2. The rationale for regulation

Financial systems are prone to periods of instability. In recent years, a number of financial crises around the world (South-east Asia, Latin America and Russia, Global financial crisis) have brought about a large number of bank failures. Some argue that this suggests a case for more effective regulation and supervision. Others attribute many of these crises to the failure of regulation.

Advocates of the so-called ‘free banking’ argue that the financial sector would work better without regulation, supervision and central banking. In the absence of government regulation, they argue, banks would have greater incentives to prevent failures.

However, the financial services industry is a politically sensitive one and largely relies on public confidence. Because of the nature of their activities (illiquid assets and short term liabilities), banks are more prone to troubles than other firms. Further, because of the interconnectedness of banks, the failure of one institution can immediately affect others. This is known as bank contagion and may lead to bank runs. Banking systems are vulnerable to systemic risk, which is the risk that problems in one bank will spread through the whole sector. Bank runs occur when a large number of depositors, fearing that their bank is unsound and about to fail, try to withdraw their savings within a short period of time. A bank run starts when the public begins to suspect that a bank may become insolvent.

This creates a problem because banks want to keep only a small fraction of deposits in cash; they lend out the majority of deposits to borrowers or use the funds to purchase other interest-bearing assets. When a bank is faced with a sudden increase in withdrawals, it needs to increase its liquidity to meet depositors’ demands. Bank reserves may not be sufficient to cover the withdrawals and banks may be forced to sell their assets. Banks assets (loans) are highly illiquid in the absence of a secondary market and if banks have financial difficulties they may be forced to sell loans at a loss (known as ‘fire-sale’ prices in the United States) in order to obtain liquidity. However, excessive losses made on such loan sales can make the bank insolvent and bring about bank failure.

Bank loans are highly illiquid because of information asymmetries: it is very difficult for a potential buyer to evaluate customer-specific information on the basis of which the loan was agreed. The very nature of banks’ contracts can turn an illiquidity problem (lack of short-term cash) into insolvency (where a bank is unable to meet its obligations or to put this differently when the value
of its assets is less than its liabilities).

Regulation is needed to ensure consumers’ confidence in the financial sector. According to Llewellyn (1999) the main reasons for financial sector regulation are:
1. To ensure systemic stability;
2. To provide smaller, retail clients with protection; and
3. To protect consumers against monopolistic exploitation.

Systemic stability is one of the main reasons for regulation, as the social costs of bank failure are greater than the private costs. The second concern is with consumer protection. In financial markets ‘caveat emptor’ (‘Let the buyer beware’) is not considered adequate, as financial contracts are often complex and opaque. The costs of acquiring information are high, particularly for small, retail customers. Consumer protection is a particularly sensitive issue if customers face the loss of their lifetime savings. Finally, regulation
serves the purpose of protecting consumers against the abuse of monopoly power in product pricing.

The most common objectives of financial sector regulation are:
1. Prudential: To reduce the level of risk bank creditors are exposed to (i.e. to protect depositors)
2. Systemic risk reduction: to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures
3. Avoid misuse of banks: to reduce the risk of banks being used for criminal purposes, e.g. laundering the proceeds of crime
4. To protect banking confidentiality
5. Credit allocation: to direct credit to favoured sectors

2.1 Existing financial sector regulatory framework in Kenya

The existing regulatory framework for the financial sector in Kenya consists of a number of independent regulators each charged with the supervision of their particular sub sectors. The creation of the Insurance Regulatory Authority completed the shift from having departments under the Ministry of Finance to having independent regulators for each sub-sector.

The current regulatory structure is characterized by regulatory gaps, regulatory overlaps, multiplicity of regulators, inconsistency of regulations and differences in operational standards. For example, some of the regulators have at least partial exemption from the State Corporations Act while others do not, some have tax exemption, and others do not. Some regulators have powers to issue regulations while in other cases the power is retained by the Minister for Finance.

2.2 Regulatory gaps

Some of the existing cases of regulation gaps are:

2.2.1 The Kenya Post Office Savings Bank (KPOSB)

The Kenya Post Office Savings Bank (KPOSB) was incorporated in 1978 under the KPOSB Act(Cap 493B). The mission of the bank is to sustainably provide savings and other financial services to customers, through a countrywide branch network, by use of modern technology in delivery of efficient and effective customer service, and to the satisfaction of all stakeholders. Section 8(1) KPOSB Act that provided for the Government guarantee over the deposits placed with the savings bank was repealed via the Finance Bill 2001. The repeal of the section implies that new avenues should be found for deposit companies_ protection. It also implies that the bank should be adequately capitalized as a first step to protect deposits against possible losses.

2.2.2 Companies Act (CAP 486)

The Companies Act, which is a holdover of pre-colonial British Law, is creating problems for private sector activities in Kenya and indeed the financial services sector. This law currently in use, is complicated, cumbersome, inconsistent and at odd with modern enabling regulation of corporations. Another layer of complexity and compliance is added to an already burdensome structure, leading to multiple disclosures requirements, overlap and expensive duplication. The regulation of companies is currently under the Registrar of Companies in the Office of the Attorney General but could be brought under the financial sector regulatory framework for more responsiveness to market dynamism.

2.2.3 Development Finance Institutions (DFIs)

DFIs have always provided the impetus for economic development be it in the developed or developing countries. In Kenya, DFIs were specifically established to spearhead the development process by:

  • Availing credit funds to those venturing into commerce, tourism and industry.
  • Assisting those wishing to venture into small-scale manufacturing enterprises.
  • Assisting in the initiation and expansion of small, medium and largescale industrial and tourist undertakings.
  • Provide long-term lending (Project financing) to sustain economic development Provide Technical Assistance/Co-operation extension services
  • Provision of special Financing and Support services to stimulate Private
  • Sector to live up to its potential and create jobs and wealth, develop and expand indigenous skills

The existing framework has potential for disharmony as they fall under different regulators. For example ICDC/KIE are under the Ministry of Trade and Industry, IDB is under the Central Bank of Kenya and AFC the Ministry of Agriculture.

2.2.4 Premium and Other Financing

A number of premium finance companies have evolved in the Kenyan market. These Companies offer financing to companies and individuals to meet insurance premium payments. This is clearly a financial service but is currently not regulated by any of the existing regulatory institutions. Similarly, there are other money lenders and financers who are totally unregulated. There is also need for regulation of leasing which is a developing financial service

The solution to financial regulation gaps and overlaps can be resolved through consolidated regulation approach. However, this approach has both advantages and disadvantages.

2.3 Advantages of consolidated financial sector regulation

2.3.1 Market developments

The need for the structure of regulation to mirror the structure of the industry is one of the most compelling arguments for consolidation. If the regulators entities are conglomerates covering banking, insurance, securities and pension then it is difficult for a regulator for a particular sub-sector to draw a view of the overall risks facing the entity. A consolidated regulator on the other hand would be able to understand and monitor risks across the subsectors and develop policies to address the risks facing the entire conglomerate. Even if the institutions are not in themselves conglomerates, the products they are offering may defy conventional categorization.

For example, In Kenya many insurance products carry investment components which are larger than the risk components. It can be argued that these products are closer to deposit taking or collective investment schemes than they are to insurance. In the developed world many traditional debt products such as mortgages, credit cards and loans have been securitized and are traded in the capital market. Indeed, the global financial crisis in 2007 and 2008 arose from securitized mortgages known as Collateralized Debt
Obligations (CDOs). Even though the underlying instrument is a mortgage issued by a mortgage lender, the resulting CDO that bundles mortgages, often with different risks, is a security primarily held by players in the capital markets. As a result when the housing bubble in the United States burst, it did not only affect the mortgage issuers but also investment banks, fund managers, pensions schemes and other financial players that were holding CDOs. In such cases a consolidated financial sector regulation would be in a better position to supervise such non-categorized products.

2.3.2 Economies of scale and cost reduction

Another popular argument for consolidation arises from the cost efficiency gains that can be obtained by consolidating multiple regulators into a single body. Clearly a consolidated regulator will only have one set of service departments such as administration, finance and human resources hence reducing on staff and other overhead costs. Indeed, even core departments like legal, research, and public awareness can be unified into a single department in the new consolidated regulator leading to significant cost savings.

Where there are overlaps in registration and licensing then consolidation will also bring cost reductions and efficiency gains by allowing regulated entities to have a one-stop licensing procedure as opposed to multiple registrations. These gains are maximized where regulation is consolidated by function as in the case of Australia as opposed to consolidation by institutions as in South Africa.

The cost reduction gains to the industry may be minimal if the direct compliance costs are much less then the indirect compliance costs. Indirect compliance costs are unlikely to change much in the face of consolidation unless such consolidation is also
accompanied by changes in compliance requirements.

2.3.3 Reduce regulatory arbitrage

Where there are regulatory overlaps, as is the case in Kenya, then having multiple regulators can allow regulated entities to engage in regulatory arbitrage. This is where entities opt to register products in those sub-sectors where regulations are weakest or most cost efficient. Again this is more feasible where products are not be easily categorized into conventional sub- sectors. With a consolidated regulator, uniform standards can be applied to all sub-sectors hence eliminating the motivation for arbitrage. Even where the
consolidated regulator has different departments regulating different subsectors, the scope for information flow between the departments is much higher in terms of both quality and quantity. In addition, a large consolidated regulator is less likely to suffer from regulatory capture by the industry.

This can happen when industry groups and regulated entities are so large they are able to dominate a small regulator especially, one with limited internal capacity and resources.

2.3.4 Strengthen accountability

Regulatory gaps often lead to regulators washing their hands of certain subsectors especially when things go wrong. Blame may be passed from one regulator to another when supervisory failure occurs. In Kenya, we have seen different regulators disavowing blame for an instrument that never came to market with no one ready to accept that they were the ones who had refused to approve the instrument. A consolidated financial regulator would be responsible for supervising all entities and products in the financial sector and would be duly held accountable. It is, in this regard, argued that CDOs in the United States would not have been unregulated if there was a single consolidated regulator in that country. A problem, however, still arises where products are encompassing more than just the financial sector. For example, is money transfer through mobile phones a financial sector product or a communications sector product?

2.4 Disadvantages of consolidated regulation approach

2.4.1 Reduced effectiveness
Large consolidated regulators are often criticized for becoming Bureaucratic Leviathans. That is, the regulator becomes so big and powerful that it is divorced from the industry it is supposed to be regulating. A consolidated regulator is likely to have a diversity of objectives and striking the appropriate balance between these may be difficult. Indeed, the different objectives may clash forcing the regulator to have to choose between policies many of which may favour one sub-sector over the others.

2.4.2 Loss of focus
Consolidation may undermine overall effectiveness of supervision if the unique characteristics of the sub sectors are not recognized. Operations may become so broad based that they deny managers a chance to understand specific sub-sectors. In developing countries where some sub-sectors are less developed than others then there is a danger of regulation of the dominant sector – usually banking – overriding the others resulting in the smaller subsectors, which may require more flexibility, not getting the attention they require to develop. Indeed where multiple regulators are merged but one premerger regulator dominates in terms of size and staffing it may subsume the other regulators at the expense of focus paid to those sub-sectors.

2.4.3 Diseconomies of scale
A consolidated regulator is effectively a regulatory monopoly which may give rise to inefficiencies and sub-optimal resource allocation associated with monopolies. There may be merit in having a degree of competition between regulators as this enable learning from each other and striving to out-perform the others.

2.4.4 Moral hazard
There is a compelling argument that a consolidated regulated framework gives consumers a false impression that all financial instruments have similar risks. When banks and securities are regulated by the same regulator consumers may fail to differentiate the very different risks in these two markets.

Similarly, all institutions licensed by the regulator may be assumed by the public to be receiving equal protection. Yet, whereas bank depositors may be protected by the Deposit Protection Fund, this is not the case for the other sub-sectors.

2.4.5 Complexity of integration
Where multiple financial sector regulators are in existence, consolidation into a single regulator may not be as straightforward as commonly believed. Some of the challenges of integrating the bodies include:

Legal Issues
Consolidation requires reviewing all the existing statutes pertaining to each sub-sector to provide for the new consolidated framework or replacing all the sub-sector legislations with a new comprehensive framework. Legal difficulties encountered in those countries that have consolidated financial regulation in the past include sources of funding, ownership of assets, powers to sign foreign treaties, powers to enforce sanctions and powers to issue and amend prudential legislation. Further, opening up legislation to changes or
replacement opens an opportunity for vested interests to reopen issues that may already have been settled within the sub sector. These could be issues pertaining, for example, to exemptions from regulation. Whichever route to consolidation is adopted, the required legal changes are likely to prove very involving, cumbersome and expensive.

Staffing Issues
The uncertainty of the merger process inevitably results in the departure of key personnel from the regulatory agencies. Once information is made available that the existing regulators will be merged, talented staff may opt to move to the private sector or retire to avoid the uncertainty and difficulty of the change. Often, it is the best staff, critical to the success of the consolidated regulator, who leave for more secure pastures. Where, for example, bank supervision is being removed from the Central Bank to a new financial sector regulator, bank supervisors may opt to remain in the Central Bank which they may consider to be more prestigious. After the merger, even those who opt to stay may be demoralized especially if there difficulties implementing a new unified organization structure.

Culture Issues
Each independent regulator will have its own culture and means of doing business. Regulators will have differing procedures and tools. Some may have international standards accreditation while others may not. Bringing these divergent cultures under a unified structure is a major challenge which requires a well conceived and effectively monitored change management program.

Systems Issues
Each regulator will have its own Information Technology and other infrastructure for doing its core business. Regulated entities may have invested heavily in having systems that can provide data in the format required by the regulator’s system. Bringing the different platforms into a unified one may not be possible without major upheavals within and without the regulators.

Contagion effects
In the event of a problem in one of the sub-sectors, the consolidated regulator stands accused of poor supervision, This is likely to damage confidence in the whole financial system whereas such effects would have been limited to one sub sector and one regulator if the regulatory regime had remained diversified.

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