Kenya banks could be headed for zero growth this year

If the low growth rates in revenue and balance sheet persist and assuming interest rate cap remains, bank earnings are likely to head towards zero growth rate in 2019, finally reflecting the tougher economic and operating environment banking is in with the interest ceiling.

Banks are the principal institutions in driving economic growth. It is difficult to imagine economic success where banking sector outlook is weak and benign. The certain risks that Kenyan banks have to navigate remain relevant in driving Kenyan economic prosperity.

Role of bank as lenders to growth sectors

Banks must stay open for business across varied economic cycles. The lenders are of most importance during economic downturns, given that the core of banking is risk management. When economies tank and banks shut their doors as was the case in Greece in 2012, economic travesty is unavoidable. It is during economic distress that banks should show their true prowess in underwriting struggling economies. Kenyan banking has not yet matured to this level.

In Kenya, we have seen small businesses locked out of the credit market for the simple reason that with the interest rate cap, margins have halved from around 20 per cent to near 10 per cent. Banks are still operating in an economy where the reality of lending to the SMEs on a portfolio basis leads to around five per cent credit losses.

Inevitably, not all loans are repaid and with legacy cost structures and investments that create rigidity on how quickly banks can reduce operating expenses, another five per cent of this margin goes to covering expenses

This effectively means at a 10 per cent income margin due to the rate cap, profit made by banks from lending to the SME sector is zero to negative, from around above five per cent pre-rate cap era.

Simply put, for as long as the interest rate cap remains, banks have the difficult decision to either lend to the SME sector that drives economic growth at negative profit to their shareholders or pursue alternative capital allocation decisions that secure returns for their shareholders while the SME sector and the economy struggles. This is a tough spot to be at for an industry whose core role is to drive economic growth, yet it cannot ignore shareholder returns given shareholder capital provides the licence to operate.

The effort of the National Treasury to drive the repeal of the cap in the last parliament was very well timed and very well intended. Kenya should continue to look out for ways to repeal the cap, as this is the single most consequential micro factor that is holding back the potential of the Kenyan economy at the macro level.

Banks earnings and the investment case for bank stocks

The new IFRS9 accounting standards provided a window in 2018 that created an anomaly in bank profits for 2018, as some banks used capital reserves to clean up bad books, including cleaning up some credit losses earmarked for 2018.

Banking revenue growth was at low single digit and balance sheet growth was near zero given the rate cap still in place, while loan losses reduced by up to 70 per cent for certain cases, hence some banks reported profit after tax numbers at a double digit growth rate.

This profit growth level seen as at the third quarter of 2018 is neither sustainable nor driven by underlying business growth. It is largely driven by accounting treatment on the credit loss line.

Pervasively we may see some upside in future for banks from loan recoveries that are associated with the cleaned books through IFRS9.

But assuming the low growth rates in revenue and balance sheet and if interest rate cap persists, bank earnings are likely to head towards the zero growth rate level in 2019, finally reflecting the tougher economic and operating environment banking is in with the rate cap.

Given certain risk exposure variables uniquely apply for each type of businesses, average Price-to-Book (P/B) of the banking industry may substantially vary from other industries. However, we have seen P/B valuations of Kenyan bank stocks below global peers at 1.24.

More than half of the listed banks (six out of 11) are trading price to book value of below 1.0 meaning banks stocks are trading at a discount even when the lenders’ earnings are on the rise — this means the stock market is discounting accounting treatment driven profit growth.

Among the NSE listed banks, only Equity #ticker:EQTY, StanChart #ticker:SCBK and Barclays Kenya #ticker:BBK are valued at a premium to book value with an average P/B slightly above global peers – from 1.3 to 1.6.

As banks cannot price for risk, as earlier mentioned, while venturing into new businesses or off-balance sheet activities, their risk profiles become difficult to construct; which have presumably made investors concerned about hidden risk exposures.

Price-to-Earnings (P/E) ratio, which is mainly based on the easily-swung bank earnings, may move around given artificially low EPS outlook. It looks like the incentive to hold Kenyan bank stocks for value investors in the short to medium term is a sustainable dividend policy, rather than a sustainable profits and returns.

Banking regulation

Industry and commerce is regulated to ensure fair play - that all players play by the rules, that consumers and broad stakeholders are protected and simply that organisations do well and do good, while remaining good corporate citizens.

Banking is particularly highly regulated given the trust the industry has to bestow, and given that trust is the most important asset for any bank. We find ourselves – although well intended – in an overregulation cycle in banking in Kenya.

With more than five pieces of new regulation coming on stream in 2018, including the Draft Banking Sector Charter and the Financial Markets Conduct Bill that seem to overlap on intent and requirements, the compliance requirements and obligations on banks are becoming more and more complex.

There’s not a right or wrong answer on how much is enough regulation, but if to learn from the reciprocal cycles of the US banking regulation and deregulation over the past few decades, it is clear that over regulation curtails rapid innovation in financial services and deregulation ensures rapid short term growth.

Over the long term, banking overregulation has a net negative impact on economies.

In 2019, we are likely to see more regulation and laws being implemented in banking, making banking operations even more complex to manage and banking services even more costly. We should also anticipate the industry to be held in highest standards to predict and prevent financial crime, failures of which will be costly.

Banking industry consolidation

There have been seven small sub-scale mergers and acquisitions transactions in banking in the last two years, mostly driven by either bank failures or the need for entry to market and license acquisition motives. December 2018 saw the most consequential and market driven M&A deal announcement without any undue regulatory pressure.

This is the clearest indication that a market driven banking consolidation cycle is upon us. An economy of Kenya’s size can effectively be underwritten by a bulge bracket where a few banks control the industry.

The bank to population ratio in Kenya is 1:1 million compared to 1:3million in South Africa and 1:10 million in Nigeria, indicating that Kenya is overbanked.

Whilst big banks are not synonymous with safe and sound banks, there’s a benefit to an economy when banks of large-sized balance sheets can fund large-scale development projects, particularly in emerging markets like Kenya where capital and credit markets are yet to fully develop and bank lending, not capital markets, is overly relied upon to fund growth. For the consolidating banks the benefits are beyond gaining market power, as expanded capital base, potential synergies from integration, lower operating costs than the sum of the parts et-cetera mean that banks can pass efficiency benefits to consumers while remaining well capitalized, sustainable and profitable.

The banking consolidation cycle is now “officially” open for those with strategic appetite. Acquisition capital is unlikely to be a show stopper given the option of share swap arrangements that have been most effective routes of acquisition currencies elsewhere where banking has consolidated.

Kenya needs fewer and stronger banks, and when big banks begin to consolidate, it is an indication that we are in the middle of a consolidation cycle.

These coming years are likely to see a further market driven consolidation towards the five to 10 big strong banks, and much fewer small niche players, as that is what the Kenyan economy needs.

Configuring Barclays Kenya's business model accordingly

At Barclays, our new Growth, Transformation and Returns Strategy is driving a business model dynamic enough to navigate these structural challenges of the industry. We see our transition to Absa, with the rebranding due by June 2020, as an inflection moment, where we begin to operate this business closer to the consumer and local markets, making faster decisions, driving innovation together with the local consumer and running without the control and oversight of London which at most times left us slow, and locally uncompetitive.

Last year was testimony to this shift; for example, as at third quarter of 2018 our balance sheet grew fastest in more than a decade, our revenue grew fastest in eight years and our returns bottomed out. We outperformed our peer set on most metrics, and improved operating profit faster than our peer set.

We took a conservative and prudent view on IFRS9 as it relates to 2018 credit losses leading to relatively higher impairment increases than other players. Excluding the accounting treatment noise, we are taking market share on balance sheet, revenue and operating profit.

We are innovating ahead of market in certain parts, with proposition such as Timiza virtual bank leading to a doubling of our customer base in few months of launch.

Simply, with Absa, the bank is set and ready to move towards regaining its market leadership position over the long term.

Barclays Kenya stock price went up 14 per cent in 2018 and outperformed all listed banks and outperforming the banking industry whose stock prices went down 14 per cent on average, a validation that our growth strategy is working and that the transformation program started over five years ago is on course.

The investment thesis to our stock is growth, outgrowing the industry on top line revenue and balance sheet, while remaining competitive on cost efficiencies and optimizing capital to generate top quartile returns, excluding the one-off rebranding and investment costs.

And throughout the rebranding cycle, Barclays Kenya as well as our parent company – Absa Group – has committed to protect minorities from the short term increase in rebranding costs; therefore, dividend policy is unlikely to be impacted, on the downside, by one-off rebranding expenses.

On a total return basis, we are confident with our potential long-term EPS outlook post the rebranding cycle, normalized EPS excluding one-off costs during the rebranding cycle, and potentially higher dividend yield across the cycle.

If we continue to get the top line income growth right, we see our stock as a buy-and-hold option for investors.

In conclusion, the banking sector remains resilient, but faces material headwinds in 2019 that can be managed if banks are to continue playing their pivotal role in driving Kenya’s economic growth and prosperity.

Mr Muthui is an ex-Wall Street Investment Banker and Director of Strategy at Barclays.