The Opportunity in Banking Consolidation in East Africa

Rainer Michael Preiss, April 2019
The East African banking sector has made significant strides in the past several years. From an industry that was once blamed for its exclusion to now being praised for its financial inclusion efforts thanks to mobile technologies, the sector has come a mighty long way. But almost in the same space of time, the sector has been experiencing a rather quiet evolution; namely consolidation. Thanks to a growing trend towards financial sector integration, increasing regional infrastructure spend and the desire to achieve economies of scale, banking capital injections in the form of mergers and acquisitions have become an increasing occurrence.

In Kenya, for instance, the industry has had a total of 7 acquisitions and 5 mergers in the past 10 years. And yet another big merger is expected this year involving the tie-up between Commercial Bank of Africa (CBA) and NIC Bank. In addition, the Central Bank of Kenya (CBK) is directing banks to consider consolidation to withstand shocks. This is after putting three financially-distressed banks – Dubai, Imperial and Chase – under receivership in the recent past. Similarly, in the neighbouring Tanzania, the Central Bank of Tanzania (BoT) has called for consolidation among the 40 fully fledged commercial banks. The Bank of Uganda (BoU) has also encouraged banks to pool resources and realise economies of scale.

What’s important, heading into the future, is that a new set of factors are emerging to keep fanning the flames of banking mergers and acquisitions in the region. In other words, consolidation as an industry play is expected to hold, albeit on different tailwinds. The agenda to merge is expected to remain alive and well in the foreseeable future underpinned by the following five factors.

Firstly, the implementation of Basel 3, which introduced new capital and liquidity standards, is likely to sustain the wave of consolidation. Already, the National Bank of Rwanda is reviewing a proposal to quadruple the minimum core capital for banks to US$22.6 million from US$5.6 million. Uganda and Tanzania have also increased the core capital for banks in line with the new standard and the region’s financial sector integration agenda. For the same reason, back in 2007, Kenya increased the minimum core capital for banks to US$10 million from US$2.5 million. CBK plans to further increase the same to US$50 million.

Related to this point, banks are also dealing with implementing International Financial Reporting Standard (IFRS) 9, which now forces them to do a lot of provisioning. IFRS 9, which is a new global financial reporting standard that came into effect in January 2017, is intended to ensure banks withstand financial shocks amid rising non-performing loans (NPLs). This is expected to encourage consolidation – voluntary or forced. To support this trend, regional central banks have expressed a desire for a strong regional banking sector that can withstand external shocks and reduce bank failures.

Secondly, we see the entry of more foreign banks into the East African banking space. New emerging market banking institutions have been seeking to build some regional presence, not only to serve their own expanding client networks, but to also tap the expanding local economies. Currently, in Kenya, there are 9 representative offices of foreign banks, up from 7 in the previous year and the trend is expected to continue. Proving the growing interest, last year witnessed the US$35 billion Moroccan-based Banque Centrale Populaire (BCP) make a failed bid to buy a stake in Rwandan lender, Bank of Kigali. The Bank is still actively shopping for deals in Rwanda, Tanzania and Kenya. Two other foreign banks, Promsvyazbank, one of Russia’s largest privately-owned banks, and JP Morgan Chase & Co, America’s largest bank, have both expressed an interest in the region.

Underlying this foreign bank interest are three key factors: impressive regional economic growth, financial inclusion and improving profitability. Concerning the later, the profitability of East African banks improved with the average return on assets rising from 1.9% to 2% between June 2017 and June 2018. The average return on equity increased from 12.2% to 13.2% within the same period. Regarding capital, most banks held adequate capital to absorb shocks, with the regulatory total capital-to-risk-weighted assets ratio averaging 20.8% at the end of June 2018, which is favourable by global standards.

Regarding financial inclusion, Kenya in 2016 counted 75.3% of its population as formally included, a 50% increase in the last 10 years. According to the World Bank, the percentage of Kenyans who own a transaction account, rose to 82% in 2017 from 42% in 2011. Financial exclusion, which is now down to 17.4%, has more than halved since 2006, according to the 2016 FinAccess Household Survey. Financial inclusion rose from 9.2% to 13.9% in Tanzania between 2009 and 2013. According to the World Bank, the percentage of Tanzanian adults who own a transaction account, rose to 47% in 2017 from 17% in 2011. In Uganda, the FinScope Survey 2018 showed that 58% of the population are now using formal financial services, compared with 54% in 2013. According to the World Bank, this figure was 59% in 2017. Economically, the region continues to post relatively strong growth. According to the International Monetary Fund (IMF), the region recorded one of the best performances of GDP growth in 2018. Ethiopia ranked first with 7.8%, followed by Rwanda at 7.1%, and then Tanzania at 6.7%. Sub-Saharan economic growth was at a lower 2.9% last year.

A third push will be the need to defend (and grow) shrinking market share, especially for smaller banks. For smaller Tier 3 banks, the alternative is an existential threat. In 2018, the Tanzanian apex bank liquidated 5 community banks that were undercapitalised. Earlier this year, it revoked the operating license of Bank M and facilitated its acquisition by Azania Bank. The country has 58 banks, but only 10 control 80% of the market share. Furthermore, smaller banks have to deal with the lopsided dominance by the bigger banks. In Kenya, of the 42 commercial banks, 8 large banks accounted for two-thirds of the market share while the bottom half controlled only 7.92%.

This is also reflected in the share of profits. In Kenya, while the sector remained profitable by posting a profit before tax of US$1.33 billion in 2017, down 9.8% from US$1.47 billion in the previous year, the large banks accounted for 80.8% of the total pre-tax profit, an increase from 78.6% recorded in 2016. The small peer group proportion of total pre-tax profit decreased from 2.2% in 2016 to negative 1.53% in 2017. A similar story exists in Rwanda. Last year, almost half of the profits were generated by Bank of Kigali. Its net profit grew by 11% to US$22 million in the nine-month period ending September 2018. In all, the push for economies of scale will certainly be a major driver for consolidation amongst the smaller banks. A natural convergence towards a few but viable banks is likely in the near future.

Fourth is the regional integration factor. As the East African Community (EAC) slowly opens up, an opportunity for banks to expand within the region exists. The EAC Custom Union, which came into force in 2005, calls for, among other things, the elimination of internal tariffs and non-tariffs barriers and the establishment of a common external tariff. The many economic, social and political benefits among the collaborating countries are plain to see. For banks, they will be opportunities to target traders involved in exports and imports across the region.

Banks with regional operations are already beginning to book gains. Subsidiaries of Equity Bank, one of the leading banks in the region, outpaced their Kenyan base operation in profit growth for the year ending 2018. Although they contributed 15% of the total profit of the group, they nonetheless gave a good signal of the potential of the region. KCB, another leading regional bank with subsidiaries in South Sudan, Tanzania, Uganda and Rwanda, plans to further deepen its operations across the region. It expects to achieve this through credit extension in the personal/household sector, agriculture, healthcare, manufacturing and housing. Although political instability in some of the countries, such as South Sudan (complete with its attendant problems like hyper-inflation and currency devaluation), has meant little value has been created, present normalcy is expected to last. To successfully finance intra-East Africa trade, the sector will need to consolidate to take full advantage.

Lastly, the ongoing investments in public infrastructure across the region calls for deeper pockets. According to GlobalData, investments in infrastructure in the region’s three largest markets of Ethiopia, Kenya and Tanzania, are expected to grow from US$25.9 billion in 2017 to US$98.8 billion in 2022. The EAC also projects that it may need over US$100 billion to plug the region’s infrastructure gap over the next four years - the gap is thought to have kept the cost of doing business in the region high. Picking up the investment in the form of infrastructure bonds and syndicated loans is going to be the playing field for banks with size only.

That said, a couple of possible hindrances stand in the way. First is asset quality. By the end of June 2018, the NPL ratio stood at 10.3% in the Tanzanian banking sector, a figure more than double the regulatory benchmark of 5%. In Kenya, the NPLs to gross loans ratio remained elevated as well at 11.97% in June 2018. A similar scenario applies in Uganda; although the NPL ratio dropped significantly to 4.4% in June 2018, it comes from a high of 8.3% in June 2016.

A factor compounding this issue further is the high portfolio concentration risks brought on by bank loans focusing on a few key sectors and a limited number of corporates. The net effect of poor asset quality has resulted in some banks slowing down their lending activities. Bank credit to the private sector as a percentage of GDP in Uganda decreased to 13.1% in 2018 from a high of 14.2% in 2015. This caution in lending is expected to persist as a result of high default rates suffered in the recent past. Though the introduction of credit bureaus has helped somewhat, it has a long way to go to reduce credit risk. In the end, as long as the industry remains vulnerable to high NPLs, the allure to consolidate may no longer be as compelling.

Another major challenge has been bad government policies directed at the industry. A good example is the Kenya rate capping law. The law, which came into effect in 2016 and aimed at addressing the high cost of borrowing, saw lending rates capped at a maximum of 4% above the CBK base rate, known as the Central Bank Rate (CBR). Deposit rates were set at 70% of the CBR. The result of the move was a decline in commercial banks’ profits as a result of reduced interest rate spreads. Industry performance in 2017 saw average pre-tax profit for banks drop by 14% to US$733 million compared to US$853 million in the previous year. However, in 2018, profitability improved owing to a decrease in general expenses. One more bad policy was the introduction of the 0.05% “Robin Hood tax” on cash transfers of more than US$5,000 in the country. The end result - daily interbank volumes dropped by half in the first week alone.

Closely related to this point is the constant governance challenges by most central banks to carry out their supervisory mandate. In most EAC states, the supervisory capacity is still constrained and under resourced. For some suitors looking for deals, this may be a deal breaker.

In closing, it’s easy to see why consolidation in the East African banking industry is here to stay. Consolidation benefits such as economies of scale, which often results in higher returns to shareholders, will ensure further combinations in the region. This is true not only in Africa, but across the globe. And with a population growth rate of 2.5%, compared to other developed countries below the 1% mark, coupled with increasing financial inclusion and a greater uptake of financial services products, the consolidation play in the East African banking sector will be alive and well.

Rainer Michael Preiss was a consultant writer with NTU-SBF Centre for African Studies. 
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