CBN orders banks to save FX revaluation gains as buffer against economic shocks

The Central Bank of Nigeria (CBN) has issued a directive to all banks in the country to set aside their foreign exchange (FX) revaluation gains as a counter-cyclical buffer to cushion any future adverse movements in the FX rate. The CBN also prohibited banks from using FX revaluation gains to pay dividends or meet operating expenses.

What are FX revaluation gains and why are they important?

FX revaluation gains refer to the increase in the value of a bank’s assets and liabilities denominated in foreign currency when there is a change in the exchange rate between the foreign currency and the local currency. For example, if a bank has a dollar-denominated loan of $100,000andtheexchangeratechangesfromN400/$ to N500/$, the naira value of the loan increases from N40 million to N50 million, resulting in a revaluation gain of N10 million for the bank.

FX revaluation gains are important for banks because they affect their capital adequacy, asset quality, liquidity and profitability. Capital adequacy is the ratio of a bank’s capital to its risk-weighted assets, which measures its ability to absorb losses and comply with regulatory requirements. Asset quality is the degree of risk associated with a bank’s assets, which reflects its creditworthiness and potential for non-performing loans. Liquidity is the ability of a bank to meet its short-term obligations and fund its operations. Profitability is the measure of a bank’s income relative to its expenses, which determines its dividend payout and growth potential.

What are the implications of the recent FX policy reforms on the banking sector?

The CBN has recently implemented several FX policy reforms to address the persistent shortage of foreign exchange in the country and stabilize the naira exchange rate. Some of these reforms include:

• The introduction of the NAFEX window, also known as the Investors’ and Exporters’ (I&E) window, in April 2023, which allows market participants to buy and sell foreign exchange at market-determined rates.
• The adoption of the NAFEX rate as the official exchange rate for government transactions and external reporting in May 2023, which effectively devalued the naira by about 8% from N379/$toN410/$.
• The discontinuation of the sale of foreign exchange to Bureau De Change (BDC) operators in July 2023, which aimed to curb speculation and arbitrage in the parallel market.
• The launch of the e-Naira, a digital currency issued by the CBN, in October 2023, which is expected to enhance financial inclusion, cross-border payments and remittances.

These FX policy reforms have significant implications for the banking sector, as they affect the naira values of banks’ foreign currency assets and liabilities, resulting in varying levels of FX revaluation gains or losses across the industry. According to a report by Nairametrics, some banks recorded FX revaluation gains of over N100 billion in their half-year 2023 financial statements, while others recorded losses of over N20 billion.

The FX policy reforms also have potential impacts on other aspects of banking operations, such as:

• Breaches of single obligor and net open position limits: Single obligor limit (SOL) is the maximum amount that a bank can lend to a single borrower or group of related borrowers, which is usually 20% of its shareholders’ funds. Net open position (NOP) limit is the maximum exposure that a bank can have in any foreign currency, which is usually 20% of its shareholders’ funds. The FX policy reforms may cause some banks to inadvertently exceed these limits due to the change in naira values of their foreign currency exposures.
• Increase in asset quality risks: The FX policy reforms may increase the risk of default or delinquency by some borrowers who have foreign currency-denominated loans but earn naira income, as they face higher repayment obligations due to the depreciation of the naira. This may affect the quality of banks’ loan portfolios and increase their provisioning requirements.
• Pressure on industry capital adequacy: The FX policy reforms may reduce the capital adequacy ratio (CAR) of some banks that have more foreign currency liabilities than assets, as they suffer FX revaluation losses that erode their capital base. This may affect their ability to meet regulatory minimum capital requirements and support their growth plans.

What are the prudential guidelines issued by the CBN for banks?

In order to mitigate the negative effects of the FX policy reforms on the banking sector and ensure financial stability, the CBN has issued some prudential guidelines and directives for immediate implementation by banks. These include:

• Treatment of FX revaluation gains: Banks are required to exercise utmost prudence and set aside their FX revaluation gains as a counter-cyclical buffer to cushion any future adverse movements in the FX rate. In this regard, banks shall not utilize such FX revaluation gains to pay dividends or meet operating expenses.
• Single obligor limit (SOL): Banks that inadvertently breach the SOL due to the FX policy will be granted forbearance upon application to the CBN. The forbearance shall apply only to existing facilities as of the effective date of this policy. Such banks shall be exempted from the regulatory deductions on the excess above the SOL limit in their CAR computation.
• Net open position (NOP) limit: Banks that exceed the NOP prudential limit due to the FX revaluation shall be granted forbearance for the breach upon application to the CBN.
• Existing prudential regulations: Banks are expected to comply with the existing prudential regulations on capital adequacy, dividend payments and foreign currency borrowing limits. Banks are also encouraged to build capital buffers to increase their resilience against potential volatility and economic shocks.

The CBN stated that it will continue to monitor emerging vulnerabilities and take appropriate regulatory action to safeguard the banking sector and the economy.