How interbank market affects the cost of loans

 

Customers queue at a KCB branch. Banks failed to share with their clients the benefits of cheaper loans. FILE  

By George Bodo

In Summary

• Banks borrowed Sh3.5 trillion from each other, Sh700 billion more than in 2012.

The interbank rate is one of two key variables that banks use in pricing loans — which are the cost of funds and the borrower’s risk. The two almost carry equal weights in pricing. The interbank borrowing rate is an important pricing benchmark for cost of funds.

Banks typically apply some marginal discount or premium, depending on whose money it is, to the prevailing interbank rate in pricing deposits.

Retail deposits, say below Sh1 million, would typically be priced at below prevailing interbank rates. Significant deposits, say Sh5 million and above, which, in most cases, belong to high networth individuals and corporate entities, would be priced at a premium above interbank.

The rate applicable is mainly dependent on the volume of deposits, with big savers normally using their negotiating power to demand higher returns.

It is generally not sustainable for a bank to continually fund itself by relying on customer deposits, and interbank borrowing rates therefore mirror the general cost of funds in the market and play a huge role in determining the average cost of loans.

Banks seemingly failed to pass on the benefits of the reduction in cost of local currency funds in 2013 to their customers.

Data from the Central Bank of Kenya (CBK) shows that, at the close of November 2013, commercial banks local currency weighted lending rates averaged at 17 per cent, compared to 19 per cent in 2012.

This marginal decline was far less than the substantial drop in cost of funds by six percentage points year-on-year. The surge in interbank borrowings also shows that local currency liquidity distribution among banks is skewed.

There are times when the CBK stated (in its weekly market reports) that its liquidity distribution index showed imbalance in the market. And so to correct the balance, it acted by pumping liquidity of about Sh1 trillion during the year to support the market (although very short term and had a maximum contractual life of 7-days).

For a bank to rely less on the interbank market as a source of local currency funding, it needs to have sufficient deposits. However, its ability to marshall low (or even non-interest-bearing) deposits lies solely on the strength of its deposit franchise, which is defined by the number of branches and their locations.

By the end of March 2013, the six tier-one banks had 51 per cent of total branches in the country with KCB, Equity, Barclays and Co-op banks alone controlling about 45 per cent and the other 40 banks sharing the remaining 55 per cent.

With this kind of scenario, there is bound to be skewedness in the local currency deposits market, which often extends into the interbank market where, at certain instances, only a few banks hold liquidity and lend to other banks at a premium, raising rates.

It could be time the horizontal repo market was activated, because it could go a long way in ensuring that borrowing banks can access some longer-term funds from the market.