Strathmore Business School Financial Sector Policy Training

Financial Crises: Kenyan Perspective

David Ndii
ndii@netsolafrica.com

Financial Crisis
A financial crisis is a disruption to financial markets in which adverse selection nd
moral hazard problems become much worse, so that the financial markets are
unable to efficiently channel funds to those who have the most productive
investment opportunities (Mishkin 1992).
An equal opportunity menace (Reinhart and Rogoff 2009) that can have domestic
or external origins, stem from private or public sectorscome in different shapes
and sizes, evolve over time in different formscan rapidly spread across
bordersoften require immediate an comprehensive policy responses, call for
major changes in financial sector and fiscal policies and can necessitate global
coordination of policies (Claessens and Kose 2013)

Unpredictable!
In the United States, where the economy is large enough to have several competing, welldiversified intermediaries, the increased diversification from geographical deregulation may
reduce management moral hazard and help eliminate the need for high future bank profits (high
charter value) to provide good incentives to bankers. If this is correct, banks and similar financial
intermediaries will be more stable in the future than in recent experience in the United States
Douglas Diamond (1996)

Types
Currency crises
Capital flows (sudden stops)
Balance of payments crises
External sovereign debt crises
Domestic debt crises
Banking crises (contagion)
Asset price (stocks, housing, credit) booms and bust

Kenya
Two episodes of moderate banking crises
1984-86 failure of first generation NBFIs
1993-94 failure of political banks

One macro-financial crisis episode 1992-93 (Goldenberg)

Systemic fragility (1996-2003)
Rapid financial development (2003-present)

Interest Rate & Domestic Credit Growth

35.0
30.0
25.0
20.0
15.0
10.0
5.0

(10.0)
(15.0)
91 day Tbill,%

Domestic Credit Growth, % p.a

Slide 6

12
20

11
20

10
20

09
20

08
20

07
20

06
20

05
20

04
20

03
20

02
20

01
20

00
20

99
19

19

19

97

(5.0)

98

Slide 7

Demographics and technology: bank customer growth

Slide 8

Theoretical Perspectives
Asset transformationsystemic fragility (Diamond and Dybvig 1983)
Imperfect Information (Lemon Market) problems (Myers and Majluf
1984, Greenwald, Stiglitz & Weiss 1984)
Contract/Principal Agent Theory (CSV Models) (Townsend 1979, Gale and
Hellwig 1984, Diamond 1984)

Theoretical Insights
Systemic fragility: illiquidity of assets provides the rational both for the existence of banks
and for their vulnerability to runs (Diamond 2007)
Deposit insurance mitigates bank run and contagion risk, but may also increase moral hazard
risk
Free rider problem necessitates privacy of information about asset quality, but in turn
introduces an agency problem between FI owners and depositors (has implications on bank
spreads i.e. intermediation is necessarily an imperfect market)
Asset diversification improves asset quality but trade off with profitability of the intermediary
Big banks better but also entail moral hazard risk (too big to fail)

Developing Country Perspectives

Financial Repression (McKinnon-Shaw hypothesis) . Competitive financial markets good for
growth
Market failures too pervasive, Government intervention necessary for growth (Stiglitz 1993)
Government failure worse than market failure (Jaramillo-Vallego 1993)

Summary and conclusions

Societys problem is to transform savings into capital. To do this has to solve all manner of
problems; transactions costs are high relative to individual savings, savers may suffer liquidity
shocks, entrepreneurs can and do cheat e.g. divert cash flows; difficult to distinguish good and
bad projects ex ante etc. FIs emerge to solve these problems-lower transactions costs,
appraise projects, provide liquidity, monitor entrepreneurs- but they too are susceptible to the
same problems they exist to solve.
There is a widely held belief that the State can improve the performance of financial markets
either by intervention to improve intermediation i.e. transformation of savings into capital, or
by making it safer through regulation. It is far from evident that the States capacity to do so
has improved over time either by way of preventing crises or by mitigating consequences-beyond Bagehots 1873 dictum (lend early, freely, at high interest against good collateral)

Summary and Conclusions

Financial intermediation continues to evolve rapidly ad in unpredictable ways. One of the
paradox of financial innovation is that reducing transactions costs and information
assymetries spurs more intermediation not less (e.g. in advanced markets, ICT has lowered
transactions costs of individual trading in stocks, but investing through mutual funds has
increasedtransactions cost based theories would predict the reverse).
Globally, the most significant innovations are in risk trading (derivatives), and investment is
increasingly financed by risk capital (venture capital, private equity), making the
intermediation theories less and less relevant.
Even here in Kenya, the most successful innovation MPESA is in the transactions/payments
space as opposed to intermediation. Another very important innovation SACCOS do not
conform to the conventional intermediation model.

Summary and Conclusions

Governments continue to be as preoccupied as ever with engineering financial development
and directing credit to their favourite enterprises (manufacturing agriculture, SMEs, youth,
women etc) as they have through the ages, with the same unimpressive outcomes.
The literature has clarified some of the factors driving crises, but it remains a challenge to
definitely identify their deeper causes. Many theories have been developed over the years
regarding the underlying causes of crises. While fundamental factors- macroeconomic, internal
or external shocksare often observed, many questions remain on the exact causes of
crises. Financial crises sometimes appear to be driven by irrational factors (Claessens and
Kone 2013)

References
Brownbridge Martin (1996) Government Policies and the Development of Banking in Kenya, IDS (Sussex) Working Paper No. 29
Claessens and Kose (2013) Financial Crisis: Explanations, Types and Implications IMF Working Paper 13/28
Diamond, Douglas (2007) Banks and Liquidity Creation: A Simple Exposition of the Diamond-Dybvig Model Federal Reserve Bank of Richmond Economic Quarterly 93/2

Diamond, Douglas (1986) Financial Intermediation as Delegated Monitoring: A Simple Example Federal Reserve Bank of Richmond Quarterly Review 82/3
Diamond, Douglas (1984) Financial Intermediation and Delegated Monitoring Review of Economic Studies 51
Diamond and Dybvig (1983) Bank Runs, Deposit Insurance and Liqudity, Journal of Political Economy 91
Gale and Hellwig (1985) Incentive Compatible Debt Contracts: The One-Period Problem Review of Economic Studies 52
Greenwald, Stiglitz & Weiss (1984) Information imperfections in the Capital Markets and Macroeconomic Fluctuations, American Economic Review
Jaramillo-Vallejo (1993) Comment on The Role of the State in Financial Markets, by Stiglitz Proceedings of the World Bank Annual Conference on Development Economics 1993
Myers and Majluf (1984) Corporate Financing and Investment Decisions when Firms have Information that Investors do not Have Journal of Financial Economics 13
Ndii, D (1994) An Assymetric Information Analysis of Financial Sector Policy in Kenya University of Oxford. Mimeo
Townsend, Robert (1979) Optimal Contracts and Competitive Markets with Costly State Verification Journal of Economic Theory 21

Stiglitz, Joseph (1993) The Role of the State in Financial Markets, Proceedings of the World Bank Annual Conference on Development Economics 1993

End. Thank you.