February 1, 2024/CSL Research

In a circular released yesterday, the Central Bank of Nigeria (CBN) expressing concern over the growth in foreign currency exposures of banks through their Net Open Position (NOP) and the associated risks, issued the following requirements with a 1 Feb 2024 deadline for compliance. Templates were provided for banks to compute their daily and monthly NOP and foreign currency trading positions (FCTP). Defaulting banks will be sanctioned and/or suspended from participation in the foreign exchange market.

The Net Open Position (NOP) limit of the overall foreign currency assets and liabilities (both on and off-balance sheet) should not exceed 20% short or 0% long of shareholders’ funds.

Banks are also required to have an adequate stock of high-quality liquid foreign assets, i.e. cash and government securities in each significant currency to cover their maturing foreign currency obligations. In addition, banks should have in place a foreign exchange contingency funding arrangement with other financial institutions.

The CBN also stressed the need for banks to hedge their FX positions naturally by ensuring they borrow and lend in the same currency. Borrowing and lending interest rates should also be on the same basis either floating or fixed. The CBN further noted that any clause of early redemption of Eurobonds should be at the instance of the issuer, and approval obtained from the CBN in this regard, even if the bond does not qualify as tier 2 capital.

The Net Open Position (NOP) of a bank’s overall foreign currency assets and liabilities represents the difference between the bank’s exposures to foreign currencies on the asset side and the liability side of its balance sheet. The NOP is a key metric used to assess a bank’s exposure to foreign exchange risk.

Essentially, NOP=Total Foreign Currency Assets−Total Foreign Currency Liabilities

Total Foreign Currency Assets: This includes all the bank’s assets denominated in foreign currencies such as foreign currency loans, investments, and even cash.

Total Foreign Currency Liabilities: This includes all the bank’s liabilities denominated in foreign currencies such as foreign currency deposits, borrowings, and other foreign currency-denominated liabilities.

The resulting Net Open Position can be positive or negative:

A positive NOP indicates that the bank has a net long position in foreign currencies, meaning it has more foreign currency assets than liabilities. The bank benefits from a strengthening of foreign currencies but is exposed to losses if those currencies weaken.

A negative NOP indicates that the bank has a net short position in foreign currencies, meaning it has more foreign currency liabilities than assets. In this case, the bank benefits from a weakening of foreign currencies but faces losses if those currencies strengthen.

In recent years, banks with significant net long FX positions have seen windfall gains with the continuous devaluation of the Naira and this has encouraged many banks to maintain significant net long FX positions.

Implication for the FX market; minimal impact on FX liquidity

In our view, these new directives from the CBN. are targeted at improving liquidity at the FX market, where rates have plummeted to as low as ₦1455.59/US$ at the official market and ₦1520/US$ at the parallel market. With the directive and a 24-hour timeline for compliance, the CBN expects banks to sell down significant net long FX positions running into billions of dollars in 24 hours. It suffices to say that many of these dollar assets are not in cash. Firstly, we believe that many banks will require CBN to grant a forbearance and will find other ways besides throwing liquidity into the market to comply such as negotiating the conversion of FCY loans to Naira loans, a conversion that many customers would likely require, given the devaluation of the Naira. Again, banks with swap positions with the CBN may likely take on the Naira equivalent of such positions. Essentially, we do not believe many banks will be in the market to sell dollars, so we do not expect a significant influx of liquidity into the FX market.

Implication for banks; Positive or negative?

No revaluation gains: Banks in recent times have kept significant net long open positions because of the weak outlook of the Naira which translates to windfall gains as the Naira depreciates. Many banks in 2023 made massive revaluation gains due to the steep devaluation of the Naira and this was a major trigger for the re-rating of banks seen in 2023. Though we have provided for very minimal revaluation gains in 2024 because we did not expect as steep a devaluation in 2024 as seen in 2023, the CBN’s directives speak to zero revaluation gains. Banks with a net short position (which the CBN has capped at 20% of shareholders’ funds) can suffer revaluation losses when there is a devaluation of the Naira, but we believe banks will likely avoid a net short position if the outlook of the currency points to a devaluation.

Loss of Hedge Against Liabilities: A net long position can serve as a natural hedge if the bank has foreign currency liabilities. If the foreign currency appreciates, the potential gains on assets can offset losses on liabilities, helping to manage currency risk. With the new directives from CBN, this potential benefit is lost.

Impact on Capital adequacy ratio: In recent years, banks with significant net long FX positions have seen windfall gains with the continuous devaluation of the Naira and this has encouraged many banks to maintain significant net long FX positions. This has also helped many of these banks to maintain adequate capital adequacy ratio as these windfall gains feed into retained earnings and help to grow capital. A naira devaluation, in theory, challenges CAR because the naira-equivalent value of risk-weighted assets (RWAs) rise given that these include foreign currency loans. The impact of foreign currency loans on RWAs are however offset by windfall gains from net long FX positions, which, in turn, boost capital. The new CBN directives imply these windfall gains will no longer be available to boost capital following a devaluation, which may imply a weakening of the Capital Adequacy Ratio (CAR). It may however be argued that this directive will likely reduce the FCY portion of the loan books and consequently minimise the growth in risk weighted assets. We believe however that the net effect will be a weakening of the CAR position in the absence of revaluation gains to boost capital.

Reduced appetite for FX currency assets – We also believe these new directives will likely reduce banks’ appetite for FCY assets, which, earn less than LCY assets and this may have negative consequences for the supply of FCY loans to support needed projects.

Potential for windfall profits: The directive is not without any gain. Banks who decide to sell of their dollar assets at current exchange rates stand to make significant realized gains which will boost their 2024e earnings.

That said, we believe the CBN will need to liaise with banks and grant forbearance given the 24hour compliance time frame and some likely areas of risks banks may be exposed to with full compliance. We also believe further directives may be issued over time.

Impact on the stock market

As expected, investors reacted negatively to the CBN’s directives, selling down bank stocks. This, we believe may continue till there is a proper understanding of the implications of the policy. That said, apart from the loss of revaluation gains, which in periods of currency stability is not a significant boost to bank profit, and a few other risks highlighted above, we do not expect the new directives to significantly affect our outlook for the banks we cover and their valuations. Core operating income lines of the banks are not affected by these directives, and we had previously forecasted very minimal revaluation gains in 2024e on the back of an expected minimal 12% devaluation of the currency. Consequently, we maintain our Buy recommendations of GTCO, Zenith, UBA, and Access Holdings.

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​​​CSL Research Flash Note – Zero net long open position; unlikely to boost FX liquidity significantly. pdf​​​​​​​​