Nigerian banking sector: how safe for investors to return?

Financial crisis and the accompanying stock market meltdown in Nigeria had set stock market investors on the run in 2008. The banking sector was the epicenter of the global financial turmoil here. Stock market runs were further induced by regulatory moves and actions in 2009 and reached its climax with bank nationalisations in August 2011.

Regulatory efforts to jack up the system turned out as devastating to investor confidence as the crack down itself. But having finally crossed the bumpy part of the regulatory restructuring in 2011, the industry is settling down for a new phase of growth. Caution is bound to rule the stock market for a while, as the level of progress towards recovery differs widely among Nigerian banks.

The stock market moves in times and seasons and after the season of broken confidence and massive losses, a new season of hope and recovery seems set to run once again. The same market where heavy losses were sustained is still the place where big profit is being made. Profit prospects from 2012 operations indicate that most banks have crossed over from struggling for survival to building wealth once again for shareholders.

Two main factors are bearing the light of optimism for the banking sector. The first is relative regulatory peace, which has been missing since the financial crisis. A number of regulatory measures introduced to deal with financial crisis have had serious fallouts for the system but a period of regulatory stability has begun since 2012.

Since the Central Bank's risk asset audit in banks in 2009, regulatory actions have played a key role in determining whether investors reap capital gains or losses from the banking sector. Regulatory actions have therefore become critical factors in determining the direction of the equities market, in which banks account for about 60% of traded volume.

Fiscal 2012 is expected to be counted as a year of an upturn for the banking sector, as interim reports have indicated generally. The stock market has so far reflected this development. The favourable developments clearly reflect the relative regulatory peace that has prevailed since the beginning of last year.

The second factor that is favouring the banking sector is resumption of growth by banks with most of them headed for new peaks in revenue and profit for the first time since 2008. Based on the third quarter interims, most of the banks are very likely to report more profit and earnings per share at the end of 2012 than they have ever achieved any time in their operating history.

Trust and confidence on which banking business runs are gradually being restored. This follows the end of uncertainty created by the question of what to do with the rescued banks. The uncertainty over the future of rescued banks and the eventual negative reactions that followed their nationalisation had resulted in major capital losses to investors in 2011.

In the uncertainty over the banking sector in 2011, there was a loss of investor confidence on banking shares, which led to huge capital losses. There was not a single banking stock that closed the year with a capital gain. But improving confidence has taken the place of uncertainty since 2012 and this is expected to be maintained for the second year in 2013. Consequently, most of the banking shares have shifted from capital losses to impressive gains.

While the banking sector is presently giving the signals for investors to return, the prospects differ widely from bank to bank depending on profit recovery/growth potential and dividend outlook. Not all the banks have been able to stabilise their operations in the post crisis trading.

Banks that have achieved stability and resumed dividend payment can be expected to improve on their performance records in 2012 while those that have just returned to profit from losses in the preceding year are more promising on capital appreciation than dividend pay-out.

It can be expected that the stock market would be somewhat cautious with banking stocks, as many people, once beaten would want to wait and see for a while. Nevertheless no other sector is considered as promising as banking in terms of profit recovery/growth and general prospects for capital appreciation in the entire stock market now.

Returns from Banking Shares in 2011

Banking stocks opened the year 2012 at about their lowest prices in many years. Hence even moderate price gains have translated into big percentage growth in values. Since capital gains/losses are the main determinant of overall returns on equities, it can be expected that banking shares will offer good returns on investment for 2012 on both real and nominal terms.

By the middle of last November, banking stocks had all moved to the gainers' side of the price table. This is a reflection of the positive shifts in earnings fundamentals. The banks that are still on the recovering journey have mostly shifted from losses into profit and those that are profitable are expected to close 2012 with new profit peaks.

Returns Outlook for Banking Stocks for 2012

The few banks that have attained new profit peaks are expected to maintain normal growth in 2012. Some others are likely to join this group to rise above their pre-financial crisis profit and dividend capacities in the year. Most of the others are also in a position to return to the recovery path or accelerate recovery process.

Generally, it is expected that most banks will be able to resume the ultimate business of building value for shareholders in their 2012 operations. The capacity to grow wealth for investors is likely to be spurred by improvement in both asset turnover and ability to convert revenues into profit.

General improvement in risk asset quality will permit improvement in asset-revenue relationship, [asset turnover] while reduced provisioning will optimise cost-revenue relationship [profit margin]. There will be a combination of capital gains and increased earnings and dividend capacity - which will expectedly push up returns from banking stocks.

The improving earnings picture for banks therefore reflects a significant cut down on problem assets and new provisioning requirements. Massive provisions for risk asset losses had eaten up revenues and eroded capital stock of banks since 2009. This has resulted in a gradual shift of banks from core credit to investment assets - mainly the low-risk government securities.

Head or tail, banks win
The shift on the income statements of banks is yielding fruits. A change in trend has happened from stagnant revenues and rising provisions to growing income and relatively declining provisions. The net effect is a sharp recovery in net profit margin.

The sustained upward trend in money market rates since May 2012 has boosted the revenue capacities of banks generally. The increase in interest rates follows the tight liquidity in the banking system caused by the Central Bank's sustained aggressive mop up operations. Cost cutting has also helped banks' bottom lines with net job losses leading the expenditure trimming strategy for the fourth year running.

Bank earnings picture is also improved by further widening of net interest spread. The Central Bank reports the average maximum lending rate of banks at 23.4% while the consolidated deposit rate has declined slightly. According to Sanusis Lamido Sanusi, governor of the Central Bank of Nigeria, the spread between the average maximum lending rate and the consolidated deposit rate widened to 19.62% at the end of June, 2012. This is the effect of the high liquidity of bank balance sheets following the shift in asset structure from risk assets to money market investments.

How ever regulatory policies have redefined the operating environment, banks seem to be making the best out of it. Penalise them for bad loans through excessive provisions, they abandon the high risk lending and shift to low risk investing. Head or tail, they seem to win!

The low risk profile of banks is good for business since they are taking lower risk to deliver higher returns to shareholders. With the prevailing high short-term interest rates, the high yield on investment assets no longer justifies the troubles of core lending in a depressed economy. All that a bank needs to make good money is liquidity, which they all have, even in excess.

Need for caution
The varying degrees to which banks were affected by financial crisis and the equally differing rate of recovery have important lessons for the investing public. The big lesson is that banks operate at various levels of risk exposure to the business. There are high-risk and there are low-risk banks.

While scouting for banking stocks with the objective of maximising returns therefore, investors need also to consider the risk with which a particular bank is taking to obtain the high returns. A big mistake that most investors appear to make is that they usually pursue high returns without considering the attaching investment risk.

Understanding the level of risk to which a bank is exposed has become necessary in an unstable market. Bearing mainly from the experiences of the financial crisis, some guides in understanding the risk exposure of a bank are provided in this study.

An important risk indicator to watch is the level of outstanding provisions relative to the volume of classified assets. A few banks had over 100% provisions for problem assets before the financial crisis. Such banks were able to absorb the huge credit losses that followed without hurting current revenues badly.

For banks with insufficient provisions, their revenues were quickly swallowed up by huge current provisions, landing them straight into huge losses. The higher the level of outstanding provisions for credit and other anticipated losses, the more current revenues are shielded from such losses and the lower the risk of profit failure.

Another important guide is the level of non-performing assets relative to equity base. An investment in a bank will be exposed to high risk if classified loans are in excess of 50% of equity resources of the bank. This is because equity capital of a bank is not meant to absorb anticipated losses.

The higher the risk of credit losses, which are anticipated, the higher the risk of such losses hitting the capital account. The Central Bank took over rescued/nationalised banks because they had become technically insolvent - ownership stakes of investors wiped off by losses.

Another major risk indicator is how big is the general reserve of a bank - that portion of equity to which a bank can fall back on to pay dividend in a down year. Banks that had robust reserve accounts were able to maintain regular dividend payment during the financial crisis. For a number of banks, even the general reserve account was depleted by losses and some of them still carried negative general reserve into the 2012 operations.

Market conditions now require that investors focus less on the share price but more on the ability of a bank to build value. This means that investors now need to consider the risk of an investment rather than focus only on return. The need to investigate company fundamentals before buying equities is the major lesson of the share price meltdown. The crisis has flagged off a warning that failure to investigate before buying stocks is one easy way of setting hard earned capital on fire.