Banking regulators in Africa generally strive to better protect depositors and maintain stability in the banking sector.
The Central Bank of Kenya (CBK), following in the footsteps of the Central Bank of West African States, the Central Bank of Nigeria and the Bank of Uganda, has through enactment of the Business Laws (Amendment) Act No 20 of 2024 on December 11, 2024, now require banks to gradually raise their core capital ten-fold to Sh10 billion by December 31, 2029.
Smaller banks are expected to action their capital planning strategies and raise additional capital to meet the regulatory thresholds. Raising additional capital can be quite challenging, especially when obtaining additional equity from the existing shareholders (Plan A).
The alternative, which would be third party equity (Plan B), may also not be very promising.
The Banking Act, CAP 488 (Banking Act), defines core capital as 'permanent shareholders' equity in the form of issued and fully paid-up shares of common stock, plus all disclosed reserves, less goodwill or any other intangible assets'.
On the face of it, core capital is ordinary shares. Equity is high risk capital, and some (if not most) third party investors may not be keen on taking such risk in a tough economy.
This means that if existing shareholders do not participate in plan A, banks will need to source for external capital.
If the outsiders do not want equity in its strict sense, capital raising may be a bit more nuanced and complex.
This is where a bank needs to lace up its creative boots and structure capital offerings that walk the fine line- enticing investors who are willing to participate in the business without stepping fully into the world of equity.
A closer look at the provisions of the CBK Prudential Guidelines (PGLs) as well as a study of market practice informs one that core capital does not have to be in form of ordinary shares only.
The PGLs expand on the definition under the Banking Act by including perpetual non-cumulative preference shares and, as part of the disclosed reserves, perpetual non-cumulative share premium, retained earnings and 50 percent un-audited after-tax profits, less investments in subsidiaries conducting banking business and investment in equity instruments of other institutions.
The PGLs, and knowledge from market practice, can guide a bank in negotiating for a capital raising structure that avoids the full risk of equity but delivers core capital for the bank.
In simpler terms, structuring the funding in a way that qualifies as core capital for the bank but mitigates the risks associated with equity would be a key objective for interested investors seeking such instruments.
It is expected that smaller banks that find it difficult to raise capital from existing shareholders or a public offering of their shares will consider mergers with the larger banks, who have strong balance sheets and are ambitious to increase their footprint.
These banks may however court the busy private equity market as an alternative to mergers with stronger banks.
Private equity firms, through their fund managers, are in the business of finding and funding promising businesses and ultimately exiting the business with a good return on their investments. In most cases however, private equity is not patient capital.
An investment horizon of about five to seven years is market practice; what this implies is that a private equity firm may not be attracted to an investment strictly in form of permanent shareholder's equity.
This calls for alternative structures of capital with an exit option. The banks may consider structuring the funding in form of, among others: subordinated term loans i.e. limited life debt instruments with an original maturity of at least five years and subordinated in right of repayment of principal and interest to all depositors and other creditors of the bank.
The banks can also consider redeemable preference shares that are redeemable only at the option of the bank for at least the first five to seven years, subject to conditions such as strong capital adequacy ratios and then redeemable after this period.
A bank must, beyond the usual terms and conditions provided for in definitive agreements for debt instruments, keenly consider what qualifies as core capital and practical exit mechanisms for the private equity investors that will not disqualify this character. Engagement with the CBK on the structure of the funding before the capitalisation is implemented, is recommended.
Apart from confirmation of what qualifies as core capital by the CBK, there are additional regulatory hurdles that must be crossed for the funding to be implemented. Acquisition of significant shareholding in a bank i.e. shareholding of five percent of the issued share capital triggers the CBK fit and proper tests and approvals for persons who manage or control a bank.
The CBK may also vet a shareholder who is not a significant shareholder if he/she can directly or indirectly control a bank. Control is defined as the ability to influence management of a bank or a corporate shareholder of a bank, or the decisions of the shareholders.
This means that the bank should consider the veto provisions it accedes to in the funding definitive agreement as they may confer control on an investor who is albeit below five percent shareholding.
If the bank is listed, or part of its business is fund management, trustee services and custody services for collective scheme investments, additional approvals and/or notification to the Capital Markets Authority, the Nairobi Securities Exchange and the Retirement Benefits Authority should be considered.
Where the bank is also involved in insurance business, an analysis of whether notification to the Insurance Regulatory Authority is triggered should be conducted.
The requirement for approval by the Competition Authority of Kenya (CAK) may also be triggered as banks raise their core capital. A merger may be achieved in various ways, beyond the ordinary acquisition of majority shareholding in a company. It is possible that an investor will acquire a minority stake but negotiate for certain consent rights which then, in competition law, lead to a change of control.
Capital management for banks has become a crucial function in an economy that is straining, and the regulator is keen on protecting depositors and strengthening the banking sector.
The banking personnel responsible for internal capital assessment and adequacy planning need to be creative, now more than ever, and structure funding options in a way that attracts investors who are keen on exiting at the end of a horizon while ensuring their capital still qualifies as core capital.
The bank must undertake a keen analysis of veto rights granted to such an investor for purposes of having sufficient oversight over their investment and seek legal counsel on the requirement for CAK approval.
A transaction is notifiable to the CAK if it results in a change of control and meets the prescribed financial thresholds. If the bank or the investor acquiring control operate in two or more member states of the Common Market for Eastern and Southern Africa (Comesa), requirement for approval by the Comesa Competition Commission should be assessed.
The writer is the Managing Partner and head of Corporate & Commercial, Banking, Finance & Projects and Competition Law practice areas at Cliffe Dekker Hofmeyr Inc. Kieti Law LLP, Kenya. Deborah Sese is a Senior Associate in the same practice
