Banks continue achieving super-profits despite growing competition and pressure for increased regulation

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1 Banks continue achieving super-profits despite growing competition and pressure for increased regulation Super-profits and the high cost of loans charged by banks have been making headlines throughout East Africa in recent years. Banks have been able to achieve high profits, at levels several multiples of the average GDP growth of 3.9% over the last ten years. The challenge for East African banks is to sustain this high growth when technological advancement is starting to enable non-industry players to enter the banking market. As a pointer to this, Kenyans in 2012 transacted business on mobile money transfer platforms worth Ksh1.5 billion (US$18 billion), which is the highest in the country s history. This is but the beginning of what is to come. With such a statistic, banks should be worried about the threat of an increasing number of non-industry players coming into the banking space. 1

2 Acclimating to regulatory pressure and getting too strong The clamour for increased regulation in the sector is a big threat to banks achieving super-profits in future. On the Capital side, from June 2014 the Central Bank of Kenya will enforce regulations that require banks to maintain a minimum core capital-to-risk-weighted assets ratio of 10.5% (up from the current 8%) and a total capital-to-risk-weighted assets ratio of 14.5% (up from the current 12%). This therefore means an increase of 2.5% extra capital to be pumped into the banks. Key questions that come out of this are: Will all 43 banks be able to meet this new regulation? Will this requirement suck capital from banks expansion and growth plans? Will this extra capital generate the same super -return that historical capital has been generating? Most banks in East Africa should be able to meet these new regulations, as they have been generating around 20% to 30% return on equity. This is an attractive sector of the economy to invest in. However, the key question is whether or not this new capital is able to generate the same kind of returns if there are restrictions on its usage for expansion and growth plans. The Monetary Policy Committee in Kenya has reduced the benchmark interest rate from 18% to 8.5% over the past three years; however, banks have reduced their base lending rates by only 5%, on average. On the other hand, they have reduced deposit rates by an average of 10%. Theoretically this should reflect an increase in spreads, however, depending on the mix of deposits and customer profiles interest spreads have eased slightly for most banks. Average cost of funds for the top five banks, as at Q2 2013, was 2.3%; however, the average base lending rates applied at the time was 16%. The jury is out, whichever way one chooses to interpret this difference. With such statistics, it is easy to see why there is an outcry from government and the borrowing public hence the increased calls for regulation to control the spreads that banks can operate within to ensure that the cost of loans be reduced. If the control advocates were to succeed, the impact will be that interest earned by banks will reduce, and this will have a direct impact on their profit figures. Banks will be forced to think innovatively in finding ways to sustain their profitability models and satisfy their shareholders. The whole picture is undoubtedly not as simple as stated above. Structural constraints in the industry have contributed partly to the high interest rate regime. A history of high levels of bad debt portfolios and high bank operating costs (including cash distribution, security and channel costs) all add up to the final price. The State has continuously been borrowing from the domestic market to finance its revenue shortfall, which has not helped the situation. The more the government borrows, the fewer the funds available for the private sector to borrow, says Nikhil Hira, Head of Tax Practice at Deloitte East Africa. Some of these factors are now being mitigated. 2

3 The road ahead According to John Kiarie, Head of Consulting in the Deloitte East Africa practice, Banks are just inviting competition with the high spreads they are operating with; if they do not change, competitors with more optimal and cost-efficient operating models will come into the market and force much lower interest rates. Against this backdrop, banks will require a lean operating model. Some banks may need to change parts of their operating model or may need to completely rethink their operating model, including looking for optimum ways of financing their balance sheets. Currently, most banks do not have a lean operating model. In some cases, for each front-office staff member there are three back-office staff members, instead of the reverse. Figure 1: Technology is a central driver of business priorities Source: Deloitte Centre for Financial Services Revenue Growth Technology Technology can be at the centre of this lean operating model and is a key driver of business priorities. The diagram below, from Deloitte research, depicts the way in which this can be achieved. Risk and compliance Operational effectiveness Revenue Growth Enhance customer experience with better digital offerings. Leverage data from compliance infrastructure and use analytics to gain meaningful insights. Risk and compliance Strengthen compliance and risk management systems, and get the board more engaged in the management of cyber-risk Operational effectiveness Enhance effectiveness of large-scale technology projects with more engagement by IT leaders in execution 3

4 Revenue growth can be achieved by investing in meaningful analytic tools which will produce the desired insights and results. Below are the steps through which data can be used to derive business value: Operational reporting Standardised and static reports (e.g. a Monday morning weekly sales report) KPI reporting Involving integrated performance reporting with interactive dashboards for providing the right level of insight Segmentation Grouping and segmentation of customers, products, etc. and then exploring the opportunities to upsell or cross-sell Predictive modelling Forecasting and predicting future outcomes, modelling and understanding correlations and causalities Simulation and optimisation Simulating and experimenting with possible scenarios, finding the best solution out of many and generating a structured business case In the area of core banking transformations, as banks pursue new strategies, willingness to invest in this area should be higher. The focus of the transformation should be the adoption of best practices which mirror leaner operating models. To enhance the effectiveness of large-scale technology transformation projects, business leaders may need to be more engaged in execution, co-leading these initiatives with IT leaders. Strengthening compliance and risk management systems has always been a concern for banks. As cyber-risks become more pronounced, the industry should continue to strengthen its defences across the threat landscape. Improving risk governance, adopting a more holistic approach to cyber-security, and getting the board and the C-suite more engaged in cyber-risk management are all likely to be crucial. 4

5 In conclusion, to keep up the high returns that banks have earned for their shareholders, business executives need to look at their operating model very keenly and focus on areas where they can drive revenue growth, rationalise cost and deliver efficiency while ensuring that enterprise risk management is embedded. This will inevitably make CFOs play a more strategic role within their institutions. Analytics will be a key area, as this will help bank executives to clearly see where their most profitable areas are and hence what to focus on and where their weaknesses lie. Good analytics could be a key differentiator between winners and losers. Core banking transformation projects will be on the rise due to the many challenges that banks continue to face with their systems, and this will be key in delivering quality customer service as a differentiator and to ensure that customers remain loyal. Priorities may seem varied for every bank, depending on size and specialisation; however, the industry is certainly in the spotlight, and expectations are for lower costs and better service to the consumers. The successful banks will be those that are proactive in addressing the concerns raised and anticipating customer needs for the future. 5

6 Contact Sadiq Merali Associate Director Financial Services Industry (FSI) Deloitte Kenya Mobile: +254 (0) Martin Oduor-Otieno Senior Advisor Financial Services Industry (FSI) Deloitte East Africa Mobile: +254 (0) Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Deloitte provides audit, tax, consulting and financial advisory services to public and private clients spanning multiple industries. With a globally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and high-quality service to clients, delivering the insights they need to address their most complex business challenges. The more than professionals of Deloitte are committed to becoming the standard of excellence. This communication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms, or their related entities (collectively, the Deloitte Network ) is, by means of this communication, rendering professional advice or services. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person who relies on this communication Deloitte & Touche. All rights reserved. Member of Deloitte Touche Tohmatsu Limited Designed and produced by Creative Services at Deloitte, Johannesburg. (807272/dbn)