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Paging Anne Robinson
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Continuing our analysis of KHCB to examine its potential to support GFHFG's new strategy ..
Quick Summary (for the Twitter
Generation): Profit Rate Risk (AKA Interest Rate Risk) appears very high at KHCB. Thus, a poor "fit" with GFH's new strategy.
Let's start by taking a look at
yield on KHCB's loan portfolio yield to set the stage.
Portfolio
Yield
Sometimes
banks don’t book “air” for AIR (Accrued Interest or "Income" Receivable). Or if they realize or are forced to
realize they have, they reverse it out. When they do this, they generally
don’t provide details. But, if the amounts are large enough, the gross
yield on the lending portfolio will decrease significantly. Lower rates
on renegotiated loans and non-accrual on income in part or full on some loans
can also depress gross yield. Trends in portfolio yield can also reveal
if a bank is taking more risk relative to its peers.
Gross
yield—which is the amount of interest owed by borrowers—is best because trends
are not masked by changes in cost of funding (COF) as they are with net
yield. However, one does need to keep an eye on COF.
Why?
Because
bank loans are generally priced over defined COF typically against bank
benchmarks, e.g., LIBOR, as a proxy for the lending bank’s cost of funds.
Note actual funding of loans is independent of their price setting
mechanism. There is nothing to prevent a bank from pricing a loan over
three month Libor and using overnight funding or more than three month
funding. That mismatch is how a bank’s Treasury earns its keep.
If
we’re using gross yield (margin + contractual cost of funds) to identify
whether changes are due to credit problems or other causes, then we need to be
able to isolate the impact of COF to determine if COF is driving changes in
gross yield through the loan pricing mechanism.
The
first step is determining COF on bank placements (deposits). If financials
provide a breakdown of COF for bank placements separate from customer
placements, the analyst’s job is easier. When they do not, analysis is a bit
more difficult as the reported COF includes both bank and non-bank
deposits. KHCB only provides a total COF which includes both bank and
client placements. In KHCB’s case, analysis is complicated further because the
relative percentages of bank and client deposits changed over the period
analyzed.
The
second step is determining the contractual pricing basis of assets. This
is usually in the “risk management note” near the end of the financial
statement. The “Islamic” equivalent of a conventional bank’s “interest
rate risk” is “profit rate risk.” That is, is the bank making loans that
reprice every three months? Every 12 months? Every 240
months?
Some
technical notes for the charts below:
1. Portfolio yield is on “Financing Assets” and
“Assets for Leasing” because gross revenue is given as a single figure for
both. Again not ideal from the analyst’s perspective.
2. COF is based on bank placements and placements
from clients (non-bank institutions and individuals) because there was no
breakdown of the components.
3. Current accounts are excluded because they are
not relevant to loan pricing as explained above.
4. Percentages are calculated using a simple average
(beginning of period and end of period) for both the loan portfolio and the
“deposits”.
5. Contractual repricing data is as of FYE (31
December) for the years shown as per respective ARs. For 2015 see AR 2015 Note
34 page 75.
KHCB Lending Yield and COF Analysis
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3Q16
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2Q16
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1Q16
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FY15
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FY14
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FY13
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FY12
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FA & LA
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5.80%
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6.34%
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6.30%
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5.91%
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6.84%
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6.63%
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7.57%
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Depo COF
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2.37%
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2.26%
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2.18%
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2.51%
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2.81%
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3.24%
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2.65%
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Contractual Repricing of FA & LA Portfolios -- KHCB and BIsB
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KHCB
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Months
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Up to 3
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3 to 6
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6 to 12
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12 to 36
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Over 36
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2015
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12%
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4%
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9%
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20%
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54%
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2014
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16%
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7%
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6%
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20%
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52%
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BIsB
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Months
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Up to 3
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3 to 6
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6 to 12
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12 to 36
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Over 36
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2015
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6%
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2%
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5%
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15%
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72%
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2014
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14%
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1%
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6%
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14%
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64%
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Contractual
Repricing of FA & LA Portfolios – QIB
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Months
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Up to
3
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3 to
12
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12 to
60
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60+
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2015
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41%
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28%
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22%
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9%
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2014
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47%
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27%
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24%
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3%
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Comments on Portfolio Yield
1. As the second chart above shows, KHCB and BIsB
are largely fixed rate lenders. So it’s no surprise that portfolio yield
is not correlated with COF.
2. Qatar Islamic Bank was “summoned” to this
discussion to show what appears to be a more commercial bank lending portfolio.
That is, heavily weighted to one year and under. QIB owns to an effective
profit rate of 4.2% (2015) and 4.32% (2014). Not bad. A natural
question is what risks KHCB is running for an extra 1.6% and whether the
risk/reward tradeoff is prudent.
3. Given this, KHCB and BIsB’s yield changes are
driven by credit “events” on existing loans and leases (nonaccrual, reversal of
AIR) and to a lesser extent by changes in market pricing for new loans and
leases. Because both banks are making long dated loans, the portfolio
turns over slowly. New financings are relatively small compared to the
existing “book”. Thus, new financings only marginally affect gross yield.
If the portfolio “suddenly” increased or decreased (write-offs for
example) by a large amount, this could affect net portfolio yield if current
market rates were substantially different than those on the existing
portfolio.
4. From FYE 2015 to 3Q16, KHCB’s FA & LA
portfolio increased BHD 64 million point to point. Looking at simple average
outstandings by quarter in 2016, the increase in 3Q16 was roughly BHD 26
million. As the below table shows that new business would have to have
been booked at less than a zero yield to cause a 50 bp drop in overall
portfolio yield. That seems unlikely.
5. Thus, the drop in yield in 3Q16 is almost
certainly credit related, e.g., non-accrual perhaps accompanied by reversal
of previous period accruals, renegotiation of loans as a lower rate, or a
combination of these factors.
6. If KHCB had maintained the 6.30% yield of 1Q16
and 2Q16 in 3Q16, gross interest revenue would have been roughly BHD0.560
million higher.
7. It doesn’t seem likely that the 3Q16 BHD2.2
million specific provision is solely responsible for the drop as nine months’
interest would be roughly BDH0.100 million using an average 6.3% portfolio
yield.
8. So what would it take?
9. Assuming the yield should be 6.3%, the table
below summarizes the single period amounts and rates at which they would have
to be accrued (0% to 5%) to reduce the overall portfolio yield to 5.80%.
Note this analysis is for the full 50 bps drop. Thus, it’s an analytical
shortcut, ignoring Q1 and Q2 potential reversals on the 3Q BHD 2.2 provision
and perhaps further back into 2015 if there was related AIR. While a
shortcut, it’s close enough for directional analysis. Also note the
required change is calculated using a simple average portfolio outstandings,
e.g., (2Q+3Q)/2.
10. In
guesstimating probabilities of the above scenarios, AA thinks that zero accrual
scenario is more likely that a massive renegotiation of loans to 5%. Or
partial accruals at the intermediate rates.
5.80%
Portfolio Yield "Required" Accrual Scenarios
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Accrual Rate
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0%
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1%
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2%
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3%
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4%
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5%
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BHD Millions
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32
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38
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46
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60
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87
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153
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% FA & LA
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7%
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8%
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10%
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14%
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19%
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34%
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Comments
on Profit Rate Risk
1. Profit Rate Risk (PRR) is the “Islamic”
equivalent of conventional bank Interest Rate Risk a measure of the exposure of
a bank to movements in interest rates. If assets and liabilities are
matched in terms of currency, actually repriced according to contractual repricing, and maturities then the
bank has no interest or profit rate risk. It has locked in its net interest
margin for the life of the loan absent credit events.
2. Banks generally don’t match 100% because they can
make additional revenue through mismatching, typically borrowing short and
lending long, assuming a “normal” upward sloping yield curve.
3. Another key factor and one which AA suspects is
at play here is that typically sources of matching long dated funding are
limited or non-existent. Banks might want to match fund but they
can’t. Banks have three choices. Make the fixed rate loan and short
fund. Refrain from making fixed rate loans for these tenors. Or make
floating rate loans that reprice frequently. An example would be a
ten year loan that is priced off six-month Libor.
PRR
(IRR) comes in two flavors: income risk and asset risk.
1. Income Risk: If a bank matches as described
above, and locks in its margin, changes in interest rates (COF) do not affect
its income. If it does not, it runs the risk that funding costs will
exceed the earnings on the asset. Think of First Penn or UBAF Arab
American (NYC). Both purchased long dated “riskless” US Treasury
securities but funded with short dated money in the repo market. As rates
rose, first profit evaporated and then earnings went negative. Both
foundered.
2. Asset Price Risk: With a fixed rate
instrument, if market rates go up, the value of the instrument goes down.
Duration and convexity are measures of this risk--most familiar to bond investors. Because loans and
leases are in KHCB’s “banking book”, they are carried at historic cost less
impairment for credit reasons. IFRS doesn’t require that banking book
assets be fair valued with losses or gains through income or directly in
equity.
3. Risk Management: In discussing management
of market risks in its 2015 AR (page 73), KHCB notes that there are Shari’a
compliant foreign exchange risk management transactions available but
says nothing about the availability of profit rate risk management
transactions. That suggests as a practical matter there are none. Further on page 75, it states “Overall non-trading profit rate risk
positions are managed by Treasury department, which uses short term investment
securities, placement with banks and placement from banks to manage the overall
position arising from the Bank’s non-trading activities.” Frankly,
AA doesn’t see how KHCB could be using short term instruments to effectively
hedge against the long term interest rate risk it appears to be carrying—up to
20 years! Perhaps, a treasurer or trader reading this could set AA
“straight”.
4. So far we’ve looked at half the PRR picture:
yield on assets. KHCB’s funding structure is the second and critical
piece of PRR. Below is a chart developed from KHCB’s 2015 AR Risk
Management Note 34 page 75.
KHCB Funding Gap Analysis - FA & LA Portfolio
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Months
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Up to 3
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3 to 6
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6 to 12
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12 to 36
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Over 36
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2015
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FA & LA
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47
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17
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34
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78
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211
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Funding
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96
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45
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70
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43
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112
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GAP
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49
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28
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36
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(35)
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(99)
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% Cover
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204%
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267%
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205%
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55%
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53%
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2014
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FA & LA
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53
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23
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21
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66
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176
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Funding
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72
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55
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68
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127
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1
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GAP
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19
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32
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47
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60
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(175)
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% Cover
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136%
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236%
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325%
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191%
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1%
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Technical Notes:
I’ve deducted both the related assets and funding for bank placements
taken and investment in sukuk shown in Note 34 page 75. The only other profit rate sensitive assets
are FA & LA. Thus, we have a
“clean” picture of how the lending portfolio is funded.
Note that a negative “Gap” number means that
there is insufficient funding for the respective time “bucket” of assets. Such “gaps” are a measure PRR.
The longer the life of a fixed rate asset the
longer the potential period of negative funding costs. Therefore, negative gaps in longer dated maturities have more PRR than in the shorter maturities as a general rule.
Also while IFRS doesn’t require that these “banking book” assets be revalued for income or balance sheet purposes, their fair value must be reported in a footnote. If the damage is severe enough, depositors and creditors may take “flight”.
Comments on Funding Gap and Profit Rate Risk
Analysis:
1. At first glance KHCB’s 2015 gap position is an
improvement from 2014. One might argue that the BDH 111 million in total
equity covers the gap in the final maturity “bucket” shown.
2. The analytical problem is that we have no way of
knowing the tenors of deposit funding versus assets. The “over three
years” category covers a wide range of possibilities. Funding may be for
37 or 120 months. Assets may be for 240 months or 36 months and three days.
Note 34 doesn’t contain enough information to determine what the gap
is. Another criticism and suggestion for changes to reporting
standards. When an institution engages in long dated transactions, it
should provide more detailed information on longer tenors.
3. IFRS may not have provided the answer.
However, we can thank the good folks at the Basel Committee on Banking
Supervision for their Pillar III requirements.
4. AR 2015 Note 3.4.6 on page 88 provides residual maturities,
not profit rate risk gap maturities. However, we can use this information
to form an opinion about the maximum tenors that KHCB extends on financings and
the length time that KHCB is exposed to profit rate risk. The former
should be shown by the maximum tenor in the note. The latter by the
residual maturities themselves as portfolio level residual maturities will tell
us how long it will take for outstandings to run off. Note with a fixed rate
lender like KHCB, repricing does not take place or is infrequent. Again a
reporting deficiency by use of the “over three years” category.
5. Sadly, Basel doesn’t require a similar note on
funding, but we can look at the funding gap “over three years category” and
form an opinion on likely tenors of deposits based on the “market”. And as
discussed below, we can look at additional notes to confirm or deny that
opinion.
Basel III Residual Maturity Note -- FA & LA
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Up to 1Y
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1 to 3Y
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3 to 5Y
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5 to 10Y
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10 to 20Y
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20Y+
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BHD Millions
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99
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78
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66
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90
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44
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11
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Percent
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25%
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20%
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17%
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23%
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11%
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3%
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1. At the beginning of Note 3.4.6, KHCB notes that
maximum exposures are 7 years for corporate and 25 years for retail borrowers,
unless the Board approves exceptions. Note that leasing accounts
for all the exposure over 20 years.
2. Looking at the chart immediately above it seems
unlikely that KHCB has found matching funding for such long tenors. Who
is placing 5 year, much less 10 or 20 year money with Islamic banks or other
banks? What depositors are placing 10 or 20 year money with regional commercial
banks? How many depositors are placing that sort of money with investment
grade global banks?
3. But there’s another way to get an insight
into deposit tenors. Note 8.3 on page 98 provides a breakdown of
“interest” paid on IAH for 2015 and 2014. The absolute amount of interest
paid falls off dramatically after 12 months. Minimal amounts of “interest” are
shown for 18 and 24 month Mudharab accounts in both 2015 and 2014. How
minimal? Less than 1% of the total interest paid to IAH holders. That suggests deposits
in the 12 to 36 month “bucket” are largely in the 12 month category. And
thus despite the apparent “match” there is a funding gap in this “bucket”.
4. But where are the 36 month and over IAH deposits
shown in Note 34 as representing 99% of the PRR Gap match funding in this
bucket. This is the most risky time period for PRR. Strangely
there is no category for these deposits. Since this maturity “bucket”
holds over BHD 112 million or over 30% of all IAH deposits, it seems strange
that there isn’t a separate category. It’s certainly “material” by
typical accounting standards.
5. There is a category for VIP Mudharab
accounts. Could this be the over 36 month category? Doesn’t look like it.
On the following page these accounts are being paid 2.00% which is lower than
the 6 month Mudharab “interest” of 2.69%. Doesn’t seem like a
preferential rate for VIPs but then the tenor is unknown because it is
unspecified. Maybe a variant of qard hassan? AA doesn’t think
so. Also the total interest paid to the VIP IAH is 14% of total interest
paid. It would seem that interest for the more than 36 months deposits
should be at least 30% of the total paid in line with their percentage of total
IAH deposits. But it is not.
6. AA has no explanation for either #4 or #5 above,
and thus the tentative conclusion is that KHCB’s profit (interest) rate risk
gap remains substantial and there is significant income risk.
7. In an environment where rates are likely to
increase driven by the US FRB, KHCB is likely to face
earnings pressure (another euphemism) as rates rise. Not exactly a good strategic "fit" for GFH Financial Group which is looking for stable income not heavily influenced by global factors.
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