to the average
rate on the 91-day Treasury bills. The Government raised Kshs 1,059 million from the
first issue of bearer bonds in December 1990 (CBK, 1991). The second issue/float raised
Kshs 645 million in April 1991. In the two issues 97.2 per cent of the issues was
accounted for by 1-year bonds while 2-year and 5-year maturity bonds accounted for
2.3 per cent and 0.5 per cent, respectively.
20
What characterises interest rates
advances against other eligible securities were made at 3.5 per cent above
the Treasury bill rate. Treasury bill market was fully liberalised in
November 1990 so that bill rates were determined through the auction
process.3  With the CBK utilising the open market type operations
(OMTO) framework for monetary policy, Treasury bill rate became an
important signalling interest rate for monetary policy action. As long as
the open market operation is driven largely by monetary policy
objectives, then Treasury bill rate sends the monetary policy stance signal.
The discount margin for advances against other eligible securities
remained unchanged at 5.5 per cent points above the latest weighted
average Treasury bill rate.
As shown in Figure 2, Treasury bill rate gained a significant increase in
the 1993/94 periods, as the CBK put effort to mop up excess liquidity in
the economy. For instance, the weighted average Treasury bill rate more
than tripled within one year, rising from 17.16 per cent in June 1992 to
70.09 per cent in June 1993. By this time the CBK had changed its practice
of floating bills of Kshs 2,000 million since 1987, to floating bills of Kshs
5,000 million. It must be understood that with CBK using the government
securities in liquidity management, the alternative it had was to attract
purchases of the treasury bills by offering high interest rates. However,
the high Treasury bill rate made Treasury bonds become unattractive
investment, squeezing it out of the preferred financial asset portfolio.
3. The amount issued per auction depends on the financing needs of the government
and the objective of monetary policy at the time of the issue. Through auctioning, the
CBK allocates the bids competitively based on the discount rates, beginning with the
lowest tender. In bidding, investors either make competitive or non-competitive bids.
The latter implies that instead of quoting the price, the investor bids for the average
rate. However, this option is only open for bids worth Kshs 10 million. There is a
withholding tax of 15 percent charged on the interest rate unless one has a tax
exemption certificate. The CBK computerised the handling of Treasury bills by
introducing the CDS in January 1997.  The objective is to facilitate development of a
secondary market for Treasury bills, and also to increase efficiency in the government
securities market.
21
Understanding interest rates structure in Kenya
The discount window was further tightened in March 1993, with the
rediscount rate set at 5 per cent points above the prevailing Treasury
bill rate for the first Kshs 50 million. In May 1993, maturity life of
securities eligible for rediscounting was reduced to 45 days or less
and new penalties for banks failing to observe the mandatory cash
ratio announced. Further, the base for determining the discount rate
on Treasury bills and rediscount rate on other government securities
was changed from the weighted average Treasury bill rate to the
highest Treasury bill rate of preceding week’s auction for amounts
not exceeding Kshs 50 million. This meant that banks had to maintain
discipline in their liquidity management or face a high cost, which
has implications on the rates they charge themselves. For example,
the tightening of the discount window saw lending rates increase from
16.71 per cent in July 1991 to 19.82 per cent in March 1993 and 24.16
per cent in May 1993 while the deposit rate moved from 15.92 per
cent in July 1991 to 14.45 per cent in March 1993 and 15.59 per cent in
May 1993. As a result, the interest spread gained an accelerated
increase from 0.79 to 5.37 and 8.75 in the period, respectively. Further,
with the rising Treasury bill rate the banking sector recorded a rise in
average liquidity from 18 per cent in July 1991 to 29 per cent and 34
per cent in March and May 1993, respectively, reflecting a shift in the
asset composition of the banking institutions from loans to
government securities.
In 1994, Treasury bills were diversified to accommodate diverse
liquidity preference. This saw the introduction of the 30, 60 and 180-
day bills, but in May 1996, the 60 and 270 Treasury bills were
discontinued leaving the 28, 91, 182 days Treasury bills. At the same
time on 9 August 1994, rediscounting was allowed to Treasury bills
half way to maturity and other government securities provided they
were 45 days or less to maturity. In August 1995, the rediscount rate
was set at 5 per cent points above the prevailing 91 days Treasury bills
22
What characterises interest rates
average tender rate. At the same time, minimum investment in Treasury
bills under OMO was lowered to Kshs 100,000 from Kshs 1,000,000
then to Kshs 50,000 to allow participation of more investors. This saw
the deposit rates gain an increasing trend as the banks competed for
the deposits in the non-financial sector. Similarly, the lending rates were
pushed upwards.
In a effort to create a secondary market for Treasury bills and improve
efficiency of CBK in the day-to-day liquidity management, REPOs were
introduced in September 1996 . REPO is an agreements made by CBK to
buy back in short notice earmarked Treasury bills sold to commercial
banks. REPOs supplement primary security issues such as new issues
of Treasury bills and security issues through open market operations
(OMO).4  Initially, REPO system was piloted among a few banks and
then extended to all banks in November 1996.
A two-way REPO was introduced on 8 April 1997 to smoothen
liquidity management. In addition, to allow for market-determined
interest rate payable on REPO bills, CBK introduced the bidding
system for REPO Treasury bill issues in November 2000. The REPO
rate follows closely the Treasury bill rate as indicated in Figure 2. On
average the spread between the REPO and the Treasury bill rate is
1.28 although the spread was wider at the initial stage. However, the
penalty is lower than that of the rediscount rate, which is 3 per cent
4. When the CBK notices excess liquidity within the banking system, its OMO desk
advertises or calls commercial banks to inform them of the mopping up.  The CBK
and commercial banks then agree on the discounted amount that commercial banks
will be debited, the commercial  banks obtain in exchange for their funds and an
agreed date for the CBK to repurchase the issued security from commercial banks.
The Central Depository System (CDS) accounts are adjusted accordingly to reflect
REPO transactions by crediting with issued securities commercial banks CDS accounts
and debiting the same to CBK CDS account. The reverse takes place when the REPO
matures.  To correct the excess liquidity, all REPO transactions are valued the same
day and tenures trade takes between one and two months.
23
Understanding interest rates structure in Kenya
points above the Treasury bill rate. This encourages banks to use the
REPO market for liquidity management, enhancing development of
the secondary market.
Further, in July 1997, banking institutions were expected to include
Treasury bonds among their liquid assets to increase investment in
Treasury bonds and allow a decline in interest rates on lending to
customers. Treasury bonds’ programme was re-launched in May 2001
with the aim of developing the yield curve and to restructure the
government domestic debt.5
Overnight lending rate
This is the rate at which the CBK lends money to the commercial banks
as a lender of last resort. The loan rate against government securities
was set at 1.25 per cent in 1988, doubling to 2.5 per cent in 1990. As the
CBK adopted tight monetary policy, in early 1990s, overnight lending
was tightened. For example, in June 1993, overnight lending by CBK
was limited to realisable value of the security pledged if such security
was discounted at the CBK. Eligible securities for overnight loans from
the commercial banks were Treasury bills, Treasury bonds and
government bearer bonds. On 6 August 1993, the process of making
5. The types of Treasury bonds issued included the floating rate Treasury bonds (FRTB)
and the fixed coupon rate Treasury bonds (FCTB). The FRTB are medium-term
government securities with a maturity of one, two and three years floated periodically
to raise budgetary resources or refinance existing debt. The minimum amount invested
is Kshs 50,000 initially; thereafter, one can invest up to any maximum amount in
multiples of Kshs 50,000. Interest is paid quarterly and semi-annually and is currently
pegged on the moving average rate of the 91 days Treasury bills plus a premium of
0.25 per cent, 0.5 per cent and 0.625 per cent on one, two and three year bonds,
respectively. A withholding tax of 15 per cent is charged on the interest payable, unless
the investor is exempted or has made arrangements to pay individually to the Kenya
Revenue Authority (e.g. banks and insurance companies). Exempted investors must
provide copies of the exemption status/certificate. The five-year amortised floating
rate Treasury bond interest rate is 0.75 per cent premium above the 91 days Treasury
bill average rate at the beginning of each interest period.
24
What characterises interest rates
overnight advances to banks was streamlined by limiting eligible
collateral to Treasury bills and registered bearer Treasury bonds held
for at least 10 days from the date of issue, but with only a life of 90 days
to maturity. The applicable rate was maintained at the highest accepted
Treasury bill rate in the previous week’s auction plus 2.5 per cent points
for the first Kshs 50 million. During this time, monetary policy was also
tightened with increased cash and liquidity ratio and also tightening of
the rediscount window.
Further, by 18 April 1994, the maximum duration for overnight loans
was limited to four consecutive days and not more than 10 days per
month. Bank lending in the inter-bank market did not qualify for
borrowing from the CBK on the same day. In July 1995, overnight lending
was tightened so that only Treasury bills held at 50 per cent or 75 per
cent of life to maturity eligible for overnight loan were allowed on
condition that the bill had two clear working days to maturity. At the
same time, the rate was increased to 4 per cent above the Treasury bill
rate or the inter-bank rate, whichever is the highest, to discourage its
use by the banks.
In the process of shifting to the indirect monetary policy, CBK established
an alternative window for commercial bank borrowing in July 1996.
Borrowing under the Lombard facility was limited to a maximum of 5
per cent of banks paid up share capital at the beginning of each quarter,
but at a rate of interest 2 per cent above the highest Treasury bill rate of
the previous auctions. Additional financing above the Lombard limit
was accommodated in the first window at 3 per cent point above the
prevailing Lombard interest rates. The amount borrowed had to be fully
secured by government securities.
Overnight lending on window 1 was raised to 4 per cent above Treasury
bill rate from 2 per cent effective 19 November while window 1 rate
increased to 6 percent. On 3 June 1997, overnight loan rate under Lombard
window 1 was reduced from 4 to 3 per cent above the prevailing 91 days
25
Understanding interest rates structure in Kenya
Treasury bill rates, while interest on rediscounting of eligible securities
and borrowing under window 2 was reduced from 6 to 5 per cent.
Window 2 was discontinued on 25 August 2000 and the window 1 rate
has remained constant at 3 per cent above the Treasury bill rate.
Comparing this penalty with the REPO market, we see an attempt to
discourage the use of overnight lending by placing a heavy penalty. This
is also an indication of a deliberate effort by the Government to promote
growth of the REPO market.
The inter-bank rate
Inter-bank market provides an avenue through which commercial banks
and NBFIs in cash deficit positions can borrow funds overnight from
their counterparts with surplus cash. The institutions agree on the
amounts and interest rates and instruct the CBK to adjust their accounts
accordingly. Instructions pertaining to inter-bank transactions have to
be received at CBK by 2.00 p.m. to be reflected in the closing balances of
that day’s value date. The inter-bank rate reflects the liquidity position
in the banking sector and it has always been market determined; we
expect, of course, that the rates that the banks are charged will affect the
rates that they eventually charge to their clients. It is, therefore, possible
that banks with liquidity constraints use the inter-bank market frequently
and therefore sustain a high lending rate or very low deposit rate.
The inter-bank rate traces very closely liquidity in the banking sector as
indicated in Figure 2. For example, the inter-bank rate takes a downward
trend as the liquidity ratio rises and vice versa. In addition, the inter-bank
rate shows a clear relationship with the money market interest rates. On
average, however, the inter-bank rate is lower than the money market rates
to encourage the use of such market for liquidity management by the banks;
the spread between the inter-bank rate and rediscount rate is 4 per cent
point, while the spread between the REPO and the rediscount is 3 per cent.
26
What characterises interest rates
The relationship among the money market interest rates
If the open market operation is such that it has a monetary policy
objective to mop up excess liquidity, then high Treasury bill rate should
put pressure on inter-bank market so that there is a clear positive
relationship indicated between the Treasury bill rate and the inter-bank
rate. Table 2 provides correlation results, which indicate a positive
correlation between the REPO and Treasury bill rate with the inter-bank
rate. In addition, the results show the expected negative relationship
between the money market interest rates and the liquidity levels in the
banking sector. Considering the direction of relationship we find, as
expected, a bi-directional link between the Treasury bill rate and the
inter-bank rate. Results also show a bi-directional relationship between
the REPO and inter-bank rate and also between the liquidity in the
banking sector and the inter-bank rate. In addition, there is observed
unidirectional relationship between the liquidity level and the REPO
and Treasury bill rate. Clearly these results confirm the hypothesis that
monetary authority responds to the liquidity levels in the market and it
could do so to increase or ease pressure on the inter-bank market. The
results also show a clear link between the inter-bank market and the
monetary policy actions in addition to the banking sector operations.
Co-integration test results show a long-run relationship between the
inter-bank and both the Treasury bill rate and REPO rate. There is also a
long-run relationship between the inter-bank rate, Treasury bill rate and
REPO rate and the liquidity in the banking sector.
Analysing the volatility of the market interest rates results show a
declining level of volatility over time as indicated in Figure 3. However,
there is an increasing trend recorded in 2003. Further, the summary
statistics show that the inter-bank rate has a lower volatility compared
to the other money market interest rate.
27
Understanding interest rates structure in Kenya
Table 2: The relationship among the money market interest rates
Panel 1       Correlation
Repo Tbill Inter Avliqb
Repo 1
Tbill .960(.000) 1
Inter .889(.000) .879(.000) 1
Avilqb -.699(.000) -.704(.000) -.630(.000) 1
Panel 2        Granger causality
Inter Tbill Repo Avliqb
Inter 4.601(.000) 3.475(.000) 1.9684(.085)
Tbill 3.6091(.000) 2.676(.0232)
Repo 3.964(.000) 2.4256(.0368)
Avliqb 2.6616 (.0238) 1.397(.2312) 1.676(.1432)
Panel 3         Cointegration
Inter Tbill Repo Avliqb Constant Eigen value LL
Cointegrating factor Statistics
1 -3.0588 36.8913 .1403 18.1648
(2.0397) (6.4)
1 -3.5304 40.2322 .1306 7.5734
(4.5615) (6.4)
1 2.3623 -11.0459 .1249 7.7390
(-35.0555) (6.65)
.0311 1 -.7945 .0944 5.7530
(-0.0445) (3.76)
.2812 1 3.9126 .0812 4.9104
(-6.5488) (3.76)
Panel 4         Volatility of money market interest rate

 Repov Interv Tbillv
Mean 6.6246 5.5851 6.9784
 Median 1.7826 1.4526 1.8778
 Maximum 94.1238 56.5066 83.0155
 Minimum 0.0002 0.0011 0.0000
 Std. Dev. 13.1497 11.3750 14.2829
 Skewness 4.6539 3.0824 3.6083
 Kurtosis 29.2813 12.2914 17.1956
 Jarque-Bera 2299.628 367.8225 750.2166
 Probability 0 0 0
Note: Inter = inter-bank rate; Repo = Repo rate; Tbill = Treasury bill rate; Avilqb =
Average liquidity for commercial banks; Repov = volatility for repo rate; Interv = inter-
bank rate volatility; Tbillv = Treasury bill volatility.
28
What characterises interest rates
Figure 3: Volatility in interbank rate (interv), repo rate (repov) and treasury
bill rate (tbillv)
Figure 3 Volatility in interbank rate (interv), repo rate (repov) and treasury bill
rate(tbillv)
140.00
120.00
100.00
80.00
60.00
40.00
20.00
0.00
98 9 9 9 0 0 0 1 1 1 2 2 2 3 3 3
p- n-
9 9 9 0 0 0 0 0 0 0y- p- n-
0 y- p- n-
0 y- p- -0n y- p- n-
0 y- p-
0
Se Ja a Se Ja a Se Ja a Se Ja a Se a eM M M M Ja M S
period
interv repov tbillv
Table 3: Summary statistics of commercial banks interest rates
Deprate Ledrate Spread
Mean 11.9066 23.8116 11.9050
Median 13.5450 23.3600 13.3700
Maximum 23.4300 32.2800 16.2200
Minimum 3.7083 15.6814 2.8300
Std. Dev. 4.8315 4.7791 3.7010
Skewness 0.1356 0.1782 -1.2857
Kurtosis 2.3636 1.5891 3.1612
Jarque-Bera 2.8717 12.7055 39.8257
Probability 0.2379 0.0017 0.0000
Note: Deprate = deposit rate; ledrate = lending rate; Spread = interest spread
29
values
Understanding interest rates structure in Kenya
4.2 Interest rates for banking institutions
Commercial banks interest rates
Interest rates for commercial banks include the deposit and lending rates,
which show variations across maturities.6  In Kenya, deposit rates for
banking institutions broadly include the saving, call, and time deposit rates.
Time deposit rates are defined by maturities that range from 3 months to
over 12 months. The lending rate includes the overdraft facility rate and the
term loans that range between 1 year and over 3 years. Banks report both
the prime rate and the actual/maximum rate; commercial banks started
reporting the base lending rates from 1 August 1997, providing investors
with a minimum rate that they would be charged in a competitive market
with no default risk premium. For the deposit rate, the base rate is reported
for deposits worth over Kshs 10 million for one and three month duration.
Interest levels
Table 3 provides the summary statistics for the interest rates. Lending
rate is twice the deposit rate, but the levels of volatility are the same.
The statistics show that while the nominal deposit rate mimics a normal
distribution with the skewness equal to zero and the kurtosis equal to
three, the nominal lending rate rejects the normal distribution with  tails
that are thinner than for normal distribution.
Figure 4 traces trends in the average commercial banks nominal fixed
deposit rate and lending rate. A gradual increase is noted in interest
6. Before May 1997, the indicative interest rate for all banks was defined as the average
maximum and minimum of deposit or loan weighted by each bank’s share in total
deposit liabilities or credit.  However, in May 1997, the average approach was adopted
so that the indicative interest rate was defined at the bank level as the sum of interest
rate on various transactions weighted by respective shares in the transactions for the
category.  At the industry level, it is defined as the sum of the average interest at the
individual bank level weighted by the share of the bank’s volume of transaction for
the category in the transaction for industry.
30
What characterises interest rates
rates in the period following liberalisation. The lending and deposit rates
increased from 16.71 and 13.5 per cent in July 1991 to 19.57 per cent and
14.24 per cent in February 1993 as the Treasury bill rate increased from
16.45 to 17.11 per cent in the same period. As a result, the spread widened
from 3.21 to 5.45 while the liquidity on the commercial banks rose from
18 per cent to 26 per cent.
Figure 4: Trends in deposit and lending rates and the interest spread
Figure 4  Trends in deposit and lending rates and the interest spread
35 18.000
16.000
30
14.000
25
12.000
20 10.000
15 8.000
6.000
10
4.000
5
2.000
0 0.000
91 92 93 94 95 6 7 8 9 0 1 2
ul- ul- ul- ul- ul- ul-
9
ul-
9
ul-
9 l-9 l-0 l-0 l-0
J J J J J J J J Ju Ju Ju Ju
Period
deprate ledrate Spread
However, interest rates gained a significant rise as CBK implemented
stabilisation policies in March 1993. In four months, the Treasury bill
rate had risen to 70.34 per cent (July 1993). Lending rates gained a peak
in April 1994 of 32.28 per cent, while the deposits picked in November
1993 (23.43%). At the same time the cash ratio increased from 6 per cent
to 8 per cent in March 1993, then to 10 per cent in June 1993, 12 per cent
in October 1993 and 14 per cent in November 1993. Cash ratio increased
to 16 per cent in February 1994 and 20 per cent in March 1994. At the
same time the minimum liquidity was increased from to 25 per cent in
March 1994.
31
Percentage
Understanding interest rates structure in Kenya
Therefore, we can attribute the rising lending and deposit rates to the
increasing implicit costs that banks were facing with the tightened
monetary policy; the peaking of the lending rate in April 1994 followed
the rise in both liquidity and cash ratio. With the rising implicit tax, the
banks had no option but to share the costs with the investors and this
pushed the lending rates very high up. The rising deposit rate could be
attributed to the efforts by commercial banks to compete for the deposits
from the public as Treasury bills were becoming an attractive alternative
asset for them, while at the same time ensuring that they have enough
deposits to facilitate investment in the lucrative government securities.
The inter-bank rate was very high compared to the deposit rate and
therefore did not offer an attractive alternative for mobilising liquidity.
The spread widened to reflect the increasing costs facing the banks. While
the aim of the CBK was to bring down liquidity levels, commercial banks
reported high liquidity ratios increasing from 26 per cent in February
1993 to 56 per cent in March 1994.
When the Treasury bill rate took a downward trend hitting a low of
22.55 per cent in February 1994, 15 per cent in November 1994 and 14.4
in March 1995, the deposit rates declined to 8.81 in May 1995, while the
lending rate reached a lowest of 22.95 per cent in July 1995. Similarly,
the spread reached 13.28 per cent in May and 12.96 per cent in July 1995
while liquidity levels reduced to 47 per cent and 43 per cent respectively.
In August 1995, the CBK revised downward the minimum investment
in Treasury bill to enable the non-financial sector participation in the
market. This saw the starting point for deposit rates to assume an upward
trend as the banks competed for the funds. Similarly, the lending rates
took an upward trend. This, together with the rising Treasury bill rate,
saw the deposit rates hit a peak in April 1998 of 18.37 per cent while
lending rates achieved a peak in May 1998 of 30.54 per cent, with the
spread loosing marginally to 12.69 per cent points.
Since early 1999, all interest rates assumed a consistent downward trend
where for example the Treasury bill rate declined from 10.70 per cent in
January 1999 to 3 per cent in June 2003. Deposit rates declined from 11.25
32
What characterises interest rates
per cent to 4.84 per cent while lending rates moved from 23.67 per cent to
15.68 per cent in the same period. The spread, however, has not come down
significantly; it moved from 12.42 per cent to 10.84 per cent in the period.
Therefore, the trends in the lending and deposit rate seem to reflect the
monetary policy actions during the period. This is confirmed by the
positive relationship indicated between the commercial bank interest
rates and the money market interest rates as shown in Table 4. The
Granger causality results show unidirectional relationship from the
money market interest rates to the deposit and lending rates. This
supports the view that banks’ interest rates respond to monetary policy
changes. A long-run relationship is indicated between bank lending and
deposit rates and the money market interest rates.
With the argument that deposit rates only change to take care of the
spread and the fact that the deposit rate is a component of lending rates,
the study considered the Granger causality between the nominal lending
and deposit rate. We would expect that when the market faces an upward
trend in lending rate—reflecting increased demand in credit—the banks
respond by increasing the deposit rate to mobilise more resources and
meet the demands in the credit market. However, this may depend on
the liquidity in the banking sector; the more the liquidity the less the
push to raise the deposit rates. It also depends on the diversity of financial
asset portfolio for the depositors. The more competitive the returns of
other financial assets as compared to the deposits, the more likely it is
for the push to raise deposit rates to compete for the deposits. If the
rising lending rate indicates rising risk premium, then the deposit rate
will not take a significant rise as it would if the rise was due to demand.
Results show a bi-directional relationship with the levels and first
difference; deposit rate Granger causes lending rate and lending rate
granger causes deposit rate. This implies that, in maintaining their profit
margin, banks will always consider a desirable lending rate in setting
the deposit rate. It also implies that any policy action aimed at reducing
the lending rate, therefore threatening their profit margin, will see  banks
33
Understanding interest rates structure in Kenya
Table 4: The relationship among the money market and banks interest rates
Correlation results
Deprate Ledrate
Repo .757 (.000) .764 (.000)
Tbill .895(.000) .903(.000)
Inter .752(.000) .742(.000)
Granger causality
Deprate Ledrate Inter Tbill Repo Spread
Inter .7549 1.3697
(.6091) (.2491)
Tbill .0233 1.7318
(.9770) (.1584)
Repo .6430 1.0183 3.6884
(.5297) (.4267) (.0049)
Deprate 2.5007 6.5440 10.8869 5.8551 2.5007
(.0915) (.0000) (.0001) (.0050) (.0915)
Ledrate 4.0440 3.1772 8.5434 5.9440
(.0231) (.0116) (.000) (.000)
Spread 2.0299 1.2743
(.1413) (.2898)
Cointegration
Ledrate Deprate Inter Repo Tbill Constant Eigen value LL
1 1.2580 -34.0610 .0877 5.3229
(1.6254) (6.65)
1 2.2579 -48.1002 .0985 6.0151
(5.4120) (6.65)
1 -22.2098 253.8531 .1074 6.5922
(421.356) (6.65)
1 -.6667 .6920 .1451 9.0924
(.0696) (6.65)
1 -.6347 -.0725 .1272 7.8918
(.0569) (6.65)
1 -1.8020 10.5146 .1833 1.74444
(.3701) (6.65)
1 -1.1530 12.7382 .1212 7.2379
(.1170) (6.65)
Note: Inter = inter-bank rate; Repo = Repo rate; Tbill = Treasury bill rate; Avilqb =
Average liquidity for commercial banks; Deprate = deposit rate; ledrate = lending rate;
Spread = interest spread.
34
What characterises interest rates
maintain very low deposit rates. In addition, the elasticity coefficient
between the deposit and lending rate showed a positive and inelastic
relationship, which corroborates the indicated lags in response between
the two interest rates; a 10 per cent increase in lending rate will see a less
than 10 per cent increase in deposit rate while a 10 per cent decline in
deposit rate is followed by a less than 10 per cent decline. The size of the
coefficient partially reflect the imperfections in the financial market. For
example, faced with a high default risk, banks keep higher lending rates.
Figure 5 shows trends in real interest rates especially capturing the period
of the 2000s. Results show the lending rate retaining its positive relationship
term even when the inflation rate is high. The deposit rates show very
huge swings then positive to negative as inflation rate rises and declines.
As a result, the Treasury bill rate and deposit rate achieve a negative relation
rate, which would discourage mobilisation of resources.
Figure 5: Real interest rate and inflation
Figure 5 Real interest rate and inflation
20 12.00
10.00
15
8.00
10
6.00
5
4.00
0
2.00
-5 0.00
9
t-9 -0
0 00 0 0 1 1 1 1 2 2 2 2 3 3
c n r- ul
-0 t-0 n-
0
r-0 ul-
0 -0 -0 -0 l-0 -0 -0 0
O Ja c
-
Ap J O Ja Ap
t n r u tJ n rOc Ja Ap J O
c Ja Ap
period
tbillr depr ledr inflation
35
percentages
Understanding interest rates structure in Kenya
Table 5 relates the interest rates and inflation, both the overall and
underlying inflation. A positive relationship is indicated between the
nominal interest rates and both the overall and underlying inflation,
while real interest rates show a negative relationship. Underlying
inflation is the main focus for the CBK in the monetary management. A
unidirectional relationship is indicated between the underlying inflation
and the real money market interest rates. However, there is significant
causality indicated between the banking institutions deposit and lending
rates. Similarly, co-integration results show a long-run relationship
between the money market interest rates and the underlying inflation.
Table 5: Correlation between the interest rates and the overall (Over) and
under (Under) inflation
Over Under
Nominal interest rate
Tbill .390(.008) .439(.003)
Deprate .397(.007) .351(.018)
Ledrate .318(.033) .217(.152)
Repo .392(.008) .504(.000
Inter .218(.150) .449(.002)
Real interest rate
Tbillr -.484(.001) -.266(.077)
Deprater -.869(.000) -.677(.000)
Ledrater -.794(.000) -.660(.000)
Repor -.529(.000) -.248(.101)
Interr -.757(.000) -.422(.004)
Note: Inter = inter-bank rate; Repo = Repo rate; Tbill = Treasury bill rate; Deprate =
deposit rate; ledrate = lending rate; Tbillr = real treasury bill rate; Deprater = real deposit
rate; ledrater = real lending rate; Repor = real repo rate; interr = real inter-bank rate.
A volatile interest rate inclines to increase risk on capital yield. Estimating
interest rates volatility using the variance indicates that lending rate has
a higher volatility (3.28) compared to deposit rate (2.55). A positive
correlation is indicated between interest rates and the measures of
volatility, which implies that interest rates reflect on the risk factors in
the market.
36
What characterises interest rates
Interest rate spreads
The spread between the lending and deposit rate captures both costs and
profit margin for the banking institution. If the lending rate were to remain
unchanged and deposit rates increase, this would squeeze the profit for
the bank. Similarly any increase in lending rate would increase profit
assuming constant costs. Considering the deposit rate, the study shows a
significant difference in the deposit rate where decreases are more
pronounced than the increases, which indicates asymmetric response.
However, we find no significant difference for the lending rate as the
deposit rate swings up and down, which would have implications on the
factors influencing the deposit and loans market. This also implies that
the widening spread is maintained by the huge downward swings in
deposit rate; we do not expect to close the gap if banks respond to
increasing risk factor in the loans market rather than the demand and
supply.
Figure 6 traces the relationship between the spread and its components
(the prime spread and the credit risk spread) and the lending rates,7
while Table 6 provides the summary statistics. Results show that the
credit risk constitutes 89 per cent of the spread, while the prime rate
spread is 11 per cent. A positive correlation is indicated between the
credit risk factor and the total spread and a negative correlation between
the prime spread and the total spread. This implies that reducing the
base-lending rate achieves very little in the efforts to narrow the spread
as it is dominated by the credit risk component. Actually, there seem
to be a substitution effect as banks target to retain their margin, with a
7. It is observed that when there is information asymmetry and imperfect enforcement
of contracts, loans become costly to the bank and borrowers are charged higher interest
rates or are rationed out of the market.  The collateral or the net worthiness of the firm
can mitigate these costs as long as the collateral can be legally pledged against the
loan.  However, negative shocks to the net worthiness restrict the aggregate supply of
credit and tend to lower production.  Taxes also explain the wedge between the deposit
rate and the lending rate.
37
Understanding interest rates structure in Kenya
negative relationship indicated between the prime rate spread and the
credit risk factor. Therefore, despite the declining base lending rate,
the interest rate spread is maintained because firms facing a high default
risk sustain their margin by charging a higher lending interest rate to
the non-prime borrowers. Results on relating the spread to the direction
of change of the deposit rate show that the spread is generally wider
with the declining deposit rate; a negative correlation is indicated
between the spread and the deposit rate. This corroborates an earlier
finding of this study: that the spread is sustained by low deposit rate.
There is a positive, though insignificant, correlation between the
lending rate and the credit risk factor and also the total spread, which
implies that credit risk premium is just but one of the major factors
influencing the lending rate.
Figure 6: The relationship between the spread, the components and the
interest rates
 
Figure 4 The relationship between the spread, its compoenets and the interest rates 
35 3.0000 
risk
30 2.5000 
Idrate
2.0000 
25 
Avbled
1.5000 
20 
val
ue 1.0000 
s 
15 
0.5000 
prime
10 
0.0000 
 deprate5 -0.5000 
0 -1.0000 
Jun-9S7e p-9D7e c-9M7a r-98Ju n-9S8e p-9D8e c-9M8 ar-9J9u n-9S9e p-9D9e c-9M9a r-00Ju n-0S0e p-0D0e c-0M0a r-01Ju n-0S1e p-0D1e c-0M1 ar-02Ju n-02 
period 
deprate ldrate Avbled prime spread risk 
38
Jun-97
Sep-97
Dec-97
Mar-98
Jun-98
Sep-98
Dec-98
Mar-99
Jun-99
Sep-99
Dec-99
Mar-0
J 0un-00
Sep-00
Dec-00
Mar-01
June-01
Sep-01
Dec-01
Mar-02
June-02
What characterises interest rates
Table 6: Summary statistics of the spread and its components
The summary statistics
Credit risk Prime spread Spread
Mean 1.4545 12.2990 13.7535
Median 1.6567 11.9125 13.5750
Maximum 2.7129 16.6780 16.2200
Minimum -2.1802 9.5553 12.0400
Std deviation 1.0408 1.3997 0.9750
Skewness -1.4250 1.1664 1.0382
Kurtosis 5.0571 3.8513 3.5753
JB 30.8847 15.4166 11.6147
Prob .0000 .0004 .0030
The correlation between the spread and the interest rates
Ledrate .167(.199) -.048(.712) .045(.733)
Deprate .179(.167) -.245(.057) -.185(.152)
Note: Ledrate – nominal lending rate; Deprate – nominal lending rate.
Spreads between interest maturities
Time is an important element in defining the structure of interest rates.
For example, if there are expectations for high interest rate in the future,
then the short-term interest rates will be higher than the long-term
interest rate. If the future is highly risky, banks may impose a higher
risk premium on long-term interest rates so that long-term deposit rates
are lower than short-term deposit rates or that the long-term lending
rates are higher than the short-term lending rates. Banks could also price
their product to make them competitive in the market especially if the
basket of financial assets is wider. For example, banks could keep the
short-term deposits rate in line with the 91 days Treasury bill rate to
keep up with the competition.
This section analyses the maturities on deposit (i.e. call, 0-3 months, 3-6
months, 6-9 months, 9-12 months and over 12 months deposits) and
lending rates (1 year, 2 years, 3 years and over 3 years).
39
Understanding interest rates structure in Kenya
(a) Spreads between deposit rates by maturities
Table 7 provides summary statistics for the various deposit maturities.
The mean values across the maturities indicate a U-shaped curve with
the M03 higher than the M36 rate, M69 has the lowest interest rate, while
M12v rate is higher than the M69 but lower than M39. Over time, M03 has
retained a higher level than other maturities although in some cases M12v
seems to have dominated as indicated in Figure 7.  This mainly traces the
91 days Treasury bill rate, which competes closely with the M03 so that
M03 shoots upwards when the Treasury bill rate is high (Figure 8).
Table 7: Summary statistics of the deposit rates by maturities
CALL M03 M36 M69 M912 M12v
Mean 12.559 14.176 13.371 12.565 12.622 12.792
Median 13.575 14.425 14.150 13.730 13.950 13.105
Maximum 31.560 29.260 25.860 24.970 26.220 21.080
Minimum 4.770 6.060 5.490 5.200 5.230 5.100
Std. Dev. 5.283 5.255 4.884 4.642 4.673 3.704
Skewness 0.868 0.544 0.173 0.188 0.296 -0.258
Kurtosis 4.622 3.149 2.552 2.652 3.022 2.426
Jarque-Bera 31.034 6.630 1.760 1.449 1.926 3.279
Probability 0.000 0.036 0.415 0.485 0.382 0.194
Note: CALL – interest rate on call deposits; M03 – interest rate on deposits 0 – 3 months;
M36 – interest rate on deposits 3 – 6 months; M69 – interest rate on deposits 6 – 9
months; M912 – interest rate on deposits 9 – 12 months; M12v – interest rate on deposits
over 12 months
Considering the mean differences across the various maturities, results
show a significant mean difference between the M03 and M36 (mean =
.805, t = 9.552(.000)) and also between the M36 and M69 (mean = .806, t
= 12.086(.000)). However, there is no significant difference between the
M69 and M912 (mean =-.058, t = 1.058(.292) and also between the M912
and M12v (mean = -.170, t = .791(.431), while M03 is significantly higher
than the M12v (mean = 1.3842; t = 5.278(.000)). These results imply that
40
What characterises interest rates
Figure 7: Deposits maturities interest rates
Figure 7 Deposits maturities interest rates
35
30
25
20
15
10
5
0
91 92 93 94 95 96 7 8 9 0 1 2 3
ul- ul- ul- ul- ul- ul- ul-
9
ul-
9 9 0 0 0 0
J J J J J J J J Ju
l-
Ju
l-
Ju
l-
Ju
l-
Ju
l-
Period
deprate call m03 m36 m69 m912 m12v
we cannot reject a negatively sloped yield curve for the deposit
maturities. It is argued that greater inflation tax is levied on current and
short-term time deposits for which there are no close substitutes, while
a smaller tax is extracted from deposits for which closer substitutes  exist.
However, the results in this study do not seem to support this hypothesis.
It is possible that the results reflect on the high demand for short-term
maturities with their higher liquidity level as compared to the long-term
maturities; the long-term maturities do not have a significantly higher
compensation to attract their demand.
Summary statistics of the volatilities of the various maturities are
reported in Table 8. They show a clearly negatively sloped volatility curve
across the various maturities. If there is a risk structure portrayed by
interest rates across the maturities, then the maturities should show
significant differences. Considering the significant differences across the
41
Percent
Understanding interest rates structure in Kenya
Figure 8: Relating the difference between the M03 and M12v with the
Treasury bill rate
Figure 8  Relating the difference between the M03 and M12v with the Treasury bil
rate
20.00 80.00
70.00
15.00
60.00
10.00
50.00
5.00 40.00
30.00
0.00
20.00
-5.00
10.00
-10.00 0.00
91 92 93 94 95 96 97 98 99 00 01 2
ul- l- l- l- l- l- l- l- l- l- l- l-
0
J Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju
Period
M0312v tbillrate
maturities we find a significant difference in variance between the M03
and M36 (t = 3.683, 0.000) and also between the M36 and M69 (t = 3.264,
001) and M912 and M12v (t = 1.943, .054), but not between the M69 and
M912 (t = .741, .460). For the M03 and M12v we find that the M03 has a
higher volatility compared to the M12v (mean = 3.8409; t = 3.747(.000)).
Therefore, we can attribute the high interest rate in M03 to the high
volatility, which could be traced also to the Treasury bill rate, which
offers competition to the short-term deposits.
Relating the deposit rates to the money market interest, we find
significant positive relationship across all maturities in relation to the
various money market interest rates (Table 9). The size of the correlation
coefficient is higher with the shorter maturities than with the longer
maturities. The coefficient is even higher with the Treasury bill rate across
the maturities.
42
Percentages
What characterises interest rates
Table 8: Summary statistics of the deposit rates by maturity volatilities
VCALL VM03 VM36 VM69 VM912 VM12v
Mean 6.243 5.384 3.463 2.828 2.691 1.543
Median 0.469 0.739 0.371 0.189 0.154 0.489
Maximum 107.848 78.958 38.803 40.291 42.990 16.558
Minimum 0.000 0.000 0.000 0.000 0.000 0.000
Std. Dev. 16.526 12.495 7.397 6.666 7.022 2.551
Skewness 3.734 3.380 2.916 3.373 3.655 3.128
Kurtosis 18.405 15.227 11.495 15.471 17.107 14.808
Jarque-Bera 1612.130 1073.511 584.024 1105.786 1388.539 982.152
Probability 0 0 0 0 0 0
Note: VCALL – variance of call rate; VM03 – variance of 0 – 3 months deposit rate; VM36
– variance of 3 – 6 months deposit rate; VM69 – variance of 6 – 9 months deposit rate;
VM912 – variance of 9 – 12 months deposit rate; VM12v – variance of interest on
deposits over 12 months.
Table 9: Correlation between the money market rate and the maturities of
deposit rate
Repo Tbill Inter
CALL 0.8149(.000) 0.9299(.000) 0.8004(.000)
M03 0.7959(.000) 0.9245(.000) 0.7959(.000)
M36 0.7647(.000) 0.8853(.000) 0.7510(.000)
M69 0.6996(.000) 0.8520(.000) 0.7133(.000)
M912 0.7134(.000) 0.8583(.000) 0.7142(.000)
M12v 0.7102(.000) 0.8385(.000) 0.6688(.000)
Note: CALL – interest rate on call deposits; M03 – interest rate on deposits 0 – 3 months;
M36 – interest rate on deposits 3 – 6 months; M69 – interest rate on deposits 6 – 9 months;
M912 – interest rate on deposits 9 – 12 months; M12v – interest rate on deposits over 12
months; Inter = inter-bank rate; Repo = Repo rate; Tbill = Treasury bill rate.
(b) The spreads between lending rates maturities
Table 10 provides summary statistics for the lending rate maturities
where the mean values indicate an inverted U-shape curve across the
maturities; it increases from YR01 to YR12 and then takes a downward
trend to Y3v. A negatively sloped yield curve would reflect the profit
maximisation effort by the bank. However, the portrayed structure may
be reflecting high preference for short-term loans. Overdraft interest rate
is higher than the term loans to a large extent reflecting on the high
43
Understanding interest rates structure in Kenya
demand for the facility to finance both the working capital and new
investment (Cotton et al, 2004).  Overdraft is generally a one-year loan
facility, which has a more flexible security structure as compared to the
term loans. The low interest rate offered for the long-term maturities
may be an effort to attract the investors to longer maturities, but the
conditions may be highly prohibitive.
Table 10: Summary statistics of the lending rates by maturities
DRAFT YR01 YR12 YR23 YRV3 SFLOAN
Mean 24.595 24.213 24.611 24.288 23.910 8.733
Median 24.145 23.785 24.310 24.465 23.985 8.935
Maximum 33.500 32.600 32.490 31.810 32.860 10.170
Minimum 13.790 17.210 16.800 16.550 16.740 6.480
Std. Dev. 5.036 4.858 4.517 4.447 4.661 0.965
Skewness 0.038 0.147 0.040 -0.078 0.100 -0.692
Kurtosis 1.806 1.542 1.687 1.667 1.658 2.649
Jarque-Bera 7.878 12.177 9.515 9.904 10.130 11.222
Probability 0.019 0.002 0.009 0.007 0.006 0.004
Observations 132 132 132 132 132 132
Note: DRAFT – nominal lending rate on overdraft; YR01 – nominal lending rate on
loans 0 – 1 years; YR12 – nominal lending rate on loans 1 – 2 years; YR23 – nominal
lending rate on loans 2 – 3 years; YRV3 – nominal lending rate on loans over 3 years;
SFLOAN – nominal lending rate on staff loans.
Figure 9 reports trends in lending rate maturities showing a changing
structure from the initial period after liberalisation to the recent years.
For example, it shows that before March 1993, YR01 was the highest
while YR23 was the lowest. However, in the 2000s period YR01 is the
lowest while YR12 has been generally the highest. Comparing the
maturities with the overdraft, YR12 and overdraft rate trace one another
very closely. However, in the recent period, the gap between the YR12
and the overdraft has widened, as the overdraft interest rate take a
downward trend almost tracking the Y01; except for the period 1993/94
when the overdraft rate is generally lower than all the maturities; in
general the overdraft is higher than the maturities except for the Y12.
44
What characterises interest rates
Figure 9: Trends in lending maturities interest rate
Figure 9  Trends in lendig maturities interest rate
35
33
31
29
27
25
23
21
19
17
15
1 2
l-9 l-9 l-9
3
l-9
4 95 96 97 98 99 0 1 2
u u l- l- l- l- l- l-
0 l-0 l-0
J J Ju Ju Ju Ju Ju Ju Ju Ju Ju Ju
Period
y01 y12 y23 yv3
The base-lending rate is an indicator of the minimal rate that default risk
free investors would fetch in the market. Considering the dispersion of
the various maturities from the base-lending rate, results show that
generally, as expected, base-lending rate is less than the actual lending
rates. The dispersions display different levels of credit risk across the
maturities where, for example, Y12 and Y23 have higher credit risk
compared to Y01 and Y3v. Volatility measure across the various maturities
indicates a U-shaped curve across the maturities, which fails to confirm
volatility as a risk factor in pricing of loan products (Table 11).
Base lending rate is expected to respond instantaneously to changes in
money market interest rate if the transmission channel is efficient. Figure
10 traces the trends in the money market interest rates and the base-
lending rate. It shows that the base-lending rate is generally higher than
the money market interest rates. A unidirectional relationship is also
indicated from all the money market interest rates to the base-lending
45
Percentages
Understanding interest rates structure in Kenya
rate. Results also show that when the money market interest rates are
declining, the base-lending rate also declines, but at a faster rate than
when it takes an upward trend.
Table 11: Summary statistics of the lending rate volatilities by maturities
and correlations with interest levels
VYR01 VYR12 VYR23 VYRV3 VSLOAN VDRAFT
Mean 3.444 3.403 2.855 3.264 0.252 4.270
Median 0.905 0.685 0.471 0.562 0.068 0.852
Maximum 42.521 44.001 35.007 44.422 2.031 56.601
Minimum 0.000 0.000 0.000 0.000 0.000 0.000
Std. Dev. 7.165 7.497 5.768 7.161 0.396 9.532
Skewness 3.283 3.286 2.987 3.334 2.302 3.462
Kurtosis 14.000 14.120 12.409 14.672 8.367 15.232
Jarque-Bera 902.624 917.752 683.196 993.834 274.955 1086.575
Note: VYR01 – variance of nominal lending rate on loans 0 – 1 years; VYR12 – variance
of nominal lending rate on loans 1 – 2 years; VYR23 – variance of nominal lending rate
on loans 2 – 3 years; VYRV3 – variance of nominal lending rate on loans over 3 years;
VSLOAN – variance of nominal lending rate on staff loans; VDRAFT – variance of
nominal lending rate overdraft.
Figure 10: Relationship between money market interest rate and the base
lending rate
Figure 10 Relationship between money maket interest rate and base lending rate
30.00
25.00
20.00
15.00
10.00
5.00
-9
7
t-9
7 98 98 8 9 9 9 0 0 0 1 1 1 2 2 2 3
n b-c n
-
ct-
9 -9 -9 -9 -0 -0 -0 0 0 0
u e u eb un ct eb un ct eb
- n-
0 t-0 b- -0n t-
0 b-
J O F J O F J O F J O F Ju Oc Fe Ju Oc Fe
period
repo tbill interbank base
46
percentage
What characterises interest rates
4.3 Interest rates for non-banking financial
institutions
The non-bank financial institutions (NBFIs) include the hire purchase
and merchant banks (HP) and the building societies (BS). As indicated
in the previous section, efforts have been made to create uniformity on
interest rates across the banking institutions and also regulatory
conditions streamlined. Figure 11 traces the BS and HP interest rates.
Figure 11: Trends in the hire-purchase (HP) and building societies (BS)
lending and deposit rates
Figure 11 Trends in the hire-purchase (hp) and building societies (bs) lending and
deposit rates
45
40
35
30
25
20
15
10
5
0
91 92 3 4l- l- l-9 l-9 l-9
5 6 7 8 9 0 1 2 3
u u u u u ul-
9 9
ul- ul-
9 l-9u ul-
0 l-0u ul-
0 l-0
J J J J J J J J J J J J Ju
Period
hpl bsl hpd bsd
Relating the BS, HP and commercial banks interest rates, Figure 12 shows
that commercial banks lending rates are generally lower than the hire
purchase lending rates, and also the building societies. At the same time,
the gap between the hire purchase and building societies’ lending rates
has narrowed. There is a significant difference between the lending rates
of hire purchase and the building societies. However, in relation to the
47
Percentages
Understanding interest rates structure in Kenya
commercial banks interest rates, the results are mixed. The relationship
with the hire purchase is significant while the one with the building
societies is not significant.
Figure 12: The spread between commercial banks and both building
societies and hire-purchase lending and deposit rates
Figure 12  The spread between the commercial banks and both building societies and
hire-purchase lending and deposit rates
15.00
10.00
5.00
0.00
-5.00
-10.00
-15.00
91 92 93 94 95 96 97 8 9 0 1 2
ul- ul- l- l- l-
9
u u u ul- ul- ul- ul-
9 l-0 0u ul- ul-
0
J J J J J J J J J J J J
Period
hpcbd bscbd hpcbl bscbl
The hire purchase average deposit rate show a declining trend, while
the gap between the highest and lowest has narrowed down. Both the
HP and BS have generally had lower interest rates compared to the
commercial banks, while their interest rates gap is narrowing. The mean
differences between the interest rates indicate significant difference
between the hire purchase and building societies deposit rates. While
there is significant difference between that of commercial banks deposit
rate and the hire purchase deposit rates, there is no significant different
between the commercial banks and the building societies. Considering
the spreads across the institutions, the HP has always had a wider gap
between the lending and the deposit rates but this is narrowing (Figure
13).
48
Percentage
What characterises interest rates
Figure 13: Relationship between commercial banks interest spread (Spread)
and the interest spread for hire-purchase and building societies
Figure 13 Relationship between the commercial banks interest spread (Spread) and the
interest spread for hire-purchase and building societies
40.000
35.000
30.000
25.000
20.000
15.000
10.000
5.000
0.000
91 92 3 4 5 6 7 8 9 0 1 2
ul- ul- ul-
9 l-9 l-9 l-9 l-9 l-9 l-9 l-0 l-0u u u u u u u u ul-
0
J J J J J J J J J J J J
Period
Spread hpspresd bsspread
Correlation results indicate positive and significant correlation between
the deposit and lending rates of the NBFIs deposit rates and the
commercial banks deposit rates. The Granger causality between  interest
rates show that building societies and hire purchase deposit rates Granger
cause commercial banks interest rates. However, a bi-directional
relationship is indicated between commercial banks and the hire
purchase. Similarly, there is bi-directional causality between hire
purchase and building societies deposit rates. It is possible that the
indicated relationship shows competition among financial institutions
for deposits from the public. For the lending rates, it seems that the hire
purchase follows the commercial banks lending rates, while the latter
follows what is happening with building societies, and this in turn
follows the hire purchase. Therefore, any effort made to reduce the
commercial banks interest rates would automatically bring down the
HP interest rate.
49
Percentages
Understanding interest rates structure in Kenya
5. Conclusions
This paper analyses the structure of interest rates in the financial sector in
Kenya. The analysis includes money market rates (rediscount rate, REPO
rate, inter-bank rate), interest rates on government securities (Treasury
bill rate) and commercial bank interest rates (lending rates – overdraft,
term loans and deposit rates – savings, call deposit, time deposit rates).
(1) Except for the inter-bank and Treasury bill rates which are market
determined, other money market interest rates are benchmarked to
the Treasury bill rate; they are defined as Treasury bill rate plus a
premium which reflect on monetary policy action. For example, with
a tight monetary policy, the premium charged is higher aimed at
discouraging use of Treasury bills by commercial banks in liquidity
management. This exerts pressure on the inter-bank market so that
a positive relationship is indicated between the monetary policy
signal and the inter-bank rate. A unidirectional causality is observed
between the other money market interest rates and the inter-bank
rate, which implies that the inter-bank market responds to  monetary
policy actions. Similarly, a long-run relationship is indicated between
the inter-bank rate and Treasury bill rate.
(2) Inter-bank rate is lower than discount window rate but the inter-
bank market is more costly compared to the REPO market. This
indicates a deliberate effort by the Central Bank of Kenya to maintain
its position as a lender of last resort, with the banks choosing the
inter-bank market as a priority in their liquidity management.
Similarly, the REPO rate encourages growth of the secondary market
for government securities, making them more liquid. Further, the
inter-bank rate has the lowest level of volatility, which makes it an
effective signalling rate.
(3) The average commercial banks nominal fixed deposit rate, lending
rates and savings rate trace very closely the monetary policy actions.
50
Conclusion
For example, all interest rates rise with the tightening of monetary
policy and take a general downward trend as the monetary policy
is relaxed. A clear unidirectional causality is also obdserved from
the money market interest rates those of banking institutions.
Similarly, a significant relationship is indicated between the interest
rates and the liquidity in the market, which implies that liquidity
management has a significant influence on interest rates.
(4) Lending rates are highly volatile compared to deposit rates, while a
positive relationship is observed between volatility and the levels
of interest rates, which implies that there are interest rates price
risk factor(s) in the market. With deposit rate as a component of the
lending rate and having a lower volatility, it means then that the
other costs that make up the lending rate are highly volatile.
(5) Interest rates spread is composed of a significant proportion (89%)
of the credit risk. This implies that imperfections in the credit market
contribute significantly to sustaining the spread. Similarly, the
movements in deposit rates sustain the spread where deposit rates
decline more sharply compared to the increases, while lending rates
increases are more pronounced compared to the declines.
Furthermore, a bi-directional relationship is indicated between the
deposit and lending rate, which would support the objective of the
commercial banks to sustain their margin.
(6) Spreads between various deposit maturities portray a U-shaped
relationship for interest rates levels but a negatively sloped
relationship for the volatilities, which makes it difficult to make
conclusions on the risk structure in the market. One explanation for
the high short-term deposit rate is the competition that banks face
with the Treasury bills. High Treasury bill rates exert pressure on
the banks to keep the interest rate high to be able to compete for the
funds from the public. Because of the close link between the Treasury
51
Understanding interest rates structure in Kenya
bill rate and the short-term deposits, the short-term deposit rates
reflect a higher volatility, which could reflect a higher risk and
therefore higher compensation.
(7) Lending rates maturities indicate a shift in the term structure in the
period 1995/98. The structure of lending rates reveals an inverted
U–shaped relationship across the various maturities, such that it is
not possible to make conclusions whether the term structure
represents a profit maximisation motive or maturity preferences.
(8) Non-banking financial institutions have generally high lending rates
but lower deposit rates compared to commercial bank rates. While
deposit rates indicate Granger causality from the NBFIs to
commercial banks, a loop is indicated with the lending rates across
the institutions. Commercial banks interest rates Granger cause the
hire purchase interest rates which in turn Granger cause the building
societies rate and in turn the commercial banks.
52
6. Policy Implications
The results of this study have various policy implications:
• Sustainability of low interest rates depends largely on the
developments in the money market.  Any increase in domestic
financing of government debt will result in rising interest rates
as the Treasury bill rates take an upward trend.  There are two
channels through which this will happen: one is in competition
for deposits by the commercial banks resulting from higher
results on Treasury bills; and two, through increased pressure
on inter-bank market which makes liquidity management more
costly.
• Although presently, with the high liquidity in the market, banks
have no pressure to increase deposit rates, the inflationary
tendency, which seems to keep the interest rates negative in real
terms, may constrain mobilisation of resources.  Given that with
both the underlying and overall inflation the deposit rate is
negative in real terms, this raises the question of how low the
inflation target for the monetary authority should be in
maintaining interest rates positive in real terms, not forgetting
that one of the objectives of the current interest rates policy is to
maintain interest rates positive in real terms.
• If there is a diversified basket of financial assets, competition for
funds from the public may keep the deposit rates high. For some
time, Treasury bills have remained a major financial asset and
banks have responded positively to raise the deposit rate when
the Treasury bill rate is high.  Therefore, diversification of
financial assets to increase competition could sustain deposit
rates positive in real terms.
53
Understanding interest rates structure in Kenya
• The lending rate has a high composition of credit risk.  While
the current shift to unsecured, but less risky, loans may keep
interest rates down, any shifts to heavy productive investment
financing may not sustain the trend especially if a competitive
credit market is not achieved.
• It is possible to adjust interest rates in the banking institutions
with a target to commercial banks.
54
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Understanding interest rates structure in Kenya
KIPPRA PUBLICATIONS
Conference Proceedings
Report of the proceedings of the AERC-KIPPRA World Trade Organization (WTO)
Workshop, 2000
Report of the proceedings of the International Conference on Finance and
Development: Evidence and Policy Issues, 2001
Discussion Papers
Njuguna S. Ndung’u (2000). The exchange rate and the interest rate differential in
Kenya: a monetary and fiscal policy dilemma. KIPPRA DP No. 1
Karingi, S. N. and Njuguna S. Ndung’u (2000). Macro models of the Kenyan
economy: a review. KIPPRA DP No. 2
Ronge, E. E. and H.O. Nyangito (2000). A review of Kenya’s current
industrialization policy.  KIPPRA DP No. 3
Nyangito, H.O. (2001). Delivery of services to smallholder coffee farmers and
impacts on production under liberalization in Kenya. KIPPRA DP No. 4
Njuguna S. Ndungu and R. W. Ngugi (2000). Banking sector interest rate spread
in Kenya. KIPPRA DP No. 5
Karingi, S.N., M.S. Kimenyi and Njuguna S. Ndung’u (2001). Beer taxation in
Kenya: an assessment. KIPPRA DP No. 6
Ikiara, M.M. (2001).Vision and long term development strategy for Kenya’s
tourism industry. KIPPRA DP No. 7
Geda, A. and Njuguna S. Ndung’u (2001). Specifying and estimating partial
equilibrium models for use in macro models: a road map for the KIPPRA-
Treasury Macro Model. KIPPRA DP No. 8
Geda, A., Niek de Jong, G. Mwabu and M.S. Kimenyi (2001). Determinants of
poverty in Kenya: household-level analysis. KIPPRA DP No. 9
Were, M., A. Geda, S.N. Karingi and Njuguna S. Ndungu (2001). Kenya’s
exchange rate movement in a liberalized environment: an empirical analysis.
KIPPRA DP No. 10
Huizinga, F., A. Geda, Njuguna S. Ndung’u and S.N. Karingi
(2001).Theoretical base for the Kenya macro model: the KIPPRA-Treasury
macro model.  KIPPRA DP No. 11
Mwabu, G., M. S. Kimenyi, P. Kimalu, N. Nafula and D. K. Manda (2002).
Predicting household poverty: a methodological note with a Kenyan example.
KIPPRA DP No. 12
Manda, D.K., G. Mwabu, M. S. Kimenyi (2002). Human capital externalities and
returns to education in Kenya. KIPPRA DP No. 13
Bedi, A., P.K. Kimalu, D.K. Manda, N.N. Nafula (2002).The decline in primary
school enrolment in Kenya. KIPPRA DP No. 14
56
Odhiambo, W. and H. Nyangito (2002). Land laws and land use in Kenya:
implications for agricultural development.  DP No. 15
Were, M. and S. Karingi (2002). Better understanding of the Kenyan economy:
simulations from the KIPPRA-Treasury Macro Model. KIPPRA DP No. 16
Nyangito, H., M. Ikiara and E. Ronge (2002). Performance of Kenya’s wheat
industry and prospects for regional trade in wheat products. DP No. 17
Nyangito, H. and L. Ndirangu (2002). Impact of institutional and regulatory
framework on the food crops subsector in Kenya: 1990-1999. KIPPRA DP No.
18
Ikiara, M. (2002). Impact of tourism on environment in Kenya: status and policy.
KIPPRA DP No. 19
Ronge, E., L. Ndirangu and H. Nyangito (2002). Review of government policies
for the promotion of micro and smallscale enterprises in Kenya. KIPPRA DP.
No. 20
 Kiringai, J., Njuguna S. Ndung’u, and S.N. Karingi (2002).Tobacco excise tax
in Kenya: an appraisal. KIPPRA DP No. 21
Were, M., Njuguna S. Ndung’u, A. Geda and S.N. Karingi (2002). Analysis of
Kenya’s export performance: an empirical evaluation. KIPPRA DP No. 22
Mwangi S. Kimenyi (2002). Ethnicity, institutions og governance and conflict
avoidance. KIPPRA DP No. 23
Ikiara, M.M., L. Ndirangu (2003).Prospects of Kenya’s clothing exports under
AGOA after 2004.  KIPPRA DP No. 24
Nyangito, H. (2003). Agricultural trade reforms in Kenya under the WTO
framework. KIPPRA DP No. 25
Odhiambo, W. and H. Nyangito (2003). Measuring agricultural productivity in
Kenya: a review of approaches. KIPPRA DP No. 26
Ngugi, R.W. (2003). Development of the Nairobi Stock Exchange: a historical
perspective. KIPPRA DP No. 27
Njuguna, A. E., S.N. Karingi and M.S. Kimenyi (2003). Alternative
methodologies for measuring Kenya’s potential output and output gap. KIPPRA
DP No. 28
Ngugi, R. W. (2003). What defines liquidity of the stock market? The case of the
Nairobi Stock Exchange. KIPPRA DP. No. 29
Nafula, N.N. (2003). Bank portfolios and bank earnings in Kenya: an econometric
analysis. KIPPRA DP No. 30.
Manda, D.K. (2004). Globalisation and the labour market in Kenya. KIPPRA DP.
No. 31.
Bedi, A., P. Kimalu, M.S. Kimenyi, D.K. Manda, G. Mwabu and N. Nafula
(2004). User charges and utilisation of health services in Kenya. KIPPRA DP.
No. 32.
Oiro, M. W., G. Mwabu and D.K. Manda (2004). Poverty and employment in
Kenya. KIPPRA DP No. 33
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Understanding interest rates structure in Kenya
Odhiambo, W., H. O. Nyangito and J. Nzuma (2004). Sources and determinants
of agricultural productivity in Kenya. KIPPRA DP No. 34
Muthaka, David I, Diana N. Kimani, Stephen Mwaura, Damiano K. Manda
(2004). A review of the regulatory framework for private healthcare services in
Kenya. KIPPRA DP No. 35
Kamau, A., S. Karingi, Njuguna S. Ndung’u, S. Mwaura. Capital requirements
and bank behaviour in Kenya: Empiical evidence. KIPPRA DP No. 36
Nafula, N. N., P. K. Kimalu, J. Kiringai, R. Owino, D. K. Manda, S. Karingi.
Budget mechanisms and public expenditure tracking in Kenya. KIPPRA DP
No. 37.
Nyaga, R.K., D.N. Kimani, G. Mwabu, M.S. Kimenyi. HIV/AIDS in Kenya: A
review of research and policy issues. KIPPRA DP No. 38.
Nyangito, H.O., J. Nzuma, H. Ommeh. M. Mbithi. Impact of agricultural trade
and related policy reforms on food security in Kenya. KIPPRA DP No. 39.
Occassional Papers
Gitu, K. W. (2001). Strengthening the link between policy research and
implementation.  KIPPRA OP No. 1
Kimenyi, M.S. (2001).  Effective private sector representation in policy formulation
and implementation. KIPPRA OP No. 2
Kimenyi, M.S. (2002). Agriculture, economic growth and poverty reduction. KIPPRA
OP No. 3
Nyangito, H. (2002). Post-Doha African challenges in the sanitary and phytosanitary
and trade related intellectual property rights agreement. KIPPRA OP No. 4
Mwabu, G. (2004). Principles of research. KIPPRA OP No. 5
Policy Papers
 Nyangito, H.O. (2001). Policy and legal framework for the tea subsector and the
impact of liberalization in Kenya. KIPPRA PP No. 1
Nyangito, H.O. (2001). Policy and legal framework for the coffee subsector and the
impact of liberalization in Kenya. KIPPRA PP No. 2
Ikiara, M.M. and H. Nyangito (2001). Effects of visa waiver and increase in airport
tax on Kenya’s tourism industry. KIPPRA PP No. 3
Special Reports
Legal and other constraints on access to financial services in Kenya: survey results.
KIPPRA Private Sector Development Division. SR No. 1, 2001
Thinking about regulating? The better regulation guide. KIPPRA Private Sector
Development Division. SR No. 2, 2002
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Policy timeline and time series data for Kenya: an analytical data compendium. KIPPRA
Macroeconomics Division, SR No. 3, 2002
Tax analysis and revenue forecasting in Kenya. KIPPRA Macroeconomics Division,
SR No. 4, 2003
Data compendium for Kenya’s agricultural sector. KIPPRA Productive Sector
Division, SR No. 5, 2003
Working Papers
Wasike, W.S.K. (2001). Road infrastructure policies in Kenya: historical trends and
current challenges. KIPPRA WP No. 1
Ikiara, M.M. (2001). Policy framework of Kenya’s tourism sector since independence
and emerging policy concerns. KIPPRA WP No. 2
Manda, D.K., M.S. Kimenyi and G. Mwabu. A review of poverty and antipoverty
initiatives in Kenya.  KIPPRA WP No. 3
Kimalu, P.K., N. Nafula, D.K. Manda, G. Mwabu and M.S. Kimenyi (2001).
Education indicators in Kenya. KIPPRA WP No. 4
Geda, A., S.N. Karingi, Njuguna S. Ndung’u, M. van Schaaijk, M. Were, W.
Wassala and J. Obere (2001). Estimation procedure and estimated results of the
KIPPRA-Treasury macro model. KIPPRA WP No. 5
Kimalu, P., N. Nafula, D.K. Manda, G. Mwabu and M.S. Kimenyi (2002). A
situational analysis of poverty in Kenya.  KIPPRA WP No. 6
Kiringai, J. and G. West (2002). Budget reforms and the Medium-Term Expenditure
Framework in Kenya. KIPPRA WP No. 7
Ikiara, M. and L. Ndirangu (2003). Developing a revival strategy for Kenya’s cotton-
textile industry: a value chain approach. KIPPRA WP No. 8
Ng’eno, N.K., H.O. Nyangito, M.M. Ikiara, E.E. Ronge, J. Nyamunga (2003).
Regional integration study of East Africa: the case of Kenya. KIPPRA WP No. 9
Manda, D. K., P.K. Kimalu, N. Nafula, Diana K. Kimani, R. K. Nyaga, J.M.
Mutua, G. Mwabu, M.S. Kimenyi (2003). Cost and benefits of eliminating child
labour in Kenya. KIPPRA Working Paper No. 10
Kimalu, P.K., N.N. Nafula, D.K. Manda, A. Bedi, G. Mwabu, M.S. Kimenyi
(2004). A review of the health sector in Kenya. KIPPRA Working Paper No. 11
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Understanding interest rates structure in Kenya
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