Stress test lessons for Nigerian banks and regulators

By Babajide Komolafe

The biggest news in the global financial markets last week was the result of the stress test conducted by the Federal Reserve Bank (Fed) of the United States to assess the ability of the country’s 19 big banks or bank holding companies (BHCs) to survive future extreme financial crisis.

The stress test referred to as Comprehensive Capital Analysis and Review Programme (CCARP) tested the ability of the banks to survive a financial crises characterised by 13 per cent unemployment level, 50 per cent decline in global stock prices and 20 per cent decline in housing prices.

The Federal Reserve assumed that the 19 banks would record losses of $534 billion as a result of this extreme situation and assessed the adequacy of their capital to cover such loses and still be able to continue to lend and do business.

Four banks failed the test. The banks namely SunTrust Banks, Inc. (STI), Metlife Inc. (MET), Citigroup Inc. (C), and Ally Financial Inc.  These, according to the Fed would  need more capital to survive the assumed crisis.

The results of the stress test and the comments it generated from operators in the global financial markets bore a number of lessons for the Nigerian banks and their regulators.

The first lesson is that the result of the test was made public. Though It was the first time the Fed  would make the result of  such test public, it is not entirely new. The European Central Bank made public the result of the stress test it conducted last year. This is very significant and quite instructive for the Central Bank of Nigeria.

Lamido Sanusi, CBN governor

First making the result public rewards institutions  doing the right thing in terms of  good banking governance, good risk management practices and compliance with  regulatory requirements. On the other hand, it puts pressure on institutions doing otherwise to change their ways. This is evident in response of the investing community to the result of the stress test.

The share price of some of the banks that passed the test rose  significantly while  that of those that failed declined. Secondly, making the result of the test public reduces the perception of regulatory collusion to cover-up the health status of banks.

In Nigeria for example, members of the banking public have severally blamed the Central Bank of Nigeria (CBN) for past banking crises. They allege that the apex bank helped the banks’ cover-up their  true health status  and hence deceived the banking public into doing business with banks that are not healthy.

This is reinforced by the decision of the apex bank to water down the segment on soundness of the banking industry in its annual report. Of course it may have done this to avoid sensationalised reporting in the media, but the downside is that it protects banks doing the wrong thing.

As evidenced in the annual reports of the Nigerian Deposit Insurance Corporation (NDIC) mere regulatory rebuke and sanctions are not enough to pressure banks’ management into doing the right  thing. Subjecting them to some form of public scrutiny as the result of the stress test has done, could prove far more effective.

The second lesson for regulators is that the stress test conducted by the Fed was backward looking. It assumed that future financial crisis would be similar to the last one or to the previous ones. It assumed that the factors that triggered the financial crisis of 2008/2009 would be the ones that would triggered the next financial crises.

But, as experienced has shown, it is not always so. The least factor or a very remote development can trigger  banking crisis. Although, this is a problem with running stress test  in general, the result can give executives and regulators a false sense that all is well. The CBN and NDIC needs to find a way to make any stress test on Nigerian banks to be forward looking.

Though at the core of every banking distress is poor corporate governance and excessive risk taking, extraneous factors can spring surprises like natural disasters, and unexpected change in government and government policy. It is also instructive to management of banks as an accommodating and a ‘kid glove’ regulator can be succeeded by a hostile and ‘hard punching’ one. The attitude is to expect the worst to survive the worst.

The third lesson, especially for banks is that they should not cover-up loses because it is tantamount to building on sand. The most surprising news from the stress test result is Citi Bank. It is one of the biggest banking institutions in the world and it conveys the impression that all is well. But it failed the test.

This according to  analysts is because Citibank has been using accounting moves to hit its profit.  “The accounting moves include wonky sounding things like debt valuation adjustments, sluicing loan loss reserves back into income, and relying heavily on tax losses to lower tax bills to the IRS and thus boost reported profits.

Two-thirds of Citigroup’s $21.9 billion in total net income for the last two years came from accounting moves. Insiders at Citigroup have told FOX Business that the bank has wanted to increase its dividend from a penny to a dime, and also execute a stock repurchase plan. Citi’s chief executive, Vikram Pandit, said last week at an investor conference that a stock buyback plan looks “attractive.”

Nomura Securities had also forecast a dividend hike and new stock repurchase plan at Citi. One of the bank’s biggest investors, Prince Al-Waleed bin-Talal, has publicly endorsed a bigger dividend. But Citi is still loaded down with first-lien mortgages, home equity loans, commercial and industrial loans, and credit card debt.