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Kenya Banking Sector Report 1H18 – Weakened but Resilient

EXECUTIVE SUMMARY

In this report, we assess the recent developments in the Banking sector, the direction going forward and provide a valuation update on the trading counters in our coverage.

Valuation Update

We update our coverage of the banking sector to capture performance under a new reporting environment (IFRS 9), given the release of 1H18 results and provide an update on emerging sector issues since our last coverage.

We maintain our HOLD recommendation on the banking sector. We note that prospects for the banking counters are improving with the changing operating environment. There still exists some uncertainty with the interest rate cap ceiling set to be maintained. We upgrade our recommendation on KCB Group and Stanbic Holdings to a BUY from a HOLD, while NIC Group maintains its BUY rating despite a 34.3% decline in the target price. We have upgraded Equity Group and Standard Chartered Bank to a HOLD from a SELL. Further, we maintain our HOLD recommendation on COOP Bank, I&M Holdings, Barclays Bank and Diamond Trust Bank from our Playbook 2018 publication.

We have revised sector Net Interest Margin (NIM) downwards to 7.5%. This is compared to earlier projections at 8.0% on average, closer to the current industry average of 7.6%. This is due to the continued NIM erosion from our last update, mainly as a factor of lower yield on interest earning assets. This is brought about by the 50bps cut in the CBR in MPC March meeting and increased investment in the lower yielding government securities.

We have revised Non-Interest Revenue (NIR) contribution to total income upwards by 50bps to 31.9%. This is driven by increased efforts on revenue diversification with the interest rate cap ceiling expected to be maintained. We expect revenue diversification to be a key driver for banks over the next couple of years.

We have revised Return on Average Equity (ROaE) to 18.0%. This is closer to our 1H18 coverage mean of 17.8%, with an expected average EPS growth of 9.9% in FY18e.

Recent Developments and Regulation

The Finance Bill 2018 seeks to amend section 33B of Banking Act

Fiscal consolidation will be key in promoting a fair pricing mechanism. The Finance Bill 2018 proposes amending section 33B of the Banking Act by removing the interest rate cap floor, whilst retaining the ceiling. However, the challenge with this approach is that the current loan pricing framework is still skewed towards the government.

Other Initiatives

1. a) Financial Markets Conduct Bill 2018 (FMCB)

The Financial Markets Conduct Bill 2018 (FMCB) proposes a comprehensive framework for regulating financial service provision to ‘retail financial customers’. However, we are concerned by the complexity of regulation and opportunities for regulatory arbitrage.

1. b) Credit guarantee scheme

The National Treasury is considering guaranteeing commercial bank loans to small and medium size enterprises (SMEs) as part of the effort to reduce their risk profile and make credit accessible. In our view, the proposed credit guarantee scheme is not viable and its introduction could possibly see the Banking sector experience challenges if the particulars of such an arrangement are not well thought out. There is the existence of a moral hazard and we highlight Sri Lanka as a case study.

1. c) CBK Banking Sector Charter

In August 2018, the Central Bank (CBK) introduced the Kenyan Banking Sector Charter in an effort to enhance discipline and responsibility in the sector. However, we believe more needs to done to ensure that the cost of credit is kept in check, such as ensuring the risk pricing framework is fair.

IFRS 9 Requirements

The challenges facing the Banking sector are the cause of systemic factors as opposed to the mere introduction of the interest rate caps. The Banking sector has been battling with increased non-performing loans (NPL), with the NPL ratio for the sector at 12.0% compared to 10.7% in 1H17, brought about by a challenging operating environment that began in 4Q15. We expect this trend to be managed as banks toe the line with the requirements of IFRS 9, which requires a forward looking approach in loan provisioning. We expect the asset quality in the sector to improve due to more stringent credit profiling brought about by IFRS 9.

Basel III – Adoption and potential effects

Adoption of Basel III could serve to impose stringent requirements on banks. Basel III, a global, voluntary, regulatory framework that emphasizes on capital and liquidity adequacy, will lead to the consolidation of the weaker banks and ensure a more prudent and stable sector. Consolidation could go a long way in solving some of the inherent risks prevalent in the Banking sector. We believe that fiscal consolidation will be key in its implementation.