Nigeria: CBN’s FX Regulation to Impact Banks’ Profitability in the Short Term says Moody’s

Moody’s Ratings has cautioned that the Central Bank of Nigeria’s (CBN) recent foreign currency regulations are poised to exert pressure on banks’ profitability in the near future, according to a note released by the agency. The amendments to the prudential requirements, which came into effect on February 1, have significant implications for Nigerian banks.

Previously, commercial banks were permitted to maintain a foreign currency long net open position, representing the disparity between their total long and short positions in foreign currency, inclusive of both on- and off-balance sheet exposures. However, following observed breaches, the CBN has revised these requirements, now mandating banks to hold 0% long of shareholders’ funds unimpaired by losses.

Moody’s views this directive as credit negative for Nigerian banks, particularly in the short term, as it curtails their ability to capitalize on profits from foreign currency revaluation gains. During periods of Naira devaluation, banks have historically benefitted from substantial revaluation gains. However, the amended regulations limit their capacity to benefit from a long net open position.

This reduction in profitability not only exposes banks to heightened potential losses associated with anticipated higher credit risks during currency depreciations but also constrains their ability to bolster capital buffers. With less retained profit available, banks face diminished resilience in the face of local currency depreciation.

Moody’s predicts a decline in Nigerian banks’ capital adequacy ratios in the event of further currency depreciation, compounded by the absence of foreign currency revaluation gains. This scenario is exacerbated by the simultaneous increase in the local currency equivalent of risk-weighted assets against static regulatory capital.

The CBN’s rationale for these regulatory changes is rooted in concerns over banks’ accumulation of foreign currency exposure, which incentivizes speculative behavior and disrupts currency stability. Non-compliant banks risk immediate sanctions or suspension from participating in the foreign exchange market.

However, certain aspects remain unclear, particularly regarding outstanding foreign currency swaps and forwards with the CBN. Resolving these instruments in an asset “sell-down” scenario presents challenges that require clarification from regulatory authorities.

While Nigerian authorities anticipate that these policies will eliminate currency speculation and enhance stability, Moody’s suggests that achieving this goal may necessitate significant increases in interest rates to curb inflation, which stood at 28% as of December 2023.

The effectiveness of these regulations will become more apparent over time as their impact on currency stability, investor confidence, and overall economic performance unfolds.