Profitability of the banking industry in Ghana
The banking industry in Ghana is very essential to the country’s economic development. The industry is one of the most competitive and profitable in the country. The banking industry’s profitability in Ghana emanates from income in the form of interests as well as fees and commissions generated in the performance of its role as a financial intermediary. The Ghanaian banking sector recorded over GH¢5.10billion in profit for the 2021 financial year. These incomes of banks are generated using assets owned. However, not all assets of banks generate interest income. The assets of banks that generate interest income are referred to as ‘Earning Assets’. These assets include interest-bearing cash, interest-bearing investment securities, interest- bearing loans and other interest-bearing financial assets.
Financial securities investments in the banking industry
Based on the published financials of banks in Ghana for the 2020 and 2021 financial years, total assets in the banking industry stood at GH¢152.73billion and GH¢177.52billion respectively. Total assets comprised GH113.36billion earning assets and GH¢39.37billion non-earning assets per the 2020 published financials. The 2021 published financials of banks showed that earning assets stood at GH¢133.64billion while non-earning assets totalled GH¢43.88billion. Financial securities constituted a major part of the banks’ earning assets in the years 2020 and 2021. The years 2020 and 2021 saw financial securities contributing GH¢71.31billion (62.9%) and GH¢87.30billion (65.3%) respectively to earning assets. This clearly showed that financial securities are very essential when it comes to profitability of the banking industry in Ghana. Therefore, it is imperative to evaluate the impact of interest rate changes on banks.
Categories of financial securities in banks
Financial securities of banks are categorised into short-term and long-term securities. However, for the purpose of financial and regulatory reporting they are classified into trading and non-trading investment securities. The class of investment security assigned to any security depends on the purpose for which it was purchased. This decision is normally taken at the point of purchasing the security. The classes of investment securities and the purpose for purchasing them are shown in Figure 1 below.
Figure 1: Classification of Banks’ Investment Securities
NB: HTS and HTCS are also referred to as Held for Trading and Available for Trading, respectively.
Impact of Interest rate on banks’ investment securities
Generally, the value of any investment security is the present value of expected future cash-flow to be derived from the security. Mathematically, this is given as:
Where P is the price of the investment security,
CF is the expected future cash-flow,
r is the yield on the investment or the expected return on the investment (i.e., interest rate)
i is the time the expected future cash-flow will be received.
Based on the above expression, interest rate or expected return is inversely related to the price or value of the investment security. This implies that as the interest rate or expected return increases, the value of an investment security reduces.
The practical explanation to the mathematical expression above is that if interest rates rise, new investment securities are issued at a higher expected return than existing investment securities. Investors (banks) with the existing securities will thus want to sell their investment securities with lower return and buy the new investment security with the higher return. For the investors (banks) to sell their existing investment securities, they must reduce the price to make it competitive compared to the newly issued investment securities with higher returns. The resulting effect is that the price of existing securities will fall.
It follows from the above explanation that the value of banks’ investment securities is expected to reduce based on an increase in interest rates (expected return). In 2022, the country began with a monetary policy rate of 14.5% and as at October it had peaked to 24.5% (a 1000 basis point increase). This accounts for the increase in expected return on most financial assets, including investment securities.
The effect of a reduction in value of banks’ investment securities is not accounted for in the same way for all classes of investment securities. It is important to note that the reduction in value applies only to securities that investors (banks) purchased without the intention of holding to maturity. It can be inferred that only Hold to Sell and Hold to Collect and Sell securities are impacted by the rise in interest rates or expected return as far as accounting is concerned. This is because since Hold to Sell and Hold to Collect and Sell investments can be sold by banks at any point in time, their book values must reflect the prevailing market values. The comparison made between book values and market values to determine the gain or loss made is properly accounted for using IFRS 13. This standard relates to fair value accounting, which is often called ‘marked to market accounting’.
Accounting for Impact of Interest rate on Banks’ Investment Securities (Marked to Market)
The accounting treatment for investment security under marked to market is different for Hold to Sell and Hold to Collect and Sell investments. The effect of interest rate changes on Hold to Sell investment securities is accounted for through the Profit and Loss (P&L) Statement, whereas the same interest rate changes on Hold to Collect and Sell investment securities are accounted for through the Statement of Other Comprehensive Income (OCI). The accounting entries for losses made due to interest rate increases are shown in Table 1 below.
Table 1: Accounting for marked to market losses on investment securities
|Hold to Sell||Dr||Profit and Loss Account|
|Cr||Hold to Sell Investment Securities|
|Hold to Collect and Sell||Dr||Other Comprehensive Income|
|Cr||Hold to Collect and Sell Investment Securities|
From the published financial statements of banks as at December 2021, GH¢13.78billion out of the GH¢87.30billion financial securities were jointly classified as Hold to Sell and Hold to Collect and Sell securities. This implies that a significant number of banks are likely to record marked to market losses in their respective 2022 financials. As such, these banks will take the necessary steps to further reduce the volume of securities held under these classes of investments. Banks that were able to properly forecast and sold off these classes of securities before the interest rate rises are likely to record higher income on the trading investment line of the Profit and Loss Statement coupled with a significant drop in trading investment assets.
Outlook on investment securities
The fall in price of investment securities also present opportunities for banks and individuals with excess liquidity to buy the cheap securities and hold them to maturity. This is because although prices are falling on the market, the securities will still pay coupons when due as well as the face value upon maturity ceteris paribus.
Going into the year 2023, most banks will be careful about the volume of securities they keep under Hold to Sell and Hold to Collect and Sell categories, bearing in mind any future increases in interest rates. This is to help them avoid taking marked to market losses that will adversely impact on profitability or other comprehensive income.
NB: Industry figures exclude Universal Merchant Bank, OmniBsic Bank and National Investment Bank (Their figures were not available).
The author is an MPhil Finance graduate of the University of Ghana Business School and a member of the Institute of Chartered Accountants, Ghana.