ADDRESSING THE MORAL HAZARD THROUGH EXPLICIT DEPOSIT INSURANCE: A COMPARATIVE APPRAISAL OF THE KENYA DEPOSIT INSURANCE ACT, 2012 by HENRY JONAH AGWEYU LUGULU Submitted in fulfilment of the requirements for the degree DOCTOR OF LAWS In the FACULTY OF LAW UNIVERSITY OF PRETORIA January 2019 SUPERVISOR: PROF CM VAN HEERDEN CO-SUPERVISOR: PROF H COETZEE ACKNOWLEDGEMENTS The decision to take up doctoral studies has been the most rewarding yet challenging decision of my academic life. Rewarding because it completes the loop of my academic studies, but challenging because it has been intense, lonely and characterised by alternating high and low spirits that would confuse even the most motivated scholar. It is therefore befitting that I acknowledge the great inspiration and strength I drew from Isaiah 40:31 that advises that, for them that wait upon the Lord, He shall renew their strength to enable them to mount up with wings like eagles, run without being weary and walk without fainting. With various health challenges beginning December 2013, I thank God for giving me the physical and mental health I needed to complete the academic journey. I acknowledge and thank my supervisor Professor Corlia Van Heerden LLD, Professor of Banking Law and Barclays Africa Chair of Banking Law in Africa, and my co- supervisor Professor Hermie Coetzee LLD, Associate Professor of Law, for their patience and dedication to my supervision. I am particularly grateful for my supervisors for expeditiously attending to my work and the detailed comments they made to guide my often incoherent drafts into this thesis. I further thank the University of Pretoria for giving me a tuition bursary and travel grants that enabled me to complete the course. In addition, I owe a debt of gratitude to Ms Moipone Williams and Ms Kate Tabane of the Department of Mercantile Law for all the support they extended to me during my visits to Pretoria. I further thank my wife and best friend Dr Joyce MA Lugulu PhD, for the invaluable support and constant encouragement she gave me, and for holding the fort to keep the family going while I undertook the course. My children Vivian and Wybo Kuperus, Julie Lugulu, Godfrey and William, also deserve special mention for the moral support and consistent encouragement they offered me. I also thank my grandson Leron, for raising my spirits whenever he called to ask me how I could possibly be managing life in South Africa without him. The completion of this thesis would have given immense joy to my late friend and father, HC Lugulu, who by teaching me that generosity was its own reward, set me up for the great generosity I have received in my endeavours. It is to his memory that I dedicate this thesis. 1 ABSTRACT This thesis appraises the Kenya Deposit Insurance Act, 2012 and evaluates its effectiveness to address moral hazard in banking. While explicit deposit insurance scheme (EDIS) enhance financial system stability by preventing potential bank runs through reimbursement of depositors of failed banks using ex ante premiums levied from the banks, they also create moral hazard when banks take excessive risks in the knowledge that their losses will be borne by the EDIS. Kenya’s first EDIS under the Deposit Protection Fund Board (DPFB) did not effectively address bank moral hazard. The thesis considers the features the Kenya Deposit Insurance Act has adopted to limit bank risk-taking and mitigate the impact of bank failure by facilitating the orderly exit of failed banks from the financial system. The appraisal of the Act is conducted in the context of the post-GFC reforms that integrate financial regulation for the safety and soundness of individual financial institutions (microprudential regulation) and the systemwide regulation of the risk emanating from the conduct of business of financial institutions for the stability of the financial system (macroprudential regulation). Using the post-GFC reforms in financial regulation, as well as South African and USA bank regulatory and supervisory and deposit insurance and resolution regime perspectives, I recommend reforms to strengthen Kenya’s macroprudential financial regulatory framework and to enhance the effectiveness of its EDIS and SRR. Specifically, I recommend reforms inter alia to strengthen Kenya’s bank supervisory framework through consolidated supervision of financial conglomerates and the incorporation of macroprudential regulation. In addition, I recommend reforms to the Kenya Deposit Insurance Act to inter alia prescribe the assessment criteria for risk-based premiums and the criteria for the enforcement of prompt corrective actions and the requirement for financial conglomerates to prepare recovery and resolution plans. Key words Explicit deposit insurance, moral hazard, microprudential regulation, macroprudential regulation, Kenya Deposit Insurance Act DECLARATION OF ORIGINALITY Full names of student: Henry Jonah Agweyu Lugulu Student number: 16395451 Declaration 1. I understand what plagiarism is and am aware of the University’s policy in this regard. 2. I declare that this dissertation is my own original work. Where other people’s work has been used (either from a printed source, Internet or any other source), this has been properly acknowledged and referenced in accordance with departmental requirements. 3. I have not used work previously produced by another student or any other person to hand in as my own. 4. I have not allowed, and will not allow, anyone to copy my work with the intention of passing it off as his or her own work. SIGNATURE . List of abbreviations AIG American Insurance Group CBK Central Bank of Kenya IMF International Monetary Fund World Bank International Bank for Reconstruction and Development IBEA Company Imperial British East Africa Company EA Currency Board East African Currency Board CDO Collateralised debt obligation CDS Credit Default Swap CPSS Committee on Payments and Settlements Systems Co-Co bonds Convertible corporate bonds CFPB Consumer Financial Protection Board DPFB Deposit Protection Fund Board EDIS Explicit deposit insurance schemes ELA Emergency liquidity assistance FDIC Federal Deposit Insurance Corporation FDICIA Federal Deposit Insurance Corporation Improvement Act, 1991. FIRREA Financial Institutions Reform and Recovery Enforcement Act, 1989. FHFA Federal Housing Financing Agency FSOC Financial Services Oversight Council FSB Financial Stability Board FSF Financial Stability Forum GFC Global Financial Crisis G-20 Group of Twenty G-30 Group of Thirty IADI International Association of Deposit Insurers IOSC International Organisation for Securities Commissions IAIS International Association of Insurance Supervisors KDI Act Kenya Deposit Insurance Act, 2012 1 Land Bank Land and Agriculture Bank LOLR Lender of last resort MBS Mortgage Backed Securities OFR Office of Financial Research OLA Orderly Resolution Authority RA Resolution Authority RRPs Recovery and Resolution Plans SARB South African Reserve Bank SIFI Systemically Important Financial Institutions SRR Special Resolution Regimes SRB Special Resolution Bill The Corporation Kenya Deposit Insurance Corporation USA United States of America US United States 2 TABLE OF CONTENTS Chapter 1: Introduction 1.1 Introduction 1 1.2 Background to the study 2 1.2.1 Special role of banks in the economy 2 1.2.2 The sui generis nature of bank insolvency 4 1.2.3 The evolution and role of explicit deposit insurance 6 1.2.4 Moral hazard 8 1.2.5 The rise and impact of universal banking on moral hazard 9 1.2.6 The GFC 25 1.2.7 Lessons from the GFC 28 1.2.8 Post-GFC international response 30 1.3 Kenyan context 31 1.3.1 Background to EDIS in Kenya 31 1.3.2 Currency board era with no deposit protection 1895 to 1966 32 1.3.3 Implicit deposit protection from 1966 to 1985 32 1.3.4 Explicit deposit insurance from 1985 to 2012 33 1.4 Research statement 33 1.4.1 Hypothesis 33 1.4.2 Research questions 34 1.4.3 Limitation of the scope of the study 34 1.5 Motivation for the study 35 1.6 Research methodology and selection of comparative jurisdictions 36 1.7 Summary and lay-out of chapters 36 Chapter 2: The international context of bank regulation, deposit insurance and orderly bank resolution 2.1 Introduction 39 2.1.1 General overview 39 2.1.2 Chapter overview 40 2.2 The post-GFC reform of the international financial architecture 41 2.2.1 Group of Twenty countries 41 2.2.2 Post-GFC reforms to international financial regulation 44 2.2.3 The Basel Core principles and Joint Forum Principles for supervision of financial conglomerates 54 2.3 The IADI Core principles of effective deposit insurance systems 61 2.3.1 Overview of post GFC prominence of EDIS 61 2.3.2 The IADI Core principles 62 2.3.3 Addressing moral hazard through the IADI Core principles 62 2.4 The FSB Key attributes of effective resolution regimes for financial Institutions 67 2.4.1 The FSB Key attributes 67 2.5 Implementation of international financial standards 73 2.5.1 Overview of local adaptation of international financial standards 73 2.5.2 Prospects and challenges in the implementation of international financial standards 73 2.6 Chapter summary and conclusions 76 Chapter 3: The regulation and supervision of financial conglomerates in Kenya, South Africa and the United States of America 3.1 Introduction 80 3.2 Regulation of financial conglomerates in Kenya 81 3.2.1 General background 81 3.2.2 Historical context of bank regulation in Kenya 82 3.2.3 Central banking and bank regulation in Kenya 84 3.2.4 Transition to universal banking in Kenya 87 3.2.5