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COVID-19, policy interventions, credit vulnerabilities and financial (in)stability

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  • Kimundi, Gillian

Abstract

At the 2014 Michel Camdessus Inaugural Central Banking Lecture (IMF), Janet Yellen posed the following question, "...How should monetary and other policymakers balance macroprudential approaches ... in the pursuit of financial stability?" This conversation has become more critical following the effects of COVID-19 on economic and financial indicators globally. Using sector-level measures of financial stability, this study seeks to investigate the effect of monetary and fiscal policy interventions on the stability of the banking sector and determine the role (if any) played by the credit environment on financial stability's response to policy interventions. A Bayesian Threshold VAR model is estimated using quarterly data from (Q1) 2005 to June (Q2) 2021, where the Threshold variable is the Credit to GDP Gap, used to define high vs low credit environments. Facilitating the analysis and discussion using expansionary policy interventions implemented during the COVID-19 period (CBR reduction, lower reserves, higher fiscal spending and tax reliefs), the results indicate that the expansionary policy stances have clear implications on financial stability aggregates capturing credit risk (NPL Ratios) and liquidity risk (depository moments). Secondly, policy effects on financial stability indicators vary depending on the credit environment they are implemented in. More of the indicators respond poorly to expansionary fiscal and monetary policy action in a high credit environment. Based on this response, it is arguable that this credit cycle presents a vulnerability to the sector, rather than evidence of financial deepening. The results also point out a critical aspect relating to the choice of monetary policy action. Lower reserves are followed by more negative responses in financial stability aggregates in both credit environments, especially those related to credit risk. Policy recommendations following these results are also discussed.

Suggested Citation

  • Kimundi, Gillian, 2022. "COVID-19, policy interventions, credit vulnerabilities and financial (in)stability," KBA Centre for Research on Financial Markets and Policy Working Paper Series 62, Kenya Bankers Association (KBA).
    • Handle: RePEc:zbw:kbawps:62
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