Kenya should prepare for crisis and economic slowdown after capping interest rates

In Kenya, like in most other countries, the public has always resented banks for raking in hugely obscene profits. Those pushing the lending cap laws which President Uhuru Kenyatta has now signed into law, knew this and ultimately took full advantage of it.

In fact, the president referred to the high return on equity Kenyan banks enjoy when compared with other sectors of the economy. What many don’t realise, however, is that not all bank profits end up in shareholders pockets at the end of the day. And that these banks in fact, need to make adequate profits if the system is to remain financially stable and to lend to the real economy.

Whereas the proponents of lending caps remained fixated with the big bank profits, they put little or no thought for the other constituents in the banking system and the complexity of the decisions banks make as they try to satisfy the desires of all their customers and capital providers while at same time, complying with ever increasing regulatory requirements.

For example, banks are now required to hold more shareholder capital. And the bank’s core capital is what protects citizens from banking crises.
The global financial crisis showed that undercapitalised banks are a huge threat to financial stability and the economy in general.

Adequate core capital in the banking system is thus a booster of confidence for all stakeholders. It provides the regulatory authority, the public and the customer with confidence in the continued financial viability of the banking system.

Confidence to Wanjiku that her money is safe; to the public at large that the banks will be and are, in a position to give credit and other banking needs both in good and in bad times and to the regulator that the banks are and will remain, a going concern.

Given the absence of deep and sophisticated capital markets, the main source of core capital for the banks in Kenya today remains internally generated capital in the form of profits.

Grab a copy of Equity Bank’s 2015 annual report and have a look at its balance sheet.

You will note that of its strong Sh72 Billion of shareholders’ equity, Sh52b is from retained earnings. That is a massive 72 per cent. In fact, according to CBK’s Banking Supervision report of 2015, retained earnings accounted for 63 per cent (Sh288.5b) of the industry’s total core capital amounting to Sh457b. That is profits which are retained in the banks and which will help banks lend more to the economy.

With an average core capital adequacy ratio of 16 per cent, it means the industry has the capacity to lend 6.25 times the Sh288.5b that is in retained earnings. That is Sh1.8 trillion in risk weighted assets that it is able to lend as a result of internally generated profits.

The banks therefore need good profits if they are to continue to provide more loans to the economy and keep capital in line with their loan books.

If the system is not generating sufficient profits for organic capital and paying dividends that enable it to attract external capital, it will be unstable and will inevitably shrink its asset base in order to improve its capital ratios by lending less, which will then hurt the economy.

And if as is suggested, the law will apply to existing deposits and loans and advances, then we are staring at a potential banking crisis and economic slowdown.

Most of the banks already have their bottoms on fire with a high stock of bad loans after the bad loan clean-up exercise initiated by Patrick Njoroge, the Central Bank of Kenya governor. Mr Kenyatta’s signature on the Bill that caps rates, therefore, could not have come at a worse time for the industry. That explains last week's bloodbath at the Nairobi Securities Exchange.

Mr Kenyatta’s administration has done what both the Moi and Kibaki administrations were rightly advised not to do. The president went against the advice of Dr Njoroge and Treasurer and opted for some kind of radical economic experiment in trying to politically allocate credit instead of sticking with the existing market-based system. You cannot have politically directed credit, however well intended. It simply won’t work.

To do so risks not just pork-barrel politics but the possibility that the administration would end up causing financial instability in the pursuit of cheaper credit to all; that will definitely not materialise.

Despite the obvious weaknesses of the old system, this was in every respect the wrong decision. The reality is that it is in all our interests that the banking industry remains stable and soundly profitable for it to lend more to the economy.