Why financial institutions need stress tests

For the average Nigerian, the intricacies of banking risk management may seem far removed from everyday life. However, the robustness of our banks' risk frameworks directly impacts every aspect of our economy, from the interest rates on your savings account to the availability of credit for small businesses. As a risk specialist who has been familiar with the complexities of financial institutions in Nigeria and the United States for nearly a decade, I have watched the Nigerian banking sector evolve – from the turbulent consolidation era of 2004-2005 to the current digital renaissance.

Before we delve into the details of stress testing, it is important to understand the unique characteristics of the Nigerian banking sector. Although there are 43 licensed deposit-taking banks, the sector is dominated by a handful of institutions. In 2023, the top five banks (First Bank, United Bank for Africa, Guaranty Trust Bank, Access Bank and Zenith Bank) controlled over 60 percent of the sector's assets. This concentration underscores the importance of robust risk management, as the collapse of any of these institutions could have catastrophic consequences.

The Central Bank of Nigeria has made great strides in aligning our regulatory framework with global standards. The implementation of Basel II and III capital requirements and the introduction of the internal capital adequacy assessment process have refined risk management practices. However, implementation and monitoring challenges remain.

Nigeria's economy is heavily dependent on oil exports and is subject to booms and busts that directly impact bank performance. The 2016 recession and the recent COVID-19-induced economic downturn in 2020 underscore the need for banks to be prepared for sudden, severe downturns. The naira's managed float regime, coupled with periodic devaluations and foreign exchange shortages, introduces a unique level of complexity in risk management. Banks must constantly hedge against potential currency shocks that could undermine their capital base and affect the creditworthiness of import-dependent borrowers.

Key sectors of the Nigerian economy such as oil and gas, power and telecommunications represent significant concentrations in banks' loan portfolios. The performance of these sectors can fluctuate dramatically due to global commodity prices, regulatory changes or technological disruption. The rapid rise of fintech companies and payment services banks is changing the competitive landscape. Traditional banks are under pressure on their fee-based revenue streams and must innovate to retain market share.

Because a significant portion of economic activity takes place in the informal sector, banks face particular challenges in credit assessment and risk modelling. Since many businesses and individuals do not have formal financial records, innovative approaches to credit scoring and risk assessment are required.

Credit risk remains the biggest threat to Nigerian banks' balance sheets. While the non-performing loan ratio has improved from the 2016-2017 crisis levels, it still stands at about 4.5 percent as of February 2024. This improvement is partly due to regulatory interventions, such as the establishment of the Asset Management Corporation of Nigeria and stricter loan loss provisioning requirements. However, several factors complicate credit risk management:

Many banks are heavily exposed to individual borrowers or sectors. The oil and gas sector alone accounted for around 39 percent of new loans granted in the first half of 2023.

A significant portion of loans, particularly in the oil and gas and manufacturing sectors, are denominated in foreign currencies. Currency devaluations can rapidly increase borrowers' debt burdens and potentially lead to defaults. In a country where land is often used as collateral, the lack of a central and up-to-date land registry system makes it difficult to accurately value and realize collateral in the event of default. Government actions such as the recent redesign of the naira or changes in import restrictions can suddenly change the business landscape for borrowers and affect their ability to repay loans.

Market risk in Nigeria is characterised by high volatility across asset classes. The CBN's monetary policy decisions, often influenced by inflation management objectives, can lead to significant interest rate fluctuations. This impacts both the trading book through bond valuations and the banking book through net interest margins. The system of differing exchange rates, periodic devaluations and foreign exchange shortages create a complex environment for managing currency risk. Banks must navigate between official rates, NAFEX rates and parallel market rates.

The Nigerian Stock Exchange, now Nigerian Exchange Group, while becoming more sophisticated, remains relatively illiquid and prone to sharp price fluctuations, particularly in bank stocks, which account for a significant portion of market capitalization. Given Nigeria's dependence on oil exports, fluctuations in global oil prices have a disproportionate impact on the wider economy and, in turn, on the performance of banks.

Given this complex risk environment, stress testing becomes both a regulatory requirement and an important tool for strategic decision-making. Nigerian banks can better control their destiny by paying more attention to stress testing. Here are my suggestions for best practices tailored to the Nigerian context: Model scenarios of oil prices falling to $30 or even $20 per barrel, considering the impact on government revenues, foreign exchange availability and industry performance. Test for sudden naira depreciations of between 20 and 30 percent, and analyze the impact on foreign currency-denominated loans and import-dependent industries.

Model scenarios where the policy rate rises by 500-1000 basis points, as happens during periods of high inflation. Develop scenarios around regulatory changes in key sectors such as telecoms (e.g. SIM card regulation) or fintech (e.g. cryptocurrency restrictions). Combine market and credit risk factors to capture second-round effects. For example, how a foreign exchange shock affects the creditworthiness of import-dependent borrowers. Incorporate elements of operational risk, such as the impact of prolonged power outages or cyberattacks, which are entirely possible in Nigeria.

Conduct stress tests at a very detailed level, considering regional and sector-specific impacts. For example, a drought might affect agricultural loans in the north of Nigeria differently than in the south. Analyse the impact on different customer segments, from micro-enterprises to large corporates, as their resilience to economic shocks varies considerably. Given the importance of liquidity in Nigeria's often volatile market, conduct comprehensive liquidity stress tests. Modelle deposit flight scenarios by drawing on historical events such as the 2008 global financial crisis. And consider the impact of sudden regulatory changes, such as an increase in reserve requirements.

Identify the scenarios that could cause the bank to fail and work backwards from that point to understand the key vulnerabilities. This is particularly important given the systemic importance of large Nigerian banks. Go beyond static balance sheet assumptions to model how the bank's portfolio might perform under stress conditions. Consider how management actions and customer behavior might change in response to stress events.

Use big data analytics and machine learning to improve the predictive power of stress tests. Implement real-time or near-real-time stress testing capabilities to respond quickly to emerging risks. Proactively engage with the CBN to ensure stress testing methodologies meet regulatory expectations. Participate in industry-wide stress tests to benchmark performance and identify systemic vulnerabilities. Integrate stress test results into strategic decision-making processes, from capital allocation to business planning. Foster a risk-aware culture where front-line staff understand the importance of data quality for effective stress testing.

Integrate climate risk scenarios, considering both physical risks (e.g. floods in Lagos) and transition risks as Nigeria transitions to renewable energy. Model the impacts of digital disruptions, including scenarios where fintech companies capture significant market share in key product areas.

In the complex dance of risk and return that defines banking, stress testing becomes the choreographer that guides our financial institutions through the complex steps of an uncertain future. For Nigerian banks, the imperative is clear: they must invest in sophisticated, locally relevant stress testing frameworks, not just as a regulatory obligation, but as a strategic imperative.

The stability of our banking sector is the foundation on which Nigeria's economic ambitions rest. From the market stalls of Kano to the technology hubs of Lagos, from the oil refineries of Port Harcourt to the agricultural heartlands of the Middle Belt, every Nigerian has a stake in the resilience of our financial system.

As we look to the future, we should not forget that in the financial world, times are quiet, and through rigorous stress testing, banks can build the resilience they need to weather shocks, seize opportunities and play their critical role in Nigeria's path to sustainable economic development.

The question for every bank executive, risk manager and regulator in Nigeria is not whether we can afford to invest in advanced stress testing, but whether we can afford not to. The future of Nigerian banking – and the Nigerian economy – may well depend on our answer to that question.

• Odunaike is an Assistant Risk Consultant at Financial Risk Group in Cary, North Carolina