Will Nigerian banks survive another global recession?

“Send your account number”—Nigerians’ favourite thing to hear. Banks have become so embedded into our society that sometimes we often forget their importance and crucial role. Most times, it’s when we can’t make transactions or access our funds we start raining curses on them, hoping that’ll make them act right. 

However, banks play a critical role in the broader economy too. Their most basic function, mobilising funds from those that need to stash their money away (savers) to those that don’t have enough to execute their plans (borrowers), sits at the heart of capitalist economies.

This is why we hear that the Central Bank of Nigeria (CBN) issues various reforms. Some include the banking sector consolidation in 2004, adopting IFRS 9 and Basel II&III accounting principles/standards etc.). All of these reforms were to ensure this crucial organ keeps on running smoothly; imagine all the veins and arteries in your body drying up all at once—Avada Kedavra!

So you can picture my face when I discovered that the oldest bank in Nigeria—First Bank of Nigeria Holdings (FBNH), is barely holding its head above water. Worse, this is happening just months after a two-year-old bank (Titan Trust) acquired Nigeria’s second oldest bank (Union Bank).

Does this signal that Nigerian banks are in trouble, and if so, why now?
 

Recession? Stagflation? Definitely murky waters

We have written extensively on the possibility of a global recession happening this year or in 2023, and the answer remains that the telltale signs are present. Even if we avoid a global recession, the pain of stagflation (i.e. high inflation and high unemployment) could persist for several years.

This outlook is further supported by the World Bank’s downward revision of its 2022 global growth forecast from 4.1% in January 2022 to 2.9% in its latest forecast in June 2022. This is a difficult time for the global economy, and given Nigeria’s vulnerability (through globalisation and our dependence on petrodollars) to external shocks, it's also a difficult time for the Nigerian economy.

But how could all these possibly be affecting banks? Afterall, they always take our monies. From the ₦65 fee we pay after every three transactions on an ATM that isn’t from the card-issuing bank to a slew of card and account maintenance charges, and lest I forget—the high-interest rates on loans. If you multiply all these by their millions of customers, that should translate into billions in profit and keep them afloat, right?

Technically, while all these remain true, other externalities affect the banks, given how embedded they are in the economy. Therefore, a shock (like a recession) will adversely impact the banking sector.

Remember the 2008 Global Financial Crisis? This crisis is a perfect example that spotlights the importance of banks to any economy and how a global crisis could permeate our economy and banking sector.

Admittedly, the 2008 crisis was initially triggered by the banks themselves. The watershed moment was the collapse of Lehman Brothers in late 2008, the largest corporate bankruptcy in United States history. No surprise then that the banking sector was the worst hit during the recession. But the point remains the same even in economic crises that start from other sectors.
 

The great recession

During the global financial crisis in 2008, Nigerian banks faced liquidity (“will we run out of cash tomorrow?”) and solvency (“can we settle our long-term liabilities?") challenges which impacted their credit ability and led to the termination of foreign credit lines.

Nigerian banks, which accounted for 60% of domestic stock market capitalisation at the time, had granted about $10 billion in margin loans, saw all these loans go bad as foreign investors pulled out investments to focus on the fires brewing in their home countries.

Consequently, between March 2008 and March 2009, the domestic stock exchange lost over 60% of its market capitalization (value). Meanwhile, as foreign investors exited with over ₦557 billion over the course of 2008, foreign reserves decreased by 27% to $47 billion over the same period.

All of these were a direct result of the “great recession”, which appeared in the form of severe contraction of liquidity and credit and is traced to the subprime mortgage crisis and rising home foreclosures in the USA.

Simply put, the global financial crisis exposed the holes and weaknesses in global banking systems. It wiped out large banks in several countries and left financial institutions across the globe in financial distress.

Post-2008, regulators across the world understood that large banks in any country were essential for the smooth running of that country due to their crucial function mentioned earlier.

As such, some of the banks were deemed “too big to fail” because they had the potential to cause serious economic damage if they failed.

This led to an explosion in the use of “Stress Testing”.

What is a stress test?

Errr… no! It doesn't measure how much your bank stresses you.

The IMF defines stress testing as a range of techniques used to assess a bank's vulnerability to major changes in the macroeconomic environment or exceptional but plausible events, e.g. financial market crash or recession.

The assessment is conducted by stress-testing a bank’s balance sheet under hypothetical market conditions and economic variables, e.g. a 10% change in interest rates or a 15% increase in unemployment.

Simply put, the test determines whether a bank has enough capital to weather an economic or financial crisis. Banks that fail must take steps to preserve or build up their capital reserves.

Unfortunately, we will not be conducting a stress test due to a lack of access to the sort of data we will need to test.

But fear not. We will still be analysing the same key indicators the CBN uses in its tests to see where banks are and how the looming crisis could impact them.

Pay attention to these key banking indicators in the table below—we will analyse them and explore how vulnerable Nigerian banks are to the negative economic situation. 

Banks at a glance

For our analysis, we would be using the systemically important banks (“too big to fail”) in Nigeria, popularly known as “FUGAZ,” i.e. First Bank, UBA, GTCO, Access and Zenith, including 2 tier II banks—Fidelity & Stanbic. Collectively, these banks control over 75% of total assets in the banking industry.

The table below offers a picture of the health and vulnerability of Nigerian banks, using the key banking indicators highlighted earlier. Figures are either from the first quarter of 2022 or the end of 2021 (for balance sheet items).

Red cells represent a reduction or deterioration on a year-on-year basis. Green cells represent an increase or improvement on a year-on-year basis. Grey cells represent no change.
 

Let’s discuss some of the more important indicators in the table above.

We can see that Nigerian banks have generally been good at making profits—all but two banks experienced year-on-year increases in profit. Despite this, when it comes to the ratios (indicators) that the CBN (and other central banks) use to test a bank's health—ROE, NPLs, CAR and LR—Nigerian banks are generally getting worse, exposing the sector’s vulnerability in the event of an economic downturn.

Now that we have a picture of where Nigerian banks are today, we can figure out how vulnerable they are to the global and domestic economic downturn. To analyse the impact of the potential recession, we will look at how banks would be affected by changes in three key variables: Inflation, Interest, and exchange rates.
 

Nigerian banks are already stressed

We’ll start with FBNH (First Bank).

On the surface, things look fine. The bank’s gross earnings (revenue) grew by 32% year-on-year going into Q1’22. Over the same period, PAT more than doubled.  

Yet these increased profits have not filtered through to the bank’s underlying health. One way we see this is by looking at the evolution of their capital adequacy ratio (CAR). Remember, CAR is the capital level a bank must have in its reserves that can cushion losses before it is at risk of becoming insolvent, i.e. declaring bankruptcy. It’s arguably the most important metric for gauging the long-term health of a bank.

FBNH currently has a CAR of 16%, barely above the CBN required minimum of 15%. The implication of a CAR so close to the threshold set by CBN is that in the event of an economic shock, the bank would probably need to raise capital inorganically—i.e., through fresh debt or equity, as its retained earnings would be insufficient to keep its CAR above the regulatory threshold. This leaves the bank very vulnerable to economic shocks. Given the bank’s systemic role in the economy, it would most likely require a bailout if things eventually go awry. 

The problem is that FBNH’s increased profits have not translated into more capital for the bank. Why? Poor quality of loans, as captured by the bank’s historically high NPLs. Despite non-performing loans (NPLs) declining from 23% of total loans in 2017 to 6% in Q1 2022, the bank has had to forego ₦565 billion in loan-loss provisioning over the past five years to deal with its age-old asset quality issues (bad loans). Basically, the regulation demands that banks set aside money (provisioning) to “cover” the losses made on loans that go bad (debtors fail to repay).

So, even as FBNH made higher profits, it kept diverting these profits to cover its bad loans, rather than using them to improve its CAR.

This puts the bank in a precarious position, as the stagflation in the global economy permeates into the Nigerian economy through imported food inflation and cost-push inflation.

Nigeria’s inflation rate has climbed from about 12% at the start of 2020 to nearly 18% today, owing to a cocktail of issues ranging from CBN’s FX import restrictions and naira devaluation to insecurity; now global inflation is creeping in.   

Inflation affects banks in two main ways: Directly through higher operating expenses and indirectly through interest rates.

With diesel now at ₦800, you can imagine how much these banks' operating expenses have skyrocketed. We have already heard banks revising operating hours to manage rising costs. The best way to see this is by going back to look at the earlier table that showed the health of Nigeria’s main banks. Notice that for the cost-to-income ratio (CIR), only Stanbic experienced an improvement on a year-on-year basis. For all the others, including the FUGAZ, their CIR has gotten worse this year.

These rising costs translate into higher CIR, negatively impacting bank profitability (PAT & ROE) and capital (CAR). For example, GTCO, which prides itself on being the most cost-efficient bank among its FUGAZ peers, has seen CIR rise from 37% in 2018 to 46% in the first quarter of this year. Although this recent increase in CIR has more to do with AMCON charges than rising operating costs (which are likely to show in the numbers in the coming quarters), the example nonetheless illustrates the impact of a rising cost-to-income ratio on the health of Nigerian banks. 

Basically, as rising inflation makes it more expensive to operate a bank in Nigeria, profits will get squeezed, increasing the need for banks to raise additional capital to ensure they are insulated from the economic downturn. 

The impact of higher interest rates

We have explored the impact of higher inflation (which is being experienced all around the world) and seen that it ultimately reduces bank profitability and eats into their capital.

Next up, interest rates.

Global interest rates are rising as central banks adopt a more hawkish monetary policy stance to tame rising inflation. In May 2022, the Monetary Policy Committee (MPC) of the CBN raised interest rates to 13%—its first rate hike in six years, as it also sought to tame rising domestic inflation.

To see how this would affect banks, it is important to remember that interest rates affect both bank revenues and costs. Banks earn money through the interest on the loans they give out (and other interest-earning assets) but banks also pay interest on the liabilities (e.g. deposits or debt capital).

So, higher interest rates would be a net positive for banks if the increase in yield on interest-earning assets is greater than the increase in their cost of funds. But they will be a net negative for banks if the increase in yield on interest-earning assets is less than the increase in their cost of funds.

How do we tell which situation applies?

We can look at where banks get their funding from as some sources are more expensive than others. Take CASA (current and savings deposits), which is one of the cheapest sources of funds for a bank because the interest they pay out on these is minimal. The chart below shows the relationship between CASA and a bank’s CoF.

Therefore, the banks that would weather higher interest rates are those that rely more heavily on CASA funds.

Apart from where banks get their funds from, we can also look at how banks’ interest income will change as interest rates rise. On the one hand, higher interest rates mean a higher “price” for the loans they give out, which is good for banks.

On the other hand, higher interest rates could discourage people from borrowing and, more importantly, make it more difficult for existing borrowers to repay their debt—especially when you remember that these higher interest rates are coming during an economic downturn. A slow-growing economy will hinder businesses' expansion, limit cash flows and impede their ability to pay back interest/principal on loans. 

Putting all of this together, we have:

• Higher interest rate = slwodown in loan growth = reduced NIM + higher CoF = less profit = reduction in ROE and CAR.

• Higher interest rate = higher NPLs = higher loan loss provisioning = less profit and lower ROE, CAR and Liquidity ratio.

At this point, it is also important to note that the CBN’s grace period for banks, which allowed banks to restructure credit facilities into a longer-tenured debt and also meant CBN intervention loans could be accessed cheaper (from 9% to 5%), expired in March 2022. This grace period was created in response to the coronavirus pandemic in 2020.

This means that industry NPLs are set to rise as reality catches up with these loans, given the gloomy outlook for the economy.

On a more micro level, a sectoral breakdown of the NPLs of these banks shows that general commerce, real estate and construction appear on almost all their balance sheets.

These sectors are also susceptible to inflation due to eroding purchasing power and slower economic activities. 

The impact of a weaker exchange rate 

Nigeria is currently witnessing an exodus of foreign funds. According to the National Bureau of Statistics (NBS), foreign capital coming into the economy declined 28.1% quarter-on-quarter and 17.5% year-on-year to $1.57 billion in Q1’22. This is due to foreign investors' apathy towards the negative real return of investing in naira-denominated assets and issues around capital repatriation due to FX illiquidity. 

The capital flow reversals have, by extension, put some pressure on our FX reserves, which are down 4.4% since the beginning of the year to $38.7 billion (despite higher oil prices).

This has negatively impacted the exchange rate, which is down 1.2% to ₦421 at the “Investors & Exporters” window (the actual official rate, rather than the artificial CBN rate) and 7% at the parallel market to ₦610. 

Currency devaluation affects the banks in two simultaneous ways that combine to hit ROE and CAR through rising NPLs.

Firstly, when the naira depreciates against the dollar, it automatically means the size of banks’ foreign currency (FCY) loan book grows due to the higher naira that is used to translate the value of the FCY loans.

Because the loan book size has increased, banks must make higher provisioning for these loans in case they go bad—even though they technically have not given out more loans.

And as mentioned above, this leads to lower ROE and CAR.

Moreover, persistent FX illiquidity could hinder a borrower's ability to meet its FCY obligations, stressing banks’ asset quality.

Another issue that will determine how currency depreciation will hurt banks is if they are net long or short on foreign currency (FCY) on their balance sheet. Simply put, do they have more FCY assets than FCY liabilities and vice versa?

A long position translates into foreign currency revaluation gains which is positive for the bank. However, a short position translates into foreign currency loss, which eats into its ROE and CAR.
 

Will they survive?

The fact remains that these are very rough times for Nigerian banks, and management will have to be intentional about being cost-effective to cushion the impact of shocks. 

With the entire banking sector industry CAR at 14.6% and LR of 43.7% remaining above their regulatory minimum of 10% and 30%, respectively, it signals the sector’s ability to withstand a certain level of shock without necessarily causing the banks to collapse. 

However, average NPLs at 5.3% (above the CBN’s 5% prudential limit) pose some downside risks to banks’ profitability, eroding capital further into 2022 and possibly 2023. 

Nonetheless, banks will have to be deliberate about shoring up capital and containing NPLs to ride the tides safely.