This article is based on dialogs between banking executives, MFI executives and financial services investors who came together at a session held earlier this year to discuss “Navigating the future of banking in East Africa”. This session was jointly hosted by EAVCA and Intellecap’s investment banking practice at the Sankalp Forum held at the Kenya School of Monetary Studies (Nairobi).

Prevailing Instability

The havoc experienced in the Kenyan banking industry for the last many months has been astonishing particularly coming into a fairly advanced industry and economy. The industry shake-up has been so significant that any discussion around business circles will most often revolve around how hard it is to access financing etc. The precariousness was initiated by uncertainty created as three banks went belly up, two of which even though considered small were fairly respected in the region. This stirred the bank customers into a run – away from “smaller banks” worsening the liquidity imbalance in favor of “bigger” banks. The second cause of the instability has been the well-publicized regulatory changes which resulted in interest rate cap and the consequential rise in non-performing loans as customers with more risky profiles could no longer access funding affecting their ability to repay existing obligations.

In yet another change expected to affect the Kenyan banking industry, the treasury plans roll-out the Treasury Single Account (TSA) starting July 2017 which is expected to have a moderate impact on the sector. Establishment of the TSA will entail moving all Government and public institutions’ deposits from commercial banks to Central Bank. These public institutions’ deposits, over the last 4 years, have averaged around 10% of total banking industry deposits. As at end of June 2016, Government and other public institutions’ deposits totaled KES 254 Billion. However, depending on how the TSA is implemented, KCB and NBK might be the most negatively impacted as the two commercial banks jointly held 62% of Government & other public institutions’ deposits by end of 2015.

It is within this context that the stakeholders brought their minds together to try and make sense of the possible macro-economic implications, and the impact to their business and portfolio even as other regional countries are considering implementing similar regulatory mechanisms. Because Kenya enjoys economic leadership relative to other nations in the region, the learnings drawn from this experience are key for the stakeholders with vested interests or who are looking to foray into the region.

You tell me how much I should charge ? Well  will tell you who to sell it to

The regions’ governments have a goal towards the reduction of interest rates just as any responsible authority would be. We cannot emphasize enough the need for access to affordable financing in job creation and economic development. While low interest rates are ‘a good thing to have’ for the authorities, it’s not an end in itself. Lowering the cost of funds in isolation may not yield an optimal solution for the intended outcomes. The ultimate goal is to increase access to lending to a wider audience within ‘reasonable costs’. This means a cost that covers the risk of a borrower, the finance & operating costs and yet leaves a scope to make returns vis-à-vis the yield. Numerous studies have shown that consumers are ready to pay a premium corresponding to their risk profiles.

The ceiling on rates has inspired many banks to make a conscious decision to slow down lending to high risk borrowers or those whose profile would warrant higher rates than the policy allows them to charge. This has led to the isolation of many SMEs and MSMEs, the very same group the policy was meant to help in the first place. With lenders’ lowering their risk appetite to match the lower interest rates, they have been presumed to be “colluding” to blackmail authorities into changing the regulations by hoarding private sector lending.

Interest rate ceiling is having a positive effect in pushing the financial institutions towards specialization. The mainstream banking is being pushed towards lending to the more stable SMEs and corporates which in the long-term will help with their non-performing portfolio positions. The gap that now exists is an organized segment of lenders that is able to serve the riskier SMEs and retail who are slowly being pushed away from the mainstream banking. Segmentation is already beginning to take root where the banks remain within the ‘high quality accounts’ space while the majority of MSMEs who tend to have less stable cashflows end up in the hands of unregulated MFIs and other less structured money lenders to meet their debt capital requirements. While a multitude of MFIs exist that can charge any rate of interest based on borrower’s profile and which have predominantly have been active in agriculture and other informal sectors, the segment remains fairly unstructured and too liberalized to serve the mass market and attract large ticket investments.Might segmentation in the mainstream banking be an alternative to consolidation? Is there a need for consolidation as the central bank has been advocating to strengthen the banking players? Would segmentation be more helpful for the wider economic interests?

Specialisation not consolidation, is the way forward

There are sentiments that in the long-term it will be profitable to have specific vehicles targeted towards lending to high risk borrowers at high rate of interest. While some of these vehicles are already in existence in the form of digital lenders, they will need to show more muscle for wider acceptability by the masses and ability to scale profitably. This also offers the large banks with an opportunity to set up ventures specifically meant to remain out of the heavy banking regulations but which can serve specific financial needs not reasonably viable at the current interest pricing. Some of these could be structured as venture debt lenders – firms willing to lend on the basis of alternative data, offer new structure products such as mezzanine finance etc.

Geographic diversification by banks into other countries to take advantage of banking arbitrage while helpful may not fully be ‘future proof’. Branching out banking offerings to reach a wider audience within current locations and at maximum efficiency levels will be more effective in gaining market share and maintaining returns to shareholders. For this efficiency to be attained, there will be need for a greater level of specialization. For instance, an institution targeting the dynamic motor bikes industry will require a certain expertise, agility and mindset that is different to a firm targeting corporate clients.

Onslaught of Brick and Mortar Operating Channels by Digital Channels

There has been a plethora of digital lenders starting operations in the region. This is in tandem with the global trend where certain developed markets have had fairly successful peer-to-peer lending and online credit market places. The growing smart phone penetration has also set a viable environment in the East African markets for technology to move into the credit market.

While use of digital channels has been on a rise (though the brick & mortar models still dominate), the concern among stakeholders is lack of convergence of the digital channels towards a single system accessible to all Banks, Financial Institutions, Telcos and other payment system providers.The interoperability of the different digital payment systems is imperative to the success of alternative banking channels, an area that Kenya has not succeeded in. Although certain initiatives have been undertaken to support interoperability, little has been accomplished thus far. For instance, Kenya Bankers Associations’ PesaLink was set up in order to create an interconnection between banks and bridge the gap created by the individual systems in existence. It’s still early to tell the success of this initiative in achieving the desired effects but it promises to avoid some of the segmentation weaknesses of the current digital solutions.

Company-to-company partnerships between telcos and banks have previously helped set up an end-to-end digital lending system for consumers, an example of this include KCB’s partnership with Mpesa as well as the Mshwari product. In the long term, a centralized system accessible to all players will lessen the need for these expensive company-to-company partnerships and make it easier for new operators and consumers to onboard. Perhaps it’s in consideration of these industry benefits that Uganda has become more deliberate in pushing towards making various products/platforms interoperable, the results of which will be seen in the future.

To conclude, just like thinning in farming is an important process to ensure surviving fruits are strong enough, the banking shake-up has created a great opportunity for disruptions and by the end of it, the Kenyan banking & financial services sector is likely to end up with more sturdy players. The shake-up is also renewing the sectors’ resolve to increase efficiency by creating alternative digital channels. And as more of the banking & financial services players increase intensity in the use of digital platforms for growth, we can only hope that they will be keen to implement it within the key success factors of agility and continuous re-invention.