Kenya's banking sector maintains its strong fundamentals

Kenya’s banking sector benefits from healthy fundamentals – a result due in large part to the Central Bank of Kenya’s (CBK) prudent regulatory oversight – which in turn has ensured steady growth in lending and assets, and strong performances for listed creditors. However, 2016 provided the sector with its fair share of challenges to navigate. Another bank closure – the third in two years – resulted in the issuing of arrest warrants and a takeover, while non-performing loans (NPLs) rose incrementally due to more stringent requirements on disclosure and a challenging business environment. External factors also dampened results, such as the outbreak of violence in South Sudan, where a number of Kenyan banks, including Kenya Commercial Bank (KCB), Co-operative Bank of Kenya (Co-op), Equity Bank and CfC Stanbic Bank, had profitable operations. Yet the most significant hurdle faced by banks was imposed domestically with the government rollout of an interest rate cap in August 2016 in an attempt to spur lending, which has led to uncertainty over near-term performance. Ultimately, the outlook for the country’s lenders is positive, however. A key driver of growth among Kenyan banks remains their ability to tailor products to meet Kenyans’ needs, which has helped the country attain one of the highest financial inclusion rates in the developing world, at 75%. As a result, the assessment for the sector’s performance is relatively encouraging.

Inclusion Indicators

As of early 2017 there were 41 licensed commercial banks operating in the sector – down from 43 in 2015 – and the mortgage-finance firm HF Group, formerly Housing Finance Company of Kenya. The number of banks is still high relative to Kenya’s 44.2m-person population. As a comparison, Nigeria has 22 banks for 180m people after a bout of consolidation, while South Africa is home to 19 banks for 55m people. Of all the banks operating in Kenya, three are owned by the state, and 13 are foreign-owned, including local subsidiaries and branches of foreign banks. The CBK also regulates three credit reference bureaus, 13 microfinance banks and 77 foreign-exchange bureaus.

In the market there are also over 4000 savings and credit cooperative societies (SACCOs), similar to credit unions in the US, of which 180 are deposit-taking SACCOs licensed by the SACCO Societies Regulatory Authority. SACCOs are often a first choice for new borrowers, particularly in the middle class and have become more influential in recent months.

By December 2015 the number of bank branches in the country had grown to 1523. A FinAccess geo-spatial mapping survey, released in October 2015, estimated that 73% of the population was living within a three-kilometre radius of a financial services touch-point, up from 59% in 2013 –one of the highest levels of any developing country. The figure is particularly impressive given that much of the population is dispersed across the country. Kenya’s urbanisation rate is only between 25% and 30%, well below that of many other emerging and frontier markets; Ghana and Nigeria, for example, have urbanisation rates closer to 50%, but have far lower financial inclusion rates.

Easy Access

The success Kenya has had in extending financial services to its citizens is partly due to the prevalence of agency banking, which has grown to include 40,224 agents registered to 17 commercial banks by March 2016. Agents, drawn from players across the commercial sector and licensed to conduct basic banking transactions on behalf of a designated bank, handled 79.89m transactions in 2015, worth KSh442.2.2bn ($4.3bn), consisting of mostly cash deposits and withdrawals. The CBK reported in 2015 that 90% of banking agents are registered with the three banks with the largest presence, Equity Bank with 16,734 agents, KCB with 11,948 and Co-op with 7956. The high penetration of ATMs, with the number of machines hitting 2656 by December 2016, also contributed to increasing financial inclusion.

Performance Figures

The performance of Kenya’s banking sector in recent years has been relatively stable. The loans-to-assets ratio fell slightly from 61.6% at end of March to 61.2% at the end of June 2016. The biggest increase in demand for credit was from financial services, and in the second quarter banks boosted lending to microfinance institutions (MFIs) and SACCOs by 42.7%, or KSh34.2bn ($333.7m). Perceived demand for credit was up in the building and construction, personal and household, and trade segments. Cash flow problems and slower business activity in certain segments meant that NPLs across the banking sector continued to climb in the first half of 2016, from a gross ratio of 7.7% of total loans in March to 8.3% by the end of quarter three. By mid-year the CBK had reported that the second half of 2016 would see the NPLs ratio fall on the back of improved macroeconomic factors; however, as of February 2017 that rate had risen to 9.7%, due in part to stricter credit standards and lacklustre credit growth.

The sector’s aggregate balance sheet saw impressive gains by end-June 2016, reaching KSh3.67trn ($35.8bn) – up 2.8% from end-March – after climbing 9.2% from KSh3.2trn ($31.2bn) to KSh3.5trn ($34.1bn) between December 2014 and 2015. Gross loans were up 1.8% to KSh2.27trn ($22.1bn), continuing the growth over 2015, a period which saw them climb 11.6% from KSh1.94trn ($18.9bn) to KSh2.17trn ($21.2bn). Deposits increased 2.6% to KSh2.62trn ($25.6bn), compared to KSh2.49trn ($24.3bn) at end-2015 and KSh2.29trn ($22.3bn) a year earlier. The CBK attributed the rise in deposits to innovative technology, and a growing number of branches and agency banking, which made it easier to mobilise deposits.

Cumulative, unaudited pre-tax profits for the three months leading up to June 2016 were KSh42.8bn ($417.6bn), up 11.7% from KSh38.4bn ($374.7m) on the first quarter. This was mostly driven by investment in government securities and increased lending interest rates. This reverses the 2015 trend where pre-tax profit was KSh134bn ($1.3bn) in December 2015, down from KSh141.1bn ($1.4bn) in 2014, as banks’ expenses climbed by 16% compared to income growth of 9%. This has done a lot to help improve the attractiveness of banks listed on the Nairobi Stock Exchange. According to local firm Cytonn Investments, Kenya’s listed lenders saw a 15.8% improved earnings per share growth over the first half of 2016 – above the expected 12.5% – compared to growth of 4.7% during the same period in 2015.

Mortgages

While mortgage loans are still uncommon, a shift in preference towards owning homes rather than renting means demand is rising with the expanding middle class. As of December 2015, 24,458 mortgage loans had been issued, up 11% from 22,013 a year before. The value of outstanding mortgage loan assets was KSh203.3bn ($198m) at year-end 2015, up 23% from KSh164.0bn ($1.6bn) from the previous year. Five institutions accounted for nearly 72% of mortgage lending, and the average loan size had reached KSh8.3m ($81,000) in 2015, up from KSh7.5m ($73,200) in 2014, due to increased property prices. The ratio of NPLs to gross mortgage loans was 5.8%, below the industry default ratio of 7%, indicating stricter requirements for Kenyan’s seeking to take out housing loans. The average loan maturity in 2015 was 9.6 years, down from 10.6 years in 2014.

Regulatory Buffers

In contrast to several other major banking markets in sub-Saharan Africa, Kenya’s banks continue to exceed regulatory requirements for capital. The capital adequacy requirement is 10.5% of total risk-weighted assets for core capital and 14.5% for total capital. Between March and the end of June 2016, the core capital ratio rose from 16% to 16.3%, while the total capital ratio increased from 18.8% to 18.9% – both well above the regulatory threshold. In 2015 the average liquidity ratio increased from 37.7% to 38.3% – well above the statutory minimum of 20.0%. While capital and reserves grew 7.7%, to reach KSh540.6bn ($5.3bn), up from KSh501.7bn ($4.9bn) a year earlier. The increase in reserves proceeded from added investment and capital by commercial banks to meet capital regulatory requirements and retained earnings from the previous year.

Interest Rates

The central bank rate (CBR) declined steadily over 2016, from 11.5% in February 2016 to 10% at year-end. The average lending rate across banks increased from 17.8% in the first quarter of 2016 to 18.1% in the second quarter, boosting bank profits for the first half of the year. However, the second half of 2016 saw the lending rate fall to 13.7%. Unsurprisingly, the sharp decline of lending rates started in September as the interest rate cap law took effect, bringing the maximum lending rate to 14% and setting a minimum 7% rate on deposits, based on the mid-September 10% CBR rate. In 2015 the average rate of interest on mortgage loans grew from 15.8% to 17.1%, with a range between 11.9% and 23%, according to the annual Residential Mortgage Market Survey 2015. Overall rates were down 10 basis points (0.1 percentage points) compared to end-December 2014. This came in spite of efforts by the CBK to reduce rates through competition and transparency. One of the main tools for this was the Kenya Banks Reference Rate (KBRR), which was introduced following discussions between the CBK, the Kenya Banker’s Association (KBA), the National Treasury and the private sector in 2014. The KBRR replaced the base-lending rate used by commercial banks to price their products and is based on the average central bank rate and the two-month moving average of the 91-day Treasury bill rate. The KBRR is set every six months and banks can determine what margin to add. A second initiative, also introduced in 2014, was the launch of the annual percentage rate, which allows for greater cost comparisons between banks.

Structure

The sector has been seeing a greater degree of concentration in recent years, which may point to potential consolidation in the medium term. The shift towards large banks – defined as those having more than 5% market share – was noticeable over the course of recent years.

The weighted market share of the seven Tier I banks, Equity Bank, KCB, Co-op Bank, Standard Chartered, Barclays Bank, Diamond Trust Bank (DTB) and Commercial Bank of Africa (CBA), rose from 49.9% in FY 2014 to 58.2% by FY 2015. That was due to a range of factors beyond performance; DTB increased its deposit base after Imperial Bank was placed into receivership, while CBA boosted deposits via its mobile-based M-Shwari savings account. Tier I banks also claimed a bigger share of the profits in 2015 at 70.3% of total sector pre-tax profit, compared to 61.0% in 2014. However, as Tier I banks continue to expand, Tier II and Tier III banks are seeing their share of the market shrink. Large banks are also a key sector player when it comes to financial outreach. This is in part reflective of the fact that many of those banks are locally owned. “Five to 10 years ago international banks used to lead the sector in primary market parameters, such as asset size and profitability. Now the top-three banks are local Kenyan banks,” Jared Osoro, director of research and policy at the KBA, told OBG.

Consolidation

With the regulator increasing scrutiny and the higher concentration of activity shifting market share to larger banks, consolidation is becoming a key focus in the sector. Further encouraging acquisitions is the moratorium on new banking licences issued by the CBK in November 2015.

In January 2015 Kenya’s largest SACCO by assets, Mwalimu National, bought a 51% share in Spire Bank – formerly Equatorial Commercial Bank – at a cost of KSh1.6bn ($15.6m), making it the majority shareholder. Adding to a series of strategic acquisitions over the last eight years, in June 2016 I&M Bank formalised its offer of KSh5bn ($48.8m) in cash and shares for control of Giro Commercial Bank. The bank was ranked 27th in the banking sector with 9000 customers served through seven branches and net profit of KSh452m ($4.4m) at the time. I&M Bank also voted in mid-2016 to acquire a 65% share in corporate finance advisory firm Burbridge Capital, although the terms of the deal have yet to be announced.

In an effort to strengthen ongoing EAC integration, Bank M became the first Tanzanian bank to enter the Kenyan market by buying a 51% stake in Oriental Commercial Bank, ranked 37nd by market share in December 2015. It has since been rebranded to M Oriental Commercial Bank. “Since the interest-capping regime was introduced, there is now uncertainty as to what value a smaller bank could bring to a larger bank which already has substantial operations. For consolidation, valuation will be at much lower priceto-book multiples than transactions completed in the previous year,” Eric Musau, senior research analyst at Standard Investment Bank, told OBG.

Anther government move which might further encourage mergers and acquisitions is the increase of the required core capital at commercial banks from KSh1bn ($9.8m) to KSh5bn ($48.8m). Cabinet secretary of the National Treasury, Henry Rotich, said he planned to introduce an increase in core capital requirements in September 2016, but Parliament voted it out, following the pattern in 2015 when the same requirement was introduced and rejected.

However, the increase in capital requirements may not translate into significant changes to the banking landscape if it is introduced gradually. “If you look at the market as a whole, new requirements may not reduce the number of banks,” Osoro told OBG. “If you increase core capital to $20m initially and move it up gradually, the number of banks falling below the threshold will be few in number.”

Microfinance

MFIs offer a variety of retail lending programmes. The two leading MFIs – Faulu, which was recently acquired by South African insurer Old Mutual, and Kenya Women Finance Trust – have a combined 80% share of the market. Several new MFIs have been licensed over the past two years, including Caritas Kenya, Daraja Microfinance Bank, Choice Microfinance Bank in 2015 and Maisha Microfinance Bank in mid-2016, bringing the total number of MFIs operating in the country to 13. By June 2016 deposits at microfinance banks amounted to KSh40.6bn ($396.1m) with lending totalling KSh49.1bn ($479.1m). Although, MFIs have the advantage of not being directly affected by the interest rate cap introduced in September 2016, many are looking into expanding operations and transforming into full-scale banks, a trajectory taken previously by locally owned Equity Bank and Family Bank, formerly building societies, which are now both fully functioning commercial institutions.

Regulations

The CBK has earned a reputation as a solid and strict overseer for the banking industry, and has increasingly sought to bolster the soundness and stability of the sector while also improving customer protections. The CBK’s regulatory regime focuses heavily on increasing transparency and data collection, improving bank resilience and innovation, and enhancing governance and accountability. “The central bank wants a much better capitalised system, and we are starting to see that with efforts to raise the level of integrity. This is important for the sector,” Musau told OBG. Over the past two years government regulation has been a particular focus, made more clear in the wake of one of the CBK’s sector reviews of key indicators. The CBK rates the soundness of commercial banks using the CAMEL (capital adequacy, asset quality, management quality, earnings and liquidity) rating system developed in the US.

In 2015 the sector received a “satisfactory” rating, compared to a “strong” rating in 2014. While the number of institutions rated “strong” was down from 22 to 11, those rated “marginal” were up from 0 to 2, “fair” from 5 to 8 and “satisfactory” from 16 to 19. The decline in performance is partially the result of changes made to the CBK’s oversight process. Gerald Nyaoma, director of bank supervision at the CBK, wrote that regulatory reforms include improving the consolidated supervision framework, and developing an improved framework to identify systemically important banks and better monitor them.

Fraud protection, risk management and internal controls have also become targets of the CBK’s regulatory reforms as data from the Banking Fraud and Investigation Department indicated that fraud cases relating to computer, mobile and internet banking was steadily increasing. In some cases the regulatory oversight has not kept up with the technology. Bank card fraud, for example, was attributed to “limited exposure to computer-based transaction processes that have not been matched with effective preventive and detective controls,” as stated by the CBK in the “Bank Supervision Annual Report 2015”.

As a result, training supervisory staff in ICT and forensic audits, and hiring more staff to reduce risk, was a key target in 2016 and part of broader efforts to boost controls, auditing and risk management.

Quick Action

Those have not been the only challenges the CBK has had to face, and 2016 certainly tested the regulator, with a number of challenges forcing it to take quick action. In March 2016 the country’s 10th biggest lender at the time, National Bank of Kenya, launched an internal audit which resulted in CEO Munir Ahmed, and five high-ranking managers, being placed on forced leave and arrest warrants being issued by the police.

In April 2016 the release of contradictory financial statements involving loans to employees, directors and shareholders saw medium-sized lender Chase Bank put into receivership by the CBK a day after it reported losses of KSh686m ($6.7m) for 2015, down from KSh2.4bn ($23.4m) in profit in 2014. The bank restated internal loans to at KSh13.6bn ($132.7m) only a week after it said they were KSh3.2bn ($31.2m). Depositors flocked to ATMs and bank branches to withdraw their money, spurred by alarmist messages spread on various social media platforms. The CBK and the Kenya Deposit Insurance Corporation (KDIC) moved quickly to sort out the problem bank, and arrest warrants were issued for executives. The KCB was appointed manager, and by the end of the month branches across the country had been reopened, and Chase was once again permitted to start taking deposits and making loans from August 2016.

Imperial Bank was placed under receivership by the CBK in early-2015 after a notification by the bank’s directors that there were “inappropriate banking practices that warranted immediate remedial action” and the discovery of massive fraud. In July 2016 the KDIC agreed to reimburse depositors. Payments continued throughout the end of the year in three instalments providing relief for the some 44,300 former customers, most of who are small business owners. As of April 2017, the bank remained under receivership.

These are not the first times that the regulator has tackled these sorts of issues, and it has frequently moved aggressively to improve the health of the sector. The CBK put Dubai Bank into receivership in 2015, before liquidating it, a result of insider trading, theft of customer funds, parallel banking and defaults which had come to light in a 2012 wrongful dismissal case.

Rate Cap

The banking sector has had to navigate other challenges over 2016 as well. Perhaps the most wide-reaching was the passage of the Kenya Banking (Amendment) Act 2016, which established a compulsory cap on lending rates at four percentage points – 400 basis points – above the base rate, which was defined as the CBR. It was signed into law at the end of August and effective by mid-September. It also required more disclosure on charges, while deposit rates had to be at least 70% of CBR.

Initially, bank shares were sent tumbling 15.6% with investors losing KSh88.9bn ($867.4m) in two days following the passage of the law. Banks with large retail bases, such as Equity and Co-op, which lend primarily to small and medium-sized enterprises (SMEs) and the sub-prime segment, were down by more than 20%.

The bill, which was passed in order to improve access to credit, particularly for low-income families and SMEs, by reducing the cost of capital and protect from exploitative interest rates, nonetheless prompted concern from lenders. Local firm Cytonn Investments said the 4% risk premium would mean less available credit to smaller enterprises. Some banks told savers they would stop offering deposit accounts, while other banks stopped issuing emergency and unsecured loans, including for motor vehicles.

Those predicted to gain from the interest rate cap include banks that lend to primary and corporate entities, individual clients with collateral on offer and alternative financing operations, such as MFIs, that are not under the jurisdiction of the new law.

The law has drawn a wide array of criticism, with IMF deputy managing director Tao Zhang recommending in January 2017 that Kenya do away with the law citing potential long-term damage to the market. By March the same year, Patrick Njoroge, governor at the CBK, hinted to local media the law may be repealed.

Technology

The middle class is increasingly reliant on recent technological innovations such as mobile and online banking; most of which have been driven by non-banking actors. Kenya has seen enormous success with mobile money to a degree that other markets on the continent have tried to replicate.

The M-Pesa system is the largest programme in the country, holding roughly two-thirds of the mobile market. The system has achieved tremendous growth in Kenya since its launch in 2007 by telecoms operator Safaricom. In FY 2016 a 13.8% growth in service revenue, a 7.8% growth in customer base and KSh41.5bn ($404.9m) in transactional revenue was attributed solely to the M-Pesa system, which plays a major role as a profit stream for the operator. Mobile money contributed 23% of Safaricom’s total revenue for FY 2016, up from 21% the year before.

The system’s success benefitted from a number of factors – including high demand, a lighter touch regulatory approach by the CBK and Safaricom’s majority market share – but crucially, it was driven by the telecoms sector rather than banks.

A number of other services have since joined the fray, including Airtel, MobiKash, Orange, Tangaza Pesa and Equitel Bank, almost all of which have been launched by mobile operators or financial technology firms (see Telecoms chapter). At the end of quarter two in FY 2016/17, according to the Communications Authority of Kenya, 262.6m mobile money transactions took place valued at KSh586.4m ($5.7m), with person-to-person transactions totalling KSh515.9 ($5m).

Competition is likely to increase further in the coming months. The CBK said it received over 60 applications for new mobile banking products in 2015. In each case, as with the existing services, the offerings are diverse, ranging from loan products that allow users to save and borrow small amounts using their mobile phones to emergency payment instruments for electricity. One of the goals of the CBK, and the government more broadly, in encouraging mobile and digital banking activity is to reduce cash transactions, which are costly and inefficient.

However, there is a long way to go. A 2014 report by McKinsey found that 94% of transactions taking place in Kenya were still in cash, for example. Online and mobile commerce is still held back by “the low penetration of credit and debit cards in Kenya – a factor that has inhibited e-commerce,” Rutendo Hwindingwi, divisional director for accounting software provider Sage in East and West Africa, told local media.

Meanwhile, efforts by the financial services sector to upgrade technology are not limited to end-user apps or services. Banks have invested heavily in back office software to reduce overhead costs and improve efficiency. The CBK said the most common core-banking systems included Oracle Flexcube, Temenos T24 and Finacle, with iMAL widely used for Shariah-compliant products. In 2014, on average, one bank employee served 770 customers; a year later that number grew to 972 customers. Banks were able to cut clerical staff by 11% in 2015, which brought overall banking sector employment down 2% to 36,200 by the end of 2015.

Regional Footprint

10 Kenyan banks, including the KCB, DTB, Bank of Africa and Equity Bank, operate in other countries in East Africa and South Sudan. Kenyan banks operate 140 branches in Uganda, 96 in Tanzania, 55 in Rwanda, 33 in South Sudan and 9 in Burundi. The biggest cross-border banks are the KCB and DTB with 64 regional branches each. Others include, I&M Bank, with a 50% shareholding in Bank One Mauritius; Prime Bank, with a 22.5% share in First Merchant Bank of Malawi; and Equity Bank, which acquired a subsidiary in Democratic Republic of Congo.

Regional business is growing and in 2015 there were KSh205.2bn ($2b) of loans –up 8.4% from 2014 – and KSh347.8bn ($3.4bn) of deposits. Nearly 69% of the total assets are in Tanzania and Uganda.

The biggest share of total regional banking profits in 2015 came from South Sudan. However, hyperinflation and the political situation have dramatically changed the profitability since, leaving banks reporting that 2016 was the slowest growth in seven years, a sharp turn from 2015’s bumper year. Outlooks for Tanzania and Rwanda seem far healthier.

Outlook

Sector challenges may have slowed growth temporarily, but the underlying fundamentals for Kenyan banks look strong and stable for the medium term. Kenya’s banks are fast-growing, responsive, innovative and increasingly more well-regulated.