What the global banking turmoil means for Nigeria’s financial sector

By Adebayo Ahmed

First, a bit of context. The COVID-19 pandemic and its effects are still rippling across the world. On the one hand there were severe disruptions to supply chains, and on the other hand there was a lot of effort by governments around the world to support their economies and to minimize the effects of measures to deal with the pandemic. The consequence of both factors was a global spike in inflation which, in many countries, rose to levels not seen in decades.

As expected, and as is recommended, the response to high and rising inflation in many countries was to increase interest rates, and to increase them enough that people remain confident in central banks’ focus on low inflation. From the United States to South Africa, most central banks went into tightening mode, increasing interest rates significantly.

Rising interest rates tend to work very well in lowering inflation in most cases. They, however, also tend to put downward pressure on economic activities. Take for example, a business which operates with financing from a bank and which has to pay interest on that financing. If the cost of financing gets too high then the business can become loss-making. If it cannot find other options to operate in a higher interest rate environment, then it may have to call it a day.

The same dynamic applies not just for regular businesses but also for financial institutions, including banks. A rising interest rate environment can have sometimes unforeseen impacts on banks through various channels. And because banks effectively run a lot on trust, negative sentiment can impact not just the bank in question but others as well, and of course can spillover on the real economy. This brings us to the cases of Silicon Valley Bank (SVB) and Credit Suisse.

What happened to SVB?

Before COVID-19, the world was in an era of very low interest rates and cheap and accessible financing. For SVB, which as you can guess was the darling of the tech-heavy Silicon Valley, this meant a rapid expansion in deposits by its economically booming customer base. As a bank, it did what banks do, by trying to use these deposits (now liabilities) to build assets. As it turned out, a significant portion of those assets were in far-maturing government bonds, which ordinarily would not be a problem.

A 2020 photo of the Silicon Valley Bank offices in Tempe, Arizona. Credit: Tony Webster, Flickr CC 2.0

However, as every finance professional knows, current bond prices tend to fall as interest rates go up. That in itself is not a problem if you are willing to hold those bonds to maturity. But if you need to sell them urgently, then you have a problem. Even worse if you are a bank and your depositors start withdrawing their funds, forcing you to sell your assets even more quickly and at discounted rates. If you get to the point where your liabilities are more than your assets, then you are at the end of the road as a bank. Although this is a simplified version of what happened to SVB, the summary is that rising interest rates exposed the weakness of the bank and sentiment turned against it.

What is happening with Credit Suisse?

What happened to SVB is in a broad sense very similar to what is happening with Credit Suisse. The bank has been in turbulent waters for some time, with risky bets on assets that have not necessarily turned out solid. Think of things like non-performing loans or investments in companies that have not delivered. In a low-interest, cheap-financing environment some of those cracks can be papered over. However, as interest rates started to rise, it became more difficult to manage those.

Photo Credit: Lea Meienberg for The New York Times

The bank had hoped that a new investor would come in to prop up its asset base. Once the news filtered through that no such investor was interested, sentiment turned against the bank. Depositors started to worry that the bank, like SVB, was questionable and started pulling their funds. The specifics might have been different but like SVB, rising interest rates exposed the weakness of the bank and sentiment turned against it.

The nerves in the global banking system are not limited to SVB and Credit Suisse. Many investors are asking similar questions about many other banks; which other bank will be exposed by rising interest rates? As a signal of these nerves, the Nasdaq bank index, an index which tracks the stock prices of some of the biggest banks, was down over 20% in the last month alone.

What does this means for Nigerian banks and other financial institutions?

On the domestic front, Nigerian banks have demonstrated that they learned from the banking crisis of 2008. The proof is in the pudding as almost all banks have been able to weather the multiple economic shocks that have hit the Nigerian economy, be it the 2015 oil price crash or the COVID-19 pandemic. The domestic environment has also been in a tightening cycle for some time.

From increasing cash reserve ratios (both general and arbitrary) to actual increases in the monetary policy rate, the banks have had to manage a tighter interest rate environment. Although there is no room for complacency, the Nigerian financial system looks to be well prepared to continue managing the higher domestic interest rate environment.

There are however some risks that will still need to be assessed and closely monitored. The first of these relates to Nigerian banks direct exposure to foreign currency liabilities, that is foreign currency loans they have taken from other global financial institutions. Since the crude oil crisis in 2014, foreign currency loans by banks have grown to be a significant portion of foreign exchange inflows.

Fig 1: Capital Importation – Selected Categories. Source: NBS Capital Importation Report

As shown in figure 1 above, foreign loans to the Nigerian economy has been at least $2bn a year since 2016, and up to $5bn in 2019 far outpacing foreign direct investment. As global interest rates rise, the costs of servicing these loans will no doubt increase. Given that the core revenue streams for most banks are Naira-denominated then there is the potential for a devaluation to add more stress.

Anecdotal evidence suggests that most banks with foreign currency liabilities have taken measures to minimize that risk such as by getting into swap agreements with the Central Bank of Nigeria (CBN). Regardless, the risks should be taken note of. The external exposure is of course not limited to loans alone. It includes other kinds of foreign currency liabilities and assets that may be affected directly by higher global interest rates.

The second risk worth paying attention to relates to FinTechs. This has been a high-growth sector in Nigeria over the last decade and much of that growth has come in an era of globally cheap financing fuelled by venture capital. These FinTechs however tend to behave like their global counterparts and so should probably be watched in similar fashion.

Do they, like SVB, have most of their assets unhedged in far-maturing securities for instance? Or given their Silicon Valley connections, are they directly exposed to SVB? Given that most FinTechs have no experience of operating in the tighter global financing environment, and given how important they have become for Nigeria’s financial landscape, such as their role in facilitating payments for many businesses, a deeper understanding of their risks is needed.

Needed: a proactive policy stance at a time of global turmoil

As observed recently by the CBN Governor, Mr. Godwin Emefiele, this is the time to be vigilant and guard against failures. What does this mean in practice?

Firstly, it could mean another round of stress tests to identify potential sources of stress to banks and other financial institutions, as well as measures to pre-emptively and tactfully deal with the risks, similar to what other central banks have done. With Credit Suisse for instance, central banks moved to force a quick sale to forestall any contagion and provided dollar liquidity to their financial systems to manage pressure. With SVB, guarantees were given that all depositors funds would be covered by insurance to minimize the risk of a bank run. The CBN should be prepared to take such quick action if the need arises.

Secondly, it definitely means better and more transparent communication to calm nerves and to ensure that sentiment does not turn against any bank. Banking is inherently a risky activity as you have to take bets on customers ability to repay loans and on businesses ability to generate a profit. However, as we have seen in previous instances and in other environments, even healthy banks can be at risk if people suddenly start acting against them and withdrawing their deposits.

Thirdly, as with every financial crisis, it could be an opportunity to update regulatory frameworks and re-examine which financial institutions need what type of regulations. Is it time to take a closer look at the regulatory requirements for FinTechs or or other loan-granting institutions?

Finally, it will also mean avoiding policy actions that put unnecessary strain on banks. It would not be a good idea to impose another cash-crisis type policy on the banks at this time.

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