2016 Zambia Banking Industry Survey: Adapt To Thrive - PwC

Survey Findings:the State of the IndustryTop issues affecting commercial banks inZambiaThe results of our banking survey show that there were fivemain issues affecting the Zambian banking industry duringthe year ended 31 December 2016.Managing costs was identified as the biggest challengefacing commercial banks in 2016, due largely to risinginflation and unexpected costs arising from the ongoingenergy shortages. In descending order, five of the six largest banks were mostconcerned about cyber security, managing costs, local GDPgrowth, managing credit risk and managing liquidity risk. This is in contrast with the industry-wide analysis wherecyber security is ranked fourth. On average, however,managing costs was consistently ranked towards thetop-end of the scale. Consequently, the top five issues have a relatively lowaverage ranking when assessed on a 10-point scale. Thisindicates that while most banks generally contend with thesame set of issues, their respective businesses are impactedin widely varying degrees.By way of illustration, when the survey responses of five ofthe six largest banks in the industry (by asset size) areanalysed, the top issues identified are largely consistent withthe industry-wide analysis, albeit in a different order ofsignificance. While the survey results generally indicate a commonappreciation for the type of issues affecting the industry,there appears to be less congruence around the issues ofmost significance. Managing credit risk was regarded as the second mostsignificant problem for banks, followed in third and fourthplace respectively by managing liquidity risk and managinginterest rate risk. Cyber security was the fifth mostsignificant challenge facing commercial banks in 2016.Survey respondents ranked issues affecting their business inorder of significance, with 10 being most significant and onebeing issues of least significance.Issues Managing liquidity risk3.6Managing credit risk3.66.4Managing costsLocal GDP growth5.4Cyber security6.6 2468Ranking (1 to 10)Average Ranking2016 Zambia Banking Industry Survey: Adapt to Thrive9

Total industry operating expenses have continuedon an upward trend, increasing by 11% to K4.67billion in 2016 (2015: K4.2 billion) on account of thegeneral rise in inflation.11%Managing costsThe most significant issue for banks in 2016 from ourrecently concluded survey was managing costs. Totalindustry operating expenses have continued on an upwardtrend, increasing by 11% to K4.67 billion in 2016 (2015: K4.2billion) on account of the general rise in inflation.The banking industry, and indeed the wider businesscommunity, also had to contend with cost pressuresstemming from the energy shortages experienced during theyear. These pressures manifested in the form of higherelectricity costs as a consequence of increased use ofgensets, which were deployed as a response to a moreintensive load-shedding regime.Consequently, the CIR has exhibited an upward trend,increasing by 2 percentage points from 69% in 2015 to 71%in 2016. With a CIR exceeding 70%, it is of little surprisethat managing costs is an issue of top priority forcommercial banks. As a result, a number of banks haveimplemented cost-rationalisation strategies with theultimate objective of bringing operating expenses withinacceptable levels.The increase in expenses outstrips annual inflation, whichwas recorded at 7.5%, indicating the presence of otherfactors, over and above inflation, that continue to exertpressure on costs.In our view, while the other top issues facing banks arelargely a reflection of the macro-economic environment, theconsistently high CIR is more indicative of systemicchallenges within the industry.Further analysis reveals that staff costs contribute thelargest portion of operating expenses, which we estimate atabout 40%. It is therefore arguable that any costoptimisation initiatives should involve a review of staffcosts.However, rationalising employee expenses without carefulconsideration for the impact on talent management, staffturnover and motivation could potentially have undesirableoutcomes in the short to medium term. Our view is that afocus should be placed on staff productivity with a view tocontaining costs, while at the same time driving revenuegrowth with the objective of reducing the cost-to-incomeratio to within sustainable levels.Automation of processes, rationalisation of branch networks,re-engineering of existing business processes andcentralised execution of essential manual processes areother measures that banks could adopt to manage costs.This, however, would require the investment of time and10PwCresources, including upgrading/replacing existingtechnologies, and retraining, upskilling and redeployingexisting staff.Credit riskThe second largest issue affecting banks in 2016 was creditrisk. When requested to identify three major causes ofnon-performing loans (NPLs) in the industry, 62% ofrespondents pointed to high interest rates and low economicgrowth. A further 38% said the delay in payment ofGovernment contractors was a major contributor to NPLs.Main causes of increased NPLsDelayed payment of Governmentcontractors38%High interest rates62%Low economic growth62%In 2015, Zambia faced economic headwinds resulting fromthe steep and sustained depreciation of the Kwacha coupledwith high levels of inflation.To counter these negative market forces, the BoZ adopted atight monetary policy stance by increasing the policy rate,the statutory reserve ratio (SRR) and Governmentborrowing with the objective of stabilising the Kwacha anddriving inflation to the target level of 7%. Consequently, theBoZ policy rate and the SRR increased from 12.5% to 18%,and 14% to 18% respectively during this time.During the same period, commercial bank average lendingrates increased by 50% from about 20% to 30%. Due to thepositive correlation between interest rates and credit risk,the significant increase in average lending rates has resultedin a rise in credit risk.The issue has been further compounded by the slowdown ineconomic growth in recent years, which has impactednegatively on borrowers’ ability to settle their obligations asand when they fall due. As a result, the industry haswitnessed an increase in NPLs with loan impairmentcharges and the NPL ratio increasing to K433 billion in 2016(2015: K295 billion) and 9.7% (2015:7.3%) respectively.

To manage their exposure to credit risk, banks increasedtheir investment in Government securities and exercisedcaution in extending credit to certain sectors, with oursurvey results indicating agriculture most affected. Otheradversely affected sectors included construction, real estateand unsecured lending.Main sectors that experienced reduced lendingPersonal31%SectorUnsecured38%Real Estate38%Construction38%Agriculture46%% of respondentsAlthough it might be considered understandable for banks toexercise more caution in extending credit to the agriculturalsector on account of the perceived high level of inherentcredit risk, reduced lending to this sector is at odds with theGovernment’s objective of diversifying the economy, and themodernisation and expansion of the agricultural sector.the policy rate to 14% and the SRR to 15.5%. While weexpect this was well-received by the industry, the issue ofwhether it delivers the desired outcomes can only beestablished in due course.Comparing policy rates across different economies would bemisleading, but we are of the view that performing a similaranalysis with respect to reserve requirements would providesome useful perspective.That being said, this has to be considered within banks’primary objective of protecting shareholder value. Thistherefore calls for specific Government interventionsdesigned to make credit to the agricultural sector moreaffordable and accessible.The third biggest issue facing commercial banks in 2016 wasliquidity risk. Since the adoption of a tight monetary policystance, liquidity in the market has been volatile, with anoverall downward trend.According to the BoZ fortnightly statistics, the averagemonthly market liquidity at the start of the year wasrecorded at K 711 billion, increasing to relatively high levelsof K 2,207 billion in March 2016 and declining to lows of K668 billion in July 2016. However, in December 2016 theaverage market liquidity was reported at K 2,714 billion – anindication of a shift in the BoZ’s liquidity tolerance.To address the issue of the affordability of liquidity in themarket, over 70% of the respondents to our survey – whichwas conducted before the BoZ monetary policy statement ofFebruary 2017 – proposed an easing of monetary policythrough a combination of a reduction in the BoZ policy rate,the SRR and Government borrowing.In their February 2017 monetary policy statement, the BoZsignalled a cautious easing of monetary policy by reducing Liquidity risk ! In our view, any proposals made with respect to themonetary policy stance adopted by the BoZ, whilereasonable in isolation, should be considered in the broadercontext of the BoZ’s objectives of maintaining price stabilityand safeguarding the stability of the financial system.Interestingly, despite commanding 75% of deposit marketshare (2015: 75%), five of the top six banks still rankedliquidity risk joint-fourth in the list of issues that impactedtheir businesses in 2016. This emphasises the pervasiveimpact of the tight monetary policy stance adopted by theBoZ.2016 Zambia Banking Industry Survey: Adapt to Thrive11

income on investments such asGovernment securities and moneymarkets.However, this optimism has beentapered by the increased credit risktypically inherent in a high interestrate environment. As mentionedearlier, several banks exercised cautionin executing lending decisions and, insome cases, froze lending to certainsectors altogether.Cyber securityThe fourth highest-ranked issue in oursurvey was cyber security. The riskposed to a bank’s systems, networksand data in cyberspace by its day-today operations continues to grow inprominence with the advent oftechnological advancements in servicedelivery as a source of operational andcost efficiency.Technology-led innovation bothglobally and locally has enabled thefinancial services sector to evolve,leading to dynamic connectivity andcollaboration extending to all facets ofbusiness. Cyber risks are expected tocontinue to increase due to thefollowing factors: Rapidly evolving, sophisticated, andcomplex technologies Increased use of mobile technologiesby customers Heightened information securitythreats from outside the countryCyber security has now become astrategic issue. Cyber security is nolonger something delegated to IT. It has12PwCbecome an enterprise risk to bemanaged and most organisations in thebanking sector are alive to this.When CEOs and boards evaluated theirmarket threats or competitors in thepast, few considered cyber threats.Today, the sheer volume andconcentration of data coupled witheasy global access throughout thebusiness ecosystem magnifies exposureto cyber-attacks. Therefore, it isanticipated that cyber securityinitiatives will be led by boards andexecutive management.The challenging liquidity environment,which was largely created by acombination of the tight monetarypolicy stance adopted by the BoZ andhigh levels of inflation, constrainedaccess to affordable deposits and meantthat banks resorted to accessing fundsthrough interbank lending andrelatively pricey fixed-term deposits.The increased demand for interbanklending pushed rates from about 15%in October 2015 to highs of 27% inMarch 2016, with a sharp declineexperienced in June 2016.Interbank lending rates have continuedto exhibit a downward trend, closingthe year at about 14%, in line with theBoZ policy rate.Lastly, the fifth most significant issueaffecting the Zambian bankingindustry in 2016 was managing interestrate risk.Due to the general rise in interest ratesduring 2016, the industry experiencedan increase in interest expense fromK1.91 billion to K2.62 billion, which ledto a significant decline in the netinterest margin from 65% to 60%.One of the manifestations of the tightliquidity environment has beendepressed interest rate margins. Thehigh interest rate regime experiencedin the industry over the last 18 monthshas provided banks with anopportunity to achieve revenue growthtargets through improved interestWhile the easing of the monetarypolicy stance will come as a welcomerelief to the industry, a moresustainable solution to managingpressure on net interest margins is themobilisation of affordable deposits andeffective execution of financialinclusion initiatives.Interest rate risk

The Road Ahead: Time toTransformAs part of our survey, PwC conducted anumber of interviews with bankingexecutives, including the DeputyGovernor of the BoZ, to gain a betterinsight into the challenges facing theindustry as well as the opportunitiesthese challenges present for the sector.The following is a summary of thefindings of these interviews.ChallengesFiscal disciplineThe Government’s ability to maintainfiscal discipline over the medium-termwill continue to have a significantimpact on the monetary policy adoptedby the BoZ. In this regard, theGovernment must meet its setbudgetary expenditure and revenuecollection targets, reduce borrowing,and dismantle the arrears owed to localsuppliers.Pronouncements by the Minister ofFinance on the need to controlGovernment expenditure should becoupled with real action to ensurefiscal targets are achieved and thepressure on domestic money marketsreduced. This is vital in establishingstable monetary policy. The BoZ faces adifficult task in maintaining thedelicate balance between ensuringfinancial market resilience andsoftening the statutory reserve ratio tofuel growth.Effects of the slowdown in theeconomyThe full effects of the slowdown in theeconomy are yet to be seen and it islikely we will witness continuedcrystalisation of NPLs in the sector aswell as the tapering back of growthstrategies on account of creditcontraction.The challenging economicenvironment has led to a number ofcredit facilities being restructured inan effort to enable borrowers to makegood on their loans. The question thatremains is whether the underlyingconditions have improved and we arenot merely seeing a delay in therecognition of impairments.The Government’s efforts to settle thearrears owed to local suppliers is apositive move. Unfortunately, the longdelay in the settlement of these debtsmeans that a lot of small Zambiancontractors have since been put out ofbusiness.The loss of collateral over the last yearfurther hampers their ability to accessthe credit needed to recover. We aretherefore likely to see a slow recoveryin locally-driven economic activity.Cyber securityAs technology continues to shape thedirection of the banking sector andhow it offers services to its customers,cyber security grows in prominence.With mobile technology being usedincreasingly to complement existingplatforms and facilitate innovation, thethreat to information security needs tobe considered carefully. Discussions oncyber security initiatives should be ledby boards and executive management,and form a core part of any growthstrategy discussions.Financial inclusionFinancial inclusion remains high on theagenda of the Government andregulator. Significant strides have beenmade towards increasing financialinclusion among the informal sectorwithin urban areas.The challenge facing the industry ishow to provide services to the‘excluded’ part of the population thatare typically located in rural areas withpoor social infrastructure. In thisregard, the call upon the Government2016 Zambia Banking Industry Survey: Adapt to Thrive13

to invest in social infrastructure, suchas improved internet access, reliableelectricity and education, remainsstrong.Market concentrationThe local banking sector is highlyconcentrated, with the top six banksaccounting for over 72% of total assetsand 75% of deposits.The ability of the larger banks to accesscheaper deposits and resourcessignificantly affects the operatingmodels of smaller banks in the market.A key question is whether the two-tiersystem remains ideal for the market,taking into consideration the noncompliance with minimum regulatorycapital requirements.OpportunitiesTechnology, the disruptorGrowth and innovation continues to betechnology-led and offers an importantalternative to the relatively costlytraditional channels of offeringbanking services.The needs of the new bankingcustomer are shifting away from thesetraditional channels, and investment intechnology infrastructure andresources will provide a critical edgefor any bank. The use of technologyoffers banks a very real opportunity torationalise their operating cost basewithout compromising service delivery.The disruptive effect of technology willdrive changes in bank operatingmodels as well as the face and natureof the competition. As an example,mobile technology supports the14PwCoffering of short-term cash advancesand money transfers, whichtraditionally would be the preserve ofbanking and micro-finance entities.The ability of a bank to identify andcapitalise on key technological trendswill be a vital factor in their futuresuccess.Regulatory consolidationThe financial services sector hascontinued to expand and a number ofentities now operate in multiple sectorssuch as banking, insurance and thecapital market.The regulatory environment is,however, still fragmented, with entitiesfinding themselves reporting tomultiple regulators. We understandthat the Pensions Insurance Authority,the BoZ, and the Securities andExchange Commission meetperiodically to discuss commonmatters affecting their sectors.This is a positive initiative which couldbe further enhanced by the regularreview of the consolidated exposurethat individual entities have across thefinancial services sector.Cost optimisationCost optimisation and rationalisationoffer banks a real opportunity to clawback some of the losses incurred as aresult of the increased cost of funds.These challenging times offermanagement teams a perfectopportunity to reassess their operatingstructure and resource base in order todetermine whether they remain fit andagile in the challenging world ofbanking.

ConclusionThe recent economic problems have presentedbanks with significant challenges. However, withthese challenges have come opportunities forlearning, adapting and innovation.It is generally believed that the economy is on thepath to recovery. With this in mind, this is theright time for the industry to take a critical lookthe efficiency of its operations.A key observation arising from the surveyfindings is the sub-optimal cost structure of thesector. Many risks arose during the period, but aconsistent message observed is that the coststructure of banks is not sustainable.Technology and innovation present banks withnot just a great opportunity to enhance theirproduct and service offerings, thereby drivingrevenue growth, b

the banking industry in Zambia. The 2016 Zambia Banking Industry Survey: Adapt to Thrive is the culmination of several months' interaction with leaders in the banking sector as well as research into the issues that have come to the fore in recent times. The banking sector has an important role to play in Zambia's economy.