4 October 2017

East Africa: Banks Face Lower Returns With New Rule on Bad Loans

Banks in East Africa are expected to take a major hit in their earnings and capital levels when a new international accounting standard takes effect on January 1.

The International Financial Reporting Standard (IFRS) 9 will introduce a more stringent way of providing for bad loans.

This is expected to eat into bank profits and erode their reserves which form part of their core capital. Small lenders in particular will be dealt a major blow while small and medium-sized businesses will suffer a credit squeeze.

The standard requires lenders to consider all credit, including to government, as risky and to set aside money that would cushion them in case of actual default.

This is called provisioning for bad loans. Setting aside of huge provisions will deprive banks of cash that could have otherwise been used to trade with to increase revenues.

Previously, banks were only required to provide for loans that had not been serviced for a period exceeding 30 days, while lending to government was considered risk-free and did not require provisioning.

Stability

The measure is expected to shield banks from sovereign defaults like those by Greece and Argentina, ensuring stability of the global sector. Greece failed to honour its debt payment in the aftermath of the global financial crisis of 2007-08 requiring bailouts.

In 2001, Argentina suffered a severe financial crisis causing it to default on its external debt, leading to a series of austerity measures.

Lenders will also be required to set aside money for trade financing transactions such as letters of credit and guarantees, which were previously considered risk-free.

In Kenya, banks are holding Treasury bills and bonds valued at over Ksh990 billion ($9.9 billion) and have off balance sheet items of Ksh804 billion ($8 billion).

Were they to provide just one per cent for the assets, the stock of impairments would be upwards of Ksh18 billion ($180 million). This would be the best case scenario, as banks are required to make a general provision of one per cent for loans that are performing.

"We see the stock of impairments by banks growing by anything between 15 to 40 per cent in line with international estimates," said Barclays Bank of Kenya chief financial officer Yusuf Omari.

None of the lenders was willing to indicate the direct hit it would suffer from the introduction of the new reporting standard.

A report by KPMG released recently said it expects the stock of impairments in Kenya to increase by 50 to 100 per cent on the first day of 2018 when IFRS 9 takes effect.

Banks are to deduct the difference between what IFRS 9 requires them to provide and what they currently have from their retained earnings. Small lenders who have low retained earnings and an appetite for risky lending will be left heavily exposed.

Aggressive in debt collection

Under the new requirements any loan that falls due by more than a day will be required to be moved to a new classification, requiring more provisioning unlike in the previous case where loans were reclassified after they fell 90 days due.

Barclays Bank said it expects lenders to be more aggressive in their debt collection efforts in order to ensure a loan does not fall due, and be choosy on which sectors they lend to in order to keep their probabilities of defaults low.

Already, Equity Bank has said it will be moving out of unsecured lending which is associated with salaried staff whose default rate has been rising owing to retrenchments as the economy took a downturn.

Further conservative lending by commercial banks in the East African region will deter economic growth with central banks already citing slow credit growth to the private sector as a concern.

In Kenya, the scenario is aggravated by the interest rate caps, which have been blamed for reduced private sector lending having limited lenders appetite for risk.

"Clearly, the combined effect of the two will not be good for the economy in terms of credit growth and the impact it has on the economy," said Kenya Bankers Association (KBA) chief executive Habil Olaka.

KCB, which is the largest lender by asset base in the region -- with operations in all East African markets -- is expected to feel the greatest pinch from the new standards owing to its huge statutory loan reserve book.

As at end of June, KCB was holding Ksh11 billion ($110 million) as statutory reserve, meaning the introduction of IFRS 9 -- which is tighter than the CBK prudential guidelines -- may wipe out these reserves before shaving off its retained earnings.

"It is better if you have nil figures on your statutory loan provisions, because it means you have been prudent in your provisioning," said Mr Omari.

Some of the large lenders with nil provisions are Barclays, Standard Chartered and Diamond Trust Bank Group.

Bear the brunt

International lenders are expected to bear the brunt of provisioning for off balance sheet items, such as letters of credit and trade guarantees, where they have been dominant leveraging on their global brands.

Standard chartered has invested Ksh115 billion ($1.15 billion), more than its loan book, in the off balance sheet items indicating it will have to take a major hit.

KBA noted that small and medium-sized banks were lagging in the implementation of the new standard, with large banks already in the process of test-running their financial strength against IFRS 9.

"Most Tier 1 banks are well advanced in terms of readiness; tier two and three are a bit behind," said Mr Olaka.

One of the concerns by small banks is whether their systems will be able to generate sufficient data to allow them to make the predictive analysis required in determining the probability of default of each borrower.

Countries where data on the general economy is hard to get will also pose a challenge for bankers who have to factor general economic environment in their default probability.

This is set to be a problem for most East African countries given the scarcity of data and even where it is available it faces queries of authenticity and consistency.

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