Analyzing KHCB’s Prospects – The Way Forward and a First Step

B&B Prepare to Launch AA on His "Deep Dive" into KHCB's Financials and Prospects 

If You Look Closely You Can See AA Holding a Candle Inside the Bathysphere

My 2017 New Year's resolutions include greater use of corporate buzzwords, but not at work where my boss fines the staff at ever increasing levels for repeated use. Hence "deep dive" above.  

As mentioned in the previous post, KHCB’s earnings history doesn’t indicate it is a likely candidate to provide GFH a stable recurring source of earnings to enable GFH’s new strategy.  But past performance is no guarantee of future results. 

Is there information in KHCB’s 2015 Annual Report that can give us an insight into possible future performance?

Yes. 

As a commercial bank, KHCB’s financial health is based on the performance of its financing (lending) activities.  In 2015 and 2014 lending (financing assets and assets for lease financing) were 59% and 57% of total assets.  Financing revenue was 69% and 78% of total revenue in 2015 and 2014 respectively.   As KHCB’s lending business goes, so goes the bank.

How do we get an insight into the future from historical financial data?

One way is to look at potential stress points and the direction and magnitude of trends.  Credit problems at more traditional short tenor commercial banks aren’t quickly fixed.  KHCB is a harder ship to turn around because it is a long tenor fixed rate lender.  

But this exercise like all other forms of fortune telling is not necessarily conclusive.  Banks are black boxes of risk.  Financials do not always capture those risks for a variety of reasons.

Road Map

Before we set out, here’s the proposed itinerary.   

1. Accrued income receivable  
2. Portfolio yield and “profit rate risk” 
3. Provision coverage  
4. Renegotiated loans  
5. Past due but not impaired loans       
6. Collateral coverage 

Let's start our journey of one thousand li with the first step as the Master would.

ACCRUED INCOME (“INTEREST”) RECEIVABLE

An early sign of problems in the loan portfolio often—but not always--is a build-up in accrued interest receivable (AIR) or the “Islamic” equivalent of accrued income receivable as I noted in my earlier post on ADCB.  In such a situation—and this is not a reference to ADCB because we don’t have enough data points to establish a definite trend at that bank—a bank books income into AIR which later turns out to be “air”.  

Think of the UAE banks merrily capitalizing interest on perpetual overdrafts—which meant they were booking interest on accrued but unpaid interest—back in the late 70s until they well and truly hit the wall. 

Or Bahrain International Bank (BIB) capitalizing interest on a loan to a “great” US fast food investment it had made, but not so “great” it could even pay $1 of interest.  Each year AIR went up by the amount of interest on the loan.  Year after year.  That wasn’t the only “funky” thing with BIB’s financials. All of which savvy investors, rating agencies, and others “missed” until BIB’s sudden impact with the wall.

KHCB doesn’t provide any explicit information on AIR, presumably because of the amounts are not “material” as a percentage of assets.   AR FYE 2015 Note 12 “Other Assets” provides information on sukuk income receivables.   A catch all category “other receivables”—where FA & LA AIR most likely is booked—increased by about BHD 3.9 million from 2014.  But no explanation was provided. Other Assets dropped to BDH9.6 at 3Q16.   Even more abbreviated details here don't allow even cursory analysis.  The 2016 AR will have more details, but is likely to have the same opacity as At 2015 so we still won't have conclusive evidence.  If there is an air problem, the amounts don't appear to serious and the drop in 3Q16 suggests there probably isn't a problem. 

The Statement of Cashflows (SOC) sometimes but not always discloses if AIR is increasing (it sure did with BIB as well as BIB’s Other Assets Note).  KHCB’s SOC is of little analytic use because FA & LA income (interest) received seems to be buried along with principal payments and disbursements in a net figure. 

The comments on disclosure of other assets and the SOC are not only meant as criticism but also encouragement for changes to financial reporting, assuming there is an interest in providing financial statement users with useful information. 

As our journey progresses deeper into KHCB's financials expect more criticisms/suggestions, particularly as AA's candle depletes the air in the bathysphere.

KHCB Strategic "Fit" with GFH - Historical Context

At the End of a Wild Ride One Winds Up Where One Started 

For the discussion about KHCB’s strategic fit with GFH, a bit of context by way of historical data, though as I noted in my 1 December post, the success of GFHFG’s strategy depends on future performance not past.

Some introductory comments.

Since my earlier analysis, I’ve introduced two comparable, Bahrain Islamic Bank (BIsB) and Qatar Islamic Bank (QIB) and provide data for two periods:  the last ten and five years. 

Definitions:

1. GFH includes income from KHCB.  
2. GFH X KHCB does not.
3. Amounts are in millions of US dollars (GFH's base currency).
4. BD and QR have been translated to US dollars using respective official peg rates. 
5. As before, STDVP = Standard Deviation of the Population and STDVS = Standard Deviation of the Sample.

Let’s start with the long view – ten years financial data.

Net Income Statistical Analysis 2006-2015
	Mean	STDVP	STDVS
GFH	-$22.87	299.36	315.55
KHCB	$15.41	31.34	33.04
GFH X KHCB	-$30.04	293.96	309.86
BIsB	-$6.82	59.71	62.94
QIB	$386.18	68.55	72.26

Over the ten-year period, KHCB generated some $154 million equivalent in net profit.  But this was largely due to two fat years—2007 and 2008—whose net profit of $128 million (note that’s 83% of the ten year’s total) was driven by investment banking fees (revenue not net profit) of $128 million.  Revenue that has not recurred and is likely to in the future. As that indicates, the commercial banking business by itself has not been wildly successful (first euphemism of this post) over the period.  

That being said, KHCB increased GFH’s net income by about $71.7—GFH’s share of the $154 million—but really didn’t “move the needle” much (AA’s corporate buzzword of the post).  The mean improved slightly, but volatility barely moved.

The ratio of STDP and STDS to mean for GFH, KHCB, and BIsB indicates the high volatility of results.  These metrics are definitely not indicators of “stable or recurring” income or profitability.  The negative means and rather “modest” (second euphemism) positive mean is another indication of weakness.

The story is much different at QIB.  There the STD is a fraction of a rather healthy mean.  In the case of QIB, we’d predict positive earnings as the most likely outcome using the above data.  Not so with the others.

Now for a five year view.

Net Income Statistical Analysis 2011-2015
	Mean	STDVP	STDVS
GFH	$0.44	11.55	12.91
KHCB	-$4.17	24.27	27.13
GFH X KHCB	$2.42	9.21	10.29
BIsB	-$14.32	49.23	55.04
QIB	$411.87	70.45	78.77

During this five year period, two things are clear about KHCB’s performance: 

1. It was more volatile than GFH’s. 
2. KHCB had a net loss over the period driven by credit problems. GFH did not, but just barely.     

In this period, GFH would have been better off without KHCB as net income would have been higher by some $10 million and volatility lower.  But GFH’s earnings would still not be stable.  Thus, with or without KHCB GFH did not achieve stable earnings.  It doesn’t require sophisticated math or even a calculator to figure out that ROE was dismal.  My earlier post has comparative ROE figures. As well, net income over the period did not rise even to “hobby” levels on an absolute basis.  

Based on a historical analysis, there is little to support KHCB as a pillar of GFH’s new strategy. 

What GFH needs is for KHCB to deliver not only a stable income but also much larger quantum of positive net income.  Neither of which KHCB has shown any ability to deliver.

But things change.

Blackberry was once the leading provider of business cell phones.   At  that point no one had ever heard of an IPhone.     

We’ll turn our attention to that issue in coming posts.

Insolvency of PrivatBank Ukraine: Euphemisms Abound

Моя Україно,За що тебе сплюндровано, За що, мамо, гинеш?

Would his anger be tempered today by knowledge that the perpetrators are Ukrainians? 

AA doubts it.

Now to the post.

AA prides himself on his skill in using euphemisms to describe financial weaknesses and ethical slips. 

This Tuesday The Bloomberg lit up with news that The National Bank of Ukraine—the country’s central bank—announced it had declared PrivatBank insolvent and that Ukraine’s Government would assume complete ownership. 

By way of background, Privatbank is the largest bank in the country.  It is privately owned with two biznesmen—described by some as “oligarchs” but always as “pro-Western”—holding over 90% of the bank’s shares. Besides his many business ventures, one of them, Mr. Kolomoiskyi, has been accused of funding the Azov Battalion.

As I read the speech by the Governor of The National Bank of Ukraine and other news, I was in utter awe at her and her colleague’s command of euphemisms. 

Professional honor compels me to acknowledge their skill.  Frankly my own efforts seem rather small and paltry in comparison.  Therefore, I offer a humble tip of AA’s enormous tarbush to Governor Ms. Gonatraeva and to NBU First Deputy Chairman Yakiv Smoliy.  

First, to the Chairman’s 19 December speech reported at The NBU website in English.  Strangely, AA was unable to find the Ukrainian language version. Italics courtesy of AA.

Inspections and stress tests carried out by the NBU revealed that PrivatBank had capital shortages. As of 1 April 2016, the bank had capital shortages amounting to UAH 113 billion, which, apart from crisis-related factors, were caused by imprudent lending policies pursued by the bank. As of 1 November 2015, related-party loans accounted for 97% of the bank’s loan portfolio, totaling UAH 150 billion.

Now for the comments: 

1. Capital “Shortage”:  As per its 3Q16 financials, Privatbank had some UAH 30 billion in capital and total assets of UAH 271 billion.   Given those amounts, calling a UAH 113 billion capital deficit— which is equivalent to 380% of equity or 42% of total assets—a “shortage” is like calling The Grand Canyon a “river valley”.  Or 2008 a “recession”.  Technically correct to be sure, but somehow the full picture is lost.
2. “Imprudent” lending policies:  When a bank needs to raise new capital equal to 380% of existing capital or equivalent to 42% of total assets, one doesn’t need a lot of financial analysis to figure out that lending standards left quite a lot to be desired.  The good folks at Bloomberg had a slightly different translation “ill-considered loan policy” which is an even better euphemism. 
3. “Related Party Loans”:  When related party loans are 97% of loans and 4 times the maximum limit set by The NBU, such behavior seems to rise to a level well above “imprudent” or “ill-considered”.  AA might apply descriptors such as “patently immoral” and perhaps even “criminal”.   That being said, AA is not familiar with the legal status of Ukrainian banking regulations.  It may be that they only rise to the level of “suggestions” sort of like the Pirates’ Code, which seems apt given the location.  On a positive note, lending to oneself has certain advantages in streamlining the underwriting process.

But at SAM we never fail to be “fair and balanced”. 

So let’s let Privatbank speak for itself.

As per its unaudited 3Q16 financials, Note 13 shows the bank’s related party exposure as minimal only UAH 8 billion down from about UAH17.8 billion at 31 December 2015.    

One note, there is no auditor’s review statement in the 3Q16 financials and so it’s impossible to know if they were reviewed (but not audited) and whether these are IFRS statements. I believe they are not.  

Privat’s IFRS AR for 2015 shows a higher figure for related party loans roughly twice the UAH 17.8 billion above (see note 31) but quite a long way from 97%.  PWC’s local firm did qualify its audit report but related to collateral seized on past due loans and the economic/security situation in the country. 

Beyond that Interfax Ukraine reported that

“Oleksandr Dubilet, who had headed PrivatBank (Dnipro) for a long time prior to the decision on its nationalization, has said the National Bank of Ukraine's (NBU) statement on 97% of insider loans in PrivatBank's portfolio of corporate loans is exaggerated.”

Also that

"At the same time, NBU First Deputy Chairman Yakiv Smoliy said the share of loans to related parties in PrivatBank exceeds 90%.  At the same time, he stressed this cannot be classified as withdrawal of funds from Ukraine."

What FDC Smoliy appears to be saying is that the related party lending scheme cannot be “classified” as a ruse to loot the bank and transfer the loan proceeds offshore.  This may be the biggest “euphemism” (one last attempt by AA to score a point) in the story. 

A side note on the dickering over percentages.  

Corporate loans comprise some 74% and 84% of total gross loans as of 3Q16 and 4Q15 so the key question is whether the percentage is of “total” loans or “corporate” loans and of course whether the percentage is being figured against net or gross loans. 

But when a bank is in this range, the exact figure is in some sense meaningless. 

What’s the practical difference between 75% and say 97%?   The bank is bust and its management and board have some explaining to do at the very least.

Khaleeji Commercial Bank Poor "Fit" with New GFH Financial Group Strategy

As promised in an earlier post, a more detailed look at KHCB.

Key Points of GFH’s 2014 Strategy

To set the stage, a recap of the key elements of GFHFG’s new strategic focus:

1.     “stable and recurring income, profitability and cashflow”—while they didn’t use the term “annuity business” that seems an appropriate characterization

2.     reduce its holdings in “land-based business” (real estate) from 50% to 40% in the midterm and to around 30% in the long term

3.     “ensure greater stability from global financial issues”  

For citations for above, see the 1 December posted linked to above.

In a series of posts to follow, I’ll explain in typical-AA excruciating detail why I think that KHCB is a poor fit with GFH’s new strategy.  Here’s a summary of my main conclusions:  

1.     Historically KHCB’s earnings have been highly volatile probably as a result of some of all of the following:  the nature of its business (long term fixed rate lending), underwriting standards, the limited size of its national market (note KHCB is only 3% or so of the Bahrain bank market by assets), possible earnings management catching up with management, etc.

2.     As a long-term fixed rate lender, KHCB is exposed to significant “profit (interest) rate risk” which threatens future earnings because KHCB’s long dated fixed rate portfolio offers less opportunities for repricing than say a shorter tenor portfolio like that of Qatar Islamic Bank. As well, if rising rates squeeze KHCB’s income, it may be forced to pay lower profit rates to depositors increasing the risk of depositor flight.  Both outcomes are particularly a threat because interest rates for the US dollar—to which the BHD is pegged—appear poised for more increases.  

3.     KHCB’s portfolio has weak credit quality metrics that suggest credit related problems will weigh on future earnings, e.g., consistent renegotiation of significant amounts of its portfolio; the sudden dramatic increase in 2015 in loans classified as “past due but not impaired”, particularly in the 90 day plus past due category; and declining loan loss provision coverage.

4.     Substantial indirect exposure to real estate—an interest rate sensitive asset class—through reliance on real estate collateral.  While direct real estate exposure may be under KHCB’s 40% limit for assets, the indirect exposure through collateral is at 55%.  To the extent that loans may have been made to marginal borrowers based on real estate, the indirect nature of this risk will become more proximate.

So with all these negatives why did KHCB become a key pillar of GFH’s new strategy?

AA thinks the answer is in GFH’s AR 2014 Report by Executive Management page 39. 

“During the year, our sale transaction for Khaleeji Commercial Bank (KHCB) fell through. However, with the revised strategy of evolving as a wider financial group, GFH is now looking to retain its investment in and grow the operations and businesses of KHCB.”

What this seems to say is that if the sale had gone through KHCB wouldn’t be a pillar.  Looks like a third party (the prospective buyer) played a critical role in developing GFH’s new strategy.  

Or in other words “If life gives you chickpeas, make hummus.”

Misleading Report about UAE Central Bank “Changes” to AML Regulations

Another cold Dubai December and to top it off AA's Biggles' hat was at the cleaners.

If you’re like AA, you might have been confused when you read WAM’s 14 December 2016  (Arabic version here) article or others in the media that the Central Bank of the UAE had amended three paragraphs in Circular 24/2000.

Without any explanation or context provided, a reader might conclude that the CB UAE has only recently moved to prohibit the opening of numbered or anonymous accounts or require fairly standard CDD on customers. 

If you read the article in Gulf News yesterday, that's certainly the impression you'd get from the article's subtitle:  "New rule strictly prohibits the opening of accounts with assumed names or numbers, among others".

If true, this would represent a serious shortcoming in the UAE’s AML/CFT efforts.

However, it’s not the case. 

The 2000 Circular already contained such requirements.  Article 4 in that Circular is quite unequivocal, e.g. "يمنع منعا باتا فتح حسابات ".  The English version is similarly strict.

So what’s going on?

The three articles are being amended to permit reliance on UAE national ID cards as proof of an individual's identity.  The 2000 Circular only permitted the use of passports. 

Someone at WAM or CBUAE missed the bus by not including this information.

AA did not. 

Ever since the fateful day pictured above, AA has been doubly careful or at least tried to be.