The role of capital requirements on bank competition and stability: The case of the Kenyan banking industry

The Central Bank of Kenya (CBK) has implemented a requirement that all banks need to build their core capital to KES 1 billion (USD 12 million) by December 2012 up from KES 250 million (USD 4 million) in 2008. The argument from the CBK's perspective is that increased capital base is important for financial sector stability and may lead to cost reduction from economies of scale which may lead to lower prices (lending rates). However, other market players with an alternative perspective argue that the banking industry is already too concentrated and increasing the capital requirement further will only create more concentration. In this regard, we investigate the role of capital requirements on bank competition and stability in Kenya for the period 2000-2011. We estimate the Lerner index and the Panzar and Rosse H-statistic as a measure of competition in Kenya's banking industry. Our estimations of both the Lerner index and the H statistic seem to suggest that competition in the Kenyan banking sector has declined over the study period. In investigating the role of capital requirements on bank competition and stability, we estimate the fixed effects panel regression model for the 36 commercial banks. The panel estimates show significant non-linear effect of core capital on competition. The log of core capital is positive and significant while squared log of core capital is negative and significant. This means that an increase in core capital reduces competition up to a point and then increases competition implying that the benefits of increasing capital requirements on competitiveness start to be realized once consolidation in the banking sector starts to take place. We use return on equity to capture bank performance and stability and the estimation result confirm a positive relationship supporting the evidence that capital regulation improves the performance of banks and financial stability.