The intricacies of bank risk management might seem distant from daily life to the average Nigerian. However, every facet of our economy is directly impacted by the robustness of our banks’ risk frameworks, from the interest rates on your savings account to the availability of loans for small businesses.

This is the submission of a risk specialist, Anjola Odunaike, who has navigated the complexities of both Nigerian and United States financial institutions for almost a decade.

Having observed the evolution of the Nigerian banking sector from the tumultuous consolidation era of 2004-2005 to the current digital renaissance, he focused his presentation on a critical yet often misunderstood aspect of financial stability; stress testing.

He describes stress testing, in essence, as the financial equivalent of crash-testing a car, it ensures our banks can withstand severe economic collisions without crumbling.

Before going into the specifics of stress testing, Odunaike, an Assistant Risk Consultant at the Financial Risk Group (FRG) in Cary, North Carolina, in a paper, said it’s crucial to understand the unique characteristics of Nigeria’s banking sector:

According to him, despite having 43 licensed deposit money banks, the sector is dominated by a handful of institutions. As of 2023, the top five banks (First Bank, United Bank for Africa, Guaranty Trust Bank, Access Bank, and Zenith Bank) controlled over 60 per cent of the sector’s assets. This concentration magnifies the importance of robust risk management, as the failure of any one of these institutions could have catastrophic ripple effects.

The Central Bank of Nigeria has made significant strides in aligning our regulatory framework with global standards. The implementation of Basel II and III capital requirements, alongside the introduction of the Internal Capital Adequacy Assessment Process, has elevated the sophistication of risk management practices. However, challenges in implementation and supervision persist.

He said: “Nigeria’s economy, heavily reliant on oil exports, is subject to boom-and-bust cycles that directly impact bank performance. The 2016 recession and the more recent COVID-19-induced economic contraction in 2020 underscore the need for banks to be prepared for sudden, severe downturns.

The managed float regime of the naira, coupled with periodic devaluations and foreign exchange scarcity, introduces a unique layer of complexity to risk management. Banks must constantly hedge against potential currency shocks that could erode their capital base and impact the creditworthiness of import-dependent borrowers.’’

Also, key sectors of the Nigerian economy, such as oil and gas, power, and telecommunications, represent significant concentrations in bank loan portfolios. The performance of these sectors can swing dramatically based on global commodity prices, regulatory changes, or technological disruptions.

The rapid rise of fintech companies and payment service banks is reshaping the competitive landscape. Traditional banks are facing pressure on their fee-based income streams and must innovate to retain market share.

With a substantial portion of economic activity occurring in the informal sector, banks face unique challenges in credit assessment and risk modelling. The lack of formal financial records for many businesses and individuals necessitates innovative approaches to credit scoring and risk evaluation.

Anjola, whose expertise in risk management and dedication to continuous improvement make him a significant asset in computational economics and finance, also listed other characteristics of the Nigeria banking sector as:

Credit risk remains the most significant threat to Nigerian banks’ balance sheets. The non-performing loan ratio, while improved from the crisis levels of 2016-2017, still hovers around 4.5 per cent as of February 2024. This improvement is partly due to regulatory interventions, such as the establishment of the Asset Management Corporation of Nigeria and more stringent loan loss provisioning requirements. However, several factors complicate credit risk management.

Many banks have significant exposures to single obligors or sectors. For instance, the oil and gas sector alone accounted for about 39 per cent of fresh loans issued in the first half of 2023.

A substantial portion of loans, especially to the oil and gas and manufacturing sectors, are denominated in foreign currencies. Currency devaluations can rapidly increase the debt burden on borrowers, potentially leading to defaults. In a country where land is often used as collateral, the absence of a centralised and up-to-date land registry system complicates accurate collateral valuation and liquidation in case of default. Government policies, such as the recent redesign of the naira or changes in import restrictions, can suddenly alter the business landscape for borrowers, impacting their ability to repay loans.

He says market risk in Nigeria is characterised by high volatility across various asset classes. The CBN’s monetary policy decisions, often influenced by inflation management goals, can lead to significant fluctuations in interest rates. This impacts both the trading book through bond valuations and the banking book through net interest margins. The multiple exchange rate regime, periodic devaluations, and FX scarcity create a complex environment for managing currency exposures. Banks must navigate between official rates, NAFEX rates, and parallel market rates.

Also, the Nigerian Stock Exchange, now Nigerian Exchange Group, while growing in sophistication, remains relatively illiquid and prone to sharp movements, especially in bank stocks which form a significant portion of the market capitalisation. Given Nigeria’s dependence on oil exports, fluctuations in global oil prices have outsized impacts on the overall economy and, by extension, bank performance.

The consultant, who earned a Master of Science in Quantitative Economics and Econometrics from East Carolina University and a Bachelor of Science in Psychology from Obafemi Awolowo University, said given this complex risk environment, stress testing becomes both a regulatory requirement and a vital tool for strategic decision-making. Nigerian banks can further control their destinies by paying more attention to stress testing.

“Given this complex risk environment, stress testing becomes both a regulatory requirement and a vital tool for strategic decision-making. Nigerian banks can further control their destinies by paying more attention to stress testing.

“Here are my suggested best practices tailored to the Nigerian context: Model scenarios with oil prices dropping to $30 or even $20 per barrel, considering the impact on government revenues, forex availability, and sectoral performance. Test for sudden naira devaluations of between 20 and 30 per cent, analysing the impact on foreign currency-denominated loans and import-dependent sectors.”

“Model scenarios where the Monetary Policy Rate increases by 500-1000 basis points, as seen during periods of high inflation. Develop scenarios around regulatory changes in key sectors like telecommunications (e.g., SIM card regulations) or fintech (e.g., cryptocurrency restrictions.) Combine market and credit risk factors to capture second-order effects. For instance, how an FX shock impacts the creditworthiness of import-dependent borrowers. Incorporate operational risk elements, such as the impact of prolonged power outages or cyber-attacks, which are feasible in Nigeria.’’

Anjola, who has been instrumental in designing and implementing advanced credit risk models, ensuring they meet regulatory standards, and improving the reliability of financial risk assessments suggested the following best practices tailored to the Nigerian context:

Conduct stress tests at a highly granular level, considering regional and sector-specific impacts. For example, how a drought might affect agricultural loans in northern Nigeria differently from those in the South. Analyse the impact on different customer segments, from micro-enterprises to large corporate organisations, as their resilience to economic shocks varies significantly.

Given the importance of liquidity in Nigeria’s often volatile market, incorporate comprehensive liquidity stress tests; model scenarios of deposit flight, drawing on historical events like the Global Financial Crisis of 2008; and consider the impact of sudden changes in regulations, such as increases in Cash Reserve Ratio requirements.

Identify the scenarios that would bring the bank to the point of failure, working backwards from this point to understand key vulnerabilities. This is particularly important given the systemic importance of large Nigerian banks. Move beyond static balance sheet assumptions to model how the bank’s portfolio might evolve under stress. Consider how management actions and customer behaviour might change in response to stress events.

Leverage big data analytics and machine learning to enhance the predictive power of stress tests. Implement real-time or near-real-time stress testing capabilities to respond quickly to emerging risks.

He also listed proactively engage with the CBN to ensure stress testing methodologies align with regulatory expectations. Participate in industry-wide stress tests to benchmark performance and identify systemic vulnerabilities.

Embed stress testing results into strategic decision-making processes, from capital allocation to business planning. Foster a risk-aware culture where frontline staff understand the importance of data quality for effective stress testing.

The consultant with a solid background in data management, statistical analysis, and economic modeling, says the intricate dance of risk and reward that defines banking, stress testing emerges as the choreographer, guiding our financial institutions through the complex steps of an uncertain future.
Akindayomi, a Financial Analyst, wrote from Lagos.

For Nigerian banks, the imperative is clear: invest in sophisticated, locally relevant stress testing frameworks not just as a regulatory box-ticking exercise, but as a strategic imperative.

“The stability of our banking sector is the bedrock upon which Nigeria’s economic aspirations rest. From the market stalls of Kano to the tech 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.”

He concludes: “As we look to the future, let us remember that in the world of finance, peace is prepared for in times of calm. Through rigorous stress testing, banks can build the resilience needed to withstand shocks, seize opportunities, and play their crucial role in Nigeria’s journey towards 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 capabilities, but whether we can afford not to. The future of Nigerian banking—and indeed, the Nigerian economy—may well depend on how we answer this question.’’
Akindayomi, a Financial Analyst wrote from Lagos. He can be reached via: [email protected]