What is the impact of CBN charges on banks' profits?

There’s no denying that regulation remains crucial to the smooth running of any economy and a country’s general economic well-being. 

However, when weighed on a scale, how good or bad do regulatory decisions have on Nigerian banks?
 

You may have heard of some regulatory decisions like the monthly Cash Reserve Ratio (CRR) debits, Asset Management Company of Nigeria (AMCON) levy, and Nigeria Deposit Insurance Corporation (NDIC) premium. Each of these decisions is a rule (or charge) for banks operating in Nigeria.

As the primary regulator, the Central Bank of Nigeria (CBN) justifies these charges as necessary to ensure financial stability. But we can no longer ignore their impact due to their increasing pressures on banks’ bottom line.

So in this data story, I will use 11 charts to examine the impact of these regulations and discuss how justifiable they are.
 

Clickity-clank, clickity-clank…into the CBN’s piggy bank

First, a little context. Every two months, the CBN’s monetary policy committee (basically the economic decision-makers) meet to review economic and financial conditions in the economy.

This committee determines the appropriate policy stance in the short to medium term, reviews the CBN’s monetary policy framework regularly, and uses tools like the CRR to adopt changes when necessary.

While reviewing the economic and financial conditions of the economy and the banking system, they look at inflation and the supply of money in circulation (amongst other macroeconomic indicators like GDP, capital flow, exchange rate etc.). This is where the CRR comes in.

Economics 101 tells us that increased money supply is a recipe for higher inflation. So when the MPC decides to raise the CRR (a percentage of a bank’s deposits that each must keep with the central bank), the idea is to limit the amount of money available for banks to give out as loans to people.

Say, during the MPC meeting, the committee found that there was too much liquidity (money) in the economy chasing a fewer amount of goods. For example, the total amount of money in the economy (₦120,000) was 20% greater than the worth of goods available or being produced (₦100,000), leading to greater demand than supply, i.e. too much money chasing fewer goods.

The MPC could decide to raise the CRR, thus limiting the funds available to banks to be given out as loans to people to purchase these goods and, by extension, reduce inflationary pressures.

In essence, central banks use it to control the supply of money in circulation. So this ratio tends to go up in eras of high inflation.

So it only made sense when the CBN raised our CRR by 500 basis points in January 2020 to 27.5% to curb the double-digit inflation that has plagued us for quite some time, right?

While that is true, the CRR in Nigeria has also become a punitive tool the CBN uses when commercial banks fail to meet its 65% loan-to-deposit mandate imposed in 2019.

I will explain. Remember when the CBN mandated commercial banks to give out ₦65 for every ₦100 deposited in the bank as loans to the public? The CBN passed this directive (LDR) back in 2019 as it sought to stimulate economic growth.

Every month, the CBN reviews the LDR position of each bank and punishes any bank that has not met its 65% mandate. The punishment? The CBN debits banks 50% of the shortfall remaining to meet its target.

Consequently, when considering the total cash reserves deposited with the CBN, most banks’ CRR is much higher than the 27.5% ratio stipulated by the MPC.

As the debits into the CBN’s coffers keep increasing due to the increased ratio and banks keep ramping up customer deposits, the most important thing to note here is that these deposits that now reside with the CBN earn ZERO interests.

Naturally, this adds another level of pressure on banks’ interest margins (I explained this in my first story) and, by extension, profitability. Now throw in the lower interest rate environment as yields on fixed-income securities fell in 2020 and 2021 and have remained subdued. Talk about a double whammy! 

How justifiable are CRR debits?

The only positive thing attributable to these debits is that loans to the private sector at ₦24.4 trillion have gone up 41.8% from 2019 to 2021, as banks try to achieve the 65% LDR mandate.
 

However, this point is muted because some banks are willing to fall short of the mandate rather than give out loans to a struggling economy. This is because the financial impact of these loans potentially going bad hurts way more than the effect of earning zero interest on these deposits.

Again, as I explained in the story cited earlier, banks typically have to create provisioning for loans. If these loans go bad, they are forced to net them off from their retained earnings and capital buffers, further exacerbating profit erosion.

Furthermore, since CRR aims to control money supply, it would have made sense for the CBN to ease its stance during the Covid-19 pandemic, as other economies did, to support their economies during the recession. However, inverse was the case, as the CBN increased our CRR by 500bps to 27.5%.

So naturally, banks experienced tighter liquidity positions and depressed margins following the hike in CRR. But again came the CBN, introducing “Special Bills”, to avail the banking system with sufficient liquidity.

Special bills are short-dated (90 days tenor) tradable securities introduced by the CBN in December 2020 to securitise banks' excess Cash Reserve Requirement balances and help improve their liquidity positions. The interest rate on these bills is 0.5%.
 

And while we saw the banking system's effective CRR drop following the introduction of the bills, its impact on margins has been muted given its low-interest rate. Similarly, banks do not tend to trade these instruments as much because of the little room for margins gained while trading.

Moreover, remember earlier when I mentioned the MPC increased our CRR to 27.5% in order to mop up excess liquidity? Let's look at how effective that has been, using total CRR debits with the CBN and money supply (M2).

For non-economists, M2 is simply a broad money supply indicator that takes into account all cash, current account & savings account deposits, money market placements and other easily convertible near money.

So M2 has been increasing despite the continuous CRR debits, essentially increasing inflationary pressures, but why?
 

Taking a deeper dive into the CBN’s financials, we see that the CBN has been debiting these banks just to credit the Federal Government. This credit facility is called Ways & Means Advance.

It is a loan facility provided by the CBN to the Federal Government to help bridge budget shortfalls to a maximum of 5.0% of the previous year’s actual collected revenue (as stated in the CBN’s Monetary, Credit, Foreign Trade, and Exchange Policy set of guidelines and CBN’s Act of 2007).

Notably, the CBN has been thwarting its own rules, by printing money at will to fund the FG, surpassing its maximum borrowing allowance.

In 2021, the CBN lent the FG a whopping sum of ₦4.3 trillion, which was way over the sum of ₦3.4 trillion the FG earned in 2020.

In summary, the CBN’s aim of mopping up liquidity via CRR debits is offset by the CBN's excessive borrowings to the federal government.

As I mentioned at the beginning of this article, CRR is just one of the charges banks have to endure under the umbrella of “regulation”. Let's look at the other charges which directly eat into banks’ income. They are the AMCON levies and NDIC premiums.
 

Asset Management Corporation of Nigeria (AMCON) Levies:

One of my favourite quotes from the Dark Knight Trilogy is from Harvey Dent (Two Face) and it goes “You either die a hero or you live long enough to see yourself become the villain”.  This is exactly what has happened to AMCON.

AMCON was established in 2010 to buy the Non-Performing Loans (NPLs) of Nigerian banks to stabilise the banking system. The rising bad loans and the need to save the banking industry from imminent collapse prompted the federal government to set up AMCON in 2010 with a 10-year mandate.

The corporation is currently funded by charging 0.5% of total banks’ assets including off-balance-sheet assets (such as letters of credit and derivatives), even so, it started at a 0.35% levy. Similarly, it receives a ₦50 billion annual contribution from the CBN and is also funded by loan recoveries from some of the bad loans it bought earlier.

In other words, as banks continue to increase their asset size, they tend to pay more levies to the corporation.

However, as we have written about previously, AMCON just like most asset management companies (AMC) around the world has a clause that says when they should automatically terminate and base their objectives on such a timeline. In some cases, the period is extended by law, and in others, there are specific objectives to gauge performance.

For instance, the Pengurusan Danaharta Nasional Berhad, (Danaharta)—an asset management company that the FG partially modelled AMCON after—existed for seven years.  Danaharta did not only stop Malaysia’s NPLs from rising; it repaid all its bonds as of March 2005—seven years after its establishment.

That said, given the fact that industry NPLs have moderated to 5.3% in 2022 and the 10-year period originally slated as the lifespan for AMCON has elapsed, this levy simply represents a penalty for growth.

In addition, given that the original banks which exposed the banking system to risk and caused the formation of AMCON are either no more or contribute less to AMCON given their current size e.g Spring Bank Plc, Bank PHB Plc, Afribank Nigeria Plc etc, it would be safe to say that newer and relatively healthy banks that have ensured proper risk management structures and governance (often at the expense of growth and higher profit margins) are paying for the “sins of their fathers”.

Finally, we take a look at the NDIC premium.
 

Nigerian Deposit Insurance Corporation (NDIC) Premium:

This fee (premium) is paid by banks in order to safeguard customers' deposits in the extreme event of a bank’s failure.

In Nigeria, the NDIC covers up to ₦200,000 and ₦500,000 of customers’ deposits in microfinance banks and commercial banks/mortgage institutions respectively.

Typically, customers are immune from this premium paid. The bank bears the cost which is included in their cost of funds. The premium paid ranges between 0.35% and 0.5% of naira deposits and as such takes up a chunk of banks’ operating expenses (opex).
 

While this seems like a fair price to pay for insurance, when the size of the coverage and the premium charge are juxtaposed against other jurisdictions, it appears that Nigerian banks pay more for less coverage.

To put things into context, In Europe, the Deposit Guarantee Schemes (DGS) - NDIC’s European equivalent, protects customers’ deposits by guaranteeing up to €100,000 (c. ₦43 million) and the premium costs between 0.5% and 0.8% of deposits, depending on member states.

The Federal Deposit Insurance Corporation (FDIC) in the United States covers up to $250,000 (c. ₦105 million equivalent); while in China, the coverage is RMB500,000 (₦31 million equivalent) at a cost range of 0.01% to 0.02% of deposits.

Therefore, for the little coverage the NDIC offers, it sure does cost the banks a lot as a premium, only serving to erode profitability and shareholder value accretion.

In summary, when we take persistently high inflation (17.7% in May 2022), we see that banks’ operating expenses keep rising, despite banks’ management’s best efforts to be cost-effective.

These all come together to erode shareholders' values in terms of lower returns on equity (ROE), lower dividend payouts and lower capital buffers.