Banks’ Net Interest Margins, lending spreads not affected by interest rates fluctuations – Coronation
Coronation Asset Management’s recent report on “Nigerian Banks, Resilience Built In”, shows that Nigerian banks’ earnings have been remarkably resilient over the interest rate cycle, their profitability is improving over time and their stock values are remarkably cheap compared to Ghanaian and Kenyan bank stocks. Ope Ani and Guy Czartoryski of Coronation Research, in this interview with Hope Moses-Ashike, give more insight into the findings of the report. Excerpt.
May we know briefly about Guy Czartoryski and Ope Ani and your experience in the Nigerian financial market?
Guy Czartoryski has covered the Nigerian financial markets since 2009 and have lived and worked in Nigeria since 2013, spending the past four years with Coronation Asset Management. Ope Ani has covered the Nigerian market since 2018 and has recently joined Coronation Asset Management from a highly successful career with Cordros Securities Limited.
Coronation Asset Management recently released its report on Nigerian Banks titled “Nigerian Banks, Resilience Built In”. How relevant is this report to Investors, banks and the economy at large?
From the investor’s point of view we wanted to see how banks would deal with the challenge of rising interest rates in 2021, so we conducted a ten-year study of their Net Interest Margins and lending spreads to see how they rode out previous changes in interest rates. This reassured us that the banks are likely to deal with interest rate changes in 2021 quite well. For the banks, the report is intended to stimulate questions about their interest rate management, growth and profitability. From the point of view of the economy, we are interested in the stability of banks as the key financial intermediaries, knowing that they took a knock in 2016 from oil-related lending and foreign exchange shocks, and before that in 2009. We believe the system has become much stronger in the intervening years.
In line with the CBN and the IMF, your report said banks are resilient – what are the drivers of this and what does it mean for the economy?
Our report looks at what makes banks’ earnings resilient over time. After all, Nigerian interest rates are more volatile than in many other markets, so one might expect Nigerian banks’ earnings to be volatile. But, for the most part, they are quite consistent. Our ten-year review of Net Interest Margins and lending spreads showed that these do not change rapidly from year to year, which is evidence of banks adapting successfully to changes in interest rates. At the same time, the average Net Interest Margins of banks are coming down slowly over time, but the profitability, or Return on Equity, is gradually improving. So, banks are able to play a key role as the key financial intermediaries in the economy, and themselves are fairly stable.
Could you please give more insight into why investors have little to fear when it comes to current fluctuations in interest rates?
Investors with their eyes on banks generally look for bank stocks generating strong returns on equity (RoE) and strong earnings. Interest rate fluctuations directly impact Net Interest Margins (NIM) and the lending spreads of these banks, which in turn impacts RoE and earnings. Looking at long-term historical trends, we have found that banks’ Net Interest Margins and leading spreads have not been adversely affected by fluctuations in interest rates. So, there is little reason to be concerned about banks maintaining their earnings as interest rates rise during 2021. This is the main finding of the report.
The report stated that banks are confident they can reprice deposits and loans advantageously this year – what is the implication of this on the customer?
In simple terms, customers who want to take out loans from banks or have existing loans with variable interest rates will be paying higher interest rates this year compared with last year. Customers who place their money in fixed deposits at banks will also receive higher interest rates on their deposits than last year. Things are getting slightly more difficult for borrowing customers and slightly better for depositors, though most customers are, to varying degrees, both borrowers and depositors.
From your findings, what is responsible for the improvement in Return on Average Equity (RoAE) and the Return on Average Assets (RoAA, or RoA) of the banks over 10 years?
Banks have made strong efforts in letting go of poorly-performing assets, deploying an efficient capital structure and optimising the mix of Tier-1 (equity) and Tier-2 (subordinated debt) capital. Additionally, diversifying their income (fees and commission, trading) and cost-optimisation have played a big part. On that last point, most banks have been successful at cutting costs through integration of back office functions and increased automation. In most of the banks we studied, the cost-to-income ratio has been improving steadily over the years.
You said financial institutions that depend on short-term funding in the marketplace and that have relied excessively on duration trades for their asset yields could be facing problems this year; what are your reasons?
Short-term borrowing costs for banks have risen sharply in the interbank market this year. Interbank borrowing costs were close to half a percent at the beginning of the year and are now around twelve per cent. Banks are also seeing falls in the values of their bond portfolio as interest rates rise. The higher the duration of these bonds/bond portfolios, the more the bond prices will drop as interest rates rise. We do not think that many banks are being caught out by this but, as in most periods of rapid interest changes, there could be banks that do not judge the situation well.
What actually is responsible for the recent rise in inter-bank rates, and what does it mean for the industry and economy?
There are a number of tools that the Central Bank of Nigeria (CBN) has at its disposal to control market interest rates. In our report, we focus on the Cash Reserve Requirement (CRR). The CBN has been controlling banking system liquidity this year by tightening the CRR. The inflection came last December when the CBN attached a small interest rate to its Special Bills, of half a percent. This signalled that it was putting floor under interest rates. Then, in early 2021, it flexed the CRR in such a way as to make liquidity just a little more scarce than it had been before. As we saw interbank rates, as well as Nigerian Treasury Bill rates, rise consistently from January through to June.
How would you assess the impact of the CBN’s Special Bills to banks at a rate of 0.5% pa. So far?
It is important to put this question in a bit of context. The Special Bills were issued because the Cash Reserve Requirement was imposing liquidity constraints on banks. To begin with, the Special Bills helped boost banks’ liquidity ratios. However, they put downward pressure on some banks’ Net Interest Margins as their interest-earning assets ballooned with the addition of the bills to their balance sheets, while they attracted an interest rate of just 0.5%. And then, the CBN’s actions last December were a prelude to enabling market interest rates to climb quite quickly in the first half of this year.
When you say banks are banks adapting to rapid changes in interest rates in 2021, are they changing their business model or what?
They are adapting by repricing loans, shortening the duration of investment securities, improving their funding mix, and expanding low-cost retail deposits amidst rising interest rates. We do not think of this as changing their business model so much as continuing to adapt to interest rate changes in the same way as they have done over the past ten years. If anything, they are getting better at it.
Is the Nigerian financial market beginning to see Investors coming back with the changes in interest rates?
The background here are the very low market interest rates that we saw in 2020, which were discouraging for savers with deposit accounts and for investors in Money Market Funds in Nigerian Treasury Bills. In 2021, we are seeing a lot more interest from investors in these products, which is encouraging, even though the interest rates fall some way short of inflation.
What other key information do you want to spotlight from the report?
It is a good time for investors to take another look at Nigerian banks, with stocks trading so cheaply compared with historical and peer valuations. The resilience in the profitability of Nigerian banks alone, amidst the challenging macros, is a great value proposition.