Credit crunch- lessons for Kenyan banks' risk management

Imho, the genesis of the current West financial crisis is the deregulation of financial services in 1970s and 1980s that allowed financial entities into activities they were previously barred from. As an example, Barclays could move from retail to investment banking. However, the skillset required to manage a retail vs. an investment bank is like chalk and cheese. Banks then started off-shoring risk in their banking or even trading books e.g. by bundling loans and offering them as collateral in exchange for loans from other financial firms. From the late 80s/early 90s financial firms then offered insurance against these bundled loans using credit derivative swaps. Infact, almost every type of risk was managed via an invented form of derivative. Factor in globalisation; the emergency of the APAC nations and a benign interest rate regime. All this took place within 20 years and risk managers and senior managers generally either couldn't or didn't keep pace with the changes although the generally bullish conditions presumably fooled some. Finally, too many banks exclusively relied on either international rules on risk (Basel accords) or what regulators stipulated. In other words, they outsourced risk management.

Risk management is very straightforward;

1. Based on your understanding of the business your entity undertakes, identify the risks it faces.
2. Measure these risks in terms of the potential monetary impact on your bank's capital/liquidity and profitability.
3. Monitor these risks.
4. Set up ways of controlling these risks. To be clear, banks as with other walks of life, will always face risks. Control entails expressing your risk limits/appetite and putting controls in place to keep within the said limits.

Where an entity doesn'tdo any of the above to a satisfactory degree, nothing (sophisticated VaR models, stress testing and scenario analysis; layers upon layers of risk management cadres) will prevent failure due to one type of risk or the other. Unwary risk management meant that Northern Rock and Lehman Brothers and others fell over whilst ticking all the boxes on capital adequacy as dedicated by Basel 2, whilst neglecting liquidity risk. Failure of risk/senior managers to keep pace with the changing dynamics of its fast growth, led to Northern Rock's failure. The complexity of Lehmans' business and legal structure meant a Tsunami was not seen in good time.

Similarly, lax risk management can also be in CBK's risk survey undertaken in 2010;

-30% of Kenyan banks didn't have a centralised risk function (so nobody apart from perhaps the CRO) knows the overall risks faced by their bank.

-to compound the above, 58% of the banks don't have a head of risk i.e. nobody to take senior responsibility for risk management.

-Just over half of Kenyan banks reviewed their risk management manuals annually. This in a very fast changing industry. Think mobile banking, internet banking, agency banking, branch growth, regional expansion, increased fx/interest rate risk, money laundering laws to name but a few.

-7 banks didn't have a dedicated MIS for risk and another 9 only collected risk MI on an annual basis. So 16 banks couldn't tell you what risks they faced at any given time.

-16 banks didn't think they needed to make any changes to their risk management practices...

When things are going well (straight growth in year on year profitability), its easy to take your eye of the ball, but remember, its only when the waves go out, that we know who is naked.

Kenya's transport system in transition

How many roads has kibz govt built during his era? 1. The northern bypass. 2. if you can call expansion of Thika Road building rather than expansion. The remainder have been re-laying of roads that have been in existence. And yet the cost has been enormous; Ksh24bn for Thika Road; Ksh4.6bn+ for Nairobi to Nakuru; circa the same for Nakuru to Eldoret bit of the road and a similar amount or more for the rehabilitation of sections of the Mombasa road; Ksh2bn for Sagana to Nyeri rehabilitation half as much for Nyeri to Nyahururu repairs. And so on. It would not surprise, to see the figure exceeding Ksh100bn for so-called rehabilitation work. In comparison, repair work on parts of the Nyeri road will cost Ksh200m.

In the airport sector, same story, yes it has been expanded but Kisumu Airport (sorry International Airport) cost just over Ksh2bn to bring it into the late 20th century. Numerous other airstrips have also been snatched from cows who were using them as grazing fields. Rehabilitation...

In the rail sector, we've neglected this key channel for so long that the cost to update it (wholesale including tracks, trains et al), will be quite enormous. Another rehabilitation job.

The point. Let GoK create a special repair and maintenance budget portion which will be increased annually as we increase the number of roads, airstrips et al such that that there is a greater concentration on repairs rather than rehabilitation. Its cheaper. Secondly, we need to think around how we can maintain this transport system. Trailers are decimating the Northern corridor because they are carrying weight that should be borne by railtracks not a road. The type of inputs used to build/rehabilitate are also important. Mbagathi Way was built using concrete and has a 20yr life expectancy. Its costs were projected to only be 8% than tarmacking which lasts at most 2 years (3 months when done by a Kenyan contractor).

Unemployment in Kenya: the rural/urban divide

Unemployment is a lot higher in urban areas in Kenya. Infact among the 15-30 age group, the unemployment is between 30-40%. There are many reasons, but ofcourse the key driver is that for the last 30 years, economic and population have competed for parity. Nationally, but in urban areas population growth has far outweighed economic growth. Its a problem that even China faces today, but its been growing at 9% compared to 2-3% for Kenya.

And yet. A friend tells of a situation where he recently hired some guys to build a stone wall for him. After spending the best part of an hour haggling over hat they'd get paid, the guys finished at 4.30pm without getting to where they had agreed. The next day, some of them turned up drank and reopened the discussion relating to the payment. In the end he had to fire the several of them including the foreman because he realised he won't get anything done. Its difficult to get people who are interested in doing sales in particular sectors for example, I know somebody who is struggling to get sellers of pcs/laptops partly because the roles are mostly commission-based.. Part of the problem is that people have lost a certain work ethic and yet desire the things that money brings. There is also certain desire for white-collar jobs which are not that many compared to their demand.

In most rural areas (specifically Central/ parts of RV), farmers are struggling with their farms because they can't farm labourers to take on various paid chores.

The question is how this bridge can closed. Firstly, is that farming needs to get more commercial such that farmers are in turn able to pay labourers living wages. Secondly, the stigma attached to educated doing farming jobs needs to be removed. In this vein, there is a school thought that says farmers need to start advertising for labourers...

NSE: what looks good for 2012?

The NSE now actively trades both bonds and stocks and both are worth considering at any given time. In 2012, we ofcourse have the natural uptick in political risk which will probably go a notch higher due to the ICC (my head and heart tells me 2-4 will see charges levied). To the mix, add the Eurozone and oil prices. I expect that the Euro will reach some kind of cliffhanger once one o the smaller states has to withdraw. Although a lot of the risk has already prompted asset shifts, this withdrawal will unhinge markets further. Oil prices for me trend upwards this year (i.e. above $100) chiefly because Iran is the problem that is not being resolved fast enough.

In Kenya, inflation will trend southwards, though not as fast as economist opine. The rains that came in November/December have impacted the food regions differently and though food will be cheaper, it won't as cheap as opined. Finally, interest rates. Banks reacted naturally to avoid a massive npl problem and lengthened the repayment periods, but a Kenyan who had a loan in August now has more liabilities than he/she envisaged. For the tightening not to become another monetary policy screw up, its imperative that the governor and his MPC team reverse the interest rate increases by March at the latest.

Assuming the above holds, I expect the NSE not to trouble 3,500 with exception of the period between now and March reporting season. I will be looking at the following stocks:

• Car & General-has an expansive product range and now has the regional coverage to cater for pretty the whole of EAC and the horn. Clearly, it does feel the pain of any fx volatility, but its products have a strong future as the regional economies all grow and consumption grows.
• Centum, there are some who are sceptical about what James Mworia is doing, but I am convinced that by 2014, this stock will look very cheap compared to a Ksh12.50 entry price.
• Crown Berger-as I have said elsewhere, real estate growth will resume next year with a vengeance and this paint seller is well placed in this market.
• Equity remains a stand out in the banking sector. The agency banking model is still not being felt, but if you talk to saccos you get the idea that many realise what this model is doing which is to pitch the battle for deposits at their level. As a general comment, I think that if the credit spread control is brought, it will impact those banks that are heavily dependant on interest income. Equity still derives a bigger chunk from F&C compared to rivals.
• Eagaads-only NSE that gives exposure to coffee. The crop is not being stolen because its become edible, but because the price per kg is now comfortably around Ksh130, For farmers. Eagadds is able to get a premium over this. Secondly, Eagadds has very good real estate in the sort after Kiambu county.