The Impact of Interest Rates on Financial Sector Investment Strategy

 “While higher interest rates slower growth and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But failure to restore price stability would mean far greater pain.” This was quoted by the United States’ Central Bank chief, Jerome Powell, during the Jackson Hole conference earlier 2023. Interest rate is a major economic instrument that influences the trajectory in an economy. As such, it is a tool used by central banks all over the world to control inflation and stabilize or boost economic development. And whilst Central Banks’ mandate is to ensure macroeconomic stability through monetary adjustments, their decisions tend to have far-reaching implications on different economic actors and sectors. For instance, the Central Bank of Kenya’s decision to increase the interbank rate from an average of 5.12% in the 2021/22 financial year, to an average of 12.57% in the 2023/24 financial year, might have slowed down inflation but triggered an unprecedented rise in borrowing rates at the micro level. Similarly, the European Central bank’s decision to quadruple its interest rates within the same period has led to massive capital flight from developing countries to the Euro area thereby creating an imbalance in foreign direct investment and forex exchange markets. Having experienced such movements both locally and globally, what is the overall long term implication of Kenya’s interests rates movement on the financial sector investment strategy?

The shift in interest rates presents both opportunities and challenges for the banking sector. In literal terms, an increase in overall interest rate is considered a positive sign in the long-term profit margins of banks and microfinance institutions. Realistically, banks incur substantial costs in restructuring their loan portfolio and their general investment strategies when interest rates fluctuate. This ultimately eats into their perceived gains. Fluctuating interest rates directly affects credit risk which, in the fullness of time, affects a bank’s capital position. If rates rise too steeply, the probability of having performing loans decreases, hence forcing institutions to increase their provision for bad debts. The opportunity cost of this provision prevents the institutions from undertaking worthwhile investments which could potentially improve its shareholder value and medium to long term profitability. Distinctly, banks and microfinance institutions are considered large purchasers of Government securities. For the longest time, Government securities have always been considered relatively safer investment vehicles compared with other classes. However, recent movements in the bond and short-term debt markets have dispelled this notion, more so for financial institutions. Deposit-taking and lending institutions that held Government securities before 2021 are counting substantial losses on their investments. Unfortunately, as the global credit market continues to shrink, most developing countries such as Kenya are finding it difficult to access credit, forcing them to increase their bonds and short-term debt instruments’ rates to attract potential investors. This market dynamics has tilted the market by rewarding new investors while punishing those who have held such instruments in their portfolios for considerably longer periods such as banks and microfinance institutions.

In the insurance industry, implications of fluctuating interest rates can be viewed from either the short- or long-term nature of their business lines. Short term insurance business creates a win for insurance companies’ investment strategy in that, their active participation in the T-bills market allows them to take advantage of the upward quarter-to-quarter movement in rates generated by the Government’s need to finance its short-term plans. Long-term insurance business stretches its benefits beyond compensating policy holders. These business lines often offer an interest return (some guaranteed) in addition to basic policy benefits to policyholders. This aspect positions long term insurers as leading purchasers of Government bonds that often have maturity periods of up to 25 years. Therefore, the impact of fluctuating rates in the bond market on investment strategies of long-term insurers is similar to those of banks and micro-finance institutions.

Whilst the uncertain movement of fluctuating interest rates present both opportunities and challenges, mitigating the implications of rising interest rates is a crucial concern for players in the financial market. Therefore, the best practice for this would be for the regulatory authorities to allow flexibility of the players to diversify their investment portfolios, allowing room to mirror the constantly adjusting macroeconomic environment. A mix of assets that may perform well with these interest rates may hedge against the predicted risks.

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