The thorny issue of bad and doubtful loans in local banks

When the International Monetary Fund (IMF) stated in its October 2015 staff report that some Kenyan banks had been forced to increase provisions for loan losses to the tune of Sh2.4 billion, it was the red flag that was needed to prompt the regulator into action.

But it was the first time in recent times that the multilateral lender had disclosed such a development. The figure would probably not have come into the public domain had the IMF not disclosed it.

What had happened is that the Central Bank of Kenya (CBK) — though Governor Patrick Njoroge was reluctant to admit it — had increased site visits and begun to tighten supervision of the lenders and had pushed the institutions to reclassify some of their loans.

“On-site supervision efforts have intensified, and the CBK has asked banks to reclassify some of their loans and increase provisioning for credit losses (Sh2.4 billion),” said the IMF in the rather ominous note about the practices of some of the institutions.

When Dr Njoroge was asked in his very first Press conference about the increase in provisions — which the banks had not originally put in their presentation of results — he said it was a “future concern” even as it clearly appeared to be a current concern then and now.

“At an industry average of about 5.7 per cent nonperforming loans are currently not an issue in Kenya. In terms of loan classification, some institutions may not fully follow the guidelines, but it is a future concern,” said Dr Njoroge.

The bad loans have since increased to 6.8 per cent, according to a banking industry report done by Cytonn Investments. From December 2014, this is an increase of more than two percentage points.

Unknown to many a customer, the directors of some of the banks have been merely waiting for depositors to bring in money so that they can casually wheel it out of the buildings in their car boots.

This would be after manipulating processes and signing papers purportedly to show the directors have borrowed it with the consent of their managers, yet it is without collateral and have no intention of repaying.

The reason that the IMF had come across that information had to do with the fact that Kenya was looking for a precautionary loan facility from the multilateral lender and had received briefings from the CBK about the state of the banking industry.

The precautionary facility, amounting to Sh153 billion, has since been given though it will be drawn only when there is a real exchange rate shock.

Race to the top

The CBK itself had not found it necessary to disclose to the public that it had come across under-provisioning for bad and doubt loans in the financial institutions operating in Kenya.

The CBK would have been expected to disclose in the banking performance reports but it did not. The regulator does not normally include controversial matters in its reports.

Investment bankers at Citi’s Global Markets had also earlier drawn attention to the rising tendency by the financial institutions to understate the massive NPLs they were incurring in a bid to inflate their profits.

The discrepancy was clear because the credit was rising quite fast yet there was not corresponding increase in provisions.

It would appear that many banks — including large ones — had ignored the prudence of providing for credit that could not be recovered as they attempted to beat their competition in profitability in what Dr Njoroge now calls “race to the top.”

Since the collapse of Chase Bank — the third such institution to go that way in his tenure after Dubai and Imperial banks —Dr Njoroge has since become a bit more forthright in discussing the unbecoming practices of some of the banks.

Using phrases such as “race to the top”, “rogue bankers”, “stealing from depositors”, Dr Njoroge is out to show that his promise to ensure that 2016 is a year of transition and increasing supervision of banks was not empty rhetoric.

The unspoken truth is that in some of the small banks, theft of depositors’ cash is facilitated by the loose structure of management and the board, in which there is hardly any separation.

It is not unusual to find the chairman or some directors who go to the office daily, giving the impression that they are indeed the real powers behind the operations of the bank.

For one, no major decision can be taken by the top management without the go-ahead of some director or directors but, worse, the same board members can cart away cash without being asked.

“Some of these things [collapse of banks] had to happen. You can’t take deposits from people and then you proceed to steal,” Dr Njoroge said in one of the recent press conferences.

Incidentally, the IMF had for a long time been pushing for the strengthening of the supervision of banking sector but there appeared to be no action of the part of the CBK for many years.

As recently as 2013-15 period, the IMF had pointed to the credit growth, global jitters — which have caused pressure on emerging market currencies — and the regional expansion as some of the factors that jeopardised the profitability and soundness of the sector.

When Imperial Bank collapsed last October, the CBK is said to have almost immediately interdicted four staffers in the supervision department.

The CBK management itself declined to confirm that but unofficially some of the top managers did.

The matter has threatened to spill over into the political sphere with some politicians calling for a scrutiny of the staff working in the CBK’s supervision department.

Supervision quality

On underprovisioning, the intention was to inflate profits, but come the results of 2015, the nine listed commercial banks more than doubled their average provisioning relative to the previous year, according to data compiled by Standard Investment Bank.

Some analysts believe that the NPLs and collapse of banks show there are concerns on the quality of supervision.

“As part of Kenya’s ongoing reform of its banking system, we have seen significant spikes in NPLs and impairment charges in the financial year 2015 results at several banks. The pace at which all of this has happened and the fact that these are structural rather than cyclical issues, has raised concerns about the quality of supervision in the sector historically,” said Renaissance Capital in their most recent report.

The provisions rose to reflect the fact that the nonperforming loans (NPLs) had increased. In ratio terms, the NPLs jumped by two percentage points in 2015 to 6.8 per cent from 4.7 per cent in the previous year.

The last time that NPLs exceeded this figure was in 2008, when it stood at 7.2 per cent. This was when Kenya had just experienced turmoil and violence relating to the 2007 General Election and the economy had hit a rocky patch to the point that the growth in the gross domestic product sank below two per cent for the first time since 2002.

But at the centre of the problems facing the small banks is the inability to access short-term credit from the bigger players.

On the day that Chase Bank fell (but reopened on April 27), Dr Njoroge revealed efforts had been made to procure cash from various institutions but nothing came of it, therefore, forcing the switch off of the core banking system.

By the time of the closure, Chase Bank had seen Sh8 billion withdrawn in less than 24 hours and there appeared to be no end to the haemorrhage.

“No bank anywhere in the world can withstand a run,” said Dr Njoroge, underlining that it was not the fundamentals of the bank that were wrong, but the mass withdrawals that were the proximate cause of the collapse.

But, again, Chase Bank’s chief executive Paul Njaga had asked the CBK in a letter for a Sh10 billion facility to rescue the bank, the regulator declined.

When asked why the CBK denied Chase Bank access to the reverse repo, Dr Njoroge strangely dismissed the matter as a “rumour,” raising questions as to whether the regulator did not itself contribute to the fall of the bank.

Some years back, one major commercial bank was said to have experienced a run at a branch in Meru — following a rumour of its imminent closure —but it quickly assembled huge loads of cash and asked depositors to line up and withdraw their cash.

The customers soon stopped withdrawing on realising they could not possibly exhaust the available amount of money.

That was a bank that could easily access the interbank market, besides having huge cash reserves of its own. However, Dr Njoroge has admitted that the interbank market does not operate as smoothly as it should yet there is enough liquidity in the market.

The governor said that seven banks control 80 per cent of the liquidity in the banking industry, thereby leaving others starved of cash.

“There is a lot of liquidity in the market, but there is a lot of segmentation. Seven banks control 80 per cent of the liquidity,” said Dr Njoroge on April 15. Yet there are more than 40 commercial banks in operation.

Many of the banks that hold significant liquidity do not have credit lines with the small banks. Even those that do, happen to have limits as to how much they can advance.

For international banks, the limits are rigidly set by the parent firms. There is also the market for horizontal repurchasing agreements (borrowing between banks without transferring security) which has tended to be affected by the same problem as the interbank market. This one is even less trusted by big banks because the collateral does not move or change hands.

The CBK has avoided naming parallel banking as the critical issue behind the collapse of many banks over the years. As it is now, Dr Njoroge has declared war on parallel banking, but he has not expressly stated it as such.

Parallel banking

In parallel banking, the deposits taken and loans given are not officially disclosed and, therefore, do not appear in the balance sheet at all. Unfortunately, the CBK knows this but has, for many years, been reluctant to address it.

As governor of the CBK, Njuguna Ndung’u never wanted to rock the boat such that not a single bank closed despite the serious weaknesses exposed in the Press, for example, about Dubai Bank.

Prof Njuguna probably knew the problem of parallel banking was not confined to a single institution and may, therefore, have feared contagion should he start the fight against it.

Prof Ndung’u is expected at some point to shed light as to what had really been going on at the supervisory level during his time as CBK head.

The question that remains: Did his concentration veer too much to financial inclusion and maintaining equilibrium in monetary aggregates to the exclusion of supervision?

The danger with parallel banking is that the owners of the deposits and loans want to remain anonymous, but their holdings pose a risk to the customers in the main bank. This is what happens in the case of both Imperial and Chase banks.

At Imperial Bank, some Sh34 billion in loans had not been included in the balance sheet while nearly Sh20 billion deposits was also missing from the official record. This emerged after due diligence was done on the bank by a consulting firm.

In Chase Bank, one of the directors had taken loans amounting to Sh7.9 billion and some of it was non-performing and had no collateral.

Another Sh8.7 billion had no proper documents and was considered to be, therefore, at the risk of not being repaid. In total, the repayment of Sh16.6 billion in loans was doubtful.

Along the way, as the CBK began making enquiries the process of collateralising the loans began and this is what has given the regulator the confidence to reopen the bank as all the assets can be traced.

Incidentally, parallel banking tends to affect depositors negatively. Many are reluctant to come forward because there will be queries from the tax authority. There are many Imperial Bank depositors who have not lodged claims.

This is what happened when Trust Bank was closed and many depositors would never appear in meetings called by the regulator, but were often seen in depositors-only meetings.

Another issue that has emerged from the Chase Bank saga is that of concentration of risk in one sector. The director who took money from the bank heavily invested in real estate, but it is understood that he is unable to sell them as he had expected.

This has reduced his cash flow and he is, therefore, unable to service a substantial part of his Sh7.9 billion loan.

This is the reason that the CBK says that the properties associated with the loans can be identified and are, therefore, available should the need arise to sell them.

The issue of external and internal auditors has arisen as well because they are seen as the gate-keepers.

Though auditors have defended themselves through their regulator, the question is how an auditor can find something right in one year and then changes their mind in another year when the management at the CBK has changed.