As part of its efforts to stimulate the economy, the Central Bank of Nigeria (CBN), vide a Circular referenced as BSD/DIR/PUB/LAB/017/005 and dated April 17, 2024 (“the CBN Circular”), issued a directive to all Deposit Money Banks (DMBs) amending and reducing the Loan-to-Deposit Ratio (LDR) from 65% to 50%.

Prior to the referenced circular, on July 3, 2019, the CBN had mandated banks to maintain a minimum LDR (known as loan to funding ratio) of 60%, which was later reviewed upward to 65% on September 30, 2019. This was done in a bid to encourage banks to increase consumer mortgage and corporate credits, thereby stimulating aggregate demand, output growth, and employment.   Accordingly, the CBN’s latest Circular marks an immediate and 15% decrease from the previously applicable LDR.

In a nutshell, loan-to-deposit ratio evaluates a bank’s liquidity by comparing its total loans to its total deposits for the same period.  To calculate this ratio, the bank’s total loan amount is divided by its total deposit amount for the same period. The objective of this directive is to ensure a balanced ratio between the funds used for loans and customers’ deposits so that loans do not compromise the availability of deposits when customers need them. Under this new ratio, banks are allowed to lend a maximum of 50% of the deposits they receive. For instance, if a bank has deposits totaling 500 million, it can only extend loans up to 250 million.

This article examines the implications of the CBN Circular for DMBs, borrowers and the Nigerian economy as whole.

The Implication of the CBN Circular on DMBs and Borrowers

In implementing this policy, banks are now required to recalibrate their lending strategies and adhere to the revised LDR of 50%. This measure is anticipated to influence the banks’ ability to offer credit, particularly impacting large and medium-scale enterprises that are dependent on bank financing for their operations.

The effect of this reduction is the tightening of the credit available to businesses and potentially escalating interest rates. However, it also positions the banks to be more cautious in their lending operations, potentially safeguarding the financial system against undue risk exposure.   This could also help banks avoid the situation that Heritage Bank Plc encountered, where it became overleveraged with loans and faced liquidity issues.

Implications for the Nigerian Economy

This policy revision is part of a broader strategy by the CBN to bolster the economy by directing bank resources more efficiently. By adjusting the LDR, the CBN aims to mitigate excessive lending risks and ensure that depositors’ funds are judiciously utilised, fostering a healthier banking sector and, by extension, a more robust economy.

The reduction in the LDR will encourage prudence in spending the available capital. However, these prudent measures might lead to tighter access to credit for Small and Medium Scale Enterprises (SMEs), which are essentially the backbone of the Nigerian real economy.  Additionally, interest rates on loans may rise due to an increase in the cost of capital and the bank’s efforts to profit from the loans they issue. These factors will raise the costs of running businesses and the prices of final goods and services for consumers, potentially slowing economic growth.

However, it is important to recognise that the reduction in the loan-to-deposit ratio (LDR) represents a shift towards a more contractionary monetary policy, as noted by the Central Bank of Nigeria (CBN) in its circular. This shift allows banks to maintain higher cash reserves, potentially decreasing the money supply. While this is intended to control inflation, it may also slow economic growth in the short term. The ultimate goal is to ensure price stability and sustainable economic growth in the long run.

Conclusion

In conclusion, while the interest rate increase and the loan-to-deposit ratio reduction may lead to higher costs for businesses and consumers, potentially slowing economic growth, this measure is part of a broader strategy to maintain price stability. The Central Bank of Nigeria’s move towards a more contractionary monetary policy, by allowing banks to hold more cash reserves, aims to control inflation and ensure sustainable economic growth in the long term.