Nature and Dynamics of Adjustment of Commercial Banks' Retail Rates to Monetary Policy Changes in Kenya

Abstract

In Kenya, commercial banks are the most dominant financial intermediaries owning 80 per cent of financial sector's assets. In this regard, they provide a crucial link in monetary policy transmission. CentralBank of Kenya reports show that adjustment of commercial banks retail rates to monetary policy changes is· sluggish thereby posing serious challenges to effective monetary policy transmission. Recent theories - more so New Keynesian and Post Keynesian theories - postulate thatcommercial banks' pricing behaviour and financial sector environment have important bearing on money supply process. Therefore, evaluation of commercial banks pricing and responsiveness to monetary policy changes is vital in understanding efficacy and conduct of monetary policy. This study investigated nonlinear adjustment of commercial banks retail rates to monetary policy changes in an attempt to understand nature and dynamics of monetary policy transmission in Kenya. The specific objectives are; to measure speed of adjustment of bank retail rates to monetary policy changes; to examine how speed of adjustment changes in the event monetary policy switches regime; to investigate how speed of adjustment varies with time; and to evaluate whether speed of adjustment is simultaneously time varying and asymmetrical in regime switching. The investigation used Autoregressive distributed lag model formulated from Monti- Klein profit maximization model. Autoregressive distributed lag model was remodeled into one linear and three nonlinear error correction models. The study utilized monthly time series data from June 1993 to February 2012. Data was sourced from CBK. The results revealed that adjustment towards equilibrium is sluggish and nonlinear. Firstly, speed of adjustment of commercial bank retail rates to monetary policy changes ranges from 5 per cent per month to 15 per cent per month. Secondly, speed of adjustment is regime switching. For example, lending rates are rigid downwards as they adjusted faster during expansionary monetary policy regime compared to contractionary monetary policy regime. In addition, there was evidence that speed of adjustment is simultaneously time varying and regime switching. However, time varying adjustment is less pronounced. The study concluded that factors such as inefficiency in financial market, structural rigidities and nature of competition in the money market have an important bearing on commercial banks pricing behaviour and in turn explain sluggish and nonlinear adjustment of commercial banks' retail rates to monetary policy changes in Kenya. The study recommended that Central Bank should include nonlinear aspects such as sign asymmetry and magnitude asymmetry in forecasting and prediction of future monetary policy action.