Dec 8, 2019

Following the release of the Q3’2019 results by Kenyan listed banks, the Cytonn Financial Services Research Team undertook an analysis on the financial performance of the listed banks and identified the key factors that shaped the performance of the sector, and our expectations of the banking sector for the rest of the year.

The report is themed “Higher Net Interest Margins and Consolidation to Drive Growth in the Post Rate Cap Era” as we assess the key factors that influenced the performance of the banking sector in the third quarter of 2019, the key trends, the challenges banks faced, and areas that will be crucial for growth and stability of the banking sector going forward. As such, we shall address the following:

1. Key Themes That Shaped the Banking Sector Performance in Q3’2019,
2. Summary of The Performance of the Listed Banking Sector in Q3’2019,
3. The Focus Areas of the Banking Sector Players Going Forward,
4. Brief Summary of the Outcome of Our Analysis, And
5. Conclusion.

Section I: Key Themes That Shaped the Banking Sector Performance in Q3’2019

Below, we highlight the key 7 themes that shaped the banking sector in Q3’2019, which include repeal of the interest rate cap, consolidation, regulation, and asset quality:

1. Repeal of the Interest Rate Cap (Banking (Amendment) Act, 2019): During the quarter, President Uhuru Kenyatta submitted a memorandum to the Speaker of the National Assembly detailing his refusal to assent to the Finance Bill 2019. The President, instead, recommended a repeal of the interest rate cap. In the memorandum, the President cited that while the purpose of the capping was to address the widespread concerns about affordability and availability of credit to Kenyans, the capping of interest rates instead caused unintended consequences that are significant and damaging to the economy and Micro, Small and Medium Enterprises (MSMEs). During the last parliamentary sitting on November 5^th when the MPs were supposed to vote on the presidential memorandum on interest rate caps law there were only 161 members present, which did not provide the two-thirds majority quorum needed to debate the issue this resulted in the failure to overturn the recommendations by President Uhuru thus allowing the repeal of the interest rate cap.

With the interest rate cap repealed, we expect increased access to credit by borrowers that have been shunned under the current regulated loan-pricing framework going forward as well as increased Net Interest Margins (NIMs) due to higher yields on interest-earning assets coupled with a reduction in the cost of funds following the removal of interest rate floors in 2018, that required banks to pay lenders at least 70.0% of the base lending rate. This has seen deposit rates hit a 36-month low in September 2019, to stand at 4.6% compared to 6.3% in September 2018 as lenders continue to ride on cheaper deposits.

Read our most recent report focusing on the interest rate cap here.

2. Consolidation: Consolidation remained a key highlight in Q3’2019 with the following being the major M&A’s activities witnessed during the quarter by the top three banks in the industry:

1. 1. On 27^th September 2019, the Central Bank of Kenya approved the merger and name changes of NIC Group and Commercial Bank of Africa (CBA), which paved the way for the merged institution to officially start operating as NCBA Group PLC. Read more information on the same here, and,
   2. KCB Group also received approval from the regulator to acquire a 100% stake in National Bank which increased its shares from 3.07 bn units to 3.21 bn units, lifting the lenders market capitalization to Kshs. 135.6 bn from Kshs. 129.3 bn. Read more information on the same here

        Other mergers and acquisitions that have happened or been announced recently include;

1. Equity Group Holdings, in its expansion strategy, has various on-going acquisitions in the region which are inclusive of a 62.0% of the share capital of Rwanda’s Banque Populaire du Rwanda, and 100.0% of African Banking Corporation Mozambique, African Banking Corporation of Zambia, and African Banking Corporation of Tanzania. These acquisitions will allow Equity Group Holdings an easy penetration into these four African countries. Further, the lender is set to acquire a 66.5% stake in Banque Commerciale du Congo (BCDC), a top bank in the Democratic Republic of Congo owned by the George Arthur Forrest family. Read more information on the same here
2. Commercial International Bank sent an application to the Competition Authority of Kenya propositioning to acquire a controlling interest in Mayfair Bank, a Tier III Kenyan bank. Mayfair is the fourth-smallest lender in Kenya and it recorded a loss of Kshs. 250.0 mn in Q3’2019, and,
3. Access Bank Nigeria is set to acquire Transnational Bank following the approval by the Competition Authority of Kenya and Central Bank of Kenya. Access Bank is expected to acquire a controlling stake equivalent to 93.57% of Transnational Bank Ltd. Transnational Bank reported a full-year pre-tax loss of Ksh 98.5 million in 2018.

Below is a summary of the deals in the last 5-years that have either happened, been announced or expected to be concluded:

Acquirer	Bank Acquired	Book Value at Acquisition (Kshs. Bns)	Transaction Stake	Transaction Value (Kshs. Bns)	P/Bv Multiple	Date
Access Bank (Nigeria)	Transnational Bank Ltd.	1.9	93.6%	Undisclosed	N/A	Oct-2019*
Oiko Credit	Credit Bank	3.0	22.8%	1.0	1.5x	Aug-19
KCB Group	National Bank of Kenya	7.0	100.0%	6.6	0.9x	Sep-19
CBA Group	NIC Group	33.5	53%:47%	23.0	0.7x	Sep-19
CBA Group	Jamii Bora Bank	3.4	100.0%	1.4	0.4x	Jan-19
AfricInvest Azure	Prime Bank	21.2	24.2%	5.1	1.0x	Jan-19
KCB Group	Imperial Bank	Unknown	Undisclosed	Undisclosed	N/A	Dec-18
SBM Bank Kenya	Chase Bank Ltd	Unknown	75.0%	Undisclosed	N/A	Aug-18
DTBK	Habib Bank Kenya	2.4	100.0%	1.8	0.8x	Mar-17
SBM Holdings	Fidelity Commercial Bank	1.8	100.0%	2.8	1.6x	Nov-16
M Bank	Oriental Commercial Bank	1.8	51.0%	1.3	1.4x	Jun-16
I&M Holdings	Giro Commercial Bank	3.0	100.0%	5.0	1.7x	Jun-16
Mwalimu SACCO	Equatorial Commercial Bank	1.2	75.0%	2.6	2.3x	Mar-15
Centum	K-Rep Bank	2.1	66.0%	2.5	1.8x	Jul-14
GT Bank	Fina Bank Group	3.9	70.0%	8.6	3.2x	Nov-13
Average			75.2%		1.4x
* Announcement date

3. Regulation - The impactful regulations of the banking sector included IFRS 9 and demonetization:
   1. IFRS 9 - The effects of IFRS 9 to banks continue to be seen as more banks use the 18-months to 24-months window to comply with the requirements of the new standards. The implementation of the IFRS will force banks to report their losses through their profit and loss statements instead of through the balance sheets as was done before. This has led to decreased profitability of the banks which can be evidenced by the increase in weighted average loan loss provisions to Kshs. 2.8 bn from Kshs. 1.8 bn in Q3’2018, and,
   2. Demonetization: In an effort to track illicit financial flows, the Central Bank of Kenya concluded the withdrawal of the older Kshs. 1,000 banknotes and introduce new notes. After the demonetization exercise, which had little impact on inflation or the exchange rate, Kshs. 7.4 billion, or 3% of the total value in the circulation of Kshs. 1,000 notes, was rendered worthless. In some cases, this exercise has tightened liquidity in the money market that prompts people to seek alternatives on digital platforms, which ultimately encourages people to use digital banking platforms more, thus, increasing NFI from fees and commissions.
4. Asset Quality - Asset quality improved in Q3’2019 with the gross NPL ratio decreasing by 10 bps to 9.8% from 9.9% in Q3’2018. However, this was still high compared to the 5-year average of 8.2%. The major sectors contributing largely to NPLs include real estate, retail, and manufacturing sectors, which saw lenders such as Stanbic Holdings suffer huge impairment losses from ARM, having lent the manufacturing company Kshs. 3.3 bn. Similarly, KCB Group and Co-operative Bank suffered from Uchumi Supermarket’s loans default which translated to the lenders having to write off loans valued at Kshs. 656.0 mn with Co-operative Bank waiving 40.0% of its loan.

The chart below highlights the asset quality trend:

5. Revenue Diversification: Listed banks continued their revenue diversification drive by growing the Non-Funded Income (NFI) segment, with various banks launching several initiatives as highlighted below:

1. 1. KCB Bank deployed its Digital Customer Service platform as part of their digital transformation efforts. Aside from improved customer experience, their platforms will be able to collect real-time data on customers, then analyze and use it to make educated decisions on how to improve operations on an ongoing basis. This launch made KCB the third company in Africa to launch a WhatsApp banking solution following First Bank of Nigeria and HF Group,
   2. Co-operative Bank of Kenya launched the Co-op Bank Property Hub under its mortgage division, which will offer property sales and mortgage origination to its clients. The Property Hub intends to serve the clients who have a property to sell and connect them to the Co-operative Bank clients who want to buy a property. The bank will also offer mortgages to the buyers of the property as it expects to leverage on its contacts with key institutions and the cooperative movements that largely own the bank to boost the property sales for its clients. For more information, please see our Kenya Mortgage Refinancing Company Update & Cytonn Weekly #17/2019,
   3. Co-operative Bank also highlighted its plan of growing the business of its leasing-focused subsidiary Co-op Bank Fleet, which intends to leverage on the synergies created by Co-operative Bank’s client base to grow its business, with the main business case of the subsidiary is the easing of the cash flow constraints of acquisitions of fleets, repair and maintenance, thus allowing businesses to focus on their core business. For more information, please see our report Nanyuki Real Estate Investment Opportunity, 2019, & Cytonn Weekly #23/2019,
   4. Diamond Trust Bank Kenya (DTBK) announced that it has partnered with SWIFT, a leading provider of secure financial messaging services, in order to provide real-time cross border payments to its clients. DTBK will be the first East African Bank to go live on the SWIFT global payment innovation service, a service that is carrying out over USD 30.0 bn worth of transactions a day, in over 148 currencies. For more information, please see our Kenya Mortgage Refinancing Company Update & Cytonn Weekly #17/2019, and,
   5. Standard Chartered Bank Kenya (SCBK) launched an innovation hub lab in Nairobi dubbed Xcelerator in a bid to boost its revenue streams and diversify by riding on financial technology. SCBK plans to allocate Kshs 10.0 bn into supporting Financial Technology (FinTech) startups to scale up and generate innovative solutions to problems in the banking sector. StanChart views FinTech firms as partners amid their growing disruption of the local financial sector, a move likely to aid the bank in generating additional revenue. For additional information, please see our Cytonn Weekly #15/2019.

6. SME Focused Services: Q3’2019 saw a majority of banks shift their focus to SME lending among other services by providing SME targeting services with various banks focusing on SME lending as highlighted:

1. 1. 1. In September 2019, Equity Group joined the global SME financing Forum only after CBA and Co-operative Bank with the goal of the forum being to promote the financial growth of SMEs. This followed the move by Equity Group to offload Kshs. 150.0 bn worth of treasury bills and redirect the funds to SME lending,
      2.  Central Bank of Kenya launched a mobile loan app called Stawi in partnership with five Kenyan banks including; NCBA Group Plc, Co-operative Bank of Kenya, Diamond Trust Bank Kenya, KCB Bank, and NIC Bank. This app will give access to MSMEs ranging from Kshs. 30,000 to Kshs. 250,000. Further, it allows for a repayment period of 1-12 months at an interest of 9.0% p.a. Clients who have paid 80.0% of the loan within a record time of 3 months receive a cash reward.

7. Rebranding: In Q3’2019, we have seen the following banks rebranding in an effort to capture more market share by improving their public image and the brands' recognition:
   1. Barclays Africa Group - Barclays Africa Group’s rebranding to ABSA has been ongoing since 2018 with the plan to rename all the subsidiaries in Africa realigning the banks to their South African roots. The new identity is meant to show the banks' scalability in Africa and reflect its strategy of being forward-looking. This move also reflected a cultural transformation where they promised that their quality and extensity of services would change and improve with the new brand,
   2. NCBA- Following the merger of NIC Bank and CBA, the merged entity NCBA announced that it would amend its logo and streamline its services whereby what will be offered will be better than the previous offering in the individual banks. They are also trying to follow suit of the other big banks by publicizing their strategy to focus on SME services and part of their goal is to close some of the overlapping branches and spread out further than the 41 counties they are currently operating to reach more SMEs especially those in marginalized areas.

Section II: Summary of The Performance of the Listed Banking Sector in Q3’2019:

The table below highlights the performance of the banking sector, showing the performance using several metrics, and the key take-outs of the performance.

Bank	Core EPS Growth	Interest Income Growth	Interest Expense Growth	Net Interest Income Growth	Net Interest Margin	Non-Funded Income Growth	NFI to Total Operating Income	Growth in Total Fees & Commissions	Deposit Growth	Growth in Government Securities	Loan to Deposit Ratio	Loan Growth	Return on Average Equity
HF Group	74.5%	(11.9%)	(16.6%)	(4.3%)	4.5%	78.9%	38.4%	129.3%	(0.1%)	(7.0%)	113.3%	(13.7%)	(3.3%)
BBK	19.0%	5.6%	17.1%	2.0%	8.5%	8.1%	32.1%	30.9%	6.9%	3.0%	82.5%	8.8%	17.4%
NCBA	16.3%	2.7%	(3.7%)	8.8%	5.3%	23.3%	47.2%	21.7%	10.7%	7.4%	66.8%	8.2%	14.9%
I&M Holdings	13.4%	7.2%	12.9%	2.9%	6.0%	14.0%	37.5%	5.1%	13.0%	(0.7%)	73.7%	6.6%	17.2%
Equity Group	10.4%	11.2%	16.8%	9.5%	8.4%	13.7%	41.1%	15.0%	18.9%	7.8%	73.0%	21.0%	21.7%
DTBK	7.5%	(7.3%)	(7.0%)	(7.5%)	5.6%	5.7%	22.3%	(2.5%)	0.3%	(1.2%)	67.8%	(2.9%)	14.6%
KCB Group	6.2%	4.6%	(0.8%)	6.5%	8.2%	16.9%	35.2%	28.5%	11.4%	7.5%	82.9%	11.7%	22.2%
Co-operative Bank	5.5%	(1.6%)	0.9%	(2.7%)	8.3%	33.3%	40.0%	46.6%	8.9%	13.6%	83.4%	5.8%	18.4%
SCBK	(1.3%)	(6.3%)	(23.7%)	0.6%	7.5%	(1.1%)	32.2%	7.0%	2.4%	(7.9%)	52.7%	6.8%	16.9%
Stanbic Bank	N/A	11.3%	9.3%	12.6%	6.9%	18.3%	47.7%	23.3%	5.4%	(33.2%)	84.6%	14.6%	18.5%
Q3'2019 Mkt Weighted Average*	8.7%	4.5%	4.3%	4.9%	7.7%	15.8%	37.9%	22.6%	11.0%	3.3%	75.7%	11.6%	19.3%
Q3'2018 Mkt Weighted Average**	16.2%	6.1%	12.5%	3.8%	8.0%	5.9%	34.5%	0.6%	7.4%	17.8%	75.3%	4.2%	18.8%
*Market cap weighted as at 29/11/2019
**Market cap weighted as at 30/11/2018

Key takeaways from the table above include:

1. The above ten listed Kenyan banks recorded an 8.7% average increase in core Earnings per Share (EPS), compared to an increase of 16.2% in Q3’2018 for all listed banks,
2. The banks recorded stronger deposit growth, which came in at 11.0%, faster than the 7.4% growth recorded in the sector in Q3’2018. Interest expenses increased at a slower pace of 4.3%, compared to 12.5% in Q3’2018, indicating the banks have been able to mobilize relatively cheaper deposits,
3. Average loan growth came in at 11.6%, which was faster than the 4.2% recorded in the sector in Q3’2018, indicating that there was an improvement in credit extension by the banks. Government securities recorded a growth of 3.3% y/y, which was slower compared to loans, and a decline from the 17.8% recorded in the sector in Q3’2018. This highlights that banks are beginning to adjust their business models back to private sector lending as opposed to investing in government securities, as the yields on government securities declined during the quarter. Interest income increased by 4.5%, lower than the 6.1% growth recorded in the sector in Q3’2018. Consequently, the Net Interest Income (NII) grew by 4.9% compared to a growth of 3.8% in the sector in Q3’2018,
4. The banks recorded a Net Interest Margin of 7.7%, 30 bps lower than the 8.0% recorded in the sector in Q3’2018. The decline was mainly due to a decline in yields recorded in interest earnings assets following the decline in government securities yields, coupled with the decline in yields on loans due to the 50-bps decline in the Central Bank Rate since the end of Q3’2018, and,
5. Non-Funded Income grew by 15.8% y/y, faster than the 5.9% recorded in the sector in Q3’2018. The growth in NFI was boosted by the total fee and commission income which improved by 22.6%, compared to the 0.6% growth recorded in the sector Q3’2018, owing to the faster loan growth.

Section III: The Focus Areas of the Banking Sector Players Going Forward:

In summary, the banking sector showed improved performance, which was largely attributable to persistent revenue diversification evidenced by the increase in NFI, majorly the growth in fees and commissions. Correspondingly, the increase in loan growth evidenced a trend of banks refocusing on core operation in Q3’2019 albeit the sector was plagued by stringent regulations particularly the interest rate cap, which contributed to the decrease in interest income and hence, net interest margins. With the loosening of the regulations particularly the repeal of the interest rate cap, the sector can focus on the following items to increase growth and profitability:

1. Continued Revenue Diversification - The increase in NFI growth outperformed that of interest income, thus, allowing the banks to remain profitable amid rigid regulatory environment. However, with the regulations having been loosened banks will need to continue diversifying their income in order to reduce their reliance on interest income, thus, decreasing the pressure on interest rates. For example, Co-operative Bank’s “Soaring Eagle Initiative” enables both channel diversification through internet banking, Mco-op cash and merchant banking among others, as well as consultancy and capacity building,
2. Refocus on Core Operations - With the option of pricing loans based on risk profiles following the repeal of the interest rate cap, banks will be able to increase interest rates with bias to credit risk rating of borrowers, which will in turn improve their interest income. This was already witnessed in Q2’2019 and Q3’2019 where banks have increased SME lending which in turn increased loan growth. This can be expected to persist post the interest rate cap era, and,
3. Expansion and Further Consolidation - With the Microfinance-Bill 2019 of increasing the minimum on core capital requirements still in its pilot stage more mergers and acquisitions would enable the unprofitable and/or smaller banks to manage the requirement and be able to increase profitability through cost efficiency and deposits growth.

Section IV: Brief Summary of the Outcome of Our Analysis:

As per our analysis on the banking sector from a franchise value and from a future growth opportunity perspective, we carried out a comprehensive ranking of the listed banks. For the franchise value ranking, we included the earnings and growth metrics as well as the operating metrics shown in the table below in order to carry out a comprehensive review of the banks:

Bank	Loans to Deposits Ratio	Cost to Income Ratio	Return on Average Capital Employed	Deposit/Branch	Gross NPL Ratio	NPL Coverage	Tangible Common Ratio	Non-Funded Income/Revenue
Co-operative Bank	83.4%	56.2%	18.4%	2.1	10.5%	55.5%	16.2%	40.0%
KCB Group Plc	82.9%	54.4%	22.2%	2.3	8.3%	56.5%	15.3%	35.2%
DTB Kenya	67.8%	52.2%	14.6%	2.2	8.9%	48.0%	15.1%	24.1%
Equity Group Holdings	73.0%	54.8%	21.7%	1.6	8.4%	45.8%	15.0%	41.1%
NCBA Group Plc	66.8%	62.0%	14.9%	4.5	12.4%	60.2%	13.6%	47.2%
Barclays Bank	82.5%	63.3%	17.4%	2.7	6.8%	78.6%	12.0%	32.1%
Standard Chartered Bank	52.7%	57.7%	16.9%	6.6	14.9%	77.0%	15.8%	32.2%
I&M Holdings	73.7%	48.6%	17.2%	5.6	12.7%	62.5%	15.5%	37.5%
HF Group Plc	113.3%	102.9%	-3.3%	1.6	28.2%	44.4%	16.9%	38.4%
Stanbic Bank/Holdings	84.6%	63.5%	18.5%	7.4	10.9%	58.9%	12.6%	47.7%
Weighted Average Q3'2019	75.7%	56.6%	19.3%	3.1	9.8%	57.8%	14.8%	38.0%

The overall ranking was based on a weighted average ranking of Franchise value (accounting for 40%) and intrinsic value (accounting for 60%). The Intrinsic Valuation is computed through a combination of valuation techniques, with a weighting of 40.0% on Discounted Cash-flow Methods, 35.0% on Residual Income and 25.0% on Relative Valuation, while the Franchise ranking is based on banks operating metrics, meant to assess efficiency, asset quality, diversification, and profitability, among other metrics. The overall Q3’2019 ranking is as shown in the table below:

Bank	Franchise Value Score	Intrinsic Value Score	Weighted Score	Q3'2019 Rank
KCB Group Plc	46	3	20.2	1
I&M Holdings	57	2	24.0	2
Co-operative Bank of Kenya Ltd	55	5	25.0	3
Equity Group Holdings Ltd	61	6	28.0	4
Stanbic Bank/Holdings	59	9	29.0	5
Barclays Bank	64	7	29.8	6
DTBK	75	1	30.6	7
NCBA Group Plc	70	8	32.8	8
SCBK	78	4	33.6	9
HF Group Plc	95	10	44.0	10

Section V: Conclusion:

In summary, the banking sector saw an improved performance albeit the core EPS growth being lower compared to that of a similar period of review in 2018. NFI income was a major highlight having grown by 15.8% compared to 5.9% the previous period supported by the increased revenue diversification which is expected to continue going forward leveraging on digital innovations. Post interest rate cap, banks’ Net Interest Margins are expected to increase on account of increased interest income following the repeal of the cap thus allowing loan pricing based on the credit risk of borrowers, coupled with low Cost of Funds aided by access to cheap deposits.

For more information, see our Cytonn Q3’2019 Listed Banking Sector Review

 

Disclaimer: The views expressed in this publication are those of the writers where particulars are not warranted. This publication is meant for general information only and is not a warranty, representation, advice or solicitation of any nature. Readers are advised in all circumstances to seek the advice of a registered investment advisor.