This research report was prepared by the Research Department of Old Mutual Securities Limited. Old Mutual Securities Limited is a securities trading company licensed by the Capital Markets Authority (Kenya) for the purpose of facilitating trade on the Nairobi Securities Exchange.

The key highlights:
  • Loan book impetus recompense dwindling margins - Amid tightening NIMs (OMS universe coverage 8.5% FY15e vs. 8.8% in FY14), loan book growth momentum will maintain NII growth (3-year CAGR of 14.4% to FY17e). We opine that corporate-orient banks preference on retail market will remain strong. We expect CoR on total RWAs to remain elevated from 0.7% in FY14A to 0.8% FY17e due to the banks‘ increasing retail exposure. The pressure on lending rates is evident as witnessed in just +15.9% y/y growth in interest income vs. +26.0% y/y growth in interest expense in FY14. This means that on average, banks will increase exposure to the under-penetrated retail market to mitigate declining margins. In FY14, sector advances grew by +25.0% y/y while customer deposits grew by +26.1%y/y.
  • Strong NFI growth momentum – There is a significant NFI contribution (35-40%) on operating income. We think this trend will maintain as banks continue to enhance their service delivery channels with a bias on internet, agency model and mobile platforms. This will shield the performance of corporate-orient banks – the likes of NICB KN & SCBL KN – which are highly exposed to interest rate risk (as highlighted by the falling NIMs) as corporate loans and deposits remain highly competitive and price sensitive unlike retail-orient banks – in the likes of COOP KN, EQBNK KN & BCBL KN - which have varied flexible pricing power. As a result, we see the sector‘s efficiency improving with CTI ratio averaging at 48-53% by FY17e.
  • Asset quality - We expect NPL ratio to remain at low levels partly driven by heightened regulatory scrutiny, banks‘ improved risk-management capabilities and also because of increased write-offs. Nonetheless, asset quality will remain a key risk, partly reflecting unseasoned loan books and the evolving nature of risk-management processes. There seems to be a shift in the drivers on NPL growth, from the consumer side to government contractors and suppliers. We note the potential risk emanating from retail segment exposure though the expected ease on interest rates augurs well on NPLs. We expect the sector‘s gross book quality to maintain at below 4.7% and as a result lead to steady cost of risk (below 0.8%). We expect the NPL coverage to improve from 39.4% in FY14 (excluding DTKL KN and IM KN) to 48.3% in FY17e.
  • Securitization; the heart of asset-liability match: Asset-liability mismatch is evident in the sector given the region‘s poor savings culture prompting for short-term bank deposits vs. long-term bank loans. We expect to see heightened financial engineering within the sector such with the launch of Asset Backed Securities (ABS) such as mortgage backed securities (MBS) as this will cement the banks‘ capital position allowing them to underwrite more loans. Nonetheless, we expect banks to maintain high liquidity buffers – with liquid assets typically exceeding 25% of customer deposits.
  • Potential regulatory changes - In February the IMF recommended that ―the CBK should remain vigilant and act as needed to head off any pressure from rapid credit growth and the envisaged scaling up of infrastructure spending — potentially by raising interest rates. Again, we note the KES 64b (USD 688m) standby loan facility by IMF which could have been possibly issued on conditions among them, a recommendation for a contractionary monetary policy and stiff regulations on banks provisioning. The pressure piles on the government to strike a balance between economic growth and managing risk. Higher interest rates would result to high NPLs; higher NPLs would lead to provisioning concerns. If CBK addresses provisioning concerns, Kenyan banks would be forced to increase their loan loss provision expense, which in turn would hurt the sector‘s profitability.
  • House of cards: The proposed change in the Finance Bill 2011 creates two centres of power and takes away Central Bank‘s independence and is not in line with global best practices (OECD and US). According to the immediate former governor, Prof. Njuguna Ndung‘u, that office undermines the unanimously accepted principle of Central Bank‘s independence. Holding the influential chairman‘s position without security of tenure exposes the occupant to political pressure whose impact on the bank is "hard to predict".
  • Strong capital base: We estimate an average of 18.5%-19.5% in Tier 1 capital ratio in FY15e, well above the minimum requirement of 14.5%, which suggests that the local banks can absorb further deterioration of the book quality. Nonetheless, these capital buffers are needed to grow the balance sheet as well as shield against volatile NPL levels and to some extend the zero-risk weightings on government securities.
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