Converting loans into equity is risky for banks

Kenya Airways CEO Michael Joseph(L) and Kenya Airline Pilots Association(KALPA) Secretary General Captain Paul Gichinga addresses the press at KICC on Monday 17/10/16

SUMMARY

• Kenya Airways borrowed money from some commercial banks but is finding it difficult to service the loans
• Apart from borrowing funds from banks, businesses can also issue bonds to the public in raising money to finance their activities

Depositors keep money in commercial banks because it’s safe and makes economic sense. Banks are also important institutions in a capitalist economy.

Commercial banks are key in an economic sense because they channel funds from those who do not have a productive use for them to those who do. In that way, banks ensure higher economic efficiency.

They are the most important financial intermediary in propelling the economic growth by supporting the expansion of physical capital, human capital and innovation.

We always hear of a consortium of banks financing key infrastructure projects such as hospitals, airports, roads, dams and harbours. A robust commercial banking system must ensure an uninterrupted flow of funds between savers and borrowers. Such a system must be information driven.

There must be credible information that is relied upon by commercial banks to make informed lending decisions. Debt market is a venue from which businesses and governments raise funds for projects. Such a market is vital to any economic activity, and is where interest rates are determined.

Apart from borrowing funds from banks, businesses can also issue bonds to the public in raising money to finance their activities. When the company issues bonds, the bond buyer gives the company cash in return for the bonds on paper that act as evidence that the buyer has lent money to the issuer of bond.

The borrower will then pay interest on a periodic basis to the buyer who has bought their bonds. Lenders do not often anticipate that borrowers will default on their debt obligation; nobody would lend money to an individually or an institution that is likely to default.

However, firms might experience financial difficulties that render them unable to honour their debt obligations.

This is the case with Kenya Airways (KQ). It appears KQ borrowed money from some commercial banks but is finding it difficult to service the loans.

The worry is that KQ wants their loan converted into share capital so that they avoid paying interest and repaying the principal amount it borrowed.

My finance background tells me that converting bank loans into shares might compromise the bank’s liquidity. In addition, shareholders’ rights in a company are significantly different from those of the debt holders, such that converting debt into shareholding results in significant shift in risk from Kenya Airways to commercial banks.

We do not know how large these loans are, but if they are substantial amounts, and that the loans were from main banks, due diligence must be taken before converting them into the share capital, if we are to avoid a financial crisis.

Such transaction can send a bank into oblivion because the bank will surrender liquidity associated with amounts advanced.

Equity capital

The differences between debt capital and equity capital are in terms of return, risk and time. Holders of debt are more certain about receiving interest than shareholder banking on receiving dividends.

Therefore, converting loans into shares might be favourable to the borrower but adversely compromises the risk complexion of the lending bank, thus impacting unfavourably on the share price of the lending bank.

Before recommending the conversion, one needs to understand how banks are managed or where the banks got the money, they lent to KQ.

The way banks work does not envisage the conversion of an amount advanced to a borrower into share capital. The primary sources of funds are deposits and borrowed funds, with share capital acting as a buffer; and banks invest the funds in loans and investment securities.

Loans are of different type, and create credit, liquidity and interest rate risks to the banks. Banks must repay the loans and deposits, and that is why it is not advisable that banks subscribe for shares in companies.

Therefore, requiring banks to convert advances to share ownership exposes them to refinancing risk. Conversion is only recommended if a bank issues additional shares, and the proceeds from the share issue used to boost the commercial bank’s liquidity.

Furthermore, banks match assets and liabilities of different maturities to maximise on their net income, therefore converting bank loans to shares complicate matters. Remember that shareholders cannot get back their money unless the firm is winding up. In any case, shares issued by a company under reconstruction cannot fetch good price at a security market. The bank might end up with shares that it will find difficult to dispose.

Such shares can be sold only at fire-sale prices. CBK and other regulators must come up with rules that guide commercial banks on limits on loan capital changing to share capital.

The Japanese banks almost collapsed when commercial banks lent heavily to real estate and subscribed for shares in corporations. It took effort of Japanese government and intervention of foreign financial institutions to save them.