Effect of Financial Market Frictions and Flight to Quality on Credit Supply in Kenya

Abstract

Adverse shocks to the economy may be amplified by financial market conditions. Before implementation of financial market frictions in Kenya, the Banking sector was highly profitable, with industry return on equity's average of 20%. The ratio of credit supply to gross domestic product was 35%. However, after its adoption, Sector loan book decelerated from a growth rate of 16.8% to 4.3%. Studies relating to financial market frictions and credit supply have produced mixed results. It was on this basis that the study sought to establish the effect of financial market frictions and flight to quality on credit supply in Kenya. Correlational research design was adopted. Secondary data from the Kenyan Market for the period January 2009 to December 2019 was analyzed. ADF and Philips-perron unit-root test was used to test the stationarity of the data. VECM was estimated to establish the long run relationships amongst the variables; Wald statistics was also estimated to establish short run causalities amongst the variables. The error correction term indicated a negative sign and was significant at 5% level (C (1) = -0.015897, .0218 < P= 0.05), an indication that there is a long run causality running from the explanatory variables to credit supply. Wald statistics also revealed that the estimated coefficients in the VECM were insignificantly different from zero (.5823; .0539; .5498; .4150> p= 0.05), an indication that there is no short run causality running from the explanatory variables to credit supply. The study therefore recommends that for Micro finance institutions to maximize their profits they should adopt new technologies like Mobile Banking for credit facilities which does not require administrative and operation costs, to cope with the market shocks and frictions.