How banks are making super profits in a tough environment

Atm machines in a bank. [Getty Images]

Central Bank of Kenya (CBK) Governor Patrick Njoroge’s stranglehold on the banks’ pricing has been so strong that lenders have hardly reaped the benefit of a liberal interest rate regime.

Since Kenya removed the interest rate cap towards the end of 2018, nothing significant has changed in loan pricing by commercial banks. The rates have at some point been oscillating at levels below the rate-cap era.

Interest rate spread - the interest rate charged by banks on loans to private sector customers minus the interest rate the lenders pay depositors for their deposits - has barely widened. In fact, it has been narrowing.

Nonetheless, banks have continued to report astronomical profits amidst a tough economic environment occasioned by the pandemic, drought, the Russia-Ukraine conflict and election jitters.

So, with the primary function of banks in the economy being financial intermediation - transferring funds from agents with surplus and who can afford to keep it to those without but have an urgent need to use them - then how are they making money?

Playing around with provisions - the money they set aside as insurance against possible defaults - is just part of the explanations for the handsome returns, says Kevin Ngige, an analyst with an investment bank, Genghis Capital.

“That is why the numbers look really great,” says Mr Ngige. In the financial year ending 2021, for example, commercial banks released Sh51.2 billion that they had set aside as insurance against defaults, data from CBK shows.

But at some point, there will be no room for banks to play around with loan-loss provisions.

Getting cheap capital, which they have, then loaned out at higher rates, is the other way banks have been able to record high profits. Lenders such as Equity, Co-operative and KCB have been able to get cheap, long-term financing at rates as low as between four and five per cent from international financing institutions.

Data from CBK shows that last year, banks and non-banking financial institutions increased their long-term funds to Sh247.7 billion compared to Sh213.5 billion in 2020.

Equity Group had one of the most long-term credit lines. Last year alone, the bank received Sh94.9 billion in long-term financing, a growth of 67.4 per cent from Sh56.7 billion in 2020.

The funds, some of which came from the World Bank’s investment arm International Finance Corporation (IFC) and the African Development Bank, will be critical in helping Equity continue posting huge profits.

Last year, Equity made a profit of Sh40.1 billion, the highest among Kenyan banks and nearly double the Sh20.5 billion the lender made the previous year.

In the first quarter of 2022, the bank made a net profit of Sh11.9 billion from Sh8.7 billion in the same period last year. KCB, whose profits also rose 54.6 per cent to Sh9.9 billion in the three months ending March 2022, also mobilised a lot of long-term funds last year.

The bank had long-term funds valued at Sh37 billion by end of last year.

Co-operative Bank’s borrowed funds, mostly long-term credit lines from development partners, grew from Sh21.2 billion in 2017 to Sh42.9 billion by end of last year.

The funds have come from such institutions as the World Bank’s IFAD and IFC, European Investment Bank, AFD and KFW.

Most of the funding, the lender said, has gone to micro and small enterprises, food security, renewable energy, mortgages, agribusiness and corporate banking.

The need to attract long-term funds partly informs the race to become the most valuable company between Equity Bank and KCB, according to Ronak Gadhia, a director at Egyptian-based investment bank EFG Hermes.

Moreover, KCB was arm-twisted to take the National Bank of Kenya due to the availability of government deposits in the latter. “That was like free money,” said Mr Gadhia.

In the absence of a mechanism to price riskier borrowers, a good chunk of that money has gone to risk-free government securities such as Treasury bills and bonds.

 Diaspora remittances

Last year, interest on government securities grew 17 per cent to Sh174.7 billion. In addition, a lot of banks have aggressively been going after non-funded income, including fees and commissions. Other sources of non-funded income have included forex, trade financing, and diaspora remittances.

Perhaps, things would have been better if banks had been allowed to charge higher interest. But the environment is not right.

When Sidian Bank - a tier-one lender whose way of mobilising deposits is largely by luring depositors with high interest and lending at even higher rates - jumped on this opportunity, the backlash from the public was fast and furious.

Some suspect that CBK, which expects banks to be customer-centric when setting their prices, must also have read the riot act to the tier-three lender.

Sidian was recently acquired by a Nigerian-based Access Bank from Centum Investment.

Interest rate spread - the difference between what banks charge lenders and what they pay depositors - has narrowed from an average of 5.77 per cent during the rate cap era to 5.43 per cent in the post-rate cap era, according to calculation from commercial banks’ weighted average interest rates given by the CBK.

Before the rate cap era from September 2018 to July 1991 when CBK started giving this data, the interest rate spread was at an average of 10.77 per cent.

In December 1995, for example, bank spread, also known as net interest margin, widened to 16.22 per cent, with banks charging lenders an average of 28.99 per cent for their loans while paying depositors an average of 12.77 per cent for their savings.

Of course, even before lawmakers put in place the interest rate controls, bank spreads had been narrowing, albeit still higher than their peers, noted the International Monetary Fund (IMF) in a 2017 report. Now, they have narrowed even further, an indicator that either loan pricing still has a rate-cap hangover or CBK has simply refused to approve most of the risk-based pricing that was the condition for the end of interest rate capping.

Only Equity Bank has received approval on risk-based pricing, at a maximum of 18.5 per cent. Others are still waiting for regulatory approvals. “We now have no excuse of leaving anybody behind because we can price risk within a reasonable range,” said Equity Group Chief Executive James Mwangi in March this year.

Lenders argue that they have to balance accessibility, affordability, and profitability and that will mean an increased rate for customers deemed riskier. CBK has had to send back several banks to rework their models to avoid high rates. For small banks like Sidian, it became difficult for them to fully price for the risk under the new regime.

Things would even be more difficult for small banks, which borrow expensively under the risk-based pricing, according to Centum Chief Executive James Mworia.

Instead of pricing your loans based on the cost of capital, you price it based on the risk of the borrower.