Kenya: What Does the Central Bank's Discount Rate Increase Mean?

The Central Bank of Kenya (CBK) in the last few weeks aggressively raised the interest rate at which banks borrow from its discount window. There has been all sorts of interpretations on what this means. There were even headlines to the effect that the CBK has "hiked interest rates", meaning that some in the media seem not to understand the difference between the discount rate and the Central Bank Rate (CBR).
The CBR and the discount rate have different purposes altogether. The discount window refers to the facilities that CBK, acting as lender of last resort, uses to provide liquidity to banks. The CBR, on the other hand, is the rate at which CBK lends to banks and other financial intermediaries.

It is the basis on which banks decide lending rates. Any change in the CBR has direct bearing on lending rates. CBK has not changed the CBR. It remains at 6.25 per cent. A key function of a central bank is to provide reserve loans to banks. That is why central banks in some countries are referred to as reserve banks. They are there to provide the reserves banks need to remain in business.
They are the lender of last resort, a safety net, for banks that could otherwise fail. The basic rationale for the existence of the discount window is that circumstances can arise when even fundamentally sound banks cannot raise liquidity on short notice.
If a bank facing a severe shortage of funds were not able to access either the interbank market or the discount window, it would be forced to liquidate its assets. The premature liquidation of assets could lead to collapse. Failure of one bank can trigger a banking system panic and culminate in a systemic collapse with enormous costs to the economy.
To meet these broader objectives and prevent such a scenario, CBK would normally lend freely but at a punitive rate to any bank with good collateral.
The punitive rate is in part to limit demand from banks as well as discourage them from taking excessive risk in the expectation that the central bank would come to their assistance with emergency credit.
The CBK discount window rate was however not charging a punitive rate and carried a lower rate than the interbank rates in the recent past. For banks, it was thus cheaper to borrow from the CBK than to borrow from fellow banks. Why was this allowed? Well, monetary authorities sometimes bend the rules for the greater good of the economy. To fight the recent global financial crisis most central banks, including CBK, utilised all available tools to improve economic conditions.
Through large open market purchases, they directly increased monetary supply in the economy, changed discount window policies and adjusted the borrowing rate to encourage banks to borrow more. CBK dramatically cut its policy rates during the crisis which also coincided with our own post election violence mess.
At some stage during the easing period, CBK reduced the discount making it lower than the CBR. By reducing the discount rate to below the CBR, the bank intentionally abandoned the traditional norm of making the discount rate unattractive in order to deal with the crisis by triggering reserve monetary expansion.
Why change now? First, now that the economy is not at emergency levels and the global financial crisis, these temporary measures have served their purpose and have no reason to remain in force.
In making the window unattractive again, CBK plans to discontinue injecting liquidity into the market. The discount rate will now be obtained by adding a penalty of three per cent to whichever is higher between the previous trading day's interbank rate and the central bank rate (currently at 6.25 per cent).
Second, in making these changes to the discount window, CBK's intention was also to eliminate the incentive for banks to do a "carry trade" by borrowing from the discount window and lending to the interbank forex market. This "carry trade" is discouraged by central banks and has in the recent past been blamed for creating incentives for banks to speculate in foreign exchange markets to the detriment of the shilling.
With these changes, banks now have to jump over a lot of hurdles before getting financing from the discount window.
Will this cause a liquidity crunch? It should not. The discount window is meant for contingency purposes and not for use in the normal course of business. Yes, some banks will miss access to the cheap reserves they enjoyed over the last few years, but they should be able to adjust by liquidating some of their liquid assets to compensate for the same.
If, as some suggest, it would be unprofitable to sell these bonds then the liquid assets are not serving the purpose for which they are held and that in itself should worry the authorities. Liquid assets should not be held for profit motives but rather for prudential purposes.
Future bailouts
Furthermore, banks should bear any liquidity costs. If they don't, the public may have to do this through costly bailouts in future. If on the other hand banks don't want to liquidate their liquid assets, they could swap their dollar liquidity (if any) for shilling liquidity which can only be good for the local currency.

Does this move suggest tightening? Hardly. Looking at the background above, one would feel that CBK's latest action should not be taken as a tightening of monetary policy so much as the beginning of a return to "normalisation" of the CBK's lending facilities.
It is normal for the discount rate to be changed from time to time to keep it in line with other interest rates.
These modifications should in theory not lead to tighter financial conditions for households and businesses as they do not necessarily signal any change in the outlook for the economy.
The markets will nevertheless interpret this as a signal that the more important rate, the CBR, could be raised soon, something which has already increased bond yields, and in itself has a tightening effect.