University of Nairobi

Banking Industry, Associated Risks and Mitigation

Strategies

Case study- Kenya Commercial Bank

By
YONI AYIEKOH

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
Table of Contents
Introduction……………………………………………………………………………..…………….3

History of Kenya Commercial Bank…………………………………………..……………………6

Challenges facing Financial Institutions in Kenya………………………………………….…….7

Inflation risks…………………………………………………………………………………7

Credit risks………………………………………………….……………………..…………7

Refinancing risks………………………………………..……….….….…..……………….7

Equity risks………………………………………………………………...…..……………10

Financial system stability risks……………………………………...……….……………11

Political risk……………………………………………………..…………………….…….11

Legal risks…………………………………………………………………………..………12

Strategies for minimizing risks…………………………………………………………………….13

Record management………………………………………………………………………13

Credit management………………………………………………..………………………13

Insurance……………………………………………………………………………………14

Partnerships and mergers………………………………………………………………...14

Due diligence……………………………………………………………………………….15

Macroeconomic forecasting……………………………………………………………….15

Conclusion…………………………………………………………………………………….…….16
References………………………………………………………………………………………….17
Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
Introduction

Banks provide a number of services that include but are not limited to cheque and cash
deposits and withdrawals, provision of credit facilities such as loans, overdrafts, and credit
cards, processing payments, asset financing, mortgages, clearing, foreign exchange,
money transfer, advisory services, safe keeping services and custodian services.

The banking industry in Kenya is governed by the Companies Act, the Banking Act, the
Central Bank of Kenya Act and the various prudential guidelines issued by the Central Bank
of Kenya (CBK). The banking industry was liberalized in 1995 and exchange controls lifted.

The CBK, which falls under the Ministry for Finance is responsible for formulating and
implementing monetary policy and fostering the liquidity, solvency and proper functioning of
the financial system.

As at December 2008 there were forty six banking and non-bank institutions, fifteen micro
finance institutions and one hundred and ninety foreign exchange bureaus. The banks have
come together under the Kenya Bankers Association (KBA), which serves as a lobby for the
banking sector’s interests. The KBA serves a forum to address issues affecting members.

According to Pricewaterhouse Coopers, over the last few years, the Banking sector in
Kenya has continued to grow in assets, deposits, profitability and products offering. The
growth has mainly been underpinned by:

 An industry wide branch network expansion strategy both in Kenya and in the East
African Community Region.
 Automation of large number of services and a move towards emphasis on the
complex customer needs rather than traditional ‘off-the- shelf’ banking products.

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
Players in this sector have experienced increased competition over the last few years
resulting from increased innovations among the players and new entrants into the market.
The main challenges facing the banking industry today include:

 New regulations, for instance the Finance Act 2008, which took effect on 1st January
2009 requires banks and mortgage firms to build a minimum core capital of Ksh 1
billion by December 2012. This requirement, it is hoped will help transform small
banks into more stable organizations. The implementation of this requirement poses
a challenge to some of the existing banks and they may be forced to merge in order
to comply.
 Global financial climate such as the global financial crisis which occurred in 2008.
Such crisis affects deposit mobilization.

Commercial banks are in the risk business. In process of providing financial services, they
assume various financial risks. As the Kenyan economy continues to grow as far as
financial services are concerned, our perspective on the risks in this sector continue to
widen. Over the last decade our understanding of these risks has increased substantially.

In Kenya, the need for stringent risk management strategies has necessitated the directive
by the Central Bank of Kenya requiring all banking institutions to set up risk management
units responsible for the task of risk mitigation (Njuguna, 2007 CBK 2006: CBK 2005)

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
History of Kenya Commercial Bank (KCB)

The history of KCB dates back to 1896 when its predecessor, the National Bank of India
opened an outlet in Mombasa. Eight years later in 1904 the bank extended its operations in
Nairobi, which had become the headquarters of the expanding railway line to Uganda.

The next major change in the bank’s history came in 1958. Grindlays Bank merged with the
National Bank of India to form the National Grindlays Bank.

Upon independence the Government of Kenya acquired a 60% shareholding in National &
Grindlays Bank in an effort to bring banking to majority of Kenyans. In 1970 the Government
acquired a 100% stake to take full control of the largest commercial bank in the country at
that time. National & Grindlays Bank was renamed Kenya Commercial Bank.

In 1972, Savings and Loans (K) was acquired to specialize in mortgage finance.

In 1997 another subsidiary, Kenya Commercial Bank (Tanzania) limited was incorporated in
Dar-es-Salam, Tanzania to provide banking services and promote cross border trading.
Since then the bank has 11 branches.

In pursuit of his vision: in May 2006 KCB extended its operations into Southern Sudan to
provide conventional banking services. The subsidiary has 11 branches.

The latest addition to the KCB family came in November 2007 with the opening of KCB
Uganda which has 14 branches. In December 2008 KCB bank Rwanda began its
operations with one branch in Kigali. There are now 9 branches.

The Government has over the years reduced its shareholding to 35% and more recently to
26.2 % following the rights issue in 2004 which raised Ksh 2.4 billion in additional capital to
the bank.

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
In the second rights issue exercise in the year 2008, the Government further reduced its
shareholding to 23.1 % after raising additional capital for Ksh 5.5 billion.

The bank conducted a third rights issue exercise in 2010 in which Government further
reduced its shareholding to 17.74 %. In the same year S& L was merged with KCB
providing access to mortgages throughout the bank’s network of 222 branches.

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
Challenges facing Financial Institutions in Kenya –Central Bank Survey 2010

Majority of financial institutions in Kenya have recognized the importance of proper risk
management by setting up independent and well-funded risk management functions.

The Risk Management Survey 2010, lunched by the Central Bank of Kenya showed that
there is enhanced risk management at 95% of the institutions hence improved efficiency
and effectiveness of risk management.

According to the survey market risk, in terms of equity risk, interest rate risk, currency risk
and commodity risk was the risk most facing financial institutions, followed by credit and
operational risks.

However the other emerging risks which are cited by the institutions as being of concern to
them are country risk, sustainability risk, expansion/ project management risk and the risk
on non-compliance with applicable prudential and regulatory requirements.

Since 2005, the Kenyan banking sector has witnessed a structural transformation which has
in turn posed additional risk to the players.

Among the transformation mentioned in the survey witnessed by the banking sector are the
massive expansions by the institutions locally and regionally in pursuit of greater market
share and the introduction of Sharia Compliant Banking whereby banks offer financial
services in conformity to sharia principles.

The survey also noted the increasing role of information technology in the banking sector,
especially the inter-linkage of the mobile phone technology and banking platforms as a
means of cutting cost while enhancing efficiency and quality of service.

The Central Bank conducted the survey in November 2010 in attempt to foster liquidity,
solvency and proper functioning of a stable market based financial system and also

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
assessing the impact and adequacy of the Risk Management Guidelines (RMGs) issued in
2005 on the banking sector.

According to John Nderi, an analyst at Suntra Investment, the main challenges facing KCB
is credit risk on the back of rising interest rates. Cost of funding is becoming huge and
peoples’ incomes are becoming squeezed because of high inflation. An outline of the risks
faced by commercial banks can be summarized as follows:

Inflationary risks

The online investment dictionary, Investopedia defines inflationary risk as the uncertainty
over the real value of your investment. This is the risk that inflation will undermine the
performance of your investment.

Recently Kenya has had the one of the worst cases of inflation since independence.
Projects that started before inflation have stalled. Fuel prices have sky-rocketed and food
prices tripled in most part of the country. This has resulted in to a vicious cycle of poverty,
pulling the middle class to poverty status. Employees want salary increments which
employers are not able to pay. This causes tension and further deepens the entire economy
to further inflation. Inflationary risk poses a serious problem to the bank. One of the major
and direct ways this affects the bank is when the clients default in loan repayments. The
bank stands to lose. Inflationary risk gives risk to other major risks. Such as credit risks

Credit risks

Credit risk exposes the Bank to loss arising from a borrower who does not make payments
as promised. Such an event is called a default. Other terms of this risk are default risk and
counterparty risk. The loss that would be suffered by the Bank includes lost principle and
interest decreased cash flow and increased collection costs which arise in a number of
circumstances:

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
  A consumer does not make a payment due on a mortgage loan, credit card, line of
credit or other loan.
 A business does not make a payment due on mortgage, credit card, line credit and
other loan.
 A business or consumer does not pay a trade invoice when due.

Credit risks can be categorized differently. These categorizations include:

 Credit Default Risk-the risk of loss when the bank considers that the obligator is
unlikely to pay its credit obligations in full. Default risk may impact all credit-sensitive
transactions, including loans, securities and derivatives.
 Concentration Risk-the risk associated with any single exposure or group of
exposures with the potential to produce large enough losses to threaten the Bank’s
core operations. It may arise in the form of a single name concentration or single
concentration or industry concentration.
 Country Risk-the risk of loss arising when a sovereign state freezes foreign
currency payments (transfer/conversion risk) or when it defaults on its obligations
(sovereign risk)

Refinancing Risks

In banking and finance, refinancing risk is the possibility that a borrower cannot refinance by
borrowing to repay existing debt. Many types of commercial banks incorporate balloon
payments at the point of final maturity; often, the intention or assumptions is that the
borrower will take out a new loan to pay the Bank.

A borrower that cannot refinance their existing debt and does not have sufficient funds on
hand to pay the Bank may have liquidity problem. The borrower may be considered
technically insolvent: even though their assets are greater than their liabilities, they cannot

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
raise the liquid funds to pay the Bank. Insolvency may lead to bankruptcy even when the
borrower has a positive net worth.

Equity Risks

This is the risk that the Bank’s investment will depreciate because of stock market dynamics
causing the Bank to lose money. The measure of risk used in the equity markets is typically
the standard deviation of a security’s price over a number of periods. The standard
deviation will delineate the normal fluctuations one can expect in a particular security above
and below the mean, or average.

Financial system instability risks

In finance this type of risk is the possibility of collapse of an entire financial system or
market. It is sometimes referred to as systemic risks. It refers to the risk imposed by inter-
linkages and interdependence in a system or market, where the failure of a single entity or
cluster of entities can cause a cascading failure which could potentially bankrupt or bring
down the entire system or market.

Political risks

Political risks are faced by investors, governments and corporations. The Bank also faces
this risk. Broadly speaking, political risk refers to the complications business and
governments may face as a result of what are commonly referred to as political decisions-or
any political change that alters the expected outcome and value of a given economic action
by changing the probability of achieving business objectives. Political risk faced by firms can
be defined as the risk of a strategic, financial, or personnel loss for a firm because of
nonmarket factors as macroeconomic and social policies (fiscal, monetary, trade,
investment, industrial , income, labor and development) or events related to political stability
(terrorism, riots, coups, civil war and insurrection)

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
For the bank the implication for political risk is that there is a measure of likelihood that
political events (in the countries which the Bank has branch such as Southern Sudan which
is still politically unstable) may complicate the Bank’s pursuit of earnings through direct
impacts (such as taxes or fees) or indirect impacts (such as opportunity cost forgone). As a
result, political risk is similar to an expected value such that the likelihood of a political event
occurring may reduce the desirability of the Bank’s investment by reducing it’s anticipate
returns.

There are both micro-level political risks and macro-level political risks. The micro-level risk
focuses on a sector, branch of the bank or project specific risk.

Macro-level political risk focus on non-project specific risks. These risks affect all
participants in a given country.

Legal Risks

Legal risk is that counterparty are not legally able to enter into a contract. Another legal risk
relates to regulatory risks. That is that a transaction could conflict with a regulator’s policy
or, more generally that legislation might change during the life of a financial contract.

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
 Risk Mitigation Strategies

Record Management

A number of strategies exist for minimizing the risks faced by the Bank. Before these
methods are analyzed, record management is a universal way that can be used to manage
and minimize the risks faced not only by the Bank but by all business entities. Record
managing is considered critical in managing risks in the banking industry. Poor record
management poses a risk to many organizations such as KCB in managing risks. A number
of scholars such as Makhura (2008), Sydney University of Technology (2008), Sampson
(2003) and Williams (2007) contend that weak records management programs, systems
and practices have remained a problem and a major obstacle to developing watertight risk
management strategies in the banking industry as well as in other financial institutions.

Credit Management

Sound credit management is a prerequisite for financial institution stability and continuing
profitability. Credit risks are enhanced by poor credit management policy. The prudent
management of credit risk can minimize operational and credit risks.

Deteriorating credit quality is the most frequent cause of poor financial performance and
condition. Therefore a Sound credit management is a prerequisite for a financial institution’s
stability and continuing profitability.

A credit union to meet standards of sound business and financial practices by ensuring it
has developed and implemented credit policies, risk and performance measurement
techniques, and risk management procedures. The policies and procedures should be
appropriate for the size of the organization. Complying with the credit union’s lending

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
license and by-laws is the first step in managing credit risk. The second step is to ensure
board approved policies exist to manage or limit other areas of credit risk like syndicated
and brokered loans and the concentration of lending to individuals and other parties (i.e.
companies, partnerships etc.)

As part of their annual planning process, the board should set goals or targets for their loan
portfolio mix. To ensure the level of risk remains within acceptable limits, the loan portfolio is
managed on an ongoing basis.

Insurance

Insuring against risks is the most common way organizations, Banks included can minimize
risks. Certain risks such as operational risk and risks occasioned by such perils as fire and
hazards such as violence are minimized by insurance. Kenya Commercial Bank has major
insurance policies by different insurance companies that cover a variety of policies. The
Bank modus operandi in procuring insurance is advertising for request for proposals. The
latest one being a press release dated 7th October 2011 in which the Bank was seeking to
procure insurance brokerage services to manage the Bank’s portfolio in Rwanda, Uganda,
Sudan and Kenya.

Partnerships and Mergers

KCB typically invests in real estate via joint venture partnerships with sponsors with specific
expertise in the asset type and geography of the asset.

KCB has forged successful and durable partnerships, the longest of which has lasted 18
years and many acquisitions. In our experience, a partnership is durable when both sides
feel they have gotten a fair deal and decisions are made on a consensual and collegial
basis. KCB believes that the keys to a successful partnership include:

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
 Quality people
 Shared Goals
 Alignment of Interests
 Compromise and Communication

Kenya Commercial Bank as described above in the history is one of the largest banks in
East African Region, going by the branches and assets. The Bank operates beyond the
home borders into countries such as Rwanda, Uganda and Southern Sudan. Operating in
foreign countries exposes the Bank to political risks. A good example is the political climate
and tension in the new independent South Sudan. The tension arising from the conflict in
the oil rich Abeyi region and the constant tag of war between North Sudan and its Southern
partner continuingly poses security threats and political instability.

To overcome this risk, the Bank can partner with local investors in the countries it operates
in and even the local governments. This assures that in the event of political unrest, the
Government in the country in question will protect its interest by assuring the Bank’s assets
are not damaged by the unrest. Partnering with local investors by issuing stock to them
assures that the locals will have a sense of ownership, thus limiting the extent of damage if
any that would have been suffered by the bank in the event of political unrest.

These partnerships with the local countries can also take the form of sponsorship activities.
These activities are undertaken by companies to partner with the society in which the
business operates in to give certain incentives to the society such as sinking in boreholes,
hospital and medical care to the community and educational sponsorships. Sponsorship
activities require some revenue from the banks side to be used to fund these programs.
Various research s have been done by various scholars that link sponsorship activities and
profits in institutions. The sponsorships also benefit the bank by portraying the bank as
human centered thus earning the bank goodwill from the citizenry of that particular country.

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
Due Diligence

KCB performs exhaustive due diligence on our joint venture partners, including:

 Track record assessment

 Management assessment
 Detailed background checks (financial and criminal)
 Reference checks

The Bank is exposed to legal risks. Some of the legal risks are occasioned by the bank
being sued by clients or the employees. Members of the public can also start legal action
against the Bank especially in matters of public interest. (There are various examples in
Kenya where the locals have sued corporate for certain reasons. The latest being a group of
women who took action against a developer in Olkalou who were protesting the alleged land
grabbing of a piece of land they allege to have owned since the 1970s)

Macroeconomic Forecasting

The economic situation differs from country to country because of the differences in
population, geography, monetary system, political situation and other factors. In addition,
within one country, there are always a number of regions that differ from one another by
their economic performance. What does the future hold? This is the question the
government, economists, investors and public all would like to know the answer

Certain types of risks such as inflationary risks have no outlined strategies of mitigation.
Macroeconomic forecasting can be used as a strategy by the Bank with the aim of
mitigating such risks. In order to accurately analyze the macroeconomic forecast, the Bank
uses the forecasts that are prepared by three different entities; government agency,
business consultants, and academic research.

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
 Conclusion

The business world is highly dynamic. Risks continue to crop up every day, and institutions
are always developing strategies of mitigation the effects of these risks. Risk issues
threaten the customer base of Kenya Commercial Bank and other financial institutions as
well as their own internal processes that direct the quality of services they deliver.

Risk management is an absolutely crucial business activity within the banking industry. This
is because the bulk of business activities in the bank are sensitive activities that relate to the
core of the economy or the money society. This implies that by the very nature of this
business, the need for adequate risk management is high.

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi
 References

Central Bank of Kenya, 2006, Prudential regulations for banking institutions, CBK, Nairobi.

Central Bank of Kenya, 2005, Risk management guidelines, CBK, Nairobi.

Central Bank of Kenya, 2000, Prudential guidelines for banking institutions, CBK,

CBK (1976), Central Bank of Kenya Annual Report

CBK (1985 to 1990); the Central Bank of Kenya Annual Reports

CBK (1995-2001), Bank Supervision Annual Reports, the Central Bank of Kenya. Credit
Suisse

Njuguna, N. (2007). “Implementation of Basel II Risk Management framework within banks

and the prevention of financial crime” Address by Prof. Njuguna

Nyaoma, G. A. (2005). “Risk Management in Banks” Press statement issued on behalf of

Central Bank of Kenya on the launch of risk management survey by the Central Bank of
Kenya.

Banking Industry, Associated Risks and Mitigation Strategies- Yoni Ayiekoh University of Nairobi