Financial System Stability: CBN Stress Test Reveals Industry Vulnerabilities

In its recently released Financial Stability Report (FSR) for June 2017, the Central Bank of Nigeria (CBN) released the result of its bi-annual banking industry stress test carried out to evaluate the resilience of Nigerian banks to credit risk, liquidity, interest rate and contagion shocks. The assessment was carried out on 20 commercial and 4 merchant banks which were tiered based on asset size into Large (N1.0tn and above), Medium (assets above N500.0bn but less than N1.0tn) and Small (total assets less than N500.0bn) banks.
Different methodologies were used in the evaluation of the industry’s ability to withstand shocks to the system. They include:

  • Solvency stress test which was carried out to determine effects of unexpected shocks on banks’ Capital Adequacy Ratio (CAR). Solvency test was evaluated using Credit Default, Credit Concentration, Sectoral Concentration and Interest Rate risks.
  • Liquidity stress test evaluated using Implied Cash Flow Analysis (ICFA) and Maturity Rollover risk.
  • Maturity Mismatch which examined assets and liabilities maturity positions.
  • Contagion Risk Analysis assessed using unsecured interbank exposures.

On the back of industry specific challenges in the Oil & Gas sector and lingering impact of macroeconomic instability which trailed the oil price shock in 2014, the CBN noted that industry asset quality deteriorated in the period under review (H1:2017) as Non-Performing Loans (NPL) ratio rose 2.2ppt to 15.0% from 12.8% in FY:2016. Consequently, average baseline CAR for the industry declined 3.3ppt to 11.5% in the same period, mainly dragged by Large (down 2.3ppt to 13.1%) and Medium (down 19.5ppt to -6.7%) banks. On the flipside, average CAR for Small banks strengthened, rising 10.4ppts to 13.5% in H1:2017. We suspect that the negative CAR ratio for Mid-sized peered group was skewed by two outliers in the Tier-2 segment.

On the back of the weaker capital ratios, the CBN Solvency stress test indicated that the Industry is vulnerable to credit risk as only Large banks exhibited resilience under a scenario of a 50%increase in NPLs, with an estimated post-shock CAR of 10.2% for the peered group - above the 10.0% prudential requirement. On the other hand, Industry, Medium and Small banks post-shock average CAR fell to 7.9%, -19.2% and 9.1% respectively, all below regulated minimum. However, when a further simulation assuming a severe shock – 200% increase in NPLs - was carried out, all peered groups were vulnerable as average CAR fell 15.2ppts, 9.8ppts, 93.4ppts and 17.5ppts below requirement for the Industry, Large, Medium and Small banks respectively. This evaluation suggests that in the event of an extreme, albeit improbable near term scenario, of a 200% spike in NPL level, most banks would fall below regulatory requirements on CAR. 

In addition to this, a Credit Concentration Stress Test was carried out to determine the possible effect an increase in NPLs of respective banks' 5 biggest obligors will have on Industry solvency. This stress test was carried out under 3 different scenarios, first of which was the least extreme scenario that credit facilities to 5 biggest corporates shifted from Pass-Through (i.e. performing loans) to Sub-standard which represents a 10% provisioning charge. The result of this scenario showed that the banking Industry has a high credit concentration risk as CAR for the Industry, Large and Medium banks fell to 7.9%, 9.2% and -9.9% respectively – all below the regulatory requirement. Only Small banks – which are mostly Merchant banks with relatively low credit exposures - displayed resilience with a CAR of 12.1%. However, two additional scenarios were simulated, one which assumes that credit facilities to 5 biggest obligors shifted from sub-standard to doubtful (representing a 50% charge) and from doubtful to lost (indicating a 100% write-off), revealed that average CAR for the industry and all peered groups will fall below regulatory minimum.

A further analysis of credit distribution by sector showed the banking industry had high exposure to the Oil & Gas industry (29.0%) at FY:2016; however, the downside risk of the high concentration on industry solvency is benign as the Stress Test of default in exposure to the sector showed that the banking industry and peered groups, with the exception of medium banks, withstood up to 20.0% default as their post-shock CARs remained above 10.0% prudential limit – Industry (10.7%), Large Banks (12.3%) and Small banks (13.3%). While the Industry displayed resilience to Maturity Mismatch and Contagion Risk, Liquidity Stress test using Implied Cash Flow Analysis (ICFA) assumptions - which assessed the industry’s ability to withstand unanticipated substantial withdrawals over 5 days and a cumulative 30-day period - suggested significant vulnerability to liquidity risks especially after the 30-day run as industry liquidity ratio fell to 7.9% from a pre-shock position of 48.1%.

The results of the CBN’s Stress Test was in line with the Article IV Consultation report by the IMF which highlighted the risks the banking sector faced, particularly with regards to solvency ratios of “four small and medium-sized undercapitalized banks (including one insolvent bank); some of these banks are kept afloat through continuous recourse to the CBN's lending facilities”. The report stated that banks needed to raise their capital buffers hence, the CBN’s directive on dividend payment was a welcome development whilst also calling a broad review of asset quality to unmask potential capital needs. Higher capital buffers and reduced government financing needs from the domestic market would spur more lending to the private sector, providing a catalyst for economic growth.

Whilst we highlight the need for the CBN to decisively address vulnerabilities in medium-sized banks, we are confident on near-term stability in the financial system on the back of improving macroeconomic fundamentals, which we anticipate will have a positive knock-on impact on asset quality, profitability and capital buffers.