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2019 Banking Sector Report

Executive Summary

We recommend a HOLD on the banking sector. We note that the challenging business environment, occasioned by regulatory constraints, coupled with weakened asset quality, serve as impediments to growth. There still exists uncertainty with the interest rate cap ceiling. Our top pick in the sector is KCB Group with a Target Price of KES 62.52 and potential upside of 39.6% from the current market price. The bank is currently trading at the sector average of 1.2x P/B, despite having an ROE of 21.9%, the highest in the listed banking sector space. Further, key performance metrics enhance its fundamental capability: Non-Performing Loans (NPL) ratio (6.9%), Net Interest Margin (NIM) (8.2%) and an attractive dividend yield (7.8%). Additionally, we recommend a SELL on Standard Chartered Bank of Kenya with a Target Price of KES 193.88, an 8.5% potential downside from the current market price. We are of the opinion that the bank’s conservative strategy will continue to curtail growth, with FY19F bottom-line performance expected to decline (-6.3% PAT). Further, we remain concerned about the asset quality, noting that the NPL ratio remains the highest in our sector coverage, which despite expected improvement, may not result in major deceleration in the ratio. However, the bank’s dividend yield (9.0%) continues to rank the highest (alongside Barclays).

We project that provisions will rise by an average 52.9% y/y in 2019 as the base effect brought about by the day one IFRS 9 write-off will have already come into effect, meaning provisions (and coverage levels) are expected to rebound to the FY17 levels.

We expect Net Interest Margin (NIM) to remain relatively unchanged at 7.6% due to the sector's focus on investment in the lower yielding government securities, balanced by moderate recovery in the loan book and CoF management. 

We expect the Cost-to-income (CTI) ratio to shift downwards moderately to 46.7% as banks adjust their business models in a bid to enhance operational efficiency.

We expect Non-Interest Revenue (NIR) contribution to rise gradually in 2019, averaging 33.5% for banks under our coverage.

We project a 35bps y/y decline in the average NPL ratio under coverage to 9.5% in FY19F. The asset quality in the sector is projected to improve gradually on account of more stringent credit profiling.

Following the High Court Ruling, we view this as an opportune time for the National Assembly to address the interest rate cap law. We anticipate a modification of the rate cap, while enhancing clarity in the provisions. We expect positive sentiment on the counters but we remain cautiously optimistic as increased bank lending to the SME segment and risky borrowers may not be fully actualized with the implementation of IFRS 9, coupled with the challenging business environment.

We see M&A activity picking up in 2019 and 2020. As a case study, Nigeria underwent reforms in 2005 and studies suggest the banking sector is more stable, in addition to promoting increased competition, efficiency, and a platform to enhance economic growth. We believe Kenya should follow a similar path and this could be achieved by increasing the core capital requirement to KES 5.0Bn from KES 1.0Bn (a proposal previously rejected in parliament), which would reduce the number of banks by half (c. 20). Additionally, consolidation would serve to strengthen the capital market.