The negative sentiment surrounding the banking sector was further heightened following the recent increase in the public sector CRR from 50% to 75%.  Nigerian banks are indeed facing the challenge of tougher regulation on CRR and banks have continued to weigh the impact of high public sector CRR on revenue and profitability.  In this report, we examine the rationale behind the increase in public sector CRR and its attendant impact on Banks earnings. Can we expect further increase of public sector CRR to 100%? What is the outlook for private sector CRR? On earnings expectation for FYE13, we highlighted the Q3-13 performance and gave an outlook on what to expect in terms of corporate benefit or action.  We also gave a general outlook on Q1-14 earnings.

Overview

The MPC met for its first meeting in 2014 on January 20 and 21. Key considerations included the dwindling external reserves despite high oil prices in 2013, a slowdown in FDI and portfolio flows in Q4-13 on the back of expectations of QE tapering, and the increasing spread between the inter-bank and BDC exchange rates. Following a thorough analysis of the mentioned challenges, the MPC decided to counteract these issues through the tightening of monetary policy by a unanimous decision to raise the cash reserve requirement (CRR) on public sector funds from 50% to 75%. Given the change in public sector CRR policy? and the likely future increase to 100% (in line with the implementation of the Treasury Single Account) ?It has become imperative to analyse the generalized potential impact of this development on the banking sector, acknowledging that certain banks are in a better position to navigate the now harsher operating environment.

Why is the CBN raising CRR on public sector funds?

Issues around public sector CRR hike in recent times are centered on rent-seeking activities of the banking system, and the pressure on the local currency. The MPC has raised concern about the situation whereby banks borrow funds from the government at very cheap rates and subsequently lend back to the FG at much higher rates through the acquisition of higher yielding T-Bills, bonds and OMO bills. This free lunch has reduced the incentive for banks to support real economic activities through the creation of loan assets. The existence of this risk-free opportunity saw broad money growth taper from the end of 2012 through the first half of 2013 given the attractive yields in the fixed-income market, and the banking sector’s increasing risk-aversion following heavy write-downs linked to impaired legacy loan assets.

Are further CRR hikes in 2014 in the pipeline?

The CRR Policy appears to have moved further to encompass issues surrounding exchange rate stability? giving its impact on price stability. Exchange rate stability now appears to be at the forefront of monetary policy considerations giving the fact that the MPC tied the latest hike in public sector CRR to its increasingly explicit mandate of achieving a stable Naira.  With this in mind, it becomes clear that forecasting the likely path of CRR requires careful analysis of the external reserves, the Naira/Dollar exchange rate, and the general level of liquidity in the system. We are of the view that the direction of the foreign reserve in 2014 is to the downside despite our expectation of stable oil prices at current levels. In our view, weaker-than-expected crude oil production and fiscal leakages are key headwinds for the external reserve. Furthermore, expectations of a slowdown in capital flows? which constitute an increasing part of the foreign reserve ? and potential reversals on the back of QE tapering,  suggests that the external reserve is in for a tumultuous 2014. In light of these considerations, we see the current account balance coming under pressure this year and this should weigh on the Naira at the RDAS and other segments of the foreign exchange market. Declining reserves and a weaker Naira should see the MPC hike the CRR on public sector funds to 100%. The move to establish the Treasury Single Account strongly supports our expectation of a 100% CRR on public sector funds as the CBN appears bent on indirectly fast tracking the process.

FYE 2013 Results Outlook: Can management deliver?

From a historical perspective, the average profitability of the banking sector improved in FYE 2012, with FY12 ROaE up by 166.7% relative to FY11 ROaE, driven by: 1) Higher Net Interest Margin (NIMs) reported due to higher fixed-income yields 2) Improving cost efficiency 3)  Improvements in asset quality in FY11 led to lower cost of risk in FY12 and 4) Very strong asset growth as banks shifted focus from recovery to growth.  While banks have ridden off the tailwind of rising interest rate – creating positive endowment effect (with little effort), the key question is: can management deliver in 2013?

The outlook for banking sector performance in Q1-14

Giving the recent CRR development and our expectation of a further increase in public sector CRR (and a higher probability of an increase in private sector CRR), we are of the view that the banking sector is in for a tough 2014. That being said, certain banks are in a better position to mitigate the negative effect of the policy change on their earnings giving the varying exposure to public sector funds. Our analysis will focus on Q1-14. We expect the divestment of fixed-income instruments by banks (especially those in the tier-2 category) with heavy exposure to public sector funds during the first quarter, and this should weigh on interest income/trading income (depending on categorization). In addition, reduced liquidity should impede on banks’ ability to create higher-yielding longer-dated risk assets as banks must reorganize their balance sheet to reduce roll-over and interest rate risk. We also expect to see rising cost of funds going forward. As at the time of writing, the average inter-bank rate was bounded by a narrow range (11.40%-11.65%) but we expect it to trend higher as the CRR hike takes effect on February 4 2014, the CBN continues its aggressive OMO operations, and as capital outflows linked to US monetary tightening increase.

Source: Cordros Capital