Introduction

In what seems like a response to the continuous fall of the Nigerian Naira and a bid to stabilise it and the Nigerian economy, the Central Bank of Nigeria (CBN), on 31st January  2024, released a circular directing all banks to take note of and adhere to the new reporting requirements regarding their foreign currency exposures. Recognising the mounting foreign currency risks banks face due to the increase in their foreign currency exposure through their Net Open Position (NOP), as they hold excess long foreign currency positions that could undermine financial stability, the CBN has taken proactive steps to mitigate these risks by introducing mandatory prudential guidelines for banks to adhere to.

Consequently, we will delve into the specifics of these requirements, examine the reasoning behind the CBN's actions, and assess the potential implications for the Nigerian banking sector. However, before we examine the reasoning behind the circular, we will provide a brief explanation of some words that will aid a better understanding of the circular in very plain terms.

Terms Explainer

• Foreign Currency Position: The foreign currency position of a bank refers to the amount of payables or receivables that a bank has in Foreign Currency (FCY). This may either be closed or open.

A closed position simply means that sale and purchase in FCY are equal. Usually, there is no attendant risk in a closed position.  An open position, on the other hand, indicates a mismatch, meaning that the sale of FCY is either greater than the purchase of FCY or the purchase of FCY is greater than the sale of FCY. This is also known sometimes as a mismatch. An open position may either be long or short.

A long position indicates that in terms of FCY positions, the purchase outweighs the sale, while a short position indicates that the sale is greater than the purchase; for instance, where the rates of FCY are increasing, a bank will likely have a long position to make gains, e.g.The bank may acquire more assets in FCY such as treasury bills of a foreign government, stocks, bonds, currencies.

However, where there is a decrease in rate, the bank will likely have a short position because it will sell more FCY to hedge against risk. For instance, the bank may sell its FCY assets to repurchase it later at a lower price.

Given that foreign currency rates are continually increasing, most banks have a long position to make gains. By its circular, the CBN seeks to minimise the risks and exposures of banks that hold excess long foreign currency positions.

• Net Open Position (NOP): In general terms, Net Open Position (NOP) refers to the total difference between the long and short positions held by an entity for a specific instrument or asset.

When trading in foreign exchange, banks often hold net open positions in debit or credit. A long net open position (also known as a net long) is characterised by a higher amount of investment liabilities in foreign exchange, which may be diversified across different portfolios. On the other hand, a short net open position (also known as a net short) implies selling more FCY assets in a market with declining rates to purchase when the rates are rising.

According to the circular, NOP is the difference between a bank's assets and liabilities in foreign currencies. To thoroughly understand NOPs - Assets in foreign currency could include all the funds and investments a bank holds in foreign currencies, e.g., loans in foreign currencies, foreign government securities, or other foreign assets. At the same time, liabilities in foreign currency could involve all of a bank's foreign currency obligations, such as foreign currency deposits, loans taken in foreign currencies, or other liabilities denominated in foreign currencies.

Mathematically: NOP = Total Foreign Currency Assets - Total Foreign Currency Liabilities. NOP limits are often placed on banks to prevent potential financial instability from excessive exposure to foreign currency fluctuations.

What is required of banks?

This directive stems from an observation by the CBN that the growth in foreign currency exposures from the banks through their NOP contributes to the free fall of the Naira, and it may also put them in a precarious position, particularly with regard to shareholders’ funds.

The directive, therefore, make provisions to curb this issue and requires that:

1. A threshold of a bank’s NOP should not exceed 20% short or 0% long of the bank's shareholders’ funds. Banks are also required to have an adequate stock of high-quality liquid foreign assets to cover their maturing obligations. In addition, banks should have a foreign exchange contingency funding arrangement with other financial institutions.

What does this mean?

This implies that banks should maintain high-quality FCY assets that are easily convertible to cash. The rationale for this would be the need for banks to be able to pull from these assets to fulfil their maturing obligations.

Please note that the maintenance of high quality FCY assets in the bank’s balance sheet must be within the prudential requirement of 20% short and 0% long of shareholders' funds. To explain this in very plain terms, a bank is required to only maintain long positions that can offset its maturing obligations and nothing more, i.e, the bank cannot hold more than it requires to offset these obligations.

When trading in foreign exchange, banks often hold net open positions in debit or credit. A long net open position (also known as a net long) is characterised by a higher amount of investments in foreign exchange, which may be diversified across different portfolios. On the other hand, a short net open position (also known as a net short) implies selling. These positions are important indicators of a bank's overall exposure to foreign currency risk.

This establishes a regulatory threshold for banks, limiting their NOP in foreign currencies to a maximum of 20% short or 0% long relative to their shareholders' funds. The intention is to prevent hoarding and excessive speculative trading and reduce the attendant risks by maintaining a balanced and controlled approach to their foreign currency positions. This prudential control can enhance market stability, instil confidence in investors, and discourage activities that might contribute to further local currency (LCY) depreciation.

By promoting a more balanced and risk-conscious approach to foreign currency management, the regulatory directive seeks to strengthen the Naira, fostering a more resilient and stable financial environment.

In order to manage the NOP in line with the directive, banks are required to:

• Keep track of their daily and monthly NOP and foreign currency trading position (FCTP) using the CBN templates attached to the circular. This measure aids the CBN in effectively overseeing and managing the foreign exchange market by ensuring that banks adhere to prescribed limits and report their positions accurately.
• Calculate the NOP in compliance with the prudential requirements using the Gross Aggregate Method.
• Banks with NOP exceeding 20% short and 0% long of their shareholders’ funds unimpaired by losses must ensure compliance within the prudential limit by 1st February 2024

Additionally, establishing foreign exchange contingency funding arrangements with other financial institutions enhances the collaborative risk management framework within the banking sector. This provision allows banks to access additional funds or support from other institutions during increased volatility or unforeseen challenges, fostering a more secure and interconnected financial environment.

Other requirements from the circular include - requirements on matching and hedging:

2. Banks should borrow and lend in the same currency (natural hedging) to avoid risks from different currency values. The term "natural hedge" refers to investment strategies that reduce the risks that arise from a financial institution's routine business operations. By aligning borrowing and lending in the same currency, banks naturally offset currency-related risks, contributing to a more stable financial position. Adopting this measure enables banks to minimise exposure to currency fluctuations and enhance risk management within the normal course of their operations.

3. The basis for the interest rate for borrowing should be the same as that of lending. For instance, if a bank borrows money with a floating interest rate, it should lend it at the same rate to avoid risks.

4. Concerning Eurobonds, any early redemption clause should be at the issuer's instance, and approval is to be obtained from the CBN in this regard, even if the bond does not qualify as tier 2 capital.

5. Banks are mandated to adopt adequate treasury and risk management systems to oversee their foreign exchange exposures, immediately bring all such exposures within the set limits and ensure all submitted returns to the CBN accurately reflect their balance sheet.

Potential Impacts of the Circular on Banks, Foreign Exchange and the Economy

The implications of the directive on banks, foreign exchange and the economy may include:

• Mitigation of risks associated with possessing excessive foreign currency by limiting banks' NOPs. By adhering to these limits, banks can better manage their foreign exchange risks and avoid potential losses in situations when the value of the foreign currency falls.
• Banks may also incur additional costs in complying with the new directives as they have to adjust their systems and processes and possibly implement new reporting mechanisms to track and manage their foreign currency exposures to ensure compliance with the requirements stipulated in the directives.
• Banks exceeding the prescribed NOP limits (having excess foreign currencies) would need to adjust their capital allocation strategies to bring their exposures within the regulatory limits. Non-compliance with the NOP limit could lead to immediate sanctions or suspension from participating in the foreign exchange market.
• The circular mandates banks to maintain adequate stocks of high-quality liquid foreign assets to cover their maturing foreign currency obligations. i.e. banks need to have enough cash in foreign currencies to cover debt in those currencies.  As a result, banks may need to optimise their liquidity management practices to meet these requirements effectively.
• By limiting banks' exposure to foreign currencies, the directive may help stabilise the foreign exchange market by reducing speculative activities and excessive volatility. This, in turn, may lead to economic stability and attract foreign investment.
• By ensuring banks do not hold excessive foreign currency, the directive may help mitigate the depreciation of the value of the Naira against foreign currencies by discouraging excessive speculation and reducing pressure on the exchange rate.
• A stable foreign exchange market and a relatively stable LCY can improve the economy by making imports and exports more predictable and competitive.

Conclusion

The CBN’s directive to cap the Net Open Position for banks at 20% short and 0% long of shareholders’ funds is a strategic move aimed at ensuring the stability of the Naira and safeguarding the financial sector from undue risks. By imposing prudent limits and other stringent requirements, the CBN seeks to encourage responsible risk management and ensure that banks operate within a framework that prioritises broader economic stability.

1. Gross Aggregate Method is not a standard finance term; however, the term "gross" implies that each position, whether it is a long position (assets) or a short position (liabilities), is considered individually without regard to the other, while "aggregate" indicates that the absolute values of all positions are added together, providing a total measure of a bank's exposure to foreign exchange risk.
2. A floating interest rate is a variable interest rate that changes periodically depending on economic or financial market conditions.

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