A fresh circular from the Central Bank of Nigeria (CBN) addresses alleged instances of excessive foreign exchange speculation by Nigerian banks.
A new set of instructions intended to lower the risks connected to these behaviors is included in the circular.
The CBN expresses worry about the rising tendency of banks keeping sizable foreign currency assets in the circular, “Harmonization of Reporting Requirements on Foreign Currency Exposures of Banks.”
“The Central Bank of Nigeria (CBN) has noted with concern the growth in foreign currency exposures of banks through their Net Open Position (NOP). This has created an incentive for banks to hold excess long foreign currency positions, which exposes banks to foreign exchange and other risks. Therefore, to ensure that these risks are well managed and avoid losses that could pose material systemic challenges, the CBN issues the following prudential requirements”
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Put simply, the central bank thinks that certain commercial banks maintain long-term holdings in foreign exchange with the intention of benefitting from them, particularly during periods of volatility in the market.
For instance, a bank may borrow or acquire $1 million in foreign exchange, but instead of lending the money or utilizing it to fund purchases for its customers right away, it keeps half of it in its own. This implies that banks that purchase the forex low and sell it high might benefit from currency depreciation.
Buying or holding foreign currency with the intention of benefitting from changes in exchange rates is a practice known as speculating. Banks may be exposed to serious risks as a result of this activity, such as fluctuating exchange rates and possible financial losses.
To address these issues, the CBN has issued prudential requirements that banks must follow. A key focus of these requirements is the management of the Net Open Position (NOP).
The NOP measures the difference between a bank’s foreign currency assets (what it owns in foreign currencies) and its foreign currency liabilities (what it owes in foreign currencies).
The circular mandates that the NOP must not exceed 20% short (owning more than owning) or 0% long (owning no more than the bank’s shareholder funds not reduced by losses) of the bank’s shareholders’ funds.
This calculation must be done using the Gross Aggregate Method, which provides a comprehensive view of the bank’s foreign currency exposure.
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Furthermore, banks with current NOPs exceeding these limits are required to adjust their positions to comply with the new regulations by February 1, 2024.
Additionally, banks must calculate their daily and monthly NOP and Foreign Currency Trading Position (FCT) using specific templates provided by the CBN.
The circular also stipulates that banks should maintain adequate stocks of high-quality liquid foreign assets, such as cash and government securities, in each significant currency.
“Banks are also required to have adequate stock of high-quality liquid foreign assets, i.e. cash and government securities in each significant currency to cover their maturing foreign currency obligations. In addition, banks should have in place a foreign exchange contingency funding arrangement with other financial institutions.” CBN
These assets are crucial for covering maturing foreign currency obligations. Banks are also advised to have foreign exchange contingency funding arrangements in place with other financial institutions.
Other requirements outlined in the circular include practicing natural hedging by borrowing and lending in the same currency to avoid currency mismatch risks.
“Banks should borrow and lend ni the same currency (natural hedging) to avoid currency mismatch associated with foreign currency risk.
The basis of the interest rate for borrowing should be the same as that of lending i.e. there should be no mismatch ni floating and fixed interest rates, ot mitigate basis risk associated with foreign borrowing interest rate risk.
With respect to Eurobonds, any clause of early redemption should be at the instance of the issuer and approval obtained from the CBN ni this regard, even fi the bond does not qualify as tier 2 capital. reporting on a timely basis.”
Banks are also advised to ensure that the basis of the interest rate for borrowing matches that of lending, thereby mitigating basis risk associated with foreign borrowing interest rate risk.
The CBN emphasizes the importance of compliance with these guidelines, warning that non-adherence will result in immediate sanctions and possible suspension from participating in the foreign exchange market. This move by the CBN signifies a firm stance against speculative activities in the banking sector, aiming to safeguard the financial system and promote economic stability.
