Dozens of small banks have found themselves in a funding squeeze amid a sharp rise in interest rates, which has impacted the cost of money in the interbank market.

This has seen tier three banks increasingly turn to the Central Bank of Kenya (CBK) for funding support via instruments including reverse repurchase agreements (reverse repos), term auction deposits and the CBK discount window.

The tools are part of CBK’s open market operations designed to either inject liquidity into the money markets or mop up.

According to data from the CBK, funding conditions in the money markets have dried up in recent weeks on rising payments to government/taxes with banks for instance failing to meet their cash reserve requirement ratio (CRR) at 4.25 percent over the past three weeks to August 3.

Commercial banks’ reserves stood at a shortfall of Sh4.7 billion in relation to the CRR requirement last week- marking a third straight week of reduced liquidity in the banking sector/money market.

Total deposits drop

At the same time, banks have been increasing lending rates among each other with the interbank lending rate which had already hit a more than eight-year high spiking again to 17.38 percent as of Thursday last week.

The drop in the sector’s total deposits held at the CBK has been deemed temporary amidst a recent spike in tax and dividend payments by the financial institutions.

The Kenya Bankers Association (KBA) says the tighter funding conditions have been more profound on small banks which mostly struggle to access funding from bigger players on perceived risks.

“Overall, liquidity in the banking sector is one of the industry’s strongest points and is one of the pillars of resilience we pride ourselves on. However, we may have some pockets of banks with some liquidity constraints which implies an issue in the distribution of liquidity rather than a question on the overall liquidity in banks,” KBA CEO Habil Olaka told the Business Daily.

With interbank lending being mostly uncollateralised, smaller banks have found themselves mostly unable to borrow funds from within the sector leading to a funding crunch.

According to the KBA, the CBK has been intervening by facilitating the horizontal trading of repurchase agreements within the industry.

Repurchase agreements usually involve banks handing over securities, mostly Treasury bills to other banks (horizontal) or the CBK (vertical) as collateral to access funds.

“The interbank lending market is usually segmented where there is an unwillingness by some banks to trade liquidity with banks in a different segment. Large banks with liquidity will for instance not trade with smaller ones. The CBK has recently facilitated horizontal repo trading which will facilitate the redistribution of liquidity across the sector,” Mr Olaka added.

Banks locked out of the interbank market have turned to the CBK, which is the lender of last resort to smoothen their funding needs.

For instance, on Thursday, the CBK disbursed Sh2 billion to an unnamed bank in an overnight facility to prop the institution’s funding at a rate of 16.5 percent.

Over the last two weeks, banks have tapped a combined Sh9.5 billion from the CBK overnight lending facility at a cost of Sh4.3 million.

Interbank lending rates have been on a tear, as have other rates on interest-bearing assets such as bank loans and government securities lift off in the backdrop of CBK’s monetary policy tightening.

Systematic liquidity squeeze

Analysts expect smaller lenders to continue navigating tighter funding conditions including access going forward in the rising interest rate environment.

“I think the current rate environment is poised to cause a systemic liquidity squeeze, especially for small-peer commercial banks with hitherto low liquidity ratios,” noted Ronny Chokaa, a research analyst at Genghis Capital.

A source close to the banking sector has, however, indicated that tighter funding conditions could be a factor in the recent migration of government securities trading into the new DhowCSD platform whose transition saw a temporary pause on securities rollover.

The pause is presumed to have temporarily stalled the repo market by limiting the use of Treasury securities as collateral in lending, forcing participants to rely on the interbank market for liquidity needs resulting in increased demand.

Broadly the banking sector is well capitalised as measured using capital and liquidity adequacy ratios.

“The banking sector remains stable and resilient, with strong liquidity and capital adequacy ratios,” the CBK stated in June.

In 2022, banking capital and reserves rose by 2.7 percent to Sh917.6 billion from Sh893.7 billion.

The improved metrics were attributable to additional capital injections by commercial banks and retained earnings from profits realised during the year.

During the year, the CBK had licensed 39 banks with nine categorised as large, eight as medium and the bulk of 22 as small or Tier III.