Why banks must recapitalize

The Central Bank of Nigeria (CBN) had firmly admitted that the financial soundness indicator of the banking sector has been resilient, due to some of its policies like the Loan to Deposit Ratio (LDR).

This was confirmed by the International Monetary Fund (IMF) on Monday in its Article Iv where it stated that banks entered the crisis with adequate capital buffers and profitability, which they are now tapping into.

However, banks are not rest on their owls but maintain stability by raising their capital buffers to contain stability risks from the COVID-19 economic fallout.

Nigerian banks’ Earnings Per Share (EPS) for Full Year 2021 (FY2021) is expected to decline by 21.1% Year-on-Year (Y-O-Y) and the average Return On Equity (ROE) drop by 580bps Y-o-Y to 13.7% in a base case scenario of 55% probability, according to EFG Hermes, an Egyptian financial services company.

EPS is the portion of a company’s profit that is allocated to every individual share of the stock. ROE simply means measure of financial performance calculated by dividing net income by shareholders’ equity.

One the reasons for the expected decline. was due to a 60bps Y-o-Y reduction in Net interest margin (NIM) to 3.8%. NIM is a measurement comparing the net interest income a bank generates from loans and mortgages, with the interest it pays holders of savings accounts and certificates of deposit (CDs).

The industry’s Non-Performing Loans (NPL) ratio has remained stable at 6 percent (above 5% Prudential ratio), albeit with noticeable variations across sectors. Impaired loans, which include stage 2 loans under the International Financial Reporting Standard (IFRS) 9, account for 24 percent of total loans with banks engaging in forward-looking provisioning in line with IFRS 9. Overall, capital adequacy ratios (CAR) have remained resilient so far, although a few large banks are close to the required minimum and high profitability has come under pressure since the onset of the pandemic. Spillovers from difficulties at foreign subsidiaries are noticeable in individual banks, in some cases requiring support measures, including recapitalization, according to IMF.

Nigeria’s banking system may likely face risks of worsening adverse macro-financial linkages with respect to the corporate sector. The pre-pandemic fundamentals of large Nigerian firms showed a steady deterioration between 2014 and 2019, with decreasing revenue-to-asset and pre-tax income-to-asset ratios. Corporate leverage relative to income also worsened, putting the debt of a third of the large firms at sustainability risks.6 The COVID-19 shock is likely to aggravate these fragilities, particularly considering that relief is currently being sought for 40 percent of loans through CBN’s forbearance measures and a surge in NPLs was experienced following the 2014-15 oil price shock. Beyond credit risk, banks are experiencing some disintermediation as large firms increasingly turn to direct market financing, taking advantage of pension funds’ search for yield in the low interest rate environment.

The Washington based Fund sees banks facing significant foreign exchange (FX) and solvency risks. Although banks are long in overall FX exposure, FX risks arise from a relatively limited short-term net FX liquidity position and lending to borrowers with incomplete currency hedges, which have prompted some banks to convert FX exposures into naira lately.
Moreover, recent CBN’s stress tests show that the system’s CAR would drop below the required minimum of 10 percent should 25 percent of the loan portfolio that is still unrestructured become non-performing. The CBN currently does not conduct liquidity or FX stress tests.

IMF stressed that continued vigilance and corrective actions are needed to prevent an increase in stability risks. The CBN’s framework for granting forbearance, requiring debt relief measures to be time-bound and limited to clients in good standing, is appropriate, and non-compliance with restructured terms should trigger proper reclassification. To contain stability risks, staff recommended to (i) closely monitor exposures to vulnerable clients, e.g. independent oil and gas producers, and safeguard timely loan loss recognition; (ii) strictly limit FX lending to clients who are fully hedged by FX cash flows; and (iii) strictly enforce FX open position limits for all banks, requiring banks to observe a minimum FX liquidity ratio, and conduct FX stress tests.

Progress with regulatory reforms and asset recovery has been mixed during the pandemic. Work on the implementation of the Basel III reform package and macroprudential instruments has not progressed much. Given rising systemic risks, staff discussed considerations for additional instruments, including measures for capital conservation and countercyclical buffers, and a debt (service)-to-income ratio. Asset recovery by the public asset management company (AMCON) has improved slightly, but on current trends will likely be incomplete by the scheduled sunset date of end-2023.

The mission welcomed progress in reaching financial inclusion objectives and recommended further measures. Notable progress has been made in narrowing gender and regional gaps in access to financial services, including through fostering financial literacy, agency banking and use of fintech technology. The CBN has started approving the new license of payment system bank to support electronic and mobile banking services. Further progress could be made by fully implementing the cashless strategy by augmenting access points and by approving the pending applications of large telecommunications operators already serving a significant share of the financially excluded population.

IMF Staff recommended strengthening the CBN’s operational framework, saying a safeguards assessment is currently in progress in connection with the RFI approved in April 2020. The analysis of the CBN Law reconfirmed the need to modernize the legal framework by enshrining price stability as the CBN’s primary objective, strengthening central bank autonomy and governance, limiting credit to the government, and phasing out of quasi-fiscal operations. There is also scope for improving the CBN’s financial reporting for closer alignment with international best practices and strengthening internal controls based on external auditor observations.

Nigerian authorities viewed the banking sector to be resilient to the current crisis and regulations to be adequate. They acknowledged elevated credit risks as evidenced by the stress test results but also pointed to mitigating factors, notably the loan forbearance measures and standing regulations to rein in NPLs. They felt that the current capital regulation requiring an additional five-percentage point buffer for international banks was sufficient at the current juncture, lessening the need for introducing the Basel III capital buffers.

They took note of staff’s recommendation to develop selected macroprudential instruments and tighten regulations to limit FX risks for future consideration. They also noted that the recent amendment to the Banks and Other Financial Institutions Act will promote financial stability by empowering the CBN and the deposit insurance corporation (NDIC) to establish a bank resolution fund.