Historically, the banking sector’s performance has always had a driving force behind it. FY’20 - Reduced profits were driven by increased impairment provisioning following the pandemic-induced lending risk increase. FY’21- Reversal of impairment provisioning saw banks increase their profits. FY’22 – We expect the PAT to be driven by increased foreign exchange income following arbitrage opportunities created by the dollar shortage. FY’23 –We expect banking sector earnings to be driven by a combination of a return to lending following the approval of Risk-based Models, fees from lending, and foreign exchange trading income.

• Risk-Based Model to Boost Interest Income: In FY’23 and going forward, we expect interest income to rise as banks increase lending to the private sector using a risk-appropriate metric for determining the lending rates. We foresee upside potential for Net interest margins (NIMs) driven by higher lending and government securities yields. The prevailing high-interest environment has created expensive deposit mobilization costs as banks compete with other financial institutions.

• Forex Trading Income to Drive Non-Interest Income: In the last three financial years, the growth of nonfunded income has been muted as banks removed charges on transfers between mobile money wallets and bank accounts as a pandemic relief in 2020. In FY’22, non-interest income growth is likely to be buoyed by a jump in forex trading income following the dollar shortage in the interbank market creating arbitrage opportunities for banks. Across 2022, we have observed that the banks’ dollar offering price has been at between 5-8.00% premium from the official CBK quoted exchange rate. We expect this to persist to FY’23 given the continued depreciation of the shilling against other major currencies and as such it will continue being a key revenue source for banks.

• Sector Valuation is at a Discount to Frontier Peers: Compared to frontier peers (with the MSCI Emerging markets banks index at a P/B of 0.99x) the local banking counters ( with a median trailing P/B of 0.85x) are trading at a discount. However, individual counters such as ABSA, EQTY, Stanbic, and Stan Chart are trading above the MSCI EM Banks Index while counters such as I & M are almost at a 50.00% discount. The above P/B trend shows that Kenyan banks are fairly priced compared to their EM peers and provide an attractive investment opportunity.

• Time to Consider Dividend Play: We view the entire sector as attractive for dividend-hunting investors. We expect conservative payout ratios but expect the final DPS to increase driven by higher profits. Stan Chart continues to have the highest payout ratio (72.20%) and expected dividend yield (17.13%) while KCB has both the lowest payout ratio (18.80%) and expected dividend yield (5.23%) in the sector.

• Our Top Picks: Our top picks are EQTY (+27.30% upside), KCB (+26.88% upside), and NCBA (+20.16% upside), largely on account of huge upside potential and expected dividend. On a comparative basis, we also find these counters reasonably priced compared to the frontier and local industry peers. However, we also find Stan Chart (17.39% Div Yield), and Stanbic (10.48% Div Yield) as good dividend plays but have reservations about their current share price, which we do not find attractive entry points

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