Nigerian banks are sufficiently well capitalised to absorb the impact of the 40% effective devaluation of the naira against the US dollar seen as of yesterday, the third day of trading under the country's new market-driven exchange-rate policy regime, says Fitch Ratings.
Currency devaluation affects banks' capital ratios largely because total risk-weighted assets are inflated when foreign currency (FC) assets are translated back into naira, while capital is denominated in local currency. We assign ratings to 10 Nigerian banks and our assessment is that, with a 40% effective devaluation, the majority will not face an immediate breach of regulatory capital adequacy ratios (CARs). However, if the naira continues to weaken, buffers between minimum and reported CARs may decline to a level which heightens ratings sensitivity.
Fitch-rated banks report CARs ranging from 14% to 21%. The devaluation will impact ratios in different ways across rated banks, depending on the level of their FC risk-weighted assets and the size of their net open FC positions. On average, 45% of net lending in the Nigerian banking sector is extended in FC (almost entirely US dollars). Balance sheets tend to be reasonably well-hedged, although CARs are primarily affected by the revaluation of their FC risk-weighted assets into Naira. In our view, the immediate impact of effective devaluation on CARs reported by Fitch-rated banks will be a 2% average reduction.
Any erosion of capital ratios may be short-lived because banks are profitable despite the unfavourable operating environment. Rated banks reported a 14% average return on equity in 1Q16, we think dividend payouts will probably be conservative in 2016 and internal capital generation is expected to remain healthy.
Banks' ability to continue to generate solid performance indicators largely depends on developments in asset quality and loan impairment trends. Impaired loans represented an average of 5.5% gross loans across our portfolio of rated banks at end-1Q16, which is reasonable considering the tough operating environment. Loan loss cover is adequate for most banks, but we expect impaired loan ratios to rise in the wake of the naira devaluation. This is because some Nigerian corporates are not adequately hedged by FC income streams and may find it more difficult to service their FC loans. Most major Nigerian corporates are well hedged.
The success of the FX move in attracting portfolio inflows and foreign direct investment has yet to be tested. If successful, and FC supply rises, we expect FC liquidity for banks to ease which would allow them to meet FC demand, and meet their internal and external FC obligations.
New impaired loans emerging in 2015 and early 2016 are often linked to the trading and manufacturing sectors where the scarcity of FC liquidity forced a reliance on the parallel currency market where FC rates were far higher. The new FX regime could bring some relief if the supply of FC improves substantially.
The oil sector is also responsible for an inflow of impairments into some rated banks. We believe that the oil sector's fundamental problems pose a threat to asset quality across the banking sector because of disruptions to production and because oil prices remain low. Around 25% of Nigerian banks' lending is to the oil sector. If problems in the sector persist, impaired loan ratios could accelerate further, further pressurising CARs.
The standalone viability ratings of the Nigerian banks are all in the 'b' range, indicating highly speculative fundamental credit quality.
