The capital markets regulator traces the current popularity of SBB transactions among banks to early last year when interest rates started rising sharply following CBK’s decision to increase its policy lending rate to bring down inflation and stabilise the shilling.
As the Central Bank Rate (CBR) rose from six per cent to 18 per cent within a space of six months, commercial banks found themselves holding treasury bonds whose value had declined by large margins due to the inverse relationship between interest rates and the value of fixed income securities.
The bankers’ lobby, Kenya Bankers Association (KBA), however, strongly defended the sale-buy-back transactions. KBA chief executive Habil Olaka said the deals were done “in conformity” with international accounting standards.
Two financial services sector regulators are locked in a battle over commercial banks trading of Treasury bonds, which is seen to cause the economy huge losses through mis-pricing of the contracts that are then passed on to ordinary consumers in the form of costly loans.
At the heart of the row between the Capital Markets Authority (CMA) and the Central Bank of Kenya is a peculiar method of trading Treasury bonds that commercial banks have used in recent years to pad their profits.
CMA wants the method of trading bonds, known in capital markets jargon as sale-buy-back (SBB), banned arguing that it is being used by banks to distort capital markets and issue misleading profit figures.
SBB involves the sale of a Treasury bond by one bank to another, with the promise of buying it back in future.
Market data shows that banks have regularly used the SBB window to dispose of Treasury bonds that would require them to book losses in their income statements, boosting the margins of profit growth and raising questions over the accuracy of their financial statements.
In a detailed memo seen by the Business Daily, the CMA has recommended a ban on all SBB transactions on grounds that they pose a risk to the financial system since they distort the interest rate yield curve-- which banks use to set the cost of loans.
The CMA also argues that the transactions are not legally enforceable contracts and have therefore been used to defraud banks and stockbrokers that are caught on the wrong end of the deals.
“The SBB transactions have led to significant distortion of the yield curve and in some instances fraud due to lack of practical rules that govern the transactions,” says the CMA memo.
The Nairobi Securities Exchange (NSE) bond yield curve is used as a primary reference point for transactions worth trillions of shillings including the setting of bank lending rates to businesses, the government, consumers, and even for pricing of corporate bonds.
SBB transactions are done outside the open market where two parties agree on an applicable interest rate different from the prevailing yield curve, hence the distorting effect. Commercial banks dominate trading of treasury bonds, with a CMA estimate showing that 60 per cent of transactions done between April and August 2011 were executed “significantly below” the yield curve.
“The contracts between the parties are also un-enforceable and that’s why in the event of default by one party, they try to seek redress from the (CMA) or CBK. In this regard we recommend that SBB should be stopped in the market and termed as illegal and unrecognized trades,” says the CMA memo.
The recommendation by CMA, which if implemented could affect the flow of liquidity in the banking system and also diminish the Central Bank (CBK’s) ability to borrow money on behalf of the Treasury through sale of bonds, did not seem to go well with the CBK.
In a circular dated November 12 that was sent to all bank CEOs and copied to the CMA and the bourse, the Central Bank instead issued new regulations that are meant to validate SBB transactions.
While acknowledging that banks were involved in “improper market conduct where stockbrokers have been executing purchase orders for government bonds through e-mail,” the banking sector regulator says the solution to this irregularity would be to have “written instructions” in SBB transactions.
“Henceforth commercial banks will be required to confirm their own accounts and its custodial accounts purchase transactions using Swift message MT599 as a confirmation of the transactions between the parties,” says the CBK circular signed by Gerald Nyaoma, the director of financial markets department.
Mr Nyaoma says in the circular that commercial banks which fail to pay for their SBB transactions will have their accounts with the regulator debited automatically. Besides helping banks to re-organise their portfolio of treasury securities, cash-short banks ordinarily borrow money from their more liquid counterparts through the SBB transactions.
CBK also relies on commercial banks to meet the Treasury’s borrowing target from the domestic market through primary bond sales, and could potentially find it hard to raise money for the national budget deficit if the lenders curtailed their participation.
Commercial banks currently hold about 50.69 per cent of the government of Kenya bonds, according to the CMA memo.
In a research report released in July, Citigroup Global markets analysts put big Kenyan banks on the spot over what they termed as “overstating” of their profits through, among other tactics, re-classifying their treasury securities whenever it suited them.
“We estimate that International Accounting Standards (IAS) 39 adjustments overstated the profits of Equity Bank in 2007, KCB in 2011, Barclays Bank in 2009, Co-operative Bank in 2008 and CFC Stanbic in 2008 by 15, 19, 23, 10 and 23 per cent respectively,” said the Citigroup report. IAS 39 provides guidelines for how commercial banks are supposed to classify treasury securities in their books.
It states that commercial banks should observe the “mark-to-market” principle, which requires them to recognise in their books any capital losses incurred as a result of holding treasury bonds meant for trading.
The mark-to-market principle however exempts bond holders from recognising capital losses for fixed income securities that are held to maturity.
The Citigroup report estimated that the 2011 pre-tax profit for Kenyan banks, reported to have been Sh89.5 billion, was over-stated by at least one third.
Interestingly, the CMA memo also alludes to IAS 39, and also supports the Citigroup observation that SBB transactions were partly meant to facilitate banks’ re-classification of their treasury bond assets to cut losses.
“Liquidity squeeze by banks led to moving of securities from trading book to hold to maturity to avoid recording huge capital losses,” says the CMA memo.
The capital markets regulator traces the current popularity of SBB transactions among banks to early last year when interest rates started rising sharply following CBK’s decision to increase its policy lending rate to bring down inflation and stabilise the shilling.
As the Central Bank Rate (CBR) rose from six per cent to 18 per cent within a space of six months, commercial banks found themselves holding treasury bonds whose value had declined by large margins due to the inverse relationship between interest rates and the value of fixed income securities.
The bankers’ lobby, Kenya Bankers Association (KBA), however, strongly defended the sale-buy-back transactions. KBA chief executive Habil Olaka said the deals were done “in conformity” with international accounting standards.
