Causal Effect of Financial Market Frictions and Flight to Quality on Cost of Credit in Kenya

Barnabas Ochieng’ Onyango ,Alphonce Odondo ,John E Odada

doi:10.7176/jesd/12-6-07

Barnabas Ochieng’ Onyango , Alphonce Odondo + Show 1 more

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Financial market conditions have been declining over the past ten years globally as most developing countries continue to adopt more liberal financial policies, such conditions may amplify adverse shocks to the economy. The Kenyan Banking sector was highly profitable before the implementation of financial market frictions, with industry return on equity’s average of 20%. The ratio of credit supply to gross domestic product was 35%; and the economy grew by 5.6 %. Nonetheless, after its adoption, listed Banks recorded negative Earnings per Share growth of 8.2%, compared to an average positive growth of 14.1%, The Net Interest Margin declined to 8.4% from 9.4%. Studies relating to financial market frictions, flight to quality and Cost of Credit have produced mixed results. It was on this basis that this study sought to establish the effect of financial market frictions and flight to quality on cost of credit in Kenya. The study adopted correlational research design. Secondary data from the Kenyan Market for the period January 2009 to December 2019 was analyzed. Augmented Dickey Fuller and Philips-perron unit-root test was used to test the stationarity of the data. VECM was estimated to establish the speed of adjustment towards the long run equilibrium; Wald statistics was also estimated to establish short run causalities amongst the variables. Based on cointegrating equations, the error correction term indicated a negative sign and was significant at 5% level (C (1) = -0.153042, .0429 p=0.05),however, Central Bank rate was found to be different from zero and significant at 5% level (.0163>p=0.05), an indication that there was a short run casualty running from the Central Bank rate to cost of credit. The study therefore recommends that for Micro finance institutions to maximize their profits they should adopt new technologies like Mobile Banking for their credit facilities, this does not require administrative and operation costs, in a bid to cope with the market shocks and frictions. Keywords: Financial Market Frictions, Flight to Quality, Cost of Credit, Kenya DOI: 10.7176/JESD/12-6-07 Publication date: March 31 st 2021

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Financial market frictions have been a major concern to many players in the financial sector
Central Bank Rate, Non performing loans, Provisions in anticipation of loan losses and Treasury Bills had a mean of = 12.57765 ( = 3.707730) ; = 171556.1 ( = 87523.47); = 137850.5 ( = 32506.62); and = 249731.3 ( = 164627.2) respectively, an indication that during the period of review, the Banking sector had an average of 12.575% CBR, Loans amounting to Kshs.171,556.1 Million were non performing, total provisions was Kshs.137,850.5 Million and had invested in kshs. 249,731.3 Million in treasury bills
Correlation results shows that Central Bank rate was positively associated with the cost of credit and was significant at 5% level ( r = .805565; .0000> p=.05); vector error correction estimates indicated that Central Bank rate is an important determinant of cost of credit in the long run (t-statistics 2 < -7.79867)

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Financial market frictions have been a major concern to many players in the financial sector. In the context of the capital asset pricing model, financial market frictions is defined as anything that interferes with trade. These frictions can cause a market participant to be exposed to more or less risk than he/she might prefer and can deviate from holding the market portfolio (Kiyotaki & Wright, 1989; Mahony & Qian, 2009; Trejos & Wright, 1995). Financial market frictions generate real costs for MFIs, recognizing these costs helps in their allocation and whether they are worth absorbing, especially transactions costs, such costs depend in part on market structure which depends on both the risk of the traded asset and trading volume. Market frictions are manifested as market power indivisibilities leading to economies of scale, economies of scope, imperfect information and incomplete market asymmetric information and positive transaction costs (Mahony & Qian, 2009; Kumar & Williamson, 1993)

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