Banks, capital markets not rivals when looking to fund firm operations

Capital markets play a very modest role in the financing of businesses, either by issuing bonds or by raising equity capital. PHOTO | SHUTTERSTOCK

An analysis carried out by Bank of International Settlements (BIS) economists showed that the depth of normal recessions in bank-oriented economies is less than in economies more based on capital markets.

But when recessions coincided with financial crises, they showed that the impact on gross domestic product was three times as severe for bank-oriented economies as it was for market-oriented ones.

The point being made is that banks and capital markets are more complementary than competing sources of capital.

With this in mind, some have suggested recently that the role played by the banking sector in Kenya should be considerably reduced, delegating to capital markets most of the responsibility for mobilising capital to meet companies’ financing needs.

The idea is to become more like the US where funds sourced from capital markets are the main financing method compared to bank money, which only accounts for between 10 percent and 15 percent of all external financing.

Worth pointing out is that traditionally, Kenya has been a bank-oriented economy with an estimated 75 percent of external financing for the corporate sector reported to come from banks.

On the other hand, capital markets play a very modest role in the financing of businesses, either by issuing bonds or by raising equity capital.

On the surface, the idea makes sense. Kenya has yet to fully realise its local capital market potential, which remains relatively small.

Besides, the desire to become an international financial centre with Sh280 billion in targeted investments by 2030 means deepening its local capital markets first.

Businesses would also have expanded options to bring their ideas to life or to expand their businesses. But is the country ready for such a shift? Not quite. Some critical elements are missing.

One good example is financial literacy. Generally, it’s been shown that the financial literacy of households and firms improves with economic development, lifting demand for services linked to market-traded securities.

But with only 38 percent of Kenyan adults considered financially literate according to a 2021 Global Financial Literacy Survey, we still have a long way to go.

And status quo could persist if the regulator keeps its investor education spend to just about three percent of its budget.

Another example cited by the BIS research is that more highly developed countries have stronger institutions. In particular, market-based finance benefits from better enforcement of property rights through stronger legal systems.

Firm size was also noted as having a bearing on the funding mix. Small firms, which account for over 85 percent in the micro small and medium enterprise landscape, typically depend on bank finance because of the fixed costs involved in tapping capital markets.

But even assuming a desired scenario where an established capital market exists, yet an equally functioning bank-based intermediation system is necessary, a balance between the two is most effective.

This is because these two spheres of the financial system are not so much opposing alternatives but rather complementary to each other. Both banks and capital markets are individually beneficial when each exists alongside the other.

Mwanyasi is MD Canaan Capital.