The Effect of Changes in Interest Rate Regulation on the Financial Performance of Banks in Kenya

Abstract

The purpose of this study is to assess the effect of changes in interest rate regulation on the financial performance of banks in Kenya. Using a panel dataset of 78 banks in East Africa comprising 1,278 observations over the period 2004–2019, we employ difference-in-difference methodology on accounting and market value measures of financial performance. Two-step generalised method of moments, is used as the estimation technique to address the problem of endogeneity, commonly found in panel data. The results, which are robust for endogeneity and other checks reveal that introduction of interest rate caps in Kenya significantly increased the profitability of banks. This increase can likely be attributed to increase in non-interest income and reduction in operating expenses. On the contrary, the impact on publicly listed banks was insignificant. The study has the potential to inform policy makers in the East Africa region on the effects of interest rate regulation. High lending interest rates has seen some countries such as Kenya impose interest rate caps and subsequently repealed. Other countries such as Uganda were in the process of considering rate caps but have deferred the decision. The study is perhaps the first to examine the effect of changes in interest rate regulation on the financial performance of countries in the East African region. The authors also employ difference-in-difference methodology and two-step generalised method of moments estimation (GMM) in the study which is different from previous studies.