Higher inflation to Weigh on African Banks' Profitability –Moody’s

Higher inflation to Weigh on African Banks’ Profitability –Moody’s

Inflation has accelerated in the largest African economies – South Africa, Nigeria, Egypt, Morocco and Kenya – in recent months and most central banks have raised their policy interest rates in response to further increases likely over the next year. Moody’s said in a report.

Although higher interest rates will boost net interest margins, we anticipate that these gains will be outweighed by lower lending volumes, higher costs and increased provisioning needs, the global rating firm added.

It said rising inflation and higher interest rates will weigh on economic growth and lending volumes. The report explains that in many African countries, slower economic growth amid inflationary pressures and tighter funding conditions will limit banks’ business generation and strain revenue growth.

In addition, the pace of increase in policy rates has so far lagged that of inflation in most countries (leading to negative real interest rates), which may lead central banks to tighten monetary policy further to forestall local currency depreciation.

South Africa increased its policy rate this year to 5.5% as the rate of inflation accelerated to 7.8% in July, and Morocco has maintained its policy rate at 1.5%, despite inflation climbing to 7.7% in June. Net interest margins will widen, with banks with short-term or floating-rate loans benefiting most.

Most African banks hold large volumes of loans that carry floating interest rates or are short-term. These will reprice upward as interest rates rise. We expect South African banks’ margins to benefit most. The impact on Nigerian and Kenyan banks’ margins will be muted because their interest rates are already high and some of their deposit rates are index-linked to the policy rate.


African banks’ sizeable holdings of government debt securities will fall in value as interest rates rise, but these unrealised losses are unlikely to crystallise. South Africa’s highly unionised workforce will push up operating costs.

Widespread labour union membership among staff will push up costs at South African banks as inflation rises. In Nigeria, staff costs will likely continue to lag inflation but the cost of their outsourced services will increase.

In Kenya, banks’ low cost-to-income ratios due to smart use of mobile technology and better efficiency will provide headroom to absorb rising costs. Loan-loss provisions will rise across the board.

Banks that lend heavily to households and small businesses will be more vulnerable to loan defaults than those that focus on large companies. Kenyan and Moroccan banks have lent extensively to households and SMEs.

South African banks also have large quantities of household loans but these are primarily mortgages, which tend to be more resilient. Nigerian banks will fare better. They have wide exposure to corporates, with a significant number linked to the oil and gas sector, a beneficiary of the current crisis.

Rising inflation and higher interest rates will weigh on economic growth and lending volumes since the outbreak of the Russian/Ukraine conflict inflation have risen sharply in several countries globally, far exceeding most expectations.

Inflation has also risen in many African countries, driven primarily by higher food and energy prices. In response, central banks are ratcheting up their policy interest rates to try to quell demand.

In South Africa the policy rate has risen by 175 basis points since the end of 2021 to 5.50%; in Nigeria, it has increased 250 basis points to 14.00%. Egypt has increased its rate by 300 bps so far, to 11.75%, while Kenya raised its policy rate by 50 basis points to 7.50%. READ: Kenyan Banks’ Rebound at Risk from Global Contagion –Fitch

An exception is Morocco where the central bank has kept its interest rate at 1.50% to support economic activity, despite inflation increasing to 7.7% from 3.2% at the end of 2021.

Higher inflation and interest rates will hamper investment and economic activity, and slower real growth will, in turn, weaken banks’ business generation and loan quality.  In 2023, Moody’s forecasts real GDP growth of 4.0% in Nigeria, 4.5% in Egypt, 1.5% in South Africa, 3.5% in Morocco and 5.3% in Kenya.

However, interest rate increases have so far not kept pace with inflation, and in South Africa, Egypt, Nigeria and Morocco real interest rates (excluding inflation) remain negative as in many parts of the world.

Some central banks may tighten monetary policy further to keep inflation under control and to forestall local currency depreciation – particularly as interest rates in the US rise, drawing capital away from riskier African economies.

Net interest margins will widen, with banks with short-term or floating-rate loans benefiting most Each bank’s asset and liability composition, in particular, the volume of loans and of liabilities (such as deposits with floating interest rates) and the duration of those assets and liabilities will determine the impact of higher interest rates on net interest income.

Net interest income, which is a measure of the difference between the interest banks receive from their assets, such as loans, and the interest they pay out on liabilities, such as deposits, is the main revenue stream for African banks.

“We expect banks will proactively change the composition and duration of their assets and liabilities in order to enhance or limit the impact of higher inflation and interest rates”.

In general, financial institutions in the five largest African banking systems have short-term assets, predominantly loans and securities, and, as these mature, they will be reinvested at higher interest rates, resulting in an improvement in interest margin.

At the same time, most African banks are also funded predominantly by short-term deposits that will also reprice upward, but we expect a time lag between the reprice of assets versus liabilities.

Banks with large volumes of low-cost current and savings accounts, particularly from households, will likely raise the rates at a slower pace than they raise their lending rates.

This will support the expansion of their net interest margins. South African margins will benefit the most as interest rates rise; the impact for Nigerian and Kenyan banks will be more modest

South African banks’ margins will benefit the most from higher interest rates, given the faster repricing of their assets relatively to their liabilities, while gains for Nigerian and Kenyan banks will be smaller, given the already high interest rates on their loans.

“We expect South African banks’ margins to benefit the most across the main African banking systems because the impact of rising interest rates on the margin tends to be greater when lending rates are lower”.

South African banks have loans with a longer duration given their high volumes of long-term mortgages, but they will also benefit given that most of their mortgages are on floating interest rates. South African banks currently charge relatively lower lending rates than other African systems and Moody’s says it expects the banks to raise them quickly.

“We expect the impact on Nigeria and Kenyan banks to be more limited because their lending rates are already high and the transmission of policy rates to lending rates is slow in both countries”.

In their 2021 financial reports, Kenyan banks recorded the widest net interest margins, while South African banks recorded the slimmest. Additionally, South African banks have made large investments in government bonds, whose rates are rising, while their institutional deposits tend to be long-term, enabling banks to lock in some of their funding costs.

However, these depositors are also financially astute and will move funds away opportunistically.

In Nigeria, competition for longer-dated deposits to satisfy Basel III liquidity requirements has resulted in growth of price-sensitive term deposit products, which will gradually increase funding costs and moderate margin expansion as those deposits are rolled over at higher rates.

In addition, regulations require Nigerian banks to pay 30% of the current monetary policy rate (MPR) on their savings deposits, which translates to an interest rate of around 4.2% at the current 14% MPR. This will increase the banks’ funding costs.

Egyptian banks are the most reliant on net interest income

For all the largest African banking systems, net interest income is the main source of revenue and therefore any increase in margins will support their revenue growth. Egyptian banks are the most reliant on net interest income as a revenue source.

The country’s banking sector had a ratio of net interest income to total revenue exceeding 80% at the end of 2021. The least dependent are Nigerian banks, with a proportion of net interest to total income at 59%.

South Africa’s highly unionised workforce will push costs up faster than for peers; Moody’s analysts expect a bank’s proportion of overheads to total costs, and staff unionisation to be key determinants of how fast operating costs rise as inflation climbs upward.

Banks with extensive low-cost digital services will be better placed to manage costs, although those that outsource these services may not fare as well. Overall, our analysis shows high inflation will increase operating costs in all systems. South Africa, Egypt and Morocco are likely to be hit hardest.

Staff costs represent between 30% and 60% of operating expenses in the large African banking systems. High inflation will affect South African banks more than peers because of the high level of union membership among their staff.

A noticeable portion of South Africa’s bank employees belongs to a union and staff expenses already makeup around 59% of the banks’ operating costs, compared with just 30% for Nigerian banks. In Nigeria, Moody’s expect staff costs to increase but at a slower pace than inflation. This is a trend at Nigerian banks that has been evident in recent years.

Overhead costs such as IT and real-estate rental charges will increase. Imported services, charged in dollars, particularly for software as banks protect themselves against cyber threats, will increase across all systems and a weakening local currency would add to the costs.

Kenyan banks will benefit from their extensive digital services and Moody’s expect the banks’ cost-to-income ratio to increase only slightly.

South Africa has the highest cost-to-income ratio but stronger revenue growth (supported by margin expansion) will likely result in stable cost-to-income ratios for the banks. Nigerian banks have a high cost-to-income ratio despite low staffing costs, which indicates that they face high regulatory charges and branch network expenses.

“We expect all these overheads to rise with inflation. Higher interest and inflation rates will increase loan-loss provisions across the board We expect a bank’s exposure to sectors most vulnerable to inflation, such as households, will be a key factor impacting their provisioning costs”.

Higher inflation will diminish the borrowers’ repayment capacity because income will be needed to meet other competing and rising costs. Higher interest rates will also add to borrowers’ debt burdens by increasing the nominal repayments. Moody’s expects high inflation and interest rates to increase provisioning needs in all systems.

In general, the firm expects banks most exposed to household borrowers will face the highest loan-loss provisioning charges. While inflation will reduce the real value of outstanding debt, household incomes may not increase fast enough to service the rising repayment costs.

In addition, unlike in some developed economies, most households in these systems did not receive cash handouts from governments during the pandemic which would have eased the debt service burden.

In contrast, banks with high exposure to corporates may fare better because many companies will be able to pass on some of price increases to their customers. South African banks have the largest volumes of household loans on their book, representing close to 40% of their lending at the end of 2021.

However, most of the South African banks’ household exposure are mortgages, which represent about 24% of total loans. Mortgages tend to be more resilient than other household exposures such as credit cards and personal loans. The Kenyan, Egyptian and Moroccan banks have a substantial volume of personal loans and loans to SMEs, which are vulnerable to high inflation and interest rates, given their less flexible balance sheets and limited access to alternative funding.

Nigerian banks have large exposure to corporates and to oil and gas borrowers that are likely to benefit from high oil prices (although downstream players may still face challenges due to higher inflation). Companies with lower pricing power, high usage of energy such as fuel and high debt levels will still be vulnerable, however.

Governments will feel the strain. High-interest rates will increase borrowing costs for sovereigns, weakening their fiscal positions. In Africa, this has a direct effect on banks’ credit profiles because the majority of African banks hold large volumes of government securities.

Moreover, as the cost of borrowing rises for governments, their arrears to private-sector businesses may increase, undermining the businesses’ ability to make timely loan repayments.

Provisioning is already sound at most African banks Most of the banks took proactive provisions following the outbreak of the pandemic and this will limit the extra provisioning required as defaults rise to some extent.

At the end of 2021, Kenyan banks’ ratio of loan-loss provisions to gross loans was the highest at about 1.58%, while Nigeria had the lowest at 0.08%. Some banks released large volumes of these provisions in 2021, supporting their profitability but it may well mean they will face higher provisions in the next 12-18 months.

South African banks have large volumes of general provisions that will moderate the need for additional provisions this year. # Higher inflation to Weigh on African Banks’ Profitability –Moody’s

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