Higher interest rates and rising inflation leave banks with a delicate juggling act

Higher interest rates and rising inflation leave banks with a delicate juggling act

The combination of high interest rates and rising inflation confer a mixed blessing on Kenyan banks. On the one hand, higher loan volumes and lending rates will boost profitability, while on the other, credit risk will rise, pushing up problem loans and loan-loss provisions. Kenyan banks have strong capital, good access to low-cost, stable deposit funding and healthy stocks of liquid assets. These underlying strengths will shield them from the worst effects of loan book deterioration. However, their large holdings of government bonds leave their capital, profitability and liquidity vulnerable to sovereign stress.

Banks’ profitability will benefit from strong business growth and higher margins. Healthy profitability will remain a key credit strength of the banks even though levels will likely drop from recent highs. Recent peaceful elections and the ongoing recovery from the pandemic will promote business activity, while higher interest rates will gradually widen the banks’ loan yields, boosting their profitability. Kenyan banks’ return on assets for 2022 will be close to 3.8%, a recent high.

Loan performance will remain weak and loan-loss provisions will stay high. Over the next 12 to 18 months, higher inflation, rising interest rates and reduced government spending amid fiscal constraints, will weigh on borrowers’ loan repayment capacity. This will hurt the banks’ already weak loan quality and will likely slow loan growth towards the end of the outlook period. Kenyan banks’ problem loans are high by global standards, at 14.2% of gross loans in August 2022.

Kenyan banks can absorb loan book weakening, but are susceptible to sovereign-related risks. We expect any rise in problem loans to be manageable, given the banks’ strong recurring profitability, solid capital (capital to assets of 14.2% as of July 2022), healthy liquidity levels (liquid assets at 40% of assets as of June 2022), and deposit-funded profiles.

Kenyan banks’ creditworthiness, however, is closely linked to the Government of Kenya’s (B2 negative) rating. This is because the banks hold sizeable holdings of government securities, at around 2.2x their equity as of June 2022. Their capital, profitability and liquidity are therefore highly vulnerable to sovereign stress.Kenyan banks’ profitability has strengthened over the past two years. Net income to average assets rebounded strongly to a high of 3.8% during the first half of 2022 as shown in Exhibit 1, supported by lower loan-loss provisions and stronger business growth. At the same time, wider adoption of digital banking services during the pandemic allowed banks to leverage their recent digital investments and improve operational efficiency.

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