Introduction

As a result of the high demand for foreign currency within Nigeria, foreign currency speculation within the banking system has become a significant regulatory concern for the Central Bank of Nigeria ( “CBN”). For some time, banks have faced accusations of engaging in foreign currency speculation, prompting the CBN, to repeatedly issue guidelines and directives aimed at curtailing this egregious practice. The practice is simple – banks buy and hold foreign currency, expecting to benefit from the fluctuating exchange rates. To check this practice, the CBN on 31 January 2024 issued a circular titled “Harmonisation of Reporting Requirements on Foreign Currency Exposures of Banks (the “Circular”).” The Circular is aimed at restricting banks from foreign currency speculation and providing guidelines that protect the banks and by extension, the wider economy, from the risks associated with foreign exchange (“FX”).

In this article, we expand on the CBN’s regulatory oversight of these practices while also examining the underlying reasoning behind the CBN's directive to all banks, compelling adherence to its prudential requirements.

Understanding the CBN’s Prudential Requirements

To protect the integrity of the country’s financial system, the CBN issued the revised Prudential Guidelines for Deposit Money Banks in Nigeria (“Revised Guidelines”) which came into effect on 1 July 2010 and serves as a guide for the operations of Deposit Money Banks in Nigeria. Under Paragraph 3.12 of the Revised Guidelines, Deposit Money Banks are mandated to comply with Net Open Position (“NOP”) and Foreign Currency Trading Position (“FCTP”) limits set by the CBN to manage the risks associated with the FX market.

A Net Open Position refers to the difference between the total open long (buy) positions (i.e., when the bank’s total foreign assets are greater than its total foreign liabilities) and the total open short (sell) positions (i.e., when the bank’s total foreign currency liabilities are greater than its total foreign assets) that a financial institution has in a single currency or a portfolio of currencies. In determining the exposure of a bank’s foreign currency assets and liabilities to fluctuation risks within the FX market, the NOP enables banks to determine the holding of excess foreign currency positions for long periods and allows banks to assess their vulnerability to such risks. To curtail abuse and risks associated with the occurrences of fluctuations within the FX system, banks are required to operate under the prudential limit periodically set by the CBN.

As provided under the Circular, the NOP limit of a bank’s overall foreign currency assets and liabilities should not be more than 20% short or 0% long of the shareholders’ funds¹ unaffected by losses employing the Gross Aggregate Method.² The implication of this requirement is two-pronged. On the one hand, in balancing their foreign currency assets and liabilities, banks are expected to not hold the foreign currency assets needed to settle their foreign liabilities by more than 20%. On the other hand, the 0% long of the shareholders’ funds requires that banks do not hold more foreign currency assets than their shareholders’ funds unimpaired by losses.

It is pertinent to note that the NOP limit previously set by the CBN was 10% long or short of the shareholders’ funds of banks, unimpaired by losses.³ With the new directive, it is expected that there will be a significant reduction in excess long positions held by banks in FX assets. The expected net effect is a reduction in the exposure of banks to FX rate risks and increased foreign currency liquidity within the market which will ultimately enhance the stability of the Nigerian Naira.

Foreign Assets Reserves and Contingency Funding Arrangements

To guard against default risks in FX obligations, the CBN requires that banks can, as a buffer, maintain sufficient reserves of high-quality liquid foreign assets (i.e., cash and government securities) in each significant foreign currency to meet their maturing foreign currency obligations. Additionally, banks may have to embark on capital raise transactions and establish FX contingency funding arrangements with other financial institutions to shore up their foreign assets reserves and secure access to foreign assets on a contingency basis.

In addition, banks are required to have FX contingency funding arrangements with other financial institutions. Banks will need to constantly assess the stability of their FX and maintain strong contingency funding arrangements with other institutions in adverse circumstances.

Early Redemption of Eurobonds

The Circular reinforces CBN’s regulatory oversight on the foreign exchange debt obligations borne by Nigerian banks. To assess the potential risks in relation to the early redemption of Eurobonds, the CBN now requires that any clause which provides for early redemption in an Eurobond transaction must make such early redemption at the instance of the issuer, and the CBN’s approval for such provision must be procured; whether the Eurobond qualifies as Tier 2 Capital or not.

Risk management systems and alignment of Borrowing and Lending Practices

In addition, the CBN mandates the banks to put in place proactive risk management measures to shield the banks from potential losses stemming from foreign currency on-lending transactions, particularly when there's a mismatch in currency value or interest rates. These measures include:

• Requiring banks to borrow and lend in the same currency to prevent currency mismatches.
• Ensuring that the basis of the interest rate for borrowing and lending is consistent to mitigate foreign borrowing interest rate risks.
• Mandating banks to employ treasury and risk management systems capable of assessing, identifying, and managing risks associated with FX.
• Obligating banks to promptly provide accurate reports of their FX exposure.

Conclusion

Banks must ensure compliance with the prudential requirements and ensure they bring all their exposures within the set NOP limits immediately. Banks must also ensure that all returns submitted to the CBN provide an accurate reflection of their balance sheet. Any bank that fails to comply with the current NOP limit will face immediate sanction and/or suspension from participating in the FX market. In an effort to mitigate risks within the FX market, we expect that the CBN will actively monitor the activities of the banks to ensure the bank’s adherence to the requirements outlined in the circular.

1. Shareholders’ fund is the residual amount available to shareholders after all liabilities have been met in the event of a bank’s liquidation.
2. As defined under the CBN’s 2015 Guidance Note on the Calculation of Capital Requirement for Market Risk Standardised Approach, the Gross Aggregate Method for Net Open Positions is computed through the addition of the Aggregate Long Position and the Aggregate Short Position
3. CBN 2017 Circular “Review of The Limit n Foreign Borrowing By Banks” BSD/DIR/GEN/LAB/10/009 accessible via circular on the review of the limit of foreign borrowing by banks, CBN, February 17 2024.