CBN FX Regulation to Weigh on Banks' Profitability –Moody’s

The Central Bank of Nigeria’s (CBN) new foreign currency regulations will weigh on banks’ profitability in the short term, Moody’s Ratings said in a note.  On 1 February, the apex bank amended prudential requirements, announced in a circular on 31 January, took effect.

The amended requirements eliminate commercial banks’ foreign currency long net open position – the difference between the total volumes of long and short positions in foreign currency, including both on- and off-balance sheet exposures.

A long net open position indicates a bank’s foreign-currency assets exceed its foreign currency liabilities, while a short net open position means the reverse.

Before the amendment, the prudential requirements allowed banks to maintain a short position of up to 20% of shareholders’ funds and a long position of up to 10% of shareholders’ funds unimpaired by losses.

However, following notable infractions, the apex bank revised its directive, and now requires banks to hold 0% long of shareholders’ funds unimpaired by losses.

In its note, Moody’s’ said the directive is credit negative for Nigerian banks, at least in the short term, because it will reduce their ability to generate profits from foreign currency revaluation gains.

During the recent devaluation of the Naira, many banks were able to book significant revaluation gains; the circular limits the ability of banks to benefit from a long net open position.

The lower profitability also exposes banks to higher potential losses associated with expected higher credit losses, which generally arise when a currency depreciates significantly.

Additionally, lower profitability means banks would have less retained profit to bolster capital buffers, which would be reduced in the event of local currency depreciation. The extent of the pressure on profitability, however, will vary depending on the size of each bank’s long net open position.

Moody’s said in its view, Nigerian banks’ capital adequacy ratio would decline in the likely event of further currency depreciation without the corresponding foreign currency revaluation gains that are typically achieved from maintaining a long net open position.

The firm noted that the reduction in ratios would occur as a result of growth in the local currency equivalent of risk-weighted assets – where banks have foreign currency loans which form the denominator of the ratio, against the numerator of regulatory capital remaining static in a depreciation scenario.

The simultaneous removal of banks’ ability to limit the capital ratio impact through higher profits from foreign exchange revaluation gains would be compounded in the event expected credit losses (ECLs) result in higher provisioning costs, weakening banks’ profits.

In the circular, the regulator said it took the action because it was concerned about the growth of banks’ foreign currency exposure through their long net open positions, which created an incentive for banks to maintain excess US dollars, leading to foreign currency speculation.

The circular said that banks unable to comply would face “immediate sanction and/or suspension from participation in the foreign exchange market”. The circular further directs banks to maintain an adequate stock of high-quality liquid foreign assets such as cash and government securities to cover corresponding maturing foreign currency obligations, as well as foreign exchange contingency funding arrangements with other financial institutions.

An area that remains unclear relates to outstanding foreign currency swaps and forwards that the banks have with the CBN, and how these instruments will be resolved in an asset “sell down” scenario. Banks have previously provided foreign currency liquidity to the CBN via swap agreements and have also purchased foreign currency forwards from the CBN.

The CBN estimates that over $2.4 billion of the headline $6.8 billion in foreign exchange forwards are invalid, following the findings of a commissioned forensic audit.  The effectiveness of the policy will become clearer over time. Nigeria, World Bank to Strengthen Bilateral Ties- Edun

According to the Nigerian authorities, they expect the policy to eliminate currency speculation, leading to greater currency stability and investor inflows. For this to be achieved, Moody’s believes interest rates would also need to rise substantially to lower inflation, which was 28% as of December 2023. #CBN FX Regulation to Weigh on Banks’ Profitability –Moody’s