INDUSTRY REPORT Founder Member of the Nairobi Securities Exchange

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DYER & BLAIR INVESTMENT BANK INDUSTRY REPORT Founder Member of the Nairobi Securities Exchange 14 TH NOVEMBER 2016 BANKING SECTOR REGULATION In the fast evolving world of finance, regulation always

Frequent modification of products and services and rigidity of laws has led to some financial instruments not being adequately covered by a specific law or being covered by different contradicting

1 DYER & BLAIR INVESTMENT BANK INDUSTRY REPORT Founder Member of the Nairobi Securities Exchange 14 TH NOVEMBER 2016 BANKING SECTOR REGULATION In the fast evolving world of finance, regulation always plays catch up with innovation. Frequent modification of products and services and rigidity of laws has led to some financial instruments not being adequately covered by a specific law or being covered by different contradicting standards. Following the Financial Crisis of 2008, there has been a worldwide push by regulators to modify laws governing financial institutions and instruments in line with innovation of new products and services. This led to changes such as the introduction of IFRS 9: Financial Instruments. Closer home, following the collapse of two banks in 2015 and the placing under receivership of another in 2016, the Central Bank of Kenya has tightened regulatory noose on financial institutions. Most of its focus has been on loan classifications, loan loss provisions, role of auditors and capital adequacy. Other changes in the financial sector have been caused through acts of Parliament. The following report highlights key regulatory changes both internationally and locally that affect the Kenyan banking sector. Scope of the audit engagement The Central Bank of Kenya (CBK) widened the scope of the audit engagement to include ICT audits on banks. This will require the external auditors to: Review all information systems within the financial institutions including core banking software and confirm whether all systems and applications are robust enough to ensure data integrity, completeness and accuracy. Perform application controls testing which include configuration controls sensitive access and segregation of duties controls, interface controls, data integrity controls and obtain reasonable assurance on the accuracy and completeness of key system reports. 1 Research Analyst KASEE MBAO mkasee@dyerandblair.com

2 Review and assess whether balances resulting from all transactions and data processed within the institution s IT System are accurately captured and reported in the institution s General Ledger, the financial statements and returns submitted to CBK. Review IT security controls including application security, privileged access, audit trails, system monitoring and maintenance, integrity and systems ability to recover from unexpected shutdowns and ability to recover from a disaster resulting in loss of data. Assess the adequacy of security measures used to prevent unauthorized access and modification of data and/or parameters of underlying financial transactions. Review any manual intervention activities within automated processes to ensure such interventions are properly authorized and controlled. This might in turn lead to an increase in the audit fees paid by banks going forward. Changes to the Banking Act by the CBK The Central Bank also introduced the following amendments to the Banking Act: Clarification of a significant shareholder as an individual who owns 5% of a financial institution. Significant shareholders are liable for vetting by the CBK to ensure that only fit and proper persons are allowed to have control in banking institutions. Giving CBK the mandate to vet a person who holds less than 5% shareholding in a banking institution if the regulator is of the opinion that the individual decreased their shareholding to avoid vetting. Restriction on the ownership of share capital by an individual and his/her associates to a maximum of 25% of the share capital of a banking institution. Issuance of perpetual licences as opposed to annual licences with licensees paying an annual fee to the CBK. The regulator also retains the right to revoke the perpetual licence in case of a breach of law by the licensee. Empowering the Kenya Deposit Insurance Corporation to take over the receivership and liquidation of a banking institution that has been voluntarily wound up. 2

3 Banking Amendment Act On the 24 th August 2016, the President of the Republic of Kenya signed into law the Banking Amendment Bill which sought to insert clauses in the Banking Act that would place an interest rate cap on credit facilities advanced by financial institutions and a floor on deposits the held in interest earning. The amendments were as follows: 31A: A bank or financial institution shall, before granting a loan to a borrower, disclose all the charges and terms relating to the loan. 33B (1): A bank or a financial institution shall set: The maximum interest rate chargeable for a credit facility in Kenya at no more than four percent, the base rate set and published by the Central Bank of Kenya; and The minimum interest rate granted on a deposit held in interest earning in Kenya to at least seventy percent, the base rate set and published by the Central Bank of Kenya. 33B (2): A person shall not enter into an agreement or arrangement to borrow or lend directly or indirectly at an interest rate in excess of that prescribed by law. 33B (3): A bank or financial institution which contravenes the provisions of subsection (2) commits an offence and shall, on conviction, be liable to a fine of not less than one million shillings, or to imprisonment for a term of not less than one year, or to both. The Act took effect on 14 th September 2016 with the CBK issuing prudential guidelines clarifying the following: The base rate as referred to in the law is the Central Bank Rate (CBR) Interest rates are applicable on an annual basis Banks should submit to the CBK copies of their policies that will ensure full disclosure of charges and terms for loans to borrowers by 30 th September

4 Implementation Banks have proceeded to implement the law with most applying it retrospectively on old loan accounts. There has been contention of the application of the law on loans disbursed through mobile banking platforms with banks initially recognising that as microfinance lending. However, it was argued that lending on mobile platforms qualifies as indirect lending by the bank, hence the applicability of the law on mobile banking platforms. Banks have applied the interest on deposits however the contentious issue is on fees and interest charged on mobile loans. CBA argued that the 7.5% charged on a loan is a one-off facilitation fee and not an interest rate hence not subject to the rate cap. On the flip side, KCB and Equity have adjusted interest charges on loans disbursed through mobile banking channels accordingly. KCB changed the structure of KCB M-Pesa by stopping lending for tenures past 1 month (3 month and 6 month loans). The bank now charges 1.17% interest per month plus a 2.25% transaction fee. This brings the total charges on the 1 month loan to 3.645% given that the 2.25% transaction fee attracts a 10.0% excise duty. Banks are also seeking to reduce concessions on fees chargeable on loans in a bid to grow the fees and commissions income. This applies only to fees that have already been approved by the CBK but were charged to customers at rates lower than the maximum approved fees. Currently, the CBK only allows banks to raise approved fees by the percentage change of inflation hence a 3.00% fee can only be increased by 6.47% (October inflation rate) to %. Finance Act 2016 The following changes affecting the banking sector have been made through the Finance Act 2016: Credit Information Sharing : As from 1 st January 2017, SACCOS, public utility companies and credit rating agencies can share information on non-performing loans and borrower credit-worthiness. This effectively widens the pool of information available to lenders in determining creditworthiness and will assist banks as they move towards more qualitative lending and risk based pricing as a result of interest rate capping. 4

5 National Treasury role in bank regulation: From 1 st January 2017, the Central Bank of Kenya (CBK) will have to consult the Cabinet Secretary of the National Treasury before entering into an arrangement with the board of directors to rectify any deficiencies in a regulated institution. Over the past 2 years, the CBK closed two banks (Imperial Bank and Dubai Bank) and placed under receivership Chase Bank due to alleged malpractices by management. However, this may delay or reduce CBK s ability to take action against rogue banks and may act as a hindrance to the regulator s ability to perform its duties as stipulated in the Banking Act. Penalties for non-compliance: Effective 1 st January 2017, the penalty for institutions and individuals that violate the Banking Act or Prudential Guidelines has been enhanced from KES 5.0MN to KES 20.0MN and from KES 0.2MN to KES 1.0MN respectively. The CBK has also been empowered to charge additional penalties of up to KES 100,000 per day (up from KES 20,000) for each day the violation continues. This is viewed as a reaction to the aforementioned closure of banks due to alleged malpractice by management and is aimed as a deterrence to future violations. IFRS 9: FINANCIAL INSTRUMENTS The International Accounting Standards Board (IASB) in July 2014 issued IFRS 9 as a replacement of IAS 39: Financial Instruments: Recognition and Measurement. The standard includes requirements for recognition, measurement, impairment, derecognition and general hedge accounting. The mandatory effective date is for annual period beginning on or after 1 st January 2018 with voluntary early adaption allowed. Some of the new additions are to tackle the recognition and measurement of hedging instruments such as derivatives which are currently not applicable in the Kenyan market. In the context of the Kenyan market, the following sections will be key for the Banking Sector: Classification of Financial Assets and Liabilities: Debt instruments such as government securities will be measured at amortized cost, fair value through profit or loss (FVTPL) or fair value through other comprehensive income (FVTOCI). Two models for analysis are to be used: Business Model Test: The objective of the entity s business model is to hold the financial asset to collect the contractual cash flows (rather than sell the instrument prior to its contractual maturity to realise its fair value changes). 5

6 Cash flow characteristics test: The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Equity instruments will be classified at fair value in the Statement of Financial Position with changes in fair value being recorded in profit and loss or other comprehensive income. Unquoted equity instruments are quoted at fair value with no exception to quote at cost. Though the categories are similar to IAS 39, the criteria for classification are significantly different. Impairment: IFRS 9 replaces the incurred loss model in IAS 39 with an expected credit loss model which means that a loss event will no longer need to occur before an impairment allowance is recognised. This aims to address the questions of over or under provisioning for loan losses. Under the new impairment model, expected credit losses are required to be measured through a loss allowance at an amount equal to: The 12 month expected credit losses (expected credit losses that result from those default events on the financial instrument that are possible within 12 months after the reporting date); or Full lifetime expected credit losses (expected credit losses that result from all possible default events over the life of the financial instrument) A fulltime loss allowance is required if the credit risk of a financial instrument has increased significantly since initial recognition. IFRS 9 considers credit risk low if there is a low risk of default, the borrower has a strong capacity to meet its contractual cash flow obligation in the near term and adverse changes in economic and business conditions in the longer term may, but will not necessarily, reduce the ability of the borrower to fulfil its contractual cash flow obligations. However, IFRS 9 contains a rebuttable presumption that credit risk is considered to have increased significantly when contractual payments are more than 30 days past due. This is in line with the CBK s push for proper loan loss provisioning, however, the impairment model will bring an implementation headache for the banking sector in terms of modelling for losses not yet incurred. 6

7 APPENDIX COMPANY INVESTMENT RATINGS Buy: Share price may generate more than 15.0% upside over the next 12 months Overweight: Share price may generate between 10.0% and 15.0% upside over the next 12 months Hold: Share price may fall within the range of +/- 10% over the next 12 months Take Profit: Target price has been attained. Look to accumulate at lower levels. Company fundamentals however remain strong Underweight: Share price may generate between 10.0% and 15.0% downside over the next 12 months Sell: Share price may generate more than 15.0% downside over the next 12 months, significant business and/ or financial risks present, industry concerns Not Rated: Counter is not within regular research coverage SECTOR INVESTMENT RATINGS Overweight:Industry performance better than that of the whole market Equal weight: Industry performance about the same as that of the whole market Underweight:Industry performance worse than that of the whole market DISCLAIMER While every care has been taken in preparing this report and it has been prepared from sources believed to be reliable, no representation, warranty, or undertaking (express or implied) is given and no responsibility is accepted by Dyer and Blair Investment Bank Limited, its related companies, subsidiaries, affiliates, its employees and agents, as to the accuracy and completeness of the information contained herein or in respect of any reliance on or use thereof. This report is solely intended for distribution to clients of Dyer and Blair Investment Bank Limited. Any information may be changed after distribution at any time without any notice. 7

Presented by Harun Katusya. Uphold public interest

Presented by Harun Katusya. Uphold public interest Sector Capital and Liquidity Adequacy Requirements; Local Legislation/Regulation in Contrast with International Accounting Standards and Best Practices Presented by Harun Katusya Uphold public interest