Stage two loans at 23% of Gross Loans- A threat to the Banking Industry’s Financial Condition
Agusto & Co. Limited, Nigeria’s foremost research house and rating institution recently released its flagship 2020 Banking Industry Report, which is the most current and comprehensive report on the banking industry in Nigeria.
According to the report, approximately 23% of the Industry’s gross loans and advances was classified in the stage two category as at 31 December 2019, according to the International Financial Reporting Standard (IFRS) 9. As at the same date, four out of the twenty-four banks covered in the report had stage two loans to gross loans ratios above the 23% Industry’s average.
Agusto & Co. believes that the volume of stage two loans is a threat to the Industry’s asset quality and future profitability. Stage two loans primarily comprise exposures with an increase in the associated credit risk compared to when the loan was disbursed.
The COVID-19 pandemic with its impact on businesses has elicited an increase in the volume of stage two loans. According to Agusto & Co., stage two loans are susceptible to adverse migrations in the face of a prolonged macroeconomic downturn.
Following the forbearance granted by the Central Bank of Nigeria (CBN) in March 2020, permitting banks to restructure loans to businesses that have been adversely impacted by the novel COVID-19 pandemic, the banking industry had restructured over ₦7.8 trillion (almost half) of the loan portfolio as at June 2020, according to the CBN.
While the forbearance is expected to keep the Industry’s impaired loan ratio, which stood at 7.6% as at 31 December 2019, at bay in the short term, Agusto & Co. is concerned about the performance of these affected loans, given that the coronavirus pandemic is yet to be curtailed and a second wave may be looming. A further slowdown in economic activities and a total lockdown may worsen an already bad situation.
The Nigerian economy is projected to shrink by 8.9% (worst case) and 4.4% (best case) in 2020, according to the Ministry of Finance, resulting in a probable recession. In our worst-case scenario, Agusto & Co. projects a 6% GDP contraction in 2020.
While we acknowledge a likely extension of the forbearance period in the event that the pandemic lingers, we expect a rise in the impaired loan ratio of the banking industry in the medium term. Our expectations are also driven by the regulatory-induced growth in the loan book driven by the minimum loan-to-deposit ratio (LDR) policy, with sanctions banks for non-compliance through additional CRR debits.
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Agusto & Co. believes that banks should not be forced to lend as this may encourage weaker risk management practices. Furthermore, the foreign currency component of these restructured loans, largely in the oil and gas and power sectors bloat the exposures in the likely event of a further devaluation of the domestic currency.
According to the report, the banking Industry’s stage two loans also threaten the sustainability of its earnings if additional provisions are required in the event of a migration to the stage three category and subsequent write off occur.
According to the report, as at 31 December 2019, provisions made on stage two loans in line with IFRS 9 as a percentage of total stage 2 loans stood at a low 7% while stage three loans had a coverage ratio of 48%. Following the 2016 recession, the banking industry had written off loans of over
₦1.9 trillion of its loan portfolio as at FYE 2019, with severe implications on capital.
Stage two loans are a threat to the Industry’s capital base, which has come under pressure in the last three to four years owing to the adoption IFRS 9 accounting standard and the recession. The COVID-19 pandemic is a further threat to capital.
While most operators have a core capital base that very well exceeds the regulatory minimum, the banking industry will need to recapitalise in the medium term in view of proposed new minimum capital requirements, though yet to be disclosed by the apex bank. Until then, Agusto & Co. expects capitalisation ratios to be sustained by an increased issuance of tier II capital, increased profit retention and revaluation gains in the event of a significant naira devaluation in the short term.
Overall, Agusto & Co. believes that the stage two loans require effective monitoring, particularly in the face of heightened macro-economic risks. The prevailing headwinds make effective monitoring of these exposures imperative to forestall significant deterioration in asset quality, subdued earnings and lower capitalisation ratios in the near term.