Global banking, both as a profession and
as an ecosystem, changed materially post-2008 financial crisis leading
up to the global economic travesty of 2009 and 2010.
However,
given the transmission channels of the crisis to emerging markets, the
effects on particularly sub-Saharan Africa (SSA) were largely muted, SSA
chartered a path unfettered by the events of Wall Street on that
fateful day of September 15, 2008 when Lehman Brothers filed for
bankruptcy.
Despite this insulation, the region, and
particularly Kenya banking has navigated unchartered territories, more
globally speaking, in the recent months.
I
left my office at the former Lehman building last September, into the
global financial services conference in New York, taking a break from
the typical 90-hour work week.
This was meant to be
another afternoon meeting with fellow bankers from across the street for
an afternoon downtime, before getting back to office.
The
content of this conference oscillated around the post-financial crisis
pivot, from 10 years back, where the overarching debate was whether
banks had learned their lessons, given an observed rally on risk in
2016.
This conference was about technical stuff, but I came
out of it with a simple, almost trite, revelation that has since changed
my philosophy of banking and financial markets: That without taking
risks banks have no real purpose to the society.
The
social contract from after the great depression in 1930 to 2008 between
the society and banks was the following — if the bank provides liquid
savers a place to keep money, that’s a good thing; if the bank takes
those deposits to lend to those who are in need of money, that’s a good
thing.
That process of lending long term from short
term deposits is the economic contribution of banks. So the notion of
taking short term deposits and converting them to 5–10 year loans —
also technically known as maturity transformation, worked for 70 years
until the crisis.
The
primordial social contract of banks has, therefore, been very simple
and non-esoteric, in that societies are propelled to economic prosperity
for most part by commerce, and the oxygen of commerce is finance which
permeates through the pipes of banking and financial markets.
This
inseparable nature of banking and its societal obligation, through
commerce, can only be true in an environment where banks can take risk.
In
the very simple nature of risk taking, commercial banks take deposits
and extend those deposits to borrowers to finance home ownership,
education or small business ventures.
In so doing,
banks assume, as is always true, that some borrowers will not pay back
their loans. That’s credit risk. Financing a home ownership of any
nature involves a view on whether the home value will change in the
future, therefore impairing the ability of borrowers to refinance with
the bank. That’s market risk.
By contract, depositors
have a right of access to their money regardless of whether banks have
utilised those deposits to on-lend to long-term borrowers.
That
creates liquidity risk. When an investment bank helps the government
underwrite a bond to finance construction of roads, rail and bridges,
with the promise that identified lenders to the government will honour
their commitments, that creates residual risks.
When
banks help oil producing country lock in a future price for crude
exports to better manage government revenues from oil sold in foreign
markets, that trade creates basis risk.
And then there
is operational risk, which in itself anchors very basic functionalities
of banking; like a cash machine working 24/7, a mobile banking app being
active when you need it and a foreign exchange desk accessing
information required to support exports for a flower farming business.
Without
taking these risks, banks will have no real purpose to the society
because finance and commerce will be structurally impaired.
This
simple fact makes pricing for bank services a very complex affair. It
is with no certainty that all aforementioned risks can be quantified
into a simple rate for a bank loan, a deposit service fees or a foreign
exchange trade commission.
Even if it were possible to
quantify the precise impact of these risks, the potential future
exposure, as a result, is a bit of a numbers game.
It
is this disconnect between the simplicity of the role of banks to the
society, and, the complexity behind pricing bank products and services
that renders any form of banking price controls, in any market,
ineffective.
Price controls in inefficient markets have
instantaneous distributional consequences given the dislocations
highlighted above. Even in markets where such controls have been used to
funnel the industry through an efficiency-seeking cycle, such
hypotheses have had their usefulness end. Case in point being the
one-sided Zambian interest rates cap that was removed in 2015.
Arguing
for the existence of interest rate capping laws is not about banks
making too much money at the face value of published profit numbers, as
that is too simplistic.
It’s true that bank returns in
Kenya are above 20 per cent but if you benchmark that against cost of
capital, which is pegged on the government paper rate — the risk-free
rate — and assuming market risk and idiosyncratic characteristics of
each bank, the value created by banks is somewhere in low single digit
of 2–5%.
Bank of Kenya building in Nairobi. FILE PHOTO | NMG
In other words, profitability of banks
in Kenya is a relative construct, which means a 20 per cent plus return
on equity is not good enough given most banks operate with a cost of
equity of 18-20 per cent.
In a developing economy like
Kenya, the cost of equity has more to do with government policy, and the
consequent government borrowing rate, than it has to do with how banks
are structured or managed.
The major component of the
cost of capital is systemic, not idiosyncratic. It is a relative
consideration that needs to be made when talking of Kenyan banks as
being the most profitable.
I put it to you that
investor fund flows to the Kenyan market have selectively pursued
companies with the highest value creation, and banks have not been part
of that cohort, even during the pre-capping law era.
It
is this reality that should lead us to conclude that a published profit
number by a bank of say Sh10 billion has very little information, when
taken at its face value.
How will banks, therefore,
honour their social contract and deliver value creation for their
shareholders, if risk taking is curtailed by the fact that risk cannot
be effectively priced? Whilst this question may attract philosophical
debates, to my mind, it’s also true that the inability to price for risk
has been a wake-up call for banks to re-design their business models,
the result of which ultimately, is good for both shareholders and the
society.
There has been a greater good here — as a result of the capping laws — that should not be underestimated.
Given
mistakes of the past, speaking more broadly and more globally,
corrective policies can be punitive but should not be prohibitive.
The
distributional consequences of the capping law that we are witnessing
are much broader than would have been initially anticipated. And given
the interconnectedness of the financial ecosystem, it is hard to predict
the precise outcomes for the future as a result of such laws.
An
economist recently told me that the impact of the interest rate caps is
likely to be 100-150 basis point drop in Kenya’s growth in gross
domestic product (GDP), which is roughly $700 million or Sh73 billion of
GDP or the entire economy of Samoa, wiped off in a year.
The
more precise backdrop is that the growth in private sector credit has
fallen to 2.1 per cent in 12 months to May from above 18 per cent a year
ago, indicating that Kenya is headed to a balance sheet-lending led
recession.
Banks
have also moved more than $1 billion (Sh104 billion) of customer
deposits into government securities since the capping law came to
effect, the opportunity cost of which is lending to the real economy.
The
consequence of all this is that the funding and liquidity spiral will
benefit “risk-free” borrowers and therefore counter-intuitive to the
social contract of banks; that of taking risks and supporting the real
economy.
Futuristically speaking, the world of maturity
transformation which underpins the existing social contract of banks is
being challenged globally, and the future is going to be differentiated
by how banks look for funds outside customer deposits (through capital
markets) to on-lend to long-term borrowers at a lower cost.
This
will make maturity transformation very risky if the reality is that
banks will become intermediaries in the future where capital anchoring
will be the role of banks in the future society.
This will therefore somewhat change the social contract of a deposit taker — and lender — to intermediaries of capital.
Whichever
route banking takes, fundamentally, the lenders will continue to hold
together the underlying fabric of commerce and should be allowed to
freely price for risk.
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