In a recent press release, the International Monetary Fund said that although Kenyan banks are sufficiently capitalised and posting good returns, the asset quality is an issue that needs extra scrutiny. Tanzania also received a similar IMF advisory note on the rising number of non-performing loans.

The specific asset quality indicators that made the IMF send the cautionary message to Kenya are the rising levels of non-performing loans and failure to maintain sufficient loan loss reserves.

According to the Central Bank of Kenya’s latest monthly economic review report, the value of gross non-performing loans increased by 32.7 per cent from Ksh81.4 billion ($891 million) in November 2013 to Ksh108.0 billion ($1.2 billion) in November 2014. Similarly, the ratio of gross NPLs to gross loans increased from 5.1 per cent in November 2013 to 5.5 per cent in November 2014.

Another key indicator is the coverage ratio, which measures the ratio of the specific provisions to total non-performing loans. Over the same period, CBK said this ratio also declined from 43.1 per cent to 39.7 per cent.

The story is no different in the other East African nations. According to the IMF, in Tanzania, the ratio of non-performing loans to gross loans increased from 7.1 per cent in September 2013 to 8.5 per cent in September 2014.

This was mainly because of underperformance of large corporates in the manufacturing, trade and agriculture sub-sectors. However, the IMF was comfortable with the levels of profitability, capitalisation and liquidity in countries like Kenya.

The Bank of Uganda said the quality of assets in the country’s banking sector has been improving, leading to a drop in the levels of nonperforming loans from 5.8 per cent to 5.3 per cent in June 2014. It is the same case in Rwanda where the non-performing loans ratio for banks fell from 6.9 per cent in December 2013 to 6.3 per cent in September 2014.

Credit facilities, in most banks, form the biggest percentage of total assets. Therefore, the quality of these assets has a huge bearing on the other financial performance indicators such as the profitability, liquidity, capital adequacy as well as the credit ratings from the rating agencies.

Indeed banking crises in most countries emanate from consistent accumulation of non-performing loans. This is the reason the regulatory authorities are usually very stringent on the type and nature of loans granted by banks and the level of loan reserves maintained.

The loan provisions generally act as a cushion for customers’ deposits and shareholders’ funds in case of defaults. For starters, bad loans provision is an expense set aside as an allowance in the event that a good loan becomes bad and is eventually written-off in case of default. Therefore, lending institutions are required to set aside such an allowance from their profits.

Central banks in various countries provide guidelines on how much is set aside for various loan classifications, which is largely based on the guidelines given by the International Financial Reporting Standards (IFRSs). Under-provisioning can lead to overstatement of profits while over-provisioning can lead to understatement of the profits, which would affect taxation, level of dividends and other variables.  

The world over, there are many examples of economies that went through financial crises emanating from among other things high levels of nonperforming loans.

In Nigeria, the central bank started a “bad bank” called Asset Management Company Nigeria (AMCON) in 2010 to buy off bad loans and help in recapitalisation of banks.

Some of these banks were reeling under huge non-performing loans, under-capitalisation, weak corporate governance and other challenges.

To recapitalise the banks, the central bank put together a huge bailout package. The then governor Lamido Sanusi won global accolades for his efforts to revive the ailing banking system, which was near collapse. Whether AMCON has achieved its targeted mandate is a discussion for another day.

Recently, Zimbabwe set up a similar special purpose vehicle that seeks to rescue several distressed banks that face huge challenges, largely linked to non-performing loans. The Zimbabwe Asset Management Company (ZAMCO) was established by the Reserve Bank of Zimbabwe (RBZ) last year to take over huge non-performing loans from these distressed commercial banks.

By the end of 2014, the total non-performing loans were estimated to have reached $750 million and were negatively affecting the growth of the banking sector. So far, RBZ said that ZAMCO has taken over $65 million in non-performing loans in an effort to rejuvenate the banking industry.

RBZ further said that the average non-performing loans to total loans ratio declined to 16 per cent as at December 31, 2014 from 20.45 per cent as at September 30, 2014.

Nevertheless, the panacea for bad loans cannot lie in establishing “bad banks” to buy off the non-performing loans. This action comes at a cost to taxpayers and sends the wrong signals to the industry and subsequently the entire economy.

Banks should maintain strong credit risk management systems to minimise the levels of non-performing loans. It is a duty these financial institutions owe not only to shareholders but to depositors and the entire economy in general.

Reasons for increases

So, what are the main reasons behind an increase in non-performing loans? They include poor credit assessment, which leads to sanctioning of loans to non-creditworthy borrowers; changes in government policies that affect the ability of some borrowers to meet their loan repayments in time; ineffective judicial or legal frameworks that make it hard for banks to recover securities pledged as collateral.

There are several effects of having too many non-performing loans for a lending institution: the loan loss provisions restrict the cash flow that used to grow operations; The increased provisions reduce the expected profits and ultimately diminish shareholders’ funds or equity value.

The alert by the IMF needs to be taken seriously and appropriate measures implemented to avert costly consequences in future. As more banks transact across borders, especially in East Africa, they must continue investing in the most robust risk management programmes, processes and technologies to ensure they are not caught flat-footed.

Macharia Kihuro is a risk management practitioner based in Nairobi, Kenya. [email protected]