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Nigerian Banking Industry: The challenge of leverage in post crisis competitiveness

Category: Oil Sector


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Nigerian Banking Industry: The challenge of leverage in post crisis competitiveness

 

 
Introduction Following the economic crises that have touched economies large and small, “developed” and developing, new risk management rules are being instituted across the globe. These will have profound implications for all banks – not least in Nigeria. Only those banks fully equipped with fully incorporate risk management into the wider objectives of customer and shareholder satisfaction will succeed.
 
Minimum Capital adequacy
 
Minimum capital adequacy requirements under bank regulation regimes, set capital as a floor percentage of risk (risk weighted) assets. In recent years, whilst minimum capital adequacy percentages were broadly in line (i.e. 8% for developed countries and 10 to 12% for developing countries), central banks worldwide were applying widely different rules in the definition of risk assets in their capital adequacy supervisory practices. In many developed countries, securitised loans could be packaged into off balance sheet structures or special purpose vehicles to escape inclusion in the risk asset calculations. In Nigeria, up to recently, commercial paper holdings were treated as off-balance sheet instruments, thus excluded from risk assets. Likewise, interbank placements are excluded from the Nigerian definition of risk assets, whereas these assets are included in the definition of risk assets in other jurisdictions.
 
Risk asset definition
 
The weaknesses in applying consistent, robust risk asset definitions globally have led to distortions of true capital adequacy positions. Banks could become highly leveraged with insufficient capital to absorb losses in times of crisis. For example, the two largest Swiss banks were regarded as some of the best capitalised banks in the world based on capital as a percentage of risk assets. However, their capital bases proved to be woefully inadequate during the crisis, requiring significant capital injections. Likewise some of the Nigerian banks, which had to be bailed out recently had capital in excess of 20% of risk assets, yet were found to be short of capital when losses materialised.
 
Leverage ratio
 
To address this problem, the Bank of International Settlements, the Central Bank to central banks, announced on September 7 that from 2011, a maximum leverage ratio will be applied to set a cap on the amount of leverage a bank may employ. This will be an international requirement.
 
Leverage is defined as total assets (not risk assets) divided by tier 1 capital (equity). The maximum leverage that will be allowed is 25. This will be applicable to AAA rated banks, of which there are now very few globally. The maximum leverage ratio for lower rated banks will be adjusted downwards.
 
Economic capital is used as a tool by international banks to determine the size of equity buffer required to absorb potential losses, to protect debt holders. Using this framework, we can derive leverage ratios for various ratings as per the table below: (See rating table)
 
 
Note that the leverage ratio will not replace the minimum capital based on risk assets. It will merely set a floor for the minimum capital requirement as a percentage of risk assets. For example, whilst a BBB rated bank has a maximum allowable leverage of 15 (i.e. minimum T1 capital of 6.7% of assets), it might be required to hold more capital, based on the risk sensitivity of its assets.
 
Leverage and ROE
 
To fulfil their intermediary role in the economy, banks must be allowed to take risk free deposits from liquidity surplus entities and transform these into risky assets lent to liquidity deficit entities. To ensure depositors would be willing to provide liquidity, asset risk must be assumed by equity providers. For equity providers to take on asset risk, they will have to be adequately rewarded. Return on equity (ROE) is therefore the most important performance metric for any bank. A bank with an average ROE of 30% and dividend payout ratio of 1/3, will grow the value of its shareholders’ funds by 20% pa. Banks with high ROE’s should thus be rewarded through high growth in their share prices.
 
To maximise shareholder value creation in UBA, we follow a ROE driver performance management framework. In term of this framework, ROE is decomposed into its various components and targets are then set and responsibilities assigned for managing the various components. ROE is determined by three drivers, i.e. Operating efficiency, leverage and tax efficiency. (See chat A)
 
Operating efficiency
 
Operating efficiency is measured by Profit Before Tax (PBT)/Assets (i.e. pre-tax ROA.). Leverage is measured by assets/equity. This measure is constrained by the economic capital percentage (the buffer to absorb potential losses) required to protect the bank’s depositors. Tax efficiency measures the degree to which tax rules can be optimised to ensure lower effective tax rates.
 
ROA is the most important internal management measure. It can again be decomposed into the following components: (See chat B)
 
 
To improve ROA, banks must improve asset yield (a function of depth of product range, sales growth, relationship intensity, cross selling, etc.). In addition, funding cost must be kept low – this is a function of the diversity of the deposit base, deposit mix, etc. Further, charges for asset impairments (investment, loans, fixed assets, etc.) must also be limited. This is a function of asset quality and risk management strength. Minimizing impairment charges/assets (through strong risk management), will lead to an improved credit rating over time, allowing a bank to take on more leverage with equity and so increasing ROE. Lastly, operating expenses/assets provides a measure of productivity – extend to which assets are ‘sweated’.
 
International competitiveness – a changing landscape – but not a level playing field
 
With the international harmonisation of banks’ leverage ratios from 2011, there will be much less scope for banks to enhance ROE and shareholder value, through regulatory rules arbitrage, enabling increased leverage, as was done in the past. Banks’ international credit ratings are constrained by their sovereign ratings. Frontier market banks with lower credit ratings will thus have a competitive disadvantage in respect of the amount of leverage they will be allowed to deploy. For example, the maximum leverage for BBB+ rated South African banks will be 16, compared to 8 for their B+ rated Nigerian counterparts. The operating efficiency of Nigerian banks will thus need to be twice that of South African banks (assuming equal tax rates) to achieve the same ROE. To remain competitive, frontier market banks will have to exploit the growth opportunities in their countries and use scale to enhance operating efficiency (ROA) and so boost their ROE’s.
 
One of the likely consequences of the Nigerian banking crisis will be a differentiation in risk assessments by rating agencies, investment analysts and others, replacing the ‘one size fits all’ assessment we have at present. Nigerian banks with superior risk management, although constrained by the sovereign rating ceiling, will thus enjoy better ratings (enabling more leverage) than their domestic counterparts with weaker risk management.
 
Conclusion
 
The global introduction of a maximum leverage ratio for bank capital adequacy levels from 2011, will have profound implications for Nigerian banks’ international competitiveness. Winners in the new game will be those banks who can best optimise their investment in processes, people and systems in relentless pursuit of customer satisfaction and operating efficiency and those that will be able to increase leverage capacity through enhanced risk management.
 
(Source:234Next)
 


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