The Central Bank of Kenya (CBK) has warned that the banking sector could face significant losses due to the increasing interest rates in the country. The CBK has conducted stress tests to assess the impact of interest rate shocks on banks’ profitability and capital adequacy.
CBK raises policy rate to 10.50 per cent
The CBK’s Monetary Policy Committee (MPC) decided to raise its policy lending rate to 10.50 per cent in July 2023, the highest level in seven years. The MPC said that this was necessary to curb inflation and stabilize the shilling, which had depreciated by 12 per cent against the US dollar since January 2023.
The policy rate is the benchmark rate that the CBK charges commercial banks for overnight loans. It influences the cost of borrowing and saving in the economy. A higher policy rate makes borrowing more expensive and saving more attractive, thus reducing the money supply and inflationary pressures.
However, a higher policy rate also affects the value of bonds, which are fixed-income securities that pay a regular interest to investors. Bonds are priced inversely to interest rates, meaning that when interest rates go up, bond prices go down, and vice versa.
Banks face valuation losses on bond portfolios
According to the CBK, Kenyan banks hold about Sh1.1 trillion worth of bonds in their balance sheets, accounting for 28 per cent of their total assets as of June 30, 2023. These bonds are classified into two categories: held to maturity (HTM) and available for sale (AFS).
HTM bonds are bonds that banks intend to hold until they mature, and they are not affected by changes in market prices. AFS bonds are bonds that banks can sell before they mature, and they are subject to changes in market prices.
The CBK said that due to the rising interest rates, banks have experienced revaluation losses on their AFS bonds, which have reduced their equity and profitability. As of June 30, 2023, banks had reported revaluation losses of Sh102.7 billion on their AFS bonds.
The CBK also projected that if interest rates were to increase further by 18.85 per cent and 19.89 per cent in moderate and severe scenarios respectively, banks would incur additional unrealised valuation losses of Sh154.8 billion and Sh208.7 billion on their AFS bonds. This would be compared to the baseline estimate of Sh96 billion.
An unrealised loss is a paper loss that occurs when an asset’s market price is lower than its book value, but the asset has not been sold yet. An unrealised loss only becomes a realised loss when the asset is sold at a lower price.
Banks remain resilient to interest rate risk
The CBK said that despite the potential losses from rising interest rates, the banking sector remains resilient and well-capitalised. The CBK conducted stress tests to measure the impact of interest rate shocks on banks’ capital adequacy ratios (CARs), which are indicators of banks’ financial strength and ability to absorb losses.
The CBK said that under the baseline scenario, the banking sector’s average CAR would decline from 18.2 per cent to 17.4 per cent, which is still above the minimum regulatory requirement of 10.5 per cent. Under the moderate scenario, the average CAR would drop to 16.6 per cent, and under the severe scenario, it would fall to 15.8 per cent.
The CBK also assessed the impact of combined shocks, such as increases in non-performing loans (NPLs) and repricing of bonds due to rising interest rates. The CBK said that under the combined severe scenario, 10 banks would require a total of Sh56.5 billion in additional capital to meet the minimum CAR of 10.5 per cent.
The CBK said that it will continue to monitor the interest rate risk in the banking sector and take appropriate measures to ensure financial stability. The CBK also advised banks to adopt prudent risk management practices and diversify their income sources.
