Kenyan Banks_A Critique to System Credit Risks_System NPLs Defying Logic but Regulators Need to Mind the Gap

8/2/2019 Kenyan Banks_A Critique to System Credit Risks_System NPLs Defying Logic but Regulators Need to Mind the Gap

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KENYAN BANKS

NPLs growthGDP growth higher risks: A critique on credit risks

Mind the gap - System assets growth outperformeconomic growth: A primary macro issue in system credit

risks analysis is the rate of system assets growth vs. its

supposed natural long-term growth (nominal GDP growth).In most Sub Sahara African (SSA) systems, the low

penetration levels imply stronger banking assets growth vs.

nominal GDP. Nevertheless, banking assets growth should

decline as penetration increases, and in Kenya the strong

penetration into the retail segment in particular, points to

possible narrowing of the gap that has expanded strongly inthe past decade.

Defying gravity - Loans outpace Non-PerformingLoans (NPLs) growth by a colossal margin: While loan

growth has materially outpaced nominal GDP growth, NPLs

growth, contrary to logical expectations, has meaningfully

lagged loan growth. Between 1H06 and 3Q11, system loans

and advances have expanded by 2.9x, while system NPLs

have declined from Kes102bn to Kes57.7bn. Rationally, one

would expect the two, particularly in Kes-terms, to movetogether, not in lock-step, but generally in the same

direction. While most investors are concerned by the impact

of high interest rates to banks trading portfolios, a mediumto long-term and more disturbing concern to us is this

divergence in loans and NPLs growth rates.

Are we cynical - Could the NPLs be gamed? Fasterwriting-off, restructuring of loans and conservative and less

objective approaches to identification of NPLs are some of

the ways the NPLs can be concealed. However, largely itdepends on the regulators ability to ensure abidance by the

prudential guidelines. In our view, the Central Bank of

Kenyas (CBK) NPLs recognition and provision guidelines are

fairly tight. That said, the choice to report under IAS39

means management discretion remains.

The hungry and the satisfied - Local banks have beengrowing market share: Against the backdrop above, localbanks, particularly Equity, Cooperative and KCB have been

gaining significant market shares in the system. Equity

which was #10 by assets with a market share of 1.9% in

CY05 is now #5 with a market share of 8% (CY10), for

example. Meanwhile Barclays, Stanchart and Citi have shed

off assets market shares from 17% to 10.3%, 11.8% to

8.5% and 5% to 3.7% respectively between CY05 and CY10.

Of course, gaining market share per se does not imply

acquiring clients from competition as penetration andnumber of accounts in the system has increased, but it is an

opportunity costs to losers.

RecommendationsBarclays Coop Equity KCB StanChart

Current price 13.85 11.95 19.00 21.25 175

P rice a t Io C 16 .7 18 .25 24.75 22.25 26 2

Loss since IoC -17.1% -34.5% -23.2% -4.5% -33.2%

Current rec. HOLD BUY BUY BUY HOLD

Rec. at IoC HOLD SELL BUY BUY HOLD

FY12 TP 14.57 14.60 22.88 24.89 164.69

Potential 5.2% 22.2% 20.4% 17.1% -5.9%

Dividend yie ld 8 .3% 6 .0% 6 .6% 9 .6% 8 .1%

Total potential 13.4% 28.2% 27.0% 26.8% 2.2%

Whats changed?EPS Forecasts Barclays KCB

2012F OLD 1.65 3.58

NEW 1.64 4.08

2013F OLD 1.81 4.19

NEW 1.77 4.68

2014F OLD N/A N/A

NEW 1.95 5.27

Target Prices OLD 14.01 22.78

NEW 14.57 24.28

Stock Performances

-2.4%

6.1%

9.4%

9.9%

15.9%

26.1%

-5.0% 0.0% 5.0 % 10 .0% 1 5.0% 20.0% 25.0 % 30.0%

Coop

Barclays

StanChart

NSE ALSI

Equity

KCB

YTD, local currency return

System Loans vs. NPLs

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Jun-06

Sep-06

Dec-06

Mar-

Jun-07

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Mar-

Jun-08

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Dec-08

Mar-

Jun-09

Sep-09

Dec-09

Mar-

Jun-10

Sep-10

Dec-10

Mar-

Jun-11

Sep-11

N et l oans Total N PLS

Peter Mushangwe

+27 11 551 [email protected]

March 6, 2012 Sub Sahara|Kenya|Banks

Industry View

CONSTRUCTIVE


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Who is swimming naked Cooperatives NPLs have reducedmeaningfully despite a bloating loan book: Cooperatives loan

book has expanded from Kes28.4bn in CY06 to Kes86.6bn in CY10,a 25% Compounded Annual Growth Rate (CAGR). Yet the credit

costs have reduced from Kes1.4bn to Kes799mn (-38.4% CAGR)

over the same period. This compares unfavourably to the systems

17.2% loan CAGR and a 9.5% credit cost CAGR. It also flatters to

Equitys loan CAGR of 48.3% and credit costs CAGR of 46.2% over

the same period. While we are not being cynical, we are sceptical

that Cooperative can continue to grow its loan book with credit

costs declining. As at 3Q11, the NPLs ratio was in line with our

universes average of 4.8%.

Recommendations - Is the fundamental trend we notice ahead fake? While we are concerned by the static NPLs in Kes-

terms (hence improving ratios), we doubt this analysis will inhibitthe current positive momentum in banks shares. We continue to

recommend investors to BUY KCB (new Target Price (TP)

Kes24.89), Equity Bank (TP Kes22.9) and Cooperative bank (TP

Kes14.6) while we HOLD Barclays and StanChart. Our top pick is

KCB. We believe KCB boasts a better balanced portfolio between

retail and corporates, lower valuation risks and betteropportunities to enhance asset quality vs. Cooperative and Equity.

Improving efficiencies and regional profitability are key catalysts in

the medium term (FY11-FY14), in our view.

A note on KCB FY11 results Outperformed our above-consensus forecast: KCB has produced a strong FY11 set of

results that beat our earnings per share (EPS) estimate of Kes3.14and consensus of Kes3.01. Compared to our forecasts, the

stronger deposit growth (32% vs. Legae estimate of 20%) led to

higher loans and advances (Kes198.7bn vs. Legae estimateKes189.1bn). Consequently interest income came higher at

Kes27.9bn vs. our forecast of Kes27.6bn. Net interest income was

2% higher at Kes23.3bn vs. our expectation of Kes22.9bn (volume

outweighed falling margins given our lower loans and advances

forecast). Non-interest income also beat our forecast at Kes9.18bn

vs. our estimate of Kes7.89bn while credit costs came in line at

Kes1.89bn as per our expectation (an outperformance though

considering our lower loan and advances estimate). Our new EPS

for FY12 is Kes4.08, a 10% growth to FY11 as we expect the highbase to restrain growth. Nonetheless, our EPS forecast is 12%

above consensus.

Management yet to grant us audience; Coop, Equity andStanChart yet to release: While management has promised to

grant us an opportunity to discuss the results with it, we find

frustrating that it has taken this long since results release date.

Coop, Equity and StanChart are yet to issue their FY11 resultshence comparisons are mainly based on 3Q11.


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Table of Contents

1. A look at the system: Always mind the gap 4

Has system credit expanded excessively vs. GDP? 4

Loan growth vs. NPLs growth: Defying force of gravity? 6

Are we being cynical? Can NPLs be gamed? 8

Are the high coverage ratios valuable? 10

2. A look at our universe: Who is swimming naked? 14

Who has been taking more risks... 14

...and who is swimming naked? 16

Forecasts, Recommendations and Price performances 17

3. KCB FY11: Outperformed our above-consensus EPS 20


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1. A look at the system: Always mind the gap

We have taken some time to look at the development of the Kenyan

banking systems credit risks indicators. We admit that the picture is

highly pleasing, with most possible metrics used in identifying risks

showing improvements year after year. In this report, we put forward a

few questions to investors. We attempt to answer them as well.

Has credit expanded excessively relative to the economy?As Fig 1 below shows, the system assets have expanded by 3.3x

vs. 2.6x for nominal GDP. In our view, this strong outperformanceis chiefly a response to the low penetration levels. As a result,

while it should generally indicate rising credit risks, (i.e. credit

growing exceedingly faster than the capacity of the economy)

investors could give the banks/system the benefit of the doubt.

But again, the explosive growth in the retail segment, particularly

by the big local banks, evokes worries. The number of accounts in

the system has increased to 11.9mn (CY10) from a mere 1.7mn inCY02. The deposit accounts/bankable population ratio is now

~63%, despite the modest banking assets/GDP ratio of


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Fig 1: Notwithstanding the lower penetration argument, industry assets growth has significantly

outperformed economic growth and its trend, particularly between CY05 and CY09...

0.35

0.40

0.45

0.50

0.55

0.60

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Assets/GDP ratio and the Gap

3.3

2.6

0.0

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4.0

2000

2001

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2010

In du str y as se ts Nomi nal GD P

Source: CBK, Legae Calculations

Fig 2: ...meanwhile penetration has increased meaningfully, especially in the retail space

2002 2006 2008 2010

Number of deposit accounts 1 682 916 3 329 161 6 428 509 11 881 114

Deposit Accounts/Population 5.2% 9.2% 17.2% 29.9%

Deposit Accounts/Bankable population est. n/a n/a n/a 62.5%Number of system branches 446 575 887 1 063

Source: CBK, Legae Calculations. *Fin Access Survey est. bankable population of ~19mn

Fig 3: Asset growth declined faster than GDP in CY10. The average credit multiplier is ~2x. As the

credit growth recovers, the multiplier should revert to its mean.

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

In du str y GD P

-1.0

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Credit multip lier average



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Fig 4: High interest rates do not necessary tame loan growth in the short term. Poor transmissionmechanisms to blame for the longer lag

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

Jun-07

Sep-07

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Mar

-08

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Mar

-09

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-10

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-11

Jun-11

Sep-11

Change in loans Change in av. lending rate

11.5%

12.0%

12.5%

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13.5%

14.0%

14.5%

15.0%

15.5%

0.0%

5.0%

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n-07

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Sep-11

Loan growth, LHS Lending rate


Will NPLs continue to lag loan growth by such a colossalmargin? Supervision reports highlight improvements in

credit appraisal and monitoring: As we pointed out above,

system credit growth has expanded in a vigorous manner in Kenya

vs. economic growth. Logically, one would expect a worsening

credit profile for the system, notwithstanding the low penetration.At best, NPLs growth should be close to loan growth. However, this

is not the case in Kenya. In fact, NPLs have materially

underperformed loan growth, and NPLs in Kes-terms are static atan average of ~Kes50bn, post a steep decline (~-40%) in CY07.

Between 1H06 and 3Q11, the net loans of the system have grown

by a meaningful 2.9x, while NPLs have declined by 0.57x, from

Kes102bn in 1H06 to Kes57.7bn in 3Q11. Gross NPLs show a

simple growth rate of -43% vs. a growth rate of 168% in Gross

loans between 1H06 and 3Q11. As a result, the system NPLs ratioand to an extent the coverage ratios have substantially improved.

The NPLs ratio has declined from 15.8% in 1H06 to 4% in 3Q11

a significant improvement by any measure in a periodcharacterised by strong economic growth headwinds. (see Fig 5 -

Fig 6). Supervision reports have mainly attributed the decline in

NPLs to improvements in credit appraisal and monitoring standards

by the banks. Recoveries are also mentioned now and then.


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Fig 5: Loans have grown faster than the NPLs between 1H06 and 3Q11...

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Jun-06

Sep-06

Dec-06

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Jun-07

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Jun-09

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Dec-09

Mar-

Jun-10

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Jun-11

Sep-11

Net loans Total NPLS

-50.0%

-40.0%

-30.0%

-20.0%

-10.0%

0.0%

10.0%

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30.0%

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50.0%

Jun-07

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Sep-11

Net loans Total NPLs


Fig 6: ...leading to improvements in most credit ratios.

3Q06 3Q07 3Q08 3Q09 3Q10 3Q11

Gross Loans 456.5 492.4 657.45 736 878.8 1192.5

Growth 7.9% 33.5% 11.9% 19.4% 35.7%

Net Loans 419.3 476.4 644.2 720.5 868.7 1181.7

Growth 13.6% 35.2% 11.8% 20.6% 36.0%Gross NPLs 103.8 59.1 56.85 60.6 61.2 57.7

Growth -43.1% -3.8% 6.6% 1.0% -5.7%

Gross NPLs/Gross loans 22.7% 12.0% 8.6% 8.2% 7.0% 4.8%

Net NPLs 66.6 43.1 43.6 45.1 51.1 46.9

Growth -35.3% 1.2% 3.4% 13.3% -8.2%

Net NPLs/Net Loans 15.9% 9.0% 6.8% 6.3% 5.9% 4.0%

Total provisions 45.1 27.5 27.3 24.8 34.3 35.4

Growth -39.0% -0.7% -9.2% 38.3% 3.2%

Specific provisions 40.8 22.8 22.6 19.4 28.9 27.7

Specific provisions/Total provisions 90.5% 82.9% 82.8% 78.2% 84.3% 78.2%

Source: CBK Legae Calculations


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Are we being cynical? Can the NPLs ratio be gamed? Whilethere are various names for the credit costs that banks recognise

in their profit and loss accounts, ranging from provision for baddebts to impairment charge, the key ratio investors often watch is

the NPLs ratio. Unfortunately, this ratio can be gamed. While we

are not being cynical and assume there is gaming of the NPLs in

the Kenyan system we highlight that the NPLs can be concealed

by: a) faster writing-off of NPLs (not necessarily a bad practice if

the intention is not to game NPLs and it is a consistent policy). The

steep decline in Kes-NPLs in CY07 seem to indicate a more radical

write-off exercise in the system than normal (see Fig 7); b)

restructuring of loans, particularly prior to classification as an NPL.

This defers NPLs recognition, and is probably the most common

practice by banks. NPLs can also be restructured although certain

conditions should be maintained (ref Fig 9); c) slower disposal ofsecurity due to legal and other judicial issues yet the loan has

been foreclosed. The NPLs would not be recognised if it is fully

secured as it is moved to foreclosed assets for a period; and d) aconservative and less objective approach to recognition of NPLs.

The IAS39 which requires impairments to be incurred if and only

if there is objective evidence of impairment as a result of one or

more loss events that have an impact on estimated cashflow on

the financial asset or a group of assets that can be reliably

estimated provides options to managers in their NPLsmanagement. Of course the NPLs ratio can, and more often than

not, decline due to improving asset quality. It could be argued that

the declining Kes-terms value of suspended interest points toconcrete credit quality improvements in the system as it is more

difficult to game than NPLs. (see Fig 8). The caveat is that the

lower interest rate vs. history could result in lower suspended

interest irrespective of the credit risks.

Fig 7: Despite strong loan growth in CY07, system NPLs declined by >40% and so did the consequent

provisions. In Kes-terms, system NPLs has remained largely static post the CY07 decline...

0.2

0.3

0.4

0.5

0.6

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Gross NPLs Total Provisions Specific provisions

-60.0%

-40.0%

-20.0%

0.0%

20.0%

40.0%

60.0%

Jun-07

Aug-07

Oct-07

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NPLs P ro vision s Spe ci fic p ro vision s



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Fig 8: ...hence with strong loan growth and static NPLs, ratios show material improvements.Suspended interest/Gross loans has also declined significantly although lower interest could have

positively affected the ratio

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Jun-06

Sep-06

Dec-06

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Gross NPLs /Gross Loans Total provisions/Net loans

0.0%

1.0%

2.0%

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Jun-06

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Suspended interest/Gross loans


A note on renegotiated NPLs: Loan restructuring is one majorcontentious issue when interest rates increase as banks attempt to

reduce their NPLs formation. Often, the duration of the loan is

lengthened - a disadvantage to the bank if there is no

corresponding increase in the interest rate charged - but a

common way to ensure affordability by the borrower. When this

restructuring is exercised prior a loan turning into an NPL, there isa higher chance the loan will remain classified Normal for longer

than it should.

However, the restructuring of NPLs is the one often monitoredmore stringently. The restructured/renegotiated NPLs are generally

more important because reclassification would not only affect the

provisions but the NPLs figure and the corresponding ratios when

some of the NPLs are reclassified to Normal or Watch status. Fig 9

below shows the prerequisites for NPLs reclassification. In our

opinion, CBKs required conditions for reclassification are stringent.

We draw attention the fact that conditions (1) and (2) are explicitand precise, but condition (3) is subjective (and subject to abuse).

This provides bank managers a leeway to reclassify NPLs as pertheir view. However, the CBK has authority to reclassify the loans,

and when that occurs, an upgrade of the loan by a bank would

require sufficient justfification.

A note on write-offs: According to the prudential guidelines,write offs should be undertaken when the bank loses contractual

control over the loan and the loan is deemed uncollectable and

there is no realistic prospect of a recovery. The banks Board ofDirectors has ultimate authority for approval of the write-off.

Writing-off also takes place only to facilities/loans classified as

Loss and within 90 days, should there be no recoveries within the

period. There are general indicators where writing-off a loan

becomes evident e.g. when borrower becomes bankrupt; where all


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forms of securities or collateral have been realised but proceeds

failed to cover the entire facility outstanding; where efforts to

collect debt are abandoned for any other reason, among others. Inour opinion, the last condition provides management with some

discretion to determine, with the approval of the board, when to

write-off NPLs. However, the guidelines are tight enough assuming

the implementation is firm. We therefore do not expect abnormal

write-offs in the system in pursuit of reducing NPLs.

Fig 9: The regulatory NPLs reclassification prerequisites tight enough in our view

NPL type Reclassified if and only if ...

Substandard to Normal (1) All past due principal and interest is repaid in full at the time of renegotiation

Substandard to Watch (2) All past due interest is repaid in full at the time of renegotiation

or (3) or a sustained record of performance under realistic repayment program has been

maintained. All principal and interest payments are made according to the modified

repayment schedule

and If condition (2) is sustained for 6 months, the loan can be reclassified as Normal; if condition

(3) is maintained for 6 months, a Substandard renegotiated loan can be classified as Watch;

The renegotiated loan will qualify as Normal if condition is sustained for 12 months

Doubtful to Watch (1) All past due principal and interest is repaid in full at the time of renegotiation

Doubtful to Substandard (2) All past due interest is repaid in full at the time of renegotiation

or (3) or a sustained record of performance under realistic repayment program has been

maintained. All principal and interest payments are made according to the modified

repayment schedule

and If condition (1) is sustained for 6 months, the renegotiated loan can be reclassified as Normal;

If condition (2) is sustained for at least 6 months, a Substandard renegotiated loan can bereclassified as Watch; and Normal if record sustained for 12 months; If condition (3) is

sustained for 6 months, a Doubtful renegotiated loan can be reclassified as Substandard;

reclassified as Watch if record sustained for at least 12 months; and reclassified as Normal if

record sustained for 18 months.

Source: CBK, Legae Securities

The high coverage ratio may not be a sweet spot after all...:The systems coverage ratio is healthy at ~75%. There are two

principal issues that we can deduce from the high coverage ratio;

a) the system has more doubtful and lost loans than otherwise

which therefore requires 100% provision as indicated by theprudential guidelines. The provisioning lag would also mean that

the coverage ratio remains high even when new NPLs formation is

declining due to the NPLs ageing and the consequent provisioning

requirements. The NPLs of loans written between CY07 and CY09

are probably reaching Lost stage; b) NPLs are falling faster thanprovision. We have noticed that between 1H06 and 3Q11, NPLs in

absolute terms declined by 49% (from Kes102bn to Kes57.7bn)

while provisions have reduced by a lower amount of 21.5%. (from

Kes45.1bn to Kes35.2bn). It can also mean both scenarios are

playing out in the system. In addition, the low mortgage

penetration (entails lower provisions as mortgages require less


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provisions due to better security/collateral values) means that the

system carry higher provisions for loans, sustaining higher

coverage ratio. Nonetheless, the provision/NPL ratio (coverageratio) has remained fairly strong at an average of 65% between

1H06 and 3Q11. The specific provisions/total provisions ratio (i.e.

specific provisions generally cover individually assessed/important

impaired exposures) would imply an improving credit scenario in

the system. (see Fig 10 - Fig 11). However, the general

provisions/total provisions ratio has increased recently, which

could signify that regulators are most likely having quiet words

with bank managers and/or credit risk, particularly retail, has

picked up materially. In all systems, regulators apply discreet

pressure to bank managers in order to curtail risk propagation.

Usually banks are asked to carry higher general provisions than

they are ordinarily required to. We are unsure if this is the case inKenya as moral suasion is highly secretive in banking and is

extremely difficult to detect. However, as we have already

indicated, the general provisions/NPLs ratio has increased to 16%

in 3Q11 from 6% in 1H06. The general provisions/total provisions

ratio has also increased to 22% from 9% over the same period.

General provisions are made based on expected losses on

undifferentiated pool of exposures such as credit cards and othersmaller facilities. They should therefore, theoretically, grow as

demand for credit increases, especially retail and SME credit prick

up. They can also reflect managements loss expectations on the

Normal loans.

...although we believe the regulatory provisioningguidelines are fair: As is the case in most SSA systems, aformulaic provisioning requirement is a key regulatory aspect in

Kenya. Fig 12 shows the provisioning prudential guidelines. A 1%

provision to Normal loans indicates the general provision that is forward looking to some extent. This is consistent with Basel 2

which requires a more forward looking provisioning practice. The

IAS39 tend to be more conservative in recognising future NPLs

(and therefore provisions), and according to the guidelines, the

difference between the impairment charges computed under IAS39

and those required by applying the guidelines is appropriated off

retained earnings and not expensed/credited to the profit and loss.


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Fig 10: The coverage ratio is high but specific provisions/total NPLs is only ~55%...

40.0%

45.0%

50.0%

55.0%

60.0%

65.0%

70.0%

75.0%

80.0%

Jun-06

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Provisions/Total NPLs

40.0%

45.0%

50.0%

55.0%

60.0%

65.0%

70.0%

Jun-06

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Mar-07

Jun-07

Sep-07

Dec-07

Mar-08

Jun-08

Sep-08

Dec-08

Mar-09

Jun-09

Sep-09

Dec-09

Mar-10

Jun-10

Sep-10

Dec-10

Mar-11

Jun-11

Sep-11

Specific Provisions/NPLS Average


Fig 11: ...as specific provisions/total provisions reduce (i.e. general provisions/total increase) along

with loan growth

-50.0%

-40.0%

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

Jun-07

Aug-07

Oct-07

Dec-07

Feb-08

Apr-08

Jun-08

Aug-08

Oct-08

Dec-08

Feb-09

Apr-09

Jun-09

Aug-09

Oct-09

Dec-09

Feb-10

Apr-10

Jun-10

Aug-10

Oct-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Loan growth Total Provisions

70%

75%

80%

85%

90%

95%

Jun-06

Sep-06

Dec-06

Mar-07

Jun-07

Sep-07

Dec-07

Mar-08

Jun-08

Sep-08

Dec-08

Mar-09

Jun-09

Sep-09

Dec-09

Mar-10

Jun-10

Sep-10

Dec-10

Mar-11

Jun-11

Sep-11

Specific provisions/Total provisions Average



13/22

Page 13 of 22

Fig 12: The regulatory provisioning requirements are fairly tight in our view.

General definition Past due by(days)

CBK Regulatoryprovisions

Normal Loans performing in accordance with loan terms n/m 1%

Watch

Loans exhibit weakness. Examples among other include

weakening collateral, deteriorating economic conditions,

adverse trend for borrower

30 to 90 3%

SubstandardLoans not adequately protected by current sound net worth

and paying capacity of the borrower90 to 180 20%

DoubtfulLoans shows weaknesses in collection in full. The possibility

of loss is high> 180 100%

LostLoans are considered uncollectable and continuance

recognition as bankable assets is not warranted > 360 100%

Source: CBK, Legae Securities


14/22

Page 14 of 22

2. A look at our universe: Who is swimming naked?

Who has been assuming most of this risk? In a system thatcould be building credit risk faster than we think, we show on Fig

13, who has been gaining market shares and possibly assuming

the greater part of the risks. The biggest market shares loser is

Barclays, which was #1 bank in CY05 with a market share of 17%

on the system assets. Barclays is now #2, with a market share of

10.3% (CY10). The biggest gainer is Equity, moving from #10 in

CY05 and with a market share of 1.9% to #5 in CY10 with a

market share of 8% of the systems assets. Equity has gained

market shares primarily at the expense of Barclays, ShanChart and

Citi. It is however important to note that market share gains do

not necessarily imply client acquisition from competitors. Thenatural growth in the system ensures that even Barclays managed

to grow its balance sheet despite losing a vast amount of market

share.

System assets almost tripled in 5 years; Equity loan bookexpanded by 14.2x: Looking at the absolute figures, the

systems balance sheet has expanded 2.6x between CY05 and

CY10. The system loan book has expanded by 2.3x to Kes876bn in

CY10 from Kes382bn in CY05. Barclays has assumed the least risk

(ignoring loan book quality for now) with its balance sheetexpanding only by 1.6x over the same period. Barclays loan book

has also grown the lowest at 1.3x to its CY05 value of Kes65.6bn

to Kes87.1bn in CY10. Equity assumed the greatest risks (growth)as its balance sheet and loan book have expanded by an

exceptionally large 12.5x and 14.2x respectively between CY05

and CY10. This is a strong outperformance to the system growth.

Equity is followed by KCB whose balance sheet ballooned from

Kes74.3bn in CY05 to Kes251.4bn in CY10. The loan book has also

expanded by a colossal 4.5x to Kes148.1bn in CY10. Cooperatives

growth approximated system growth on both assets and loans with

a 3.0x. Cooperatives total assets increased from Kes51.8bn in

CY05 to Kes154.3bn in CY10 whilst the loan book enlarged from

Kes29.1bn to Kes86.6bn over the same period. StanChart, like

Barclays, lagged system growth, with total assets doubling to

Kes142.7bn and the loan book expanding by 1.8x to Kes60.3bn

(see Fig 14).


15/22

Page 15 of 22

Fig 13: Equity bank has gained enormous market shares mainly at the expense ofBarclays, StanChart and Citi...

Institution Assets Market share Rank

Institution 2005 2007 2009 2010 2005 2007 2009 2010

KCB 12.1% 11.8% 12.7% 13.3% 2 2 1 1

Barclays 17.0% 16.6% 12.2% 10.3% 1 1 2 2

Cooperative 8.4% 6.9% 8.2% 9.2% 4 4 4 3

StanChart 11.8% 9.6% 9.2% 8.5% 3 3 3 4

Equity Bank 1.9% 5.6% 7.1% 8.0% 10 5 6 5

CFCStanbic n/a n/a 7.2% 6.4% n/a n/a 5 6

Comm. Bank of Africa 4.8% 4.2% 4.3% 3.8% 4 8 7 7

Citibank 5.0% 5.0% 3.8% 3.7% 6 6 9 8

NBK 5.3% 4.4% 3.8% 3.6% 5 7 8 9

Diamond Trust 2.6% 3.2% 3.5% 3.5% 9 10 10 10

NIC 3.4% 3.3% 3.3% 3.3% 8 9 11 11

Total 72.3% 70.5% 75.2% 73.6%

Institution Deposits market share Rank

insutitution 2005 2007 2009 2010 2005 2007 2009 2010

KCB 12.1% 12.1% 13.7% 13.2% 2 2 1 1

Barclays 16.7% 15.4% 12.5% 10.0% 1 1 2 2

Cooperative 8.7% 7.7% 9.1% 10.0% 4 4 3 3

StanChart 11.9% 10.4% 8.6% 8.1% 3 3 4 4

Equity Bank 1.8% 4.4% 6.5% 7.7% 10 7 5 5

CFCStanbic n/a n/a 5.6% 5.9% n/a n/a 6 6

Comm. Bank of Africa 5.3% 4.7% 4.4% 4.3% 6 6 7 7

NBK 5.4% 4.9% 4.2% 3.9% 5 5 8 8

NIC 3.4% 3.5% 3.7% 3.7% 8 9 9 9

Diamond Trust 2.7% 3.4% 3.6% 3.6% 9 10 10 10

Citibank 4.7% 4.2% 3.3% 3.1% 7 8 11 11

Total 72.6% 70.7% 75.2% 73.5%


Fig 14...and has expanded its balance sheet 12.5x between CY05 and CY10 vs. system

average of 2.6x.

Assets Loans

2005 2010 CAGR Growth x 2005 2010 CAGR Growth x

Barclays 104 522 172 415 10.5% 1.6 65 562 87 147 5.9% 1.3

Cooperative 51 835 154 340 24.4% 3.0 29 089 86 618 24.4% 3.0

Equity 11 453 143 018 65.7% 12.5 5 524 78 302 69.9% 14.2

KCB 74 338 251 356 27.6% 3.4 32 849 148 113 35.1% 4.5

Stanchart 72 970 142 746 14.4% 2.0 34 043 60 337 12.1% 1.8

System 636 731 1 678 112 21.4% 2.6 381 544 876 357 18.1% 2.3

Source: CBK, Company reports, Legae Calculations


16/22

Page 16 of 22

...And who is swimming naked? To an extent, the comparison isimpaired by the fact that banks report different items in their

balance sheet and income statements of accounts. Some reportprovisions charges, some bad debt charges and other impairment

charges, among other variants. Nonetheless, we analyse the credit

costs that each bank has pushed through its income statement

vs. loan growth to see how this charge has developed vs. loan

growth. We note that Cooperatives loan book has significantly

outperformed its credit costs growth, with a loan growth of 25%

vs. credit costs growth of -13.5%. As the loan book expanded to

Kes86.6bn, credit costs declined to Kes799mn from Kes1.4bn. We

understand that, like the system, Cooperative has some legacy

issues particularly borne in the early part of the past decade, but

we do not believe that the current trend is sustainable. It is also

out of synch with peers. Our view is irrespective of CBKsSupervision reports that point to considerable improvements in

credit screening and monitoring procedures. StanChart credit costs

growth has also lagged loan growth, with credit costs growing by -3% while loans expanded by 11%. Barclays and KCBs credit costs

growth largely mirror loans and advances growth rate. For Equity,

possibly as a reflection of its elevated credit risks, its credit costs

soared by 94.3% vs. a loan growth of 48.3% between CY06 and

CY10. (see Fig 15).

A look at the 3Q11 state of affairs: Looking at 3Q11, we notethat StanChart has the best performing loan book with a NPLs ratio

of 1.2% (vs. an average of 4.9% for our universe). Barclayss NPL

ratio is high at 5.8% (2nd

to KCBs 7.9%) chiefly as it does notindicate any suspended interest. However, the coverage ratio for

Barclays is also high at 87% due to a high amount of specific

provisions, hence a low Net NPLs ratio. We should highlight the

worryingly high ratios for KCB (vs. peers), with a NPLs ratio of

7.9% (vs. average of 4.9% for the universe). Provisions are ~50%

of the total NPLs amount of Kes12.2bn. As at 3Q11, KCB

accounted for ~60% of our universes NPLs vs. a contribution of

~30% to the universe loan book. (see Fig 16).

Fig 15: Cooperative banks credit costs have declined despite a strong growth in loans and

advances. Hopefully no surprises in future.

Loan Credit costs Difference

2006 2010 CAGR Growth, x 2006 2010 CAGR Growth, x

Barclays 73 907 87 147 3.4% 1.2 881 1 200 8.0% 1.4 4.7%

Cooperative 28 421 86 618 25.0% 3.0 1 425 799 -13.5% 0.6 -38.4%

Equity 10 930 78 302 48.3% 7.2 133 1 905 94.5% 14.3 46.2%

KCB 40 659 148 113 29.5% 3.6 735 2 144 30.7% 2.9 1.2%

Stanchart 35 762 60 337 11.0% 1.7 502 447 -2.9% 0.9 -13.9%.

System 396 149 876 357 17.2% 2.2 7 672 11 048 9.5% 1.4 -7.7%

Source: CBK, Company reports, Legae Calculations


17/22

Page 17 of 22

Fig 16: Who was swimming naked by Q311? KCB has the highest NPL ratio

Barclays Coope rative Equity KCB StanChartLoans and advances 98 901 106 434 109 367 174 464 94 390

Gross NPLs 5 699 5 585 3 503 13 834 1 500

Suspended interest 0 1 056 542 1 684 354

Total NPLs 5 699 4 529 2 961 12 150 1 145

Loss Provisions 4 941 3 668 1 523 6 254 441

Net NPLs 758 861 1 438 5 896 704

Gross NPLs/Loans and advances 5.8% 5.2% 3.2% 7.9% 1.6%

Suspended interest/Loans and advances 0.0% 1.0% 0.5% 1.0% 0.4%

Total NPLs/Loans and advances 5.8% 4.3% 2.7% 7.0% 1.2%

Loss provisions/Loans and advances 5.0% 3.4% 1.4% 3.6% 0.5%

Net NPLs/Loans and advances 0.8% 0.8% 1.3% 3.4% 0.7%

Provisions/NPLs 86.7% 81.0% 51.4% 51.5% 38.5%

Source: Company reports, Legae Calculations

Forecasts and recommendations: We show our universessalient assumptions on Fig 17. We underscore the following:

We model our loans and advances estimate as a product of thedeposits and the LDR. As a result our loans and advances

forecasts are directly a result of our deposit growth and LDR

estimates.

For Barclays, our deposit growth of 5% and 7.5% for FY12 andFY13 respectively are risky given the banks unpredictablestrategy. As a result, our growth forecasts could

outperform/underperform materially as recent growth rates

have been unpredictable. Barclays has historically managed

credit risks well, but strategy goes beyond credit risk

management and we wonder whether the bank will better

execute (and communicate) its strategy than in the past.

Generally, we expect banks in our universe to continue to growEPS, supported by resilient interest spreads and momentum in

fee and commission income growth. We do not believe that

there is sufficient room for further reductions in credit costs

(both in an absolute basis and as ratios) hence improvements in

credit costs should have minimal impact to earnings. For FY12we expect EPS growth of 5.4% for Barclays. Coop (+5.4%);Equity (+10.8%) and KCB (+9.7%) will be affected by relative

higher FY11 bases. Our StanChart growth of 25.8% is the

highest in our universe, but remains materially lower than

consensus by 12%.


18/22

Page 18 of 22

Our EPS forecasts vs. consensus: For FY12, we are aboveconsensus on KCB, (+12%), Equity (+4%) and Barclays (+2%).

For KCB, we believe investors are underestimating the banksoptimal mix between its corporate and retail segment which should

bode well for its credit costs development (vs. Equity and Coop).

We believe investors could also be underestimating the benefits of

its regional subsidiaries and the growing market share in mortgage

lending. For Equity bank, our above consensus is also pivoted on

regional contribution and further credit improvements in the local

market and efficiencies.

The primary caveats to our analysis vs. consensus are: a) some ofthe consensus EPS are averages of a small number of analysts. For

example Barclays and StanCharts consensus EPS are based on

only 5 analysts; and b) some of the consensus figures could be

stale. We reiterate our BUY recommendations on KCB, Equity and

Cooperative; Investor sentiment is positive, NSE ALSI up by

~10% YTD: The current market sentiment is on average bullish,with the NSE ALSI up by 9.9% on a YTD basis. Banks have

benefited from this positive sentiment, with KCB and Equity share

prices increasing by 26.1 and 15.9% respectively. Coop, which we

initiated with a SELL recommendation has lost 2.4%, and the

valuation risks has reduced to levels we believe provide an

attractive risk-return profile. (see Fig 18 - Fig 19). We maintainour BUY recommendations on Coop, Equity and KCB with forecast

potential total returns of 28.2%, 27% and 26.8% in that order.

However, we believe that in the short-term, Coop may continue tosuffer from poor sentiment (perceived poorer franchise, higher

credit risks etc). The catalyst would be a stronger delivery in

earnings, to include the quality of earnings.

Fig 17: Our salient assumptions

Barclays Coop Equity KCB StanChart

2012F 2013F 2012F 2013F 2012F 2013F 2012F 2013F 2012F 2013F

Deposit growth 5.0% 7.5% 20.0% 17.5% 22.5% 20.0% 20.0% 17.0% 15.0% 15.0%

Deposits 130 418 140 199 182 101 213 969 159 909 191 891 311 171 364 070 132 917 152 854

LDR 80.0% 80.0% 75.0% 75.0% 80.0% 80.0% 80.0% 80.0% 75.0% 75.0%

Loans and advances 104 334 112 159 136 576 160 477 127 927 153 513 248 936 291 256 99 687 114 641

Loan growth 5.3% 7.5% 20.0% 17.5% 22.5% 20.0% 25.3% 17.0% 15.0% 15.0%

Interest income/IEA 12.0% 12.0% 8.7% 8.7% 12.6% 12.4% 10.7% 10.5% 8.5% 8.5%

Interest expense/IBL -1.10% -1.25% -2.11% -2.20% -1.49% -1.48% -1.25% -1.25% -1.00% -1.25%

NIR/Total assets 9.3% 9.8% 4.7% 4.5% 6.8% 7.0% 4.9% 4.8% 3.3% 3.3%

Credit costs/Loans -0.9% -1.0% -1.3% -1.3% -2.3% -2.3% -1.0% -1.0% -1.0% -1.0%

Profit 8 884 9 602 7 124 8 007 11 566 13 383 12 046 13 805 5 839 6 768

Growth 10.0% 8.1% 5.4% 12.4% 10.8% 15.7% 9.7% 14.6% 25.8% 15.9%

EPS 1.64 1.77 2.04 2.29 3.12 3.61 4.08 4.68 20.34 23.57

Consensus EPS 1.61 1.79 2.09 2.47 3.00 3.36 3.66 4.12 23.21 23.49

Variance 2% -1% -2% -7% 4% 8% 12% 14% -12% 0%



19/22

Page 19 of 22

Fig 18: We continue to favour local banks with regional exposure and which are buildingstronger mortgage lending books although we keep an eye on credit risks

Barclays Coop Equity KCB StanChart

Current price 13.85 11.95 19 21.25 175

Price at initiation 16.7 18.25 24.75 22.25 262

Loss since Initiation -17.1% -34.5% -23.2% -4.5% -33.2%

Current rec. HOLD BUY BUY BUY HOLD

Recommendation at initiation HOLD SELL BUY BUY HOLD

FY12 TP 14.57 14.60 22.88 24.89 164.69

Potentia l 5.2% 22.2% 20.4% 17.1% -5.9%

Dividend yield 8.3% 6.0% 6.6% 9.6% 8.1%

Total potential 13.4% 28.2% 27.0% 26.8% 2.2%

Source: Bloomberg, Legae Calculations

Fig 19: KCB share price has rebounded strongly from 3Q11 lows and has increased by 26% on a YTD

basis; Coop is down 2%

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

02-Mar-11

23-Mar-11

13-Apr-11

04-May-11

25-May-11

15-Jun-11

06-Jul-11

27-Jul-11

17-Aug-11

07-Sep-11

28-Sep-11

19-Oct-11

09-Nov-11

30-Nov-11

21-Dec-11

11-Jan-12

01-Feb-12

22-Feb-12

Barclays Coop Equity KCB StanChart NSE ALSI

-2.4%

6.1%

9.4%

9.9%

15.9%

26.1%

-5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

Coop

Barclays

StanChart

NSE ALSI

Equity

KCB

YTD, local currency return

Source: Bloomberg, Legae Calculations


20/22

Page 20 of 22

3. A note on KCB FY11 results: Strong performance

FY11 beat our above-consensus: KCBs FY11 EPS of Kes3.72beat our expectation of Kes3.14 (to include our initial EPS forecast

of Kes3.48 which we actually revised downwards in 3Q11) as well

as consensus of Kes3.06. The Chairmans statement indicates

transformation initiatives that increased revenues as well as

efficiency. The turnaround in regional operations that all recorded

profitability was also constructive to earnings growth.

Legae forecasts vs. Actual Our lower deposit forecastmeant lower loans and advances and lower interest income:

Our deposit growth of 20% was lower than the 32% growth rate

that the bank delivered, taking deposits to Kes259.308bn. As a

result, most of the income statement forecasts that depend ondeposit growth lagged. We had modelled an 80% LDR vs. the

banks 77% LDR, slightly below our expectation but due to astronger deposit growth the loans and advances was higher than

our forecast at Kes198.724 vs. Kes189.095bn. Interest income

was Kes27.9bn vs. Legae est. of Kes27.6bn while interest expense

was slightly lower at Kes4.62bn vs. our estimate of Kes4.7bn. The

resultant net interest income was 2% higher at Kes23.3bn vs.

Kes22.9bn. The fee and commission income was stronger as well

as Kes9.18bn vs. our est. of Kes7.98bn. As a result total operatingincome was 7% higher than our expectation at Kes39.3bn vs.

36.7bn. Loan loss was in line at Kes1.89bn vs. our expectation of

Kes1.89 but an effective outperformance given our lower loansand advances forecast. Operating expenditure came in 3% higher

than our expectation of Kes21.6bn while tax was also higher at

Kes4.72bn vs. our forecasts of Kes3.96. The bottom line was

higher than we anticipated at Kes10.89bn vs. Kes9.26bn.

Assumption changes and our forecasts We grow depositsby 20% in FY12; LDR at 80%: We issued this report before

engaging management as the teleconference date was yet to be

agreed on. We find it frustrating. We hope in future there will be

improved communication especially with foreign

analysts/investors. Nonetheless, we provide our forecasts, pivoted

primarily on our understanding of KCB and the Kenyan system

than management guidance. Fig 20 below shows our leadingassumptions. The salient assumptions are :

Deposit growth of 20%: We have grown deposit by 20% forFY12 and maintain our initial LDR of 80%;

Interest income/interest earnings asset and the costs/assetratios inferior to history: Our interest income/IEA is inferior to

history as we expect interest rates to decline this year. Theoperating cost/assets ratio is higher than history to accommodate

further regional expansion costs; and

On average in line with history: On average our assumptionsare in line with history although our deposit growth is below the 5-

year average. Our resultant EPS growth is below history as well.


21/22

Page 21 of 22

Valuation: We increase TP to Kes24.89, we maintain ourBUY: Our new TP is Kes24.89, primarily due to the increase in the

Book value per share, as our Justified PBVR remained constant at1.4x (rounded off). We maintain our CoE of 19.5% but the average

ROE has increased to 22.7%. We forecasts a dividend yield of

9.5% (50% payout ratio) and our total potential return of 26.8%.

We maintain our BUY recommendation.

Risks to our recommendation/forecasts: 1) Credit costs:Despite improvements in the system, credit risks continue to worry

us (as detailed in this report). For KCB, there was a significant

improvement in NPLs between 3Q11 and FY11, aided by stronger

recoveries. However, the elevated inflation level, higher interest

rates in 2H11 and a robust loan growth are unconstructive to bad

debts and NPLs formation; 2) macro and politics: macro and

political risks, could grow as election draws near; and 3) possibleadverse margin development: In FY11, our interest/IEA ratio

reduced to 10.7% from 12.2% in FY09 and an average of 11.8%

for the past 5 year. Meanwhile, cost of deposits has reduced

slightly to 1.6% (from 1.7% in FY10 and vs. an average of 1.6%).

Competition seems to be reducing asset yield and increase costs of

deposits in the system, notwithstanding the high interest spreads,which is unhelpful to spreads and margins.

Fig 20: Salient assumptions: Below history on deposit growth and earnings growth for FY12 due to

FY11 high base; below history on interest/IEA as we expect lower interest rates.

OLD NEW OLD NEW Historical2007 2008 2009 2010 2011 2012F 2012F 2013F 2013F 5-year Av.

Salient assumptions

Deposit growth rate n/m 34.2% 28.7% 2 0.8% 31.6% 15.0% 20.0% 10.0% 17.0% 28.8%

Loan/Deposit ratio 68.1% 73.8% 75.2% 75.2% 76.6% 80.0% 80.0% 80.0% 80.0% 73.8%

Interest income/Interest earning assets 11.0% 12.9% 12.5% 12.2% 10.7% 12.3% 10.7% 12.0% 10.5% 11.8%

Interest expense/interest earning liabilit ies -0.9% -1.8% -2.1% -1.7% -1.6% -2.0% -1.3% -1.5% -1.3% -1.6%

Fees and commission income/Tota l assets 3.8% 3.0% 3.0% 2.8% 2.8% 3.0% 3.3% 3.0% 3.0% 3.1%

Fees and commission expense/Total assets -0.2% -0.1% -0.2% -0.1% 0.0% -0.1% -0.1% -0.1% -0.1% -0.1%

Dividend income/total assets 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Fore ign exchange income/To tal a sse ts 0.7% 0.9% 0.8% 1.1% 1.1% 1.1% 1.1% 1.1% 1.1% 0.9%

Othe r opera ting income /total a sse ts 0.4% 0.2% 0.5% 0.6% 1.0% 0.7% 0.7% 0.8% 0.7% 0.5%

Bad and doubtful debts expense/loans -1.2% -1.5% -0.6% -1.4% -1.0% -1.0% -1.0% -1.2% -1.0% -1.1%

Other operating expenses/total assets -7.6% -6.3% -8.0% -7.4% -6.7% -7.5% -7.8% -7.5% -7.5% -7.2%

Taxa tion/PBT -29.6% -30.3% -35.2% -26.7% -27.4% -30.6% -29.8% -29.1% -27.9% -29.8%

EPS 1.50 2.00 1.84 2.76 3.72 3.58 4.08 4.94 4.68 25.5%



22/22

Legae Securities (Pty) Ltd

Member of the JSE Securities Exchange

1st Floor, Building B, Riviera Road Office Park, 6-10 Riviera

Road, Houghton, Johannesburg, South Africa

P.O Box 10564, Johannesburg, 2000, South Africa

Tel +27 11 551 3601, Fax +27 11 551 3635

Web: www.legae.co.za, email: [email protected]

Analyst Certification and Disclaimer

I/we the author (s) hereby certify that the views as expressed in this

document are an accurate of my/our personal views on the stock or sector

as covered and reported on by myself/each of us herein. I/we furthermore

certify that no part of my/our compensation was, is or will be related,

directly or indirectly, to the specific recommendations or views as expressed

in this document

This report has been issued by Legae Securities (Pty) Limited. It may not be

reproduced or further distributed or published, in whole or in part, for any

purposes. Legae Securities (Pty) Ltd has based this document on information

obtained from sources it believes to be reliable but which it has not

independently verified; Legae Securities (Pty) Limited makes no guarantee,

representation or warranty and accepts no responsibility or liability as to its

accuracy or completeness. Expressions of opinion herein are those of the

author only and are subject to change without notice. This document is not

and should not be construed as an offer or the solicitation of an offer to

purchase or subscribe or sell any investment.

Important Disclosure

This disclosure outlines current conflicts that may unknowingly affect the

objectivity of the analyst(s) with respect to the stock under analysis in this

report. The analyst(s) do not own any shares in the company under analysis.

Disclosure & Disclaimer

Documents

Kenyan Banks_A Critique to System Credit Risks_System NPLs Defying Logic but Regulators Need to Mind the Gap