The Sensitivity of Central Bank Interest Rate on Commercial Banks’ Stock Market Returns in Kenya

Commercial banks occupy a significant position in the transmission of monetary policy through the financial market. Furthermore, commercial banks have assets and liabilities which are interest rate sensitive, and their stock returns are believed to be particularly responsive to changes in the central bank base lending rates. Therefore, this study investigated the sensitivity of central bank interest rate changes on stock returns of listed commercial banks in Kenya for nine year period, from 2006 to 2014. The study used a hybrid of cross sectional and longitudinal quantitative surveys method, applying GMM panel data regression model on the secondary data from the 11 listed commercial banks in Kenya. The study found out that there is a significant strong positive sensitivity of average annual changes in central bank interest rates (CBR) on the stock returns of the listed commercial banks in Kenya, from 2006 to 2014, measured using CAPM. Hence, listed commercial banks’ managers in Kenya should monitor, keenly, the changes in the central bank interest rates and make investor related decisions accordingly.

fluctuations in interest rates (Kasman, Vardar, & Tunç , 2011). Korkeamä ki (2011) found out that most commercial bank managers view interest rate sensitivity as the second most significant risk factor, after credit risk. In addition, determination of the relationship between commercial banks' stock market returns and their financial risk parameters, such as central bank interest rate changes, can provide financial managers and commercial banks' regulators with additional information, including information on how to improve commercial banks' stock market returns through better management of interest rates sensitivity.
Traditional asset pricing theories assert that the value of an asset equals the present value of the future cash flows derived from the asset (Lumby & Jones, 2015). Changes in the central bank interest rate can affect individual bank's stocks by changing the expectation of future cash flows and the required rate of return (Yin & Yang, 2013). Yin and Yang (2013) argued that an increase in the central bank interest rate signals a contractionary monetary policy to the market and leads to an expectation of less cash inflow in the future. At the same time, the shareholders' required rate of return increases, as the increase in the central bank interest rate increases market interest rates and returns in bond. It is also expected that a decrease in the central bank interest rate should have the opposite effect.
The popular post Keynesian's theories, including Keynes liquidity preference, neoclassical synthesis ISLM and Basil Moore's Horizontalist or endogenous money are the major theories of interest rate (De-Juan, 2007;Wray, 1992). However, for post-Keynesian moneytary theory to be truly distinct from various neoclassical versions of money theory, both the loanable funds approach and the natural rate of interest concept incorporated in the neoclassical synthesis ISLM theory had to be discarded (Lavoie, continued to persist and attracted a lot of debate in both public and policy forums". In addition, Tarus, Chekol, and Mutwol (2012) argued that interest rates were liberalized in Kenya with the main objective of improving efficiency in the intermediation process by reducing the interest risks, which in turn was to improve the listed commercial banks' stock returns. According to the authors, this still seems to be a major challenge within the Kenyan banking sector. Therefore, this study attempted to investigate the sensitivity of central bank interest rates on stock returns of listed commercial banks in Kenya.
The banking system through its ability to give credit and offer savings services can be influenced, and to some extent their stock market returns are affected, by the interest rate levels. Therefore, changes in interest rates are watched closely by bond and fixed income traders, as the resulting price fluctuations will affect the overall market returns of the securities (Gitman, Joehnk, & Hubbard, 1999). Korkeamä ki (2011) argued that corporate managers, including those of commercial banks, view changes in interest rate as the second most significant risk factor, after credit risk.
Given the importance of banking institutions in facilitating financial intermediation, several studies have been conducted in Kenya on the changes of interest rates, mostly to identify the determinants of interest rate spread (Tarus et al., 2012;Were & Wambua, 2014). Others such as Irungu (2013) Section 36 (4) of the Central Bank of Kenya Act specifies that the Central Bank shall publish the lowest rate of interest it charges on loans to banks and that rate shall be known as the Central Bank policy factors, such as interest rate sensitivity still remains unresolved.
The level of prevailing market interest rates may provide a single instrumental variable representing the changes in the investment opportunity within an economy (Tai, 2000). According to Tai (2000), this implies that studies might want to include the interest rate sensitivity as one possible extra-market factor which affects the stock returns of firms, using the capital asset pricing model (CAPM). Therefore, many studies have suggested that changes in interest rate is one of the major factors in most of the stock markets which influence stock returns of firms such as commercial banks (Fernandez-Perez, Ferná ndez-Rodrí guez, & Sosvilla-Rivero, 2014;Frijns et al., 2015).
In other words, monetary policy decisions, such as central bank interest rates, influence various short-term interest rates which in turn, affect the discounted present value of expected future cash flows and may thus increase or decrease stock returns of firms (Zare, Azali, & Habibullah, 2013). The authors noted that most studies have come to a general consensus that stock returns are inclined to monetary policy decisions of the central bank, such as interest rates. Furthermore, according to Yin, Yang, and Handorf (2010), how bank stock returns react to monetary policy changes, such as central bank interest rates, not only reveals their effect on bank performance but also barometrically determines the efficacy of monetary policy in regulating the economy.
In addition, during the financial crisis period, banks have become the main subject of many monetary policy interventions, especially through the central bank interest rates (Fiordelisi, Galloppo, & Ricci, 2014).In line with the above argument, it is particularly important to understand what the main determinants of bank stock returns and their response to monetary policy changes are (Ricci, 2015).
According to Fiordelisi and Molyneux (2010) bank common stock prices and bank stock returns, depend on both macroeconomic and bank-specific factors. Among these factors, a crucial role is played by changes in monetary policy, such as central bank interest rate changes, because of the interest rate sensitivity of both bank assets and liabilities (Yin & Yang, 2013). Yin et al. (2010) present a detailed discussion of how interest rate changes may affect bank stock returns.
However, most of these studies have found that interest rate sensitivity is a major factor for the overall stock market returns, amongst other factors such as bank size, funding sources and soundness of the bank (Yin & Yang, 2013) . Few studies, such as Yin and Yang (2013) Commercial banks play an essential role in the economy of a nation, such as Kenya, by undertaking receiving funds from the public by accepting demand, time and saving deposits or borrowing from the public or other banks, and using such funds as whole or in part for granting loans, advances and credit facilities and for investing funds by other means (Tarus et al., 2012). According to Tarus et al. (2012) there are 44 commercial banks operating in Kenya and the sector has experienced higher interest rate sensitivity over the nine year period, from 2006 to 2014. According to the Central Bank of Kenya (2014a) report, 11 of the 44 commercial banks have been listed on the Nairobi Securities Exchange.
The financial services within the commercial banks in Kenya have remained expensive, as evidenced by high interest rate sensitivity and account fees (Beck et al., 2010). Furthermore, Barako and Gatere (2008) also argued that in a survey conducted by the Central Bank of Kenya, a number of financial institutions in Kenya, including commercial banks have no risk management frameworks, which always help organisations to manage risks such as interest rates sensitivity. In the recent economic recovery strategy, the government of Kenya acknowledged that the commercial banks in Kenya, including the listed banks were experiencing difficulties that would undermine the achievement of the objectives set out in the strategy, including inadequate returns from the banking sector and persistence of wide interest rate sensitivity leading to a high cost of credit (Beck et al., 2010). Therefore, this study endeavoured to contribute towards the economic recovery strategy by identifying the trend of the sensitivity of interest Several alternative theories of interest rate have been developed (Brillant, 2014). According to De-Juan (2007) the theories can be classified into classical and post Keynesian. The classical theory, also referred to as loanable funds approach, was proposed by classical economist, Keyne who held the view that economic activities were guided by some kind of invisible hand i.e. through the self interest motive and price mechanism, and that government interference was unnecessary (Keynes, 1937;Ohlin, Robertson, & Hawtrey, 1937;Wray, 1992). According to loanable funds theory, the interest rate is simply the price of loan, and is therefore governed by the supply of and demand for loan, with no influence from the government economic policies, such as the banking system (Brillant, 2014). Although the theory has a certain amount of validity, it has been criticized by many economist, such as Keynes (1937) and Ohlin et al. (1937). The critics argued that the theory assumes money is borrowed entirely for the purchase of capital assets which is not true, since money can also be borrowed for purchase of consumer goods.
The main proponents here are Keyne, John Hicks and Basil Moore. The post Keynesian's theories, also referred as monetary theories, include Keynes liquidity preference, neoclassical synthesis ISLM and Basil Moore's Horizontalist or endogenous money (De-Juan, 2007;Wray, 1992). Keynesian liquidity preference theory, which is also called the monetary theory of interest rate, was put forward by Keynes in 1936 (Brillant, 2014). In other words, Keynes rejected the classical loanable funds theory when he defined the interest rate as a reward for not hoarding money (Wray, 1992). Unlike the Keynesian liquidity preference theory where interest rate is determined by the stock equilibrium, in the ISLM www.scholink.org/ojs/index.php/jepf Journal of Economics and Public Finance Vol. 7, No. 5, 2021 Published by SCHOLINK INC.
model, however, the interest rate is determined at the point where the goods, bonds and monetary markets are in equilibrium. In other words, interest is determined as a result of both stocks equilibrium and the flows equilibrium (Gerrard, 1995).
The Horizontalist theory claims that the central bank of a country is in a position to set nominal rates and even real rates of interest by adjusting the nominal rates to the actual or expected inflation rate (Lavoie, 1996). The theory argues that what the rate of interest exactly depends on is not really significant provided it does not necessarily increase with the level of economic growth. The Horizontalist highlights that the rate of interest can be determined exogenously with respect to the income generation process (Rochon, 2006). Hence, the theory asserts that the rate of interest is exogenous.
In other words, the Horizontalist theory argues that the base interest rate is not a market phenomenon, but a bureaucratically determined rate, which may be more or less influenced by the political class and national financial systems (Lavoie, 1996 In the recent economic recovery strategy, the government of Kenya acknowledged that the commercial banks in Kenya, including the listed banks, were experiencing difficulties that would undermine the achievement of the objectives set out in the strategy, including inadequate market returns from the banking sector and persistence of wide interest rate sensitivity leading to a high cost of credit (Beck et al., 2010). Therefore, this study attempted to contribute towards the economic recovery strategy by

Methodology
The study applied a hybrid of cross sectional and longitudinal quantitative surveys. Rindfleisch, Malter, Ganesan and Moorman (2008) Where ( ) represents the required rate of return of a security, and represents the risk-free rate.
While, is the expected market return and represents the systematic risk of security j. Capital Asset Pricing Model therefore can be used to calculate the expected stock return for ordinary shares of firms, such as listed commercial banks. Risk premium is the market risk premium Where ( , ) represents the covariance between the security's return and the market, and 2 is the market variance systematic risk is referred to as market beta.
On the other hand, panel regression model of the form used by Yin and Yang (2013) The new variable − is the lagged value of the banks stock return, with its coefficient . The presence of the lagged dependent variable − controls for autocorrelation or serial correlation within the dependent variables (Fiordelisi & Molyneux, 2010). In addition, the data analysis was done using both the Statistical Package for the Social Sciences (SPSS) and Data analysis and Statistically Software (STATA) and the presentations and discussions of the results shown in chapter four.   be greater than the risk free rate (Firer, Ross, Westerfield, & Jordan, 2012).

Results
In addition, the CAPM return, which is the annual relative change of CAPM rate of return, indicates a positive mean of 0.018 (1.8%). This is slightly higher than the mean of price return (1.5%), though all have shown a mean positive annul relative change over the period. Table 1 also shows the summary statistics of the Central Bank interest rate (CBR) and the annual relative change of the same. The maximum CBR during the period was 18% and the minimum was 5.75%, with a mean of 9.316%. On the other hand, change in CBR, which is the main independent variable of the study, had a maximum value of 0.11 (11%) and a minimum of -0.136 (13.6%), with a mean -0.002 (-0.2%). The table indicates that the annual relative change of CBR was averagely on the decrease but not so much pronounced since the standard deviation value was only 0.04 (4%) compared to 0.081 (8.1%) and 0.052 (5.2%) of the corresponding dependent variables of CAPM return and price return, respectively. However, the Table 2 also shows a positive correlation between CBR and CAPM rate of return, and a negative correlation between CBR and CAPM return (change in CAPM rate of return), though both the corrections are significant. Furthermore, the correlation between price return and change in CBR is negative, though not significant. Interestingly, there is also a significant strong positive correlation between price return and market return, suggesting a possible influence of market return on price stock returns of listed commercial banks in Kenya.

The Trend of Central Bank Interest Rates in Kenya
In

Banks in Kenya
The main objective of the study was to investigate the sensitivity of central bank interest rate changes on stock returns of listed commercial banks in Kenya for the nine year period, from 2006 to 2014. The objective was achieved using the GMM panel data regression model 4, which applied the CAPM return as the main dependent variable and change in CBR as the main independent variable, with the market return and the lagged CAPM return as control variables. Table 3 presents the GMM panel data regression results for study model three, using these main study variables at 95% level of confidence interval. Sargan test also indicate that the model's results are valid and reliable. According to Bond (2002), the p-value of Arellano-Bond test for AR (1) this should be less than 0.05 and that of AR (2) should be greater than 0.05. While the p-value of Sargan test should be less than 0.05. This is the case for the GMM panel data regression results for CAPM return model (i.e., AR (1) p = 001, AR (2) Table 4 below. These results are in confirmation of the previous studies results, though, the negative sensitivity is not significant (p = 0.565) and the Sargan test (p = 0.279) does not indicate reliability and validity. Table 4 also shows that there is a significant strong positive (1.2421) relationship between the market return and the price return. This implies that the market return has a strong positive influence on the stock prices of listed commercial banks in Kenya. The study further analysed the GMM panel regression using CAPM return as the dependent variable and Central Bank interest rate (CBR) as the independent variable, with NSE index and lagged CAPM return as the control variables. The corresponding results as presented on Table 5 below also shows that there is a significant (P= 0.000) positive sensitivity (0.3452) of CBR on the CAPM return of listed commercial banks in Kenya. The results of this GMM model is also valid and reliable as illustrated by the p -values of Arellano-Bond and Sargan tests (i.e., AR (1) P = 0.001, AR (2) p = 0.093 and p (chi2) only respond to surprise changes in the central bank base lending rates. Yin and Yang (2013), studying the listed commercial banks of United States for the 10 year period, from 1988 to 2008, also found out that the bank stock returns are negatively related with changes in the central bank interest rates, which was consistent with prior empirical findings in the literature.
However In addition, the study further finding when CAPM return was applied as the dependent variable and Central Bank interest rate (CBR) as the independent variable, with NSE index and lagged CAPM return as the control variables, also revealed a significant positive sensitivity of CBR on the CAPM return of listed commercial banks in Kenya. Furthermore, the robust test using CAPM return as the dependent variable and change in central bank interest rate, NSE index, market return, CBR and risk free rate as independent variables also confirmed the significant positive sensitivity of changes in central bank interest rates (CBR) on the CAPM return of listed commercial banks in Kenya.
It can be concluded, from the study's findings, that the central bank base lending rate changes may have a strong positive sensitivity on the stock returns of listed commercial banks in Kenya. This may be so since Kenyan is still is under-developed and the main country's stock market (Nairobi Stock Exchange) is not very efficient, making most investment decisions being influenced by the macroeconomic factors such as changes in central bank interest rates. This is confirmed by the study form developing economies of Thailand and Malaysian done by Tarazi and Gallato (2012) for listed companies, which also found a significant positive sensitivity of changes in interest rates on stock returns. Therefore, it can further be concluded that changes in interest rates, including central bank interest rates (CBR) have a positive impact on stock returns of listed companies, particularly banks, form developing and under-developed economies, such as Kenya.