Searching for Investor Confidence - Nigerian Banking Sector Report 2016

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Tuesday, October 04, 2016 4:45pm / Afrinvest Research

Executive Summary

Global Economy and Global Banks

Over the last two years, policy makers in emerging and frontier markets have had to deal with a cross current of headwinds arising from internal and external sector imbalances occasioned by several factors including, the crash in commodity prices, normalization of monetary policy by the US Fed, faltering global growth (led by China) and the heightening risk outlook posed by Brexit, illiquidity in domestic capital markets and volatility in global financial markets.

For Nigeria, the fall in global oil prices as well as militancy induced output disruptions have fundamentally crippled the fiscal earning capacity of government and also undermined external sector and financial system stability. Depressed government revenues have significantly weighed on the viability of Sub-Nationals in particular, with some 26 Sates unable to meet their employee wage obligations, prompting the Federal Government to provide bail out packages in order to preserve social security.

In addition, lower foreign exchange receipts have weakened the country’s external reserves and ultimately deflated the CBN’s politically inspired defense of the local currency. Consequently, most macroeconomic indicators have deteriorated as the economy grapples with a recession amid galloping inflation and rising unemployment.

In response, the fiscal authority rolled out an expansionary 2016 budget of N6.1tn, with the aim of reflating the economy.


Similarly, the Apex Bank has had to take tough policy decisions to restore confidence and make the economy attractive for foreign capital inflows. The introduction of a flexible foreign exchange policy which resulted in a circa 37.0% depreciation of the naira at the interbank as well as the hike in MPR to 14.0% were some of the positive steps that have been taken. The CBN further surpassed consensus expectation by introducing hedging products (forward and futures) to further deepen the FX market and reinstate positive market sentiments.

In this edition of the Report, we review developments in the global economy including policy outlook across key advanced markets such as the European Central Bank (ECB), the Bank of England (BoE) and the Bank of Japan (BoJ) all sustaining momentum on their respective stimulus programmes. The US Fed on the other hand continues to guide a gradual normalization of monetary policy in the medium term, given the aftershocks of lower oil prices, faltering global growth and heightened risk outlook posed by Brexit.

However, growth in key Emerging Markets (EMs) has shown some signs of improvement given recent uptick in oil prices (Brent crude price settled at US$50.50/b on 19/08/2016) in H1:2016 plunging 67.3% between June 2014 and December 2015. Brexit poses the greatest risk to global stability at the moment, following the decision of the United Kingdom (UK) in June 2016 to exit the European Union (EU).

Our analysis suggests that though Brexit will afford the UK the chance to tighten its stance on migration from the EU and reform welfare benefits, uncertainties resulting from the referendum has heightened macroeconomic headwinds both in the EU and Britain. In addition, developing economies such as Nigeria, with strong trade and capital ties to the UK may be affected, but the impact on the Chinese and US economies is anticipated to be broadly minimal.

Accordingly, the IMF projected in July 2016 that global growth for 2016 will remain flat at 3.1%, revised downward from 3.2% earlier forecast in April 2016. Growth in Advanced Economies (AEs) is expected to ease to 1.8% in 2016 from 1.9% in 2015, weighed down by the UK and EU economies which are estimated to slow from 2.2% and 1.7% in 2015 to 1.7% and 1.6% in 2016. Emerging Markets’ growth will improve slightly from 4.0% in 2015 to 4.1% in 2016. Meanwhile, growth in Sub-Saharan Africa (SSA) is projected to decline from 3.3% in 2015 to 1.6% in 2016 weighed down by weaker growth in South Africa and Nigeria.

Against the backdrop of these challenging macroeconomic conditions, we examine the key themes shaping the global banking landscape to include; technological integration of core banking operations as well as increased regulatory supervision via stress testing and capital buffers provision.

Domestic Macroeconomic Highlights
Key risk factors in the global economy shared by most commodity exporting nations, particularly lower oil price environment, dictated the pace of Nigeria’s macroeconomic fundamentals and capital market performance in the period from Q4:2014 till date. Nigeria’s over-reliance on crude oil earnings for macroeconomic stability over the years has made the economy highly susceptible to price volatility and also crippled its fiscal buffers and resilience, hence the current recessionary shock.

The overwhelming impact of the Central Bank of Nigeria’s (CBN) FX policies on domestic economic conditions influenced most of our themes in this edition of the Banking Sector Report. We analyse the domestic socio-political and external sector developments, paying particular attention to FX market dynamics and its impact on domestic economic activities.

Reviewing President Buhari’s first year in office, we observed that despite the largely pro-business agenda set by the President in his inauguration speech as well as the perceived gains in both the anti-corruption efforts and counter insurgency, the inability to make pro-market choices in pricing and allocating increasingly scarce resources (especially foreign exchange and energy) amid steeper drop in oil prices culminated in a double jeopardy that further constrained economic activities in the country. Thus, the groundswell of hope built on the promise of “change” appears to be waning, overwhelmed by the onset of recessionary economic policy choices.

With close to 26 Sub-Nationals on record as owing salaries in light of the fiscal crisis ravaging many States, the Buhari led government leveraged on its strong, albeit fast diminishing anti-corruption goodwill, to deflect a major industrial action following the hike in petrol prices by NNPC in May 2016.

Although the military has recorded significant gains over Boko-Haram insurgents in the North-East, the socio-political environment remains fragile with a resurgence of Biafran agitators in the South-East, sporadic killings by suspected Fulani Herdsmen mostly within the North-Central and South-Eastern sections of the country while pockets of kidnappings and abductions in South-West and the increased spate of attacks on crude oil production facilities by the Niger Delta Avengers in the South-South only serve to stoke the smoldering embers of insecurity.

We review the developments in the domestic economy which have shaped performance since 2015 to include the following.

1.       The return to “recession economics” and double-digits inflation
2.      How capital account rigidity and fiscal policy inertia triggered a confidence crisis, forcing the economy into a technical recession by Q2:2016
3.      The realities of lower oil prices, trade and current account imbalances in the context of CBN’s demand management and restrictive policies on FX utilization
4.      The CBN’s belated but positive adoption of a flexible exchange rate regime
5.      How far we think the “Budget of Change” can really go.

Monetary Policy and Regulatory Environment
This edition of the banking sector report also reviews how the regulatory and policy environment has been shaped by a plethora of events in the last 15 months. We focus on monetary policy tools which were deployed very frequently in the period with foreign exchange stability dominating the discourse. We note that policy actions were largely guided by the apparent desire of the CBN to sustain its naira peg against the dollar despite lower FX receipts and depressed global oil prices - a situation which drove the parallel market rate to a record low while eroding banks’ profitability.

In the context of the range of policy options available to the CBN, the effectiveness of policy actions on all fronts appear rather disappointing judging by key indicators in the economy. This was mainly because the CBN’s decision to fix exchange rate at N199.10/US$1.00 while imposing capital control measures, came at a significant cost of galloping inflation rate (16.5% as at June 2016), contraction in real economic activities (-0.4% as at Q1:2016), increasing unemployment (12.1% as at Q1:2016) and significant depreciation of the Naira at both the official and parallel markets.

Nevertheless, we laud the courage of the CBN in reversing its initial stance of supporting a rigid FX framework and replacing this with a flexible FX arrangement particularly the creation of derivative products that provide avenues to hedge investment positions.

Nigerian Banking Sector in 2016
Our assessment of performance indicators in the Nigerian Banking space indicated that performance softened in 2015 as events in the socio-political, economic and regulatory environment heightened risk consciousness, slowed the pace of credit expansion, deteriorated asset quality and weakened earnings capacity across all tiers in the sector. 

Aside from this, other major regulatory issues that defined the performance of the banking sector in 2015 were;

i.            harmonization and subsequent downward revisions of the Cash Reserves Ratio (CRR) to 25.0% and 20.0% before an upward adjustment to 22.5% in March 2016,
ii.            implementation of the Treasury Single Account (TSA) by the Federal Government, and
iii.            increase in general loan loss provisions to 2.0% (from 1.0%) in the face of sharply rising Non-Performing Loans (NPLs) and weaker asset quality.

Accordingly, the resilience of the Nigerian banking sector was put to the test as elevated risk concerns triggered a spike in NPL ratio and slowed the pace of credit expansion dramatically.

Gross loans and advances dipped 1.9% in 2015 across our coverage universe compared to the 26.6% growth in 2014 as lower oil prices, FX volatility and liquidity concerns dampened risk appetite amidst a hazy economic road map. Thus, growth in industry gross earnings moderated to 10.3% in 2015 (compared to 14.6% in 2014). At the same time, liquidity in the banking system (especially among Tier-2 banks) was pressured by the TSA implementation which sterilized approximately N1.2tn from the banking system.

As a result, sector profitability was depressed in 2015 with Profit before Tax (PBT) tumbling 28.4% Y-o-Y as industry NPL ratio spiked to 4.9% from 3.0% in 2014. Furthermore, Return on Equity (ROE) moderated to 9.1% from 15.5% in 2014. Capital Adequacy Ratio (CAR) was strained on account of revised computation guidelines and increase in general loan loss provisioning settling at 16.5% in 2015 (relative to 19.7% in 2014). Total deposits dipped 1.8% Y-o-Y to N20.7tn while total assets (+3.3%) and liabilities (+1.1%) increased Y-o-Y.

Against the backdrop of lower oil prices which has weakened macroeconomic fundamentals, the outlook for the sector in 2016 was expected to be dominated by developments in the FX market. Accordingly, we identify risk areas for Nigerian Banks to include;

1.       Credit exposure to high risk sectors: We see four high risk sectors to asset quality in 2016 to include Upstream Oil & Gas, General Commerce, Manufacturing and Power.

 

o   Default risk arising from General Commerce and Manufacturing due to liquidity challenges in the FX market together with the recent devaluation has weakened operating margins and constrained cash flow of debtors in both sectors;

 

o   Credit concentration risk emanating from upstream oil & gas loans due to lower oil price and the Niger-Delta uprising despite increasing efforts by banks to restructure these loans; and

 

o   Potential default risk arising from power asset loans which are predominantly denominated in FCY (US dollar).


2.      Pressure on Capital Adequacy Ratio (CAR) in the aftermath of the depreciation of the naira

3.      Restrained appetite for both sovereign and corporate Eurobonds

Against the backdrop of the issues reviewed above, we highlight our expectations for the performance of the banking sector below.
 

1.      Risk Assets to Expand Nominally due to Currency Adjustment: Although real loan growth is expected to be muted in 2016, the 29.1% effective devaluation of the local unit will translate into a circa 15.0% nominal expansion in industry loan book given the significant (37.0%) FCY denominated risk asset exposure as at FY:2015.

 

2.      Weaker Asset Quality: Newer threats to asset quality in the Nigerian banking system are expected to emerge given the level of concentration in select high risk sectors as highlighted above. Thus, NPLs are expected to remain pressured despite efforts by the banks to restructure significant portions of their loan books. We project industry NPL ratio at about 12.1% in 2016.

3.      Constrained Gross Earnings: We project gross earnings growth to slow down further in 2016 due to a number of factors, including

 

a)     The pace of interest income growth will soften on account of credit tenor and obligation restructuring amidst rising NPLs and weaker risk asset growth (notwithstanding the aforementioned nominal expansion in loan books).

 

b)     Nominal expansion in loan book may not translate into an increase in interest income given that recessionary pressure in the economy as well as cash flow constraints may increase default risk in the system.

c)      Trading income is expected to remain depressed despite the recent reforms in the interbank FX market as liquidity remains a major challenge.

 

In contrast to the above, we expect Non-interest income to increase due to FX gains from naira devaluation. 

4.      Higher Yield Environment Positive for Interest Yielding Assets: Given the recent increase in MPR, the yield environment has become quite attractive. Increased deployment of funds to investment securities which started since 2015 will likely continue in 2016/17 until the structural and macroeconomic concerns in the country are allayed. More so, upward review of MPR implies a higher rate on loans and improved yields on fixed income securities which in turn will increase the overall rates on interest yielding assets.

 

5.      Cut Back in OPEX and Retrenchment: We expect banks to make further cut back on operating expenses. ETI, ZENITH and DIAMOND are already downsizing following reports that approximately 1,040, 240 and 200 employees had been laid off, respectively, by the three banks in H1:2016.

 

6.      Reduced Profitability: Profitability is expected to further moderate despite cut backs in operating expenses. Lower gross earnings due to weaker interest income and strains on non-interest income despite rising impairment charges will pressure margins. Hence, PBT and PAT margins are expected to soften.

 

7.      Lower Capital Adequacy Ratio: CAR is expected to come under intense pressure in 2016 following the devaluation of the naira and a nominal expansion in risk weighted assets due to significant foreign currency exposure. Our analysis suggests a 2.2% average decline in industry CAR in FY:2016 for all the listed players under our coverage. However, majority of the banks (except for SKYE) appear well capitalized to withstand the pressure given the stringent regulatory guidelines. We suspect the possibility of SKYE, DIAMOND and FBNH raising capital in 2016/17 as their current CAR levels remain close to regulatory threshold.

 

8.      Low Probability for Mergers & Acquisitions (M&A): Against the rising speculation of further consolidation in the banking industry due to capital adequacy threats, we do not foresee much M&A transactions in 2016/17 given the size of banks now relative to pre-2005 consolidation. In our opinion, most of the banks are adequately capitalised to withstand the pressure in the horizon. Accordingly, we think the possibility of M&A amongst the 15 listed banks is slim. Nevertheless, we may not rule out the likelihood of M&A with the indigenous private unlisted banks and Keystone Bank (which is currently being offered for sales by AMCON).


Searching for Investor Confidence
With the economy underperforming its potential, the oft-repeated investment case for Nigeria has shifted from the resilient economy with unexploited natural and human resources, attractive demographic features and high profit margins to confidence metrics such as, policy consistency, sound governance, regulation and reforms. Despite recent reforms in the oil & gas and foreign exchange markets, key macroeconomic indicators – galloping inflation (17.1% as at July 2016), GDP (-2.1%growth in Q2:2016), exchange rate depreciation and fast rising unemployment rate (13.3% as at Q2:2016) – have deteriorated with no sign of a reversal in the horizon.

In addition, significantly weaker asset prices with no buyers in sight aptly captures the degree of pessimism in the Nigerian economy and markets by investors, producers and consumers. Accordingly, Afrinvest Research believes that restoring confidence in regulation, policies, markets and governance appears to be the single most important factor required to rekindle investors’ interest in the Nigerian economy and financial markets. In the present circumstance, the 11th edition of our Banking Sector Report therefore focuses on this theme with the title, “Searching for Investor Confidence”. We are of the view that rebuilding confidence in the Nigerian markets would require broad-based policy measures encompassing fiscal and monetary policy as well as further structural reforms. We highlight the following as imperatives:

1.      Ensure Monetary and Fiscal Policy Co-ordination
We think there is an urgent requirement for the economic managers to re-organize recent policy actions to ensure both fiscal and monetary policies are in harmony. More importantly, efforts must be put in place to ensure policy actions are prudent, predictable and consistent going forward. In addition, we recommend a complete liberalization of the foreign exchange market, devoid of any suspected invisible control of the CBN. Having delayed adjustment to a flexible FX framework, the CBN needs to consciously ensure regulatory consistency and stay the course of its new FX framework to regain lost credibility and boost confidence among investors.

The huge spread between the official and parallel market FX rates is a source of concern and continues to form the basis upon which most foreign investors perceive the true value of the naira. We think that after over one year of excluding 41 items from accessing forex from the interbank window, the fiscal authorities should have either banned or increased duties on these items by now. This would remove one of the major factors driving the parallel exchange rate lower and leading expectations of lower exchange rate at the official market. Resolving the FX dilemma and giving up restrictions would enable the CBN regain control of monetary policy and focus on reducing interest rates from the current high levels stifling credit access.

Beyond embracing reforms to reduce recurrent expenditure and engender probity in public sector finances at all levels, we believe the fiscal authorities can still do more in building fiscal resilience through diversifying revenue base. Although higher taxes could be a drag on growth in a period of recession, it could also reduce the credit risk of the Sovereign and unlock borrowing potentials required to invest in infrastructure and buoy growth. Hence, underexplored tax potentials, especially relating to consumption may need to be reviewed. Nonetheless, tax breaks and holidays should be given to high employment sectors such as agriculture, tourism and real estate to spur private sector investment.

2.     Fix the Niger-Delta Crisis and Press OPEC Further to Cut Supply
Oil prices and production volume remain indirect nominal anchors of foreign capital inflows into Nigeria. With the protracted crisis in the currency market, we think it is pertinent for the federal government to urgently find a long lasting solution to the lingering crisis in the Niger-Delta region in view of developments in the global oil market.

Perhaps adopting a more diplomatic approach rather than force may save the economy a few more barrels of crude while still keeping dialogue open. Beyond recent efforts to restructure the NNPC for efficiency and the partial deregulation of the downstream oil and gas, we reiterate our advocacy for a comprehensive reform of the oil industry and privatisation of the NNPC. This will go a long way towards nipping the recurring militancy issue in the bud while immediately unlocking latent value to the Government in new revenue opportunities.

Meanwhile, we strongly believe Nigeria should put forward a stronger case against OPEC’s current strategy on crude oil production while pressing the cartel further for supply cuts to strengthen oil prices in the global market. This would have a positive impact on GDP figures, fiscal revenues, foreign exchange earnings and power supply.

3.     Structural Reforms to drive Self-Reliance
Current trade policies of the federal government and FX policy of the CBN suggest a policy environment focused on import substitution (and demand management) as opposed to export-led growth. We think less emphasis needs to be placed on import substitution as a strategy but propping non-oil export industries via promotional campaigns and infrastructure support programmes.

The need to improve infrastructure stock of the country was captured in the 2016 budget with more allocations going to capital projects. Yet, we think infrastructure spending needs to be more strategic with an overarching focus to promote agriculture, industry and services.

Perhaps, a plan stating the economic vision of the administration and the action plans to ease the difficult conditions of doing business in Nigeria will better communicate government’s strategy. Government should embark on a comprehensive re-organization of the agricultural industry, increase investment in processing and storage plants and also drive expansion in exports in a bid to expand source of foreign exchange earnings.

4.     Unwavering Commitment to Sustained Economic Reforms
The Nigerian government must signal actual commitment to long term economic reforms by according the same level of seriousness it has shown in the fight against corruption and insurgency towards resolving the current economic challenges.

Given the urgency of the need, government must work extra hard to dispel the seemingly growing perception that it lacks the requisite knowledge and managerial nous needed to take the economy out of its present challenges.

Indeed, with the first anniversary of the appointment of the current cabinet fast approaching, it may be useful to undertake a broad assessment of the performance of government at the institutional level, as well as a more detailed evaluation of the performance of ministers as individuals.

Whilst it is impossible to retroactively establish metrics and benchmarks for such evaluations, it may however be necessary in order to truly demonstrate a divergence from the status-quo (change!), while communicating the message that poor performance will also be rewarded.

5.     Wanted: An Economic Blueprint and Turnaround Experts
Rather than spend energy launching social programmes, the government urgently needs to commission a team of experts to layout a comprehensive economic blueprint for Nigeria within weeks. This should be complemented by appointing a handful of individuals that have proven experience and credentials to implement such a plan. 

President Buhari must then throw the full weight of his authority behind such individuals to enable them proactively take the necessary critical steps required to stem the current economic hemorrhage and reset Nigeria towards the path to growth. 

Recent evidence from the currency market shows  that the economy has suffered gravely from the feedback effect of reactionary and hesitant policy responses where the delayed decision to adopt a flexible exchange rate weakened investment confidence and deteriorated key macroeconomic variables.. 

Thus, to restore confidence in the system, the new economic team must have the capacity to advocate for pre-emptive and timely policy measures and insist on the proper co-ordination and alignment of such policies amongst both fiscal and monetary authorities.

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