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Kenya’s Banking Sector in Transition

With three of Kenya’s banks in receivership and a report following a government audit of the country’s financial institutions still impending, it is becoming increasingly clear that the turbulence being experienced by the country’s banking sector is far from over. With consolidation and stiffer regulations in the offing, it is still unclear how the country’s nascent capital markets will evolve as a result.

Jul 26, 2016 // 4:56PM

Kenya’s banking sector has seen a seismic shift over the past year as three of the country’s small and mid-sized lenders were placed under receivership by the Central Bank of Kenya due to liquidity and mismanagement.

In August last year the Central Bank of Kenya (CBK) appointed the Kenya Deposit Insurance Corporation (KDIC), an arms-length agency governed by members of the Treasury and the Central Bank, as a receiver for Dubai Bank Kenya Limited after the company began regularly breaching its daily cash reserve ratio requirements.

“Dubai Bank has been experiencing serious liquidity and capital deficiencies which have raised the CBK’s concerns that it will most likely not be able to meet its financial obligations as and when they fall due,” the Central Bank said in a statement at the time.

After multiple attempts by shareholders to revive the bank and at one point stall its closure through the courts earlier this year, it has since begun liquidating its assets – and expects to pay back just 40% of the money owed to depositors with the proceeds of the sale.

Just three months later another Kenyan bank, Imperial Bank Ltd., was placed into KDIC’s receivership after CBK began investigating troubling allegations that the institution effectively ran parallel books.

Two weeks after the bank was placed under the auspice of KDIC, the CBK said it found “fraudulent activities of substantial magnitude, and the misrepresentation of Imperial Bank Ltd.’s financial statements.”

“These activities relate largely to irregular granting of loans by Imperial Bank Ltd. management, contrary to the legal and regulatory requirements, and the internal policies of Imperial Bank Ltd. In particular, these irregular loans were a violation of the statutory limit of lending to a single borrower, and inadequate loan loss provisions, thereby overstating Imperial Bank Ltd.’s capital adequacy position.”

The scandal, which has since seen CBK staff implicated, saw Imperial Bank Ltd used hacked IT software to create false reports. It reported a balance sheet of KES52bn in its last financial report with a loan book of KES4bn. But after being placed into receivership, it was discovered that deposits totalled KES85bn.

With the equivalent of US$684mn in assets reported at the end of Q2 2015, the bank was substantially larger than Dubai Bank and sat in the mid-range of the country’s bank rankings according to Cytonn Investments Management Ltd., a Nairobi-based alternative investment house and advisory. More recently, NIC Bank has tried to take over the troubled lender, but those efforts have since stalled after being challenged in courts by Imperial Bank Ltd’s shareholders.

The CBK’s decision to place the bank under receivership coincided with Imperial Bank Ltd’s bid to list its KES2bn (US$19.40mn) offered in August 2015 on the Nairobi Securities Exchange (NSE), a move that was halted by the country’s capital markets authority just days before it was due to commence trading.

Finally, in early April this year, Chase Bank Kenya Ltd., another of the country’s midsized-lenders, became the third Kenyan bank to be placed under receivership with KDIC “following inaccurate social media reports and the stepping aside of two of its directors” because of a liquidity shortage. The move caused a run on the bank by panicked depositors. It later emerged that the lender used Islamic instruments to sanitise bad loans.

The bank was reopened on April 27, with depositors restricted to accessing up to KES1mn, and while KDIC has suggested it is currently monitoring the bank with a view towards lifting the receivership, withdrawals have dropped by nearly 90%.

While the performance of the country’s banks over the past three decades has largely been solid – with average return on equity sitting between 20-30% annually – some analysts are keen to point out that the collapse of Dubai Bank, Imperial Bank Ltd. and Chase Bank Kenya Ltd. could have long term implications for the sector.

Peeling Back The Onion’s Layers

Maurice Oduor, an investment manager at Cytonn Investments Management Ltd. has spotted four key trends seen in the country’s banking sector at present: Continued sectoral realignment via mergers, acquisition and strategic differentiation; a flight to quality among depositors and investors; increased supervisory of banks; and new capital adequacy requirements.

“The collapse of the three banks has created a crisis of confidence in Kenya’s banking system. As a result, depositors are shifting from Tier II and III banks to the larger Tier I entities, and to some extent investors are following suit,” Oduor says.

Cytonn regularly ranks the banks operating in the country, taking into account a wide range of measurements including core EPS growth, deposit growth, loan growth, NPLs, and return on equity among others. In Q1 2016 Standard Chartered and Equity Group, two of the six top tier banks operating in the country, saw double digit core EPS growth.

“The country’s top tier banks saw deposits grow more quickly than Tier II and III banks on average, and Q1 2016 weighted average deposit growth for the entire sector stood at just 11%, down from 16.5% seen during the same quarter the previous year.” Loan growth has also slowed from 21.3% in Q1 2015 to 15.8% in Q1 2016.

The top 10 banks in Kenya account for roughly 70% of the market in terms of deposits, a figure some analysts believe is actually approaching closer to 80% off the back of the events seen over the past year.

At 43 commercial banks (which doesn’t include the 180 savings and credit cooperative societies, or SACCOs) and a population of just over 44 million, Kenya, with nearly 1 bank for every million inhabitants, is overbanked. The country has three times the number of banks per capita than South Africa and ten times the number of banks per capita than Nigeria.

The CBK has already announced a moratorium on new banking licenses, which observers believe will herald a protracted period of M&A in the sector. We are already seeing early signs of this: CDC Group is looking for an 11% stake in Kenya’s I&M Bank, while Bank M of Tanzania recently secured the CBK’s blessing to acquire a majority stake in Oriental Commercial Bank.

While most are keeping their cards close to their chest, our sources suggest and Credit Bank and ABC Bank could put themselves up for sale if the right buyer came along. “Equity Group has also shown some interest in acquiring a local bank if it makes sense from a business perspective,” one banker says.

“The banking sector will likely see some mergers and acquisitions over the next few years, and it will be the banks that have a really strong niche or strategic focus that will win out,” Oduor explains. “At the same time, we are seeing the Central Bank double down on supervisory and liquidity risk management, slightly shifting its focus away from financial inclusion, the dominant theme in the country’s regulatory landscape for years.”

In response to the banking sector woes the CBK introduced a liquidity support framework for banks, available to both commercial and microfinance institutions struggling with liquidity shortfalls, which some believe could end up exacerbating the situation further. As a result of the massive liquidity injection interbank lending rates have dropped from over 10% to just over 2% since the decision was taken.

“Smaller banks don’t want to be seen borrowing from the Central Bank because they don’t want to be seen to be struggling,” says a banker at one of Kenya’s smaller lenders. “It’s something the creates internal stability issues and struggles, beyond what it communicates to the market.”

At the same time, Kenya’s Treasury Secretary Henry Rotich is looking to boost the minimum amount of capital banks must set aside as a safety cushion from KES1bn to KES5bn over the next three years after plans do to so were shelved last year, and amend the country’s banking laws to allow the government greater influence in managing the country’s financial institutions. Rotich has also called for plans to make the KDIC more autonomous.

Adesoji Solanke, who heads up research at Renaissance Capital’s Nigeria office says we could see a new round of capital raising if Rotich is successful in boosting the minimum capital reserve threshold, particularly as credit growth is expected to slow from 25% into the mid-teens.

“It is possible we could see more borrowing to shore up their capital reserves, though we could just as easily see some of the liquidity shortfalls be made up by going directly to the CBK; some of this will work itself out naturally as depositors shift from smaller to larger banks. But that also means the new rules will likely put many of the country’s smaller lenders under even greater pressure.”

Disadvantaging some of the country’s smaller lenders was a central reason guiding the government’s initial decision to drop the capital reserve reforms last year, but some would argue that with the economic and banking environment having since eroded, the measures – while disproportionately painful for some – are critical for ensuring economic robustness.

Observers and analysts tend to believe Central Bank of Kenya Governor Patrick Njoroge, who assumed his role at the Bank in June last year, will have little choice but to introduce more stringent rules.

Njoroge was one of the chief proponents of canning the new capital ratio requirements last year, but with the Treasury supporting stronger rules and the Central Bank still weary of introducing them, some analysts believe could see a protracted tug-of-war between the institutions which could end up threatening the independence of the Central Bank.

“We have seen a fairly significant shift in asset quality over the past two years – including increases in loan loss provisions and non-performing loans, which have shot up from 4.9% in 2015 to 8.7% this year, and delinquencies are at all-time highs; the loan to deposit ratio is getting quite skewed as well. Capital requirements weren’t at issue for the past few years given the good yield we’ve seen, and confidence in the sector. But that is now changing and the Central Bank will be left with few choices,” says Brian Chege, a senior investment analyst at Britam.

“Confidence in the Central Bank, in its supervisory function, is sitting fairly low. For the long term health of the sector, and the credit environment, this needs to change.”

The reform process could accelerate depending on the results of an audit of the country’s commercial lenders currently being carried out by the CBK. The results of the audit were supposed to have been announced at the end of Q1 2016, but the CBK has so far declined to publish its report, sparking speculation that the poor performance and governance issues so far uncovered or known to the public is just the tip of the iceberg.

“What many are worried about is that we could see a couple more shockers during the year as the report was consistently delayed,” says another East Africa-focused investment analyst. “It could be the case that the CBK has uncovered a situation far worse than expected, and are looking for a way of communicating the information so it doesn’t scare borrowers and investors – the sector has already taken quite a bashing.”

Implications for the Capital Markets

The challenge with the banking crisis currently unfolding is that its implications and causes seemingly outstretch the sector.

“Kenya’s economy is running on a single engine plane. The strong performance of the economy last year can be put down to agriculture, construction, and to some extent manufacturing. But if you look at the manufacturing and construction component, much of that has been driven by government demand and direct or indirect spending,” Chege says.

Debt to GDP in the country jumped from 38.9% in 2013 to 52.8%, and although the pace of the jump is worrying those levels are considered fairly healthy by most. But its tax collection to debt servicing costs tell a different story.

It looks like the government is on track to collect less than KES1.1tn, its initial target, over the fiscal year ending in August – so far it has collected KES970bn – but the country’s debt servicing costs will hit KES400bn this year, or 40% of its total tax take, in part because it has a higher proportion of debt coming due over the next two years.

By comparison, the proportion of its debt servicing costs to its total tax take last year was 20%. It is one of the reasons the country’s Treasury is currently looking to refinance its debt through the issuance of a Eurobond – so that it can retire a syndicated loan that is coming due.

“The drop in tax collection is worrying and an overall drop in deposits suggests the economy isn’t growing as quickly as the government claims,” says Chege. “Kenya will be able to secure external funding because liquidity is available and the hunt for yield is still prevalent, but it is becoming clear problems are beginning to fester underneath.”

The country is looking to borrow between KES462bn and KES689.1bn in international markets and up to KES225bn from the local market to plug its yawning budget gap according to analysts at Standard Bank, and it may pull the trigger sooner rather than later as prices continue moving in its favour.

Yields on the country’s 90-day Treasury bills have fallen over 330bp in the past year – in part because Kenya’s long term institutional investors are shifting their money out of bank deposits / investing in banks directly into government paper; asset managers acting on behalf of pension funds are amongst the largest depositors in the country, and the largest domestic buyers of bonds. Kenya’s sovereign yield curve has steepened over the past year, however, so longer term funding will come at a premium.

“We don’t see Kenya struggling to raise the funds from the foreign market, particularly after the drop in US Treasury yields following the Brexit vote pulled down yields on African Eurobonds. But of greater concern is whether the government will end up crowding out the local credit market – which will put upward pressure on rates and put a strain on certain sectors,” says Phumelele Mbiyo, a fixed income analyst at Standard Bank.

Borrowing costs have risen over the past year in the local market, in large part because banks are struggling to raise deposits, and because domestic investors are becoming increasingly picky, explains Johnson Nderi, Head of the Corporate Finance Advisory team at ABC Capital Kenya.

“You wouldn’t be able to get away with a vanilla bond. The vast majority of capital markets deals getting done either have some sort of exotic structure, or are large guaranteed notes,” Nderi says. “I don’t think secured notes or junior notes are cutting it these days.”

Pension funds are moving their deposits out of banks. The cost of borrowing is rising, and are prohibitive for an increasing number of corporates. Banks are lending less and less. And with delinquencies on the rise, investors, even long term investors, are getting skittish. The result is among other things a fairly high dependency on international funding, which means more vulnerability.

Given the right circumstances, corporates could issue bonds in order to satisfy their borrowing needs. Nderi believes one of the reasons the bond market hasn’t taken off – particularly at a time when deposits are dropping and banks have an incentive to keep toxic assets off their books while maintaining growth and collecting fees – is because the country’s long-term institutional investors, the backbone of most bond markets, aren’t sufficiently incentivised to think beyond the short term.

A source working at one of the country’s medium-sized insurers agrees. “Fund managers in these institutions have their performance reviewed on an annual basis and very rigid standards have to be met in terms of return, and when trading is thin – as it is in Kenya’s bond market – it is very hard to net out that consistent level of growth. So you become much more opportunistic and selective in terms of what credits you are willing to hold, and pile in on the upward trend to generate returns,” she says.

Still, Kenyan institutional borrowers tend to gravitate naturally towards traditional loans for debt financing and lean more heavily on their relationship banks, in part because the option of refinancing and the flexibility of interest payment extensions – which were on the rise in the second half of 2015 – is more widely available, according to Linet Muriungi, Head of Research and Edwin Chui, Senior Fixed Income and Banking Sector Analyst at Dyer & Blair Investment Bank in Nairobi.

“Rather than limit their asset growth by encouraging bond issuances, we’ve seen banks seek to aggressively expand their liability base through securing Tier II capital and trying to grow their deposits,” Muriungi explains. “This is part of the reason why we have seen the likes of Equity Bank enter the telco space, with its mobile virtual network operator (MVNO) presenting itself as a direct competitor to Safaricom’s MPESA, as well as the Kenya Bankers’ Association recently launching an interbank Switch as an avenue to mobilize deposits.”

Although a number of “what ifs” persist, particularly around the legislative agenda, what is clear is the banking sector in Kenya looks set to undergo a protracted transition period, perhaps for the better – not unlike what was seen in Nigeria some years ago when its banking sector saw a significant shift followed by a series of M&As, Solanke explains. “Change and consolidation is coming, and the banking sector will be healthier as a result.” 

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