Nigeria: IMF Technical Note on Stress Testing of Nigerian Banks

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Wednesday, May 29, 2013 / IMF

 

 

This technical note on Stress Testing for Nigeria was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed in May, 2013. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Nigeria or the Executive Board of the IMF.

 

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Summary

 

I. INTRODUCTION, KEY FINDINGS, AND RECOMMENDATIONS

 

1. Stress tests were undertaken jointly by the Nigerian authorities and the Financial Sector Assessment Program (FSAP) team. The exercise covered all 20 commercial banks (100 percent of the Nigerian banking sector) and included several methodological components. Most of the actual calculations were carried out jointly by staff of the Central Bank of Nigeria (CBN) and the FSAP team. An important goal of the exercise was to provide an opportunity for a two-way exchange of experiences and technical expertise on solvency and liquidity stress testing, as well as network and contagion analysis. The aim was to see the results on the banks of the various stress tests and analytic processes, as a key element for assessing financial stability in Nigeria.

 

2. The stress tests were built around four complementary pillars:

(i)           top-down sensitivity analysis for solvency risk (credit, interest, and FX) carried out jointly by the CBN and FSAP teams, using data for the overall banking system;

(ii)          top-down calculations for liquidity risk carried out jointly by the CBN and FSAP teams for the same set of banks;

(iii)         bottom-up sensitivity analysis conducted by eight large commercial banks (about 70 percent of the overall banking system); and

(iv)          network analysis and assessment of contagion risks. The FSAP team collaborated closely with the CBN on the methodology of the stress testing. The authorities shared supervisory data on individual banks with the FSAP team, subject to confidentiality.

Going forward, the authorities are encouraged to include all 20 commercial banks in the bottom-up stress testing exercise and conduct it on a regular basis.

 

3. The exercise included macroeconomic scenario analysis and its transmission into a range of factor shocks, as well as other tests. It included medium and high risk macroeconomic scenarios for aggregate credit risk and a range of tests for liquidity and solvency risks, based on agreed assumptions and scenarios (Section III). The shock sizes took into account recent (2009 domestic banking crisis) experience from, recent global crisis experience, as well as past FSAP practice. The scenario design was informed by the recent World Economic Outlook (WEO) update (April 2012 and September 2012) as well as by several discussions with the Nigerian authorities.

 

4. The stress tests did not derive from the use of econometric time series analysis (so called macro stress tests) because of lack of data over a sufficient time period and structural breaks within the data. The banking sector time series (including that for the nonperforming loans (NPLs)) have very recent and fundamental structural breaks due to the major consolidation of the banking sector that took place since 2005–06, and the significant changes in the structures of the banks’ balance sheets during the 2009 Nigerian banking crisis. Amongst the effects, the aggregate NPLs were reduced from about 35 to about 5 percent in the year 2011, as part of the adopted crisis resolution framework. Overall, the number of banks fell from 89 in 2009 to 20 in 2011.

 

5. With these caveats in mind, the exercise suggests that the Nigerian commercial banking system as a whole can absorb credit and market risk shocks, withstand liquidity pressures, absorb moderate potential losses, but is exposed to credit concentration risk. This reflects the high capitalization and currently low NPL ratios of commercial banks, which in turn reflects the banking system restructuring and recapitalization after the 2009 domestic banking crisis. However, while the banking system as a whole is quite robust, some individual banking institutions appear vulnerable, and one is insolvent even before any stress test. Equally important, the Nigerian economic situation can quickly deteriorate due to a global oil price shock or increasing security concerns in the Northern regions, generating the possibility of large multi-factor shocks on the banking system. The single-factor sensitivity calculations described above suggest that the system would be able to withstand a range of sector-specific and risk-specific shocks occurring in isolation. The shock with the most severe impact on the banking system is credit concentration risk, since a default of five single-name or group borrowers would result in a failure of several banks. The banking system seems to be well positioned to withstand liquidity pressures from funding and market side. Going forward, the authorities may consider conducting liquidity tests for Basel 3 liquidity ratios to monitor preparedness of banks to Basel 3 requirements.

 

6. The network and contagion analysis indicates that the interbank market is segmented and, in part as a consequence, contagion effects would have relatively little impact. The Nigerian banking system is a tiered system, with some banks being net lenders and others net borrowers on the interbank market. The interbank market appears quite resilient to contagion from the failure of large net borrowing banks. In the situation of market segmentation (or clustering), the simulated failure of major net borrowers or net lenders may have a significant negative effect on either credit or funding of banking institutions; however the propagation of contagion beyond the first stage would be limited.

 

7. While the current system of stress testing is quite developed, the authorities are encouraged to conduct integrated stress tests on a regular annual or semi-annual basis and close related data gaps. This note, in addition to presenting the methodology and the results of the stress testing exercise, identifies the key data and analytical gaps, and makes recommendations for further improvements in stress testing (Box 1).



 

8. The structure of the note is as follows: Section II presents the overall design and methodology of the exercise. Section III provides a brief overview of the macroeconomic scenarios and their links to the shocks and combination of shocks for the sensitivity analysis. Section IV discusses results of the sensitivity analysis; Sections V is devoted to liquidity risk. Section VI analyzes bottom-up (BU) sensitivity analysis results and compares them with the top-down results. Section VII is devoted to discussion of network analysis and contagion stress tests. Finally, Section VIII summarizes and concludes.

 

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