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When banks sneeze, the economy catches a cold

Economists generally agree that when banks are faced with declining growth or unique business challeng- es, the resulting negativeconsequences tend to quickly prop- agates through the whole economy. The 2008 global financial crisis, which still casts its long shadow on the global economy today, is by far the quintessential example. The cri- sis, considered by economists as the worst financial crisis since the Great Depression in the 1930s, had its gen- esis in mismanaged American banks, most famously Lehman Brothers.The global financial crisis underscored the causal relationship between the health of the banking sector and the health of the econo- my, perhaps more persuasively than textbook economic theories on the same subject. This is because the crisis, in an immediate, visible and measurable way, reaffirmed the tru- ism that the health of the economy is greatly influenced by the health of the banking sector. To put it in another way, when banks sneeze, the economy catches a cold.Although the global economy may have fully learnt this important lesson about the elementary role of banks in the economy, Kenya seems to  be  relearning  this  vital lesson afresh. The Banking Amendment Act, which came into effect in September 2016, is having detrimen- tal effects on banks and the economy in general.The popular law caps the inter- est rate charged on loans by com- mercial banks at 4 per cent above the Central Bank Rate and the rate paid on deposits at 70 per cent of the Central Bank Rate (the Central Bank Rate was 10 per cent at the time of writing).Naturally, banks have been adversely impacted by the law, which has substantially reduced the interest spread from the average of between 11-15 per cent to    around7 per cent. In layman terms, the interest spread can be defined as the difference between the cost of ‘buying’ money from a saver (deposit

rate), and price at which the money is ‘sold’ to a borrower (lending rate). A thinner interest spread translates into less profits for banks. The new law has therefore impacted banks’ financial health and, unsurprisingly, the health of the broader economy.

Lenders

Because of the shrinking profit mar- gin environment, banks are now more averse to borrowers that are deemed risky. Lenders want to make safe bets and are weary of any bor- rowers with a higher propensity to default. As a result, credit is now inaccessible for many businesses in the economy, especially SMEs, which are the engines of economic growth, accounting for 45 per cent of GDP and 80 per cent of the work force. There has also been a sharp decline

 

There will be continuation of the reorganisation of banks, with institutions analysing their business models to ensure they are operating sustainably in the new environment,” Habil Olaka Kenya

Bankers Association chief executive in private sector lending as banks flee from private sector borrowers to government securities such as bonds and T-bills, which generally have a lower level of risk. Similarly, thinner interest spreads and a slowdown in the growth of banks’ loan books has negatively impacted the sector’s overall profitability, leading to job cuts and posing a risk to revenue collection by the taxman.

It is clear that the challenges fac- ing Kenya’s banking sector are now morphing into full-blown economic challenges. Key pillars that support the economy such as the SME sector, private sector lending, revenue col- lection and job creation have been adversely affected by the slowdown in the banking sector.

Because the Banking Amendment Act came into effect in September 2016, it is likely that the first effects of the law will be seen after February 2017. This is when most lenders will release their full year financial statements for 2016. Analysts will be

keen to look at Q4 earnings (October to December), as this is when the effects of the rate capping laws will begin to show due to the date on which the act was effected.

Prevailing market developments strongly suggest that the rate cuts have impacted banks’ bottom lines adversely. Some banks have swift- ly instituted cost cutting measures in anticipation of slower growth in both revenues and profits. In this regard, Cytonn Investments “cau- tions that banks will have relatively lower earnings as the law is expected to suppress earnings, especially Q4 (2016) earnings.”

The effect of the lower earn- ings for banks are twofold. Firstly, the largest taxpayers in the country will have less  taxable  income.  It is instructive to note that banks, specifically the Tier 1 banks  such as Barclays, Standard Chartered, Equity  Bank  and   KCB   routine- ly feature in the Kenya Revenue Authority’s (KRA) annual listing of largest taxpayers in Kenya.

 

Revenue collection

A dip in profits in the banking sector is therefore likely to have an adverse effect on tax collection. This is a position supported by Cytonn Investments, which stresses that depressed earnings in the banking sector may “stifle revenue collection by the KRA.”

Lower revenue collection is the last thing Kenya wants given the cur- rent troubling state of public finance in the country. Lower revenue

collection will compel the gov- ernment to borrow more in order to meet spending targets. This is ampli- fied by the fact that that there is little wiggle room for borrowing. Kenya’s public debt increased from 42.1 per cent of GDP in 2012/13 to 55.1 per cent of GDP in 2015/16. The World Bank has noted that the scope for future borrowing is reducing.

The impact of lower profitability in banking on employment cannot be underestimated. Many highly specialized workers in the banking sector have been laid off as lenders readjust to the shrinking profit mar- gin environment by slashing back costs.

In the last quarter of 2016, more than 1000 bankers lost their jobs. These layoffs cut across the board, affecting Tier 1 banks such as Equity Bank and Standard Chartered, Tier

 

2 banks such as NIC Bank and even Tier 3 Banks such as Sidian Bank, which recently rebranded from K-Rep.

Highly specialized workers in sectors such as banking generally find it harder to move to new careers in other fields due the uniqueness of their skills, meaning that many people will go without jobs if the woes in the banking sector persist. Furthermore, the job cuts in the banking sector are expected to be more severe in 2017.

“There will be continuation of the reorganisation of banks, with institutions analysing their business models to ensure they are operating sustainably in the new environment,” said Kenya Bankers Association chief executive Habil Olaka while giving his outlook on the current situation in the sector.

 

SMEs and private sector lending The banking sector has an essential role to play with respect to the allo- cation of funds to the most profitable investment opportunities. Currently, the most profitable opportunities are the ones in the SME space due to their high potential for growth. However, high growth potential typi- cally goes together with higher levels of risk. Therein lies the problem.

Interest rates are generally a reflection of the risk level of a bor- rower. A risky borrower tends to attract a high interest rate than one deemed less risky. The current lend- ing rates of 14 per cent are deemed too low to accommodate the com- paratively high level of risk within the high growth SME sector. The effect is that banks have given the sector a wide berth, impacting the cash flow of most small businesses, disrupting their growth plans, put- ting many out of business, and many more out of jobs.

When the rate capping laws were introduced last year, banks said that about 40 per cent of new borrowers would be side-lined. This has come to pass as indicated by the num- ber of banks that have phased out unsecured loans, reduced lending to SMEs and locked out many retail customers.

 

Interest rates

The CBK also commented on the impact of the move on SMEs, with the  governor,  Dr.  Patrick Njoroge,

noting that SMES would take the hit. In a commentary published in the dailies in August last year, Dr. Njoroge cautioned that: “reinstating interest rate caps will lead to the emergence of credit rationing and the unavailability of credit to a wide segment of the population—particu- larly SMEs, new and small borrow- ers—with immediate adverse conse- quences on job creation and poverty.” The negative impact of the rate caps on lending to SMEs and indi- vidual borrowers was highly antic- ipated.     Cytonn Investments, for instance, noted before the law was passed last year that one of the expected effects of the rate cap was that “credit would not be accessible to the riskiest, who have the least access and the most need for credit.” Indeed, banks are avoiding risky loans and have retreated to safer bets, at least until they readjust  to

the current environment.

This means that besides SMEs, some ordinary businesses with rel- atively safe risk profiles in private sector are being avoided in favour of ‘risk free’ government securities such as T-Bills and bonds.

While commenting on the cur- rent shift by banks from private sector to government securities, Rich Management CEO, Aly-Khan Satchu, noted that: “I think it is increasingly clear that there has been a stampede into Government of Kenya (secu- rities) considered ‘risk free’ on the (bank’s) balance sheet paper. This has been singularly helpful for the government, but it has come at a cost, particularly to the SME sector which has been crowded out.”

Bank’s huge preference of gov- ernment securities over private sector borrowers is impacting the flow of capital to the private sector. Private sector credit growth  stood

at 5.5 per cent against a CBK target of 18.8 per cent, according to data presented in the November 2016 Monetary Policy Committee meet

ing. This mismatch underlining the tremendous degree by which banks have cut back on lending to private businesses.

 

Adding to economic troubles

As outlined, the banking sector’s woes are negatively impacting SMEs, private sector, jobs and public finance. These implications, which are all detrimental to the economy, couldn’t have come at a worse time. They are adding to already deepen- ing economic troubles.

This is because the issues in banking, and their effect on key pillars that support the economy, are dampening the economic growth outlook in a year already fraught with its own unique challenges. 2017 is an election year and economic growth is widely expected to be muted during this period in line with the historical trend of previous elections. While commenting on the impact of the elections on economic growth, the Kenya National Chamber of Commerce and Industry (KNCCI)

National Chairman, Kiprono Kittony, noted that: “although Kenya’s politi- cal scene is approaching maturity, business expansion across all sectors will be on hold as investors adopt a wait and see attitude as a matter of caution.”

Besides politics, other challenges in 2017 include the slowdown in manufacturing and the stagnation in agriculture. The latter could worsen due to the prolonged dry weather. According to an advisory note by the United Nations in December 2016, there could be worse drought conditions in 2017 than previous years, affecting agricultural output, increasing food prices and driving up inflation.

 

Challenges

These unique economic challenges, coupled with the fresh challenges that the banking sector’s woes are introducing into the economy, under- pin the bearish economic outlook for 2017. Many businesses will stagnate while others will close up altogether. This will lead to job loss or at best a hiring freeze, which could be costly considering the country is already facing an alarmingly high unemployment rate of around 40 per

cent, according to the World Bank.

Treasury has forecasted a growth rate of 6.2% for 2017. If attained, this would mark a modest improve- ment from the expected 6% growth in 2016. But under current condi- tions, it appears these growth esti- mates may be missed by a huge mar- gin when economists finally crunch the numbers at the end of the year.

The lesson here is that the next time policy makers push for inter- ventions in the banking sector, it may be prudent to first analyse the long-term implications, cognisant of the fact that banks are one of    the primary levers of the economy and that they dictate how fast the econ- omy grows and in what sectors this growth comes from.