Finding the sweet spot between tight and loose lending

The government has identified the cost of finance for small and medium-sized enterprises (SMEs) as a major challenge to the country’s long-term goals. Indeed, the lending market has proven to be one of the more contentious topics for the country’s banking sector. By the spring of 2014 the problem was approaching its third year as a topic of debate, and in early April the government announced an expectation: within a year, loans should be available at less than 10% interest. “We believe very strongly that to be able to develop our financial sector we must make credit affordable,” deputy-president William Ruto said at a press conference on April 7, 2014. The National Treasury was asked to study the issue, consult with banks and make recommendations to the presidency.

By The Numbers

Despite discussions over interest rates, lending has generally been robust in Kenya. The total value of loan books in the banking system rose to KSh1.58trn ($18bn) as of December 2013. That was an increase of 18.7% from KSh1.33trn ($15.2bn) a year earlier, according to the Central Bank of Kenya (CBK), with the growth spread across all sectors of the economy. Two sectors account for almost half of the total: personal lending and trade, which together claimed 46% of total loans. Manufacturing and real estate were the only other areas with a market share of at least 12%, and all others had less than 7%, according to CBK figures. The biggest jumps in lending for the year came in energy and water, where the total disbursed jumped 26.9%, from KSh52.2bn ($595.1m) to KSh66.2bn ($754.7m), and in real estate, which saw a 25.9% rise to KSh222.7bn ($2.5m). These two segments were closely followed by personal lending, which grew 24.7% to reach KSh408.2bn ($4.7bn) IMPLEMENTATION CHALLENGE: Asset quality, however, deteriorated on the year, with non-performing loans rising from KSh61.9bn ($705.7m) to KSh81.9bn ($933.7m), implying a ratio of 5.2% of total loans in the market. According to the CBK, the increase in defaults came as a result of high lending rates and a reduction in public spending in the lead-up to the general election. As of June 2013, the budget implementation rate fell between 63% and 89% of total allocations across the nine categories tracked by the World Bank, barring national security, which saw a 100% implementation rate.

As a result, bank customers had less to spend, more time waiting on government contracts, and therefore struggled to meet their own debt obligations. The scope of this issue was likely greater in early 2013 due to the roll-out of devolution, which saw mandates shift to 47 newly created counties. The turnover to the new government also featured a drop in the number of ministries from 44 to 18, and this period of forming new agencies and institutions exacerbated the issue by slowing the resumption of normal procurement spending after the election.


The problem of interest rate spreads began in late 2011 as a by-product of Kenya’s large current account deficit. Imports rose and the value of the shilling plunged on international markets. The inflation rate surged to almost 20% by November 2011, and the CBK responded by hiking interest rates. The benchmark jumped from 6.25% to 18% in the space of three months, and banks’ lending rates rose accordingly. Spreads for large banks over the following six months jumped from about 12% to a range between 14% and 16%, according to a study by the Kenya Bankers Association (KBA), a lobby group. For small and medium-sized banks, the spread increased from about 10% to a range between 11% and 12%.

These reactions to market data were expected and anticipated. But after August 2012, when macroeconomic indicators had stabilised and the CBK began to bring its policy rate back down, lending rates to the private sector did not fall in kind. While the policy rate is now at 8.5%, banks have lowered their lending rates by a far smaller amount, creating the double-digit rate spreads most customers face today. During the period in which the CBK was chopping its rate from 18% to 8.5%, the average commercial lending rate fell from 20.3% in June 2012 to 16.97% as of June 2013. “We are going to see spreads in single digits within the next five years,” said the director of research and policy at the KBA, Jared Osoro. “So long as there is market stability, spreads will come down, but in the past few years there has not been stability.”

Accusations of collusion and monopolistic behaviour among the largest handful of lenders are common across media. A KBA study agreed that size is a factor but also found that other bank-specific factors help explain the spread. “These include bank size, based on bank assets, credit risk as measured by the non-performing loans to total loans ratio, liquidity risk, return on average assets and operating costs,” the report said. Data analysis by the World Bank confirms that the big banks are the most profitable, and often those with the fattest spreads.

However, consumers themselves are partly helping to create this condition. According to a 2011 academic survey cited by the KBA study, many Kenyans choose their bank for its reputation and perceived stability, rather than for the best deposit rates. “Segmentation is based on size but shaped largely by social factors that determine the level of trust between banks and their clients,” according to the World Bank.

SME Factor

To be sure, interest rates in Kenya are elevated in part because – as in so many other frontier and emerging markets on the continent – they reflect the risks of extending credit. This is particularly true for SMEs, many of which lack transparent processes and credit history.

Several public-sector efforts under way could help reduce reliance on the banking sector, the two chief ones being the development of a junior board at the Nairobi Securities Exchange (NSE), and a reduction in government competition for loans. At the NSE, the Growth Enterprise Market Segment (GEMS) was established in 2013 and was home to just one listing as of early 2014. The board hopes to attract more SMEs by offering reduced reporting and compliance responsibilities. It has adopted the nominated advisor (NOMAD) system popularised by the London Stock Exchange’s Alternative Investment Market, in which a licensed investment bank serves as a NOMAD, responsible for helping a company establish a listing and stay compliant on a permanent basis. A poll of Kenya’s top 100 mid-sized companies in 2013 indicates that the idea of a GEMS listing may be getting a more serious look – 28 of them said they were considering it, according to the World Bank’s study.

The government can further help by reducing the frequency and value of local-currency sovereign bond auctions, at which domestic banks are the main buyers. Reinvesting their capital in short-term government debt is seen as far safer than lending to the private sector, creating a significant disincentive to financial intermediation. The desire to redirect banks’ attention away from government bonds is one reason for Kenya’s debut issue of $2bn in dollar-denominated sovereign bonds in June 2014, which was more than four times oversubscribed. In early April, Ruto called this an exit strategy from borrowing in the local market.

Additonal Funding Options

Kenya’s spending plans are significant, however, and that means that multiple new sources of funding will be under consideration. Public-private partnerships for infrastructure are one such option. All the same, the KBA does not expect that these solutions will offer a quick change. “Our system is a bank-based system, as opposed to a markets-based one,” Osoro told OBG. “To transition will take 20-30 years.”

Future reforms that could help include stronger protection for creditors. According to the World Bank’s research, an average of 190 days is required to recover a bad loan in Kenya, with the recovery rate at approximately 80% of the loan amount. That is better than in some other countries against which Kenya benchmarks itself, such as Rwanda (135 days, 85%) and Nigeria (246 days, 30%). Nevertheless streamlining the process would help reduce the perceived risk.

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The Report: Kenya 2014

Banking chapter from The Report: Kenya 2014

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