CBK targets rogue bank directors with fresh audit of insider loans

The Central Bank of Kenya (CBK) has ordered an audit of insider loans across the entire banking system in a tightening of supervision that has caused panic among some institutions.

The move comes after Chase Bank went into receivership on April 7, prompted by a run that was caused by the restatement of accounts showing loans to directors and employees more than quadrupled to Sh13.6 billion last year.

Chase Bank reopened its doors yesterday.

READ: Relief as Chase Bank reopens with mixed fortunes for savers

The CBK wrote to all external auditors of banks last Friday, asking for an audit of insider loans by May 31.

“The central bank hereby instructs all external auditors of commercial banks and mortgage finance companies to conduct audits on institutions’ insider lending as per the attached terms of reference,” CBK governor Patrick Njoroge wrote in the letter sent to the banks, adding that “the report of the special audit should be submitted to the central bank by May 31, 2016”.

The CBK letter says the objective of the audit is to ascertain that insider lending by the institutions complies with Section 11 of the Banking Act, which places restrictions on advances, credits and guarantees.

The auditors are to obtain and review a list of all individuals (officers, directors, and significant shareholders) and their associates and companies.

Loans to these entities are to be compiled and compared with insider lending officially reported to the CBK to determine whether all lending to the related parties are actually disclosed to the regulator.

Auditors are also mandated to ensure that all insider loans were fully secured, got full board approval, made in the normal course of business and on terms similar to those offered to ordinary customers.

The audits should also find out if the CBK was notified of such loans within seven days after approval.

Besides, auditors must ascertain that the amount lent to one person does not exceed 20 per cent of an institution’s core capital and that all insider loans do not exceed 100 per cent of the core capital in aggregate.

The CBK has powers to aggregate the indebtedness of associated entities or those with common interests, meaning that the regulator can find insiders to be in breach of the set limits if they have spread their borrowing over many entities to circumvent the law.

Several penalties await offenders, including removal of directors and key officers, who will also be forced to compensate an institution for any loss arising from such lending. Auditors will furnish the regulator with an executive summary, background and methodology, scope, findings and recommendations on prioritised actions and timelines.

Audited institutions will foot the bill of the special audit.

Corporate governance

The move is seen as a bid by the CBK to get a true picture of banks’ risk exposures and corporate governance standards in line with the overall theme of cleaning up the banking sector.

Some lenders have, however, termed the regulator’s action hasty, adding that it could have the unintended consequence of causing a new wave of panic in the industry.

“It is good to weed out bad bankers but the urgency with which it is being implemented could cause the failure of more banks,” a CEO of a bank, who cannot be named criticising the regulator, told Business Daily.

The source further claimed that the CBK had denied some small lenders liquidity support — a move that leaves them with the option of merging with bigger rivals.

The bank executive said this latest move represents a big shift in Dr Njoroge’s position on consolidation of banks, having vehemently opposed the proposal when Treasury secretary Henry Rotich made it in last year’s budget.

Though not confirmed, denial of liquidity to a distressed bank would also represent a big shift in the CBK’s position.

The financial services sector regulator two weeks ago pledged unlimited support to all deserving banks that suffer a liquidity crunch in the wake of Chase Bank’s failure.

Ironically, Chase Bank had itself been denied similar line of credit days before it ran out of cash to pay depositors.

The special audit is expected to reveal the full extent of directors’ and shareholders’ dealings with their banks and whether these were done prudently and within the law.

“My reading of this is that the CBK wants to establish how problematic insider lending is so as to effectively deal with it,” a senior partner in one of the major audit firms said, adding that Chase Bank’s insider loans may have awakened the regulator to a potential blind spot that it now seeks to tackle.

The audit of Islamic banking assets/loans has, however, proved controversial after former Chase Bank chief executive Duncan Kabui insisted they are not loans in the normal sense but rather represent joint equity investments with customers in line with Shariah law.

Mr Kabui revealed that the bank was forced to reclassify the investments as insider loans, breaking with the tradition that had previously not been objected to by its auditors Deloitte East Africa.

This, he said, resulted in the restated accounts showing a Sh10.4 billion increase in total insider loans to Sh13.6 billion in the year ended December, compared to Sh3.2 billion the year before.

Most of the insider loans were held by directors, shareholders and associates, and employees.

Mr Kabui, who insisted that the audit work had not actually been completed, said he was a director in the investment vehicles as a trustee for Chase Bank’s Islamic banking business and that classifying him as a borrower was erroneous.

The upcoming audit could help resolve the treatment of Islamic banking assets in financial statements.