Kenya’s banking sector is going through a phase of sluggish growth. In the six months ended June, the sector’s overall profitability grew at the slowest pace in six years. In light of this increasingly tougher operating environment, banks have been compelled to look at new ways of making money. BUSINESS MONTHLY compiled this report.
The combined profit of the 43 banks in Kenya reached Sh76.9 billion in the six months ended June, industry data shows. Although this represented an 8.3 percent year on year growth in profits, banks are everything but delighted. In fact, one would rightfully submit that they are alarmed. This is because the pace at which profits are growing is slowing down and the current growth rate is the lowest seen in six years.
The Kenyan economy has decelerated this year, albeit modestly. In the second quarter, economic growth was 5.5 percent compared with 6 percent over a similar period in 2014. This marginal economic slowdown partly explains the slower growth in the banking sector, which typically grows in tandem with the broader economy. For the most part, however, the decline in banking sector growth has been attributable to shrinking interest margins. That is, the difference between deposit/CBK rates and the rate of interest on loans issued to customers.
Interest margins have been shrinking on account of the rising Central Bank Rate as well as a general increase in the cost of deposits. Customers are demanding higher rates on deposits due to the oversupply and deep penetration of saving products, including mobile-based ones such as M-Shwari. As a result, average net interest margins for the industry fell to 7.9 percent in half one of the year compared to 8.6 percent in a similar period in 2014.
Banks have not been able to fully pass the higher costs of funds over to customers in the form of higher rates. This is primarily because there is currently very little headroom to increase rates. Considering some customers are currently servicing loans with rates as high as 20 percent, it would suffice to say that the rates are already high as things stand. Any rates beyond this will inspire defaults and lower the appetite for new loans, both of which harm banks and customers.
In order to sustain profitability in the prevailing low interest margin environment, banks have been pursuing a raft of cost cutting measures. Some have embraced technology while others have streamlined operations. These cost cutting measures have allowed some banks to make a bountiful profit in spite of the difficulties in the broader market.
Co-op Bank, for instance, performed remarkably well in the first half of the year. Its profits rose 32 percent year on year during the period to Sh6.24 billion. The bank’s managing director, Gideon Muriuki, ascribed this good performance to a decline in operating costs. In light of the tighter liquidity in the second half of the year, Co-op admits that there will be some difficulties in growing the loan book. “We expect a much better performance in the second part of the year but we could see a bit of a slowdown as far as the loan book is concerned, because of the tight liquidity in the market,” Mr. Muriuki remarked.
Equity Bank, which is the second largest bank in terms of assets after KCB, recorded a 12 percent year on year increase in pre-tax profit to Sh12.1 billion during the first half of the year. Its profits would have grown more robustly had it not been for the company’s gargantuan investment in the backend technology needed to support its new mobile banking system Equitel, which was officially launched in July.
With the high interest rate environment expected to persist—due to extended weakness of the Shilling—the only likely scenario is that interest margins will contract even further and banks, keen to sustain profitability, will cut back on costs. The alternative is clear; fail to cut back on costs and face slower growth, possibly even contraction.
But cost cutting has never led any bank, nor business for that matter, to the fulfilment of the lofty goals typically outlined in strategic plans or company visions and missions. Cost cutting is just a stopgap measure and banks need to find other sustainable ways of making money, in spite of the general weakness in the core lending business.
For the bigger banks with cross-border operations, the slowdown in Kenya’s banking sector has not come as a big obstacle to future growth. This is because growth in other countries in the region is much higher, offsetting much of the stagnation exhibited in the Kenyan market.
KCB, for instance, saw a modest improvement in its cross-border operations, a development that no doubt helped drive its 13 percent year on year earnings growth to Sh9.2 billion in the first half of the year. The bank’s Uganda, Rwanda, Tanzania, Burundi and South Sudan units turned around and contributed at least 10 percent of the lender’s earnings in the period.
Equity Bank, on the other hand, registered robust growth in the regional market. Its subsidiaries in Rwanda, South Sudan, Tanzania and Uganda achieved a huge 41 percent increase in earnings to record collective profits of Sh920 million in the half year ended June.
A regional presence is a major competitive advantage as regional markets often act as a counterweight to the local market. That is, weakness in the local market can often be offset by growth in the regional market.
Banks without a strong regional presence, or without one at all, have been compelled to confront the decline in interest income in a different way. They are pursuing other avenues of non-interest income.
Analysts at Genghis Capital say that lenders’ non-interest income is growing on account of the heightened interest in bancassurance and mobile banking, which attract fees for transactions. The firm further projects that a continued compression in banks’ net interest margins (NIMs) will inspire a sharper focus on non-funded income, which is simply income made in other areas other than the core lending business. “With the raising of the CBR to 11.5 percent, we expect bank’s NIMs to compress even further thus necessitating the banks to focus on non-funded income to grow their revenues,” said Genghis capital in a note.
The focus on non-interest income has seen a number of banks expand the proportion of overall earnings that they get away from the core lending area. Barclays, Diamond Trust Bank, NIC Bank and National Bank of Kenya saw their non-income interest rise by 32.3 percent, 25.6 percent, 30.6 percent and 38.3 percent in the first half of the year, respectively.
Whereas some banks are focusing on areas away from the core lending business, others are looking for cheaper source of funds in order to widen their interest margins. Getting cheap funds is understandably hard, especially in markets such as Nairobi, Mombasa, Kisumu and other major urban areas. This is chiefly because these markets are saturated with savings products and customers have more leverage in determining rates—a scenario that, of course, leaves banks paying much higher than they would have otherwise paid on deposits.
However, in the counties, especially the underserved ones, penetration of banks and financial services is still low. Some banks are taking advantage of this apparent vacuum in the counties to mobilize cheap deposits at the county level.
Kenyan banks opened 33 new branches in the six months to June, data from the CBK shows. Most of these branches have been opened at the county level, signaling banks’ search for cheaper deposits. “This increase (in branches) was distributed across all the counties in the country,” said the CBK, whose new governor, Dr. Patrick Njoroge, is currently committed to strengthening the Shilling.
The use of physical branches is also complemented by agency banking, which has allowed banks to penetrate markets that would have otherwise been difficult to enter due to impediments such as infrastructure and staff recruitment. The agency model is also effective in gauging the volume potential in an area before opening a branch. It is therefore a useful tool and quite often than not precedes the opening of a physical branch.
The Kenya banking market, despite the recent slowdown, is still seen as attractive. This explains why there are 43 banks fighting for a market that is for the most part concentrated in Nairobi, the regional financial hub. There are, however, some big opportunities that the market does not seem to appreciate. So big are these opportunities that foreign players have begun taking interest.
The opportunity to serve the expansive Small and Medium Size sector has largely been ignored. Although some banks have in the recent past made attempts to venture into this sector, most of these efforts have been half-hearted. Very few banks present attractive propositions for SMEs in terms of accessible interest rates. This is despite the fact that this sector is the life force of the Kenyan economy. SMEs contribute about 25 percent of the country’s GDP and employ around 11 million people, which is roughly 50 percent of the working population.
Qatar’s Doha Bank Group, which is expected to join the Kenyan banking sector and become bank number 44 in the market, sees the SMEs segment as an unexploited opportunity. “What we hope to do is partner with local banks to offer affordable cost effective credit facilities,” said the bank’s chief executive, Raghavan Seetharaman.
Doha Bank’s Mr. Seetharaman sees the prevailing interest rates as prohibitive to small borrowers. “For a country whose inflation is about 6 percent, it is not logical to have lending rates above 15 percent,” he said. Upon its entry into the market, Doha Bank wants to remedy this situation in order to reel in SMEs. “We can structure loans below 10 percent and even as low as 8 percent. This would do wonders for SMEs, which can then scale up to the mutual benefit of our economies,” he added.
Doha Bank Group will focus on agricultural processing, energy, transport and low cost housing. All these areas are high growth areas and present a slew of opportunities, especially low cost housing. There is currently an alarming housing deficit in the lower end of the market because developers, even if they wanted to, cannot build affordable houses. Material is expensive and the cost of financing is even steeper. With cheaper loans, which Doha Bank Group wants to leverage on, building cheap homes for the bottom end of the housing market will become more feasible.
In business, the magnitude of an opportunity often lies in the extent to which a market has not been served but demands the service. And in the SME sector, the scarcity of affordable loans is acute while the demand for the same is immense. In fact, endless surveys have authoritatively shown that the biggest concern for SMEs is accessing low cost funding. This is something that Industrialization Cabinet Secretary Adan Mohamed has not shied away from. When launching Kenya’s industrialization blueprint, Mohamed explained that there would perhaps be a need to launch an industrialization fund further down the road to meet SMEs’ and manufacturers’ demand for cheap credit.
The SME sector is an area that banks need to renew their focus on. This will benefit everyone. Banks will be able to exploit a new avenue of growth while the general economy, which is driven by SMEs, will also improve. Meanwhile, banks will continue prioritizing cost efficiency and non-interest revenue streams in order to cushion themselves from thinning interest margins.
There is also a likelihood of mergers and acquisitions further down the road, though the possibility of this happening in the imminent future has been lessened by parliamentarians. Treasury had unsuccessfully suggested that the minimum capital for banks increase fivefold from Sh1 billion to Sh5 billion through 2018 in order to allow banks to participate more strongly in large infrastructure projects. This would have inspired mergers and acquisitions. Parliament, however, shot down the move, saying higher capital requirements would squeeze out small banks.
Parliament’s rejection of Treasury’s proposal, however, only pre-empts the possibility of consolidation in the near future, but does not preclude the same from happening in the long run. In the long term, banks will consolidate in order to better exploit big ticket deals, especially in energy and transport.