Nowadays, whenever I introduce myself as a banker, it is almost certain that the next comment will be about the ‘huge profits’ that banks reported for 2021.
And almost always tied to that is another comment that the good outturn is as a result of banks’ ‘high’ returns from lending.
It is, therefore, worth debunking the myth of ‘high’ cost of credit, which means literally opening the box to discuss the drivers of the cost of bank credit. Since 2017, commercial banks – working closely with the Central Bank of Kenya (CBK), have been very intentional – in the spirit of transparency – in supplying full information to customers on the total cost of credit for a variety of loan products available in the banking system on a website co-hosted by the Kenya Bankers Association and the CBK. The website supplies bank-level data on the total cost of credit to enable customers to compare the costs of different bank loans based on interest rates as well as other applicable bank charges.
Even with this information, however, there is a need to step back and discuss the drivers of the cost of bank credit. Principally, and in line with global practice, banks basically mobilise deposits and extend the mobilised funds as loans.
This places customer deposits at the core of banks’ lending practices. In Kenya, deposits account for about 88 per cent of total liabilities that banks hold, out of which about 70 per cent are converted into loans. As this financial intermediation occurs, banks are confronted with costs – which are perhaps higher than what other sectors of the economy face, as we shall notice shortly. These costs feed into the overall cost of credit, which is primarily driven by two factors.
Interest rate element
First, is the interest rate element that reflects each bank’s base rate and a risk premium. Take the base rate as the rate of interest that enables a bank to cover only its costs in the absence of risk as well as an average return on assets. The base rate would reflect the bank’s overall cost structure, mainly the cost of deposits and total operating costs. As at the end of 2021, the average deposit rate, which covers the average cost of loanable funds, stood at 6.5 per cent.
From an average lending rate of 12.2 per cent in December 2021, the cost of loanable funds, the deposits, knocks off more than half of the earnings from loans, leaving 5.7 per cent to cover all other costs that banks face as well as a return on the investment. In 2021, total operating costs took up 58.1 per cent of total income generated by the banking system. As banks faced these costs, they were also required by law to deposit 4.25 per cent of total deposits at the CBK as part of the Cash Reserve Requirements (CRR). These funds are unremunerated, that is, they do not earn any return.
In addition, and as required by international financial reporting standards (IFRS 9), banks must also set aside funds as provisions, which also do not earn any return, to cover expected losses on loans extended. In fact, banks would be required to make additional provisions in an environment where credit risk is elevated since the expected credit losses would increase. As at the end of 2021, the industry made loan loss provisions equivalent to 12.2 per cent of total operating income.
Loan loss provisions
The cash reserves and loan loss provisions, both being unremunerated, limit the extent to which banks can invest the funds and earn a return, and yet all long-term sources of funds for banks are remunerated. In 2021, the average return on assets invested in the banking industry stood at 3.3 per cent, slightly up from two per cent in 2020.
This return, being much lower than the average for other firms – such as those in the telecommunications, manufacturing and energy sectors, whose return on assets all stood at above five per cent in 2020 – and given the banking sector asset base of Sh6.0 trillion, implicitly reflects the high costs that banks face.
Upon ascertaining the base rate, the other consideration is the risk that banks are exposed to as they lend depositors’ funds. Being funds due to depositors, the loans must be prudently processed and managed.
To this end, a risk premium is computed based on the risk present in the economy; specifically focusing on the industry the borrower is engaged in, business activity, financial position of the borrower and borrower’s previous loan performance, if any. Here, it also matters whether there is enough information describing the creditworthiness of the borrower – without which the consumer would be deemed riskier and thus attract a higher risk premium.
As at the end of 2021, credit risk was elevated, as the value of loans that were non-performing stood at 13.1 per cent of the total loans extended by banks to the private sector. This ratio has since risen to 14 per cent by end of February 2022, and the concern with banks would be the elevated risk in lending as more loans suffer non-repayment.
As such, banks would be required to make additional loan loss provisions even for existing loans. For the new loans under such conditions, credit standards would be tightened, leading to the deployment of more stringent risk assessment and the need to effectively load a higher risk premium on loans.
Second, and beyond the interest rate, banks, just like any other economic agents, would charge application and processing fees for the service of lending. Other costs associated with the loans are the third-party costs that are beyond the control and purview of banks and would ideally cover legal fees, life and other insurance charges associated with taking out credit, government levies and valuation fees. These costs add to the total cost of credit faced by customers.
As we reflect on these, and while the discussions on bank profitability would never be devoid of the ‘billions that banks are making’, all these must be seen in the light of an average return on assets of 3.3 per cent, and the balancing act that banks face in safeguarding customers’ deposits and at the same time ensuring that all forms of investments they engage in earn a positive net return for the shareholders. The discussions also present an opportunity for policymakers to identify areas of intervention to reduce the cost of credit particularly via a reduction in the costs faced by banks.
Dr Olaka is the CEO of the Kenya Bankers Association.