The peer monitoring role of the interbank market and implications for bank regulation: Evidence from Kenya

This paper investigates whether the interbank market in Kenya is effective as a peer monitoring and market discipline device and can thus complement official bank regulation. We use a unique quarterly dataset on 43 banks which participated in interbank transactions in Kenya over almost a decade. We uncover a new and interesting result the impact of interbank market activity on bank risk levels mimics a U-curve: At average levels of interbank activity, we find a stable inverse relationship between interbank activity and bank risk levels, after controlling for other bank risk determinants and macroeconomic factors; however, if a bank increases its interbank position beyond a threshold level, the impact on bank risk is reversed from risk-reducing to risk-increasing due to possible contagion effects. We also find that, after grouping banks by different characteristics, the risk reduction effect due to peer monitoring is smaller for less risky banks including larger, listed, foreign and older banks. Overall, we conclude that Kenya’s interbank market discipline role may complement official bank regulation. This finding may have exemplary implications for other countries at a relatively early stage of financial development. JEL classification: G21; G28; E58