Do bank regulations matter for financial stability? Evidence from a developing economy
| DOI | https://doi.org/10.1108/JFRC-12-2020-0114 |
| Published date | 03 August 2021 |
| Date | 03 August 2021 |
| Pages | 514-532 |
| Subject Matter | Accounting & finance,Financial risk/company failure,Financial compliance/regulation |
| Author | Antony Rahim Atellu,Peter Muriu,Odhiambo Sule |
Do bank regulations matter for
financial stability? Evidence from
a developing economy
Antony Rahim Atellu,Peter Muriu and Odhiambo Sule
School of Economics, University of Nairobi, Nairobi, Kenya
Abstract
Purpose –This paper aims to establish the effect of bank regulations on financial stability in Kenya.
Specifically, the study seeks to uncover the effect of micro and macro prudential regulations on financial
stabilityand their trade-offs or complementarities.
Design/methodology/approach –Using annual time series data over the period 1990–2017,the study
uses structural equation model (SEM) estimation technique. This solves the problem of approximating
measurementerrors, using both latent constructs and indicator constructs.
Findings –Study findings reveal that macro and micro prudential regulations are significant drivers of
financialstability. Further, prudential regulationsare more effective when they complement each other.
Research limitations/implications –This study centers on how bank regulations affect financial
stability. Future researchcould be carried out on the effect of Non-Bank Financial Institutions regulationson
financialsystem stability.
Practical implications –Complementing macro and micro prudential regulation is more effective and
efficient in ensuring stability of the financial system other than letting the two policy objectives operate
independently.
Social implications –Regulatory authorities should introduce prudential regulations that would
encourage innovationsin the banking sector. This ensures easy deposit mobilization that enhances financial
inclusion. Prudentialregulations that ensure financial stability will be effectivewhen low income earners are
includedin the financial system.
Originality/value –To the best of the authors’knowledge, thisstudy is the first to investigate the role of
banking regulations on financial stability. This study is also pioneering in the use of SEM estimation
technique, in examining how prudentialregulations affect financial stability. Previous cross-country studies
have focusedon macro prudential regulations ignoringthe importance of micro prudential regulations.
Keywords Financial stability, Structural equation model, Bank regulation, CAMELS
Paper type Research paper
1. Introduction
Financial stability has increasing received attention from both researchers and
policymakers particularly after the 2007–2009 global financial crisis. The crisis
demonstrated that banking stability is important for the real economy, as banks influence
economic growth, entrepreneurship and the economic opportunities (Demirguç-Kunt and
Zhu, 2010). A stable financial system plays important roles in an economy which include
availing credit to borrowers, intermediating financial activity and facilitation of payments
(Beck, 2007). An unstable banking sector increases uncertainty about future output growth
(Monnin and Jokipii, 2013). Therefore,financial stability is an important policy objective for
smooth functioningof an economy.
JEL classification –G21, G28, G24
JFRC
29,5
514
Received16 December 2020
Revised16 April 2021
Accepted23 April 2021
Journalof Financial Regulation
andCompliance
Vol.29 No. 5, 2021
pp. 514-532
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-12-2020-0114
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1358-1988.htm
Globally, both financial stability and regulations remain high on policymakers’agenda.
For instance, the G-20 has sought for global commitment towards the advancement of
financial regulations (Basel III Implementation, and other regulatory reforms) and
enhancing financial stability (the Financial Stability Board). The global financial crisis
demonstrated that microprudentialregulation is not sufficient in preventing banking crises
since it ignores systemic risks (Allen and Gu, 2018). Thus, macroprudential regulation has
become the main focus of policy design in both emerging and advanced economies (Ozge
and Olmstead-Rumsey, 2018;Butzbach, 2016). However, the appropriate regulationsremain
an open question (Carreraset al., 2018) and our understanding of the role of macroprudential
regulation on financial stability is limited (Ozge and Olmstead-Rumsey, 2018). Therefore,
the inherent limitations of both microand macroprudential regulations raise the question of
complementariness.
There can be important policy trade-offs between financial regulations and stability. To
promote financial stability, there is need for tighter financial regulations. This will enable
banks build strong buffers to meet any financialdistress (Delis, 2015;Pasiouras et al.,2009).
On the contrary, strict regulations may destabilize the financial system. The burden and
challenges of regulations may translate to higher implicit costs on the growth of financial
institutions. This may hinder the ability of banks to provide financial resources to the real
sector (Hakenes and Schnabel, 2011). The unregulated financial institutions might also
impair the stability of the regulated financial intermediaries (De la Torre et al.,2013).
Although Basel III regulatory framework brought about new measures that enhance bank
stability, it is costly to banks’business model, which in turn affects credit policies and the
real economy. In particular, Basel III does not address the growing digital finance that is
able to circumvent the new regulations(Vousinas, 2015).
Theory and existing empirical evidence on the influence of bank regulation and
supervision on financial stability remains inconclusive and with ambiguous policy
implications. This has igniteda growing body of literature that examine the effectiveness of
macroprudential regulation, on curtailing excessive credit growth and asset price booms
(Kuttner and Shim, 2016;Vandenbussche et al., 2015;Cerutti et al.,2017). There is also
evidence that emerging economies use macroprudential regulation especially targeting
foreign exchange more frequently than developed economies (Cerutti et al.,2017). Evidence
on the role of macroprudential regulation on financial stability is however scant. These
studies also ignore the importanceof microprudential regulation in ensuring stability of the
financial system. The direct and indirect effects of prudential regulation on financial
stability which are criticalin policy formulation are therefore not well understood.
This paper seeks to establish the effect of bank regulations on financial stability in
Kenya. Specifically, we seek to uncover the effect of micro and macroprudential regulation
on financial stability. We further evaluate the existing trade-offs or complementarities
between these variables. Several reasons justify the relevance of this paper on the Kenyan
financial sector. First, the country is the source of cross-border banking within East and
Central Africa which exposes the entire region to possible systemic risk/contagion effect in
the event of a bank failure (Mwega, 2014). Evidence also shows that cross-border bank
inflows are higher in borrowercountries with higher adoption of macroprudentialregulation
associated with circumvention motives (Cerutti and Zhou, 2018). Second, relative to other
countries in Africa, Kenya has made considerable strides in financial sector reforms
particularly banking regulations so as to cope with the ever changing domestic and global
financial risks. However, interlinkages between micro and macroprudential regulation in
ensuring financial system stability is still not clear. Third, Kenyan economy is bank
dominated with a thin illiquid capital market (Ochengeet al.,2020). Therefore, any shock in
Evidence from
a developing
economy
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