Bank NPLs (2) - The Banking Industry and Its NPL Position


Saturday, May 16, 2020 07:00 AM / by Debtors Africa/ Header Image Credit:  EcoGraphics


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"Running into debt isn't so bad. It's running into creditors that hurts." -Unknown


Bad bank loans are as old as banking itself. Borrowers of money from banks default on agreed repayment terms for a variety of reasons which include, but are not limited to, the following:

  • Weak character of the borrower or where a borrower has capacity but lacks the willingness to pay could easily drum up bad debts on bank books.
  • Poorer economic conditions that materially affect the assumptions relating to the initial loan request.
  • Regulatory challenges that compel a review of the terms of the original loan
  • A government policy change that affects the business outcome of organizations (such policy change wiped out Nigeria's hitherto thriving textile industry in the early 1990s)
  • Sharp adverse foreign exchange movement which raises the local currency exchange rate (this kind of disruptive "external" factor was a major cause of the challenges faced by local airline operators who faced upwardly sticky airfare price adjustments to cover rising operating expenses)


Cyclical downward movements in economic activities, especially for fast-moving consumer goods (FMCGs), could cause a spike in inventories and a fall in cash flows, thereby worsening the ability of corporations to repay their debt (this has been noticed increasingly between 2015 and 2019). Most banks have had a non-performing loan (NPL) ratio above the Central Bank of Nigeria's (CBN's) benchmark of 5% (see table 1 below). Notably, however, between 2017 and 2019 the average industry NPL ratio has started to decline.


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  • Liquidity challenges emerging from external shocks such as the more recent Chinese Coronavirus which disrupted the supply chain of a few manufacturers in Nigeria. The virus also created problems for exporters who found out that their earlier cash flow expectations were no longer feasible. The times Interest Coverage ratio for these manufacturers melted down the longer the virus threat halted trade between Nigeria and China. The banks that loaned money to these manufacturers discovered that repayment obligations were no longer practical based on original loan repayment agreements. These types of loans were, however, more easily treated under a restructuring arrangement. Liquidity challenges were not unique to the Nigerian economy as other countries such as US, China, Italy etc. faced similar challenges as a result of the supply chain disruptions caused by the pandemic coronavirus.


Bank loans go bad for a variety of reasons, why the loans go bad is a basis for deciding the best path to remediation and loan recovery. If the character of the borrower is not considered dubious or if the customer has a willingness to repay but suffered a sudden and unexpected fall in cash flow, the bank can and would likely arrange a loan work out. The work out option would assist the customer in improving cash flow and strengthening repayment capacity. Increasingly this has required corporate 'handholding' or a situation where the bank offers technical managerial and financial services to help the company gain firmer control over revenues and costs.


The State Of The Industry

Nigerians banks have had a harrowing experience with Non-performing loans. The history of bad and doubtful bank loans has competed with some of the worst horror movies in the world. Poor loan asset positions led to the banking sector consolidation of 2005, where 84 local banks were reduced 25 by Professor Chukwuma Soludo, the erstwhile central bank Governor. Soludo's principal arguments for the consolidation and recapitalization of the banks was that:

  1. Most of the banks were technically insolvent and had books with negative shareholder capital as equity became completely eroded by provisions for poor loan assets.
  2. The banks were not fit-for-purpose in an economy anxious to run and play catch-up with contemporary emerging market counterparts. For the economy to grow at a pace required to create sustainable employment and match the then Asian tigers, banks needed to have larger unimpaired capital bases.
  3. Some banks were family-owned with poor governance standards and accountability frameworks, resulting in insider abuse of the internal control processes and eventually compromising the solvency and profitability of the business.
  4. Development finance requires large ticket financing, insisted Soludo at the time.  The best way to ensure adequate capital funds to meet large project needs, according to Soludo, was to have banking institutions with equity capital of at least US$100m. The new perceived capital requirement prompted the CBN to insist that banks should recapitalize to N25bn if they wanted to retain their operating licenses by the end of 20o5. The new equity capitalization rule meant that banks needed to increase their capital base from the previous N2.5bn in 1999/2000 in 2005 or by ten times their previous equity base.


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In terms of pricing and yield on earnings assets, the banking industry recorded a ratio of 9.85 percent in 2005 as against 14.17 percent in 2004. The banking industry also recorded a very low return on assets and equity to the tune of 1.85 percent and 12.97 percent, respectively in 2005 (see Table 3).

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Clear Vision, Mixed Outcome

The recapitalization of the banking sector in 2005 tidied up a large part of the poor loan position of banks. But what it did not address was the moral hazard, adverse selection and issues that arose from global financial crisis (2008) that was responsible for the bad loans in the first place. Moral hazard relates to the possibility of borrowers defaulting as a result of a loan environment that encourages unusual risk-taking.  The fact that a borrower escapes the penalty for defaulting encourages poor loan repayment habits and creates governance challenges for banks, particularly where the borrower has insider influence. The loan default epidemic between 2000 and 2004 came from the high incidence of insider credit. Banks that were owned by dominant individuals or their families suffered higher rates of loan delinquency.


The problem of powerful insiders (a problem that persists till today) created an issue of adverse selection or a condition where banks systemically loaned money to the least qualified of borrowers as a result of poor loan appraisals and overbearing insider influence. Professor Soludo's consolidation exercise cleared up the problem of bad debt to equity ratios but could not resolve the problem of proper credit appraisal and loan selection; the banks continued to book high-risk assets despite larger equity capital. The size of a bank did not stem from the problem of the quality of loans.


The stability of banks and other financial institutions in the country were also threatened by the global financial crisis. Many of the banks were already exposed to the oil and gas sector when it was booming and were left counting their losses when oil prices fell. Others had also placed huge bets on the stock market and it was estimated that the banks lost over N900bn to the stock market crash. Huge loans had also been granted to firms and individuals who defaulted on payment and to make matters worse, the loans were not backed by adequate collateral. The Non-Performing Loan (NPL) ratio of the banks rose to 20.7% in 2009, which is close to the 22% NPL that preceded the banking consolidation of 2007. The banks were already filled with toxic assets and facing serious liquidity challenges, which impaired their ability to give credits to the real sector. Many of the banks even had to downsize on staffs and tighten expenditure to scale through the challenges; thus, increasing the number of the unemployed in the country.


Professor Soludo was clear about his intention of promoting larger financial institutions that could finance bigger projects, but the outcomes of his intervention were less clear or successful. The larger financial institutions neither cleaned up their loan problems nor took care of their widening integrity gap. The problem was that the chief executives of many of the now bigger banks were "Peter principled" or elevated to a management status that they were ill-prepared to handle. Observers noted that CEO's that found it difficult to handle equity capital of N2.5bn competently were somehow expected to manage a capital base of ten times that amount judiciously, the sector was primed to face its subsequent challenges.  


In 2009 with the appointment of Lamido Sanusi Lamido as the new CBN governor, the perspective of the regulator shifted from an ability of local banks to fund big-ticket transactions to their ability to manage risk. Lamido, the immediate past Managing Director of First Bank of Nigeria, brought his reputation a risk-management czar to his duties at the CBN by pursuing a policy of systemic stability. The then CBN governor was more assertive on issues related to the quality of bank credit than he was with the size of banks. The policy pendulum of the regulator moved towards keeping the bank's non-performing loans (NPLs) as a proportion of their total loans outstanding relatively low. The decision to keep credit risks tight and flat led to the CBN orchestrating another round of bank consolidation with banks with high NPLs selling their assets at a discount to the newly created CBN debt-resolution company, the Asset Management Company of Nigeria (AMCON). In 2009 to save the banking system from imminent collapse resulting from a contagion effect of the financial crisis in global markets between 2007 and 2009, Sanusi intervened in some banks with the injection of N620bn and the removal of eight bank chief executive officers (CEOs). Sanusi's actions arguably stabilized the local financial markets and provided needed liquidity.


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Return on equity and return on assets increased from 18.97% and 2.32% in 2013 to 20.03 and 2.04% in 2014. Similarly, operational efficiency, measured by cost-to-income ratio, improved to 72.92% in 2014 from 73.88% in 2014.


Yield on earning assets decreased from 15.05% in 2013 to 14.53% in 2014. While average earning assets increased by 12.40% over the period, the interest income increased by 8.52%. The net interest margin decreased to 8.43% in 2014 from 8.80% in 2013 (see Table 4).


Sanusi considered the global and domestic crises as products of bad lending decisions and insisted that to avert a recurrence of the circumstances that needed the huge CBN bailout, banks needed to have more intelligent and diligent credit appraisal and risk management processes implemented. Sanusi ascribed the challenges of banking in the period to eight key factors that included the following;


1.      Macro-economic instability caused by large and sudden capital inflows

2.     Major failures in corporate governance at banks

3.     Lack of investor and consumer sophistication

4.     Inadequate disclosure and transparency about the financial position of banks

5.     Critical gaps in the regulatory framework and regulations

6.     Uneven supervision and enforcement

7.     Unstructured governance & management processes at the CBN/Weaknesses within the CBN

8.     Weaknesses in the business environment.


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Riding Weak Camels


Sanusi felt that the traditional evaluation of banks by way of a CAMELS assessment was inadequate. The erstwhile CBN governor's skepticism was understandable. The C in the CAMELS rating approach represents capital adequacy. Between 2004 and 2009, despite the Soludo consolidation exercise between 2004 and 2005, bank capital had again become inadequate given the background of high-risk assets several banks warehoused on their statements of financial position or balance sheets.


The inadequate capital of banks at the beginning of the Sanusi CBN era was the converse side of the declining quality in bank loans or risk assets. The A in the CAMELS rating that referred to a bank's asset quality was in decline. Many banks suffered from an over-concentration of their loan portfolios into a narrow market or business segment. The external shocks that occurred after the rupture of stability in the oil & gas and energy sectors as a result of trouble in global financial markets led to a deterioration in the quality of bank loan books. The problem worsened as a result of a large number of loans granted being of an insider-related nature, making loan recovery difficult. Large Tier 1 banks were especially affected by risk-concentration challenges.


Management the M in the CAMELS rating was a major problem for Sanusi. Bank boards lacked rigorous engagements with their banks and the board credit committees, according to Sanusi, were rubber stamp appendages of the managing director's office. The inability of bank boards to thoroughly and professionally assess the credit request of management led to all kinds of loans destined to fail. 


The E, which stands for earnings in the CAMELS rating framework, is a key metric in evaluating a bank's performance because the quality just as much as the size of a bank's earnings provides insight into the quality of a bank's management. Creative accounting by the understatement of impairment charges (before 2018's IFRS9 Implementation by local banks) or the restatement of bad debts into longer-term performing assets creates problems of integrity. It highlights the weak governance ethos surrounding bank management, which represented a challenge for the sector between 2009 and 2014. 


According to Sanusi, in a lecture delivered in February 2010 at the Convocation ceremony of the Bayero University, Kano, "Governance malpractice within banks, unchecked at consolidation, became a way of life in large parts of the sector, enriching a few at the expense of many depositors and investors."


"Corporate governance in many banks failed because boards ignored these practices for reasons including being misled by executive management, participating themselves in obtaining unsecured loans at the expense of depositors and not having the qualifications to enforce good governance on bank management. Also, the audit process at all banks appeared not to have taken fully into account the rapid deterioration of the economy and hence of the need for aggressive provisioning against risk assets."


Sanusi noted further that, "As banks grew in size and complexity, bank board's often did not fulfil their function and were lulled into a sense of well-being by the apparent year-over-year growth in assets and profits. In hindsight, boards and executive management in some major banks were not equipped to run their institutions." Reinforcing the systemic culture of poor forward-thinking governance that needed firm attention to prevent a financial meltdown.


An equally significant limitation of banks between 2009 and 2014 was liquidity, which represents the L in CAMELS. Several banks had bad credit positions that weakened liquidity and, therefore, lowered their ability to grow credit and meet customer deposit demands. Indeed, problems with liquidity resulted in most banks buckling over as they failed to meet interbank settlement obligations. The CBN's asset resolution company, AMCON, later bought these weaker banks and sold them off to other private sector investors, including larger or more stable competitors.


For Sanusi, risk management was at the centre of good banking conduct. Therefore, the CBN during Sanusi's period took a special interest in the S of the CAMELS Assessment Criteria, sensitivity or riskiness of banking credit assets required new assessment frameworks and fresh mitigation strategies (see illustration 1, CBN Governors and their key strategies 2005-2019).  


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Pushing The Reform Plate

Sanusi's reform agenda sat on four pillars (see illustration 2 below):


Pillar 1: Enhancing the quality of banks

Pillar 2: Establishing financial stability

Pillar 3: Enabling healthy financial sector evolution

Pillar 4: Ensuring the financial sector contributes to the real economy


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Banking Governance and Its Building Blocks


Pillar 1 involved the CBN initiating a 5-part programme to enhance the operations and quality of banks in the country. Sanusi had hoped that the first pillar would fix the major causes of the crisis in the sector; he was wrong. Pillar 2 concerned itself with financial system stability, which involved strengthening the financial stability committee within the CBN itself. The scheme also involved establishing a hybrid monetary and macro-prudential set of rules to nudge economic policy in a particular direction and support counter-cyclical fiscal policies by the government. Pillar 3 involved financial sector evolution, which involved banking industry structure, banking infrastructures such as credit bureaus and registrars, the cost structure of banks, and the role of the informal sector. Pillar 4 related to establishing a nexus between the financial and real sectors of the economy. Sanusi noted that specialized financing institutions had failed at their mandates. Nigeria's development finance institutions were, unfortunately, insufficiently strategic and efficient to meet the goals of linking financial sector support to real GDP growth.


To get the financial service sector to contribute to real sector growth, Sanusi suggested the following measures:


  1. Leveraging the CBN Governor's role as advisor to the President on economic matters to ensure that the financial sector contributes to the real economy
  2. Taking the lead in measuring more accurately the relationship between the real economy and financial sector and the transmission mechanism
  3. Evaluating the effectiveness of existing development finance initiatives such as agriculture credits and import-export guarantees continuously
  4. Taking the public lead in encouraging examination of critical issues for economic development (impact of infrastructures such as power, port and railways)
  5. Leading further studies on the potential of venture capital and private-public partnership initiatives for Nigeria
  6. Cooperating with a state government to run a pilot programme in directing the financial sector's contribution to the State's social-economic development.


Emefiele and A New Perspective

When Governor Emefiele resumed office as the new CBN boss in 2014, he adopted a new remit. Emefiele decided that the financial system required a few urgent decisions to be taken immediately including the following:

1.      Foreign exchange stability

2.     Fiscal policy accommodation

3.     Aggressive intervention to grow the real sector through a series of specialized funds at single-digit interest rates


The policies taken together have created a heterodox approach to monetary policy (see illustration 3). The approach of the CBN to monetary in the last five years has raised a few concerns locally and internationally. The International Monetary Fund (IMF) in 2019 expressed its doubt over the appropriateness of the monetary measures of the Bank, especially its defense of the external value of the Naira.


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Related Reports (PDF)

1.      Download the Full PDF Report - Debtors Africa, May 13, 2020

2.     Executive Summary PDF - Proshare, May 14, 2020

3.     AMCON and Financial Services Debt Burden in Nigeria - Aug 17, 2018

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