Khaleeji Commercial Bank – Dismal FY 2019 Results & Suggested Questions for Shareholders for the AGM

UPDATED FOR INFORMATION CONTAINED IN KHCB'S OGM/EGM ANNOUNCEMENT. 

Comments below in boldface red font.

Link to new post here.

Some quick comments on KHCB’s FYE 2019 financials.

Plus an additional section with suggested questions for shareholders for the AGM.

The bank reported a net loss of some BHD 15 million due to BHD 20.4 million in provisions for FY 2019.

But if you’ll look a bit closer you’ll see that actually provisions for troubled debt were really more than BHD 20.4 million. 

They were just called something else.

As often occurs with the adoption of new accounting standards financial institutions are allowed to make prior period adjustments.

That is, they do not have to include the amount of the total adjustments or provisions required in current year’s income, but only the current year's portion.

So they "pretend" that they made the adjustment in the previous financial year (hence the need to restate that year's numbers) and only have to book the "catch-up" since then in current year's income.

This is the case with AAOIFI’s FAS 30.

Sometimes there is an added benefit. The new standards do not require a formal restatement of the prior period financials.

What that means is they make the change in the prior year's financials but do not have to label that year as "restated".  

This is the case with FAS 30 as outlined in Paragraph 63.

This isn’t idiosyncratic behaviour on AAOIFI’s part. IAS and FASB do allow this on some of their new standards.

What this means is that you don’t see the word “restated” above the comparative numbers for FY 2018 in KHCB’s FY 2019 financials.

Why is that a potential problem?

The word "restated" alerts you to the fact that a material change has been made in the financials. 

When it's not there, you might overlook a significant development.

Usually prior period adjustments are not positive events, though sometimes they are.

That’s why you can’t just look at the Balance Sheet and Income Statement. You also need to look at the Cashflow Statement and the Changes in Equity Statement and read the notes.

Looking at the Statement of Changes in Consolidated Equity in KHCB’s FY 2019 report, you’ll notice a BHD 11.1 million prior period adjustment for FY 2018 associated with FAS 30.

What this means is that the provisions required were actually BHD 31.5 million.

Why care?

That is roughly 33% of shareholders’ equity.

As a result of these provisions, KHCB’s equity fell to BHD 85.7 million as of 31 December 2019.

As their auditor points out in Note 1, this is below the minimum capital of BHD 100 million required by the Central Bank of Bahrain.

Further in that note, you will “note” that

The Board of directors has mandated an international bank to assist it with issuing additional tier 1 capital (AT1) of BHD 37.7 million to help strengthen its equity and meet the regulatory requirements.

Suggested AGM Questions for Shareholders

In light of these developments some suggested questions for shareholders to raise at KHCB’s AGM.

Amount of New Capital

1. CAR remains a very acceptable 16.5%.
2. Why is KHCB raising BHD 37.7 million 2.5x its capital shortfall of BHD 15 million?
3. KHCB have announced they will seek EGM approval for up to a USD 200 million sukuk as new capital.
4. Why is KHDB now raising potentially 5x its BHD 5 million equity shortfall?
5. Does the Board or management anticipate the need for further provisions or the occurrence of other problems?
6. Is the CBB requiring that KHCB have more than the minimum BHD 100 million in shareholders’ equity? Admittedly a difficult question for the Board for a variety of reasons.
7. Is KHCB planning any acquisitions?
8. Have existing major shareholders advised whether they intend to participate in the new equity?
9. Hint: It’s not a good sign if they are not interested.

Form of New Capital and Impact on Shareholders

1. Is the AT1 Capital going to be in the form of preferred stock or a similar instruments, e.g. cocos?
2. KHCB will ask shareholders at the EGM to approve up to a USD 200 million Sukuk as the instrument.
3. That’s a more likely scenario than additional common equity because the potential direct dilution of existing shareholders would be significant unless they contributed additional equity.
4. Assuming the new equity is in the form of preferred stock or similar preferred instruments, what will be the impact on shareholders’ ability to receive dividends?
5. Usually these instruments have preference over common equity so payments to the new AT1 Capital will reduce the amount available for common dividends.
6. It’s likely that the new AT1 Capital will lead to a reduction in the market price of common stock given its size relative to existing equity, its likely pricing and privileges vis-a-vis common equity.
7. If on the other hand, it is going to be issued as common equity, what is the dilution impact on existing shareholders? 
8. It would appear to be rather large because of the amount required.
9. AT1 Capital of this size is not going to be cheap.

Alternatives – Treasury Shares?

If you’re like AA, you will have noticed the BHD 11.79 million in Treasury Shares and wondered if these were an alternative that would spare the existing shareholders some pain.

But note this is "efficient" only if KHCB has to raise BHD 15 million not BHD 37.1 million in new Tier 1 capital.

Treasury Shares are deducted from equity. Somehow removing these from the balance sheet would increase equity and thus reduce the amount of new capital required.

If KHCB could sell them at its cost (BHD 11.79 million), it could reduce its BHD 15 million capital deficit to roughly BHD 3 million.

Perhaps, the CBB could even be persuaded that the amount was so small that KHCB could be given the “grace” to cover it from profits over a couple of years.

That would obviate the need for new capital and prevent loss of value of the existing shareholders.

Alas, KHCB’s average cost per Treasury Share is BHD 0.1138.

If it could sell all its shares at market price – not a likely scenario given the size of the “block” and less than enthusiastic appetite for KHCB shares--, it would as a best case raise about BHD 5.4 million based on the closing price of its shares on 2 March  2020. 103.6 million Treasury Shares* BHD 0.052.

However, selling such a large block of shares would decrease the realized price. So the actual amount would be less.

The BHD 6.4 million “loss” on the best case sale (=103.6 million TS * (BHD 0.052-BHD 0.1138) would be a transfer of BHD 6.4 million from the Treasury Shares sub-account in equity to Retained Earnings in Equity.

So it would not affect the total for shareholders’ equity.

And thus not increase or decrease the amount of funds KHCB has to raise to “cover” the BHD 15 million shortfall. Only the cash received would decrease the amount needed to be raised.

Now, if KHCB were to cancel its Treasury Shares, it would recognize a loss of par value (BHD0.10) less average price (BHD0.1138) times 103.6 million shares or roughly BHD 1.5 million.  

That would mean that the BHD 15 million deficit would reduce to about BHD 5 million. The same logic for grace might apply, thus eliminating the need for any new capital.

The question would be the trade off.

Is the benefit to existing shareholders (quantified in BHD terms) of avoiding the issuance of new equity worth more than the cost of canceling the shares and wiping out forever the BHD 11.79 million spent on Treasury Shares.

One would probably want to analyze this in terms of various presumed "recovery" rates (selling prices) of the Treasury Stock. 

If, however, KHCB must raise BHD 37.1 million, then this method would be of limited utility.

As an aside, shareholders might want to ask their Board to remind them again of the compelling business logic of KHCB acquiring roughly 10% of its shares as Treasury Stock.

This may also be a topic that KHCB’s regulator should consider though sadly retroactively.

There’s not much that can be done about past purchases, but KHCB could be required to gradually decrease its holdings of Treasury Shares to a much lower level.

It may also be a 'wise" move for the CBB to ask all regulated entities with significant holdings of Treasury Shares to report to the CBB if the average cost of the holdings is materially different than the current market price.

Bahrain Middle East Bank FY 2019 Review and Suggested Shareholder Questions for the AGM

Lots of Tunnel Little Evidence of Light

A quick review of BMB’s FY 2019 financials provide no real reason for optimism.  

Based on that review, I’ve included some suggested questions for shareholders attending the upcoming AGM.

FY 2019 Performance Review

As might be expected given the problems BMB is facing, its business activities were adversely affected. For the year net income was a loss of USD 3.6 million.

Other information of note.

1. Non performing bank obligation: BMB identified a USD 13.1 million non performing obligation from a “locally incorporated” financial institution. I did not see an explicit reference to this in the FY 2018 report. 
2. Non performing Assets Under Management: As per Note 28 some USD 32.897 million of Assets Under Management as of FYE 2019 (91.5% of total AUM) are placed with related parties. These assets are non-performing. I missed this in the FY 2018 report which shows it pays to read all the notes.
3. Focus on recovery means little to no focus on income generation: The Board has identified recovery of related party exposures as its primary mission. The Central Bank of Bahrain has also placed restrictions on the bank’s activities. A sensible step given its financial condition.

Questions for the AGM

Shareholders will rightly be focused on the progress and prospects for recovery of related party exposure.

Below are some suggested additional questions.

Recapitalization

1. The long term future of BMB depends on getting new capital. Otherwise the bank will be liquidated. 
2. Liquidations generally result in less recovery than ongoing concerns. 
3. Recapitalization is key to a long term future for BMB.
4. As per BMB’s Articles of Association-which mirror the Bahrain Commercial Companies Law-, the minimum acceptable quorum for an Extraordinary General Meeting requires attendance by shareholders holding 25% of the bank’s shares.
5. Since ANI owns just under 81% of the bank, it appears that an EGM cannot be held without their active participation. That seems unlikely given the risks such participation would expose them to.
6. How, if at all, can a recapitalization take place if an EGM can’t be held?

USD 32.897 Million in Non Performing Assets Under Management

1. Are the assets non-performing because of underlying economics of the investments?
2. Or was there fraud?
3. Are the related parties the same entities as with the credit exposure, i.e., the Turkish Three Amigos?
4. Does the bank have any legal liability to make its customers whole? Note this particular question is likely to be one that the bank may prefer not to answer.

USD 13.1 Million Non Performing Bank Obligation

1. Is the bank unable to pay BMB?
2. Or is the bank unwilling to pay BMB perhaps because this is entwined with related party transactions?
3. The bank appears to be located in Bahrain. Is the Central Bank helping BMB with collection, assuming this is not a case of general insolvency of that bank.

If AA were to attend, you can bet he’d have questions about the single regional financial institution to which BMB owes some USD 127.6 million.

As per the financials (Note 2 and Note 12), it seems clear that that bank is constrained from removing its deposits from BMB.

AA would want to know why this is the case? And of course the identity.  Another question that the bank and its regulator may prefer to avoid.  

Link to earlier post here.

Por una Cabeza

Anti Money Laundering Some Inconvenient "Facts"

Not a Red Arrow in the Quiver

Last month Matthew Collin published a blog entitled “Angola and the money laundering paradox” in which he noted that the dos Santos case highlighted certain paradoxes about money laundering.

His key points were that contrary to what many believe a large volume of money laundering takes place in jurisdictions that score well on Transparency International’s Corruption Perceptions Index, have good ratings (mutual evaluations) on their anti money laundering regulations and system from the FATF or similar bodies, score high on transparency,, etc.

Be sure and read his article it is full of worthwhile insight and information.

None of this is surprising to those involved in international finance nor to those who follow money laundering.  

There are more inconvenient "truths" or at least observations about money laundering. 

As usual, AA is not shy about highlighting them.

First, the "developed and well-regulated" markets are where the bulk of large value money laundering takes place over all three stages of the process: placement, layering, and integration. 

As the chap in the picture above (Robin Hood or Robin Gud) will tell you, the best place for a “hood” to hide out is where there are lots of trees.

It’s much easier to get lost among the trillions of dollars of daily transactions in the major "developed and well-regulated" markets.

These are places that you’d like to hold financial or other assets (properly disguised of course) for a variety of reasons:  greater liquidity, potential for appreciation, systems that protect your rights from arbitrary actions.

Those with assets to sell or banking services to provide in those markets are keenly interested in maximizing sale proceeds or service revenues. And perhaps not of the sort to get overly "fussed" about the source of funds.

A booming property market and vibrant stock market are every government's dream.

This is no secret. There are reliable official estimates of money laundering that cut through imaginary "halos", including those of their own jurisdictions. 

Here are two examples.

Each year the US Department of State publishes the International Narcotics Control Strategy Report pursuant to a statutory requirement. Usually in late March covering the prior year. The INCSR is based on input from various US governmental agencies.

As you'd expect with any national source, it is not free from political considerations. 

Within Volume II of the INSCR is a list of “Major Money Laundering Jurisdictions”. 

You’ll find the list of such countries for 2018 in the INCSR 2019 Volume II pages 14 -15. 

Tucked in among the usual suspects of Afghanistan, Uzbekistan, the UAE, you’ll find the United Kingdom, the United States, etc. 

In past years, the DoS would rank countries as being of “primary concern”, “concern”, and “other countries monitored.”

In the “primary concern” list, the United States, the UK and several European countries were routinely included.  

Here’s an archived version from the 2017 INSCR. 

The UK’s National Crime Agency notes that “Although there are no exact figures there is a realistic possibility that the scale of money laundering impacting the UK annually is in the hundreds of billions of pounds.” 

If you think about a country like Angola, any serious money laundering through the financial system there would be noticeable because of the lower volume of transactions. Not enough trees. In some cases countries only have “bushes". 

Here's an example of how "lack of trees" can aid in identifying unusual, perhaps even suspicious transactions.

Back in 2016 SWIFTs August RMB Tracker noted further imaginary progress in the development of the RMB as an "international currency" citing a spike in RMB transactions in "South Africa".

A fairly cursory examination of publicly available material disclosed that the spike wasn't only in transactions for South African customers.

More importantly that analysis disclosed the spike was primarily due to a single RMB 2.7 billion transaction in Mauritius.

Second, fines give a fairly good idea of where money laundering is taking place and how serious it is.

By amount the bulk of money laundering fines are levied by regulators in the USA and Europe on banks operating within their jurisdictions. The size of these fines indicates the volume and seriousness of the infractions.

According to AccountancyDaily, there were 58 AML penalties worldwide in 2019 totaling USD 8.14 billion nearly double the amount of the 29 penalties in 2018.

US regulators were the most active with 25 penalties totaling USD 2.3 billion, the UK with 12 penalties totaling USD 388 million.

(Fines like the UK's aren’t going to do much to combat money laundering. They’re unlikely to silence the laughter in board rooms.) 

France took the record that year for the largest penalty USD 5.1 billion levied against UBS who are appealing the fine. 

In terms of money laundering and sanctions violations penalties (the latter a particular preserve of the USA) there have been some USD 36 billion since the 2008 financial crisis according to a recent report by Ferengo who publish this data annually. 

Again the countries whose banks were “tagged” with the fines come from “developed and well-regulated” markets. You won’t find Angola or Iran among them.

Third, despite apparent precision attempts to quantify money laundering, corruption, and other illicit activity results in crude estimates at best and often in semi-educated guesses. Sometimes they measure less than we think they do.

Here are some examples from previous posts.

1. The generally accepted quantum of annual money laundering. Or the 2 to 5% solution.  
2. Difficulties in modelling illicit financial flows.    

Sometimes they don't model everything we think they do.

For example, Transparency International’s Corruptions Perceptions Index is based on perceptions.  There are no public statistics on corrupt transactions, except those arising from legal cases.

More importantly TI considers only governmental corruption as clearly outlined on TI's website.

A fuller discussion here. 

The latest TI CPI rated Denmark as the least corrupt country in the world tied with New Zealand.  In 2018 Denmark stood atop the CPI alone.

Yet, Den Danske Bank’s branch in Estonia was involved in a Euro 200 billion money laundering scandal over more than a few years.

According to reports, the Central Bank of Russia informed both Danish and Estonian regulators in 2007 and 2013 that Danske's Estonian branch was being used for money laundering.

It would appear that warning was not acted upon, presuming that these reports are correct.  

Denmark and several other TI highly rated countries are victims in a multi billion euro tax fraud based on “dividend stripping” or a “cum/ex” operation. Denmark Euro 2 billion, Germany 5 billion. 

Major European banks colluded with clients to implement the scheme. Not one Angolan bank in the mix.

So, if you’re relying on TI to frame your money laundering risk profiles, think again. It's only a partial source and has its own limitations. 

Most money laundering takes place through private sector not public sector banks. And be aware that other rankings of financial crimes risk use the CPI as input. 

Fourth, assessments (mutual evaluation reviews) of anti-money laundering regulations and systems miss key factors.

Much of these are based on whether there are laws on the books that cover the key elements in a good AML regime (based on FATF recommendations) and how strict they are.

Geography plays in important role in this process because "zip code" is used to risk exposures.

MENA countries are likely to be scrutinized more for terrorist finance than Latin American ones. Deficiencies found in MENA will be treated as more serious than those in Latin America.

Checking the robustness of legal regimes is certainly important. 

But, if laws are robust but ignored, they are of little use.  If they provide less than perfect solutions as all legal systems do, then reliance on them should be tempered by this knowledge.   

The same with individual financial institutions procedures for enforcing the national AML regime.

Fifth, compliance with AML regulations involves a lot of "box ticking".

Financial institutions are required to perform two key AML tasks:  (a) conduct CDD (customer due diligence) prior to accepting a customer and (b) monitor a customer's transactions and conduct of its relationship to detect suspicious activity. The bank should investigate suspicious activity and where warranted file a report with its financial regulator.

CDD consists of "proving" a customer's identity, financial condition, etc. and assessing whether the potential customer is not engaged in illegal or terrorist activity. 

This involves obtaining various documents depending on whether the potential customer is a legal entity or a natural person, e.g. passports, commercial registrations, financial statements, etc. 

As a general rule, one can say that individuals and businesses that need their money laundered have rather high gross margins. Thus, they have ample budgets to pay intermediary fees and make facilitating payments.

They have the money to pay for the creation of documents to comply with AML requirements and to set up complex structures to hide realities. 

Here it's important to note banks are not required to “verify” documents but can accept them on their face as valid unless the documents are clearly forgeries or inconsistent. This is similar to their obligations regarding the authenticity of documents presented under letters of credit. 

That makes sense.

Unless it’s a rank amateur forgery how will a bank in Country A, verify your Country B passport?  Or your financial statement?  Or a letter from a lawyer confirming you inherited USD 100 million from your Uncle Abdullah?

Money launders are also able to hire “name” professional advisors and intermediaries. 

The sort of “names” that would add a “halo” to the client.

"If XYZ is dealing with Ms. X, she must be “clean” because they are an international firm and must have done proper 'due diligence'.

Most national AML laws and regulations are based upon the recommendation of the FATF an international body that develops AML standards. FATF Recommendation 17 allows a national regulator to permit its banks to rely on a third party to perform some of the key steps in CDD or customer vetting.  

This can also be a convenient excuse for a bank not to look too closely for fear of finding out something it doesn't want to know or aggravating a potentially lucrative customer.. 

What's hopefully clear from all of this is that there is a great deal of "box ticking" in the CDD process. 

As an internationally mobile individual, I have had to open accounts in a variety of foreign jurisdictions.

In most cases I have been called on to sign a letter that states I won’t use the account for illegal purposes or to fund terrorist activities.

I also have been asked to self-report my income and net worth. Provide proof of my address, e.g., a letter addressed to that address, a utility bill, a driver's license, etc.

But not in every case!

And that's not just overseas, in one case when I lived overseas and wanted to open an account with one of the largest banks in the USA, my Social Security number, a deposit, and a smile were all I needed to open an account.  I wasn't asked to "show" my passport or driver's license! 

Luckily for the banks I deal with, I’m an honest person. But not every client is.

This concept of self-certifying oneself as “not a crook” is an interesting one.

Once while opening an account with a foreign bank, I asked its representative if he thought that a person who wanted to use an account for illegal purposes or terrorism would have his or her conscience troubled by lying in such a letter. 

His retort was “If you don’t sign the letter, no account”. 

Letter signed, box ticked, financial integrity protected, we moved on.

To be fair, how would a bank determine if a potential customer were a terrorist or criminal?

Are banks smarter than law enforcement and certain organs of state security?

Do banks have access to information that these official bodies do not?

Bank financial performance seems to suggest that as a group they are less "smart" and have less access to information about their clients than is commonly imagined. 

Once a customer is accepted then the bank must monitor the account relationship for transactions that don't seem to be compatible with the information provided on financial capacity or contain money laundering patterns. The FATF publishes a list of these, if you're interested.

In general this is "easier" than the CDD step.  A lot of this can be automated fairly simply primarily where the account is being used for many transactions.  

However,if the account is being used for a one off or infrequent transactions, this becomes a harder task.  

Six, The phrase "pecunia non olet" explains why money laundering occurs.

In fact the more you have the sweeter the smell, particularly when fees for advising and handling that money are based on amount.

Ms. dos Santos was clearly a “PEP” (politically exposed person). 

Standard practice AML procedures would require that she be subject to enhanced due diligence at the inception of a relationship and thereafter by ongoing enhanced monitoring by banks, professional service providers, and intermediaries.

She must have had quite a convincing story about how she legally accumulated her wealth and then kept on legally accumulating more. 

Plus a trove of very credible looking documents.

Or maybe it was the “sweet smell” of success?

Or the fear that too intrusive an approach would take her to finding another bank, advisor or professional service provider? 

The rich are different than you or me.  Not only do they have more money than we do.  But their bankers are more deferential.  

Perhaps, a even more compelling story is that of Rabobank NA, the US subsidiary bank of Rabobank in the Netherlands.

According to the US Department of Justice, two of the bank's rural branches in California--Tecate and Calexico cities right on the border with Mexico--had a "lot" of US dollar deposits.

So much that the bank had to send at least one armoured car per week to collect the cash. Depositors then typically wired or otherwise transferred the money out of the accounts shortly after making the deposits.

Now one (at least AA) would think that large cash deposits well beyond economic activity in the area--at least legitimate activity--might be a "red" flag of potential money laundering, warranting at least an investigation.

The immediate transfers would typically also be considered a "suspicious" transaction.

Well Rabo did investigate and apparently decided it was.

So they did what any "responsible" financial institution might do.

They devised a "verified customer scheme" to facilitate continued acceptance of the deposits in an ultimately unsuccessful attempt to hide the transactions from USA authorities. A seemingly high risk strategy.  What were they thinking?.