Hold-to-maturity Accounting Disguises Bank’s Loan Impairment



Tuesday, 18 August 2015 11:09 AM / By  Kingsley Ughe

With the near completion of the latest Central Bank of Nigeria’s banking “stress tests”, the sharp rise in earnings of the banks in the last quarter of 2012, and the growth in Nigerian Stock Exchange All-Share Index, there lingers the temptation to luxuriate and relapse into lethargy yet again, in the idle belief that the Nigerian banking industry is clearly out of the woods and out of crisis.

Defining and putting a closure on the economic crisis when conceived in this way will not only amount to a misinterpretation of the core issues involved but a charmed and distant illusion. For  what many have been regarding as a single credit crisis is in reality the tale of a twin, closely related but different crises, each with its own pace, duration, and demand on banks to rediscover operational discipline in a harsh economic and regulatory environment.

Burying the Credit Crisis In A Shallow Grave

The banking crisis that almost brought the Nigerian economy to its knees, centred on the aggregate percentage of non-performing loans (NPLs) of banks that stood at an alarming 49.87 percent. Almost all the banks were chronic borrowers at the Expanded Discount Window (EDW) of the CBN, which is a depressing indication that they had little cash on hand. 

In actual fact, the last credit crisis started around Year 2000 and became noticeably worrisome by 2003 and 2004. In 2004, the banking industry of Nigeria consisted of 89 banks. The industry was fragmented into relatively small, weakly capitalised banks with most banks having paid up capital of $10 million or less. The best capitalised bank had capital of $240 million, compared to South Africa where the least capitalised bank had capital of $636 million at the time. Recapitalisation of the banks and consolidation of the industry under Prof. Charles Soludo (then CBN Governor) in 2004 notwithstanding, impaired credit portfolio ultimately resulted in the demise of Oceanic Bank, Afribank, Finbank, Intercontinental Bank, and acquisition of Union Bank.

The current CBN Governor, Sanusi Lamido Sanusi, had to enact arguably the most far-reaching reforms and banking intervention in Nigeria to contain the banking crisis. The intent of his regulatory reforms is to improve corporate governance of Nigerian banks by avoiding the “sit-tight syndrome” whereby bank executives with limitless tenure of office manage the banks as personal businesses as opposed to publicly held corporations accountable to shareholders, depositors, and government regulators.

All in all, the reform programme introduced by Sanusi rests on four legs: enhancing the quality of banks, establishing financial stability, enabling healthy financial sector evolution, and ensuring the financial section contributes to the real economy.

If the measure of stability in the economic landscape of Nigeria is anything to go by, one must concede that the reforms have worked, granted the need for adjustment and re-examination here and there. The stable outlook of the banks is in part due to the clarity provided by the stress test exercise and the ongoing commitment on the part of government not to allow a large-scale bank failure again.


Hold-to-Maturity Accounting: A Shadowy Ghost

However there is another crisis looming. The other crisis is a commercial bank lending crisis. The solved episode of credit portfolio impairment of the banks involved bad residential mortgages, but to a larger extent, it also involved a broader array of lending in the oil and gas sector, including commercial real-estate loans, state government loans, auto loans, and leveraged/high-yield loans, all of which are now going bad because of the aftermath the recent economic downturn.

The complexity of this crisis is due to the nature of these loans. The bulk of these loans are subject to hold-to-maturity accounting, which, in contrast to fair-market accounting, typically does not recognize losses until the loans default. It is a frightening prospect that this crisis is still in its early stages and will become pronounced in about two years ahead.

On a general note, all large financial institutions hold both kinds of credit assets on their books. Some of the largest broker–dealers hold 70 percent of their assets at fair value, while banks hold up to 90 percent of their assets in hold-to-maturity accounts. For the banking and securities industry as a whole, about two-thirds of assets are subject to hold-to-maturity accounting.

While it may seem odd that accounting methodologies could make such a big difference, at the end of the day, what counts is the net present value of the cash flows from each asset, but those are not immediately discernible until after a debt is repaid.

Fair-value accounting, based on mark-to-market principles, immediately discounts assets when the expectation of a default arises and ability to trade the assets declines. Fair-value therefore makes the holder of the assets look worse, sooner.

Hold-to-maturity accounting works in reverse and makes the holder look better for a longer time.

Many of the banks reported a return to profitability in the first quarter of 2012. The comfort this provided to markets is not necessarily misplaced. First-quarter 2012 operating earnings for Nigerian banks were $3.7 billion, compared with breakeven in the first quarter of 2011. An analysis of these results shows that quarterly non-interest revenue for corporate- and investment-banking activities (that is, largely broker–dealer operations) increased by a surprisingly large $1.3 billion from the prior year. Fair-value accounting losses depressed 2011 results but in 2012 were replaced by fair-value gains.

Large additional trading profits were made possible by arbitrage and other trading opportunities that became available as market conditions improved. While the worst may be over for the broker–dealer sector, first-quarter 2012 results tell a different story for commercial-banking activities at the same major banks. These banks took $2.7 billion in loan-loss provisions in the first quarter, $1 billion more than in the 2011 period. Most of this increase—$1.7 billion—was from retail-banking and government loans. In other words, the pace of defaults on these credits is rising.



This merits concern because loan provisioning under hold-to-maturity accounting is a lagging indicator of future loan losses. Under hold-to-maturity accounting, loan losses are delayed even when they are highly probable, because loan-loss provisioning doesn’t take place until the loans actually is defaulted. And since many of these loans have terms and conditions that allow the borrower to pay interest out of a line of credit, such loans won’t be defaulted until the line of credit is exhausted.

Hence, eventual losses may grow as the lines are drawn down, but the timing of the losses is delayed.

When loan-loss provisions start rising rapidly, it is likely that more losses lie ahead. While 2011 was the year for taking losses on broker–dealers, this year and next will be the years for taking losses on assets subject to hold-to-maturity accounting.

These are the losses that show up in stress tests, in which regulators make assumptions about how the economy will perform and calculate the resulting loan losses under various economic outcomes. For example, credit card losses are highly correlated with unemployment. By projecting unemployment rising to a certain level, stress testing can then project the attendant credit losses.

New Direction

The “Sanusi reforms” have provided drivers and indicators for stress testing of institutions and finance houses. Stress testing may have set the stage for restoring the health of individual institutions because it has provided the financial markets with information on the quality of each individual institution’s loan portfolio. The more transparent the information on the composition of loan portfolios is, the better analysts will be able to make their own estimates of losses on hold-to-maturity loans. Moving in this direction is essential to restoring confidence in the quality of bank balance sheets and to providing discipline against unwise risk-taking going forward.

The tests also marked a turning point because they provided much greater clarity regarding how the Nigerian government will handle troubled institutions in the future. The Nigerian government has demonstrated to the financial markets’ satisfaction that it has both the resources and the will necessary to ensure that there will be no more bank failures. The government is clearly prepared to use whatever combination of funding support, guarantees, and capital injections are required to ensure that any future resolution of troubled financial institutions will be orderly.

It is also essential for banks and securities firms to begin reducing operating expenses more programmatically. Although one might assume that banks and securities firms have been reducing costs in response to hard times, stress-tested institutions have actually increased annual operating expenses by 32 percent since 2011. Many banks need to target reductions in non-interest expenses by 20 percent or more from 2010 levels.

Banks with broker–dealers especially those banks in a Holding Company structure such as FCMB and STABIC IBTC should have an abundance of opportunities as the markets continue to thaw. The pent-up demand for credit securities issuance, acquisitions, and spin-offs is considerable. Moreover, trading opportunities should be numerous for strong counterparties.

Even the strongest of the major Nigerian banks face a challenging environment for the foreseeable future. Not only has the economic shock thrown financial markets and industry structures into flux, but the process of saving the banking and securities industry has transformed the nation’s social contract with the industry. The entire industry is now dependent on government support of all kinds, ranging from low-cost funding (courtesy of the CBN), to debt guarantees, asset guarantees, and capital injections.

There is no clear path to restoring the industry to independence from the Nigerian government. Major changes in regulation are coming, and the industry is going to be subject to more government involvement and oversight than it would like for a long, long time. Against that backdrop, stress testing has removed much of the generalized fear that painted all institutions with the same brush. It has also removed the uncertainty related to how the Nigerian government is going to treat individual institutions. But it will remain for the industry’s current leaders to put in place the operational efficiencies and discipline that may determine when—and how—the credit crisis is finally resolved.

Kingsley Ughe can be contacted vide k.ughe@aol.com

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