How do commercial banks make money?
The Covid-19 pandemic has triggered a global economic crisis. So far, our local banks appear to have shown resilience, partly due to lessons learnt from the 2008 Global Financial Crisis. It has however become clear that this particular typhoon is likely to have an even more devastating tail which will put our financial system under tremendous stress.
Even before COVID-19 hit town, our traditional banking model was already being redefined by enhanced regulation, low interest rates, and increased competition from Shadow and Neo banks.
Commercial banks make money by providing loans and earning interest income from these loans. The deposit liabilities generated from customers is what is used to fund such loans.
“Interest earned on loans is the premium that a bank earns for undertaking the risk of lending”.
Loans created with such funds should be properly appraised, risks mitigated as much as possible, and the tenors matched with that of the underlying deposits. Because, for demand deposits, the depositor can ‘demand’ for it at any time, while tenured deposits may have to wait till the contract is extinguished or can be broken at any time, but with a penalty charge applied.
“Commercial banks should not apply depositors’ funds to take equity risk. This should be left to Non-deposit taking risk finance companies, and shadow banking institutions; Venture Capitalists, Hedge Funds, Angel Investors, Impact Investors / DFIs, Private Equity firms etc”.
Now we have the basics out of the way, please hold these thoughts while we delve into today’s presentation proper.
In 2006, while I was a Senior Investment Officer in the Africa Department of the Netherlands Development Finance Company, otherwise known as the FMO, I was involved in two Retail Centre projects. One was the 11 ½ years tenured US$30 Million Inter City Hotels and CDC promoted Accra Mall project in Accra Ghana, and the second was the US$12.6 Million Khayelitsha Mall, part of a bigger Khayelitsha Business District (KBD) Project, a Public Private Partnership (PPP) urban development initiative of the City of Cape Town, Rand Merchant Bank (RMB), and Futuregrowth Property Development Company Ltd. (FG).
While I was the Project Team Lead on the Accra Mall project, I was also the Back-Up to the Team Lead for the KBD project. Both were Unfunded Risk Participations. The first with the Standard Bank Group of South Africa and the second with the First Rand Group of South Africa.
At the time, in their respective markets, both were projects local commercial banks typically would not touch.
An Unfunded Risk Participation means that FMO did not provide funding / liquidity. It participated in underwriting the risk to the tune of an agreed percentage. In the event that the borrower/obligor failed to fulfil payment obligations at maturity, FMO would have had to make corresponding payments for creditor’s rights in accordance with its pro rata share.
Now, why do you think these two big South African banks would want to engage in an Unfunded Risk participation with the FMO or that FMO would like to provide such a Guarantee?
Given the size of all parties involved, it could not be because they did not have enough deposit liability or liquidity to lend.
“Risk underwriting should be separated from funding. We need to better understand the role that risk enhancement plays in funding transactions in sectors that commercial banks will often not touch”.
In Nigeria, we have somehow come to believe that the panacea to getting commercial banks to fund key and often ignored sectors of the economy is by providing longer tenured deposits. But then, in investment banking we say that “money flows to where there is value”.
Why is it that money from the commercial banks has refused to flow to and fund these sectors?
The answer is in the complexion of risk involved.
So what did I learn from here?
“Providing long tenured liquidity will not solve the problem of getting required funding to key sectors of the economy if we do not address risk underwriting capacity, and risk enhancement.”
Anyway, at some point during the preparation of my credit approval, my boss asked if I had handled a Retail Centre project before. My response was in the affirmative and I was quite confident. Back home in Nigeria I had funded quite a number of supermarkets, so a couple more should not be a problem. Just to make assurance doubly sure, my boss suggested that I have a chat with FMO’s resident Retail Centre specialist. His name escapes me now but I recall that he must have been from Asia.
The day we scheduled our talk, this fellow comes over to my desk and asks me to join him at the coffee machine for a drink. While we were grabbing our coffees, out of the blues he shoots “what is the most perishable item in a Retail Centre?”
Fruits and vegetables? I responded.
Bread and pastries? Still trying my luck.
“Newspapers” he responded matter of factly. “If you don’t finish selling them in the morning, they become stale news.
Then he launched into a treatise on Retail Centre idiosyncrasies. He first distinguished between a Hypermarket, a Retail Centre and a Supermarket. Explained to me why in Europe, you always have to walk down to the end of the aisles to find milk and bread in every Retail Centre and why these centres outdid themselves in selling their milk and bread at a discount.
He made the connection between this and why Retail Centre anchor tenants are located at the end of several line shops, and why Retail Centres often barely break-even on the rent to anchor tenants but make up for this from the footfalls the anchor tenants bring to the centre.
He talked about the science behind locating Retail Centres in high traffic, premium real estate while the warehouses supplying them are built in much cheaper real estate in the suburbs. At a calculated distance to ensure steady and uninterrupted (often as many as four times a day) Just-in-Time inventory supply.
He talked about the science of renting shelf space and the pricing of shelf space sold to the major FMCG companies, and why the Retail Centres’ brand is often seen on the cheaper shelves that are below eye-level while the eye-level shelves are the most expensive to rent.
I found out that checkout speed is a ‘’thing”, and that the average time that it takes a person and items to be rung up is part of designing the checkout points.
The more he talked, the more it dawned on me that I needed help to better understand this sector. Note that at this point, we had not even started talking about the actual lending yet!
With humility, I admitted to myself that none of these idiosyncrasies and technicalities had been part of my considerations while designing the “supermarkets” I had funded in Nigeria.
“Though it is trite knowledge that in project finance, risk is allocated to the party best suited to bear the risk, however, what we have often not fully dimensioned in Nigeria is the depth of industry expertise required to discern the party best suited to bear the risk”.
Part II – Nigeria, Prior to COVID-19
The inability or unwillingness of commercial banks to fund certain aspects of the economy has long been of concern to both the Central Bank and the Federal Government. To address this, both parties have come up with a number of initiatives.
One of such measures is the setting up of local Development Finance Institutions (DFIs).
Development Finance Institutions.
These DFIs are mandated to intervene in gaps created by the inability of the financial markets to fund transactions in certain parts of the economy, despite the expected high social and economic returns.
Interventions of DFIs are supposed to have “additionality”, providing technical assistance for the preparation and execution of development projects, often providing long term funding or mezzanine debt, making projects more attractive for local commercial banks to participate.
The major DFIs we have in Nigeria include the following;
1. Bank of Agriculture (BOA)
2. Bank of Industry (BOI)
3. Development Bank of Nigeria (DBN) Plc
4. Federal Mortgage Bank of Nigeria (FMBN)
5. Nigeria Export Import Bank (NEXIM)
6. The Infrastructure Bank
BOA, FMBN and Infrastructure bank are sector specific, NEXIM focuses on exports with BOI and DBN left as the two local DFIs whose mandates cut across all sectors of the economy.
But there is a problem.
While DBN largely disburses its intervention funds through local commercial banks, the BOI will typically require a guarantee from a local bank through which they will disburse the facility to qualifying obligors. Commercial banks that receive this funding will on-lend to the ultimate obligor, charging a 1% guarantee fee, and earning a portion of the interest. Consequently, the responsibility of risk underwriting has again been shifted back to commercial banks without commensurate returns, while the local DFIs have simply become liquidity providers rather than risk underwriters.
Industry Non Performing Loans (NPLs) and Loss Given Default Vulnerabilities
Though Nigeria’s Tier 1 banks are said to be well capitalized, the banking industry as a whole is still struggling with acquisition loans granted power investors during the privatization of power assets.
Also, at the peak of the oil price boom of US$115 per barrel in 2014, Nigerian banks gave loans to indigenous oil prospecting companies to purchase assets of the international oil companies like Shell, Chevron and Total.
By Q4 2018, loans to the oil and gas sector accounted for 31% of the N15.134 Trillion gross loan portfolio of the nation’s banking system. It however declined from N4.646 Trillion in Q4 2018 to N3.589 Trillion by Q4 2019, representing just 21% of the increased industry gross loan portfolio of N17.187 Trillion by Q4 2019.
Loans to the power and energy sector which was at N712 Billion or 5% of gross industry loans of N15.134 Trillion as at Q4 2018, declined to N671.4 Billion or 3.9% of gross industry loans of N17.187 Trillion as at Q4 2019.
According to the National Bureau of Statistics (NBS), industry Non Performing Loans also reduced significantly within this period. Oil and Gas NPLs crashed from N878.41 Billion in Q4 2018 to N219.47 Billion by Q4 2019 (declined by N658.94 Billion or 75.02%), while Power and Energy NPLs declined from N161.8 Billion in Q4 2018 to N46.13 Billion as at Q4 2019 (declined by N155.67 Billion or 71.49%).
These two sectors largely account for the N728.94 Billion (or 40.75% decline) in total industry Non Performing Loans, from N1.788 Trillion in Q4 2018 (13.22%) to N1.059 Trillion (6.57%) by Q4 2019.
What is however not evident is whether this decline was via write-offs, repayments, erstwhile NPLs returning to performing status or a combination of all factors.
Beyond this, it goes to show how vulnerable the industry loan portfolio is to these two sectors.
Differentiated Dynamic and Unremunerated Cash Reserves Requirement (CRR) Regime
In July, 2018 the CBN introduced the Differentiated Dynamic Cash Reserve Requirement (DDCRR). This was ostensibly to incentivise commercial banks to increase lending to the manufacturing and agriculture sectors, fund projects targeted at backward integration and those that would enhance Nigeria’s import substitution strategy. The objective was to direct cheap long term bank credit at 9% (with a minimum tenor of seven (7) years and two (2) years moratorium) to employment elastic sectors of the Nigerian economy.
Cash Reserves are statutory requirements obliging banks to hold a designated minimum level of cash deposits at the Central Bank. Today, CRR in Nigeria is Unremunerated, meaning that the CBN pays banks noting on such deposits.
The CBN has traditionally deployed CRR to mop up excess liquidity in the system towards exchange rate and inflation targeting, i.e. to manage the amount of Naira chasing limited goods, services and available US Dollars.
The current Unremunerated CRR is 27.5% (an increase from 22.5% in January 2020) implying that at any point in time, 27.5% of a money deposit banks (or aggregate industry’s) total naira deposit liabilities must be sterilized at the CBN at zero interest.
Consequently, Unremunerated Cash Reserves Requirement is an effective tax on banks, thereby adding to the cost of doing business which the banks simply pass on to their borrowers through increased lending rates.
An Unremunerated DDCRR simply means that even if a bank’s deposit liability reduces, the CBN may not reimburse the excess CRR, this, for a number of banks, leads to an effective CRR that is more than the prescribed 27.5%.
In addition to the Unremunerated DDCRR, the current CBN FX bid model requires banks to prefund for their bid with the requisite Naira. The CBN however only sells a fraction of the bid to the bank while still withholding the cash. Then the bank still prefunds for the next bid, leading to more funds sterilized at the CBN.
The combination of the Unremunerated DDCRR and the aforementioned FX bid model is a Rube Golberg liquidity management strategy that the CBN is using to manage both exchange rate and inflation.
Increased Loan to Deposit Ratio (LDR)
In a letter to all banks dated September 30, 2019, the CBN increased the minimum LDR target for all Deposit Money Banks (DMBs) upwards from 60% to 65% effective December 31st 2019, and confirmed that failure to meet this requirement will result in a levy of additional CRR equal to 50% of the lending shortfall implied by the target LDR.
Though the CBN advised banks to strengthen their risk management practices with regards to lending operations, this cannot be achieved by fiat. Levying the banks’ additional Cash Reserve Requirement equal to 50% of the lending shortfall may ultimately be cheaper than the potential Non Performing Loans that will be created by this forced lending policy.
Part III – The Twin Shocks of COVID 19 and the Oil Price War.
We potentially face another banking industry crisis in Nigeria due to the twin shocks of the COVID-19 pandemic and the earlier oil price wars. There is no doubt that Nigeria is headed into another recession. According to the World Bank, this might be the worst recession that the country has experienced in the last 4 decades.
It is expected that if the spread of the virus eases and oil prices remain stable, Nigeria’s economy could contract 3.2% in 2020 with a slow recovery thereafter. The worst-case scenario is that the economy would shrink by 7.4% with a recession that will run well into 2021.
Fiscal Revenue and Exchange Rate Pressures
Government is projecting that receipts from crude oil sale will crash by as much as 80%. The implication is dire as crude oil revenues make up over 90% of Nigeria’s foreign exchange earnings and more than 60% of Government revenues. Being the largest spender, a decline in government’s revenue will affect key sectors such as oil and gas, power, construction, manufacturing, real estate and general commerce.
With this, we expect a deterioration in the quality of loans extended to aforementioned sectors.
We also expect significant pressure on the exchange rate and the ability of banks to source FX for their clients.
Low FX earnings could impair the CBN’s ability to defend the Naira resulting in weaker macroeconomic indicators; increased inflation and currency depreciation. This can significantly increase the industry’s foreign currency loan book (especially loans in the oil and gas and import dependent sectors) and lead to a deterioration of the capitalisation ratios of banks.
While banks have received approval from the CBN to restructure about a third of the loan book, this debt relief can potentially mask the poor going concernability of a number of the affected obligors, kicking the NPL can further down the road.
Measuring Expected Credit Losses (ECLs) in line with IFRS-9
Despite these happenings, banks cannot run away from estimating their Expected Credit Losses (ECLs) in line with IFRS-9.
ECL is supposed to reflect an unbiased and probability weighted amount, determined by evaluating a range of possible outcomes. Disclosures are a critical component of ECL reporting, identifying significant increases in credit risk (SICR).
Because substantial judgement will be applied, approaches and estimates for individual cases will depend on factors such as local conditions, portfolio exposures, available data and existing models.
Under IFRS 9’s ECL model, an expected credit loss will still arise even where full recovery is expected on a loan, if payment is delayed and interest does not accrue during the deferral period at the effective interest rate of the loan. This is because there is a loss in terms of the present value of the cash flows.
Part IV – Housekeeping
An Igbo adage says that a man needs to know where the rain began to beat him in order to determine when and where to begin to wipe his body.
Before we begin to consider opportunities post COVID-19, I believe that we need to go back to first principles.
CIBN has a major role to play in industry research and capacity development. Have we developed trainings for the local idiosyncrasies we find in lending to the target economic sectors or do we simply borrow programs and modules designed for other jurisdictions?
Where are our Retail Centre Finance specialists? Hospital and medical equipment experts, local rice paddy and mills finance experts, horticulture, yam, legume, aquaculture, education, kilishi and beef products etc finance experts?
If risk is allocated to the party best suited to bear the risk, have we invested in preparing local expertise to dimension and understand the parties suited to bear the risk?
Risk Underwriters versus Liquidity Providers
I think it has become clear that the reason why local commercial banks are not lending to some sectors is not just about unavailability of longer term funding but more of risk underwriting capacity.
So far, most, if not all the solutions put forward are all targeted at providing long tenured funding and liquidity without addressing risk enhancement and underwriting.
The real danger is that 18 to 24 months down the line, we will potentially face an explosion in NPLs in the very sectors that we are trying to drive funding to. Agriculture has already witnessed a 41.93% uptick in NPLs between Q4 2018 and Q4 2019 and it will not be surprising if other target sectors follow this trend by Q4 2020 / Q4 2021.
As for our local DFIs, in-house risk underwriting capacity has to be built. While it may be difficult to inject equity to most of the projects given limited exit options, other Mezzanine funding equity earnings structures such as royalties should be explored to compensate for the equity risk undertaken.
As at June 30, 2020, total industry CRR with the CBN stood at N11.119 Trillion. Compare this to total industry Loans and Advances of N16.028 Trillion and total Industry Customer Deposits of N28.272 Trillion (out of which N22.063 Trillion are Naira deposits).
This DDCRR at 39% of total industry customer deposit and 50% of total industry customer naira deposit is a significant tax on the banks.
Especially if you juxtapose this against the balance on the Federal Government’s Ways and Means Account with the CBN, it suggests that to manage inflation, the CBN while forcing down deposit rates, is lending the DDCRR balances to Government at a margin of circa 5%. This amounts to approximately N556 Billion earnings per annum which could have gone to depositors whose savings are now earning interest at less than 1%, which amounts to negative returns given that inflation was at 12.56% as at June 2020.
If this analysis is correct then it throws up an ethical dilemma.
Central banks are known to use Unremunerated Cash Reserve Requirement of money deposit banks to drive policy. However, once they begin to lend the same money that is being sterilized, who then should that earned income go to particularly as central banks are meant to be policy driven rather than profit oriented institutions.
It appears that in a bid to manage inflation and exchange rate pressures, we are running a damaging liquidity management strategy that is weakening the foundation of financial intermediation. Bearing in mind that financial stability is the constitutionally defined responsibility of a Central bank, one is of the opinion that this is the main reason why DDCRR should be deployed, not to manage inflation or exchange rate.
One thing that we learnt from the 2008 Global Financial Crisis is that the collapse of the banking system is much more dangerous than inflation growth or exchange rate pressures, consequently we may have to significantly lower this high DDCRR to timely provide liquid assets if it begins to threaten one or more systemically important banks.
Part V – Opportunities.
Nobody knows for sure how this crisis is going to play out so my recommendation is for banks to support vulnerable customers, and provide them with a credit lifeline where necessary. Helping customers carve a path forward creates opportunities for banks to build trust with the customers and be part of resetting and reasserting their role in this Big reset.
A neobank, also known as an online bank, internet-only bank, or digital bank is a type of direct bank that operates exclusively online without traditional physical branch networks.
Neobanks banks are here to stay and the COVID-19 pandemic restrictions only made their relevance more apparent. Still not sure how this pans out in Nigeria however digital transformation has been in full swing in the local industry for some time now.
Reinvention and Differentiation
There is an Igbo saying that every bad day has someone that it favours. It is left for us to position ourselves to benefit from and not let this crisis go to waste.
Competitive reinvention and differentiation will be key to positioning a bank for a new era of innovation and growth.
Mergers, Acquisitions and Collaborations
M&As are quite likely, however probably not for strategic reasons, and more as rescue missions. Warren Buffet famously noted that “It is only when the tide goes out that we know those who are swimming naked”. A crisis like this will typically suck out the tide of liquidity in the system and possibly expose hidden cracks of nakedness.
As for collaborations, for instance, banks who do not have the in-house capacity may seek Joint Venture partnerships with international Neobanks to protect and increase market share.
If at the beginning of this presentation you were expecting to hear specific sectors where banks can play post COVID-19 then I am sincerely sorry for disappointing you.
The landscape has changed alright; COVID-19 is the great reset. However, the Nigeria banking industry still has some anchors weighing it down in its past. It is only after we have addressed these issues that we can confidently and profitably take advantage of the CBN advised target sectors without having to cough up all our earnings in Loan Loss Provisions two years down the line.
Dr. Jekwu Ozoemene is the MD/CEO of Lyceum Alliance Limited, a full-scope and pre-eminent Financial Advisory and Management Consulting firm based in Port Harcourt, Nigeria.
This is text of a paper presented by Dr. Jekwu Ozoemene at the Chartered Institute of Bankers of Nigeria, Rivers State Chapter’s Webinar on “Opportunities and Challenges for the Banking Industry During and Post the COVID-19 Era” on July 25, 2020.