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Chasing The True Numbers

[vc_row][vc_column width=”2/3″][vc_column_text]Last week I started reflecting about the key issues that were driving the current turmoil in the banking sector, and concluded that both the regulator’s banking supervision unit as well as the guilty bank boards were culpable. Today, I want to take a closer look at the financials of one of those banks, Chase Bank, as much was written last week regarding the disputed audited financials that gave rise to the run it experienced that led to its closure.

I began by pulling up what they published on their website as the audited financials for the year 2014. I then looked at what was published in black and white, tucked into the back end, classified section of the Standard Newspaper on Wednesday, April 6th 2016. I will refer to these as the gospel truth accounts. This was a good six days after a full set of color financials had been printed in the Nation newspaper on March 31st 2016, which was the last date that a regulated financial institution in Kenya could publish their full year audited accounts. A few items clearly stood out as having been restated in the 2014 audited accounts. What do I mean? The 2014 audited accounts that were published in 2015 did not have a qualified opinion (I will refer to these as the chameleon accounts). However, when the gospel truth 2015 accounts were published on April 6th 2016, a few items in the 2014 numbers had been restated, which begs the question: what caused the chameleonic changes? Let’s begin at the top. In the published 2014 chameleon accounts, customer loans had been booked at Kes 53.8 billion. In the gospel truth accounts, customer loans for the same 2014 financial year were now reflected as Kes 64.4 billion, a difference of Kes 10.6 billion. Evidently in the 2015 audit, the auditors decided to treat certain assets differently, and found Kes 10.6 billion worth of new loans in the 2014 financial year, which had previously not been picked up in the 2014 audit that had been passed. But a balance sheet doesn’t just change dramatically; the movements on one line have to balance with movements on another. So I dug a little deeper and found the offending items. In the 2014 chameleon accounts, “other assets” were booked at Kes 11.9 billion. This is where the Islamic financing assets were said to have been parked. In a sudden change of heart (likely caused by missing documentation to convince the auditors that the other assets were indeed booked appropriately as Islamic financing products) the 2014 numbers restated “other assets” as Kes 3.4 billion, suddenly yielding up Kes 8.5 billion as the corresponding surprise entry in loans into the gospel truth accounts.

But that means that I needed to find Kes 2.1 billion in order to balance the figure of Kes 10.6 billion in new loans that appeared in gospel truth accounts. The only other significant movement that I found was that 2014 chameleon accounts showed that cash held at the Central Bank was Kes 7, 105, 986 by December 31st 2014. The gospel truth accounts reflected a different position of Kes 4, 953,180 by the same December 31st 2014, a difference of Kes 2.1 billion. Now that is a remarkably curious finding to which I have no answer. How does the same auditor convert funds that are reflected as held at the Central Bank in one year into customer loans the following year?

I bundled on some roller skates and slid into the profit and loss statement, as this was becoming an interesting ride. The 2014 chameleon accounts reflect a total staff cost figure of Kes 1.9 billion while gospel truth accounts restate this amount to Kes 1.7 billion a difference of Kes 200 million. The auditor, come the 2015 review, clearly did not accept some staff costs. What did the auditor discover that was different? I guessed that the answer was sitting in the other operating expenses line as it had moved by a similar Kes 200 million, from Kes 2.3 billion in chameleon accounts to Kes 2.5 billion in gospel truth accounts. Someone had tried to park Kes 200 million worth of expenses as staff costs, and while the auditor bought that story in 2014, he clearly wisened up in the 2015 audit process and restated the 2014 numbers accordingly.

That was just a cursory view on the 2014 numbers, as much attention has been paid to the 2015 full year numbers without looking at the significant restatements of key areas of the 2014 results. This restatement was a key contributor then to the growth of two numbers: the gross non-performing loan (NPL) numbers in 2015 as well as insider loans to directors, shareholders and associates. Gross NPLs moved from Kes 3.1 billion in 2014 to Kes 11.3 billion in 2015, an increase of Kes 8.2 billion and a figure quite close to the movement in the other assets line stated above. Insider loans grew from Kes 1.3 billion to Kes 10.5 billion in 2015, an increase of Kes 9.2 billion. This would mean that includes Kes 8.2 billion of “other assets” plus an extra Kes 1 billion that has emerged as new loans. Insiders had a few busy years clearly! The challenge for the receiver or for any new investor were the bank to be sold, will be to realise the securities held against these insider loans, assuming of course, first that the insiders do not have the capacity to repay these surprise loan entries and secondly that the true realizable value of the securities is reflected. If the insiders do have the capacity to repay, then that’s another story. Public focus has largely been on the insider loans, but the rubber will meet the road when proper due diligence is undertaken on the existing loan book, a large part of which sits as un-amortizing over drafts. Therein lies the true challenge in establishing capacity to repay.

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

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Banking Crisis in Kenya

[vc_row][vc_column width=”2/3″][vc_column_text]The Kenyan banking sector is in turmoil with vicious rumours swirling about the health of many banks and discerning where the truth is sandwiched between various shades of grey is remarkably difficult. It would be remiss to discuss a few banks without looking at the whole industry to begin with, and the macroeconomic environment that they are operating in that has led to the current state of dire illness in some banks. Mariana is a businesswoman. Since 2011, she has been running a small security guarding company, providing guards to small businesses. In 2014, she was encouraged to grow her business using the preferential supplier incentives that the government was providing for women and youth. She bid and successfully won a tender to supply guarding services for a government ministry that had multiple installations that required security. All of a sudden she had to recruit two hundred new guards and purchase uniforms and boots for them. She approached her bank and showed them the government contract against which they provided an overdraft facility for her, using her retired parent’s house as security. In the beginning, the cash was good, Mariana was paid on time and she was able to pay salaries and slowly start reducing the overdraft. But in 2015, her invoices to the Ministry started taking three to four months to be paid, and she increasingly turned to the ballooning overdraft facility to pay her guards’ monthly salaries. Within 3 months she had reached her limit on the facility and the bank was reluctant to increase it. She was desperately in trouble: hundreds of salaries to pay, an overdraft facility to reduce and her parents’ house in jeopardy. Mariana is not alone. This story is replicated hundreds of times at both national and county government level. Small business owners who have provided goods and services to national and county governments but experienced the sharp cash crunch that occurred in 2014 and 2015 which meant that their payments were significantly delayed. Some of these businesses had been responsible, cash was received and ploughed back into the business’s working capital cycle to pay for the goods and purchase more. Some of these businesses were irresponsible, and buoyed by the huge payments in their accounts for the first time in their lives, diverted some cash into non income generating assets like cars and land. Whatever the case, many businesses had used commercial bank loans to fund the sudden expansion caused by a large buyer of their goods and services. The slowdown in government spending has hit these businesses hard, and invariably impacted their ability to repay their loans. This is very apparent in the growth of the non-performing loan book amongst the banks as well as the reduced profitability of most of the banks judging from the 2015 end year financials.

Now let’s take a step back and look at the role of the regulator. That the government had slowed down its spending has not been a secret. The role of a banking regulator is to constantly monitor the financial and operational health of the banks under its watch. Basic economics: a slow down in money supply will cause the economy to contract and for businesses to start exhibiting financial stress. A basic prudent requirement therefore is for a central bank to require their licensees to undertake stress testing of their loan books for a number of reasons, key of which is to determine if the banks are making adequate provisions for the deteriorating loans as well as to establish how much of their loan book is exposed to the key economic metric that is causing the stress, in this case reduced government spending. In so doing, the regulator quickly establishes exactly what percentage of the banking industry’s assets are likely to be of a diminishing quality, what impact that will have on the respective banks’ balance sheets and whether discussions regarding additional capital injection need to be had with bank managements.

Do we have rogue banks? The recent events point to the fact that we do. The existential crisis that is emerging is that the regulator’s banking supervision unit is not on top of its oversight game. But it’s not only the regulator on the spot here. The audit committees of some of these banks have clearly not been holding their internal auditors to account. The internal auditors, who, together with the credit risk teams, are supposed to be regularly reviewing the credit quality of their loan books and have a duty to raise the flag on non-performing loans, or insider loans that do not have the appropriate documentation and requisite securities against which banks have recourse in the event of default. Some clever institutions know exactly how to manipulate the bank system so as not to reflect the poor servicing of bad loans at month end. They also know how to suppress non-performing loans by keeping them as overdrafts whose deteriorating quality is difficult to discern, as there are no monthly amortization repayments that would indicate non-serviceability. Section 769 of the new Companies Act 2015 requires shareholders of quoted companies to appoint members of the audit committee. The mischief that this is supposed to cure is to ensure that the shareholders take ownership of who is providing appropriate governance over the books of the company. Shareholders must ensure that the audit committee members are not only financially literate individuals, but, in the case of quoted banks, at least one should have some commercial banking operational experience and therefore know how to identify where dead bodies are being buried. The Central Bank prudential guidelines require bank audit committees to be chaired by independent non-executive directors. What is becoming crystal clear is that the oversight capacity of these audit committees is seriously wanting as there seems to be a lack of knowledge on how internal systems can be manipulated to hide bad loans. Nobody is blameless in this crisis at both regulator and board director level.
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Twitter: @carolmusyoka[/vc_column_text][/vc_column][vc_column width=”1/3″][/vc_column][/vc_row]