The Act establishes a ceiling on commercial banks’ lending rates at 400 basis points above the base rate as set by the Central Bank of Kenya. The Act also sets a floor on deposit rates at 70 per cent of the base rate (as set by CBK).
The regulator, on a point of clarification, then designated its policy rate — the Central Bank Rate — as the base rate for purposes of the Act. At the current CBR quantum of 10 per cent, the ceiling stands at 14 per cent while the floor stands at seven per cent.
I am convinced that Kenyan banks will struggle to adjust to this new operating environment and that it will lead to consolidation in the sector. The same will apply to Tanzania, Uganda, Rwanda and Burundi.
While Kenya continues to play the guinea pig for its EAC neighbours on how to implement lending rate caps as well as deposit rate floors, these markets still aren’t capable of handling such regulations. Broadly speaking, capping of lending rates as well as setting of floors on deposit rates creates four problems for banks.
First, lending rate caps sterilise the sensitivity of a bank’s loan book to interest rates. Previously, banks could pass on rising balance-sheet funding costs to their customers by re-pricing them upwards (raising the rate at which they lend to them). Not any more.
Second, deposit rate floors desterilise the funding side by increasing the sensitivity of deposits to interest rate movements — especially when floors are priced off a policy rate. When it comes to pricing, banks will be operating in a closed cubicle — with a defined floor as well as ceiling, making it difficult for them to handle refinancing/ re-pricing risks.
Third, in such an environment, banks need to be extremely efficient by limiting the extent to which operating expenses are factored into risk-asset pricing. In fact, in a closed cubicle environment, the cost-to-income ratio (CIR) must not rise above 40 per cent for a bank to continue generating positive shareholder returns. Few banks in the EAC are operating at that quantum.
Fourth, because income has to be volume-driven rather than margin-driven, the contribution of the non-funded revenue portfolio has to be elevated to half of total revenues. Again, commercial banks in the EAC are so asset-driven that non-funded revenues only accounted for 27 per cent of total revenues, on average, at the close of 2015.
The negative business dynamics in the Kenyan market are even more pronounced in the other four EAC markets. For instance, when it comes to funding, the top Tier 1 banks usually have a strong grip on the current-accounts-savings-accounts (Casa) market. Casa is the biggest source of low-cost deposit liabilities and banks with a grip on the market usually tend to have a cost of funding that is below five per cent.
Concentration levels on the funding side are high. In Tanzania and Uganda, the top six banks account for two-thirds of total funding liabilities. In Rwanda and Burundi, the largest banks account for a third of total funding liabilities. In Kenya, the figure stands at 50 per cent.
This often leaves smaller lenders with a very small pie to scramble for. In fact, the mid-sized Tier 2 and smaller Tier 3 banks tend to have a penchant for purchased (term) funds, which are very expensive. This phenomenon is replicated across East Africa.
If Uganda and Tanzania were to consider enacting a similar law, then we would see consolidation in those two markets. Rwanda and Burundi are still at the nascent stages of widening formal inclusion; banks in those two markets — especially the new smaller entrants — can hardly enforce such regulation in its Kenyan form.
Beyond funding, there is efficiency. Except for Kenya, banks within the EAC are not efficient. In Tanzania, commercial banks’ efficiency, as measured by cost-to-income ratio (CIR), stood at 66 per cent at the close of 2015. The ratio was 70 per cent, 66 per cent and 61 per cent for Uganda, Rwanda and Burundi respectively.
However, Kenyan banks stand out in terms of efficiency with the ratio standing at 50 per cent at the close of 2015; thanks, partly, to mobile phone technology.
In a closed cubicle environment, banks in these four markets may not survive.
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