Rife speculation abounds in Kenya as the debate intensifies over the credibility of the banking sector’s corporate governance structures and overall soundness. Following a turbulent period that witnessed three mid-sized banks fall into receivership since 2015, including the most recent case of Chase Bank this past April, an emerging pattern suggests a possible widespread existence of systemic challenges in the banking sector: questionable governance practices, weak supervision and rampant fraudulent activities.

Intensifying concerns, the Kenya Revenue Authority is broadening recent fraud-related investigations to include the National Bank of Kenya, Commercial Bank of Africa and Cooperative Bank of Kenya for corruption and tax evasion, with plans to include several other banks with suspected similar syndicates.

While anxiety is mounting, the present moment may represent a critical juncture in Kenya’s banking sector shaped by a powerful convergence of pressures. A substantial consolidation of banks is expected in the near future, while painful regulatory oversights are being accepted as important learnings are proactively translated into improved legislation and measures. Meanwhile, innovative, but disruptive activity in the fintech space challenges the status quo, not only in Kenya, but regionally as Nairobi establishes itself as East Africa’s financial hub. These developments generate ripples far and wide of positive and negative concerns, with decisions currently being made that shape the future of the banking space. The degree to which stakeholders can anticipate opportunities as this period of transformation comes underway, will be a determinant of success.

With the banking sector featured prominently as part of Kenya’s Vision 2030 and prioritised accordingly as one of six key drivers of economic growth, addressing and overcoming challenges in this space will be particularly consequential to achieving a positive development outlook. More so, with the government intending “to become a regional financial services centre” and aiming “at creating a vibrant and globally competitive financial sector” with well-defined savings and investment targets, the present situation offers predictive insights into the broader trajectory and possible areas of opportunity limited not just to Kenya, but to the broader East Africa region.

Clashing perspectives

Among the flurry of journalistic reports in the wake of several bank collapses, the majority of reports seem to assign blame squarely on a widespread existence of collusion between regulators, auditing firms and corporate clients, putting at risk investors’ money and the entire Kenyan economy. According to some experts, the extent of deterioration is huge and the worst is yet to come for the banking sector. These claims, however, have both been supported and tempered by a wide-ranging community of industry analysts, regulators and third parties. From the macro perspective to specific cases, competing views and contradictory evidence muddled insights into the recent turbulence in a rapidly developing market.

Analysts at Citi, Renaissance Capital and BPI Capital raised earlier warnings over exaggerated bank profits and the risk to operating performances. As far back as 2012, Citi raised red flags that the operating performances of banks are at risk because of inaccurate profit statements. In fact, they recently estimated that six of the largest banks may be under-provisioned by US$208m.

The Central Bank of Kenya, however, has been quick to voice optimism in an attempt to reassure confidence. After placing Dubai Bank, Imperial Bank and Chase Bank Kenya into receivership, their subsequent communications described these recent events as “isolated and not contagious”, re-assuring the public as recently as April 6, 2016 that Kenya’s banking sector is not suffering from systemic problems. The body continues tightening regulations, while rolling out reactionary measures, with central bank governor Patrick Njoroge committing “financing to any lender or microfinance institution that was facing liquidity problems through no fault of its own”. With the central bank expecting consolidation in the sector, some express hopefulness that this stress will ultimately drive towards more positive outcomes: increased merger and acquisition activity, tightened business practices and an overall leaner and stronger banking sector.

Despite re-assurance from the central bank, analysts are nevertheless drawing comparisons between the present situation and the speculation that ensued in 1988, 1993 and 1998 during major bank failures that claimed more than 50 financial institutions due to systemic weaknesses in the sector. It begs the question, should the recent turbulence of the past year be considered an indicator of structural flaws, or rather lapses in regulatory oversight due to strain and unpleasant growing pains of Nairobi’s emergence as East Africa’s financial hub?

First, Dubai Bank Kenya goes under

The first domino to fall was Dubai Bank Kenya, going into receivership on August 14, 2015 and with orders to close soon after on August 24, 2015. To many it was not a surprise. Three years of allegations, investigations and, more recently, a teetering daily cash-reserve ratio, precipitated in this eventual outcome.

The symptoms soon became blatant and apparent, with initial outside allegations that the bank failed to pay its debtors, escalating to accusations from the former managing director Nereah Said herself, that the lender’s chairman and principal shareholder, Hassan Zubeidi, was abetting fraud and stealing clients’ funds. She was fired soon thereafter. Another managing director, Binay Dutta, was accused of fleeing the country on May 8, 2015 in the middle of a Central Bank of Kenya investigation into his role in a suspect share sale guarantee scheme that threatened to bring down the lender. It was the daily cash reserve ratio requirement breeches that landed the bank on the Central Bank of Kenya’s watch-list, starting July 14, 2015, leading ultimately to its downfall.

A month thereafter the bank was placed into receivership, with orders to close no more than two weeks later following a recommendation from the Kenya Deposit Insurance Corporation: “The KDIC report indicates that considering the magnitude of weaknesses of Dubai Bank Kenya Limited, liquidation is the only feasible option,” according to the Central Bank of Kenya. “CBK as a prudential regulator has considered and determined that Dubai Bank’s violations of banking laws and regulations, including failure to maintain adequate capital and liquidity ratios, as well as provisions for non-performing loans and weak corporate governance structures, are detrimental to the interests of its depositors, creditors and the public.”

Then, Imperial Bank

A few months after the Dubai Bank Kenya collapse, the country in October 2015 watched again as another institution, Imperial Bank, went under as regulators took the drastic decision after learning that “unsafe and unsound business conditions to transact business” existed in the bank. As a medium-sized retail bank, at the time the total asset base was valued at about $500m and ranked as the 19th largest lender in Kenya, while operating Imperial Bank Uganda subsidiaries in Kampala.

Details on the exact nature of these identified concerns vary; however, sources point to an internal fraud scheme motivating the move. According to Central Bank of Kenya governor Patrick Njoroge, “The board of directors of Imperial Bank brought to the attention of the CBK inappropriate banking practices that warranted the immediate remedial action in order to safeguard the interest of both depositors and creditor.” This was said during announcements that the Kenya Deposit Insurance Corporation would be appointed as the manager for the lender for the next twelve months.

Since the move, the Washington DC-based firm FTI Consulting has been appointed to review transactions, and over the past 32 weeks have examined around 1.2 terabytes of electronic data. If recent threats against FTI are any indication, the findings that will be unearthed during the audit will not be blameless: “There are forces that wanted us to go the other way, but we said no thank you for your advice. My staff have received numerous threats to their lives,” according to Njoroge.

During the fallout, Ugandan authorities followed their Kenyan counterparts in swiftly placing Imperial Bank’s five Uganda-based subsidiaries under statutory management, magnifying concerns to a regional-level. As such, the situation added to mounting anxiety whether Kenyan lenders are being properly and sufficiently scrutinised by the regulators and to what extent could other questionable practices be eluding the watchdogs.

Most recently, shockwaves from Chase Bank Kenya

Then, for the third time in less than six months, another mid-sized lender fell, as Chase Bank Kenya was put into receivership this past April 2016 for failing to meet its obligations and following a run on deposits. With analysts pointing to weak supervision and outright fraud by directors, this most recent case has incited fears that the recent turmoil of Kenya’s banking sector is being caused by structural weaknesses and systemic concerns. According to the central bank, Chase Bank was not able to “meet its financial obligations on April 6, 2016”, following recent liquidity difficulties exacerbated by inaccurate social media reports and the departure of two directors.

The credibility of the bank’s financial statements came into question, when on April 6 the bank’s liabilities and loans were re-stated at Ksh.13.6bn ($134.18m), when only a week earlier these figures were published at Ksh.3.24bn ($31.96m). In the wake of this uncertainty, the bank was closed, but soon re-opened on April 27 as blame shifted to its auditor of 20 years, Deloitte & Touche. According to former directors in a briefing to the national assembly, Deloitte insisted on having certain Islamic finance products, Musharakah assets, acquired over 2012-15, re-classified as insider loans, an issue never raised in previous year audits. The lender says its managers emphasised to Deloitte that such treatment contravenes the principles of Islamic banking and breaches the Islamic Depositors and Banking Act.

As this dispute comes to light, it seems trust is being quickly restored in Chase Bank. Regulators have also placed a portion of blame on unreasonable interest rates in the mid-sized banking segment, interest rates that are forcing unhealthy pressures on the margins of smaller banks, while larger banks operate at a competitive advantage at lower rates. With an effort underway to address the issue among legislators, proposals are being pushed through parliament to put in place mechanisms “aimed at capping commercial banks’ lending rates at four percentage points above the central bank’s benchmark rate.”

In the two months following its April 27 reopening, more than Ksh.5.4bn ($53.28m) was transacted and 1,343 new accounts opened, according to the Kenya Deposit Insurance Corporation. In a further vote of confidence, the institution’s apparent soundness had attracted several other institutions’ strategic conversations, including M&A, with the likes of KCB, I&M Bank, Bank of Mauritius, South Africa’s First Rand Bank, Centum Investment and Atlas Mara Group.

Isolated instances or widespread concern?

Whether the recent turbulence represents isolated incidences or is a manifestation of widespread structural and systemic concerns, there is much contradictory evidence and a clash of arguments across both sides of the table.

In response to recent events and actions undertaken by the regulators, President Uhuru Kenyatta has been supportive of the central bank. Echoing the sentiment of Njoroge, he characterises recent developments not as a crisis in the financial sector, but triggers for more proactively cleaning-up non-compliant institutions. “I support the governor on this, he is saying we must strengthen and remove weaknesses in the financial sector,” said President Kenyatta. There was greater optimism that unethical financial institutions, especially those culpable for contravening anti-laundering laws, would be punished when last November President Kenyatta ordered unprecedented sanctions, including loss of bank licenses.

However, it was not long ago that the Financial Action Task Force (FATF), an inter-governmental body established by the Ministers of its Member jurisdictions, placed Kenya on its list of high risk and non-cooperative jurisdictions, characterised by weak regulatory environments and measures to combat money laundering. By 2014, however, the FATF seemingly welcomed “Kenya’s significant progress” and noted that “Kenya has established the legal and regulatory framework to meet its commitments in its action plan regarding the strategic deficiencies” that were previously identified. As such, Kenya was removed from FATF monitoring, but to some the move was premature.

The Global Financial Integrity, a non-profit, Washington, DC-based research and advisory organisation, was clearly dismayed: “the fact that Kenya has been removed from the (FATF) list should be terrifying to everyone, both due to what it means for Kenya and for what it says about FATF – the international anti-money laundering standard setting body.” Pointing to researchers at the University of Texas-Austin, Brigham Young University and Griffith University, “Kenya still remains the single easiest place in the world for a criminal or terrorist to open an anonymous shell company to launder their illicit proceeds,” an obvious barometer for widespread regulatory weakness and fraudulent activity in the banking sector.

The concern was only compounded by a recent joint report by the African Union (AU) and the United Nations Economic Commission for Africa (UNECA), illustrating the extent to which the Kenyan economy continues to suffer from illicit financial outflows in the billions, resources which could otherwise be channelled towards opportunities that would accelerate economic progress and development. According to the report, “Kenya is believed to have lost as much as $1.51bn between 2002 and 2011 to trade misinvoicing” and ranks 7th in Africa in terms of its vulnerability.

Assessments of the sector by the International Monetary Fund late last year and by Moody’s earlier this year, tempered concerns to a certain extent. However, among the pockets of optimism, an urging of caution remained, especially towards Kenyan banks expanding regionally.

In the IMF’s review of Kenya’s economic situation, financial indicators were described as favourable, especially as risks from the global financial and economic conditions lessened. Nevertheless, the IMF emphasised the need to be guarded, with a close monitoring of those Kenyan banks implementing cross-border expansions. Indeed, growing regionalisation will require added banking supervision to ensure that these moves do not compromise institutional soundness. Likewise, Moody’s was also positive, releasing a study that assessed the stability of Kenya’s 42 banks and concluded that most lenders have promising growth prospects. However, citing asset quality risk from structural weaknesses, rapid loan growth and rising interest rates, the IMF was not alone in recommending prudent caution in its assessment.

Will regulators keep pace?

The Central Bank of Kenya ranks liquidity management issues as highest among the more serious macro challenges facing Kenya’s banking sector. Of Kenya’s 42 banks, the top seven hold 80% of all the cash of Kenya’s 45 million population. This is a very disproportionate bank-to-population ratio when compared to other countries throughout Africa. In the case of Nigeria, for example, the country has only 22 banks serving a population of 180 million, and in the case of South Africa, only 19 banks for 55 million.

Commenting on the recent bank failures, Governor Njoroge acknowledges that banks are starved of liquidity and high interest rates are strangling mid-sized players, for some time before even Imperial Bank failed.

“The problem did not start with Imperial Bank, it predates all these issues in the sector. If you look at the interbank market for instance, some banks will trade at reasonable favourable rates, but when they lend to another smaller bank, it’s like four times the rate, there is this sort of segmentation in the market. So you have some banks that are playing in the wading pool, while others are in the swimming pool… You cannot tell me even with the risk profile an institution is four times the price to another institution, there is something wrong with that model.”

Without liquidity moving smoothly, banks will face a precarious situation, further aggravated by nonperforming loans becoming more prevalent in the sector. That is in addition to banks facing added cost as they build up capital and other provisionary requirements in response to Imperial Bank and Dubai Bank. Among listed banks in Kenya, loan loss provisions have increased by 85.4%.

For 2015, according to the Cytonn Banking Sector Report, the high interest rates described by Governor Njoroge restrained the full potential of bank growth, with depositors motivated to opt for government securities during the recent period. But, despite these constraints, the banking sector still achieved impressive growth. Aggregate gross loans and advances grew by 17% to Ksh.1.8tr ($17.76bn) in December 2015, while deposits grew 14.5% to Ksh.2tr ($19.73bn) in December 2015. In the same period, total assets grew 14.9% in December 2015 to Ksh.2.8tr ($27.63bn), from Ksh.2.4tr ($23.68bn)in 2014.

The momentum is difficult to ignore and will lead to more opportunity creation. “This is the time that banks need to think through their own business; it’s a transition point where they need to strengthen their business model and also consolidate with other institutions, find strategic investors that will make the bank more resilient,” says Treasury Cabinet Secretary Henry Rotich. Beyond Kenya’s 42 commercial banks, the country also has 86 foreign exchange bureaus, 14 money remittance providers, 12 microfinance banks, eight representative offices of foreign banks, three credit reference bureaus, and one mortgage finance company. With the growth certain to continue and consolidation highly expected in this dynamic and crowded sector, many stakeholders question how well the already strained regulators will keep pace.

Robert MacPherson is an adjunct researcher at the NTU-SBF Centre for African Studies and vice president at Reciprocus International, a global M&A advisory boutique headquartered in Singapore.