How will rising costs impact bank profits in H2' 2022?

Last week, I examined how key factors like the recovery from covid-19, the Russia-Ukraine war, rising inflation and interest rates, and domestic regulatory policies have impacted the banking sector’s earnings in the first half of 2022. 

I explained that the higher interest rate environment, loan book growth, and increased mobile banking service adoption supported bank earnings.

These factors were enough to cushion the impact of the higher interest payments made by banks to their customers. As such, they translated into profit after tax (PAT), growing by an average of 18% y/y in H1’22. The highest increases were recorded in FBNH (49%), Stanbic (36%) and Fidelity (21%).

Despite this double-digit growth in the first half of the year, I warned that higher contractionary monetary policies (i.e. higher interest rates) and higher inflation were risks to banks’ earnings in the year's second half.

Higher interest rates are a double-edged sword in that while banks could earn more interest payments from loans and investments, they also see higher expenses on interest paid to depositors for saving with them. Higher interest rates could also hamper a borrower’s ability to repay its loans as the loans become more expensive, thus impacting banks’ earnings.

In true testament to the glum outlook for Nigerian banks, a global credit rating agency—Moody’s, announced the likely decision to downgrade the credit ratings of nine Nigerian banks. This was due to the negative impact of persistent foreign exchange (FX) scarcity and naira depreciation. Moody explained that these factors would impact banks’ ability to meet financial obligations denominated in FX and their customers’ ability to fulfil their foreign currency obligations to the banks. Both spell trouble for banks in terms of reduced capital buffers and higher non-performing loans (NPLs), thus the possible downgrade in credit ratings.

So to finish up the review of Nigerian banks’ performance in H1’22, I will examine the impact of inflation and regulation on banks’ costs and asset quality and why they pose such a risk to the industry’s earnings going forward. 

We shall begin with costs. 

Inflation and regulatory pressures weigh on costs

In a previous article, I explained how different regulations like the monthly cash reserve ratio (CRR) debits, Asset Management Company of Nigeria (AMCON) levy and Nigeria Deposit Insurance Corporation (NDIC) premium are regulatory charges banks must pay.

However,  these charges keep growing yearly as they are calculated as a percentage of either loans or deposits. I.e. the higher your loans and deposits, the more regulatory charges you pay as a bank. For instance, First Bank posted a 71% y/y rise in regulatory costs to ₦52.5 billion in H1’22 (versus ₦30.7 billion in H1’21), as deposits and loans rose 7.8% and 17.3% y/y, respectively. 

So when you throw in rising inflation (20.77% as of September versus 15.6% in January 2022) to this cocktail of rising regulatory charges, banks continue to face cost pressures, which negatively impact profitability.

This manifested in the 135bps y/y rise in average cost-to-income (CIR) for these banks to 61.9% in H1’22 versus 60.5% in H1’21. In simple words, CIR is a measure of efficiency that shows the banks’ expenses as a percentage of their revenues.
 

As we can see from the chart above, CIR rose across most banks, reflecting the impact of rising operating expenses outpacing income growth. Take Fidelity bank, for instance, with a CIR of 70%—it means that for every ₦100 the bank makes in revenues, it spends ₦70 to service its costs (like salaries, auditor fees, regulatory charges etc.).

Despite recording the steepest deterioration in H1’22, GTCO still has the lowest CIR (49%). Meanwhile, Stanbic’s improvement in CIR (from 70% in H1’21 to 60% in H1’22) was due to a faster rise in income (up 44% y/y) than costs (up 23%).
 

Together, these costs comprised 25 - 50% of the banking sector’s operating expenses (OPEX) in H1’22, spotlighting their weighty burden on banks’ profitability.

Another interesting trend across the banking sector was the rise in the effective tax rate (percentage of income banks paid as taxes to the FG). This was due to higher tax expenses following the expiration of tax exemption on investment securities.

In January 2022, the Companies Income Tax Exemption Order 2011, which decreed tax exemption on fixed-income instruments, expired (except for FG bonds). So, banks started paying tax on income earned on these instruments, accounting for 7 - 19% of banks’ assets in 2021.
 

The rise in effective tax rates translated into higher taxes paid (as seen above) and, in turn, lower profits. In GTCO specifically, the 88% y/y jump in the bank’s tax expenses from ₦13.6 billion in H1’22 to ₦25.7 billion in H1’22, was enough to eat into its profits, contributing to the 2% y/y decline in PAT to ₦77.6 billion in H1’22 (versus ₦79.4 billion in H1’21).

In summary, banks bore higher operating expenses in the year's first half due to high inflation, higher regulatory charges and effective tax rates.

Next, we look at asset quality. Asset quality simply looks at the quality of loans in banks’ balance sheets. This is particularly important for banks as loans are banks’ biggest assets and an important source of income for banks. 

Asset quality remains stable

The average non-performing loans (NPL) ratio declined marginally by 41bps y/y to 4.04% in H1’22 as the economy sustained its recovery momentum (GDP growth at 3.3% in H1’22 versus 3.4% in FY’21).

A borrower’s ability to pay back on loans is largely impacted by the broader macroeconomic performance, as a stable and growing economy allows for steady cash flow, enabling borrowers to meet debt obligations.

The decline in NPL ratio among the top banks under our coverage correlates with data from CBN, which states that the total banking industry NPLs stood at 5% in June 2022 (versus 5.7% in June 2021). 

The most impressive improvements in NPL ratios were recorded in FBNH (5.4% in H1’22 versus 7.2% in H1’21) and Stanbic (down 60bps y/y to 2.62%). However, some deterioration was seen in GTCO (up 14bps y/y  to 6.18%) and Zenith (up 20bps y/y to 4.4%).

The major driver of the improved NPL ratio was the 10% average loan book growth in 2022. The NPL ratio is calculated as a percentage of total bad loans divided by gross loans. Therefore, a faster rise in gross loans (than bad loans) will improve the NPL ratio. 

As we can see from the chart above, when we compare loan book growth and NPL ratio trend, we see that banks with higher loan book growth witnessed better improvements in asset quality. Take First Bank, for instance, with a 17% boost in loans, saw a 180bps y/y reduction in NPL ratio to 5.4% (versus 7.2% in H1’21).

As 2022 gradually wraps up, banks will have to be more cautious with loan book growth to avoid deterioration in asset quality. This is due to more risks in the Nigerian economy---elections (political risks), a potential naira devaluation (exchange rate risks), and low economic growth due to contractionary monetary policies.

Another cause for concern is concentration risk. Banks, on average, have almost 30% of loans in the upstream oil and gas sector. And as we know, oil theft and bunkering (oil production down 38% YtD to 0.94 million barrels per day as of September 2022) has plagued the sector.

Oil and gas loans turned bad in the wake of the global oil crash in 2016. This led to the CBN ordering the immediate recapitalisation (raising additional capital) of banks after they failed to hit the minimum capital adequacy rate of 10% before June 2016. The alternative was to liquidate (i.e. the bank is shut down due to insolvency and its assets distributed to stakeholders).

However, banking sector health indicators like capital adequacy ratio (CAR)—i.e. banks’ emergency reserves and liquidity ratio (liquid assets banks can easily convert to cash to settle short-term financial obligations) help boost optimism. Total banking sector CAR and liquidity ratio stood at 13.4% and 40%, respectively, in August 2022; well above their respective minimum requirements of 10%  and 30%, respectively.

This view is also supported by FitchRatings, which started in July 2022 that Nigerian banks could absorb up to $6 billion of credit losses without breaching minimum regulatory requirements for CAR.
 

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, combined with higher tax expenses. 

Lastly, asset quality remained positive due to the rise in loans, although some risks (e.g. political and exchange rates) persist.

So what should we expect in H2’22?

Higher costs and lower profits

Given the three monetary policy rate hikes (to 15.5%) by the CBN in the second half of the year, the outlook is that interest rates would continue to rise in H2’22 and even into 2023. This should support banks’ earnings, which will come under even more pressure in the year's second half.

On the flip side, higher interest rates could discourage lending, as it becomes more expensive for Nigerians and businesses to take on these loans, thus limiting loan book growth and revenues.

Furthermore, net interest margins (NIMs)—the spread banks make on interest income after paying interest expenses, are set to decline due to higher interest payments made on customer deposits. In a bid to mop up excess naira liquidity, the CBN increased the savings rate on deposits with commercial banks from 10% of MPR to 30% (i.e. savings rate was increased from 1.3% in May 2022 to 4.65% in September 2022. This means more returns for depositors and higher interest expenses.

Overall, the effect of the increase in interest rates might prove negative to the sector’s revenues. As stated in the prequel to this article, 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. Relying on this source of funds would help mitigate paying higher expenses. 

Similarly, I noted that the increase in cash reserve ratio (CRR) from 27.5% to 32.5% in September 2022 is negative for banks’ revenues. The effective CRR for most banks was already higher than the previously stated 27.5%. For instance, the CBN kept 37% of Stanbic’s deposits as CRR last year instead of 27.5%. Therefore, a CRR hike can prove harmful to profitability and capital buffers.

That said, recent diversification efforts by Nigerian banks, as seen with the evolution of top banks into “Holding Companies”, a.k.a Holdcos and other mergers and acquisitions (M&As), should be positive for earnings. The Holdco structure has enabled top banks to acquire other non-bank financial institutions (NBFIs) in and outside Nigeria. Some notable M&As in the industry include Access Bank’s acquisition of First Guarantee Pension PFA, GTCO’s acquisition of the pension and asset management businesses from Investment One Financial Services, Titan Trust’s acquisition of Union Bank etc.

These M&A activities alongside other Holdco verticals—Payco, Lendco and Insureco—should help unlock the other sources of revenues for Nigerian banks, given the backdrop of weak macro fundamentals, lower margins, competition from fintechs for deposits, punitive CRR debits and incessant regulatory constraints.

Interestingly, Zenith is the only bank among its “FUGAZ” peers that is yet to unveil its plans to evolve into a Holdco. 

Moreover, banks will continue to face increased costs as operating expenses rise due to high inflation, regulatory charges and higher taxes.

Asset quality might deteriorate given the negative impact of a volatile naira on banks’ customers and their ability to pay back on foreign currency (FCY) loans. According to Moody’s, FCY loans make up about 40% of loans extended by top Nigerian banks to their customers. Again, remember what happened to the banking sector when 30% of the loans went bad.

Deterioration in asset quality means higher impairment charges (a reduction in the value of an asset) and higher provisioning (money set aside to cover bad loans). Both of these also bode negatively for banks’ profitability and capital buffers.

From all that’s been said, it's clear that 2022 is a very difficult year for a Nigerian bank. Revenue growth in H2’22 is set to decline and erode some of the gains recorded in H1’22. As such, I believe that average PAT growth will taper down to single-digit growth, i.e. less than 10% in H2’22 (versus 18% in H1’22).