How have top banks performed in 2022?

2022! What a year it's been. Following the covid-19 vaccine rollout and a gradual oil price rebound in late 2021, the expectation was for 2022 to kickstart global economic growth. But, along came the Russia-Ukraine war, which led to high inflation and higher interest rates as central banks worldwide aimed to curtail rapid price increases.

Such shocks make economic sectors vulnerable, especially the banking industry, which provides an essential function of mobilising funds from those that need to stash their money away (savers) to those that don’t have enough to execute their plans (borrowers). 

In my Stears debut article, I examined the banking industry based on their Q1 2022 financial reports to see if the banking industry at that time could withstand shocks from another global recession. I highlighted the impact of high inflation, rising interest rates and exchange rate devaluation on banks’ financials, concluding that despite these downside risks, the Nigerian banking sector has what it takes to survive another recession. Still, after analysing different banking sector metrics such as return on equity (the return shareholders get for investing), Non-performing loans (bad loans), etc., it was clear that banks were in difficult times. The verdict was that banking management must be intentional about being cost-effective to cushion the impact of shocks.

However, more events in reaction to the global economic climate have unfolded after April and affected the financial performance of the banking sector. So, following the release of banks’ 2022 first half (Q1 + Q2) financial reports, it’s worth reviewing how they have weathered the storm so far.

Before we begin, it's important to quickly update you on the macroeconomic environment and some policies affecting banks. 

What has impacted banks in 2022?

As mentioned earlier, higher inflation has caused global central banks to increase interest rates. The US Fed (America’s version of our CBN) announced its 5th rate hike this year by 75bps to 3.25% in September.

Nigeria hasn’t been left out. With August 2022 inflation numbers coming in at 20%, the CBN shifted from an expansionary monetary stance (low-interest rates) to a contractionary stance (higher interest rates).
 

At the monetary policy committee meeting in September 2022, the CBN stated that it was concerned about the rapid rise in inflation and decided to increase rates, aka monetary policy rates (MPR), for the third time this year, to 15.5% from 11.5% in May 2022, to tame inflation. 
 

Now, higher interest rates impact banks because, at their core, a bank’s business is to receive customer deposits and disburse loans. I’ll explain.

The MPR represents the benchmark interest rate against all other interest rates (mortgages, loans or the returns on investment securities). Therefore, an increase in MPR means these other rates will naturally rise and translate into a higher “price” for the loans they give out, which is good for banks.

But, higher interest rates could also discourage people from borrowing. And, more importantly, make it difficult for existing borrowers to repay their debt. This situation is especially true when you remember that these higher interest rates are coming when economic growth is fragile. A slow-growing economy will hinder businesses' expansion, limit cash flows and impede their ability to pay back interest or the principal on loans.

On the other hand, customers save with banks which pay interest on deposited funds. So higher interest rates also translate to higher expenses (paid as interest on savings) for these banks and could limit banks’ revenues.

While I acknowledge other factors like inflation (rise in prices of goods and services) and the expiration of the 2011 Companies Income Tax Exemption Order in January 2022, which affect costs and, in turn, profitability, this article will focus on analysing the impact of macroeconomic indicators on banks’ revenues in H1’22. 

Before we go on, it's important to note that even though the CBN announced the first rate hike in June 2022 (end of H1), there had been a gradual shift in the CBN’s stance from expansionary to contractionary monetary policies before the announcements. The CBN, which raises debt on behalf of the Federal Government, had slowly increased rates on these instruments to attract investors and mop up excess naira liquidity in H1’22. Therefore this shift still impacted banks’ earning ability, as evident in the increase in yields across Nigeria’s yield curve (charts that show interest rate changes).

As we can see from the chart above, interest rates across different fixed-income instruments increased between March and June 2022, enough to impact banks’ revenues during that period.

So we will review banks’ earnings and profits in H1’22 to see how these factors have played out. For our analysis, we will focus on the systemically important banks (“too big to fail”) in Nigeria, popularly known as “FUGAZ,” i.e. First Bank, UBA, GTCO, Access Holdings (formerly Access bank) and Zenith, including two tier II banks—Fidelity & Stanbic. Collectively, these banks control about 80% of total assets in the banking industry.

So let's dive in. How did banks react to these shocks?
 

Impressive topline growth supports bottom-line performance

On average, profit after tax (PAT) grew by 18% y/y in H1’22 due to increases recorded at FBNH (49%), Stanbic (36%) and Fidelity (21%), which offset the 2% decline in GTCO.
 

The main factors responsible for the rise in PAT across board were the 28% and 21% y/y average increases in net and non-interest income, respectively.

We shall take the bank's income lines individually and analyse the factors contributing to the increases recorded. Firstly, net interest income. 

Net interest income

Net interest income is the difference between the interest earned (from loans) and paid out (on savings) by banks. This definition shows banks should typically earn higher interest income when they give out more loans. So if bank A earned ₦1 million on all the loans it gave out in the first half of this year and paid  ₦600,000 as interest to its customers for saving with them in the same period, the difference—₦400,000 in this case—is the net interest income. Intuitively, banks have a higher chance of increasing their net interest income in a higher interest rate regime when they give out more loans. And in the first half of the year, Nigeria’s top banks really increased the loans they gave out. Banks’ loan book grew by an average of 9.7% y/y in H1’22, owing largely to the FBNH, Stanbic, Fidelity and Access banks (see chart below). 

So when you combine higher interest rates on current loans plus more loans being given out at higher interest rates, these translate to higher interest income.

The increases in interest income were enough to cushion the rise in interest expenses, which also increased due to higher interest rates and increased deposits (more on this soon).
 

Also reflective of the improvement in net interest income was the average rise in net interest margin (NIM) from 5.27% in H1’22 to 5.54% in H2’22. Net interest margin is the spread banks make on interest income after paying interest expenses. So, as banks gave out more loans at higher interest rates and invested in higher-yielding investment securities, the margins (i.e. NIM) they made also increased (see below). 

To be clear, interest expenses did increase due to higher interest rates. We see this in the rise in the cost of funds (CoF) to 2.2% in H1’22 versus 1.9% in H1’21 (see below). 

CoF represents the interest rate banks pay on funds such as deposits, which they use as loans. However, it is important to note that banks earned more interest income than their incurred interest expenses in the year's first half. Next, we take a look at non-interest income. 

Non-interest income

Non-interest income represents revenues from non-banking operations. These include income derived from transaction charges, fees and commissions and even some FX devaluation gains derived from holding some foreign currency assets.

Except for the FX evaluation gains, deposit growth largely influences non-interest income. Think of it this way, as more people open accounts with a bank and utilise their banking platforms, USSD codes, ATM cards etc., the more charges banks earn. 

As you can see, these have nothing to do with the core banking operations (i.e. disbursing loans) and are not susceptible to movements in interest rates.

That said, non-interest income grew by 22% y/y on average due to increased adoption of mobile and internet banking services and the rise in customer deposits (see below). 

As we can see from the chart above, most banks have seen increased deposit growth complemented by a rise in non-interest income. The only exceptions are FBNH (flat y/y) and Fidelity. The decline for Fidelity is linked to the 118% (₦10 billion) drop in net FX gains to a loss of ₦1.5 billion in H1’22 from ₦8.4 billion in H1’21.

In summary, we have seen how bank earnings have performed in H1’22 and the various contributors to performance. However, it's important to note the limiting effect of regulation on banks’ profits.
 

CRR limits earnings potential 

The cash reserve ratio (CRR) represents the percentage of a bank’s deposits that they must keep with the CBN. The CBN uses this ratio to mop up the money supply in the system, as banks must keep this fraction of money in the CBN's vaults instead of loaning it out. 

However, the issue is that the effective CRR for banks has been higher than the regulatory requirement of 27.5% (as of June 2022).
 

As we can see from the above, most banks had effective CRRs above 27.5%. For example, Stanbic had 37.5% of its deposits sitting idle with the CBN and not earning any interest for the bank.

The idle cash balances with the CBN represent an opportunity cost in terms of lost interest for these banks and could have helped banks post better profits.

So far, we have noted some key trends across the banking sector in H1’22. Profits were majorly driven by higher net interest income (due to higher interest rates and more loans) and non-interest income (driven by a rise in deposits). However, banks battled with increased cost pressures due to higher inflation and regulatory charges.

But what should we expect in H2’22?

Margins under pressure

As I noted above, most of the policies affecting the banking sector were announced in H2’22 and would be more pronounced in their results for the second half of the year. On the back of that, I expect banks to experience some depression in profit growth.

The latest increase in CRR to 32.5% from 27.5% means fewer funds to give out as loans and would also weaken profitability. So the CBN's recent CRR decision will likely prove harmful to profitability and capital buffers.

In conclusion, banks that will prove resilient to this storm must be intentional about being cost-effective to cushion the impact of shocks. Banks will have to rely on the cheapest sources of funds, i.e. the ratio between a bank's current account savings accounts (CASA), to take advantage of the higher interest rates and to avoid paying higher interest expenses. As we see from the chart above, banks with higher CASA generally have lower cost of funds (CoF), which should provide some respite for banks’ performances in the year's second half.