Commercial banks borrowed from the Central Bank of Kenya’s emergency discount window to finance purchases of government securities as they saw a profit opportunity from the lower interest rate on the facilities compared to treasury bonds.
The discount window was supposed to be used to provide temporary liquidity to banks but is now used to finance the lender’s short-term investment activities.
The International Monetary Fund (IMF) revealed this development as it continues to warn against the over-reliance of some institutions on the main bank for financing.
The IMF said: “Many banks continue to rely on the Central Bank of Kuwait’s discount window to manage reserves or to invest in government securities, as their returns have been periodically higher than the Central Bank of Kuwait’s discount rate since August 2023.”
The discount window sees the Central Bank of Kuwait as a lender of last resort that provides secured loans to commercial banks on an overnight basis at a fine or penalty rate higher than the central bank rate.
The penalty rate aims to restrict banks from requesting financing only from the market and resorting to the discount window as a last resort to fulfill their obligations in exceptional circumstances.
However, reforms to monetary policy operations allowed commercial banks to access the window at a relatively lower cost, while interest rates on government securities, including Treasuries and bonds, rose, creating an opportunity for arbitrage – profit from interest rate differentials.
This means the bank can borrow from the window cheaply, buy Treasury bills and bonds, and earn a higher return.
The interest rate spread was at its highest levels in November last year when the 91-day bond yield reached 15.32 percent against a discount window rate of 14.5 percent. The difference in interest rates can lead to huge profits when billions of shillings are invested.
The spread has since closed with the 91-day Treasury note rate falling to 13.96 percent last week while the discount window rate currently stands at 15 percent.
In August last year, the Monetary Policy Committee of the Central Bank of Kuwait reduced the interest rate applied to the discount window from six to four percentage points above the central interest rate, opening up an arbitrage opportunity that had been in place for several months.
The IMF has consistently noted the reliance of some banks on the window, which have routinely exploited this facility to obtain financing.
The Kenya Bankers Association (KBA) did not comment on its members’ access to the window, instead referring responsibility to the Central Bank of Kuwait.
The Central Bank of Kuwait has not yet responded to inquiries sent to it, but its disclosures about discount window operations show that the main bank audits banks that exploit the facilities regularly and more than twice a week.
“The Central Bank of Kuwait does not have an automatic standing facility in relation to overnight lending. Access to the window is subject to rules and guidelines which are reviewed from time to time by the Central Bank of Kuwait. Banks using this facility are audited more than twice a week, and take Supervisory procedures.
The aim of lowering the discount window interest rate, part of the monetary policy modernization, was to improve the performance of the interbank market, narrow interest rate spreads, reduce market fragmentation and monetary policy transmission.
In 2011, the Central Bank of Kuwait pointed to violations of the discount window, noting that some banks had turned to facilities as a permanent source of liquidity.
This saw the Central Bank of Kuwait set rules, including preventing banks from accessing funds from the window and the interbank market on the same day and capping one-week borrowing at the same level as each lender’s cash reserves.
Banks cumulatively tapped Sh81 billion from the discount window in the year to the beginning of August, according to market sources.
However, lenders have deployed reverse repurchase agreements – a form of open market operations (OMO) from the Central Bank of Kuwait – to leverage most of the funding from the apex bank, with Sh4 trillion reached over the same period.
Reverse repurchases (repo) entail the Central Bank of Kuwait’s purchase of government securities from commercial banks to enhance money market liquidity during periods when liquidity levels are below desired levels.