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The Unintended Consequences Of The Banking Amendment Act 2015

[vc_row][vc_column width=”2/3″][vc_column_text]Wednesday, August 24th 2016 will go down in history as the day Kenyans collectively chose to wet their whistles prematurely, in celebration of the Presidential assent of the Banking Bill (Amendment) 2015. But who can blame their souls that were weary from years of punitive interest rates in a regime where demand for credit by far outstripped supply?

Let me begin from the beginning. Banks take your deposits and in turn lend these out to borrowers who range from individuals borrowing unsecured loans on the back of a salary check off program, to small, medium and large businesses borrowing to finance their working capital needs or capital expenditure purchases, and who secure these facilities with a piece of property or equipment. But the Central Bank of Kenya (CBK), like any good regulator who wants to protect depositors, sets out the amount of capital that the shareholders of the bank need to maintain, in order to lend to these various types of borrowers with varied risk levels. The requirement for capital is literally to ensure that banks have “skin in the game” effectively causing banks to exercise caution in lending out customer deposits (which then become assets on the bank’s books) to entities that have demonstrated the ability to repay.

So the next time you throw a cursory glance at your bank’s financial statements, cross over to the bottom, a fairly innocuous section called “Other Disclosures” and particularly the section titled “Capital Strength”. This, good people, is where the rubber meets the road. There’s one line, usually section (f) titled Total Risk Weighted Assets. CBK requires banks to allocate capital to all the assets on their books. But different assets attract different amounts of capital. So, for instance loans to the central government via treasury bills and bonds attract a zero capital charge. The same applies to loans guaranteed by the central government as well as OECD governments. If the regular borrower, Wanjiku, also wants to give 100% cash collateral for her loan, that attracts a zero charge as well.

By the way I’m quoting from the CBK Prudential Guidelines, a document whose detail is so technical that it is recommended reading for anyone having trouble falling asleep at night. The flip side is painful: lending to anyone else – be they an individual who’s provided their Sunday best clothes as security or a corporate whose provided a prime Mombasa road property as collateral – attracts 100% capital charge. So a bank has to allocate 100% of its capital (on a weight adjusted basis) which as you know is a finite and fairly expensive resource, for your loan. It may interest you to know that mortgages which are well secured and performing only attract a 50% capital charge. Why you ask? Shelter features fairly high under Maslow’s hierarchy of needs, therefore risk of default is much lower.

Because of how much capital a bank has allocate to a loan, it’s much easier to simply place deposits in government paper. But low risk means low returns and banks have therefore taken the fairly lucrative business of lending to individuals, SMEs and corporates which are higher risk, require higher capital charges but which capital charges are resoundingly compensated by high interest returns.

However, let’s call a spade a spade. Banks in Kenya have been smug and lazy. Since demand outstrips supply, they have chosen to treat all borrowers the same. Wanjiku who has borrowed 20 loans in the last thirty years, servicing all of them well without a single default, is charged the same 19% rate as Paul, who just got his first job at a government parastatal and can use his payslip to get a check off loan to buy furniture for his new apartment. The insurance industry is willing to give Wanjiku a no-claims bonus, which is a reduction on her annual insurance policy for her car as a reward for not having any accidents in the past year. But the banking industry wants to treat Wanjiku as if her good repayment record doesn’t deserve a reward. The reduction in interest rates will force banks to do one of two things: move out of higher risk rated assets as the returns will not be commensurate with the capital charge and secondly, begin to provide much needed granularity in the way they have chosen who to lend to based on positive credit reference bureau ratings. I’ve beaten that granularity drum before, but I’m not about to get tired. Good borrowers do not warrant the high interest rates that are currently being charged to cover (lazy) banks from bad borrowers. Enough said.

In these dying column minutes let me draw your attention to one thing: the Banking (Amendment) Bill 2015 was horrendously drafted and has as many holes as my grandmother’s favorite crochet table cover. Section 33B (1) and (2) refer to a base rate set by Central Bank of Kenya. The media is using the Central Bank Rate which is a rate used by CBK to loan to banks and is NOT a base rate for lending to the public. Of course this can be cured when the CBK publishes the regulations required to operationalize the Act, by creating such a base rate which can be set wherever CBK feels is the right point including aligning it to the Kenya Bankers Reference Rate. Secondly, Section 33B (2) refers to “minimum interest rate granted to a deposit held in interest earning to at least 70% the base rate”. There seems to be a missing word there after interest earning, perhaps the drafter meant to put the word “account”. Whatever the case, the regulations will now have to prescribe what a “deposit” means for purposes of Section 33B (2). Chances are that to enable stability in the banking sector, a deposit will have to be an amount placed for a contractual period rather than just any amount in an interest bearing account (such as a savings account). The result is that banks will set up minimum amounts for which they are willing to enter into “deposit” contracts, perhaps from Kes 50 million and above to justify that high interest rate payable. Finally, if banks move to lending to GoK rather than to Wanjiku, the treasury bills and bond rates will decline dramatically and institutional investors such as pension funds will see a significant drop in their returns, meaning their pensioners will also suffer. Such are the unintended consequences of this Bill.

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Twitter: @carolmusyoka[/vc_column_text][/vc_column][vc_column width=”1/3″][/vc_column][/vc_row]

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Bankers are business people too

[vc_row][vc_column width=”2/3″][vc_column_text]A distraught investor called his financial advisor. “Is my money really all gone?”
He wailed. “No, no,” the advisor answered calmly. “It’s just with somebody else!”
I need to disabuse some readers of the notion that banks are charitable institutions. The amount of energy spent chanting dirges about how “banks are out to fleece us” or the more recent, “banks want to finish Kenyans with interest rates” is energy better spent understanding that a bank is a business like the neighborhood kiosk, providing a service of convenience. The less than palatable solution to the purveyors of negative energy is this: put your spare cash under your mattress and go borrow your financial needs from the knee-cap breaking shylock two streets down the road from your house. Enough said: if you’re mildly irritated at my incendiary introduction, let’s keep rocking and rolling as I explain why you need to get over yourself.

The months of September and October 2015 were difficult ones for the Government of Kenya. Cash flows got mismanaged as more money was being paid out than was being received and they had to come to the domestic market to borrow funds to meet their obligations. Bank treasurers as well as savvy institutional investors smelt blood in the water. They had already done a quick back of the envelope calculation on the use of the proceeds from the now infamous Eurobond and figured out that the government had come up short when there were multiple domestic as well as international obligations to be paid. These things really don’t require a rocket scientist, after all, housewives have been calculating and balancing kitchen budgets for years. Word soon spread that the government needed money, and banks as well as institutional investors were happy to step up to the plate. But remember that banks place your deposits in two places: in loans to businesses and individuals or in loans to government via treasury bills and bonds.

Two things will always happen when the government suddenly becomes exceedingly thirsty for cash and dips its beak into the private sector. Firstly, the arbitrage sharks that are always looking for an opportunity will strike. If an individual or corporate with a good credit history at their bank can borrow at 12% as was the case with some, then they will borrow and take the money to the government via the T-bill auction that was giving rates above 22%. That 10% spread is easy money. So easy that the bank’s initial reaction will be to raise interest rates to reduce the arbitrage opportunities that it is providing to some of its clients. Which then leads to the next question, why should the bank be the only one allowed to make money from government borrowing? Well, the fact is, everyone who was flush with cash and spotted the opportunity jumped into the high interest rate bandwagon. Large depositors demanded that the banks give them double digit interest rates or they would withdraw their funds and open CDS accounts at the Central Bank themselves in order to buy government paper. I know an individual who got 19% on his large deposit at a multinational bank in September this year. Now if you recall, I did say that banks fund their loans from customer deposits. When a large number of deposits start to re-price, the obvious impact will largely be on the future loan book that will be funded from the re-priced deposits. There is also an impact on the existing loan book because a bank is constantly trying to manage the profitable bridge between interest received (from loans) and interest paid (on deposits). The net interest income will obviously be impacted from the re-priced deposits. And banks are accountable to shareholders you know, the owners of the business who are demanding a return on their heavily regulated capital.

A final point to the business of banking: contrary to popular belief, it is not all champagne and roses when banks have to consider raising interest rates. The credit risk director will typically sit through that Assets and Liabilities Committee -ALCO meeting (assuming he’s invited) with a furrowed brow and a sinking feeling in the pit of his stomach. Why, you ask? The credit director knows very well about the elasticity of the borrower’s pockets. There is only so much stretching a borrower can do before he decides to throw in the towel and default on a bank loan that is causing more grief and sleepless nights than a private developer’s illegal boundary walls coming down. A borrower has typically submitted cash flow projections to his banks demonstrating that he can comfortably make the principal plus interest repayments over the lifetime of the loan. A minor rate increase will cause some level of digestive discomfort. A major rate increase will cause cardiac level discomfort. Which is why banks ask individual borrowers for their pay-slips and information about other borrowings so that they can tell what the “debt service coverage ratio” is for the individual borrower. How much of her disposable income is going towards servicing loans? The rule of thumb is that it should not be beyond 30% of one’s net income which allows one to pay rent, buy food and basically live decently rather than skating on the edge of financial despair. The same applies for business loans, as there is an ideal leverage ratio for businesses that are in the manufacturing or in the service industries (manufacturing businesses are permitted higher leverage ratios due to their propensity to use loans for purchasing capital equipment).

Therefore it’s not an easy ALCO decision to raise interest rates as the bank will be balancing a need to maintain the net interest spread while managing the increased risk of borrower default. Since the escalated government borrowing had cooled down in November, the banks last week could thus start to yield to the Central Bank Governor’s exhortations to stop loan interest rate increases. Total relief in sight for distraught borrowers!

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Twitter: @carolmusyoka[/vc_column_text][/vc_column][vc_column width=”1/3″][/vc_column][/vc_row]