Key risks to watch in the Nigerian financial sector for second half 2010

Inflation

This is the biggest risk facing the Nigerian financial sector going forward. Various factors are coming together to inflate the Nigerian economy. These factors include a huge budget deficit of about 35% of the budget, and about 5.3% of GDP that has no obvious source of financing. The Federal government is planning a N500 billion capital raising in the international markets, those this is just one third of the anticipated deficit still leaving about a trillion naira which the government will struggle to finance. Considering this is an election year, the efficiency public expenditure is expected to be lower than its traditional low as politicians will be looking more at cornering money for electioneering campaigns than on production ventures.

Though President Jonathan has submitted a proposal to the National Assembly asking for a reduction of the budget from N4.6 trillion to N4.2 trillion, He also simultaneously submitted a supplementary budget of about N600 billion. By implication the final budget expenditure for 2010 will come to about N4.8 trillion higher than the original budget which the government is seeking to reverse downwards. A good part of the supplementary budget increase will go into increasing staff salaries for civil servants, a good source of inflationary pressure on the economy.

Already the economy is sitting on a N650 billion bank bailout cash injected by the Central Bank of Nigeria in a bid to rescue banks said to be in a grave situation. The CBN also has another N500 billion set aside to invest in the real sector while the Asset Management Company, which is expected to take off toxic assets from bank balance sheets is expected to be another source of liquidity in the system.

The situation is also complicated by the fact that the CBN in a bid to unlock the credit market has deliberately kept its benchmark interest rate at a low of 6%. The CBN capacity to increase this rate is constrained by its desire to unlock the credit markets. Going forward, the CBN will have to strike a delicate balance between the threat of inflation risk and the need to unlock the credit market. The AMCON which is the CBN's key to unlock the credit market will also most likely be the CBN's biggest threat to unlock the inflation dragon as it will not only pump liquidity into the financial system but also possibly free the banks to lend again sparking off increased economic and possibly inflation.

Other sources of inflation risk in the system include the possible deregulation of the downstream sector being pursued by the Federal government as well as the possible increase in electricity tariffs except it goes with increased power supply. It will be double jeopardy for industries if there is deregulation of downstream sector, tariff deregulation and poor power supply at the same time.

Naira depreciation

Macroeconomic management for the Central Bank of Nigeria (CBN) will be a big challenge if crude oil prices drop lower. Some analysts have contended that the CBN's best strategy to fight inflation going forward will be to appreciate the Naira. What are the chances of the CBN appreciating the Naira? The Naira has benefited lately from the financial crisis in Europe which has seen the weakness in the euro and pounds improve the exchange rate of the Naira. But going forward, the ultimate fate of the Naira is tied to crude oil. The CBN has strongly defended the value of the Naira in the last one year with heavy intervention in the interbank market. This has been helped by the surge in crude oil prices within the period, the source of 90 percent of Nigeria's forex earnings.

The heavy defense of the Naira by the CBN however has its downside. Rapid depletion of the country's external reserves which now averages $38 billion enough to cover 16 months of imports. Though this is still healthy and well above the minimum four month cover need for external reserves, increasing capital flight during an election year fuelled by public sector corruption and uncertainty in the banking industry will further put pressure on the reserves.

The recent steep drop in crude oil price witnessed in the international markets has also increased uncertainty over crude oil prices. If crude oil prices drop anymore and stays low, it is not certain if the CBN will generously defend the value of the Naira as it has done so far.

Continuing Credit Freeze

Can the CBN unlock the credit market? The CBN is banking on AMCON to do this. The AMCON bill has been passed by both houses of assembly but needs to be harmonized and signed into law by the President. The earliest this may happen is late July considering the pace at the which the national assembly and presidency works and also hoping that the assembly will not inset any clause that will make the President refuse his assent to the bill.

But even if AMCON comes on stream in late July, it may need another two months to take off and perhaps another two months to start buying off toxic assets. That will take us to the end of the year. What this means is that any hope of AMCON unlocking the credit market will not happen this year. Best case scenario will be first quarter of next year.

So what are the options open to CBN for unlocking the credit market? There are not many. Moral suasion in the uncertain economic climate will not have any effect on bank lending. Direct credit guarantees as the CBN is doing with its N500 billion real sector fund may help but it stands the risk of creating easy credit with a high risk of delinquency in future.

Besides the eight taken over banks are still largely operating outside the credit loop. They will continue to operate outside this loop until their current ownership; management and recapitalization challenges are fully sorted out.

Low bank earnings

Bank earnings will continue to come under pressure for the rest of the year raising the question of how long banks going to sustain their level of operations considering the current low earnings in the sector? The key question will be what will suffer, more staff cuts, branch close downs, or international expansion shut down? Will depressed earnings force consolidation in the industry or banks shared services as being as advised by the CBN?

With banks not giving out new credit, existing credits deteriorating at a very fast pace banks are beginning to depend on fee based income to survive. But with fee based income traditionally just about 30% to 40% of earnings, and operational costs not yielding, banks will come under pressure on how to sustain their current level of operations. Already some banks are considering branch rationalizations, after laying off staff in early part of the year.  

Unresolved Banking recapitalization

The CBN insistence that it will not allow shareholders to recapitalize the banks it took over has resulted in a recapitalization stalemate for the affected banks even as foreign investors interest in buying into the banks seemed to have waned.

Foreign investors interest in acquiring the taken over banks seemed to have waned partially due to the risks of buying over banks with several court litigations pending against the CBN actions in taking over the banks as well as the series of regulatory policies that has changed the status quo in the Nigerian banking industry.

Some of the policies include the recategorization of banks in which the CBN seeks to license banks with minimum  capital as low as N15 billion as against the current N25 billion and the enforcement of a maximum of two terms of five years each for managing directors of banks. Foreign banks wishing to enter the Nigerian banking market may be wondering if it is not easier to pick up a fresh regional banking license for N15 billion in the lucrative Lagos-West-East axis of the Nigerian economy rather than buy a taken over bank with all its attendant legacy challenges. The subjection of the tenure of a managing director to the discretion of the CBN may also have dampened foreign investor's passion for the Nigerian market.

As long as the eight banks, which constitute about 40% of the Nigerian banking industry remain uncapitalized and run by the CBN appointed management, their operational level will remain low keyed depriving the Nigerian economy of a vital source of credit.

Wema Bank, Unity Bank, Savannah Bank and SGBN  

How is the CBN going to handle the unresolved recapitalization issues surrounding these banks? Wema Bank and Unity Bank narrowly escaped being taken over by the apex bank in 2009 when Sanusi carried out its banking shake up. They were both given up June 2010 to recapitalize. Currently, just few days to the expiration of the deadline, both banks are in the process of raising fresh capital to escape the dangling axe of the apex bank? The key question is would they succeed?

If they succeed, the credible question will be why are other shareholders of the eight taken over banks not given a similar option? If they do not succeed in their recapitalization bid, would the CBN rock confidence in the financial industry further by taking them over?

In the case of Savannah Bank and SGBN, they won litigations against the apex bank which gave them a breather to recapitalize by June 2010. Indications are that the banks may not have succeeded in achieving their recapitalization objectives.

How the CBN handles the recapitalization challenges of these banks will either send the right or wrong signals to both international and local investors as well as the banking community?