Background of the study

Solvency is defined as the degree to which current assets of business exceed the current
liabilities of that business. It is also the ability of a business to meet its long term fixed expenses
and long term expansions and growth. Therefore, bank solvency can be defined as the ability of
any given financial institution to meet all its financial duties be it short, middle or long term.
Solvency involves the financial institution meeting these obligations in the event of liquidity.
Since a bank is only considered solvent when the available assets are greater or equal to all the
liabilities otherwise the bank is insolvent and cannot therefore pay its debts hence a bank needs
to be solvent at all times. The probability of default of a representing bank can easily be shown
by the risk of insolvency (Jackson et al, 2002).

Generally, we can define insolvency as the inability of a financial institution to pay its debts. In
some cases, a commercial bank may end up owing more than it owns that is, its liabilities exceed
its assets. In Kenya today, we have increasing cases of bank insolvency. Like in insurance
companies where its surplus funds fall below zero, banks in Kenya also face this and we say it
has run out of money hence ruin has occurred. In our project we consider ruin as insolvency.

We can look at probability of ruin from a different angle and think of it as the probability that at
some later time, a bank needs to add in more capital to finance a given portfolio for instance pay
for interest rates. In the process of doing this maybe even once or many times, it may end up
insolvent and then we say ruin has occurred.

Descriptive ruin theory

Ruin theory uses mathematical models to describe an insurer’s vulnerability to insolvency. The
main aspects of these model are; the probability of ruin, distribution of surplus immediately prior
to ruin and the deficit at the time of ruin. Ruin is defined when the surplus of the portfolio
becomes negative. That is, ruin occurs when the average inflow of money (premiums) is less
than the average outflow of money (claims).

Classical ruin theory was developed by Lundberg in 1903 and later refined by crammer in 1930.
The theory describes the evolution of surplus of an insurance company over time. Insurance
companies begin with an initial surplus then receive premiums continuously at a constant rate
c>0 over a period of time. Claims of different sizes arise at random and independent times and
those are paid off according to a compound Poisson process with intensity λ. It is assumed that
the insurer’s premium per unit time is greater than the expected claims outgo. That is

c > λE[X]

Thus, let

c = (1 + θ) λE(X), where θ>0 is the premium loading factor.

The surplus process is therefore defined as:

U(t)=u+ct-S(t), t>=0.u>=0

Where

Ct=total premium income received in the time interval [0, t]

u=U (0) is the initial surplus
N(t )
S (t) = ∑ Xk, aggregate claims in the interval [0,t]
k=1

Where

N(t)=number of claims at time t

Xk =amount of the k-th claim, k=1,2,3…

The probability of ultimate ruin, where the firm’s surplus falls below zero is denoted by:

Ψ(u) = prob ( U(t) < 0, for some t|U(0) = u)

The model assumes that claims are paid off as soon as they occur and that no interest is earned
on the insurer’s surplus.

Considering the Lundberg inequality;

Ψ(U) ≤ exp [−RU]

Where U is the insurer’s initial surplus, R is the adjustment co-efficient that gives a measure of
risk for the surplus process.
The adjustment coefficient takes into account the aggregate claims and premium income. If it
exists, the Lundberg inequality allows us to obtain an upper bound for the probability of ruin. A
larger adjustment coefficient implies a smaller ruin probability.

R is defined to be the unique positive root of

λMx(R) = λ + cR

Mx(R) = 1 + R (1 + θ) E(X), since c = (1 + θ) λ E(X)

The Sparre Andersen Model

Unlike the Cramer-Lundberg inequality that assumes affirmatively that time of claims has a
Poisson distribution, E. Sparre Andersen (1957) extended the Lundberg inequality model,
deviating from this assumption and proposing a generalization of the classical (Poisson) model.
He proposed that the inter-claim times have a general distribution, but retained the independence
assumption as per the Lundberg’s inequality.

Sparre Andersen’s model assumes the following:

a) The inter-claim times and the amount of the nth claim are identically distributed.
b) The inter-claim times have a general distribution, other than an independent
exponentially distributed inter occurrence of claim times.
c) The means of the claim amounts and the inter occurrence times exist and are also finite
variables.
d) The gross risk premium per unit time is independent of time.
e) The claim sizes are exponentially distributed.

If we let the inter-claim times to be T1, T2, Tn, such that Tr is the time between the (r-1) th claim
and the rth claim; T3, for instance, shall be the time between the second and third claim, and so
on.
We denote the amount of nth claim by Xn. We also denote the risks reserves at time t as Yt and
the initial risk reserve as u such that u>0.

The model models the risks reserve process as follows:

Yt=u+Ct-Xt; where Ct denotes the gross risk premium at time t,

t =n
Xt=0 if T1>t and Xt= ∑ Xj.
t =1

Nt is called a renewal process and Xj’s are non-negative random variables that are independent
and identically distributed. Hence:

Nt
Vt=v+βt-∑ Xj
j=1

If T1+T2+...+Tn≤t<T1+T2+…+Tn-1, we can have that:

t =n t =n
Yt =u+∑ ( cTn−Xn ) + c(t−∑ Tn)
t =1 t =1

Our focus narrows down to the probability of ruin during either an infinite or finite time that is
the probability of Yt<0 for some fixed finite time t between (0,T] or for some time t>0, the
probability of Yt<0.

The expression for the ruin probability is given as:

Ѱ(v)= prob(inft>0 Vt<0|V(0)=v)

Nt
Such that Ѱ(v)=pr(minn(v+∑ ¿¿βTj-Xj}<0))
j=1

Sparre Andersen assumes that the claim size is exponentially distributed, e.g., exp(ɵ), therefore;
 R −Rv
Ѱ(v)=(1- ¿ e for all v>0 and R is the adjustment coefficient.
ɵ

The probability of ruin in this model, which supposes that inter-claim times have a general
distribution and the claim sizes are exponentially distributed, and with adjustment coefficient R
sets the solution to the moment generating functions below:

My(s)=Mx(s)l T ( β s ) =1

β
Where Mx(s) = is the MGF of the claim sizes while Lt represents the Laplace
β−s
Stieltjes transform.

Bank insolvency

Bank insolvency is defined as the ability of a financial institution to meet its short, middle and
long term financial obligations. A bank is considered as solvent if the existing assets exceed or
equal total liabilities. However, if total assets are lesser than current liabilities, the bank focuses
an insolvency risk and cannot pay its debts. That means that any financial institution should be
solvent. Therefore, we can say bank solvency is the ability of a bank to pay it obligations when
they occur without the bank’s normal activities being interrupted. (TCIIAC, 2014)

There are three seasons when insolvencies had a major impact: The Great Depression in the early
1930s, Savings and Loans crisis (in the years between 1980 and 1990) and the Great Recession
(in 2007-2013to date). (Kirby Cundiff, 2013) However the largest banks insolvencies that
occurred in the 1970s brought about the establishment of the Basel Committee of Banking
Supervision (BCBS).

The BCBS aims to preserve and improve the stability and reliability and the banking supervision
of the international financial system, to encourage standardize and unify practices in financial
institutions. As a result, there should be some international cooperation in prudential supervision.
(TCIIA, 2014) We also realize that over the years, the committee was influenced by the growing
sophistication and complexity of international financial markets, the increasing globalization,
shift from micro-macro prudential perspective and evolution of its role in monitoring the
implementation of committee standards. (Ingves, 2013)
Thus we can come to a conclusion that all the measures that have been put in place to curb bank
insolvencies have not been successful so far and many more cases have been experienced. We
can see the example of Kenya when Chasebank experienced an insolvency.

Basel Accord and credit risk

The Basel Committee on Bank Supervision(BCBS) issued the first Basel Accord Known as
Basel I in 1988. This is a set of minimum capital requirements for world banks focusing mainly
on capital adequacy of financial institutions. Basel I solely focused on credit risk making it frail
because banks face many other forms of risk.

In 2004, the Revised Capital Framework, better known as Basel II was designed to include liquid
risk, market risk and operational risk. Basel II focused on three main areas, also known as the
three pillars:

a) Minimum capital requirements.

b) Supervisory review of an institution’s capital adequacy and internal assessment process.
c) Effective use of disclosure as a lever to strengthen market discipline and encourage sound
banking practices

After the Lehman Brothers’ collapse of 2008 sent shockwaves in the economic world, the BCBS
restructured and strengthened the Accords. In 2010 they introduced the Basel Standards (Basel
III) as a continuation of the three pillars whose goal is to improve banking’s ability to absorb
shock from financial and economic stress. The accord currently under gradual implementation
from 1st January 2013 has a technical implementation deadline of 31st March 2019. The Accord is
however criticized because it fails to acknowledge variability in riskiness of assets considered.

The excessive variability in riskiness prompted the currently ongoing Basel IV. It is still in the
oven with most recently the committee releasing a consultative paper seeking out views on its
plan to change how capital requirements and market risk are calculated.

Banking Amendment Act (2016)

The spread of interest rates in Kenya which is among the highest in the world has become a
public concern. This spread fortunately or unfortunately is being blamed on avarice of
commercial banks. The recent collapsing in this sector has been attributed to their charging of
large interest rates and sometimes lower interest rates.

The Central Bank of Kenya (CBK) is in charge of regulating this spread.in the past years’
attempts had been put in place such as the Amendment Act 2001 (The Donde Act), and the
Public Finance Bill which were declared unsuccessful ways of regulating the interest rates.

The CBK has published the Central Bank of Kenya Reference Rate (CBKRR) which is at 10%
making the maximum charges to credit facilities to 14%.

The Act requires that these commercial banks disclose their rates to the public. This act majorly
is here to ensure that banks don’t get to extort the public through greed by charging extremely
high interest rates. However, these high rates can be justified since they also incur transaction
costs and risks that come with lending out money (Fernando), it may pose difficulties to the
regulation body in differentiating between profitability and greed. These commercial banks need
to make these profits so that in the case lenders default in payment, they come upfront to cover
for the risk.

Statement of the problem

Of the factors affecting commercial banks we have interest rates as one of the major factors.
Among other factors, Gardener et al (2005) says that interest rates greatly influence the
profitability of these banks. Macro-economics is facing the problem of high interest rates and
efforts to eliminate this seem to not be working. In Kenya today, the banking sectors get to enjoy
high interest rates at the expense of clients who sometimes know less about the rates affecting
them. It is because of this that economic observers in the country point out that high interest rates
are negatively affecting our economic development and this led to the introduction of the
Banking (Amendment) Act, 2016.

From the amendment act, it’s evident that commercial banks are heavily affected by the spread in
the interest rates, Mang’eli (2012). The regulations have effects on financial institutions almost
forgetting that that they incur high cost of loans. In the recent years before interest rates capping,
that is when the banks had the opportunity of charging high borrowing interest rates and in return
improving in financial performance, some of them were still reported to make losses despite
having the same regulatory body(CBK). This makes it our concern that these regulations may
raise the chances of ruin of commercial banks.

In addition to this, instances of lower interest rates expose banks to many a higher client base and
consequently higher risks of credit. Some of these clients the banks may have little knowledge
about them which increases credit risk.

Objectives

The main objective of this research is to find the effects of credit risk and interest rates on bank
insolvency.

Specific objective

a) To find out if Ruin Theory can be used to find bank solvency as in insurance.
b) To investigate whether capping interest rates increases the higher probability of ruin in
the objective above using Sparre Andersen Model.
c) To find out the effects of reduction of interest rates below normal and effect of defaulting
on ruin probability on banks.

Research questions

a) Can the probability of ruin be used in the banking industry as used in insurance industry
to find solvency?
b) Does interest capping increase probability that ruin will occur?
c) Does lowering interest rate and risk of default affect probability of ruin?

Significance of the study

We are coming to a realization that bank insolvencies have become more common in the last
century. The measures put up to control these instances of insolvencies have not been quite
successful at reducing the rate at which banks are going bankrupt. In Kenya, more so there is a
lot of doubt in the banking system and industry despite all the measures put in place and
assurances from the Central Bank of Kenya (CBK).
Therefore, we aim to use ruin theory as one of the measures that can be applied in curbing
solvency and risks and try to understand the solvency position of the Kenyan banking sector.