Tuesday, April 24, 2012 / ARM Research
  

CBN’s new stress test as turning point 

The Central Bank of Nigeria (CBN) has indicated that plans are underway to conduct another official appraisal of Nigerian banks before the end of 2012 as part of the Financial Sector Assessment Programme under a technical assistance programme provided by the International Monetary Fund and the World Bank. This will be a follow-up to the (now infamous) stress test in 2009 which revealed that 9 out of the industry’s 24 banks had huge non-performing loan exposures (mainly to the capital market and oil & gas sectors) that effectively rendered them insolvent.
 

The tests also revealed pervasive weakness in risk management, corporate governance, illiquidity and significant capital impairments across the industry and eventually culminated in regulatory interventions that resulted in a number of mergers, acquisitions and nationalisation in 2011; altering the industry landscape. A second round of regulatory scrutiny in 2011 was not quite as dramatic, but also resulted in significant provisioning for exposures the CBN considered doubtful of systemically risky. The 2011 examinations and accompanying provisioning did much to deflate burgeoning (at the time) confidence in the banking sector, putting paid short lived optimism about the emergence of the industry out of its recent crisis. In our view, it also helped kept alive lingering doubts about industry asset quality, dampening the sector’s recovery.

Figure 1: Provision for bad loans (N’ billions) 

Source: Company Financials and ARM Research

Third time lucky?

Subsequent to the first test, the CBN implemented several initiatives to tackle the issues raised which have been viewed as positive thus far. In our view therefore, another stress test can have only two possible outcomes – endorse recent signs of improved health amongst banks or reveal new hidden issues in the banking system; both scenarios which could significantly alter market outcomes for banks going forward. We therefore believe that a preliminary assessment of the likely outcomes is important within the context of the softer issues that will likely attend the test.
 

The result of the special audit in 2009 put average  industry’s NPL ratio at ~20.8%; on the back of which AMCON was established and commenced operations in November 2010 with the mandate to buy up bad loans from banks. As at the end of 2011, NPLs averaged 6.1%, with a considerable number of banks falling below the 5% long term regulatory target. 
 

Figure 2: Banking Sector NPL Ratio  

Source: Company Financials and ARM Research

In addition there has been significant improvement in coverage ratios. For FY 2011, banks with available figures reported an average NPL coverage ratio of 91%, with majority of them reporting above 100% coverage, reflecting increased provisioning in 2011 and the reduction in NPLs. This was a significant improvement from the 87% in FY 2010. 
 

Figure 3: Banking Sector NPL Coverage Ratio 

Source: Company Financials and ARM Research

The sale of bad assets to AMCON in earlier rounds and in some cases additional capital raise also had the impact of slowing the decline in Capital Adequacy Ratio (CAR) and put it comfortably above regulatory requirement for most banks in our coverage. Current CAR levels at 23% represent a slight deterioration from 2010 average of 25%.
 

Figure 4: Banking Sector Capital Adequacy Ratio 

Source: Company Financials and ARM Research

All this has been accompanied by significantly improved profitability, and—much more importantly—limited provisioning amongst banks that have released results thus far in 2012. Nevertheless, quarterly reports are unaudited and expecting a clean bill of health from banks on the strength of this could yet prove premature—as was the case in 2011.  
 

Is all this enough? 

To answer this question, we attempt to “read between the lines” in the recent happenings in the industry. Where the unexpected levels of provisioning in 2011 were quite disheartening for investors, it was accompanied by fairly robust operational performance—albeit supported by an unusually favorable money market environment. More to the point though, it does appear to reflect deliberate attempts by many banks to draw the line under problematic assets where they could and make a fresh start in 2012.
 

Notable in this regard were provisioning levels that were well ahead of guidance in Q4 2011, and it is instructive that this came after the engagement with regulators in Q3. Initially hesitant, some eventually found a viable policy in honesty, and sought to alleviate any misery this may have caused in the ample company of fellow penitents. In our assessment, prior engagement with regulators was the basis of most of the write-downs taken in Q4 and we believe many banks took the decision to take any required baths under cover of the industry-wide trend, with a view to avoiding negative outcomes of future scrutiny. In order words, banks were likely preparing for the next examination.
 

Surprisingly under the circumstances, the market apparently took kindly to preannounced transgressions with many concerned banks staging quick recoveries afterwards, suggesting that to some extent, investors had a similar interpretation, which, in part, is why the next test will be important. 
 

Likely outcome  

We are inclined to cast out lot with the market’s reading of the situation. However we note that a substantial majority of investors have taken a wait and see approach to the matter in the comfort of the sidelines which raises the stakes considerably. Our sense, however, is that the structural and operational improvements that are indicated by the latest round of results are much more genuine than in previous iterations and while systemic risks still exist, banks are much less vulnerable than at any time in memory and the industry is much better equipped to function as it should.
 

In our view, while the provisioning occasioned by the bank examinations of 2011weighed heavily on the sector, it did buy the CBN some credibility as a tough regulator. This credibility may well pay off for the banks in the long run when the CBN does provide a clean bill of health. We also believe that this will substantially be the case after the next round of tests, meaning that possible outcomes for the banking sector have developed a much more positive skew making the sector a much better proposition than it has been in recent months.  

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