Dr. Ajibola Awolowo
It is always a huge pleasure to receive emails from listeners of the podcast. These emails motivate me to continue putting in little drops into the vast ocean of financial education available to the retail investor knowing fully well that someone somewhere is benefiting from it. I am humbled by the feedback I get. Thank you very much to everyone that keeps in touch.
Recently, I got an email from Mr Temitope Ariyo. He not only gave positive feedback but also asked a thought-provoking question. He had lived through the Great Financial Crisis (GFC), the resultant stock market crash in Nigeria and has the scars to show for it. He was worried about the possibility of a repeat performance of a stock market crash particularly since there has been the collapse of some major banks across the world this year alone.
I had no immediate answer for him but the question made me think, research the subject and, hopefully, come up with a framework to help the retail investor understand what is going on at present and if it is different to what happened in the GFC.
First, let me state that I am not an expert in the subject matter. I am not a banker. Neither am I an economist. I am just a retail investor and a medical doctor with a curious mind who likes to share his thoughts. If I blaspheme any hallowed accounting or economic principle while sharing my thought in this article, forgive me. I can genuinely claim ignorance in this subject.
Secondly, I think it is important we first understand the strategic position banks occupy in every economy, how banks make profit and why strong oversight is necessary in that sector. I will devote this first article to the above.
I remember back in secondary school, most likely in SS1 class. I had a bright idea to start an Esusu (ajo) contribution scheme for a few friends in my class. I cut up some cardboard paper and made a registration card. I don’t know how I did it but I convinced a few friends to daily save their money with me and at the end of the month, I’ll give them back all they have saved after removing my own commission for the safe keeping of their funds.
Business was good until some of the money my friends had deposited with me got stolen. I was in a big fix. Here I was, a teenager who did not have a job or earn a stipend, owing money to all his friends who had entrusted their savings to me for safekeeping. Thankfully, a friend of mine in class came to my rescue and gave me the missing balance. God bless you, Tosin, wherever you are now. I promptly paid everyone back their money and shut down the business. Come to think of it, I never asked him where he got the money he gave me from.
Little did I know it at the time, but I had stumbled on the model used by banks in their business. Banks are institutions that guaranty the safe keeping of people’s money. The contract between the banks and their depositors is that the banks will keep depositors money safe while the depositor can come into the bank at any time to collect their money, no questions asked.
This mutual trust between the depositors and the banks is the soul of banking. Without it, all hell will break loose. Banks incentivise depositors to lodge their capital with them by paying them interest. The longer you leave your fund with the bank, the higher the interest you earn. Banks in turn take the deposits they have raised and deploy it into ventures that can earn them a return which is higher than the interest they are paying the depositor. They, therefore, make the bulk of their profits from the spread between the returns they earn on deploying deposits and the interest they pay the depositors.
In earning a return on the deposits they receive, banks can choose to lend the money to individual, corporate organisations or sovereign entities who need capital for durations ranging from short to medium and to long term. Banks need to skilfully find a balance between short term lending and long term lending.
If they lend too much funds to short term clients, they’ll have a fantastic quarter result but cannot guaranty steady future earnings and will need to keep taking high risks in lending to new clients every time. If too much lending is done for long term purposes, if depositors demand their money in the short term, the bank will struggle to raise capital from the long term investments to pay the depositors.
This is why banking is difficult. It takes skill to balance the higher risks of short term lending which may give more assured cash flow to meet possible client deposit demand against the more stable/ predictable earnings from long term lending which tie down client deposits for long periods.
Banking is akin to a tight rope balancing act. If you lean too much to one side, you lose your balance and come crashing down. If the trust between depositors and their bank is broken and all depositors show up in the banking hall to collect their funds (This is termed a bank run), the bank will become insolvent as no bank holds enough cash to payback all its depositors on any day.
As the fate/ health of banks is highly intertwined with the economy and sovereign in which it operates, the industry is one of the most regulated industries worldwide. The Central Bank of Nigeria regulates and has oversight function over the banks. Using its monetary policy and various banking prudential ratios, the CBN keeps its fingers on the pulse of the economy and each individual bank.
A few important prudential rations are:
- Capital Adequacy Ratio: This is a measure of how much capital a bank must have in relation to the amount of risk it bears. This is pegged at 15%, at present, for Nigerian banks with an international licence. In very simple terms (oversimplified, if I am being honest), the capital (equity) of every bank must be a minimum of 15% of all its loans (risk). This is to ensure that when there are defaults in loans, the bank is strong enough to absorb those losses without becoming insolvent.
2. Liquidity ratio: To make sure that every bank can meet its obligations to its depositors, they must hold a minimum of 30% of total deposits (liability) in cash and liquid assets such as treasury bills.
3. Loan to deposit ratio: Having ensured that they have 30% of all deposits in liquid assets, the CBN mandates all banks to loan out 65% of total deposits to individual and corporate clients in a bid to stimulate growth in the economy. This is the loan to deposit ratio.
4. Non-performing loans: To make sure that banks are not reckless with how they issue out loans, the CBN monitors the percentage of borrowers who cannot repay their loans as a percentage of total loans given out by the bank. The maximum permissible proportion of bad loans to total loans is presently pegged at 5%.
Without the tight oversight performed by the CBN, banks can become reckless in how they operate. The Nigerian banking reforms of 2005 led to the creation of bigger, stronger and export worthy banks. Our banks now have footprints all over Africa and the world at large. International analysts and global funds now cover and have stakes in our banks, though that fluctuates in size.
Since, at present, our banks may be the strongest they have ever been, is there any cause for alarm considering the spate of failed banks in the United States and in Europe? Catch my next article to follow my train of thoughts. Thanks.
Dr Ajibola Awolowo
Value Nigeria Podcast
valuenigeriawithajibola@yahoo.com