Banking Sector Recapitalisation for a $1 Trillion Economy: A Cosmetic Show or a Serious Business?

“Esteemed guests, considering the policy imperatives and the projected economic growth, it is crucial for us to evaluate the adequacy of our banking industry to serve the envisioned larger

economy. It is not just about the stability of the financial system in the present moment, as we have already established that the current assessment shows stability.?

However, we need to ask ourselves: Will Nigerian banks have sufficient capital relative to the financial system's needs in servicing a $1.0 trillion economy in the near future? In my opinion, the answer is "No!" unless we take action.

Therefore, we must make difficult decisions regarding capital adequacy. As a first step, we will be directing banks to increase their capital”

Those were the words of the Central Bank Governor, Olayemi Cardoso, during his policy direction speech at the bankers' dinner event that held recently. The announcement, together with several other announcements, have generated mixed reactions from the public. Personally, I am already losing patience and less interested in all these numerous announcements with little or no traction. I mean, a lot was said at the Nigerain Economic? Summit Group (NESG) conference some weeks back and there’s been nothing much. I prefer that a proper framework is already put in place and then an announcement is then made. But that’s by the way.

What is the idea behind a banking recapitalisation?

The business of banking is quite straightforward. The model is simple - raise capital, acquire deposits (and/or raise debt), and use the combined equity and debt to create assets (including lending and investing in various securities or financial instruments). From the assets created, interest income is earned. Interest expense is paid on the deposits or debt raised, and the bank goes home with a net interest income (the spread between interest income and interest expense). Then, it is from this net interest income that a bank spends on its operating expense and other cost of operations (including loan monitoring and technology costs). This simple trend is if everything goes according to plan.?

Sometimes, things don’t go according to plan. Some of the assets created by a bank are risky (especially loans). Thus, there are chances that a loan could get bad. Even some risk-free assets can go bad (re: Ghana Eurobonds). When a loan goes bad, it is a loss (impairment) for the bank which hits its capital. If loan losses are significant, there is a possibility that a bank’s capital is wiped off and it will close down. Therefore, capital adequacy is extremely crucial for a financial institution (in fact, having robust capital levels is crucial for any kind of business).?

Because banks are important institutions in the economy, given the financial intermediary role they play between individuals/investors and businesses; the financial health of a bank has to be sound. If the economy must grow, then the banking system that serves as a facilitator of that growth must be up to the task. Generally, the idea of an economy growing is when there is increased business activities (i.e., when there are many new businesses and/or when existing businesses expand capacity). Think about a Chicken Republic opening multiple outlets across the country. Or think about a Nestle, or a Flour Mill building more factories. Think about new startups coming to life. All these mean increased economic growth, and the bottomline is job creation.?

A new Chicken Republic would require employment of food attendants, store managers, security personnel, inventory manager, cleaners etc. It would also mean increased demand for rice, pepper, tomatoes, onions, chairs, garments etc. This demand is also a form of increased revenue to the firms supplying these items - and they too would, in turn, have to expand capacity to meet the increased demand. You could also personalise this. See how some of your tailor and other online business friends become excited when you get a good-paying job. They know that it will trickle down to them in the form of patronage. That’s how it spreads and the multiplier effect crystalises. y

Hence, the banks (in a normal setting) become relevant to fund these increased business activities. Thus, it makes sense that if the Nigerian economy aspires to become a $1 trillion economy, the financial market has to be strong to facilitate that ‘dream’, of which the banking sector is a fundamental player.?

What are the benefits of a well-capitalised banking industry??

For banks to fund larger tickets and bigger loans that will drive concrete economic growth, they have to be well-capitalised. Imagine a bank that has ?100 billion in capital and the regulation says no single obligor should account for more than 20% of your equity, it means that for a single company to raise ?20 billion to build a factory, it will have to raise the money via a consortium of banks which can be time consuming, costly, and somewhat inefficient (approval delays, overanalysis etc.).?

Other potential benefits could be:

→Increased liquidity in the banking sector that could lower lending rates in the future

→Potential dilution of bank ownership, which may translate to enhanced corporate governance

→Improved depositor confidence?

→Enhanced economies of scale enjoyed by banks, thus potentially leading to reduced bank charges to customers

→Potential inflow of foreign direct investment (FDI)

But there are challenges??

→I consider the current unfriendly funding environment across the globe, given the rising interest rates as the biggest challenge . The foreign investors are the ones with the wherewithal to provide meaningful capital (because the local investor base is weak). Meanwhile, the higher interest rates may make valuation and fundraising relatively difficult because of higher opportunity costs for these foreign investors

→This is arguable, but there are whispers of the potential rise in unemployment rate that could be an unintended consequence of the banking recapitalisation. The Nigerian banking sector is one of the major employers of labour. The last time a bank recapitalisation took place (in 2004/2005), 89 banks shrank to 25. Although the overall economy was probably better-off, the associated job losses were painful. It is even more worrisome at this time when the economy is feeling the heat of the outcome of economic mismanagement in prior years.

What can we expect ahead?

I’d also like to add that the details of the potential exercise have not been made public yet. It is relatively difficult to know what to expect for now, but the players in the financial markets are proactive. They don’t wait for the eventuality to happen before making decisions or positioning ahead. Therefore, my opinions below are just scenarios and possibilities. When the guidelines or additional information is released, it could be materially or markedly different from expectations.?

Currently, the minimum capital requirement for banks is:

→?50 billion for international banks (i.e., banks allowed to operate in 36 states of Nigeria, FCT, and outside the country)?

→?25 billion for national banks (i.e., banks allowed to operate in 36 states of Nigeria and FCT only)

→?10 billion for regional banks (i.e., banks allowed to operate in two geo-political zones and the FCT only)

There are other types of banks with their minimum requirements too such as non-interest banks, merchant banks etc., but I am restricting my assessment to the three broad licences listed above.?

The last time a banking recapitalisation occurred was on July 6, 2004, when the Central Bank of Nigeria (CBN) announced the recapitalistion of banking sector from ?2 billion (then $15mn) to ?25 billion (then $190mn). Based on the table below, it appears that the major banks in the table below are all above the threshold.

In that case, the question everyone is interested in is ‘what will the new capital requirement be?’ I sampled the opinion of my colleagues, acquaintances, and friends and they all used different approaches to arrive at a reasonable guess.?

Using the Naira Equivalent of the Previous Dollar Capital

The common opinion was that the ?25 billion minimum capital in 2005 was $190mn. Hence, if we use the Naira equivalent to estimate the new capital with a ?750 or ?1,000 exchange rate, we could expect to see a new capital requirement of ?150 billion - ?190 billion. For international banks, it could be as high as ?500 billion.?

In this case, the majority of the banks will scale this hurdle, except for a few banks such as the new generation banks. The big banks (i.e., the tier-1 banks) that account for 75%-80% of total banking assets will not flinch one bit. Personally, based on substance, I don’t want to think the banking recapitalisation will be hyped by the CBN, only for it to really matter for the smaller banks… Or maybe I am the one overthinking it.?

10x of Current Capital Requirement

The second opinion I got was that the CBN could likely ask the banks to 10x their minimum capital requirements. That is, the international banks capital requirement would rise to ?500 billion, national banks’ would rise to ?250 billion, and the regional banks’ would rise to ?100 billion. Afterall, the previous recapitalisation was a 12x increase from ?2 billion to ?25 billion

My thought on this is similar to the first opinion. Only the smaller banks will be bothered and the exercise will be cosmetic in my view. Again, I may be overthinking it but one important thing that I am considering is that the CBN Governor confirmed that financial soundness indicators are already solid. Therefore, the purpose of the recapitalistion is not because of perceived weakness in the banking sector, but for the banking system have a robust capital base to support a $1 trillion economy.?

What is the Level of Banking Capital Required for a $1 Trillion Economy

And then I came up with a logic to think about what to expect. I started by checking Nigeria’s peers across the African and Asian continent. I identified seven (7) countries in Africa including South-Africa, Egypt, Algeria, Morocco, and Kenya. I also identified seven (7) countries in Asia including India, Indonesia, South Korea, Vietnam, Thailand, and Phillipines. Although an outlier, I included China. Overall, I identified fourteen (14) economies and the average (I used median to remove the effect of outliers) banking assets to GDP is 73%, which mirrors the African average (see table below).

As of September 2023, I estimated a total banking asset of ?100 trillion ($134 billion) and a total equity of ?9 trillion+ ($13 billion), which means an equity ratio of 9%. The size of the total banking assets was propelled by the recent foreign exchange revaluation gains recorded by the majority of the banks. The combined total assets of the tier-1 banks accounted for 78% of the entire pool, while the combined assets of the tier-2 and other national banks accounted for the rest. Using the annualised nominal GDP for 2023 (based on 9M 2023 GDP figures), the banking assets ratio to GDP stood at 46% in September 2023.?

We thus have our scenarios:

Scenario 1: the first scenario says that the target nominal GDP is $1 trillion and the banking asset ratio is assumed to be 46% (the same current ratio), which means that the Nigerian banking asset should be $461 billion. Working with an equity ratio of 9% (which I consider very healthy), the total banking sector equity should be somewhere around $43 billion to $44 billion - a 3x to 4x increase from current levels.?

Scenario 2: the target nominal GDP is still $1 trillion but the banking asset ratio is estimated at 73% - the comparable peers average. In that case, the total banking asset will be $733b billion, and using a constant equity ratio of 9%, the total banking sector equity should be somewhere around $69 billion to $70 billion.?

I think scenario 1 is a more plausible option, and if that assumption holds true, then I expect the tier-1 banks capital requirement to rise to $4 billion - $5 billion (c.?3 trillion). This is a stretch… a long one indeed. But as I emphasised earlier, I am thinking this through the lens of a banking sector capitalisation for a $1 trillion economy. And I expect the capital raising exercise to span multiple periods (i.e., a step-like increase over five (5) or (10) years).?

When I saw $4 billion - $5 billion, I rolled my eyes because it seemed a lot. But then again, when you look at the top five banks in Africa (all operating in an economy with less than half a trillion GDP size), you’d see total asset sizes of $100 billion (of a single bank). For context, the biggest bank in Africa, South-Africa's Standard Bank Group’s total asset size is R3 trillion ($169 billion), and its equity size is R260 billion ($15 billion) - an equity ratio of 9%.

Anyway, these are random thoughts of mine. We would see as events unfold. In all of these, investment banking firms (like Stanbic IBTC Capital, Chapel Hill Denham, FBNQuest, United Capital, Vetiva etc.) and advisory firms like (KPMG, PwC, Deloitte, EY, Standard Chartered and the likes) are about to feed fat! Well, the extent of deal, activities, and business opportunities will still depend on the exact guidelines from the CBN.