The Banking Bill: A State of Transition for the Kenyan Banking Sector

NAIROBI (Capital Markets in Africa) –  Banking (Amendment) Bill by Parliament to cap banks’ lending rates at 400 bps above the Central Bank of Kenya’s base rate and impose a deposit floor at 70% of the CBR was signed into law on 24th of August 2016. If the law is implemented immediately, banks will charge a maximum of 14.5% on loans while paying about 7.35% on deposits held in interesting earning deposits.

Impact on Banks
The true impact on Kenyan banks cannot be estimated until the Central Bank of Kenya announces the implementation timelines as well as the operational framework. Assuming an immediate implementation, however, expect impacts on:

Yields from loans and advances: The average lending rate as per the Central Bank of Kenya currently stands at 17.96% with multiple reports indicating that the personal unsecured rate is at around 24.0%. A 14.5% would, therefore, result in at least 346 bps reduction in yields from loans and advances all else held constant.

Deposit rates: In FY15, the average deposit rate stood at 6.9%. A 7.35% deposit would thus raise the cost of deposits by about 45 bps. In an effort to maintain asset-liability mismatches while keeping the cost of funds low, banks have relied on a tiered deposit account structure with some accounts such as term deposits attracting higher rates due to their characteristic long tenors and large opening balances. As banks will henceforth have to pay a minimum rate of 70% of the CBR on all interest-earning deposits, we expect them to restrict interest-earning deposit accounts to longer tenors and larger opening balances.

Net interest margins: The decline in yields from loans and the rise in the cost of funds will result in NIMs compression across the banking universe. Assuming yields from loans at a maximum of 14.5%, and cost of deposits at a minimum of 7.35%, NIMs from banks core business will stand at 7.15%. With the FY15 average lending and deposit rates at 17.96% and 6.9% respectively (NIMs at 11.06%) this will present a 391 bps reduction in NIMs. As we explain further in this report, such an analysis assumes no variation in the Central bank’s base rate, banks complete acquiescence with the new regulations among other key issues.

Corporate deposits and loans: For some banks, especially those in the Tier I and II sectors, corporate deposits are critical as such banks are unable to leverage either international parentage or stronger relations with DFIs. Consequently, they tend to lend directly from their deposit base. Such banks have in the past focused on niche marketing in a bid to compete for wholesale corporate deposits in the market. A legally binding deposit floor rate will thus extend more leverage to corporates to negotiate even higher rates on their deposits which will effectively raise the cost of funds in these tiers.

Small and Medium Enterprises: With respect to the SME space, we see two likely scenarios. Firstly, to the extent that there is a substantial number of viable SMEs that have been locked out of borrowing by high-interest rates, banks should see an uptick in the number of loan applications by SMEs in the short term which may give them an opportunity to maximize on volumes to mitigate the effects of the rate cap. On the flip side, it is possible that banks will in the short term be unwilling to extend credit to the more risky SME sector without viable collateral which should effectively facilitate credit shortages.

Mortgages: Although demand for mortgages has been rising steadily y-o-y, the number of mortgage loans still remain subdued primarily because of pricing. According to the Central Bank of Kenya, mortgage loans in the market rose 11.1% y-o-y in FY15 to 24,458 due to increased demand from the expanding middle class. This represented a 23.0 % y-o-y rise in the value of mortgage loan assets outstanding to KES 164.0 BN. The interest rate charged in 2015 on mortgages on average was 17.1% and ranged between 11.9%- 23.0% as compared to 15.8% average with a range of 8.0%-21.3% in 2014. That rates were high can be inferred from the 8.3% y-o-y rise in the outstanding value of non-performing mortgages to KES 11.7 BN in FY15. Anecdotally, a 14.5% rate on Mortgage loans is still quite high to drive up mortgage uptake substantially. If banks are to compensate for the drop in direct lending by increasing their mortgage lending they will have to incentivize their clients by charging at a substantial discount from the cap.

Key Questions
Will the law be applied retroactively? As most of the lending is on flexible terms, a retroactive implementation will certainly cause a dent in FY16 bank’s performance. Does the rate apply to all loan classifications equally? Equal treatment of all segments will distort risk pricing in the market. Banks may also append various fees and commissions on lending that would effectively keep the cost of credit high. At the moment some banks have already suspended some of their loan products, for instance, personal unsecured lending.

Does the rate apply to all deposit classifications equally? Banks may raise the criteria for opening a savings account or attach more/higher processing and maintenance fees. Mobile products: There is uncertainty on what will happen to lend through mobile platforms especially Mshwari and KCB Mpesa which are partnerships between Safaricom with Commercial Bank of Africa and KCB Group respectively. As margins are shared between each of the two companies, individual banks do not have discretion on the rates applied. In addition, that KCB and CBA classify margins from these products as fees, the interest rate cap (as written) may be inapplicable in which case we can expect CBA and KCB to divert more funds into these products.

Banks FY15 income analysis: In FY15, circa 65.66% of banks’ income arose from loans and advances either as interest or as fees with 14.9% arising from investments in government securities.

Banks’ interest expenses: The banking sector expenses rose 16.3% to KES 322.8 BN in December 2015. Interest expenses accounted for 41.2% of the total banking sector expenses in 2015 compared to 24.8% in 2014. This increase was in line with the average rise in the cost of deposits to 5.5% in FY15 as compared to 4.9% in FY14. Assuming a total a customer deposit growth forecast of 8.5% y-o-y (as in FY15), a deposit rate of 7.35% (CBR at 10.5%), a loans and advances growth of 11.2% (as in FY15) and an interest rate of 14.5%, the consequent banking sector net interest income would decline 1.3% y-o-y to circa KES 144.359 BN. Therefore, all else held constant and assuming a seamless implementation, a rate cap may not result in a huge income decline in the sector as a whole.

Sectoral distribution of gross loans: According to the Central Bank of Kenya, loan accounts in FY15 were distributed as follows:

The relatively high weighting of the personal/household sector numbers does give credence to the argument that banks have focused their lending on the riskier but the economically less productive sector of the economy. It is thus plausible that a smooth implementation of the interest cap may incentivize banks to lend more to the more productive sectors of the economy which as per the data above do not yield as much non-performance.

Impact on NSE listed equities
Listed Banks: In the short term, we anticipate a panic-driven sell-off of listed bank equities in the Nairobi bourse due to uncertainty on the impact the cap will have on banks’ profitability. Indeed, a volume weighted prices of all bank stocks fell today one day after the decision. The market is also replete with sellers as buyers continue to wait and see if prices will drop further. Other counters: If the law is retroactively implemented, companies with local debt such as Kenya Electricity Generating Company (KenGen), Kenya Power and Athi River Mining (ARM) will stand to benefit as their finance cost will be substantially reduced. Impact on the fixed income market

Primary market: As banks are the dominant players in the treasury bills and bonds primary auctions, and in the continued absence of official primary market makers, we anticipate high bidding and oversubscriptions in the weekly and monthly auctions. This month, the Central Bank of Kenya offered a 10 year Treasury Bond for a total amount of up to KES 25.0 BN. The total number of bids received was 795 amounting to KES 26.31 BN. However, 105 bids were accepted amounting to KES 18.3 BN of which KES 13.2 BN was from competitive bids. The market weighted average rate was 15.267%. With lending capped at 14.5%, we believe that Banks will shift a key portion of their assets to government securities. However, given that banks are the most dominant players in the fixed income market there is a chance for collusions in the bidding process in an attempt to lock in high coupon rates. In the absence of collusions, and assuming banks hold back on lending, then they will be stuck with huge cash balances that if redeployed to government securities should also push the yields down. In the long term, therefore, government securities may offer no respite.

Secondary market: We anticipate that banks will scramble for any bond in the market with at least a 14.5% annual coupon rate. We also anticipate that banks may opt to hold such bonds and those acquired during primary auctions to maturity. Impact on the macroeconomic environment. Portfolio outflows: As banking stocks are the most dominant in the Nairobi Securities Exchange in terms of daily turnover numbers, we are concerned that a sustained sell-off, especially by foreign investors, may trigger substantial short-term portfolio outflows from the Kenyan equities market.

Foreign exchange: Substantial portfolio outflows may lead to further depreciation of the Kenyan Shilling against major currencies which may lead to a rise in the cost of imports that may, in turn, trigger a rise in inflation. Syndication prospects: An interest rate cap may boost prospects for syndicated lending by mitigating price differentials among banks. This may come in handy especially in the financing of infrastructural projects such as still in the works road annuity program.

This article features in the October Edition of INTO AFRICA Magazine, a special focus on the Banking Sector in Africa, with an overview of the current trends and opportunities in the Sector.

Contributor’s Profile
Edwin Chui joined Dyer & Blair Investment Bank in 2016 and is responsible for covering tier I banks. Dyer & Blair is renowned for topping investment bank rankings, having executed several landmark transactions including transaction advisor for the USD 840mn Safaricom IPO, Sole advisor to the USD 180mn acquisition of Equity Bank’s 24.99% stake by Helios and USD 317.5mn capital restructuring programme by Kenya Power Company Limited. The brokerage division executes transactions across the equities and fixed income markets and provides access to the Kenya, Uganda, Tanzania and Rwanda markets for both retail and institutional investors. Prior to joining Dyer & Blair, Edwin worked at Bank of New York Mellon in the wealth management department.