African bank profits up but productivity remains low

Much has been made of recent growth in African bank profits, with some announcing figures 30% or even 40% up on last year. Yet consultants McKinsey argue that overall profitability has fallen in recent years because the profits do not reflect growth in assets and revenue – resulting in return on equity (ROE) that is low by international standards.

This could be tackled by boosting productivity, particularly through greater adoption of digital technology – a process that is already well underway.

Covid-19 undoubtedly hit bank revenues and profits hard but both figures are rebounding strongly across the sector. The continent’s biggest bank, South Africa’s Standard Bank Group, reported a 33% increase in profits from R15.73 ($0.87) per share to R20.87 per share for the year to the end of December 2022. It attributed the rise to higher credit card and insurance transactions, as well as higher interest rates.

Announcing the figures on 9 March, CEO Sim Tshabalala warned that the effects of continued warfare in Ukraine, particularly through food shortages, and the risk of more sovereign debt default on the continent, posed increased risks for 2023 African bank results.

Moreover, the impact of infrastructural shortcomings, including regular power cuts and poorly performing rail and port infrastructure, could affect the results of all South African banks over the next couple of years.

Kenyan banks enjoyed record pre-tax profits of KSh223.7bn ($1.67bn) for the 11 months to the end of November 2022 as a result of increased lending, according to the Central Bank of Kenya.

Among those announcing the biggest increases, Standard Chartered Bank Kenya recorded a KSh12.44bn ($95.7m) profit for 2022, 38% up on the previous year. Absa Bank Kenya saw a similarly impressive increase, up 34.2% to KSh14.6bn ($112.3m) for the same period.

Aside from increases in retail, business banking and wealth management income, Kenyan banks benefited from higher foreign exchange revenues as a result of currency volatility caused by the war in Ukraine.

Elsewhere, figures from Bank of Botswana show  that Botswanan banks collectively generated P1.67bn ($125m) in profits before tax for the first eight months of last year, a rise of P440m ($33m) on 2022.

The central bank attributed the good performance to lower provision for bad debt – a common theme across the continent as fewer companies and individuals were unable to repay their loans than expected – and to high net interest income. Total Botswanan bad debt provision fell from P279m ($21m) in the first eight months of 2021 to P87m ($6.5m) for the same period last year.

Low productivity hits ROE

However, in a report published in December, McKinsey argues that profits are lower than they could be because return on equity (ROE) in most African markets is depressed by weak productivity.

It calculates that banking ROE, which is a measure of financial performance calculated by dividing net income by shareholder equity, is still 1-2 percentage points lower than before the pandemic across most of the continent.

Even Standard Bank’s ROE was lower in its recent good results than prior to 2022, although it did rise from 13.5% in 2021 to 16.4% last year. It has set a ROE target of 17-20% by 2025, which would be slightly higher than its average pre-Covid level.

According to McKinsey, profitability in four out of Africa’s five biggest banking markets – Egypt, Kenya, Morocco and South Africa – has fallen since 2016, including a big decline of 9.5% in Egypt and 2.7% in South Africa.

Nigeria is the one exception out of the big five, with a 3.6% increase as a result of reduced risk following the economic reforms imposed after the 2016 recession and a partial recovery in oil prices.

Most African banks also have higher cost-to-income ratios than their counterparts in the Middle East, Southeast Asia and Latin America. Moreover, their average cost-to-asset ratio of 4-5% is almost twice the global average, partly because of low banking penetration rates. About half the adult population of Africa still has no access to banking services.

Possible reasons for this include greater competition, partly from the digitalisation of financial services, and declining fee margins at a time when operating costs have stayed constant.

The average operating costs of Moroccan banks, for instance, remained at about 2.3% over the period 2016-21 but net interest income fell from 2% to 1.8%, driving down average ROE from 9.2% to 7.1% over the same period. However, reduced profitability could also stem from lower interest rates over the past few years, so it will be interesting to see whether the recent upturn in interest rates will have a positive impact on ROE.

International regulations, including Basel II, Basel III, and International Financial Reporting Standards (IFRS) 9, are forcing banks to change their capital requirements, which can also feed through into ROE.

For instance, IFRS requires banks to hold additional capital to cover their risk portfolios and this is having a bigger impact in Africa than elsewhere because of lower average capital levels.

Solution already on the way

“A turnaround is much needed to put African banks on a more positive trajectory in this time of macro uncertainty, and banks already have the building blocks for what is required,” said McKinsey. Those building blocks – digital adoption and more general efficiency measures – were already available before the Covid-19 pandemic but the crisis greatly speeded up their adoption.

Competition in the African financial services industry has increased greatly over the past few years, with mobile money providers, fintech developers, digital-first banks and telecoms companies all entering the market, while there has been increased cross-border investment by established banks in other markets.

The continent’s biggest banks have responded by investing in digital platforms, which involve high initial development costs but which should enable lower long-term operating costs through reduced back office processing and pared-back branch networks.

Digitalisation is also driving up banking penetration rates, which in turn should reduce cost-to-income ratios and boost profitability.

It is interesting that the one African market that McKinsey identifies where banking ROE has recovered to pre-pandemic levels is Kenya, given that it is one of the most competitive markets and one where early technological adoption and acceptance of digital banking platforms had already increased access to banking services from 26% of the population in 2006 to 83% in 2021.

As well as digitalisation and more general IT improvements, McKinsey recommends greater flexibility in the use of bank real estate, with more employees working from home, while making sure that the real estate assets they retain are fully utilised.

It also advises greater use of AI for payment processes, such as through optical character recognition; and machine learning, including for procurement projects and in determining cash stocks.

Finally, McKinsey says that African banks “may need to review their cost base and operating models, especially if they want to increase access to the banking system in a cost-efficient manner – a necessary condition for driving much- needed financial inclusion.”

Achieving all this at a time of global economic uncertainty will not be straightforward but the industry already has many of the tools it needs to increase long-term productivity levels, boosting banking inclusion in the process.