Two months ago, the author of this article wrote a piece on the debate about capping of bank interest rates. On 24th August 2016, the bill was signed into law and the banks woke up to a new world; an end to liberalization of interest rates into a world of limited sources of income.
This new installment reviews the future of banking in Kenya, how the law affects the financial stability of the banking sector over a twelve months horizon and the new challenges that dawn on the regulator of the banking sector. The surprising thing is that most banks in the sub Saharan Africa face some caps on interest of some sort including Nigeria and South Africa and this was noted by The Economist Newspaper quoting a World bank a 2014 study; The newspaper also goes further to state that most of the countries with interest rate caps have lower growth as banks ration credit to risky sectors and individuals especially SMEs.
We dedicate this article to highlighting the future of banking in an era of controlled interest rates for loans and savings. What will the future of banking in Kenya be, how the law affects the financial stability of the banking sector over a twelve to eighteen months horizon and the new challenges that the dawns on the regulator of the banking sector faces.
It is worth to note that none of the banks has reported any financial results since the law came in to law and that the third quarter results will show minimal impact.
We sample a few banks to simulate various scenarios to assess the impact of the new rates; We look at twenty two banks; small, medium and large ones, The sample selection was entirely random.We look at their full financial results of the year 2015 and undertake scenario analysis to see the full impact. We intend to keep it real and keep the scenarios very simple.
The scenarios have one major assumption, that all banks implement the law full and the numbers look at banks financial statement will appear in 2017 September. Further we assume that if a bank is already paying higher than legislated, they will continue to do so.
We create two scenarios and they both share one major assumption, that all banks implement the law full. The full effect of the law will be fully felt in the month of March 2017 when banks report the first clean statements without revenues from the old regulatory regime.
The first scenario takes the basic assumptions; capping the average interest earned to 14%; That a bank will be required to pay a minimum of 70% of the CBR rate for deposits, that is now 9.8%.
The results are startling; what happens is that the profits from the sampled banks drop from 109 billion to 39.9 billion loss(Note that this is not the entire banking sector);
This is 136.4% drop in profits compared to the full financial year ending December 2015. When you look at the distribution of the profits after the changes, the top 5 banks in the sample contribute 16.5 billion to total losses but the total profits for the sample after the changes drops to a loss of 39.9 billion. The bottom 5 banks have a loss amounting to 29.1 billion while the number six to ten banks(from the sample) contribute 192 million the overall position(figure too small to appear on the graph; see Figure 1) this is a significant drop for total profits from 26.4 billion. see figure 1.1 and 1.2
The bottom 5 in the sample makes losses totaling to 31 billion. This is ten times the loss reported in compares to the full financial year 2015 where the bottom 5 banks made combined loss of 3.1 billion as at 2015 full financial year. And the bottom 5, only 2 were loss making before the changes but after the impact assessment, all the bottom 5 make losses.
In total out of the 22, only three were loss makers before but after the changes, eighteen (68 % of the sample) are in the cohort of loss makers. This is more than fivefold increase in number of loss making entities.
Further simulation indicates how long it would take the banks that are loss making to fall below the capital ratios: Out of the 22 sampled, 18 of them start hemorrhaging cash through losses and the three that were loss making before the law, start losing cash at a higher rate than before; See figure 1.2
Six of these take less than three months to fall below capital ratios because of losses; three institutions take four to Six months to breach capital ratios while seven take between 6 and twelve months to breach; one banks survive capital buffers for between 12 and 18 months; one takes over eighteen months but eventually they breach the capital ratios. One loss maker has enough buffers to take it to over four years. See figure 1.3
It is also observed that bigger banks in the sample have their combined profits decline by a significant but lower rate of 120.39% compared to smaller ones in the sample whose profits decline by 1,110.3% and the small ones all end up making losses compared to only three that made losses in 2015. See Figure 2
The sampled banks take a little shorter time to breach liquidity ratios; they all take less than six months to breach liquidity ratios. Only one goes beyond 18 months
We simulate a second scenario where banks increase non funded incomes by 30% and the top 5 banks manage to reduce the rate of increase in deposit rate to just about just double of what they were paying before. The assumption on the reduction of deposit rate reduction can only fly for the top 5 banks in the sample who are faced by an inelastic demand for their bank deposit services;
We simulate the second scenario with two additional real world possibilities: Less interest paid on deposits for top banks; and that their interest expenses just double and increase fees and commission income by 30% . See figure 2.1 , last bar.
To anyone estimate, this seems more of a plausible scenario compared to the first scenario where we assumed that banks will just sit and do nothing to adjust their strategies.
Further observations are as follows; In total out of the 22, only three were loss makers before but after the changes, 14 or (68 % of the sample) are in the cohort of loss makers. This is almost than fourfold increase(366%) in number of loss making entities. This seems to be a lower proportion of new loss makers.
What happens is that the profits from the sampled banks drop from 109 billion to 20.7 billion : That is 81.1% drop in profits but the top ones in the sample are all profitable. This is better than the forecast of 39 billion loss in the previous scenario for the top banks.
When you look at the distribution of the profits after the second scenario, the top 5 banks in the sample contribute 31.0 billion to total profits and they are all profitable as compared to the first scenario.
The bottom 5 banks have a net drop in loss amounting to 10.8 billion while the number six to ten banks contribute 5.8 billion. This is an improvement over the first scenario that has merge 192 million profits for that segment.
Further simulation indicates how long it would take the banks that are loss making to fall below the capital ratios:
Out of the 22 sampled, 14 of them start hemorrhaging cash through losses and the three that were loss making before the law start losing cash at a higher rate than before;
Five of these take less than three months to fall below capital ratios because of losses; Two institutions take four to Six months to breach capital ratios while two take between 6 and twelve months to breach;
Three banks survive capital buffers for between 12 and 18 months; Two takes over eighteen months but eventually they breach the capital ratios and one of these loss makers (already in the above two)has enough buffers to take it to over two years. See figure 2.2
It’s also noted that bigger banks in the sample have their combined profits decline by a significant but lower rate of 61.65% compared to smaller ones in the sample whose profits decline by 212% and the small ones all end up making losses just like the scenario one.
The 14 loss making ones take a little shorter time to breach liquidity ratios in the second scenario jut like in the first scenario but at least three banks go beyond 6 months; they all take less than six months to breach liquidity ratios. Only one goes beyond 18 months. See figure 3.2
How do banks respond? Should they go to court and argue a case for repeal? Will some banks will stop any capital expenditure plans with huge investment tickets since they just drain capital with no return as well as Further lending to any risky segments ?
One finding is that banks may find ways of paying less for deposits, even by 500 basis points,(five percentage points); will they manage to find ways to avoid all unnecessary and expensive deposits and increase their non-funded incomes like commissions?
Will the banks adopt a strategy of either to stop lending the unsecured segments and divert to government bills and lend to each other since that attracts lower capital and lower risk? Will they try to build a capital buffer by stopping lending to households and businesses in favor of risk free government papers?
Now you ask, why should anyone care?, This is why it matters; when a large proportion of financial institutions make losses, this is of concern to a regulator and even the general public that the laws sets out to protect: loss making institutions are bad for the investor in the bank and it complicates the position of the owners and he could be under pressure to keep his capital safe by taking risky bets outside the regular banking assets in a hunt for yield; This is precisely what happened in 2008 to the western financial systems where the system has become more fragile and regularly requiring bailouts every time there is a major volatility in the financial markets, especially when the interest rates rise significantly. For our markets, even a currency shock will spill over and spread contagion to the banking sector unless the central bank decides not to undertake its mandate of exchange rate stabilization and decides no to intervene to stem short term volatility in exchange rate: the interventions in currency exchange normally take the form of increase in the interbank rates and nominal interest rates and this would sink more banks into the loss making.
Other challenges face the regulatory regime; should licenses for all loss making institutions that branch capital and liquidity ratios be withdrawn?
Loss making also matters to Cabinet secretary, Treasury because the finance bill of 2016 states that the regulator cannot take administrative action on any institution without involving treasury; that means that Treasury may offer a lifeline to banks providing whatever support may be required to support an institution going through a rough patch; and that is a good indicator of confidence in terms of financial stability.
What is the solution to this dilemma? in the meantime, the consumers with good credit history and working with stable employers and government are the ultimate beneficiaries as risky borrowers face stringent vetting and capital rationing from the sector;
This is purely hypothetical and for educational purposes only and no one can really predict what will happen hence do not rely on the document for any decision making.Distribution and copying part or all of this document is allowed on condition that the credits given to www.econblogglobal.org @haiyay