Commercial bank's portfolio selection and the crowding out effect in Kenya

Abstract

During the macro-economic instability period of the early 1990's the less developed countries that was occasioned by the aid-conditionality liberalization prescribed by the Brettonwoods institutions, financial institutions in Kenya had two choices which were either to lend to the govcrmucnt at a negative real interest rate or lend to the private scctur albeit a high default rate (Ndungu 1995). Whereas the negative real interest rate resulted from high intlation levels that prevailed at the time, the high default rare was caused by poor economic g."owth rate that increased the expected returns of the private sector. Of the two choices the banking system prefer-red to lend to the government at the expense of the private sector thereby .causiug what the supply side economists and monetarists refer to as the "crowding out effect" (Ray Powell 1(93). This banking systems/action was hittcrly resented by hoth the general public and politicians alike until the latter crafted, supported and passed a bill in parliament to clip the wings of the banking system thus the Central Bank Amendment Bill (2000) popularly known as the "Doude" Bill hut the implementation of the bill has remained cuntruversial with courts being called in to arbitrate. The Cl"owding out effect is not a new phenomenon in Kenya as Koori (l9H4) in his study the 'Nature and existence of crowding out effect in Kenya' found out that bbeing displaced in the water and clccrricity sub sectors. In his study, Koori notes that the cnn"liing out effect was not caused by increased government borrowing perse but rather by the reasons that cause the increase in government borrowing. In this particular study, the crowding out effect is understood in terms of how the banking systems' portfolio selection crowds out the private sector (Brunson W.H 19S8). As such the banking system is taken as an investor out to make a decision on where to invest (read asset portfolio selection I) on the hasis of modified Ha r ry Mckowitzs prescr-iption tor investment that include expected returns frum an asset, the perceived rixk on the asset and the available infonnation reglll"ding alternative invcstmcntst Chnudra P 19(0). In this study, the expected returns variable is proxied by the ratio of interest rate on loans advanced to the interest rate on treasury hills while the perceived risk is pruxicd hy non-performing loans (assuming that they are held by the private scctnr) whereas the available information on the alternative investment is pruxicd by the infonnation available to the banking sector on the level of govenllllent deficit (and the govemments' inability to finance it given the stand-off hetween the Kenya guvernmcnt and the Brettonwoods institutions over the Iurmcrs ' slow pace in implementing the reforms.) As already mentioned, the investment decision the banking system was to make involved the choice on whether to lend to the govenllllent 0." lend to the private sector 011 the backdrop of the circumstances based on modified Mckowitz's investment pr-inciples focus in this study heing the banking system's decision on both whether III" 110t to lend to the private sector. From the afurcmcnriuncd , the ratio of the interest loans to the interest rutc of Treasury hill (expected returns) is expected to be positively related to the banking systems lending to the private sector while the nun-pcrtnr minj; loans portfolio (risk] is expected to he negatively related to banking systems lending to privutc sector just as the information available level of thc budget deficit. financial and resuurccs crowding out existed with the private sector completely