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Country reportsApril 2 2006

The first step

Central bank governor Charles Soludo has overseen a massive consolidation of the banking sector but that is only the start of his reform plan, says James Eedes.
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Proving his doubters wrong, Central Bank of Nigeria governor Charles Soludo emphatically delivered on his promise to overhaul the Nigerian banking sector, culling 89 mostly weak banks down to 25 and pulling the plug on another 14. He did this in just 18 months in a remarkably orderly process. In recognition, he scooped the title of The Banker’s Global Central Banker of the Year 2006.

The hard work is far from done, however. In many respects, the job has become a lot more difficult.

On July 6, 2004, just weeks after taking office, Mr Soludo decreed that banks’ minimum capital requirement would be hiked from N2bn to N25bn ($190m). Banks that missed the December 31, 2005 deadline faced being shut down.

The need for reform was clear-cut. Despite many challenges to offering full-service banking in Nigeria (which this report examines in detail in later articles), the 89 banks that were operating added little economic value and were mostly weak. As chief architect of the National Economic Empowerment and Development Strategy (NEEDS), the government’s reform blueprint, Mr Soludo knew better than anyone just how crucial a viable, efficiently functioning banking system was as a spur to economic development, by mobilising savings and extending credit to the productive sectors.

Tough inheritance

What he inherited was anything but that. Total bank credit as a ratio to gross domestic product (GDP) was about 20%, low even by developing world standards. The central bank (CBN) estimated that as much as N400bn (4% of GDP) was sitting outside the formal banking system, most of it stashed under mattresses, and indicative of low levels of confidence in the banking system.

Structurally, the banking sector was highly concentrated, with the 10 biggest banks holding 71% of total assets and 86% of savings deposits. Of these, the biggest had Tier 1 capital of just $240m, one 25th the size of South Africa’s biggest bank.

Most other banks had less than $10m in capital, however, and a number of them were engaged in suspect and often outright illegal practices. The most common was foreign exchange ‘round tripping’, buying foreign currency at the official rate and selling it to importers at the black market rate, creaming off an easy profit in the process. Not only was this illegal but, having not declared why the currency was required and avoiding any customs audit trail, importers would typically skip paying import tariffs.

Other corporate governance abuses were widespread, such as weak disclosure and false reporting. When Mr Soludo joined the CBN, up to 25 banks faced collapse. It was a malaise that had many causes: Nigeria’s historic political instability had weakened institutions, eroding regulatory functions and fuelling corruption; fiscal mismanagement created ongoing short-term financing requirements, offering low-risk returns that crowded out private sector borrowing; while economic uncertainty led to under-investment in the economy, the stagnation of the non-oil sector (and hence reduced credit needs) as well as a brain drain that pushed Nigeria’s brightest talent abroad, not least bank managers.

This dismal state of affairs was the trigger for swift and decisive action, principally in the form of the new minimum capital requirements, which were designed to increase size, strengthen capacity, spark product development and stimulate more aggressive intermediation.

Stronger capital base

At its conclusion, the policy more than doubled the capital base of Nigerian banks from about $2.5bn in June 2004 to about $5.8bn at the end of last year. This was achieved without systemic distress, despite the protestations and forewarnings of mainly entrenched interests, notably families and shareholder cliques of many of the small banks that had enjoyed ill-gotten riches.

“This was the first time a fundamental policy reform was announced in Nigeria with clear timelines and milestones, and implemented to the letter without reversals and modifications, despite monumental opposition by strong vested interest groups,” says Mr Soludo. If the governor did ever second guess his own stringently tight 18-month deadline or worried for his personal safety following numerous death threats, he never showed it. Indeed, his attitude since successfully concluding the process has not been one of relief but rather one of ‘I told you so’.

The governor is quick to point out that this is the first step in the banking sector reform process, which is one piece of the wider national economic reform puzzle. He reticently concedes that there may yet be post-consolidation hiccups, though nothing he has not anticipated and planned for. “We had to start somewhere and make progress. I always expect the worst and plan accordingly,” he says.

Mr Soludo faces a number of immediate concerns. First, the CBN needs to resolve the liquidation of the 14 banks that failed to meet the N25bn threshold quickly. Previous liquidations have been held up for years in court, preventing the payout of frozen deposits. After initially saying that depositors would see their cash within 90 days, Mr Soludo now admits that there could be delays but insists depositors should be paid by year-end.

Second, the CBN needs to clarify its full liability with respect to the frozen deposits. Early indications were that up to N177bn was trapped in the 14 failed banks, of which only N70bn was covered by the Nigerian Depositor Insurance Corporation. A final figure will only emerge once the CBN has been able to audit the failed banks but Mr Soludo has guaranteed private individual and corporate deposits. He is sticking to his guns that the consolidation will be the lowest cost restructuring of its kind anywhere in the world, with even a 100% blanket guarantee to depositors estimated at less than 1% of GDP.

The third concern is that rumours persist that a number of merged banks are facing integration challenges. The rule that seems to apply in the marketplace is that any bank merger involving four or more banks has a less than 50% chance of survival. Eight banks fall into this category; another six are three-bank mergers. “Integration is the only possible outcome; to break up would be commercial suicide. Once the central bank reissues licences to the new banks, there is no going back,” says Mr Soludo.

Analysts say that the CBN is in a corner. It wanted to reduce the total number of banking licences but at the same time avoid bank failures, and the consequent liquidation process and deposit liability. As a result, the central bank was quick to grant regulatory approval to mergers and until the end was open to ideas to help banks meet the N25bn hurdle. It must now keep a close watch on a number of banks that are struggling to overcome difficulties, not least clashes at board level over strategy and pecking order.

Mr Soludo will only say that the CBN is prepared for any eventuality, which already includes lining up some of the bigger banks to acquire smaller banks that fail to resolve integration challenges. He sees no risk of a deposit run on smaller banks or, worse, a fast-spreading systemic crisis if integration issues do not subside. High cash reserve requirements plus the fact that many of the smaller banks have already weathered deposit withdrawals (flight-to-quality) during the consolidation process suggest the governor’s confidence is not misplaced.

The fourth concern Mr Soludo faces is that rumours also abound of banks using ‘creative’ ways to meet the minimum capital requirements. One story is that some banks used depositors’ cash to finance the purchase of their own newly issued equity; another story is that a bank forced its own staff to take loans to buy into a share issue. Such tricks are likely to be quickly spotted by the CBN – but how it will handle them is unclear.

Drawing a line

If drawing a line under this first phase of consolidation occupies one half of the governor’s mind, pushing ahead with banking sector reforms occupies the other half. Mr Soludo is quick to admit that consolidation is not a panacea for the industry’s historically weak levels of corporate governance and regulatory oversight. Indeed, bigger banks and more varied assets entail new difficulties. But consolidation was the unavoidable first step, he insists.

He argues that focusing on 25 banks is more effective than keeping tabs on 89 mostly weak and often teetering banks, and the dilution of ownership stemming from new share issuance has been an immediate spin-off. Whereas many banks were formerly family-owned or tightly held, and consequently beset with corporate governance risks, all of the locally owned banks are now listed on the Nigerian stock exchange, subjecting them to new layers of supervision from the exchange and the Securities and Exchange Commission.

In terms of direct intervention, the CBN has a two-pronged approach. The first is a set of corporate governance proposals that have been circulated to banks. These still have to be discussed and formally adopted but it is a first attempt to set down and seek implementation of a codified set of guidelines. The second is a shift to risk-based supervision, implying a more interventionist and hands-on supervisory role for the CBN.

The right direction

Although it is too early to judge the effectiveness of these measures, it is a shift in the right direction. Moreover, Mr Soludo repeatedly emphasises his willingness to invest to solve the central bank’s supervisory weaknesses, particularly in skills.

He knows he has to move quickly; banks are flush with equity capital and the temptation to grow assets in a competitive environment – and satisfy shareholder demands – could lead to reckless lending. The CBN’s best hope of avoiding unsustainable asset growth and rising non-performing assets is to supervise vigorously and insist on better internal risk management systems, a large part of which is skills development.

“I think the overall quality of risk management is now relatively good. The consolidation process has removed the worst offenders from the system,” says Mr Soludo.

Still, the CBN plans to assist banks in skills development. It is this help to the country’s newly transformed banking sector that will be crucial to realising Mr Soludo’s wish that Nigeria becomes the financial hub for Africa. He insists that in 10 years’ time he would like to see a Nigerian bank among the top 100 world banks, if not among the top 50.

In a research paper published late last year, investment bank Goldman Sachs outlined a scenario in which Nigeria grows to become the 12th largest economy by 2050, not so much affirming the country’s existing economic policies and growth trajectory but rather highlighting the enormous latent potential arising from a large population and substantial resource assets, not least oil and gas. The role of the banking system will be crucial and Mr Soludo is correct to insist that Nigeria needs bigger banks that can fulfil their intermediary function more capably and aggressively.

For the moment, and even after consolidation, the banks are still too small to play anything more than a bit part in big ticket transactions, limited to participation in loan syndicates and forced to leave bigger, more complex deals on the table for foreign briefcase bankers. This, in turn, prevents competitive downward pressure on the cost of capital, particularly on the sorts of projects that are crucial to sustaining and broadening the country’s economic development – infrastructure, solid minerals extraction and large-scale manufacturing.

Local banks such as Zenith are not sitting idly by. With total shareholders’ funds of N37.8bn ($270m) at the end of June last year, Zenith laid down a marker to competitors in February, going back to the market with a N50.7bn public offer. As The Banker went to press, there was strong demand for shares.

It remains to be seen how long the appetite for bank shares will last. After Mr Soludo decreed the new capital requirements, banks stormed the Nigerian Stock Exchange, raising $3bn in the process. However, the overall market capitalisation ended 2005 up 1%, casting doubts over the depth of the market. How hardy these investors will be when almost inevitably banks’ return on equity slumps to below pre-consolidation levels remains unknown. With Nigerian insurance companies set to turn to local capital markets to meet their own new minimum capital requirements, easy equity finance may soon prove a thing of the past.

Capital carrot

Earlier this year, Mr Soludo put a carrot in front of the noses of Nigeria’s bankers, promising that any bank that reached Tier 1 capital of $1bn would be allowed to participate in the management of the country’s burgeoning reserves. The modest fee income on such an arrangement can hardly justify the risk of massive over-capitalisation; instead, the policy signals Mr Soludo’s eagerness to encourage local banks to grow in size. To get there, the governor bets that further consolidation will be inevitable, envisaging 25 banks trimmed down to perhaps 10 or 12 megabanks – his original target at the outset of the consolidation exercise.

Questions remain beyond that, however. In many ways, the fortunes of the banking sector are hostage to developments elsewhere. For instance, pension reforms promise the mobilisation of long-term savings, which are crucial for the establishment of a mortgage market; a necessarily long track record of fiscal responsibility is needed to build appetite for longer dated government borrowing instruments, which is the precursor to establishing a yield curve; and, at a mundane level, a working postal system is needed for viable retail banking services. Of course, there has to be political and economic stability to encourage growth and development of the real economy for the banking sector to participate in. All these and more are largely beyond the remit of the CBN, yet are crucial to banking sector development.

Mr Soludo insists that there are opportunities aplenty already but adds that the broader reform programme is on track, meaning that by the time the banking system is operating efficiently, the opportunities in the wider economy will be ripe.

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