As the real es­tate walls come tum­bling down

The East African - - FRONT PAGE - MACHARIA KIHURO Macharia Kihuro is a credit risk ex­pert work­ing with a pan-african fi­nan­cial in­sti­tu­tion.

Re­cently, the press has been awash with sto­ries of how bor­row­ers are strug­gling to re­pay their loans. Some say that even the dreaded auc­tion­eers are no longer at ease. It is be­com­ing in­creas­ingly difficult for them to sell some of the prop­er­ties of­fered to the mar­ket at auc­tion prices. If such in­for­ma­tion is fac­tual, this is a har­bin­ger of tough times ahead.

The ques­tion there­fore is: What hap­pened? Why the sud­den spike in non-per­form­ing loans? Are they a prod­uct of a tough busi­ness en­vi­ron­ment or weak credit risk man­age­ment prac­tices? This is a hot topic of dis­cus­sion that has at­tracted great in­ter­est from many credit risk prac­ti­tion­ers and re­searchers. The jury is still out. How­ever, the English say, “an ounce of preven­tion is worth a pound of cure.” It is ev­i­dent that in­sti­tu­tions that can craft a ro­bust and re­li­able credit risk man­age­ment sys­tem stand a bet­ter chance of facing the daunt­ing chal­lenge.

The lat­est quar­terly re­port by the Cen­tral Bank of Kenya shows that the num­ber of non-per­form­ing loans con­tin­ues to soar. The CBK said that as at the end of Oc­to­ber 2018, the ra­tio of NPLS to the to­tal gross loans was 12.3 per cent. The in­ter­na­tional credit rat­ing agency, Moody's picked up the is­sue of the high num­ber of NPLS in the Kenyan bank­ing sec­tor in a re­cent re­port. It at­trib­uted the de­te­ri­o­ra­tion of as­set qual­ity to weak credit risk man­age­ment prac­tices and noted that de­lays in pay­ing con­trac­tors and sup­pli­ers by the govern­ment have ag­gra­vated the sit­u­a­tion.

It can­not be de­nied that some key changes in the in­ter­na­tional fi­nan­cial re­port­ing sec­tor will im­pact the fi­nan­cial sys­tem even fur­ther. As of Jan­uary 1, the re­quire­ments of In­ter­na­tional Fi­nan­cial Re­port­ing Stan­dards (IFSR) 9 came into force. Reg­u­la­tors may of­fer a few con­ces­sions, but the re­al­ity is that an ag­ile len­der must pre­pare for the worstcase sce­nario.

The ex­pected in­crease in loan pro­vi­sions will lead to lower prof­its while the tighter re­quire­ments of Basel 3 de­mand higher cap­i­tal ad­e­quacy ra­tios. An in­crease in NPLS will lead to an in­crease in risk weighted as­sets, which leads to a lower cap­i­tal ad­e­quacy ra­tio.

This is not a chal­lenge unique to the Kenyan fi­nan­cial sys­tem. It is global. Mid last year, the World Bank Group or­gan­ised a two-day con­fer­ence in Vi­enna, Aus­tria whose only agenda was to come up with a com­pre­hen­sive ap­proach to re­solve the rise of NPLS. The con­fer­ence at­tracted enor­mous at­ten­tion from many coun­tries that ac­knowl­edged that the high lev­els of NPLS are a chal­lenge that must be ad­dressed. Such con­fer­ences and meet­ings demon­strate how sig­nif­i­cant the is­sue of as­set qual­ity is to the per­for­mance of the in­di­vid­ual banks and the en­tire fi­nan­cial sys­tem — na­tion­ally and glob­ally.

Var­i­ous stake­hold­ers, in­clud­ing cen­tral banks, take a keen in­ter­est in the per­for­mance of loan as­sets and re­lated credit fa­cil­i­ties. This is be­cause a prop­erly func­tion­ing bank­ing sys­tem trans­lates into a stronger fi­nan­cial sys­tem and ul­ti­mately demon­strates the solid na­ture of the econ­omy. If the bank­ing sys­tem is bullish, the gen­eral econ­omy is ex­posed to huge eco­nomic and in­fras­truc­tural de­vel­op­ments. A strong econ­omy leads to an in­crease in em­ploy­ment op­por­tu­ni­ties, eco­nomic growth and im­mense po­lit­i­cal cap­i­tal for a coun­try's lead­er­ship.

Loans or credit fa­cil­i­ties are the ma­jor stock-in-trade of many com­mer­cial banks or lend­ing fi­nan­cial in­sti­tu­tions. A len­der faces sev­eral chal­lenges: First, how to raise suf­fi­cient funds to en­sure they re­main in busi­ness. Se­cond, per­haps the tough­est, is to en­sure loans are re­paid within the pledged time frames.

Banks must study changes in the eco­nomic en­vi­ron­ment where they are op­er­at­ing. Dif­fer­ent coun­tries will face dif­fer­ent eco­nomic chal­lenges. Changes in the inflation rates, GDP growth rates, lev­els of in­ter­est rates, for­eign ex­change rates, among other key eco­nomic fun­da­men­tals, could change the busi­ness en­vi­ron­ment.

How­ever, ac­cord­ing to CBK fig­ures, the real es­tate sec­tor con­tin­ues to gen­er­ate the big­gest chunk of NPLS in the bank­ing sec­tor. This changes from one mar­ket to an­other. Ac­cord­ing to the Cen­tral Bank of Nige­ria, the oil and gas in­dus­try ac­counts for about 30 per cent of the to­tal gross loans and about 47 per cent of the NPLS in that coun­try's bank­ing sec­tor.

Many fac­tors have been blamed for the volatile na­ture of real es­tate busi­ness in Kenya. Some an­a­lysts have opined that the cap­ping of in­ter­est rates in­tro­duced in 2016 was one of the ma­jor rea­sons. But how could a drop in the lend­ing rates, which was ex­pected to lead to a growth in credit through af­ford­able loans, be coun­ter­pro­duc­tive? Why would such a change im­pact the real es­tate sec­tor in a coun­try where the to­tal stock of mort­gages is a measly 30,000?

Oth­ers have at­trib­uted the slow­down in the real es­tate mar­ket to an over­sup­ply of hous­ing units. An­other school of thought would ask why we talk about over­sup­ply of hous­ing units in a coun­try where the an­nual deficit in hous­ing, ac­cord­ing to the World Bank Group, is two mil­lion units? These fig­ures must be more gran­u­lar. When one dis­cusses hous­ing deficit, it is im­por­tant to in­di­cate which seg­ment of the mar­ket is af­fected by the over­sup­ply. Is it the high­end, mid­dle or lower seg­ments of the pyra­mid?

Un­doubt­edly, the con­struc­tion busi­ness is sensitive to changes in the mar­ket. That would ex­plain why very few com­mer­cial banks have an ap­petite to fi­nance big projects. It is a com­plex and highly spe­cialised busi­ness where small changes in key vari­ables can swing a project from be­ing prof­it­mak­ing to loss mak­ing.

Proper ap­praisal of real es­tate projects is para­mount and pro­jected rev­enue needs to be as re­al­is­tic as pos­si­ble. These es­ti­mates must also be stress tested to as­cer­tain how the worst-case sce­nario would look like in case of ad­verse changes in the busi­ness en­vi­ron­ment.

Proper mon­i­tor­ing of such projects is crit­i­cal to en­sure any changes on key vari­ables are noted in good time and ap­pro­pri­ate cor­rec­tive mea­sures taken.

The fi­nancier must al­ways be cog­nisant of the fact that the loan re­pay­ment for such a project will only be pos­si­ble once it is suc­cess­fully im­ple­mented and sold or rented out. Fail­ure to ad­here to these sim­ple pro­ce­dures will guar­an­tee a white elephant project that will end up be­ing a non-per­form­ing loan. Could this be the rea­son most of the NPLS are em­a­nat­ing from this sec­tor of the econ­omy? Time will tell.

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