EFFECTS OF INFLATION ON COMMERCIAL BANKSâ€™ LENDING

EFFECTS OF INFLATION ON COMMERCIAL BANKSâ€™ LENDING [A CASE OF KENYA COMMERCIAL BANK LIMITED]

Code No: 166603

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ABSTRACT

The purpose of this study was to determine the relationship between annual inflation rate and Kenya Commercial Bank base lending rate, new lending volumes and loans defaulting. This study was guided by the following three research questions:(i) What is the relationship between annual rates of inflation rate and base lending interest rate in Kenya from the year 2004 to 2013?, (ii) What is the relationship between both inflation rate and base lending rate and KCB new annual lending volumes from the year 2004 to 2013? (iii) What is the relationship between inflation rate and KCB annual loan default rate?

The study adopted both descriptive research design with the target population comprising of 450 KCB employees from both management and non- management staff spread in all the 15 branches within Nairobi County and secondary data on inflation rates, new volumes of lending to creditors, loans default volumes and bank base lending rates. A sample size of 199 KCB staff was selected through multi-stage sampling procedure while purposive sampling was used to select secondary data on KCB new lending volumes, loan defaulting, KCB base lending rates and the annual inflation rates. Secondary data was obtained from banks administrative records and documentation while data on inflation rates was obtained from the Kenya National Bureau of Statistics, through email. Primary data was mainly obtained from KCB employees using self administered questionnaires.

Primary data was analyzed using descriptive statistics and secondary data was analyzed using inferential statistics with an aid Statistical Package for Social Sciences (SPSS) program. Results of regression analysis and primary data were presented using frequency tables, charts and models.

The first major findings was the positive relationship between inflation rate and the base lending rate charged by the bank, as inflation levels rises, so did the bankâ€Ÿs base lending rate both from the key informant figures and the regression analysis of the secondary data, showing that inflation has a significant effect on KCB base lending rate. The second major finding was that inflation has moderate effect on KCB new lending volumes; however an increase in base lending rate contributed most towards the reduction in the lending volumes. The third finding revealed that a rise in inflation led to high rate of loan defaulting activities in the bank.

Conclusion drawn from the findings indicated that a rise in the inflation figures contributes to an increase in the base lending rate, this may be attributed to the fact that a rise inflation leads to a reduction in the purchasing power of money hence the bank demands a higher base lending rate to cover for assuming this credit risk. Secondly inflation by itself contributes marginally to the lending volumes, however as the base lending is increased the uptake of loans is significantly reduced which may be attributed to fact that customers repayment ability is hampered with increase in the base lending rate. And finally a rise in inflation also affects the loan default rate, since the banks are forced to increase their interest charged ,serious affecting customers ability to service their loans ,on the other hand arise in inflation may lead to an influx of less credit worthy borrowers who may easily default on their repayment obligations.

Based on the findings various recommendations were made. First the banks should have policy on minimum base lending rate to be charged on loans and in order to maintain this, the bank would need to diversify to other sources of incomes streams such as aggressively undertaking non interest related activities e.g. collection of commission and fees, to cushion it during high inflation period when the uptake of loans dwindle since the organization has no control of macroeconomic factors affecting the inflation of the country. Secondly the bank can encourage borrowers to take fixed interest loan repayment offers, rather than the flexible repayment models to reduce the rate at which loans are defaulted as a result of fluctuation of the repayments amounts.

CHAPTER 1

1.0 INTRODUCTION

1.1 Background of the Study

Inflation is generally the persistent increase of price level of goods and services in an economy over a period of time. When price level rises, each unit of currency buys fewer goods and services. Consequently, inflation results into a reduction in the purchasing power per unit of money, a loss of real value in the medium of exchange and unit of account within the economy (Boyd and Champ, 2004).They further observes that high inflation rates are caused by excessive growth of money supply in the economy compared to the rate of economic growth, a lower rate of inflation is thus favored since it reduces severity of economic recessions by enabling the labor market to adjust more quickly in a down turn. The chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the consumer price index) over time, The consumer price index measures movements in prices of a fixed basket of goods and services purchased by a typical consumer, The inflation rate is the percentage rate of change of a price index over time.

Lending is the most important services that commercial banks do render their customers, in other word banks grant advances and loan to individuals, government and business organization (Cheboi, 2012). Commercial banks are the most important savings, mobilization and financial resource allocations institutions, consequently these roles make them an important phenomenon in economic growth and development. In performing this role, it must be realized that banks have the potential, scope and prospects for mobilizing financial resources and allocating them to productive investments. Therefore, no matter the sources of the generation of income or the economic policies of the country, commercial banks would be interested in giving out loans and advances to their numerous customers bearing in mind, the three principles guiding their operations which are, profitability, liquidity and solvency (Cheboi, 2012).

Chodechai (2004) while investigating factors that affect interest rates, degree of lending volume and collateral setting in the loan decision of banks, under notes that Banks have to be careful with their pricing decisions as regards to lending as banks cannot charge loan rates that are too low because the revenue from the interest income will not be enough to

cover the cost of deposits, general expenses and the loss of revenue from some borrowers that do not pay. Moreover, charging too high loan rates may also create an adverse selection situation and moral hazard problems for the borrowers. However, commercial banks decisions to lend out loans are influenced by a lot of factors such as the prevailing interest rate, the volume of deposits, the level of their domestic and foreign investment, banks liquidity ratio, prestige and public recognition to mention a few. Interest rate is the amount charged as percentage of principal by a lender to a borrower for the use of assets based on the risk level that is the compensation for the loss of assetâ€Ÿs use by the lender.

Inflation is a key determinant of commercial banksâ€Ÿ lending rates globally. According to Santoni (1986), inflation depreciates the value of money such that a percentage increase in inflation results into a similar percentage fall in value of the countryâ€Ÿs currency. Broadly, inflation theorists attribute inflation to monetary causes and mal adjustments in economic system (Chand, 2008). The performance of commercial banks has been a considered issue in the developing countries. This phenomenon is attributed to the crucial role of the commercial banks in the economy. Further, the performance of banking is important to depositors, owners, potential investors and policy makers as banks are the effective executors of monetary policy of the government (Mian et al.2013). This suggests that the volumes of bank lending may partly depend on the performance of commercial banks.

Taner (2000) study on the effects of inflation uncertainty on credit markets reveals that unpredictable inflation raises interest rates, decreases loan supply and affect loan demand. This therefore suggests that an increase in inflation may raise the bank lending rates and lead to low bank lending volumes. Emon (2012)confirms this assertion and states that lenders are very aware that inflations erodes the value of their money over the time period of a loan, so they increase the interest rates to compensate for the loss. The increased interest rates may therefore influence the borrowing patterns for any commercial bank. This also suggests that there is a positive relationship between the inflation rates and the lending rates even though the extent to which one affects the other for different time periods is not certain. This study will therefore strive to determine the pattern of Kenya Commercial Bank (KCB) lending volumes as a result of the countryâ€Ÿs inflation rates over a period of time.