Apr 10, 2016

Following the release of the FY’2015 results by banks, we carried out an analysis on Kenya’s banking sector to decipher any material changes from our Q3’2015 banking report. In our analysis of the banking sector, we recommend to our investors which banks are the most attractive and stable for investment from a franchise value and from a future growth opportunity perspective. See report at: Cytonn Downloads.

The report was themed “A Sector in Volatile Transition” to sustainable and stable growth, and two days after the report, Chase Bank, a mid-tier bank, was placed under receivership. This was the third bank in Kenya to fail over the last one year.

Consequently, this week we give a quick status overview of the Kenya banking sector 2015 financial performance, explain what is going on in the sector, and potential ways to avoid aggravating the current panic in the sector.

On the back of a growing and stable economic environment in Kenya, the country’s banking sector has also experienced robust growth over the years, with the financial services sector in Kenya currently contributing 10.1% to Kenya’s GDP growth, from a 3.5% contribution 10-years ago. This is as a result of the sector’s ability to develop products that respond to the needs of Kenyans, such as (i) convenience and efficiency through alternative banking channels such as mobile and agency banking, (ii) increased financial inclusion and banking the informal market, and (iii) a demographic boost in Kenya, such as a growing middle class, which has led to increased demand for intermediary services such as banking. Despite the tough operating environment that was witnessed last year, the banking sector still recorded core EPS growth of 2.8%, even though this was lower than 9.3% the previous year.

Key Metrics of Listed banks in Kenya
Bank	Core EPS Growth	Deposit Growth	Loan Growth	Interest Margin	NPL/Total Loans	Cost to Income**	ROaE	ROaA
I&M Bank	26.2%	16.4%	13.6%	7.2%	4.4%	35.0%	24.5%	3.7%
Co-op Bank	25.4%	21.9%	16.2%	8.8%	3.8%	53.2%	25.1%	3.7%
KCB Group	12.1%	12.5%	21.9%	7.9%	6.8%	50.1%	25.0%	3.7%
DTB	11.5%	20.6%	29.0%	6.5%	2.8%	41.0%	18.7%	2.9%
Equity Group	1.0%	23.1%	26.0%	6.5%	3.4%	52.9%	25.5%	4.8%
Barclays	(0.2%)	0.2%	15.9%	10.2%	3.7%	53.0%	21.6%	3.7%
NIC	(2.6%)	11.9%	13.7%	6.1%	12.4%	41.6%	18.0%	3.1%
CFC	(13.7%)	18.7%	26.6%	6.4%	4.8%	50.6%	17.1%	2.6%
HF	(18.5%)	15.4%	17.2%	6.3%	7.7%	47.4%	16.9%	2.2%
Standard Chartered	(28.7%)	11.7%	6.2%	9.4%	12.8%	44.6%	15.5%	2.9%
NBK	(232.5%)	5.6%	3.3%	6.4%	17.3%	78.2%	(19.3%)	(1.0%)
Weighted Average*	2.8%	14.3%	14.5%	7.4%	7.3%	49.8%	17.1%	2.9%
*Averages are market cap weighted **Without loan loss provisions charge

There are three take-aways from the table above:

• While core EPS growth was anaemic at 2.8%, Co-op, I&M, KCB Group and DTB still managed to report respectable double digit EPS growth. Equity Group, Barclays and NIC were relatively flat and the rest (CFC, HF, Stanchart and NBK) reported significant EPS declines.
• Only 4 banks, Co-op, I&M, Stanchart and NBK reported deposit growth faster than loan growth, even though in the case of NBK, it appears that weak deposit growth was greater than loan growth only because loan growth was extremely weak.
• NBK was the only bank to report negative return on equity.

Following the strong growth achieved by the banking sector over the last 10 years, there is need for the sector to transition into a more stable and sustainable sector. The Central Bank of Kenya (CBK) is at the forefront of this initiative, pushing for the observance of prudential guidelines, including using a risk-based approach to bank capitalisation, better corporate governance of financial institutions and increased transparency in reporting of results. As indicated in our FY’15 Banking Report, the core areas of transition include the following key 4 areas:

• Clarity around strategy & niche markets: As Warren Buffet says, “you only get to know who is swimming naked when the tide goes out.” In good times, all banks were reporting profits, but then in 2015 given the difficult operating environment, it seems that only banks with a clear strategic advantage and / or niche market reported positive profitability.
  1. Strong deposit gatherers with a strong branch network and alternative distribution channels such as agency and mobile banking did well. This category includes KCB, Co-op and Equity, who seemed to have fared well in 2015 compared with those with limited branch coverage
  2. Banking the informal sector, which is also closely intertwined with strong branch coverage, hence favouring those with strong networks and alternative distribution channels, seemed to have helped performance. On the other hand, inability to adapt to local dynamics seemed to have weighed down the big foreign banks like Stanchart and Barclays, whose parent is contemplating abandoning the African market
  3. Niche market players such as DTB and I&M, which are viewed to offer good service to mid-level corporates, and have reasonable flexibility, also did well
  4. Disciplined growth was helpful as evidenced by the top two profitable banks (Co-op and I&M) who had deposit growth faster than loan growth, and revenue growth outpacing expense growth, while a historical strong growth bank like Equity is beginning to get distracted by regional expansion such as expansion into Congo, which has been dilutive to EPS, as well as forays into telecommunications

• Scale will become increasingly important: Kenya is overbanked with 1 bank for every one million people, compared with South Africa and Nigeria, which have 0.3 and 0.1 banks for every one million people. It is going to be increasingly difficult for the small banks to survive unless they have a clearly defined competitive advantage or are serving a specific market niche. Otherwise, the faster they merge, sell out or bring strategic investors (as can be seen in the table highlighting Kenyan Banks by Size), the better for them, as evidenced by ECB’s sale to Mwalimu Sacco, Fina’s sale to GT Bank, Fidelity’s sale of stake to Duet of London, and Giro Bank’s sale to I&M.

Kenyan Banks by Size
Tier	Local Banks	Banks with significant foreign ownership	Banks with Gov. Participation
Tier I >5% Market share (a)	· Commercial Bank of Africa · Equity Group Holdings · Co-operative Bank	· Barclays Bank · Standard Chartered	· KCB Group
Tier II >1%&<5% Market share (a)	· Diamond Trust Bank · Chase Bank* · Family Bank · Imperial Bank* · I&M Holdings · NIC · Prime Bank	· Bank of Africa · Bank of Baroda · Bank of India · CfC Stanbic · Citibank N.A · Ecobank · Guaranty Trust	· HF Group · National Bank
Tier III** <1% Market share (a)	· ABC Bank · Credit Bank · Equatorial Bank · Fidelity Bank · Giro Bank · Guardian bank · Jamii Bora Bank · Middle East Bank · Oriental Commercial · Paramount · Trans-National · Victoria · Sidian	· First Community · Habib A.G. Zurich · Habib Bank · Gulf African · United Bank for Africa	· Consolidated Bank · Development Bank

* - Under receivership

** -Given that Kenya is overbanked, and the sector is in transition, these are the banks ripe for consolidation or being bought out by larger banks

(a) – Market share by net assets, total deposits, total equity, deposit accounts and local accounts

• Better Corporate Governance: The market, CBK and CMA are all going to be demanding better corporate governance going forward. It is clear from the market’s swift and decisive negative reaction to Chase Bank’s qualified financial accounts, which revealed previously not fully disclosed loans to directors of over Kshs 10 billion, that corporate governance and professional ethics are key for investors and depositors. One key commonality between the two recent bank failures at Imperial and Chase Bank is a colossal failure of corporate governance and existence of bad ethical practices.
• Increased Regulation & Emphasis on Compliance: With the new CBK governor, there is going to be increased regulation, emphasis on compliance and market discipline. CBK has made it clear that it is increasing its surveillance and supervision capacity.

While there is broad public perception of a sector in crisis, we view the incidences at Imperial and Chase Bank as isolated cases of ethical malpractices in a sector that otherwise remains fully functioning, safe and sound. Key metrics such as interbank rates, exchange rates and money market yields do not point to a systemic issue in the banking sector and the money markets remain well functioning.

While the Governor appears to be enjoying broad public support for his intolerance to indiscipline in the banking sector, and is doing all the right things to restore discipline, we think that there could be a better resolution of cases such as Imperial or Chase Bank. In the interest of stability of both the economy and financial markets, closing a bank should be the option of the very last resort. While the Kenyan situation is nowhere near the banking crisis faced by the US banks during the global financial crisis of 2009, there are techniques and tactics that we think the Governor and the Government should consider borrowing from the approach deployed by the US Government and Fed in resolving potential bank failures. When it was clear that a bank was losing market confidence, banks were coerced by heavy-handed regulators to sell to stronger banks, which immediately restores market confidence.

From October 2015 when questions began to surface around Chase Bank to the bank’s eventual failure six months later in April 2016, there has to be a range of strategic alternatives that either bigger banks or private investors could have brought to shore up confidence in Chase Bank. There still exists market concerns around a few banks, the regulator should be very heavy-handed in terms of asking the respective boards to take decisive actions to restore market confidence and failure upon which CBK should orchestrate take overs of weak banks by stronger banks. Well-functioning financial markets are critical to funding economic growth. Consequently, it is in our national interest to speedily and aggressively resolve any issues that threaten continued economic growth and financial markets stability, such as weak or unethical market participants.

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Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted- as the facts may change from time to time. This publication is meant for general information only, and is not a warranty, representation or solicitation for any product that may be on offer. Readers are thereby advised in all circumstances, to seek the advice of an independent financial advisor to advise them of the suitability of any financial product for their investment purposes.