Nigerian Banks: Surviving a Triple Whammy

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By Adesoji Solanke

COVID-19 has been disruptive, upending individual lives and that of businesses, including banks. The scale of disruption remains uncertain and investors assume the worst. But can these banks survive and how does today compare with times past?

In Nigeria, we find the big banks are awash with dollar liquidity, even as foreign investors are heading for the exit. Compared to the last crisis, the demand shock this time around has reduced domestic demand for dollars and trade facilities. That said, the Central Bank of Nigeria (CBN) continues to supply dollars, but with a noticeable lag, and we acknowledge the $15 billion worth of open FX futures contracts, which give an indication of potential formal future FX demand. For the banks, the decision they are having to make is whether to use their own dollars to meet customer needs or ration this while waiting to receive FX from the CBN. The latter seems to be the order of the day.

Restructuring conversations with trade-related clients and import-dependent manufacturers are happening, but it is still early days. One key difference vs 2014-2016 when oil prices crashed and Naira devalued is the significant efforts by manufacturers to backward integrate, which has helped reduce import needs. However, one key risk is that should Nigeria fall into another recession, this could affect the performance status of some large manufacturing exposures in the banking system that were already restructured after the last crisis. There is also now a list of banned import items that was not in place then.

Is this time really different?

Low oil prices and a weaker naira are the risks that Nigerian banks are quite familiar with, but COVID-19 brings a twist. The backward integration by manufacturers, the list of banned import items and the weak macro since 2015 have led the large banks to reduce their off-balance sheet letter of credit (LC) exposures by c. 40 per cent versus full year 2014, to $4.9 billion.

On-balance sheet FX exposures are still sizeable, representing 51 per cent of full year 2019 loans on average versus 45 per cent in full year 2014. Many oil loans now have hedges in place that will be extended, or the loans restructured. Given COVID-19, estimating credit losses will require judgement by each bank.

Naira devaluation important for the Nigerian banks’ investment case That the CBN has quickly allowed the naira to weaken, by six per cent to NGN380/$, suggests a more flexible stance on the currency this time around vs 2014 when oil prices last collapsed. In addition, the CBN’s recent weakening of the FX rate on onshore FX forward contracts is indicative of a potentially weaker rate over time. The pressure is building and our Sub-Saharan Africa (SSA) economist Yvonne Mhango now expects the naira to close the year 25 per cent weaker year-on-year. Currency moves are important for the Nigerian banks’ investment case because of their net long dollar positions, which they have built over the years from their considerable dollar loan books. These positions tend to translate to revaluation gains when the naira weakens and is a material upside risk in this environment.

Revaluation gains provide a meaningful buffer against which Nigerian banks can offset some of their impairment losses and we have seen this reflected in 1Q20 numbers.

Looking at potential downside risks from a devaluation, we highlight dollar-denominated costs and the naira cost of dollar borrowings getting inflated, as well as dollar loans getting inflated in naira terms and causing banks to breach their sector exposure and single-obligor limits. Devaluation also tends to weaken the quality of loans to general commerce, manufacturing, power, downstream oil and gas, and state governments.

What should Nigerian banks do?

Revenues are under immense pressure from low interest rates, an excessively high and rising cash reserve ratio (the highest across all the frontier and emerging markets we cover) with liquidity implications, and cuts to banks’ fees. This makes cost control even more critical in this environment. The regulator has prevented banks from laying off employees. While reducing pay is an option, this would not only make the economic pain more acute for employees (as pay has been broadly flat for a few years now), but is unlikely to deliver as significant a win as focusing on non-fixed costs (i.e. costs excluding pay, depreciation, deposit insurance and AMCON charges). Poor cost control and governance issues have historically prevented the least efficient banks from delivering cost savings. With COVID-19, we hope to see meaningful cuts, more so as some costs will fall off organically.

Global regulators have loosened the provisioning rules for banks and the same is happening in SSA, although each country has unique twists in its approach. In Nigeria for example, we find auditors telling banks that uncertainty does not preclude them from estimating expected credit losses (ECL). We agree. We would have liked to see the banks raise impairment charges in 1Q20, when their profits were likely the highest for the year but the charges we saw were too low. This is even as investors are unlikely to give the banks much credit, if at all, for reporting better-than-forecasted numbers.

Nevertheless, we believe no two quarters this year will be the same as the economic realities of COVID-19 will become progressively more apparent.

Finally, we think the barrage of regulatory and macro dynamics the banks are faced with buttress the need for any management team serious about creating economic value to revisit its underlying business model. This is with a view to finding high impact and differentiated, yet low capital intensive and high return areas to which it can allocate capital to bolster group returns. We have recently been proponents of opportunities within payments and asset management. Banking returns are challenged and fresh thinking is critically required.

Bad news does not always mean bad numbers

The uncertainties are high and there are many moving parts – low and fluctuating oil prices, oil contractor rates getting slashed, COVID-19 still marching on and risks to the naira continuing to build – meaning forecast risks are high. That said, being banks, bad news does not always mean bad numbers. Nigerian banks already had their backs against the wall before the triple-whammy of COVID-19, low oil prices and devaluation hit. We believe those that can reduce funding and operating costs are best placed to offset revenue and asset-quality pressures. Big banks that can lower funding costs position themselves well for outsized margin gains when the rate cycle turns.

Those with fluid balance sheets and strong capital bases will grab even more market share. For investors, we believe they must be even more selective in stock picking as the quality of the banks’ earnings and balance sheets are probably the most uneven they have ever been; some are disproportionately more reliant on mark-to-market, derivative and revaluation gains versus others. Nevertheless, successful investing is about buying a business below its fundamental value having fairly factored in its risks and growth prospects.

Solanke is the Director, Frontier / SSA Banks Research,
Renaissance Capital