Kenya Financial Inclusion Paper

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Kenya: Meeting the Challenge of Creating an Inclusive Financial Sector 1. Summary:

When Kenyas new government came to power in 2002, it inherited a poorly performing economy and a weak financial system. Its programme of economic reform set out a clear commitment to a market economy and private sector led growth. Policy for financial sector development sought to improve stability, increase efficiency and expand access. Following a long period of poor economic performance through the 1980s and 1990s, Kenyas economy has started to show signs of a sustained recovery. Growth has exceeded 5% per annum for the last three years. Emboldened by this performance, the Government is developing a long term national vision for transforming Kenya into a middle income country by 2030. Sustained economic growth of 10% annually is required to achieve the goals of Vision 2030. An inclusive financial sector can enable all Kenyans to participate in, contribute to and benefit from this significantly rising growth rate and mobilize the necessary savings and investments needed to realize the national vision. A recent study on access to financial services in Kenya, FinAccess, reveals that fewer than one in five of the Kenyan adult population is currently formally banked. Alternative financial institutions such as SACCOs (credit unions) and micro-finance institutions (MFIs) reach one in seven. Collectively these institutions provide services to only just over a quarter of the population the formally financial included. Half the population uses informal financial services. Together Formal and informal financial institutions serve just over three fifths of the population, but this leaves nearly two Kenyans in five financially excluded. While these figures compare favourably with Kenyas regional neighbours on overall financial inclusion, the new economic vision calls for greater ambition. Better macro economic management and improved regulatory capacity have been critical in stimulating a private sector driven expansion in financial access. This is reflected in increasing number of accounts, and growing bank branch and ATM networks. Innovating financial institutions such as Equity Bank have rapidly expanded outreach and demonstrated the ability to meet a significant unmet demand. Kenyas recent performance is strongly consistent with the argument that a market based approach can deliver on financial inclusion. Government and its donor partners need to respond to the challenges of poverty, isolation and weak infrastructure which drive financial exclusion. While doing so, they need to adopt approaches which further encourage market based solutions.This paper was prepared by Sukhwinder Arora and David Ferrand based on extensive analysis undertaken by Financial Sector Deepening Kenya and other sources listed at the end of the paper. David Cracknell has provided valuable support. This paper was commissioned by Financial Sector Team, DFID as background material for the DFID and HM Treasury Financial Inclusion Conference, London (19 June 2007) and does not constitute official DFID views or policy.

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Table 1: Key Country Data Population 34 million GDP $ 19 Billion

Land Area 0.58 million km2 GDP (average annual 2.1% 1995-2000 growth) 3.4% 2000-05 Population below the 23% population below $1/day poverty line (1997 data) 58% population below $2/day Domestic Credit to the 26% of GDP in 2005 private sector 33% of GDP in 1990 Bank Branches 1.4 per 100,000 Phones 14300 Per 100,000 people people (2005) Formally Included 27% adult population has access to financial products supplied by legally governed institutions (19% formal banks and 8% others) Informally served 35% adult population is only served by informal arrangements such as Rotating Savings and Credit Associations (ROSCAs) Financially Excluded 38% Source: World Development Indicators 2006, online; FinAccess Data 2007

2.

Background

Following a long period of poor economic performance through the 1980s and 1990s, Kenyas economy has started to show signs of a sustained recovery. Growth has exceeded 5% per annum for the last three years. In 2006 the growth rate reached 6.1%. While Kenya remains strongly dependent on agriculture, these growth rates have been achieved despite adverse weather over this period. The level of poverty is starting to reduce with 45.9% of the population below the national poverty line (2005/06), down from a peak of 52.3% (1997). From independence to the late 1980s, the Government intervened significantly in the financial sector, through both regulation and direct participation in markets. Commercial banks, constituting the largest part of the financial sector, were subject to interest rate controls, required to lend minimum proportions of their portfolio to the agricultural sector as well as open rural branches in strict proportion to those opened in urban areas. Policy directed lending to priority sectors including agriculture, tourism, industry and small enterprise, was routed through state owned commercial banks and development finance institutions. During this period, the overall policy thrust was strongly oriented towards increasing access to finance by emergent Kenyan business, which a foreign bank dominated system was felt to serve poorly. Reflecting economic development thinking at the time, this policy emphasised access by the formal economy. By contrast the livelihoods of most Kenyans were dependent and continue to depend on the informal economy. Policy therefore effectively gave rather less attention to the broader issue of financial inclusion. Echoing experience across the world, after some early gains, this interventionist approach proved counterproductive. Kenya embarked on a general programme of economic liberalisation from the late 1980s. Weak regulation during the 1980s combined with poor growth performance, resulted in a succession of banking crises with the collapse of many small locally owned institutions. With the large banks well entrenched in mainstream

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markets, these institutions had a greater incentive to innovate and unlock new markets. The loss of these institutions is therefore believed to have resulted in a set-back for developing a more inclusive financial system. Better regulation might have prevented this loss. As a part of financial sector liberalisation, interest rates and exchange controls were removed in the early 1990s. However in the context of an already poorly performing economy, lack of discipline in macro-economic management and a weak banking system, the move to liberalise financial markets produced disappointing results. The macro-economic crisis of the mid-nineties produced a spike in interest rates which pushed many businesses into difficulties and generated a large non-performing portfolio which persisted into the following decade. Subjected to political direction, the state owned and influenced financial institutions performed especially badly. A lack of real commitment to the liberalisation programme resulted in only partial privatisation of the state-owned banks and reform of the development finance institutions was deferred. Reflecting a growing emphasis in the banking industry on improving cost structures, there was a contraction in branch networks in the less profitable rural areas and the minimum account operating requirements were raised. While accurate data is unavailable for this period, there was thought to be a significant contraction in access as a consequence. During 1990-2003, the credit to private sector as a proportion of GDP actually fell from 33% to 24%. Closely linked to the perceived abandonment of lower income markets by commercial banks, this period saw the emergence of Savings and Credit Co-operatives (SACCOs - Kenyas credit union movement) and microfinance institutions, seeking to fill the gap. A new government inherited a weak financial system and a weak economy in December 2002. The Economic Recovery Strategy for Wealth and Employment Creation for 2003-07 (ERS) sets out a clear commitment to a market economy and private sector led growth. The ERS emphasised the importance of the financial system and improving access across the economy especially in the agriculture sector and among micro and small enterprises. Policy with respect to financial sector development was developed around three inter-dependent objectives: improving stability, increasing efficiency and expanding access. The immediate focus was on getting the fundamentals right. Early policy actions included reduced government borrowing, a reduction in the central bank cash ratio and strengthening financial sector regulation. The Government has also resisted calls for the re-introduction of interest rate controls, despite strong political pressure. A new economic strategy the Vision 2030 has been developed to follow on from the ERS. Ambitious goals have been set to achieve middle income country status by 2030. Sustained economic growth of 10% annually is required to achieve this vision. In order to generate this level of growth, the World Bank notes that unprecedented increases in investment and productivity growth are required that require major changes in policies and institutions that mobilize producers, investors, savers, donors, and the government to make this possible (World Bank 2007). As part of the planning process, a comprehensive financial sector reform and development

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strategy is to be adopted. An inclusive financial sector can enable all Kenyans to participate in, contribute to and benefit from this significantly rising growth rate and mobilize the necessary savings and investments needed to realize the national vision. 3. Access to financial services in Kenya 3.1 Defining the access baseline: In developing a bold strategy for financial sector development, which will for the first time explicitly address financial inclusion, it is vital to clearly understand the extent and nature of the challenge faced and to provide a credible means of measuring progress. A Financial Access Partnership was formed in 2005 to tackle an information gap. Composed of key stakeholders in the financial sector from Government, Central Bank of Kenya, banks, micro-finance institutions, SACCOs, development partners and research institutions, the partnership has guided the creation of a national survey on access to financial services - FinAccess. The first FinAccess study, carried out in August 2006 and financed by the multi-donor funded Financial Sector Deepening Kenya (FSD Kenya) programme, provides nationally representative data on financial service usage and financial exclusion. 3.2 Headline findings on Access: The FinAccess study reveals that just over a quarter of Kenyans can be regarded as formally financially included. Less than one in five (18.5%) of the Kenyan adult population are banked, that is using a regulated commercial bank, building society or the Post Bank. Only a small number of institutions were responsible for a significant proportion of this outreach. The Post Bank alone accounted for 5.6% of the usage. The Savings and Credit Co-operatives (SACCOs) provide services to 13.1%, while the currently unregulated micro-finance institutionsi (MFIs) reach 1.7%. Based on either large scale formal employment or smallholder commercial agricultural commodity production, the SACCOs are able to offer both basic credit and savings services to their members. The MFIs, strongly oriented towards informal business or micro-enterprise, have been limited until very recently to offering credit services primarily through group-based non-collateralised lending. A large number (42.9%) of those using SACCOs also maintained accounts with a bank. Many people borrow from SACCOs perceiving them as offering a cheaper or more accessible source of credit. Collectively the formal institutions, banks, SACCOs and MFIs, provide services to just over a quarter (26.6%) of the population.

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Figure 1: Financial access strata

Formal others, 8.1% Formal, 18.5% Informal, 35.0% Excluded, 38.3%

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

Source: FinAccess 2007

Half the population (50.6%) make use of various forms of informal financial service. The most common of these are rotating savings and credit associations (ROSCAs), often referred to as merry-go-rounds or tontines in Africa. These provide a simple means through which to save and accumulate a lump sum through the regular pooling of usually small contributions in a group which is taken by each group member in turn. More sophisticated arrangements allow for a less regimented approach with members contributing and borrowing from a group more according to their needs rather than the dictates of their turn. Interestingly a significant proportion of those with access to the formal providers also use informal mechanisms. Over a third of those with a bank account also use an informal service. The use of informal systems increases the level of total financial inclusion in Kenya by 35.0% to reach 61.7%. This however leaves over a third of the population (38.3%) financially excluded. 3.3 Patterns of inclusion and exclusion: The aggregate figures conceal considerable variations in access according to gender, age and geographical location. Only 14.0% of adult women in Kenya are banked and 20.6% are formally financially included. Banks and SACCOs have notable gender imbalances in usage and equal usage is only seen among micro-finance institutions which have tended to explicitly target women to address concerns over exclusion. Overall levels of financial exclusion are however reduced as a result of the strong usage of informal mechanisms by women. Patterns of usage vary significantly between rural and urban areas. As would be expected, the banks concentrate activities in the urban centres. Nearly a third (31.0%) of Kenyas urban population is banked while the level of penetration drops by half to 14.4% usage in the rural. However SACCOs, largely driven by the agriculturally based societies, help to partly redress the balance. 14% of the rural population makes use of a SACCO (compared with 10% in the urban areas). Informal group usage is only slightly lower in the rural as compared with urban population.

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Disaggregated regional data reveal significant gaps in formal sector outreach across regions. Population density, remoteness and wealth levels have a strong influence. The arid, sparsely populated areas of the country in the north have especially low levels of formal access. North Eastern province which is entirel...