The Nigerian banking crisis should force another close look at the health of the Kenyan banking sector. Deepak Dave argues that Kenyan banks, despite their rosy performance in 2008, show signs of weakness that deserve more attention from the regulator.
Between January 2005 and Christmas 2007, attention, marketing and, most importantly, capital were lavished upon Nigerian banks from the pool of capital devoted to Africa in London and New York. For those involved in the African banking markets and the struggle to obtain financing, it was a heady time. Over USD25bn flowed into the country, and stock market valuations soared on the back of revenue predictions that outstripped all expectations.
For a while, it appeared a matter of time before the Kenyan sector would also go through consolidation, recapitalization and regional expansion. Private equity investors and merchant banks began to look at Kenyan banks and the revolution appeared imminent. Then, however, the post-election violence of 2008 and the ensuing drying up of investable liquidity certainly cooled enthusiasm as did the conservative nature of central bank, treasury and banks’ owners.
So news of the shake-up in the Nigerian banking market over bad debts, alleged mismanagement (or worse) and fraud should trigger reflection. There is enough drama in Lagos for an entire novel, eclipsing the turmoil the developed economies’ banking players faced in 2007 and 2008. For those who witnessed the near meltdown of the Kenyan banking sector in 1998 (and the smaller tremors of 1993 and 2003), the stories from Lagos have eerie echoes.
Whether, how and why the Kenyan banking sector escaped the credit crisis remains to be seen. The self-congratulation within the sector seems muted and the startlingly good performance of our banks is puzzling at first glance. Market players and the CBK seem unruffled by longer term risks and instead seem focused on a single metric, the interest rate charged customers. This is vital to macro-economic growth, but I would also consider whether the banks will actually be around to offer any rates at all.
The positive assessment of the banks’ performance is driven by an examination of profitability as opposed to the risk inherent to their business models or assets. Stock prices are poor predictors of liquidity and credit risks: Every one of the giant European banks bailed out in 2008 had profits in 2007. There are certain indicators of trouble brewing for a bank, and I believe that some of these are flashing amber, if not red, for particular Kenyan banks and have been inadequately addressed. These relate to the degree of provisioning for loans, the deployment of funds allied to poor capital structure and opaque ownership.
Provisioning for Non-Performing Loans
Provisioning is often underestimated as an indicator of risk. If a customer fails to make loan repayments on time, the bank first treats the loan as non-performing (NPL). Strict Central Bank of Kenya (CBK) rules apply to this and banks have little control over defining NPL. Subsequently, an estimate is made of the value of any collateral that might be recoverable, and the final loss, i.e. the severity, is what gets written off against the banks’ capital. Provisioning refers to this “write-off” and is shown on the income statement. When I am shown a bank with a non-performing book that differs widely from its final provisioning, I am concerned. Since the definition of NPL is out of the banks’ hands, there is considerable leeway that management have in defining the provision they take.
However, let us consider the case for this: A bank that shows a low proportion of provisions to NPLs is signalling one of three things. First, it might not know how to manage its customer, i.e. repayment terms are loose, branch managers are too lax with delinquents etc. Second, it might have a remarkable ability to realise security, assuming it has any in the first place e.g. a bank with a large mortgage business should be reasonably able to recover its money. Finally, and least happily, it shows management might be manipulating the provisioning numbers to be able to boost profits. Boosting profits in a non-financial firm does not necessarily translate to cash flow to fund short term drainage of capital through dividends. For bank, it is very easy and needs to be watched out for.
A number of the recent bank reports show that NPLs have risen everywhere, but a few banks have provisioned for very low portions of this. Providing for less than 50% of NPLs might signal smugness on management’s part. Providing for less than 25% of NPLs would require management to have superhuman abilities to recover loans, particularly if the bank in question is known to mostly focus on unsecured loans in the first place. Even more unnerving are CBK’s and CMA’s insistence that margin trading is not allowed in Kenya. For the last three years, a number of commercial banks have advertised their loans as being expressly for purposes of share trading. I am baffled as to how the market has dropped by 30% and yet I have not seen any indication of concern on CBK’s part. Swathes of unsecured loans should be showing as deeply in the loss column, yet no explicit mention has been made of this.
The booming real estate sector, where prices seem to have lost any relationship to facts on the ground, also has a profound effect on bank lending: The poor property rights inherent in our land system mean that a finite amount of development-worthy land in urban centres and along passable roads is overinflated in value. This drives ever increasing lending against ever (seemingly) safer collateral. A valuation crisis similar to the West sweeping across Kenya would be a disaster. We have few external sources of capital willing to purchase even at fire-sale prices, no large local pool of liquidity that can be generated to provide a floor price to real estate and a fragmented market that prevents block purchases of property. Where is the analysis of the exposure to real estate, and what happens if economic stresses magnify any problems?
Deployment of Funds
Another area of concern is the deployment of funds. Banks raise funds through four different means: One, the most visible, is the raising of deposits. Two others are the raising of short and long term debt, inter-bank borrowing and bonds being examples respectively. Finally the bank can raise capital, either through issuing common shares or preference stock. The nature of modern banking being that depositors expect their money on demand means banks never lend out more than a judicious portion of their deposit base, generally 75% in developed economies and 60% in smaller ones. The discrepancy arises due to poorer economies having less non-deposit funding alternatives available.
The Kenyan interbank market is skewed towards the deposit collectors such as Barclays, KCB and Equity with large branch networks, and in any case inter-bank funding is not meant to serve as a deposit backstop. The bank debt market is poorly developed in Kenya. Indeed, the lack of an active market for subordinated debt has actually failed to give depositors and regulators a very important price signalling mechanism into the health of the banks that is often available in richer countries. Raising money through asset sales is a non-starter for now as we have no securitization or asset-backed securities markets, and none for the packaging and sale of loans. Neither do we have the people nor the laws to regulate and drive the market or execute deals.
Some of the assets held on bank balance sheets also give rise to concerns. In some cases, I have been surprised by the constant revaluations of the principal property portfolio (branches and head offices) to boost the value of tangible assets. With respect, selling your headquarters is hardly the means to deal with a queue of depositors at your door.
Large banks often take the risky path of lending ever higher portions of deposits. Loan-to-deposit ratios of over 65% are of concern, those of over 90% should signal cataclysm. The explanation that these figures are supported by issuance of tier 2 capital is unconvincing. Tier 2 capital can be structured in various ways: If set up as non-cumulative preference shares that can “absorb” losses, then it may be capital. But in cases where the stock is linked to a cumulative dividend, redeemable at holders’ wish or convertible into common equity at particular strike prices, this ‘capital’ could lead to a bank actively making poor decisions to drive share prices higher or lower, or generate short term profits, precisely to pay off this capital tranche. Without more information being in the public domain, we cannot be certain that the bank involved will be able to survive a reassessment of its asset books or a major run on liquidity.
Ownership
When looking at ownership, it is important not only to consider the ownership of the shares in the banks, but also the institutions or individuals controlling the owners themselves, e.g. the families behind medium sized banks through nominee shareholders. My concerns here concern the ability of those owners to stabilise a bank facing a capital call or a run on deposits by injecting liquidity. I know from personal experience some years ago of a prominent local family that relied on its own creditworthiness to procure overnight liquidity from a major multinational bank. Yet the sums involved in a major run would most likely exceed the capacity of most of such owners.
A further complication is that there is hardly any mechanism for dealing with bank capital rights issues, i.e. the issuance of new shares giving preference to existing shareholders to ‘top up’ their stake. Particularly in a crisis where systemic stability was threatened, the opaque ownership and private holding structures mean that there are few immediately viable options open to the CBK. In the developed markets, only small banks are owned by a private equity consortium. Even then, the end investors have to put down specific guarantees without limit as owners. But where a systemically sensitive large bank is involved, we have a different problem. In case of a cash or capital call on that bank, does CBK actually have any leverage over the special purpose vehicle created for the purpose of holding the shares, not to mention being able to actually coerce a capital injection from liability shielded investors? Again, we have no transparent rules or published details to work with.
Perspectives
This final point summarizes the dilemma facing the government and CBK. With a weak economy, rising unemployment and low confidence as well as rapid inflation, they must all hope that the banks keep up with the remarkable run of performance. We have little hope of a systemic crisis being within the government’s capacity to solve. CBK’s track record with ‘Lazarus’ banks such as Oriental and City Finance shows that the conversion of deposits to equity massively overcapitalizes the bank, but leaves the revenue generating asset base threadbare, and does nothing to improve liquidity.
This is the troubling outlook: The bank that falls next may well be much bigger than the minnows of the past, and we need to know what will be done when a problem appears.
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However, assuming banks implement your idea of reducing the proportion of lending, won't that bring about deflationary pressure that would further excerbate the problem? if a re-evaluation of collateral and assets was done in the current enviroment (of pessimism) then the lower valuations would affect that ability of banks to lend and attract lending...leading back to deflationary pressure.
I think that there is a deliberate attempt by the Central bank of kenya to address the issues you have raised. They are currently trying to deepen the debt markets, creating an umbrella regulatory body to oversee insurance, pensions, capital and banking industries, and reforming the land policy by computerizing and increasing land transfer legislation to deepen the market.