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By Chinwendu Obienyi
Following the Central Bank of Nigeria (CBN)’s decision to reduce the loan-to-deposit (LDR) to 50 per cent, there have been arguments from economists and analysts that this could render banks’ ability to effectively give out loans to Small Medium Enterprises (SMEs), businesses and individuals. However, the Acting Director, Banking Supervision at the CBN, Dr Adedeji Adetona, gives insight into the apex bank’s measures to improve lending to the real sector during a podcast monitored by Daily Sun.
He further noted that it is imperative that banks maintain a strong capital base to absorb losses and remain solvent especially in the face of unforeseen events like exchange rate volatility.
Excerpts
Review of the LDR amid contractionary tightening
The loan to deposit ratio is a kind of metric that is used to evaluate banks’ lending activities relative to their deposit base. This rate that is out there is very crucial when you are assessing the capacity of our banks in terms of lending and also, it is very crucial as well in managing risk, as well as ensuring financial system stability. Prior to 2019, it was observed that there was a serious slowdown in credit growth and that led to the introduction of regulatory measures to encourage or to increase lending to the real sector of the economy, which is generally referred to as LDR policy. This particular policy was aimed at ensuring that money flows into the real sector of the economy, this policy among other things, then set a minimum threshold for LDR. First it was at 60 per cent and then later increased to 65 per cent.
When you talk of the contractionary targets as of now we look at what happened when it was increased. There was an observed boost in the industry credits across all sectors of the economy at a time. So when you experience such, there will be multiplier effects based on the impact it will have on the activities in the economy, productivity, employment and all that.
Then, after that, the current developments in the economy, the central bank management has adopted a tightening stance to combat inflation and if you want to combat inflation using the orthodox method, you have got to balance what to do with the monetary policy tools and other measures you need you can use to achieve your objective.
When you say contractionary stance or contractionary measure, it means that you want to reduce the money supply and when the economy is experiencing an inflationary pressure that we are experiencing currently and the central bank has decided to use an orthodox means, what you have got to do is to ensure price stability. In ensuring price stability, you have different ways of achieving this and one of the ways that commonly open to monetary authority is for you to tamper or to adjust the money supply and if you want to do that want to maybe reduce the money supply something like loan to deposit and what you need to do is whatever level it is, you have to bring it down. Bringing it down means you are curtailing that ability of banks to lend more to the society, you are curtailing the ability of banks to pump in more money into the circulation. So in line with the contractionary stance of the management of the CBN, the only thing we can do at that point is to align with what we have done, combating the inflationary pressure is for us to reduce LDR.
The connection between reducing LDR and the transmission effect on inflation and price
When you have this kind of situation (inflation), you want to put it under control. One of the approaches is for you to mop up the excess liquidity in the economy and that is to reduce the quantum of the money supply and you can see that already reflected in the decision taking by the MPC was that when they increase the monetary policy rate, they also increased the Cash Reserve Requirement (CRR). So if you look at the two stances taken by the MPC, when you increase rates, the effect is that it will limit the ability of people to borrow from banks.
Hence, if you say you want to achieve a policy stance that is contractionary and then you leave the banks to increase credit, then it means that your policy position is tantamount to expansionary standing. So the monetary policy has already announced to the whole world that what it is doing is contractionary. So it will be counterproductive on one hand to be doing that and on the other hand you are doing something that will have an expansionary effect on the economy, then we cannot achieve our objective. There is an inverse relationship between the LDR, Monetary Policy Rate and CRR vis-à-vis the desired objective if you are doing something contractionary, you have to increase MPR and also increase CRR Having established what you want to do, to achieve your objective further, from the point of LDR, what you can do in that regard is to reduce.
Is the LDR an ancillary tool to correct the contraction base stance?
Yes, that is very correct and vice-versa because if the opposite is the policy stance of the central bank, instead of reducing it, we will increase it but that is not what we are doing. Because it is a contractionary stance, we have to reduce, so that that will curtail the ability of commercial banks and other deposit money banks (DMBs) to lend more money.
What does this mean for businesses?
When you reduce the money supply, naturally, the rate of interest will go up. Why? If you reduce the quantum of money in circulation, what it means is, if the loanable funds that are available to the banking sector is N1 trillion. If you reduce it to let us say, N500 billion, if the number of people that wanted to borrow money, when it is N1 trillion has not reduced, then the pressure on the available loanable funds will make the interest rate go up because of higher competition for these loans. So when interest rate goes up, many businesses will not be able to afford the current rates and if they are unable to afford the current rate, it then means the credit to that particular sector where these customers have gone to will go down. When the credit supply goes down, it will impact on the ability to expand their productive endeavor and if that happens, the number of people course the salary, new wages at that point, is unlikely to go up. If it doesn’t go up, it will curtail the level of production to a certain level and at that point, demand will slow down. The ultimate objective is for us to combat inflation, and that is what we are doing. Although our reforms will have an impact in some areas and I know some economists will argue that some of the reforms could impact economic growth, but in economics, you cannot fight two things at the same time. If you are fighting inflation, you cannot fight unemployment at the same time and even if you do, you will not get the desired result, so you have to choose even though they are critical to the development of the economy. So it is very important that we concentrate on fighting inflation. By the time we bring inflation down, we start talking about economic growth.
Significance of the decrease in LDR
Like I explained earlier, if you say you are pursuing contractionary measures as a monetary authority policy, you will not want to encourage something that will also be expansionary in nature.
We have increased the policy rates, MPR, CRR after we have announced to the whole world that we are going contractionary, of course the loan to deposit ratio, which suggest that the certain percentage of your deposit which must be lent to your customers, if we allow it to be at the level it was before the increase in the MPR and increase in CRR, then you need to be counter-productive. Banks must still continue with their intermediation function. We have only reduced and not removed their ability to lend and we have reduced it in line with the policy measure of CBN and MPC which is a contractionary stance.
How do all the rate adjustments improve lending to the real sector?
When this policy commenced in 2019, we have had a kind of sustained credit growth in the industry, but now with the reduction it will not impact negatively, it will only help the bank to improve on their credit quality. You know, sometimes it is not the quantum of credit that you are able to churn out that matters, what matters is the quality of the credit you are able to package.
What we mean by quality of credit is quality of your risk assets. If the LDR is high and then banks recklessly give out these loans without minding whether those that are being given the loans have the capacity to pay and are not mindful of their risk management practices within its system, when the credit goes bad, then it is useless. But when you have a percentage that is not up to that and the quality of your credit is of high standard, then that is good. The reduction that we have done is marginal, not so significant, hence it will not have a negative impact on the banks’ ability to lend to the real sector. This is a business decision for banks to prioritize their lending and ensure that they have very good quality risk assets. As time goes on, we will be monitoring the development and if we see the need to adjust or increase, we will do so but for now, it is a contractionary stance and even though we have done this, it does not take away the function of banks to intermediate. We have only reduced, we have not eliminated so it is just a reduction. So of course it will not have a negative impact on the credit risk sector of the economy.
Do you see a possibility of banks bringing down the ratio of non-performing loans?
Yes, there is a strong possibility of that happening, the NPLs will naturally come down and that is why I said it is all about the risk management practices, compliance. It is a situation where the management of the banks say that if they give out loans, they are sure that there is a 99.9 per cent of them recovering back the loans. This is more important than just having a high LDR and so the focus is that the few ones that are able to give should have a good quality risk asset.
Could this bring up the credit rating of banks?
That’s correct. Because you know why this is very important is there is what we call capital adequacy ratio (CAR). What is making the banks’ CAR to be coming down is because of NPLs. When you have so much nonperforming loans, do you know where it goes? It hits the capital of the banks. This is why the recapitalization exercise, we are saying that we are not going to consider certain reserves but instead we’re going to use the issue paid off capital, as well as share premium. We know that others belong to shareholders, but we want fresh injection of capital into the economy because that will serve as tier-one capital and the loss of solvency on Take a look at what happened with the exchange rate volatility that was never planned for and even when banks were doing their forecasting for the 2024, i doubt if any bank will predict that the exchange rate will get to N1,500-N1,800/$1 before the measures taken by the management of the CBN who have now been able to bring down the rate to $1,024/$1. What makes a bank to be in business is its capital base, it is your capital that will be able to absorb losses and this is why we are saying that you must have capital that will commensurate with the quantum of risk a bank is carrying.
