Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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It is a pleasure to address this group of seasoned bankers and eminent scholars in the field of soundness in the banking industry. My comments are based on experience witnessing the sickness, eventual death, and burial of a number of banks in Kenya.

From the other papers in this volume, one comes to the conclusion that the banking sector has a number of safety nets or safety systems to promote bank soundness. These include the lender of last resort facilitated by central banks, deposit guarantees of various forms, active and routine supervision by a supervising authority, strict disclosure regimes, such as that of New Zealand, and good management. Good management is a safety system in the sense that banks that come close to the grave can be turned around by new managers.

Deposit Guarantees

The main focus of these comments is deposit protection. There are two types of deposit protection and guarantees: explicit and implicit. Explicit systems are characterized by precise and documented guarantees with deposit protection arrangements. They tend to vary in design depending on funding arrangements, the structure of the banking system and banking supervision. Typically, deposit protection arrangements are established by the central bank law or banking laws, which usually specify the types of institutions and deposits covered, coverage limits, membership and management of the funds, funding arrangements, and procedures for the resolution of bank failures. Explicit systems are prevalent in the developed countries of Europe and North America.

Implicit systems, on the other hand, are not backed by banking laws or government or other official sector rules. Rather, bank management and depositors assume that the government will protect the banking system in case of a bank failure and will ensure that the public receives at least some of its deposits after a bank has failed.

However, there is no legal obligation on the part of the government, central bank, or other agency to come to the assistance of depositors or the financial system. Bank managers and the public can only expect assistance on the basis of precedent or government tradition. As a result of the lack of rules regarding coverage limits, form of compensation, or funding in the event of failure, there are many gray areas in this type of system. For example, payments by the government are discretionary. Implicit deposit guarantees are prevalent in developing countries, particularly in Africa, where most banks are government owned.

Deposit Protection in Kenya

In Kenya, there is an explicit deposit protection arrangement. Between 1896, when the first bank was established, and 1984, depositors’ confidence in the banking system was high and well founded, as there were no bank problems over this long period. Toward the end of this period, however, the seeds of bank insolvency were sown. During the late 1970s and early 1980s, there was a rush to establish new banks and nonbanking financial institutions, and a lot of banks came onto the scene. The potential for failure, stemming from this expansion, was increased by the enactment of an ill-defined banking law that overlooked aspects like insider lending, unsecured loan portfolios, credit concentration, undercapitalization, and a lack of internal controls, compounded by ineffective boards of directors.

The rapid expansion of the financial sector led to aggressive competition for deposits as well as shortage of well-qualified banking personnel. Insufficient internal controls allowed for the establishment of politically connected banks, which were established, in part, to take deposits from parastatals without competition from other banks.

Problems started to show up in the system in 1984, with Kenya’s first bank failure. Since then, 29 others have failed. In addition to the reasons for failure cited above, poor asset quality and overreliance on high-cost funds contributed to problems in the Kenyan banking industry.

The Banking Act was revised in 1985 to address these failures. Its main features are a higher paid-up capital requirement, enhanced supervision powers of the Central Bank of Kenya, establishment of the Deposit Protection Fund Board, and introduction of statutory reserves and gearing ratios for unimpaired capital vis-à-vis deposit liabilities. The establishment of the Deposit Protection Fund Board was perhaps the most important structural change in the banking system to emerge after the 1984 bank failure. It translated a deposit protection arrangement from an implicit to an explicit one, thus adding transparency to the system.

The Chairman of the Deposit Protection Fund Board is the governor of the Central Bank of Kenya, and the other members include four representatives from licensed banking institutions and the permanent secretary of the Ministry of Finance. Institutional membership is compulsory by virtue of carrying on banking business in Kenya; members pay annual contribution fees equal to 0.15 percent of the average deposits held in a period of 12 months or K Sh 300,000, whichever is higher. These contributions constitute the main source of income for the Deposit Protection Fund Board and are supplemented by interest income mainly from assets that are invested in treasury bills and, if necessary, loans from the central bank.

The key functions of the Deposit Protection Fund Board include surveillance of members’ institutions, insurance of deposits, and responsibility for liquidation of insolvent banks. In its surveillance role, the board supervises banks on an off-site basis in conjunction with the Department of Bank Supervision at the Central Bank of Kenya. The board receives reports from commercial banks and non-bank financial institutions for analysis; if it detects an element of stress or any other problem, it alerts the central bank, which in turn orders an on-site inspection.

All types of deposits are insured to a maximum of K Sh 100,000 (about US$1,700). This ceiling protects small depositors because when it was established, 96 percent of depositors had balances under K Sh 100,000. Interbank placements are treated as credits, and claims on these are paid when specified institutions declare dividends.

The Deposit Protection Fund Board is usually appointed by the central bank as liquidator of insolvent banks or nonbanking financial institutions. Liquidation involves selling the institution’s assets, paying off protected deposits, debt recovery, paying dividends to eligible creditors and shareholders, and finally, closing institutions. Currently, 16 institutions are under liquidation by the board.

A notable experience under the current explicit deposit protection arrangement in Kenya is that a systematic procedure has been developed for use before any institution is declared insolvent and placed under liquidation. A four-step procedure comes into play when a bank is managed in a manner that is detrimental to the interests of the depositors or members of the public or in a manner that contravenes the Banking Act. The central bank first gives advice and makes remedial recommendations through its bank supervision department. These recommendations are written and the bank is given a deadline for implementing them and the department monitors progress.

The second step is taken if the situation does not improve. The central bank issues directives for further remedial measures to be taken or appoints an advisor to help the institution implement the prescribed corrective measures. This advisor might be from the central bank or the industry and works with the bank’s management. The third step is taken if there is continued deterioration in the conditions of the institution. The central bank appoints a statutory manager who takes full control of the bank and is expected to discharge his duties in accordance with sound banking principles. Statutory managers trace and preserve all the property and assets of the institution, recover all the debts due, and evaluate the capital structure and management of the institution. The purpose of this step is to recommend a restructuring program. The statutory manager may declare a moratorium on payments to depositors and creditors of the institution and may limit the minimum rate of interest that may accrue on deposits or other debts payable by the institution during the moratorium.

The fourth and final step, if necessary, is a liquidation in which the operation of the bank is closed. The Deposit Protection Fund Board is normally appointed as the liquidator by the Central Bank of Kenya. Once this is done, there is no reversal, and the process of liquidation must continue.

Kenya’s Experience

Following the collapse of a number of small indigenous banks and financial institutions in the 1980s, there was a marked shift of depositors to well-established banks, which were mainly foreign banks. These banks raised their requirements for minimum balances and imposed other conditions to safeguard their interests. As a result some depositors were unable to open and operate deposit accounts.

Before the four-step procedure outlined above was fully in place, the government formed the Consolidated Bank of Kenya, which amalgamated 14 failed institutions. A new management team took over all the assets and liabilities of these distressed institutions. The Consolidated Bank of Kenya is still in operation today, although it has not been very successful in meeting the intended objectives. On realizing the various limitations associated with the grouping of problematic institutions under a consolidated bank, the Central Bank resorted to restructuring problem institutions. Some banks were successfully restructured and are now functioning, while others were declared insolvent and placed under liquidation as they could not be turned around.

The Deposit Protection Fund Board has created a lot of confidence in the market. Most people know that if banks have problems, the majority of the depositors are protected, and about 90 percent of the depositors will get their money. The credibility of this type of deposit protection depends on the speed with which protected depositors are paid. If they are paid after three years, they lose confidence; however, if they are paid within a short time, there will be confidence in the protection system. Following the amendment of Kenya’s Banking Act, legal provisions have been incorporated to facilitate legal actions against the management and board of directors of failing institutions. The speed with which actions are taken against management and directors is also important. As soon as the institution is placed under management, the irresponsible officers must be prosecuted, an action that enhances confidence. The problem is that legal systems in developing countries are complex, and a case may take a long time to be concluded.

There is no simple universal answer to any of the depositor protection questions. There are only pragmatic answers to deposit protection arrangements. Payout should be swift to bolster confidence, while limits and rules should be established explicitly in advance. Limiting insured amounts can help to limit moral hazard problems, as can the promise of prompt action against management and directors. Bank management, the deposit insurance scheme, and bank supervisors must pay careful attention to coordinate appropriate deposit arrangements.

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