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Monday, 31 December 2012 00:00
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Nigerian banking industry perspectives in 2012

Following the economic crises that have touched economies large and small, “developed” and developing, in recent years, new risk management rules are remained the fulcrum of banking being instituted in the financial landscapes across the globe.

These  have had profound implications for all banks – not least in Nigeria. Only those banks fully equipped with fully incorporate risk management into the wider objectives of customer and shareholder satisfaction are adgudged successful, in the present scheme of banking.

For instance, salient issues like Minimum capital adequacy requirements under bank regulation regimes, set capital as a floor percentage of risk (risk weighted) assets. In recent years, whilst minimum capital adequacy percentages were broadly in line (i.e. 8 per cent for developed countries and 10 to 12 per cent for developing countries), Central Banks worldwide were applying widely different rules in the definition of risk assets in their capital adequacy supervisory practices.

In many developed countries, securitised loans could be packaged into off balance sheet structures or special purpose vehicles to escape inclusion in the risk asset calculations. In Nigeria, up to recently, commercial paper holdings were treated as off-balance sheet instruments, thus excluded from risk assets.

Likewise, interbank placements are excluded from the Nigerian definition of risk assets, whereas these assets are included in the definition of risk assets in other jurisdictions.
 Risk asset definition

 The weaknesses in applying consistent, robust risk asset definitions globally have led to distortions of true capital adequacy positions. Banks could become highly leveraged with insufficient capital to absorb losses in times of crisis.

For example, the two largest Swiss banks were regarded as some of the best capitalised banks in the world based on capital as a percentage of risk assets. However, their capital bases proved to be woefully inadequate during the crisis, requiring significant capital injections.

Likewise some of the Nigerian banks, which had to be bailed out recently had capital in excess of 20 per cent of risk assets, yet were found to be short of capital when losses materialised.

 Leverage ratio
To address this problem, the Bank of International Settlements, the Central Bank to central banks, announced on September 7 that from 2011, a maximum leverage ratio will be applied to set a cap on the amount of leverage a bank may employ. This will be an international requirement.

 Leverage is defined as total assets (not risk assets) divided by tier 1 capital (equity). The maximum leverage that will be allowed is 25. This will be applicable to AAA rated banks, of which there are now very few globally. The maximum leverage ratio for lower rated banks will be adjusted downwards.

 Economic capital is a tool adopted by international banks to determine the size of equity buffer required to absorb potential losses, to protect debt holders.

Leverage ratio can not and will not replace the minimum capital based on risk assets. It is said to merely set a floor for the minimum capital requirement as a percentage of risk assets. For example, whilst a BBB rated bank has a maximum allowable leverage of 15 (i.e. minimum Tier 1 capital of 6.7 per cent of assets), it might be required to hold more capital, based on the risk sensitivity of its assets.

 Leverage and ROE
To fulfil their intermediary role in the economy, banks must be allowed to take risk free deposits from liquidity surplus entities and transform these into risky assets lent to liquidity deficit entities.

To ensure depositors would be willing to provide liquidity, asset risk must be assumed by equity providers. For equity providers to take on asset risk, they will have to be adequately rewarded. Return on equity (ROE) is therefore the most important performance metric for any bank. A bank with an average ROE of 30 per cent and dividend payout ratio of 1/3, will grow the value of its shareholders’ funds by 20 per cent annually.

Banks with high ROE’s are  rewarded through high growth in their share prices.
To improve ROA, banks are expected to improve asset yield (a function of depth of product range, sales growth, relationship intensity, cross selling, etc.). In addition, funding cost must be kept low – this is a function of the diversity of the deposit base, deposit mix, etc.

Further, charges for asset impairments (investment, loans, fixed assets, etc.) must also be limited. This is a function of asset quality and risk management strength. Minimizing impairment charges/assets (through strong risk management), will lead to an improved credit rating over time, allowing a bank to take on more leverage with equity and so increasing ROE.

Lastly, operating expenses/assets provides a measure of productivity – extend to which assets are ‘sweated’.

With the international harmonisation of banks’ leverage ratios from 2011, there will be much less scope for banks to enhance ROE and shareholder value, through regulatory rules arbitrage, enabling increased leverage, as was done in the past.

 Banks’ international credit ratings are constrained by their sovereign ratings. Frontier market banks with lower credit ratings will thus have a competitive disadvantage in respect of the amount of leverage they will be allowed to deploy.

For example, the maximum leverage for BBB+ rated South African banks will be 16, compared to 8 for their B+ rated Nigerian counterparts. The operating efficiency of Nigerian banks will thus need to be twice that of South African banks (assuming equal tax rates) to achieve the same ROE.

To remain competitive, frontier market banks will have to exploit the growth opportunities in their countries and use scale to enhance operating efficiency (ROA) and so boost their ROE’s.

One of the likely consequences of the Nigerian banking crisis is the differentiation in risk assessments by rating agencies, investment analysts and others, replacing the ‘one size fits all’ assessment that obtains lately.

Nigerian banks with superior risk management, even though constrained by the sovereign rating ceiling, will still enjoy better ratings (enabling more leverage) than their domestic counterparts with weaker risk management.

The global introduction of a maximum leverage ratio for bank capital adequacy levels from 2011,  have had profound implications for Nigerian banks’ international competitiveness. Winners in the new game are those banks that can best optimise their investment in processes, people and systems in relentless pursuit of customer satisfaction and operating efficiency and those that will be able to increase leverage capacity through enhanced risk management.

On the whole, the new model adopted by Nigerian banks has been adjudged to be the best  that will go a long way in promoting transparency and the nation’s economy.
According to a Shareholders' interest advocacy group,  the Constance Shareholders Association the model adopted by the CBN in 2004 and, in 2010, directed all bank to divest from non-core banking businesses.

its quest to ensure professionalism in the financial sector, which  the universal banking structure, which was introduced in 2004 and, in 2010, directed all bank to divest from non-core banking businesses would not only create value for shareholders, it would also promote transparency, which would in turn boost the economy.

President of the group, Mr. Shehu Mikail, said: “Basically, the system that these financial houses are introducing actually will create more impact; there will be more avenues for the institutions to improve; with members of staff having to be more creative and provide better services to their customers.”

He, however, stressed that the system, which UBA was introducing, was better than the holding company structure other banks were adopting because the outcome of UBA’s restructuring would be that four companies would be listed on the Nigerian Stock Exchange, rather than one holding company.

“Listing four companies (on the NSE) is going to create more avenues for investors to come in and invest. It will also boost the business activities of those other companies because they will be able to improve their structures and services,”he explained.
Mikail added that, besides attracting investors to the capital market, the new structure would ensure that financial reports would be more detailed, thereby encouraging transparency.

He admitted that by scrapping the universal banking structure, the CBN was indeed promoting professionalism in the industry as the banks would focus on their core business – banking.

Under the universal banking structure, banks had been allowed to engage in non-core banking businesses. Consequently many of them had diversified into areas such as insurance, pension funds management, brokerage firms and mortgage banks, among other interests.