Banks should let go of large capital piles in their vaults

 

In the middle of the coronavirus scourge, and at a time when businesses and households are still pandemic-scorched, Kenyan banks doubled their net earnings year-on-year to Sh50 billion during the second quarter of 2021.

By GEORGE BODO
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SUMMARY

• Essentially, banks are convinced that the worst of the pandemic on their obligors is over and it’s time to claw back some of the impairment losses they recognised in 2020. Which is exactly what they did.
• To a very large extent, IFRS 9, the accounting wizardry on which banks recognise and measure their financial assets, took away prudence when it comes to risk judgements.
• Nonetheless, if indeed banks believe that the worst of the pandemic is over, then they should now let go of the large capital piles they are holding.

However, upon review, these ‘strong’ earnings were primarily driven by reduction in loan impairment charges (as bad loan impairment charges were down by half year-on-year during the quarter).

Essentially, banks are convinced that the worst of the pandemic on their obligors is over and it’s time to claw back some of the impairment losses they recognised in 2020. Which is exactly what they did.

To a very large extent, IFRS 9, the accounting wizardry on which banks recognise and measure their financial assets, took away prudence when it comes to risk judgements.

Nonetheless, if indeed banks believe that the worst of the pandemic is over, then they should now let go of the large capital piles they are holding.

First, they have stopped lending and have instead resorted to piling liquidity elsewhere.

They are now buying more and more Treasury Bills and Bonds to the extent that the share of debt securities to total assets crossed 30 per cent at the close of the quarter, while the share of loans and advances to customers, their core business, dropped to below 50 per cent, from a high of 60 per cent six years ago.

Banks are now so liquid that overall liquidity ratio hit a record high of 57 per cent in the second quarter, which means that for every shilling of customer deposit they were holding, 57 cents was sitting in liquid assets that can be converted into cash on demand (such as reserve and clearing account balances, Treasury bills and bonds, placements locally and abroad).

Banks are only required to hold a minimum of 20 per cent of deposits in liquid assets.

Equity Bank, for instance, closed the quarter with a staggering liquidity ratio of 88 per cent, the highest among its larger Tier one peers; followed by Standard Chartered at 70 per cent (there was even a medium-sized bank with 100 per cent liquidity ratio).

In fact, it is high likely that overall banking sector liquidity ratio will hit 60 per cent by the close of the year (a level which also present its own set of challenges). A major challenge here is balancing between the cost of funding and the returns on assets.

If the cost of funding remains sticky while the yields on assets fall, as has been the case since 2017, then potentially business margins will continue softening. Which is the major reason why banks have lately been unable to return their cost of equity.

With returns on equity plunging to below 15 per cent in 2020 against cost of equity of around 17 per cent, economic returns on bank capital have been negative. And yet bank shareholders have seemingly deployed excess capital to guarantee less capital-intensive banking activities.

Buying Treasury Bills and bonds requires zero capital allocation (and is a very inefficient use of capital). Capital adequacy, which measures the ratio of total capital bank holds to its risk-adjusted financial assets, hit 19 per cent in the second quarter against the minimum of 12 ½ per cent.

If banks are still unwilling to move up the risk curve, then they should just return some of the capital back to shareholders.

The writer is a bank analyst and the founder of Callstreet Reasearch and Analytics Twitter: @GeorgeBodo www.callstreet.co.ke