What Kenya can do to reduce the high number of bad loans

The best indicator of an economy that is performing well is low levels of non-performing loans (NPLs). Although in the last one year, the gross loan portfolio grew by 0.6 per cent, NPLs grew by 6.6 per cent, which signals loan repayment challenges by companies and households. NPLs tend to rise during economic downturns and decline during prosperity.

Currently, bad loans stand at Sh717 billion. NPLs have risen from 16.4 per cent in December 2024 to 17.4 per cent in March 2025, the highest level in 20 years. NPLs remain heavily concentrated in the corporate sector. For example, the recently released first quarter financial performance of Equity Bank (Kenya) reveals that NPLs rose from 15 per cent in December 2024 to 19 per cent in March 2025, mainly driven by the corporate sector where NPLs surged from 22.4 per cent in December 2024 to 26.7 per cent in March 2025. This explains the dramatic rise in property auctions in the country.

Lessons drawn from Africa show that in countries where the economy is performing well, NPLs are also low. For example, NPLs in Botswana stand at 3.2 per cent, South Africa 5.2 per cent, Mauritius 3.8 per cent and Egypt 2.4 per cent. When the late President Mwai Kibaki was elected, the economy was growing at 0.5 per cent and NPLs were at 35 per cent. By the time he left office in 2013, NPLs were at 5 per cent. The previous government left NPLs at 13.9 per cent in 2022, having escalated during the period of economic slowdown associated with the Covid-19 pandemic.

How did the Kibaki regime manage to lower the NPLs? First, by shifting the focus from domestic borrowing, interest rates fell dramatically. Banks began aggressive lending to businesses and households at single-digit rates. The creation of the Monetary Policy Committee (MPC) in 2008 ushered in an independent Central Bank Rate (CBR). CBR forms the basis for all monetary policy operations by coordinating movement in short-term interest rates. It anchors inflationary expectations to ensure that inflation remains within the 5 per cent target range. The goal is to curb excessive credit growth. During the Kibaki era, the Central Bank of Kenya (CBK) conducted a procyclical monetary policy with a view to stimulating private sector credit and economic activities.

But has CBK been effective in stimulating private sector credit? The current 4.1 per cent inflation is lower than the 5 per cent CBK target, but CBR remains high at 9.75 per cent. The 0.25 per cent reduction in CBR on 10 June 2025 was too little, too late. Since December 2024, the federal funds rate in the United States has ranged from 4.25 per cent to 4.5 per cent, but the annual inflation rate is at 2.1 per cent. While inflation in Rwanda is at 6.3 per cent, CBR is at 6.5 per cent. This explains why Rwanda's economy grew by 8.9 per cent in 2024 while Kenya dipped to 4.7 per cent.

CBR has implications on banks’ lending rates. The average bank lending rate stands at 15.77 per cent, which is costly to businesses. The high cost of credit can be traced back to September 2022 when CBK raised CBR from 7.5 per cent to 8.25 per cent. Although inflation was at 8.5 per cent, CBR was not the right policy instrument for dealing with supply-side inflation. Monetary policy works largely via its influence on aggregate demand in the economy − not supply-side shocks. The 4.5 per cent year-on-year inflation reported in 2024 was the lowest in the last five years, but mainly attributed to favourable weather conditions.

During the same period, the transport cost index eased to 5 per cent compared to 12.2 per cent in 2023, largely due to a drop in diesel and petrol prices. All these inflation indicators are supply-driven and therefore cannot respond to CBR adjustment. There is therefore no justification for the high CBR other than sustaining high appetite for domestic borrowing by the government.

Whenever CBK raises CBR, banks are quick to adjust lending rates upwards, but when CBR falls, they are reluctant to lower rates. Could this signal weak enforcement by CBK? While some banks have lowered lending rates commensurate with a decline in CBR in April, others such as Middle East Bank are lending at 20.63 per cent.

Second, rather than borrowing domestically, Kibaki's government turned to divestiture of parastatals. What is the implication of high domestic borrowing on NPLs? Composition of the public debt matters for private investments. Much of the public debt is domestic at 51 per cent. Sustained high domestic borrowing leads to a "crowding-out effect", where government borrowing reduces the availability of funds for private sector investment. Banks prefer lending to government since treasury bills and bonds are risk-free. The private sector is therefore constrained on credit, as private businesses are deemed riskier. The risk-based lending model also implies that private sector businesses borrow at a premium/higher rate than the government, which exacerbates NPLs.

Third, high and unpredictable taxes affect business ability to repay bank loans. Kibaki did not increase taxes but rather, through tax administrative reforms, expanded the tax base to make tax collection more inclusive under the slogan 'kulipa ushuru ni kujitegemea'.

To stimulate economic activities during the Covid pandemic, the government cut both corporate and income taxes from 30 per cent to 25 per cent. VAT was reduced from 16 per cent to 14 per cent. CBR was reduced from 8.25 per cent to 7.25 per cent. CBK also reduced the Cash Reserve Ratio from 5.25 per cent to 4.25 per cent. This stimulus package bore fruit. In 2021, the economy registered a dramatic growth of 7.6 per cent from -0.3 per cent in the previous year. NPLs fell from 14.5 per cent in 2020 to 14.1 per cent in 2021.

High NPLs can severely limit the ability of banks to provide new credit and support economic growth. Banks that hold large NPLs on average provide fewer loans. To promote high employment and economic growth, CBK must reduce CBR significantly. To free up funds for private investments, the government should reduce domestic borrowing and opt for external concessional loans.

The pending bills for goods and services supplied to the government create loan repayment difficulties for domestic suppliers, exacerbating NPLs. After the verification committee rejected Sh268 billion, the remaining Sh526 billion should be paid. This is important for the stability of the banking sector.