Effects Of Inflation On Commercial Banks’ Lending
[A CASE OF KENYA COMMERCIAL BANK LIMITED]

1.0 INTRODUCTION

1.1 Background of the Study

Inflation is generally the persistent increase of price level of goods and services in an economy over a period of time. When price level rises, each unit of currency buys fewer goods and services. Consequently, inflation results into a reduction in the purchasing power per unit of money, a loss of real value in the medium of exchange and unit of account within the economy (Boyd and Champ, 2004).They further observes that high inflation rates are caused by excessive growth of money supply in the economy compared to the rate of economic growth, a lower rate of inflation is thus favored since it reduces severity of economic recessions by enabling the labor market to adjust more quickly in a down turn. The chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the consumer price index) over time, The consumer price index measures movements in prices of a fixed basket of goods and services purchased by a typical consumer, The inflation rate is the percentage rate of change of a price index over time.

Lending is the most important services that commercial banks do render their customers, in other word banks grant advances and loan to individuals, government and business organization (Cheboi, 2012). Commercial banks are the most important savings, mobilization and financial resource allocations institutions, consequently these roles make them an important phenomenon in economic growth and development. In performing this role, it must be realized that banks have the potential, scope and prospects for mobilizing financial resources and allocating them to productive investments. Therefore, no matter the sources of the generation of income or the economic policies of the country, commercial banks would be interested in giving out loans and advances to their numerous customers bearing in mind, the three principles guiding their operations which are, profitability, liquidity and solvency (Cheboi, 2012).

Chodechai (2004) while investigating factors that affect interest rates, degree of lending volume and collateral setting in the loan decision of banks, under notes that Banks have to be careful with their pricing decisions as regards to lending as banks cannot charge loan rates that are too low because the revenue from the interest income will not be enough to

cover the cost of deposits, general expenses and the loss of revenue from some borrowers that do not pay. Moreover, charging too high loan rates may also create an adverse selection situation and moral hazard problems for the borrowers. However, commercial banks decisions to lend out loans are influenced by a lot of factors such as the prevailing interest rate, the volume of deposits, the level of their domestic and foreign investment, banks liquidity ratio, prestige and public recognition to mention a few. Interest rate is the amount charged as percentage of principal by a lender to a borrower for the use of assets based on the risk level that is the compensation for the loss of asset‟s use by the lender.

Inflation is a key determinant of commercial banks‟ lending rates globally. According to Santoni (1986), inflation depreciates the value of money such that a percentage increase in inflation results into a similar percentage fall in value of the country‟s currency. Broadly, inflation theorists attribute inflation to monetary causes and mal adjustments in economic system (Chand, 2008). The performance of commercial banks has been a considered issue in the developing countries. This phenomenon is attributed to the crucial role of the commercial banks in the economy. Further, the performance of banking is important to depositors, owners, potential investors and policy makers as banks are the effective executors of monetary policy of the government (Mian et al.2013). This suggests that the volumes of bank lending may partly depend on the performance of commercial banks.

Taner (2000) study on the effects of inflation uncertainty on credit markets reveals that unpredictable inflation raises interest rates, decreases loan supply and affect loan demand. This therefore suggests that an increase in inflation may raise the bank lending rates and lead to low bank lending volumes. Emon (2012)confirms this assertion and states that lenders are very aware that inflations erodes the value of their money over the time period of a loan, so they increase the interest rates to compensate for the loss. The increased interest rates may therefore influence the borrowing patterns for any commercial bank. This also suggests that there is a positive relationship between the inflation rates and the lending rates even though the extent to which one affects the other for different time periods is not certain. This study will therefore strive to determine the pattern of Kenya Commercial Bank (KCB) lending volumes as a result of the country‟s inflation rates over a period of time.