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Banks continue understating credit risks despite huge rise

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Despite the stock of risky loans provision going up, banks are still not painting the true picture of the situation. FILE PHOTO | NMG

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Summary

  • In 2019, commercial banks’ total statutory loan loss reserves grew by 59 per cent year-on-year to Sh19.9 billion, according to disclosures.
  • This is a significant rise and shows lenders continue to understate credit risks. By definition, a credit risk is simply the likelihood of a borrower defaulting on their loan obligation(s).
  • But I must say that establishing whether a commercial bank is recognising the full extent of its underlying credit risks can be such a painful task, at least from my own years of experience.

In 2019, commercial banks’ total statutory loan loss reserves grew by 59 per cent year-on-year to Sh19.9 billion, according to disclosures.

This is a significant rise and shows lenders continue to understate credit risks. By definition, a credit risk is simply the likelihood of a borrower defaulting on their loan obligation(s).

But I must say that establishing whether a commercial bank is recognising the full extent of its underlying credit risks can be such a painful task, at least from my own years of experience. How a commercial bank treats certain relevant line items in its balance sheet though, can give you an idea of what is going on.

One such line item is statutory loan loss reserves, which, in simple terms, is some kind of a prudential warehouse.

There are two systems that provide the basis on which a bank assesses the risk of default: (i) accounting standards; and (ii) the prudential requirements (in this case the Central Bank of Kenya).

Accounting standards, in this case the International Financial Reporting Standards version nine (or IFRS 9), provide guidelines on how a financial institution assesses and treats its credit risks in a truthful and fair manner. However, given domestic circumstances, the regulator can override accounting assessments and impose additional requirements.

In summary, how a bank sees risks can be different from the way the regulator sees it. And therein arise some monetary differences.

On an ongoing basis, a commercial bank may assesses customer X and conclude that the risk of the client defaulting is medium; in which case it goes ahead and makes, for illustration purposes, a Sh100 in provision to cover a default event.

However, upon a supervisory audit of the customer’s file, the regulator, having gotten additional information about the customer by the bank, decides that the customer’s risk of defaulting is actually quite high (and not medium). Consequently, the regulator asks the bank to provide, for illustration purposes, Sh200 (instead of Sh100).

That difference in risks assessment results in a monetary under-provision of Sh100, which the bank promptly recognises in its books as a statutory reserve. However, if the converse was the case, then the statutory reserves would be recorded as nil.

On the accounting side, IFRS 9 has provided a very robust front-view mirror approach to risk recognition and treatment (as opposed to a previous rear-view mirror approach). Under the current regime, financial institutions have to build various price points that would help them assign a credit-risk rating to borrowers, which then determines their probability of default.

As opposed to its rear-view predecessor, it’s so strict that I expect to find stronger assessments that would not require prudential additions.

In short, under IFRS 9, statutory reserves should be nil. But in a case where they are growing by 59 per cent year-on-year, it just means that the prudential gap remained wider and I am left to wonder whether commercial banks are painting the true picture of the health of their loans.

The biggest culprits were the Tier one banks whose statutory reserves nearly doubled to Sh7.3 billion in 2019: In terms of quantum, Tier 2 banks had the highest reserves at Sh9.6 billion (being the result of a 21 per cent year-on-year growth). Tier 3 names, on the other hand, recorded the second largest annual growth of 46 percent to Sh3 billion.

@GeorgeBodo