Why CBN must conduct Stress Test for Nigerian Banks

Category: Money Market


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Why CBN must conduct Stress Test for Nigerian Banks

 

March 28, 2012
 
In order to avoid a repeat of the 2009 banking sector crisis, CBN on Thursday 15th March, 2012 said Nigerian Banks are to undergo a new round of stress testing to measure whether the institutions have adequate capital or assets to respond effectively to various adverse scenarios.
 
It would be recalled that the first stress testing carried out by the CBN with the help of the International Monetary Fund, IMF in 2009 led to the bail out 8 of the country’s 24 banks, after Non-Performing Loans (NPLs) hit over a third of total loans across the banking system and also led to the removal of the executive management team of the failed banks.
 
What are stress tests?
 
Stress tests are unlike Audits or routine supervision tasks. Indeed, an objective driven definition of “stress testing” describes it as a practice aimed at assessing the coherence between the business model, the (target) risk profile and the risk bearing capacity with a view to take corrective action in order to safeguard the financial and operational soundness of the institution.
 
Specifically, stress testing measures whether the institution has adequate capital and/or assets to respond effectively to various, adverse scenarios presented by the computer program.
 
According to Stefan Walter, Secretary General, Basel Committee on Banking Supervision – “There are many factors that led to the build up of the crisis. At the top of the list is excess liquidity, resulting in too much credit and weak underwriting standards. The vulnerability of the banking sector to this build up of risk in the system was primarily due to excess leverage, too little capital of insufficient quality, and inadequate liquidity buffers”.
 
The end game it would seem would be to determine the “fit” between Nigerian banks’ business model, their risk bearing capacity and their target risk profile.
 
This stress testing will be done though the aid of computerized assumptions that evaluates an institution's reaction to different situations.
 
A far more important reason to conduct the test
 
Stress testing is a key component of the Basel III agreement and all jurisdictions are taking similar steps to ensure compliance with global assumptions as well as local realities.
 
Recall that on the 16th of December 2010, the Basel Committee issued the Basel III rules, which presents the details of global regulatory standards on bank capital adequacy and liquidity agreed by the Governors and Heads of Supervision, and endorsed by the G20 Leaders at their November 2010 Seoul summit.
 
The rules text presents the details of the Basel III Framework, which covers both microprudential and macroprudential elements.
 
The Framework sets out higher and better-quality capital, better risk coverage, the introduction of a leverage ratio as a backstop to the risk-based requirement, measures to promote the build up of capital that can be drawn down in periods of stress, and the introduction of two global liquidity standards.
 
In Nigeria, it would appear that the CBN would conduct this stress test to determine how the emerging banking landscape can meet the Basel III requirement as well as determine how the system would deliver a reasonable level of capital even following possible losses associated with a major economic downturn or changes in business condition.
 
At this time, the banks all appear to be in sufficient good health and are within or above expected capital-adequacy targets.
 
In effect, the stress test envisaged by CBN does not reflect any concern as to the health of Nigerian banks but a feature of the improved risk consciousness of the regulator and a compliance imperative with global benchmarks.
 

Related Reports

Basel III - A Risk-Management Perspective 2011 - PWC

Stress Test - Euro perspective by Goldman Sachs

 



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