Kenyan banks have continued to enjoy growth, recording a 37.7 per cent rise in the five-month profits to May riding on high interest spreads that have however seen their non-performing loans rise.

Fresh data from the Central Bank of Kenya shows that the banks’ pre-tax profits were at Ksh43.79 billion ($521.3 million) as at May this year, compared with Ksh31.8 billion ($378.5 million) posted in the same period last year.  The five months performance surpasses half-year profits in 2011, when the banking sector reported Ksh40.8 billion ($485.7 million) in after-tax profits.

This is an indication that the sector is headed for another good year even as it faces the ire of the general public, which is calling for interest rates to be lowered at a faster rate. The drop in the cost of deposits, which was the main expenses for banks in the three months to March, contributed to the faster growth in profits this year. With the lending rates remaining constant, banks enjoyed wider interest margins.

“The cost of funds has generally decreased across market segments and bank categories since April 2012 due to improved liquidity in the market,” noted the Monetary Policy Committee in its monthly market survey. “Average interest rate spreads rose slightly between April and May 2012 but remained lower compared with the level in March 2012,”added the Committee.

However, banking sector officials say there is a misconception among the public that wider spreads mean better profits.

“The misconception among the population is that spreads equal profit. In actual fact, spreads equals revenues,” said Richard Etemesi, CEO of Standard Chartered, speaking at an online forum with the public organised by the Kenya Bankers Association.  He added that banks have to factor in the cost of operations, provisions, and other costs to come up with their profits.

As Kenya’s banks reported a rise in profits, a controversial report released on Thursday last week by Citi Group Global Markets claimed they were overstating their profits, an argument dismissed by bank executives as false. The Citi Group report, titled Don’t get caught when the music stops, also warned about the exposure banks have to bad loans. The analysts said banks had not provided for bad loans worth Ksh20.8 billion ($247 million) for the full year 2011.

Mr Etemesi, who is also the Standard Chartered chief executive, dismissed the allegations as ridiculous. But are the banks making a killing at the expense of Kenya’s banked population? That is the question analysts, investors, depositors and borrowers are asking, as banks continue to rake in higher profits in an environment clouded by high interest rates on loans despite the Central Bank’s push for lower rates.

Barely a fortnight ago, the CBK lowered the key lending rate to 16.5 per cent from 18 per cent, in a signal to banks to lower lending. The signal saw at least five banks — Barclays Bank, Cfc Stanbic, Commercial Bank of Africa, Bank of Baroda, and Standard Chartered — reduce their lending charges by 1.5 per cent. Other banks are likely to follow suit in coming weeks, which will see interest rates decline but still remain high, analysts at Standard Investment Bank said.

“Some banks have however pointed out that a sudden drop in interest rates may not be possible as they are still holding expensive wholesale fixed deposits,” said the analysts last week in a research note to investors. A fall in interest rates could put pressure on banks’ profit margins. However, a growing tendency by the CBK to mop up excess liquidity in the repo market could offer a reprieve to the banks.

“We think this move will continue to support wide margins for the larger banks (which have cheap deposits), with credit growth in the economy remaining constrained in the near term. This could point to a robust performance for banks such as KCB, Standard Chartered, Equity Bank and Barclays Bank, “ said Standard Investment Bank.

(Read: Kenyan bankers shun costly large depositors, turn to retail savers for cheap funds)
As banks continue to push loans to their customers, they are faced with the challenge of adequately providing for bad loans should interest rates remain high in 2012.  Banks conduct business by charging more interest on their loans than they pay out on secure deposits. In banking terms, this is referred to as the interest rate spread. With high interest rates constraining their key source of income, they are increasingly making hundreds of millions of dollars in transaction charges, such as ATM and over-the-counter withdrawals, salary processing, electronic fund transfers and receipt of bank statements, among other things.

The performance of the banking sector, whose fate has traditionally been linked to consumer confidence, is seen by analysts as a signal of an ongoing resurgence of the economy, as it means manufacturers are taking in more money to expand production to meet rising demand. The wider implication is a sign of growing confidence among commercial banks that is expected to speed up credit expansion in an economy that needs money to finance growth.

“The banking sector is still resilient. The fundamentals that threatened the sector like inflation and volatility in the currency markets are beginning to stabilise” said Equity Bank chief executive James Mwangi in an interview with The EastAfrican last week. But with the interest rates rising, banks have been forced to pay more for their deposits. Interest on deposits contributed 40 per cent of the banking industry’s total expenses in the first quarter of the year.

Expensive deposits are not the only concern for the banks. The high interest rates charged by the banks to ensure they maintain their margins have resulted in more borrowers lagging behind in their loan repayments, exposing the banks to losses.

In the two months between March and May this year, the industry’s gross non-performing loans rose to Ksh56.52 billion ($672.8 million) from Ksh53.7 billion ($639.2 million).

Curse of high interest rates

Analysts attributed the rise in loan defaults to the high interest rates and cost of living, which has forced households to weigh between meeting their basic needs and funding their credit obligations.

“Even with CBK capping the increase of monthly instalments at 20 per cent, it was not sufficient as food prices had also gone up,” said Vimal Parmar, head of research at Kestrel Capital.

He noted that there was usually a three-to-four month lag between the onset of a high interest rate regime and a rise in non-performing loans, as banks are required to report loans that have not been serviced for over 91 days.

To stave off bad loans, banks were extending loan repayment periods to allow for marginal increases in monthly instalments. However, such extensions were not viable for long tenure loans such as mortgages.

The banks are optimistic that the rise in defaults is momentary and a drop in interest rates will see a turn in the tide.

“It is a timing problem with the drop in interest rates; as we see banks reduce their base rates, we expect this to reverse,” said Habil Olaka, CEO of the Kenya Bankers Association.

High interest rates have dampened appetite for loans, with the industry loan book growing to Ksh1.29 trillion ($15.3 billion) from
Ksh1.24 trillion ($14.7 billion) in March this year.

“Yes, there has still been some credit expansion but at a much slower pace,” said Joseph Njuguna, head of finance at Consolidated Bank.

The rise in profitability in the industry was said to be limited to the banks that had high liquidity, especially large banks, with the small tier institutions still bogged down by high cost of funds.
“Some of the large cap banks have the benefit of cheap deposits but banks lacking liquidity are suffering, as they still have to pay high rates in fixed and call deposits to attract cash,” said Mr Parmar.

As per Central Bank of Kenya data, large banks had an interest spread of 15.9 per cent while small banks had 11.6 per cent spread.

In the first quarter, some banks such as Ecobank had announced a drop in profits owing to high interest expenses