Kenya: Should over-liquid banks return capital to shareholders?

Kenyan banks see the risk trajectory as strengthening and have already begun clawing back some of the impairment losses they recognised in 2020. To a very large extent, the international financial reporting standard 9 (or famously referred to as IFRS 9) – the accounting wizardry on which banks recognise and measure the performance of their financial assets – took away prudence when it comes to risk judgements, by handing management of commercial banks a lot of discretion.

First, they stopped lending and instead resorted to piling liquidity elsewhere.

They are now buying more Treasury bills and bonds. At the close of the second quarter, the share of investment securities to total assets crossed 30%, which is a record high, while the share of loans and advances to customers, their core business, dropped to below 50%, from a high of 60% six years ago.

The net result of not lending, since 2017, is that commercial banks are now so liquid that the overall liquidity ratio hit a record high of 57% in the second quarter, which means for every shilling of customer deposit they were holding, 57 cents was sitting in liquid assets that can be converted into cash on demand (such as reserve and clearing account balances, Treasury bills and bonds, placements locally and abroad).

Equity Bank, for instance, closed the quarter with a staggering liquidity ratio of 88%, the highest among its larger Tier one peers, followed by Standard Chartered Bank at 70% (there was even a medium-sized bank with 100% liquidity ratio). There is some context to this surging liquidity.

New law passed

In September 2016, a law was passed that capped the price of money. It established a ceiling on commercial banks’ lending rates at 400 basis points above the Central Bank of Kenya’s base rate. Banks responded by freezing lending, citing their inability to fully price for risk(s).

The law was eventually repealed in November 2019. However, before banks could restart lending, the coronavirus pandemic struck. Meanwhile, customer deposits grew by 41% versus 19% growth in net loans during that period.

In Kenya, banks are only required to hold a minimum liquidity ratio of 20%. However, given the current momentum, it is highly likely that overall banking sector liquidity ratio will hit 60% by the close of 2021, a level which also presents its own set of challenges.

A major challenge here is balancing between the cost of funding and the returns on assets. If the cost of funding remains sticky while the yields on assets fall, as has been the case since 2017, then business margins will continue softening, which is the major reason why banks have lately been unable to return their cost of equity. With returns on equity plunging to below 15% in 2020, against cost of equity of around 18%, economic returns on bank capital have been negative.

Bank shareholders have seemingly deployed excess capital to guarantee less capital-intensive banking activities…

Capital adequacy, which measures the ratio of total capital bank holds to its risk-adjusted financial assets, hit 19% in the second quarter against the minimum of 12.5%. Equity Bank, with the largest balance sheet in the region, has seen its capital adequacy ratio stabilise at 20% between 2015 and 2020, while return on equity dropped to 14.5% from 24% in the same period.

KCB Group, with the second largest balance sheet, equally printed a drop in return on equity from 24.2% in 2015 to 13.8% in 2020, while its capital adequacy rose from 16.9% to 21.6% in the same period. DTB Group, another large regional player, printed the largest drop in return on equity in the same period, from 15% to under 5%, while capital adequacy ratio rose from 18% to 22.5%.

Bank shareholders have seemingly deployed excess capital to guarantee less capital-intensive banking activities, as buying Treasury bills and bonds requires zero capital allocation (and is a very inefficient use of capital).

No return to capital piles

These three banks make a strong case for lenders to return the large capital piles back to their shareholders if they are still unwilling to move up the risk curve. Furthermore, regulatory disincentives can also be rolled out to discourage the build-up of liquidity as well as purchase of treasury bills and bonds.

One of the regulatory disincentives can be the imposition of a minimum loans-to-deposit ratio (LDR), a key deposit intermediation metric. In 2019, Nigeria’s Central Bank imposed a minimum LDR of 65% to encourage Nigerian banks to lend to the real economy.

In Kenya, during the period between December 2014 and 2020, industry LDR plunged to 66% from 85%. Equity Group has seen its LDR drop from 95% to 75% in the same period. KCB Group, on the other hand, has seen its LDR drop moderately from 90% to 83%.

Standard Chartered posted the biggest plunge among its Tier one peers, dropping from 67% to 47% in the same period. A minimum LDR can be rolled out to encourage lending to the real sectors.