Financial Regulations, Financial Literacy, and Financial Inclusion: Insights from Kenya

ABSTRACT

This paper examines the relationship between financial regulation and financial inclusion in Kenya. Employing Probit regression on cross-sectional household level survey data and fixed effect regression on banks panel data, we find that: (i) agency banking regulations and financial literacy could improve formal financial access, and (ii) know-your-customers rules and capital and liquidity macro-prudential regulations could harm financial inclusion. Results are robust to alternative specifications. Given our findings, Kenya should boost financial literacy efforts, relax customer identification requirements in specific instances where they may jeopardize financial inclusion efforts, and stabilize macroeconomic environment to mitigate unintended adverse effects of macro-prudential regulations.

KEY WORDS:

• financial inclusion
• financial literacy
• financial regulation
• Kenya

JEL CLASSIFICATION:

• I3
• G2
• O1
• R2

Acknowledgment

I am indebted to Prof. Paolo Coccorese for computing and providing me with the Lerner indices of Kenyan banks and to Prof. Kalu Ojah for constructive comments on an earlier draft of this paper. I would also like to thank participants of the 84th International Atlantic Economic Conference in Montreal, Canada, 5–8 October, 2017 for constructive feedback. All errors are mine.

Supplemental Data

Supplemental data for this article can be accessed on the publisher’s website.

Notes

^1. Small-scale agricultural enterprises are defined in the CBK Statistical Abstracts to include individual farmers, groups of farmers (not co-operative societies), and farming companies that own 50 hectares of land or less.

^2. The distribution of credit by sector over the period 2010–2015 is presented in Figure S1 in the Supplementary Material, available online. The figure shows that Agriculture commands a relatively small proportion of total bank lending. By implication, the banking sector tends to reduce its exposure to default by avoiding lending to riskier economic sectors, which does not help the case for greater financial inclusion. Figure S2 shows lending to various agricultural sub-sectors to total sectoral lending: in general, small-scale agricultural lending lags behind lending to large-scale agriculture.

^3. http://www.worldbank.org/en/news/press-release/2015/04/15/massive-drop-in-number-of-unbanked-says-new-report, accessed on 16 March 2016. The interplay between mobile telephone technology and banking has resulted in the adoption of the mobile banking concept (M-banking) worldwide.

^4. Another important measure taken by CBK was an amendment to both the Banking Act and Microfinance Act to provide sufficient protection to all relevant parties (e.g., credit reference bureaus) from liability arising from disclosure of information, in good faith. Stronger protection was necessary to address credit information asymmetry and build greater confidence in the information sharing framework.

^5. Agency banking refers to the provision of banking (or financial) services to customers by a third party (agent) on behalf of a licensed bank or financial institution (principal).

^6. Financial integrity is a term that has been used to refer to “measures that protect financial services against abuse for money laundering and terrorist financing purposes” (De Koker and Jentzsch 2013).

^7. http://fsdkenya.org/publication/finaccess2016/ (accessed on 12 August 2016).

^8. The age of majority in Kenya is 18 years. The survey covers individuals aged 16 years and above as explained earlier. The actual count of respondents aged 16–17 is 457, which is approximately 5% of the 8665 surveyed. Thus, about 9% of the surveyed respondents aged 18 or more have no identification documents. When I run the tests excluding those aged 16–17, the empirical results remain qualitatively similar to the ones reported here.

^9. Financial inclusion could also be measured through bank lending to individuals and to micro- and small-scale enterprises in general. However, data on lending are only available for the variable that we have used.

^10. Net interest margin is an indicator of profitability. In the current context, we perceive a change in net interest margin as the minimum change in profitability that the bank will be comfortable to earn on its stock of liquid assets without eroding value of its shareholders’ position.

^11. One might also use the change in money supply for this purpose. In Kenya, because the cash reserve ratio constitutes an important policy tool that is commonly used to manage commercial banks’ flexibility to lend from their deposits, it is interesting to investigate financial inclusion using it rather than money supply.

^12. Z-score, a measure of the bank exposure to bankruptcy, is computed as$Z=\left[RoA+\left(Equity/Assets\right)\right]/SD\left(RoA\right)$.

^13. I express our sincere gratitude to Prof. Paolo Coccorese for providing me with the Lerner indices of Kenyan banks.

^14. If one defines the net interest margin as bank profitability rather than bank’s required rate of return, this result would simply imply that more profitable banks are more likely to extend credit to more borrowers, including risky ones.

Additional information

Funding

Funding from the African Economic Research Consortium (AERC) (Grant No. RC15502) is gratefully appreciated.