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Banks in H1 2020: Imagining Beyond COVID-19

Proshare Confidential	12628 VIEWS
Proshare Confidential
12628 VIEWS

Sunday, October 11, 2020 / 11:50 AM / by Proshare Research / Header Image Credit: EcoGraphics

Executive Summary

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

Nigeria's Banking sector in H1 2020 pulled in its neck and sauntered into the COVID-19-induced headwinds of Q1 and Q2. The brave challenge of a health and economic pandemic saw the sector with lower growth in topline income and decapitation of growth in bottom lines. The banking sector regardless of its weighty operational problems during the year has done a creditable job of remaining at the forefront of longer-term growth.

Indeed, markets are no strangers to shocks but with the advent of a global health pandemic both the nature and extent of the 2020 market shocks have been unprecedented and complex. A fall in the global demand for crude oil as a result of lockdowns in China and Europe started a trade war between members of the Organization of Petroleum Exporting Countries (OPEC) and the so-called OPEC plus nations which includes Russia.

The disagreement over the size of production cutbacks between both groups led to Saudi Arabia in February breaking rank to provide deep discounts on its oil and to also drop prices, the consequence was a sharp tumbling of international oil prices. The fall in oil price has prompted the Nigerian fiscal authorities to revise the benchmark oil price for the 2020 federal budget twice. From an initial assumption of US$57 per barrel in October 2019, the Q1 2020 fall in oil prices compelled the fiscal authorities to revise average oil price expectations down to US$30 per barrel in April 2020 and this toppled further to US$20 per barrel in May 2020.

Falling oil prices have meant a drop in revenues for most oil-producing African countries and this has had major effects on African economies across different economic sectors with the domestic financial service sector feeling a large part of the emerging pain.

Nigeria's Banking Sector; Taking The Pain with The Gain

Nigerian banks recorded mixed results in profit before tax in H1 2020. Eight (8) Nigerian banks among the thirteen (13) banks listed on the Nigeria Stock Exchange recorded an increase in profit before tax while five banks (5) banks recorded a decline in profit before tax. The top five banks with the highest profit before tax were Zenith Bank N114.12bn, GT Bank N109.71, Access Bank N74.31bn, ETI N64.13bn, and UBA N57.13bn while the three banks with the least profit before tax were Unity Bank N1.12bn, Wema Bank N1.73bn, and Sterling Bank N5.68bn. Wema Bank recorded the most significant year-on-year (Y-o-Y) decline of -33.72% in profit before tax (PBT) while FCMB recorded the most significant growth of PBT at +25.51%

The mixed performance of banks in Q2 2020 reflected the diversity of their balance sheet structure and how close loans and advances were to the Central bank of Nigeria-imposed 65%. The banks that were already close to this ratio in Q4 2019 would not have seen much growth in Q2 2020 on a Y-o-Y basis as the additional earnings growth had already been almost completely factored into their performance. But banks that had to rapidly ramp up loans and advances and therefore profit numbers would have witnessed a more significant rise in PAT in Q2 2020 Y-o-Y.

The gross earnings of the majority of banks listed on NSE was unaffected by the coronavirus pandemic. Only three banks recorded a decline in their gross earnings in H1 2020. The three banks that recorded a decline in GE were Sterling Bank -2.8%, Wema Bank -6.6%, and ETI -3.3%.

Before the Storm

Months before the COVID-19 outbreak, some banks had realized that to stay profitable and sustainable they needed to restructure their businesses to be fit-for-purpose in a fast-paced new digital reality. Operating costs needed to decline as industry consolidation was beginning to look more inevitable to improve economies of scale and scope. Small-sized banks would exist for a season but as asset quality became more of an industry concern, larger-sized institutions would be at a competitive advantage as they serviced high net worth corporations and individuals with higher credit ratings while smaller banks are left with dregs of the loan bucket having to service riskier customers. In other words, smaller banks would have to face larger credit risks, higher impairment provisions, and lower profitability. The weaker balance sheet positions of smaller-sized banks had nothing to do with a virus and were the outcome of natural market logic. In finance small is not exactly beautiful.

Some banks had realized this quite early and built buffers into their operations to withstand sudden shocks to the lending system. Early in 2019, for example, Access Bank as part of its five-year strategic growth plan, merged with the erstwhile Diamond Bank, thereby creating Nigeria's largest lending institution by asset size. But what was more critical was that the bank leveraged the merger to strengthen its digital foundry and sandboxes and redesigned its institutional skill sets and workforce requirements.

The reconfiguration of the bank's business model meant that workers needed to be streamlined into the new competitive banking landscape. For a bank like Access Bank, this inevitably required a redesign of its workforce architecture, meaning some jobs had to shrink in number while others grew. The paradigm shift was similar for UBA which had to let go of over a thousand employees in January 2020 and ETI that laid off a large part of its older workforce and disengaged staff on contract in the middle of 2019.

Understanding the New Normal

Banks will have to cope with a new customer environment defined by less physical interaction, more demanding digital user experience and interaction (UX/UI) and greater fluidity in consumer loyalty as millennials begin to become a larger segment of bank's customer base, even though they may not constitute the largest demography by nominal deposit value.

The growth of generation Z and Y and their digital competence would gradually change the state of engagement between banks and customers. However, the change would be far from a sea change alteration, as Nigeria's large informal sector is still fairly digitally unsophisticated. While it is true that the unstructured supplementary service data (USSD) codes have been very successful in meeting the mobile payment solution needs of retail customers, the small enterprise solutions are yet to be as popularly adopted (see Table 1).

Table 1: New Enterprise; Understanding The Fintech Buzz

Nevertheless, the banking sector is creatively improvising to pull the informal sector into a banking payment and settlement loop by the promotion of agency banking in communities that do not have formal branches or cash centres or automated teller machines (ATMs). It is still early to tell how successful agency banking will be, but from reports of the larger tier 1 banks, the rural penetration rates have been impressive.

Digital banking will increasingly thrive in local cities but informal businesses on the fringes of urban economies will adopt new technology more slowly. The mortal error banks could commit in the new post-COVID-19 era is to believe their hype. Digital banking services will increase as more people go online to initiate and complete financial transactions, but the less fanciful services of banks must equally be addressed. Digital natives may be pleased with financial geekdom but digital nomads would likely feel more comfortable with a set of less exotic services, and since nomads typically have more spending power than natives, banks can only ignore them to their peril (see Table 2).

Table 2: Coming To Terms with Macroeconomics and the New Digital Normal

Increased social distancing in 2020 and 2021 would require banks to observe higher standards of environmental and health governance, by way of increased expenditure on hand and hard surface sanitizers, queue management technology, 'menu' costs of reminding customers of appropriate physical distancing rules and the cost of retraining of staff on handling physical customer interaction such as the use of non-medical face masks.

Dodging A Bullet

Can banks avoid the impact of global contagion on the Nigerian financial system? That would be desirable but near impossible. As long as bank customers have foreign product supply linkages and export-oriented operations both the banks and their customers would be affected by foreign exchange translation costs. The local businesses would also be affected by movements in global interest rates as investors move money across territories in search of superior returns. Sterilization of the impact of changes in international trade conditions on modern domestic open economies is improbable. Dodging external economic bullets is desirable, but like a man tied to the stake, the probability of survival is slim. Nigeria's economy with a heavy dependence on crude oil export is a ship on stormy global waters, the ship's stability depends on the dexterity of the captain and the courage of the crew, so far Nigeria's economic managers have found themselves tossed around like a tennis ball.

Banks would, therefore, need to gradually wind down their exposure to the oil and gas sector and take a second look at the power sector too. But can local banks afford to ignore two of the largest sectors of the local economy? Perhaps not. Banks may need to build stronger operational buffers to survive the uncertainty of the near future. A crucial area banks may need to address is the size of their shareholder's funds, the larger the funds the more resilient the bank would appear to be. The implications would be that going into 2021 some mergers and acquisitions (M&As) may occur to consolidate the industry and strengthen corporate balance sheets. Tier 1 institutions such as FBN may consider growing inorganically by searching for smaller tier two competitors with weaker balance sheets but strong potential value addition if relieved of constraining liabilities such as Asset Management Company of Nigeria (AMCON) obligations and negative or marginally positive shareholder's funds.

Back of The Book

The new business era is a game of innovation, creativity and efficiency. Banks will need to ramp up digital capacity very fast while also building creative less exotic service solutions for the large informal sector and the over 40.5m micro, small and medium-sized businesses (MSMEs) in the country.

Conventional banking will have its place, but that space could shrink at a disconcerting pace depending on how the international business outlook shapes up for the country in 2020 and 2021. An optimistic outlook would see banks reposition quickly to prepare themselves against future economic shocks, but if the outlook appears pessimistic the banks would likely be more focused on immediate tactical survival than on the finer points of strategic corporate longevity. As banks realize in the words of US Army General GB Sullivan, "Hope is Not a Method". They will have to survive by being trimmer, sharper, and more customer-centric.

Holding an umbrella against a cyclone is brave but ineffectual, likewise, banks would have realized by now that to survive the swiftly changing dynamics of domestic financial service delivery being small is a thick leg chain tied to a massive tree trunk. As safer loans float towards bigger lending institutions smaller banks will find themselves holding less qualitative risk assets making their books more vulnerable to the next business downturn, if anything is likely to happen to protect systemic stability, it is likely to be a dash towards industry consolidation. Being bigger may not be elegant but in the business of lending, it is far from ugliness.

Section 1 of the report takes a broad aerial view of Nigeria's banking landscape in H1 2020, capturing the nuanced landscape of a COVID-19-endangered financial system. It captures the efforts the local banks have made to break through the storm and hold up earnings as best as possible.

Section 2 of the report digs deeper into how Nigerian banks have evolved short-term strategies to fend off the more severe consequences of COVID-19 and oil price declines on their operations. The section dwelt heavily on the various types of risks that banks had to face and how they were required to navigate the challenges. The section pointed out that the second wave of restrictions on economic activities in 2020 could lead to a very exotic double-dip or wavy W-shaped recovery. According to the report "The spread of the virus will hurt businesses and individuals affecting their customer's ability to repay loans. Also, further restrictions if the virus persists might lead to an increase in withdrawals by depositors. To further compound issues, banks might record increased defaults and higher delinquent credit exposure as a result of the slowdown in economic activities".

The report further noted that "Banks with a mismatch in their foreign currency (FCY) denominated assets and liabilities may experience significant exposure to currency risk occurring from expected defaults on their foreign currency assets compounded by recent adjustments in exchange rates by the CBN".

Section 3 of the H1 2020 Banking analysis Breaks into the industry numbers for H1 2020, highlighting where each sector showed strengths and weaknesses while analyzing its opportunities and threats. The section does a drive-by observing the valleys, hills, and sharp economic bends that have made 2020 a rough year for financial market operators. The impact of the economic and health shocks of the double whammy of COVID-19 and fiscal decline is captured in a series of tables and charts that show the vulnerability of the domestic financial system to external uncertainties. The report noted that "Nigeria has a peculiar and distinct domestic economy. Unlike other economies were banks recorded a significant decline in profit in H1 2020, a sum of the profits of thirteen banks listed on the Nigerian Stock Exchange revealed that there was an increase in gross earnings by +5.18% and a mild decline in profit before tax by -1.47%".

Section 4 breaks into a deconstruction of the banking sector bank-by-bank exposing the underbelly of each bank based on its H1 financial records. According to the report "The majority of the banks listed on the Nigeria Stock Exchange (NSE) recorded an increase in their gross earnings in H1 2020. Ten (10) banks among the listed banks on the NSE recorded an increase in their gross earnings while three (3) banks recorded a decline in gross earnings. The top five banks with the highest gross earnings in H1 2020 were Access Bank N396.76bn, ETI N392bn, Zenith Bank N346.09bn, UBA N300.6bn, and FBNH N296.4bn while three banks with the lowest gross earnings were Unity Bank N22.87bn, Wema Bank N38.15bn, and Sterling bank N70.23bn"

The report provides readers with an opportunity for assessing how well each local bank has coped with the challenges to domestic credit and tumbling consumer expenditure and savings. A peculiarity is that two banks (Unity Bank and Heritage Bank) have maintained negative shareholders funds for over three years and still walk the Banking bistro without consequences. This is a curiosity both domestic and foreign investors and academics have tried to understand and explain without success they have been stumped by theory and practical global regulatory best practices. In the case of Unity Bank, the bank has been able to drum up marginal profit before tax thereby incrementally reducing the capital deficit but Heritage Bank remains a stellar example of a puzzle wrapped in an enigma.

Section 5 enters into a pre-wrap up phase of the report by encapsulating issues around the forward-view of the industry and key takeaways from analyzing the H1 2020 financial statements of the banks. It detours into the monkey games that some agriculture-related Fintechs have played over the last half-year. The report points out that "Increasingly Fintech companies, especially those targeted at the agricultural sector have been offering returns on investments far above returns in alternative money market assets with investors piling into these digital investment wonders in search of superior returns. The problem with such schemes is that there is no underlying 'real' asset trading in a growth market that justifies the returns on offer. The schemes speak to the parable of the monkey market".

Section 6 ends the report by capping with issues raised in earlier segments and introduces the VUCA matrix as a tool for assessing the challenges of the unfolding Holdco structures that virtually all tier 1 banks in the country have chosen to adopt.

Illustration 1: Bank Holding Structure and the Mistiness of Progress

The report says, "With the future shrouded in uncertainty, the outlook for banking is a gamble on the institutional resilience, far-sighted corporate leadership and the creative application of technology in the course of day-to-day business. The ability of local Nigerian banks to unhinge their hooks from the general economy provides hope that at least tier 1 banking institutions would provide backstops to an economic downturn in 2020 and 2021."

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