Effect of Exchange rate, Gross Domestic Product, Real Interest rate and Inflation on Banking Financial Stability in Kenya

Abstract

Financial institutions and markets are the backbone of any economy and the banking sector is the most important engine for economic growth development of any country. Kenya has a vibrant banking sector and well regulated, however it has had a history of bank failures, with about thirty-seven banks failing between 1986 to 1998. In 2015, three Kenyan banks were placed under statutory management due to financial distress. The stability of commercial banks in Kenya has not been that robust. With financial openness and liberalization, financial stability issues in the banking industry in relation to the macroeconomic environment has become a concern. It was therefore vital to investigate the relationship between macroeconomic variables and financial stability. Specifically, the objectives of the study were to; determine effect of real Gross Domestic Product (GDP) on banking financial stability; Examine the effect of real interest rates on banking financial stability; Evaluate the effect of exchange rates on banking financial stability; Determine the effect of inflation on banking financial stability in Kenya. The study was anchored on the Mundell-Fleming Model also known as AD-AS-IS-LM-BOP framework. The study was quantitative in nature and adopted a positivist research philosophy, having a correlational design using the econometric methodology. The study used the Autoregressive Distributed Lag Model Cointegration and error correction; Variance decomposition and impulse response in its data analysis. Data presentation was done by use of tables and graphs. The findings indicate existence of both long run and short run relationship between the exchange rate, GDP, real interest rate, inflation and Banking financial stability in Kenya. The error correction coefficient was estimated to be -0.2122 (0.0025) and significant, and this implies that there is a fairly 21% of speed of adjustment to equilibrium after a shock. The Variance decomposition and Impulse response indicates that exchange rate and GDG has a large effect on financial stability as compared to Real interest rate and inflation rate. The results further indicate that financial stability in the sector depends so much on the previous year’s performance, this has been attributed to the regulatory framework in the sector. The study recommends that the regulator continues to lay the macro prudential regulations to maintain the stability of the sector. Secondly, the central bank needed to grow its exchange rate reserves if it were to face down the threat of external and internal drains on the exchange rate that later has an in effect to financial stability. Thus, reserve adequacy has to be gauged against the size of the banking sector.

Keywords: Exchange rate, GDP, Financial Stability

DOI: 10.7176/JESD/15-7-02

Publication date: July 30th 2024