Nigerian banks’ market-based reporting of FC exposure may impair capital adequacy, says Fitch

Fitch Ratings has said that if Nigerian banks adopt a more market-based presentation of foreign-currency (FC) assets, liabilities and profit-and-loss items, small banks would not be able to meet their capital adequacy requirements as specified by the regulatory authorities.

In a statement released Thursday, the international rating agency noted that financial statements with FC items translated more in line with market exchange rates would give a more realistic representation of banks’ FC positions and capital at risk from potential further depreciation of the naira.

It said in the event that the naira depreciates to N450/$ in the market, the bigger banks may withstand the scenario without impairment on their capital adequacy requirements.

“We found that that the largest banks – Access, FBN Holdings, Guaranty Trust Bank, United Bank for Africa and Zenith – would be able to withstand this scenario without breaching their minimum CAR requirements.

“However, second-tier banks had mixed results,” it said, adding that capitalisation is an important ratings differentiator for Nigerian banks, albeit within a narrow rating range.

“We calculated banks’ capacity, based on end-September 2017 data, to withstand a hypothetical severe naira depreciation to NGN450/USD without breaching their minimum regulatory total capital adequacy ratios (CARs),” it noted, adding that exchange-rate risk warrants scrutiny for Nigerian banks because about 40 percent of assets and liabilities in Nigeria’s banking sector are denominated in US dollars and not all banks operate with matched FC positions.

The Central Bank of Nigeria sets different minimum CARs for Nigerian banks: 16 percent for those it considers to be systemically important, 15 percent for those with international banking licences and 10 percent for the rest.

“Our discussions with banks that we rate suggest that most will publish their 2017 financial statements based on the Nigerian Foreign Exchange Fixing (NiFEX) rate (about NGN330/USD) instead of the official exchange rate of NGN305/USD, which they previously used,” it said, adding that some may use a blended rate.

The NiFEX rate is the Central Bank of Nigeria’s reference rate for spot foreign exchange transactions, widely used on the interbank market.

Fitch noted that adopting the NiFEX rate is, however, only a partial step towards using market exchange rates. IFRS guidelines say that companies operating in countries with multiple exchange rates should translate their FC assets and liabilities into local currency based on the exchange rates at which they expect to settle them. But the guidelines leave scope for considerable judgement and flexibility, and Nigeria operates with multiple exchange rates, which adds to the confusion.

“In our view, the exchange rate used under the Nigerian Autonomous Foreign Exchange Rate Fixing (NAFEX) mechanism is the closest to a true market rate,” it stressed.

NAFEX was introduced last year and rates are set by market participants, giving investors and exporters a more transparent way to sell FC. NAFEX attracts greater volumes than other exchange mechanisms. The NAFEX exchange rate is about NGN360/USD.

“Switching to NiFEX or a blended rate would give a more meaningful representation of banks’ FC positions than using the official rate, in our view. But banks would still be translating FC into naira at a rate significantly below the NAFEX rate.

“We do not expect banks will go further at this stage as every increase in the exchange rate used could lead to a drop in reported regulatory capital ratios, due to inflation of FC risk-weighted assets, even though the impact would be partially offset by FC translation gains,” it further said.

It said its stress test also included increasing the risk-weight on FC loans to 130 percent (from 100%) to reflect extra difficulty for borrowers servicing FC loans with a weaker naira.