The minimum Loan-to-Deposit Ratio (LDR) for banks set by the Central Bank of Nigeria at 60 percent was further reviewed upward to 65 percent in September 2019. Compliance to the upward review was expected to commence at the end of 2019. The central bank is clear about the reason for this policy: increase lending to the real sector of the economy. Many banks in the past have preferred investment in risk-free assets to lending especially to small and medium scale enterprises due to the volatility of the Nigerian economy and sometimes lack of predictability of the business environment in the country. Other reasons for bank’s reluctance to lend to companies include the poor character of borrowers and high interest rate on risk-free assets, among others.
The minimum LDR policy by the Central Bank of Nigeria compels banks to lend. The fact that there is a higher weighting on the loans granted to SMEs, Retail and individual borrowers makes them an attractive option for banks to meet up with the policy. However, it still remains difficult for banks to take the higher risk of offering loans to individuals or corporate firms for whom repayment is not guaranteed or certain and where the loan recovery rate is low. The penalty for non-compliance with the CBN regulation is 50 percent of the shortfall in LDR in additional cash reserve requirement at 0 percent interest rate and this will be debited directly from the banks’ holding with CBN.
In October 2019, the central bank of Nigeria demonstrated her readiness to penalise banks who do not meet up with the new policy by debiting up to N499.1 billion in additional cash reserve from about 12 banks who were found to be in violation of the directive and had below the expected minimum LDR requirement of 60 percent at the time. This stance by the apex body in October 2019 confirms that they are ready to follow through on the penalty as stated in the circulars sent to banks to ensure compliance with the policy.
Nigerian banks are now clearly in a dilemma. Should they lend to low-quality borrowers with the attendant high risk or allow CBN penalise them for non-compliance at 0 percent interest rate? This is no doubt the case of choosing between the devil and the deep blue sea. A choice between the two will definitely involve a marked trade-off between risk and return.
If banks choose to lend to low-quality borrowers, SMEs, individual and retail lenders, there is a high risk of default and this might even have nothing to do with the character of the borrowers as they might just not have the capacity to repay due to the volatility of the business climate in Nigeria, foreign exchange risk or even changes in government policy. If banks do not lend to them however, their chances of meeting the LDR requirement will be low and markedly reduced and they will then have to face the penalty of 50 percent of the shortfall in additional cash reserve at 0 percent interest rate. The potential penalty is particularly expensive for banks as they will be denied billions in liquidity and this will have an adverse effect on both their business operations and profitability. It will grossly reduce the funds they have for trading and investment in less risky assets which has characterised the operation of Nigerian banks for some time.
Foreign banks operating in Nigeria will particularly feel the full brunt of this policy due to the typically stringent measures they have for granting loan requests. Even some large corporates find it difficult to meet up with some of the requirements of these banks. It remains to be seen how retail and individual borrowers will meet up. It is not clear if these banks will lower their standard in order to be able to grant the loan requests of lower quality borrowers or if they will choose the possibly less risky measure of facing the penalty of additional cash reserve at 0 percent interest rate and ultimately experience reduced returns and profitability.
Banks are clearly faced with a difficult choice and what they choose to do will depend on how much trade-off between risks and return that the banks are ready to make. If the banks choose to increase their lending to the real sector as required by CBN, they will most likely be in the good books of the apex body which is determined to drive economic growth through monetary policy, but might have to expose themselves to a higher credit risk and bad debt which will ultimately have a negative impact on profitability. If the banks however choose to face the penalty of additional cash reserve with funds growing at 0 percent, they will have grossly reduced liquidity which will impact their business negatively and won’t be in the good books of the Central Bank or customers either.
Banks have to find a delicate balance between the increased risk associated with lending to individual and small and medium scale enterprises and incurring penalty on their LDR shortfall in additional cash reserve. Which is better, I obviously cannot say but banks might have to test the waters to determine which the better is for them; a choice between the devil and the deep blue sea. Both will surely impact profitability.
Philip Oguntoye
