Are banks better off running electricity firms?

News of Fidelity Bank Plc taking over the boards of three electricity distribution companies (discos) should no longer be surprising. Yesterday’s story explained why the discos—including Fidelity’s Benin, Kano and Kaduna—couldn’t repay loans they acquired in 2013 to fund their privatisation.

This is just the latest in a string of disco takeovers. Before this news story broke, we had heard of UBA taking over Abuja’s disco in December last year and AMCON’s takeover of Ibadan disco earlier this year. As Noelle, Stears’ senior energy analyst, explained, the entire electricity value chain is plagued with various issues, but the most significant is the sector’s liquidity.
 

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From metering issues to energy theft, the sector's lack of funds makes it nearly impossible to fix these issues. Given that the discos are the collection agents of the industry, their poor financial performance affects the rest of the value chain, including the transmission company of Nigeria (TCN) and the generation companies (Gencos).

Despite various government and CBN interventions, these have not been enough to lift the sector out of the trenches. Some interventions include the ₦213 billion Nigerian Electricity Market Stabilization Facility (NEMSF), ₦600 billion tariff shortfall (subsidy) intervention and the recently disbursed ₦120 billion intervention designed for mass metering. 

From the banks’ perspectives, it would appear that the decision to take over the management of the discos comes just a few months after the end of the CBN’s restructuring allowance in March 2022. The CBN introduced the allowances in 2020 to cushion the negative impact of the Covid-19 pandemic. This allowed banks to restructure the terms of their loan agreements with clients and be more lenient in their classifications and loan provisions—which supported liquidity positions and improved the health of the banks.

For example, First Bank of Nigeria Holdings (FBNH) and Zenith bank restructured 14% and 18% of their total loan books in 2021, amounting to about ₦434 billion and ₦666 billion, respectively. FBNH also revealed that 92% of these restructured loans sit under stage 2 loan classification (underperforming loans) and the rest as stage 1. We’ll explain these terms in detail later on, but restructuring was essential to stop these stage 2 loans from deteriorating into bad loans, which means the borrower can no longer repay.

The restructuring helped banks reduce their non-performing loan (NPL) ratios, with FBNH posting a decline from 7.7% in its 2020 Financial Year (FY’20) to 6.1% in FY’21. Zenith’s NPL ratios also dropped 100bps to 4.2% in FY’21.

The timing is significant because the end of the restructuring allowance likely revealed a more realistic picture of the health of these loans in FY’22. Most of the power sector loans are also stage 2 loans, and the takeover could have been Fidelity bank acting proactively to prevent the disco loans from going bad.

This was confirmed by Samuel Obioha, the head of investor relations at Fidelity Bank Plc. He says, “The takeover action was timely to ensure the loans do not deteriorate”. It is not unusual that a bank would take over the management of loan defaulters. In fact, most banks will opt for this option (where applicable) rather than write-off loans. You see, loans are banks’ primary assets and a significant source of revenue. But, write-offs hinder future revenue regeneration (interest income) and eat directly into the banks’ profitability via higher impairment charges. 

For example, in 2017, Access bank Plc and some other Nigerian banks took over the management of the former telecommunication giant—Etisalat following its inability to restructure the repayment of the syndicated loan of c. $1.2billion. That same year, Skye bank Plc (now Polaris) also took over the Lagos Intercontinental Hotel from its owners Milan Industries Plc who couldn’t pay the interest and capital on loans of  c. $29.8million, and ₦3.8billion lent to build the hotel.

Notably, all these takeovers ended with the acquired businesses being sold to investors or the Asset Management Corporation of Nigeria (AMCON) and helped improve bank cash flows. This takeover by Fidelity is not different from these examples. Still, we won’t be Stears if we don’t try to contextualise the rationale behind Fidelity bank’s decision to take over the discos. To unpack this, we must first answer one question. 

What could have happened if they hadn't taken over?

According to a report by the CBN on Bank NPLs and profitability, the interest derived from loans contributes significantly to banks' interest income.  Loans contribute to about 85% of banks' total income, thus exposing banking businesses to credit risk.

Credit risk is associated with the possibility of a borrower’s failure to pay back a loan or meet up with scheduled payments. As such, when there’s a decline in interest income due to higher loan loss provisioning, it hampers overall profitability and what goes into the capital buffers of these banks. For shareholders, that could mean lower dividends and return on equity.

The same report spotlights that “historically, the incidence of banking sector failure, resulting from insolvency has often been associated with massive accumulation of non-performing loans.”

To unravel the potential impact on banks’ financials if these power sector loans had turned bad, we will examine the effect of the 2015-2016 recession on oil and gas loans as a proxy. 

2015/2016 Recession: A period banks can never forget

According to the World Bank, “between mid-2014 and early 2016, the global economy faced one of the largest oil price declines in modern history. The 70%  drop during that period was one of the three biggest declines since World War II and the longest lasting since the supply-driven collapse of 1986.”

As such, many oil and gas companies in Nigeria were quickly strapped for cash due to reduced revenues and FX illiquidity that plagued our import-dependent economy. Even worse, they couldn’t afford to meet up with contractual obligations.

For instance, in FY’15, Seplat recorded a 74% decline in profit after tax (PAT), as the oil & gas firm’s revenues dropped by 26% to $570million and interest payment on loans (finance costs) rose 70% to $83million. This was a common trend in the financial performance of most players across the oil & gas value chain.
 

In 2016, oil & gas loans represented 30% of total loans granted to the private sector.

A bulk of these loans quickly went bad, reflecting the contraction in economic activities. As depicted in the figure below, banks' asset quality deteriorated, represented by higher NPL ratios.

By the end of 2015, the CBN had ordered three commercial banks to recapitalise (raise additional capital). This came after they failed to hit the minimum capital adequacy rate of 10% before June 2016 or risk being liquidated (i.e the bank is shut down due to insolvency and its assets distributed to stakeholders).

In a previous article, I wrote about the importance of stress tests. They are a range of techniques used to assess a bank's vulnerability to significant changes in the macroeconomic environment or exceptional but plausible events, e.g. financial market crash or recession.

The CBN conducted a sector-wide stress test in 2016, showing that the banking industry could have taken a 20% default on these oil and gas loans with a reduction in the average Capital Adequacy Ratio (CAR) from the 14.8% baseline to 13.98%. However, a 50% default would have taken the industry CAR to 9.5%—below the prudential regulatory limit of 10%.

In simpler words, the test result showed that the banking sector, with a healthy CAR of 14.8% (above the prudential limit of 10%), could withstand the loan defaults of 20% of oil and gas loans disbursed by commercial banks. This meant that if commercial banks gave out ₦1 million in loans to the oil and gas sector, the banks could afford to let ₦200,000 go bad, as the industry’s CAR would have only fallen to 13.98%. However, if ₦500,000 (50%) of these oil and gas loans went bad, the industry CAR would fall to 9.5% (below the limit).
 

By June 2017, the banking industry baseline CAR had dipped to 11.51%. By December 2017, it had hit 10.23%, as most of these loans had gone bad (NPLs had risen to 14.8% in 2017 from 5.3% in 2015).  Consequently, banks suffered lower revenues and higher loan losses, which reflected the banking industry's fragile health at the time.
 

To rescue the banks from their dire straits, the CBN had to step in by allowing banks to write off fully reserved NPLs by the end of 2016 in a one-off policy change. Remember, the CBN has a prudential NPL ratio limit of 5%. Usually, when this target is breached, the apex bank can impose measures to boost capital (like it did with the three banks ordered to recapitalise referenced above) or even place restrictions on dividend payments.

This restructuring allowance was granted again in 2020 to help cushion the effect of the Covid-19 pandemic. These allowances have contributed significantly to the recovery in asset quality the banking sector has witnessed.

For instance, First Bank had NPLs as high as 23% of gross loans as of June 2017. Yet, thanks to the CBN’s support, First Bank’s NPLs decreased from 25.9% in 2018 to 9.9% in 2019. As of Q1’22, the bank’s NPL was 6%.
 

While we’ve just covered the extent to which an increase in NPLs can affect banks, the state of the Nigerian economy in 2022 isn’t that far off from 2016. Alarm bells are going off about a looming global recession, and banks must exercise caution to prevent a repeat of 2016’s events.  

Suppose the recessionary pressures persist for long enough. In that case, they will eventually trickle down into the Nigerian economy due to our import dependence. This would be terrible because we would see higher domestic inflation, further exchange rate devaluation and illiquidity, slower economic activities, etc.

Most importantly, these recessionary pressure points threaten other significant bank loan books sectors, including manufacturing, general commerce and power. The harsh effects of the 2015/2016 recession on the banks have made them cautious, which explains their proactive approach to dealing with the discos.

As the saying goes, once bitten, twice shy.

Let's bring it back home to Fidelity

A quick look through Fidelity’s FY’21 financials reveals that power sector loans currently contribute 8.6% of gross loans at ₦149.7billion (a relatively small number to inflict significant damage). Interestingly, the bulk (97.4%) of these power sector loans were classified as Stage 2 loans, i.e. “underperforming loans”.

Here’s what this means. According to the International Financial Reporting Standard (IFRS) 9 (a guide for banks to classify and measure assets and liabilities), loans are classified under three stages.

Once a loan is disbursed, a loan loss provisioning is created due to the possibility of default by the lender. All loans are initially classified as stage 1 loans and will continue to be so if the borrower meets payment obligations within 0 - 30 days of the payment date. Stage 1 loans are also known as “performing loans.”

Next up are stage 2 loans. Let’s assume the borrower has not been able to make payments within 31 - 60 days of the payment date. The bank will move these loans from stage 1 to stage 2, reflecting the higher credit risk associated with that loan. IFRS 9 dictates that provisions for loan losses be made on expected rather than incurred (actual) loan losses.

As such, provisioning increases, and a charge called a lifetime expected credit loss (ECL) is booked on the loans, making them even more expensive for the borrower. These loans are known as “underperforming loans''.

Finally, we have the stage 3 loans, also known as “bad loans”. Under this category, the borrower has either been unable to meet obligations within 61-90 days, or the 90 days grace period hasn’t even elapsed. Still, the bank believes it can no longer expect future loan payments. The credit risk on these loans is so high that they are now considered credit impaired which could affect the borrower’s ability to access loans in the future.

Unfortunately, most power sector loans are in the stage 2 category. This further supports the negative impact of the power sector’s challenges on the discos’ creditworthiness and their ability to pay back loans.
 

Another cursory look, this time at the disco’s financial statements as of 2020 (most recent), shows that Fidelity bank Plc guarantees ₦7.04 billion and ₦14 billion for Kano and Kaduna discos. Both favour the Nigerian Bulk Electricity Trading (NBET) and Transmission Company of Nigeria (TCN). Benin disco is in a similar position but had its guarantee split between Keystone and Fidelity banks.

This simply means that the banks stand in on behalf of these discos to guarantee the discos’ invoice payments to NBET and TCN. So when the discos default on invoice payments, Fidelity bank should step in to cover the bill.

Ideally, the discos would repay the banks within a few days. However, this has never happened because the power sector is far from ideal. But as the government moves to implement cost-reflective tariffs, NBET could start enforcing the guarantee that the discos cannot afford in their current state.

Further research into their books reveals that on the ₦7 billion guaranteed by Fidelity bank for Kano disco, the disco owes c.₦190 billion in payments to NBET. At the same time, the Kaduna disco also owes c. ₦206 billion to NBET, with an additional ₦1.7 billion owed to Fidelity bank in overdrafts.

This paints a rather grim picture of the financial health of these discos.

According to Mr Obioha—head of Investor Relations at Fidelity Bank Plc, the bank has currently made provisions for up to 10 - 15% of these loans. With the takeover, it would not need to make any more provisions. But, suppose the bank’s management did nothing and allowed these loans to transition to “stage 3”. Provisioning would have had to increase to 100% of the loans, and Fidelity Bank would have coughed up an additional ₦19.3 billion to cover the loan loss.

Let’s break it down. Kano and Kaduna discos owe ₦22.7billion (credit guarantees—₦ 7 billion and ₦14 billion plus ₦1.7 billion overdrafts). Fidelity bank made provisions for 15% of these loans, which equals ₦3.4 billion. To fully cover the loans, the bank would have to increase its provisionings by about ₦19.3billion (₦22.7billion minus ₦3.4billion). As I explained earlier, higher provisionings and loan write-offs are bad for the bank regarding its profitability and capital buffers.

That said, Fidelity bank’s NPL coverage ratio (provision for NPLs) and CAR at 2.9%, 147.8% and 20%, respectively, spotlights the bank management’s commitment to risk management.
 

With NPLs below the CBN’s prudential limit of 5%, Fidelity could afford to take on a little bit more bad debt. Two of the discos (Kano and Kaduna) make up just 15% and 1.3% of the power sector and total gross loans, respectively, signalling their inability to severely impact asset quality for the bank.

But as we say, it's better safe than sorry. This appears to be Fidelity’s creed as they don’t want to leave matters to chance, especially in a very precarious year like 2022.

Also, given how sensitive the energy sector (this refers to oil and gas plus power sectors) is to external shocks (like oil price crash and rising global energy costs), it's not so far-fetched that the bank’s management opted to keep asset quality under wraps. Energy loans currently contribute 34.7% of Fidelity’s loan book, and as we saw above, that amount of loans going bad can be detrimental to the bank.

Finally, the economy's slow growth translates into depressed margins for banks as they struggle to disburse loans to credit-worthy borrowers. With rising regulatory costs, higher inflation and cash reserve ratios (CRR), now more than ever, every penny counts. Fidelity’s management plan for the discos will be to optimise operations and get them in shape to be sold off to the highest bidder.