Effects Of Prudential Capital Regulations On Systemic Risk And Financial Stability In The Banking Sector In Kenya

ABSTRACT

The prudential regulation's main objective is to mitigate financial instability's threat and macroeconomic costs. In the last decade (2007 to 2018), the banking sector in Kenya has expanded rapidly, making some banks operate within thin capital margins, while others have begun regional operations exposing themselves to cross-border country risks. The country needs to be cautious about risks to the financial system and spillovers of these risks to the economy. The aim of this research was to analyse the effect of the implemented prudential capital regulations policies on systemic risk and financial stability in Kenya. The first objective of the study was to analyse how prudential capital regulations policies can effectively curb financial risks in Kenyan banks. To achieve this objective, the dynamic Generalized Method of Moments model was estimated. The results suggest that banks with capital adequacy ratios, either above or below the applicable regulatory minimum limits, have reduced portfolio risk of assets in response to stringent risk-based capital requirements. It may be impossible to implement effective capital regulations where transparency, deterrence and accountability are very weak. Therefore, the Kenyan government must fix the vulnerabilities that remain in the institutional environment in order to ensure the effectiveness of regulatory capital requirements. In addition, bank capital is a required but insufficient prerequisite to stab a bank. The second objective was to investigate the impact on financial stability in Kenya of the existence of foreign banks. The analysis found a double result, i.e. the lower or higher financial strength for international capital-owned banks than for all the country's banks. The analysis used the regression of binary logits. The findings indicate that there is no substantial direct link between the share of foreign banks and stability in the banking sector in Kenya; rather, financial stability depends on the credit policy of banks and their balance sheet structures, regardless of ownership form. Positive macroeconomic development drives Kenya’s financial stability, increase foreign banks penetration, and encourages them to expand through aggressive credit policies. The findings suggest that it is the conditions of the host country that affect the stability of foreign-owned banks, which implies that they have to react to local conditions. The success of foreign banks is same as the success of the host country. The study analysed objective three by investigating the effectiveness of prudential capital regulations on Financial Stability using panel vector autoregression model. The research results indicate the importance of capitalization of the banking system in ensuring financial stability that can be used to shape and size the policies being applied. To increase transparency, regulatory and supervisory authorities need specific guidelines to maintain financial stability. Including mitigation of systemic risks should be viewed as an explicit goal for the concerned central banks and regulators. The purpose of the study was to shed some more light on the effectiveness of the implemented prudential capital regulations policies.