Foreign-currency shortages at local companies pose a risk for Nigerian banks, according to ratings agency Moody’s Investor Service in its latest report on the Nigerian banking sector.
Banks providing trade finance for import-oriented corporate clients must typically cover any shortfall should the firms default on their FX liabilities.
To mitigate that risk, Nigerian banks have over the last 12 months been reducing the size of their trade exposures, collecting more cash collateral from trade-finance clients, or ensuring in advance that clients can source FX.
“We estimate that the off-balance sheet trade-related exposure of rated Nigerian banks amounts to around $9.8 billion in June last year, representing over 54% of their FX liquid assets,” Moody’s said.
Sound FX liquidity held by the banks provide a buffer however, Moody’s noted.
“Rated Nigerian banks carry sound FX liquidity, with $18.2 billion in FX liquid assets that cover 45% of their FX liabilities. Public information on the portion of banks’ FX liabilities due over the next 12 months is limited, but they do not have outstanding eurobonds due in 2023-24. Banks’ FX deposits and correspondent banking lines remain stable,” Moody’s said.
Constrained domestic oil production, higher prices for imports of refined petroleum products and capital outflows are causing acute shortages of foreign currency in Nigeria.
In response, the central bank, the main provider of foreign exchange in the country, has scaled down its foreign-currency allocations to local companies.
This has led to a material gap between official and unofficial exchange rates in the country.
The foreign-currency rationing entails reduced, partial or delayed allocation of foreign currency to import-oriented companies, increasing the risk that these firms fail to meet their import-related payments.
These commitments are typically covered by traderelated instruments (e.g. letters of credit) issued by the banks.
If the company is unable to make the payment, the instruments normally would require the banks to cover from their own foreign-currency reserves the full or remaining amount of the purchase.
This would potentially put their FX liquidity under pressure. Foreign-currency shortages faced by importers also limits the volume of cross-border transactions that these companies can conduct with banks, something that will weigh on bank revenue.
The banks also carry on-balance sheet trade-related exposure, which would typically be less vulnerable to FX shortages than off balance sheet exposure. This primarily includes regular lending (e.g. term loans and working capital financing) extended to companies active in trade transactions.
Risk management practices reduce the risk to banks
Actions taken by Nigerian banks to mitigate these foreign-currency risks vary across banks and tend to be most conservative at the largest banks, Moody’s said.
Some banks have reduced the overall size of their trade exposures by becoming more selective in the type of customer or the type of transactions for which they are willing to open letters of credit.
Others require clients to post a material cash deposit as collateral (either in foreign currency, or in local-currency equivalent with a buffer to cover a potential material currency depreciation) before the opening of letters of credit.
Most banks also try to avoid the risk that a client would be unable to source sufficient foreign currency by, for example, requiring clients to secure a foreign-exchange forward allocation from the central bank before the opening of a letter of credit.
Foreign-exchange forwards, (where the central bank commits to sell to a corporate client a predefined amount of foreign currency for settlement at a future date at a pre-agreed exchange rate), help the central bank smooth demand for foreign exchange by moving some of the foreign currency demand from the spot market to a later date.
Some banks are also building into their liquidity management the potential for a delay in the central bank delivering promised foreign currency to their clients.
Another practice involves banks trying to ensure that export-oriented clients wanting to sell foreign currency prioritise their import-oriented clients, Moody’s said.