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    Banks

    www.fitchratings.com 9 September 2010

    Kenya

    Special Report

    Kenyan Banking Sector: AnnualReview and OutlookEarnings to Benefit from Improving Economy

    Summary and OutlookFitch Ratings expects the Kenyan banking sector to benefit from the improvingeconomic environment in 2010, with forecasted GDP growth of 4.0%. The bankingsystems 2009 performance remained relatively buoyant despite the weakeroperating environment due to the prolonged drought in the country and thenegative economic effects of the global financial crisis, helped by reduced loanimpairment charges and rapid credit growth during 2008.

    The agency expects that most Kenyan banks should benefit from higher levels ofnoninterest income and improved efficiencies in 2010, although these gains couldbe partially offset by margin pressures and higher credit impairment charges forcertain banks.

    The asset quality of the Kenyan banking sector remains a weakness. The sectorsFitchcalculated nonperforming loan (NPL) ratio reduced to 6.8% at end2009(2008: 7.3%) as further credit growth offset the increase in NPLs during 2009.Coverage ratios in the sector remain low, with specific impairments for NPLs at51.7% at end2009 (2008: 53%). Fitch notes that the rapid credit growth reported bycertain Kenyan banks since 2006 may result in deteriorating asset quality and higherimpairment charges as these loans begin to season.

    Capital adequacy in the system should be seen in the context of the potentiallyvolatile operating environment, loan growth levels, risk concentrations and levels ofloan loss reserves covering NPLs. In addition, banks are beginning to expand intoother East African countries. Given these features Fitch considers core capitalratios as being tight for a number of banks. While the banking sectors Tier 1 andtotal capital adequacy ratios (CARs) remained stable and appear more comfortableat 18.4% (end2008: 18.0%) and 20.6%, respectively, at end2009 (end2008: 20.2%),these ratios benefit from a couple of banks being relatively well capitalised.

    Moves by the Central Bank of Kenya (CBK) to phase in progressively higher minimumcapital requirements is a positive trend, particularly if it results in someconsolidation among the smaller banks in the system. The Kenyan government alsointends to divest from public financial institutions. If this occurs, this may give

    further impetus to consolidation in the sector.

    Other positive initiatives by the CBK include the formal introduction of agentbanking and antimoneylaundering legislation during 2009. The introduction ofagency banking offers a more costeffective channel through which to serve Kenyassizeable unbanked population. During 2009, the CBK also licensed its first deposittaking microfinance institution and, with eight other microfinance institutions atvarious stages in the licensing process, this could lead to increased levels ofcompetition while providing individuals with improved ability to access financialservices.

    Analysts

    Frederick Fouche+27 11 380 [email protected]

    Denzil De Bie+27 11 380 [email protected]

    Anthony Walker+27 11 380 [email protected]

    Related Research

    CfC Stanbic Bank Limited (August 2010)

    http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=539605mailto:[email protected]:[email protected]:[email protected]
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    Kenyan Banking Sector: Annual Review and OutlookSeptember 2010 2

    Profile

    CompositionThe Kenyan banking sector comprised 44 commercial banks and two mortgagefinance companies at end2009 (end2008: 45). The industry is concentrated, withthe 10 largest banks controlling 71.9% of the banking sectors assets at end2009.

    ClassificationThis report focuses on the 12 largest commercial banks by total assets included inthe 46 Kenyan financial institutions (see Table 1), segmented into three categories:foreignowned banks, stateowned/stateinfluenced (SOSI) banks; and secondtierbanks. The full list of banks is available in Annex 1.

    ForeignOwned BanksCommercial banks with foreign shareholding in excess of 50% and local branches ofinternational institutions represented 13 of the total number of commercial banksin Kenya.

    The report focuses on the four largest by system assets: Barclays Bank of KenyaLimited (Barclays Kenya); Standard Chartered Bank (Kenya) Limited (StandardChartered); CfC Stanbic Bank Limited (CfC Stanbic); and Citibank N.A. Kenya(Citibank).

    SOSI BanksSOSI banks refer to banks that have government participation and/or significantgovernment shareholding or are influenced by the Kenyan government.

    The entities that will be covered in this report under this category are: NationalBank of Kenya Limited (NBK; 70.6% stateowned at end2009); Kenya CommercialBank Limited (KCB; 28.8% stateowned); and Cooperative Bank of Kenya Limited(Cooperative).

    SecondTier BanksSecondtier banks are largely privately owned and historically held a niche position,such as servicing highnetworth individuals or asset finance, before they convertedto commercial banks. The secondtier banks referred to in this report are:Commercial Bank of Africa Limited (CBA); NIC Bank Limited (NIC Bank); DiamondTrust Bank (Kenya) Limited (Diamond Trust); I&M Bank Limited (I&M Bank); andEquity Bank Limited (Equity Bank).

    Presentation of AccountsFitch has prepared this report with reference to the banks audited resultsannouncements, prepared in compliance with CBK guidelines, and the CBKs annualbanking supervision report at 31 December 2009. The agency notes that in certain

    instances the figures disclosed for loan loss reserves and nonperforming loans inthe audited financial statements for some institutions may differ from the figuresdisclosed in their audited year end results announcements. This may arise as aresult of different reporting requirements under International Financial ReportingStandards (IFRS) and CBK guidelines. In terms of the CBKs guidelines, Kenyan banksare required to appropriate certain retained earnings to a statutory loan lossreserve to account for the difference in loan loss reserves calculated in terms ofthe CBKs provisioning guidelines and IFRS.

    Possibility of ConsolidationFitch considers the key drivers of consolidation in the Kenyan banking sector will bethe continuation of state divestment from public financial institutions, increasingCBK capital requirements and higher levels of IT investment.

    Fitch has been advised by the CBK that the Kenyan government intends to divestfrom NBK and Consolidated Bank of Kenya Limited (77.8% stateowned). Anothergovernmentled initiative is the CBKs requirement for commercial banks to attain

    Table 1: Kenyan BankingSector ProfileForeignowned banksBarclays Bank of Kenya LimitedCfC Stanbic Bank LimitedCitibank N.A. KenyaStandard Chartered Bank LimitedSOSI banksCooperative Bank of Kenya LimitedKenya Commercial Bank LimitedNational Bank of Kenya Limited

    Secondtier banksCommercial Bank of Africa LimitedEquity Bank LimitedDiamond Trust Bank LimitedNIC Bank LimitedI&M Bank Limited

    Source: Fitch

    Small and fragmentedbanking sector

    Increased minimum capitalrequirement and ITinvestment heighten thepossibility of consolidationamong smaller banks

    Government intends toprivatise public financialinstitutions

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    Kenyan Banking Sector: Annual Review and OutlookSeptember 2010 3

    minimum capital levels of KES500m by end2010 (end2009: KES350m), KES700m byend2011 and ultimately KES1.0bn (about USD12.6m) by end2012 (see Annex 2).The increased capital requirements led to the merger of Southern Credit Banking

    Corporation Limited (Southern) and Equatorial Commercial Bank Limited (EquatorialBank) during 2010 (see Capital).

    The operating efficiency of the banking sector remained almost unchanged during2009, with the operating expenses/average assets ratio at 6.3% at end2009 (end2008: 6.4%), which is weaker than that of more efficient banking systems. Recent ITinvestment by certain large Kenyan banks (see Operating Expenses), which includedusing mobile phone technology as a delivery channel, is likely to improveoperational efficiency and customer service, promote financial access to theformally unbanked population (see Introduction of Agency Banking), and reducefraud losses.

    Consolidation of the Kenyan banking sector is also a key driver in improving theefficiency and profitability of Kenyan financial institutions. However, mergers may

    be hampered by the fact that many of the smallerscale banks are privately held,with owners less inclined to sell off their investments.

    Recent Regulatory ChangesCredit Reference Bureau EstablishedThe Banking (Credit Reference Bureau) Regulations, 2008, paved the way for thelicensing of the first reference bureau in Kenya, namely, Credit Reference BureauAfrica Limited, in March 2010. The regulations mandate the CBK to supervise creditreference bureaux and require institutions licensed under the Banking Act to reportnegative borrower information. The sharing of credit information by theseinstitutions became mandatory from 31 July 2010.

    The sharing of quality credit information through the bureaux is likely to help to

    improve risk management practices within Kenyan financial institutions and tomake credit more accessible and affordable to the broader Kenyan population.

    New Legislation on MoneyLaunderingThe Proceeds of Crime and AntiMoney Laundering Act, 2009, which took effect on28 June 2010, criminalises money laundering, prescribes procedures forinternational collaboration in investigations and proceedings, and establishes anumber of related bodies. The Financial Reporting Centre (FRC) will aim to identifythe proceeds of crime, assisted in an advisory capacity by the AntiMoneyLaundering Advisory Board (AMLAB). The Assets Recovery Agency will seek torecover the gains derived from criminal activity. In support of these initiatives, theCBK is permitted to share bank information with fiscal, tax agencies and fraudinvestigation agencies. The AMLAB acts in an advisory capacity to the director of

    the FRC.

    In addition, the legislation requires reporting institutions to monitor and reportsuspected moneylaundering activity, to verify customer identity and to establishand maintain customer records.

    Introduction of Agency BankingAgent banking was formally introduced into Kenya by the Finance Act, 2009. Theact permits financial institutions to contract CBKapproved third parties (agents) toconduct banking activities on their behalf. Agent banking offers a more costeffective channel through which to serve the formally unbanked segment, whichaccounted for 77.4% of the Kenyan population at end2009.

    Deposittaking microfinance institutions are another avenue through which the CBKaims to enhance financial access. The CBK licensed the first deposittakingmicrofinance institution, Faulu Kenya Limited, during 2009 following the rollout ofthe Micro Finance Act during 2008. At end2009, eight applications to become a

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    Kenyan Banking Sector: Annual Review and OutlookSeptember 2010 5

    Interest income on advances remained the primary source of interest income during2009, contributing 75.5% of gross interest income (2008: 73.4%). Following aslowdown in credit extension and an inflow of deposits during 2009, banks

    channelled their surplus liquidity into government securities, comprising treasurybills and bonds. Interest income earned on government securities and interbankplacements was negatively affected by a significant reduction in market ratesduring 2009.

    As a result, Fitch estimates that the industrys net interest margin reduced to 7.8%in 2009 (2008: 8.0%) as lower returns on government securities and interbanklending offset higher lending rates despite the CBKs efforts to reduce rates.

    NonInterest IncomeGrowth in noninterest income was subdued at 4.6% in 2009 (2008: 32.6%) onaccount of a 9.3% reduction in foreignexchange earnings (2008: increase of 74.4%).Foreignexchange earnings weakened because of lower customer flows attributableto the negative economic effects of the global financial crisis during 2009.

    Operating ExpensesOperating expenses increased by 17.4% during 2009 (2008: 27.1%). Personnelexpenses grew by 16.0% as banks sought to retain highcalibre staff and managerialstaff accounted for a larger percentage of the sectors staff complement at end2009. The investment in IT infrastructure and electronic distribution channels werethe main drivers of the 18.9% increase in other operating expenses (2008: 25.9%).

    Rising operating expenses were partially offset by improved net interest income,which limited the weakening in the sectors Fitchcalculated cost/income ratio to58.1% (2008: 55.9%). The foreignowned banks continued to report efficiency ratiosin line with the average of the sector. SOSI banks generally have highercost/income ratios than the industry average or other categories of Kenyan banks.

    Loan Loss ProvisionsThe industrys impairment charge for 2009 decreased by 16.3% during 2009 (2008:increase of 84.8%), despite rising NPLs (see Loan Loss Experience and Reserves).There were some exceptions to the reduced 2009 impairment charges: NIC Bank (up138.2%), Cooperative (up 55.8%) and Diamond Trust (up 51.8%).

    ProspectsFitch expects the 2010 financial performance of the Kenyan banking sector toimprove on 2009 in light of the continuing Kenyan economic recovery, increasedlevels of noninterest income and lower operating costs. However, theseimprovements may be partially offset by margin pressures and higher creditimpairment charges for certain banks.

    Agent banking and the banks investments in IT infrastructure and electronicbanking channels should improve efficiencies and generate higher levels oftransaction income.

    Tighter interest margins may arise from increased competition for customerdeposits, reduced treasury bill rates and a migration of customer deposits tohigheryielding instruments as Kenyan banks lower their lending rates during 2010.Rapid credit growth reported by certain Kenyan banks since 2006 may increaseimpairment charges as these loans begin to season.

    Risk ManagementThe sophistication of risk management in the Kenyan banking industry is increasing,but remains in a developmental stage relative to global peers. However, Fitchacknowledges the CBKs efforts to facilitate greater information sharing and cooperation between regional supervisors. Fitch believes that moves to consolidated

    Credit risk is the main riskin the Kenyan bankingsystem

    Weak asset quality withincreasing NPLs during2009

    Operational risk is on theincrease as the

    implementation ofnumerous IT solutionsgives rise to changemanagement challenges

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    Kenyan Banking Sector: Annual Review and OutlookSeptember 2010 6

    supervision will enhance effective monitoring of Kenyan banks as they expandregionally and their risk profiles change. Credit risk represents the primary risk typeand relates mostly to domestic lending activities.

    Credit RiskGrowth in gross loans (net of interest in suspense) moderated to 13.9% during 2009(2008: 26.6%) within a difficult operating environment. Recent strong credit growthcould lead to higher levels of NPLs and impairment charges as portfolios season.Five of the 12 selected banks, namely Equity Bank (up 45.0%), NBK (up 35.3%),Standard Chartered (up 30.2%), KCB (up 27.5%) and Diamond Trust (up 24.6%)reported credit growth in excess of 20% during 2009, despite a tougher lendingenvironment.

    At end2009, the banking sectors lending portfolio was concentrated in terms ofeconomic sector, with the personal/household sector (29.3% of total loans), thetrade sector (17.9%), the manufacturing sector (14.0%) and the real estate sector(10.1%) as the largest sectors. At end2009, the agriculture sector accounted for5.8% of total lending compared with the sectors 23.4% contribution to Q309 GDP.Lending to this sector may be stimulated by the introduction of crop insurance in2010 and governments planned increase in the size of irrigated land.

    The loan books of Kenyas five largest banks represented about 55% of the sectorstotal loans at end2009. Relatedparty lending in the Kenyan banking sectoraccounted for 5.4% of gross loans (end2008: 4.8%). About 61.0% of these loansrelated to lending to the banks own employees (end2008: 60.8%).

    Lending for the purposes of acquiring shares by some Kenyan banks has been arecent feature, although this form of lending is not separately disclosed by banks.

    Loan Loss Experience and Reserves

    The Kenyan banking sectors asset quality weakened in 2009: NPLs (net of interestin suspense) increased by 5.6% to KES50.9bn at end2009, although more slowlythan the 15.0% recorded for 2008. The sectors asset quality indicators, however,benefited from further loan growth during 2009, with the Fitchcalculated NPL ratio(net of interest in suspense) reducing to 6.8% at end2009 (2008: 7.3%). Thesectors specific impairment coverage ratio worsened slightly to 51.7% (2008:53.0%) as NPL growth outpaced the increase of 3.1% in loan loss reserves. Fitchconsiders loan loss reserve coverage to have been low at end2009.

    Although collateral is widely used by Kenyan banks to mitigate against credit losses,the realisation of collateral in Kenya can prove challenging, which is an issue beingreviewed by the authorities. Fitch estimates that the sectors Tier 1 capitaladequacy would have reduced to 15.8% at end2009 if Kenyan banks were to

    maintain a 100% specific impairment coverage ratio (see Capital).

    SOSI banks asset quality was weaker than those of foreignowned and secondtierbanks at end2009, contributing 37.9% to the sectors NPLs (see Chart 1). At end2009, the NPLs of five banks accounted for between 60% and 70% of the sectorsNPLs. Fitch notes that Equity Bank (up 91.2%), Diamond Trust (up 50.0%) and KCB(up 48.1%) reported significant yearonyear increases in NPLs and considers thatfurther deterioration is possible in light of the recent rapid credit growth.

    0

    20

    40

    60

    80

    100

    Gross loans NPLs

    Foreign banks SOSI

    Secondtier Rest of sector

    Chart 1: Loans and NPLs

    (%)

    Source: Fitch

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    Kenyan Banking Sector: Annual Review and OutlookSeptember 2010 8

    LiquidityFitch considers the liquidity of the Kenyan banking sector at end2009 to beacceptable, supported by the improvement in the sectors gross loans/customer

    deposits ratio to 74.3% (2008: 76.0%). The increased holdings of governmentsecurities, which qualify as liquid assets, boosted the industrys average liquidityratio to 39.8% (end2008: 37.0%; regulatory minimum: 20%).

    Less attractive returns on government securities may encourage surplus liquidity toflow into some planned capital market issuances. In the past, particularly largeissuances have put pressure on system liquidity, with some banks being moreaffected than others.

    CapitalThe CBKs minimum Tier 1 and total CARs of 8% and 12%, respectively, arecomputed on a bankonly basis. The Kenyan banking sector reported stable bankonly capital ratios for 2009: the Tier 1 ratio was 18.4% (end2008: 18.0%) and the

    total CAR 20.6% (end2008: 20.2%). Capital levels benefited from retained profitsand capital injections, with shareholders funds increasing by 18.4% (2008: 28.1%).

    Fitch notes that while investment in subsidiaries is impaired against capital, a bankonly capital adequacy computation may not adequately capture the additional risksand changing risk profile associated with the recent regional expansion into otherEast African countries.

    The sectors average Tier 1 ratio is inflated by certain banks holding significantlevels of capital in excess of the minimum: NBK (40.9%), Citibank (29.0%), EquityBank (25.8%) and Cooperative (20.3%). In contrast, many banks reportedsignificantly lower Tier 1 ratios. At end2009, two banks Southern and CityFinance Bank Limited (City) held capital and reserves below the CBKs regulatoryminimum of KES350m (see Annex 2). Southerns noncompliance with the regulatoryminimum was, however, addressed by its merger with Equatorial Bank during 2010.Similarly, City has been amalgamated with a Kenyan microfinance institution during2010.

    Fitch views the planned increase in the minimum levels of core capital as a positiveinitiative but notes that this is only likely to affect smaller institutions in thesector. Consequently it is unlikely to address the vulnerability of the banks in thesystem to risk concentrations, both from a sector and a single obligor perspective.Fitch considers the industrys overall level of Tier 1 capital to be low in light of lowimpairment coverage ratios and strong credit growth (see Credit Risk).

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    Kenyan Banking Sector: Annual Review and OutlookSeptember 2010 10

    Annex 2

    Kenyan Banks With Capital and Reserves of Less Than KES1bn atEnd2009Bank Capital and reserves at end2009 (KESm)

    UBA Kenya Bank Limited 996.0Oriental Commercial Bank Limited 982.0Habib Bank AG Zurich 958.0Victoria Commercial Bank Limited 935.0Consolidated Bank of Kenya Limited 927.0Middle East Bank Limited 904.0Guardian Bank Limited 873.0Giro Commercial Bank Limited 857.0Habib Bank Limited 747.0Equatorial Commercial Bank Limiteda 730.0Credit Bank Limited 728.0First Community Bank Limited 663.0

    Paramount Universal Bank Limited 527.0Fidelity Commercial Bank Limited 490.0Dubai Bank Limited 463.0City Finance Bank Limited 315.0Southern Credit Banking Corporation Limiteda 5.0

    a See CapitalSource: CBKs 2009 Banking Supervision Annual Report

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    Kenyan Banking Sector: Annual Review and OutlookSeptember 2010 11

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