Macro Analysis /
Kenya

Kenya banks: Lucrative SME potential undercut by low yields and asset quality

  • SMEs account for 20% of the total loan book but growth is dependent on banks embracing new lending products

  • Equity Group has the largest SME loan book but margin suppression derails income: Q2 21 NIM at 6.6% vs. 11.8% in Q2 16

  • SMEs contribute 12% of total banking income but low loan yields and poor asset quality hinder growth prospects

Kenya banks: Lucrative SME potential undercut by low yields and asset quality
Faith Mwangi
Faith Mwangi

Equity Research Analyst, Financials (East Africa)

Tellimer Research
18 November 2021
Published by

The Central Bank of Kenya (CBK) has released a new study on small and medium-sized enterprises (SMEs), already an important sector for Kenyan banks but one with a great deal of growth potential.

Our key takeaways on what the report means for the banks we cover:

1. SME segment accounts for 20% of industry loans, but there is untapped potential

The management teams of the Kenyan banks we cover argue that the SME sector is the next growth frontier. In our view, though, the majority of their loan products are still designed and structured to favour large corporates and medium-sized enterprises. The documentation and collateral requirements are unlikely to be met by SMEs, which are forced to take credit in the form of overdrafts. The banks have yet to design products that can accelerate the growth of SMEs, despite the demand for credit in the sector.

Of the Tier 1 banks, Equity Group has done better than its peers in this respect, with its grassroots banking model giving it access to small businesses around the country.

2. Net interest margin advantage has eroded, hindering growth

According to the study, SMEs accounted for 12.2% of total industry (commercial banks and microfinance institutions) lending-related income in 2020, compared with 25.2% in 2017. The decline can largely be attributed to reduced loan yields in light of the cap on interest rates. The cap has been repealed, but the CBK has yet to approve new risk-based lending models that would allow banks to price in the risk associated with SMEs.

Although there is clear room for SME loan book growth, we believe the low margins that the sector now attracts (loan yields are now at 11-12% compared with above 20% prior to the rate cap) will hinder any expansion.

Equity Group commanded the highest net interest margins back in 2016, at 11.8%, but this has shrunk to 6.6% (Q2 21), thereby eroding its margin advantage over its peers.

3. Asset quality concerns still plague the sector

According to the CBK, the NPL ratio for loans to micro, small and medium-sized enterprises (MSMEs) was 15.5% in December 2020, with NPLs in the MSME sector comprising 22% of total banking industry NPLs. This compares poorly with segments such as personal lending, whose NPL ratio is typically below 5%.

The banking sector is currently dealing with a decade-high NPL ratio of 13.9% in August 2021. At the same time, banks have seen their cost of risk rising with the implementation of IFRS. Moreover, banks are demanding additional collateral as asset prices continue to decline and the process of off-loading assets is now taking longer than in previous years. As a result, despite the high credit demand from SMEs and the potential for growth, we still expect growth to be slow.

In the survey, the regulator used the statutory definition of SMEs as follows:

Kenya's Statutory Definition of MSMEs

KCB (target price KES54.00) is our top pick in Kenya banks

Of our coverage, Co-op Bank, DTB, Equity Group and KCB have the largest SME loan books and would stand to benefit the most from accelerated growth in the SME sector. However, as noted above, the large SME loan books offer little room for interest margin advantage.

From an overall business perspective, we therefore prefer KCB Group as our top pick.

Our Buy recommendation is based on its:

  1. Sector-leading net interest margin, with cost of funds remaining low;

  2. Earnings performance, which represents an upside risk to our valuation;

  3. Cost efficiency, with management hitting its target of a cost/income ratio of below 45%; and

  4. Fee and commission income growth driven by digital channels, especially mobile – as at H1 21, the bank's digital (mobile) income made up 29% of its total fee and commission income.

SME sector accounts for 20% of loan book, but loan sizes are shrinking

According to the CBK, as of December 2020, the SME sector accounted for 20% of overall sector loans in 2020 (versus 19.2% in 2017) and 5% of loan accounts. In terms of loan distribution, medium-sized enterprises account for 11% of total sector loans, SMEs for 7% of sector loans and micro SMEs a mere 1% of total sector loans.

The average loan sizes have declined from KES498,000 (micro SME), KES3.2mn (SME) and KES14.4mn (medium-sized enterprises) in 2017 to KES86,000, KES2.9mn and KES7.7mn, respectively.

The decline in loan values can be attributed to:

  1. The interest rate cap implemented in 2016, which reduced the attractiveness of the overall SME sector as banks could no longer charge higher rates to accommodate the higher risk. Even after the lifting of the rate cap in 2019, the sector remains subdued as CBK is yet to approve the banks' risk-based pricing models. This has significantly eroded the net interest margin advantage Equity Group used to have over its peers due to its large SME loan book. (SMEs account for 50% of its loan book).

  2. The increase in mobile loan accounts through which SMEs can borrow lower-denominated loans with more flexibility.

  3. The decline in lending growth in 2020 due to Covid. The sector is yet to experience a full recovery despite private sector credit growth showing some positive momentum this year.

Trade is the largest lending segment for SMEs

According to the CBK, the trade segment accounts for 42% of lending to SMEs. This mainly involves wholesale and retail trade, with some import and export business as well. The smallest segment for SME lending is finance and services, an industry that typically requires significant capital for new entrants.

Trade is the biggest SME lending segment for Kenya banks

Equity Group has the largest SME/retail book

Looking at our covered banks, Equity Group has the largest SME/retail book, which accounts for c71% of its total loan book. This has been driven by the bank’s grassroots banking model, which has enabled it to capture market space in small business accounts.

ABSA has the second-largest SME/retail book, at 59% of its loan book. Most of this is individual accounts, with the bank now focusing on growing its SME loan book as part of its new medium-term strategy.

NCBA has the smallest SME/retail book, at only 31% of its total loan book. The bank’s origins are in corporate banking – it mainly accesses the retail space via its relatively strong mobile banking offering.

Kenya Banks loan book structure

SMEs account for 12% of total industry income

According to the regulator, SMEs accounted for 12.2% of total industry (commercial banks and microfinance institutions) lending-related income in 2020 compared with 25.2% in 2017. This was on the back of an overall 5% decline in income generated from SMEs, from KES74.1bn in 2017 to KES70.8bn in 2020.

The continued suppression of interest rates and rising NPLs in the sector have been the major contributors to the income decline. Medium-sized enterprises, SMEs and micro SMEs account for 54%, 30% and 16%, respectively, of total income derived from the MSME segment.

Income generated by SMEs for banks (KES Bn)

On average, interest rates on MSME sector loans range from 11.0-12.3% in commercial banks and 12-22% in microfinance institutions. This compares with 10.1-12% for banks and 19.0-19.9% for microfinance institutions in 2017.

The banks' inability to attach a premium to more risky SMEs has significantly cut into their net interest margin.

Net interest margin advantage for SME/retail banks was eroded by the loan rate cap

Prior to the loan rate cap implemented in September 2016, banks that had an SME/retail loan-dominated book enjoyed a superior net interest margin, with Equity Group topping the list at 11.8%. SME retail loan books attracted loan yields of above 20%, which allowed banks in SME/retail to attract higher than their peers. The average net interest margin for our covered banks has declined to 6.5% in Q2 21 from 9.3% in Q2 16 (prior to the interest rate cap).

Although we expected the loan rate cap repeal to result in an increase in net interest margin, banks have been kept in limbo by the CBK, which has yet to approve new risk-based loan pricing models. Therefore, banks are left pricing loans close to the loan rate cap rates of below 14%. This has stemmed the growth of SME loan books, with banks now preferring to lend to government – yields on longer-dated government securities are now close to loan yields.

Although talk of growth in SME lending has been a major point for management across all the banks we cover, we believe the low interest rates will mean banks will continue to favour corporate borrowers, to whom they can cross-sell their products.

Loan interest rates have yet to recover despite loan rate cap being repealed in 2019

Kenya banks' margins yet to recover post loan rate cap repeal

SME asset quality continues to be a concern for the sector

According to the CBK, the NPL ratio of MSME loans was 15.5% in December 2020 compared with 13.6% in December 2017. NPLs in the sector comprised 22% of total banking industry NPLs as of December 2020. The industry wrote off c2% of MSME-related NPLs in 2020, a lower-than-expected figure considering the impact of Covid-19 pandemic on small businesses.

For our covered banks, the MSME segment remains negative for asset quality. In Q3 21, Equity Group's MSME NPL ratio was 17.5% and its SME NPL ratio was 13.2%. These ratios were above the 8.9% overall group ratio. Although Co-op Bank does not provide a segmental breakdown of its NPL ratio, its trade segment (which contributes 12% of its loan book and is likely to be mostly SME loans) had an NPL ratio of 30% in Q2 21. KCB Group recorded an 11.8% NPL ratio for its SME and MSME book in Q2 21. The bank, however, has a weak corporate loan book, with an NPL ratio of 17.9% in Q2 21, bringing the overall NPL ratio to 11.9%.

At the sector level, SMEs were reprieved in 2020, when banks were allowed to restructure loans and offer moratoriums to businesses impacted by the pandemic. The CBK reported that the MSME sector has 90% of restructured loans as performing loans. However, 2021 has in general been better than expected for asset quality.

In April 2021, the CBK carried out a stress test on Kenyan banks' asset quality. Under its baseline scenario, the regulator expected the NPL ratio to range between 15.5% and 17.7% by June 2021, and between 15.7% and 18.9% by December 2021. As of August 2021, the NPL ratio was at 13.9%, a much better outcome than anticipated.

For H2 21, we do not anticipate weaker asset quality given there has been no lockdown in the period, the curfew was lifted (thus extending business hours) and the movement of goods and people has returned to something closer to normality and vaccine the supply of vaccines has improved.

In conclusion, although the SME segment possesses great potential for growth, without banks being able to be compensated for the risk they take in lending to smaller businesses, that potential is unlikely to be realised. Banks will however continue to invest in digital banking in order to take advantage of the transactional activity on SMEs. Equity Group so far has led the pack in digital banking income generation and we continue to expect other banks to leverage their digital platforms to increase fee and commission income.