In a significant move to counteract suspected cases of excessive foreign currency speculation and hoarding by Nigerian banks, the Central Bank of Nigeria (CBN) has issued a circular titled “Harmonization of Reporting Requirements on Foreign Currency Exposures of Banks.”
This comprehensive circular introduces a set of prudential requirements aimed at curtailing the risks associated with these practices and fortifying the stability of the financial system.
CBN’s Concerns and Objectives
The circular, released recently, underlines the CBN’s concern about the increasing trend among banks to accumulate substantial foreign currency positions, primarily through their Net Open Position (NOP). The NOP measures the variance between a bank’s foreign currency assets and liabilities, indicating potential exposure to exchange rate volatility and financial losses.
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“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,” the circular stated.
The CBN’s primary objective is to manage and mitigate these risks effectively while fostering responsible banking practices to ensure the overall health of the financial system.
The guidelines focus on the meticulous management of the Net Open Position (NOP). The circular mandates that the NOP must not exceed 20% short or 0% long of the bank’s shareholders’ funds. To calculate this, banks are directed to use the Gross Aggregate Method, which provides a comprehensive view of a bank’s foreign currency exposure.
Banks with existing NOPs surpassing these prescribed limits are obliged to adjust their positions promptly, aligning with the new regulations by February 1, 2024. This stringent deadline is indicative of the CBN’s commitment to swift action to curb speculative activities.
In addition to NOP management, banks are instructed to maintain ample reserves of high-quality liquid foreign assets, such as cash and government securities, to cover their maturing foreign currency obligations. The circular also advocates for the establishment of foreign exchange contingency funding arrangements with other financial institutions to ensure robust risk management.
To further mitigate risks, the circular instructs banks to adopt natural hedging strategies by borrowing and lending in the same currency. This practice minimizes the potential for currency mismatch risks, providing a more stable financial position. The basis of interest rates for borrowing and lending should align to mitigate basis risk associated with foreign borrowing interest rate risk.
“Banks should borrow and lend in 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 in floating and fixed interest rates, to mitigate basis risk associated with foreign borrowing interest rate risk,” the circular specified.
Emphasizing the critical nature of compliance with these guidelines, the CBN warns that any non-adherence will result in immediate sanctions and may lead to the suspension of banks from participating in the foreign exchange market. This stern approach underscores the central bank’s commitment to maintaining financial discipline and stability.
“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.”
Potential Impacts on the Forex Market
This proactive measure by the CBN signifies a robust stance against speculative activities in the banking sector, with the primary goal of safeguarding the financial system and promoting economic stability. If the circular’s intent proves successful, banks will be compelled to liquidate their net long positions, effectively injecting forex into the market.
This move could provide immediate relief for the forex market, potentially triggering currency appreciation. The directive aims to restore market confidence, discourage speculative activities, and create a more stable and predictable foreign exchange environment for businesses and investors.
Thus, the CBN’s directive represents a multifaceted and comprehensive strategy to address potential risks in the banking sector, with the hope of fostering a more secure financial industry in Nigeria. It remains to be seen how banks will adapt to these new guidelines and the impact they will have on the broader economy and the foreign exchange market.