Almost five years after a domestic banking crisis, there are encouraging signs that Nigeria’s financial sector is slowly returning to health. But while progress has been made, there are still a number of factors that could lead to renewed instability in the country’s vulnerable banking system.

The collapse of the Nigerian banking sector in 2008-2009 was a result of loose monetary policy and lax regulation, which set off a boom in lending. After the 2005 bank consolidation and capitalization, Nigeria experienced rapid credit expansion, as banks broadened their activities and moved to the untapped retail sector, and borrowers speculated in the equity market (margin lending collateralized by shares).

The oil price drop and currency devaluation in 2008 stressed particularly those banks with heavy concentration in Nigeria's dominant energy sector, while the stock exchange downturn affected banks exposed to margin lending.

By 2009, the banking sector was in crisis. Widespread insider abuse and inappropriate related-party lending were identified. The bursting of the lending bubble caused 10 banks to fail, and Nigeria’s All-Share Index to slump by 70 percent.

The government was forced into emergency measures to prevent a systemic collapse. Nigeria implemented new banking regulations and fired eight chief executives of the country’s 24 banks.

The government’s "bad bank," the Asset Management Company of Nigeria (AMCON), was established in 2010 to buy bad debt from banks and save the industry from collapse as lenders reeled when loans to stock speculators and fuel importers turned bad after the global financial crisis in 2008. The agency spent 5.6 trillion naira (about $35 billion) in 2011 to acquire non-performing loans and incurred losses of 2.4 trillion naira (about $15 billion).

Since then however, Africa’s second-largest economy has been growing at around 7 percent a year. The International Monetary Fund describes the major banks today as “well capitalized, liquid and profitable.”

The banking system is dominated by six banks out of 20 in total. At the end of 2011, the six dominant banks (one pan-African and five domestic) accounted for about 60 percent of total banking sector assets. Unlike in many other sub-Saharan African countries, European banks in Nigeria held only 4 percent of total assets.

The capital adequacy ratio was 18 percent at the end of 2012, a massive improvement from a ratio of 2 percent in 2008 due in large part to government efforts to write off debt and recapitalize the financial system, according to the IMF.

Furthermore, Nigeria currently has one of the lowest loans-to-deposits ratios in the emerging world. “This means that banks are not reliant on wholesale funding or foreign capital to increase their lending, leaving them well-insulated against a worsening in the external financing environment,” Capital Economics African economist Shilan Shah said in a note to clients.

Meanwhile, Nigerian banks’ ratio of non-performing loans to total credit plunged to 3.8 percent in April from 35 percent in November 2010 as bad debt was shifted to the government-sponsored AMCON.

“Stress in the financial markets has eased over the past year or so,” Shah said. “For example, the spread of the 3-month interbank rate over the main policy rate has narrowed significantly in this time.”

Bank shares have climbed steadily over the past year and AMCON is now beginning to unwind its operations, aiming to sell its three nationalized banks next year.

However, despite a new, cleaned-up banking landscape in Nigeria, there are worries that non-performing loans might start to tick back up again.

Many banks, driven by competition, are seeking to increase household lending and push corporate loans to sectors wider than the traditional base of oil and gas, manufacturing and telecoms.

Standard and Poor’s said in a recent report on Nigeria’s banking sector:

"We expect asset quality to be stable in 2013, reflecting our expectations of strong economic growth and political stability. However, we believe rapid loan growth and increased competition will raise the inherent credit risk and conceal the growth of problematic assets, thereby raising credit risks for 2014 and 2015.

"Moreover, with oil receipts generating 75 percent of government revenue, a sharp and sustained fall in oil prices would affect the economy as a whole. These risks are amplified in the banking sector. Loans from Nigerian commercial banks tend to be highly concentrated in the hands of a small number of companies that have direct links to the energy sector. Therefore, a fall in oil prices leaves the banking system vulnerable to just a handful of non-performing loans."

It seems as though the Nigerian banking sector has come some way in restoring credibility since the crisis of 2008-2009. “But to ensure that it continues to rebuild its reputation, the key challenges for the banking sector now will be to diversify its loan books and continue making improvements in regulation,” Shah said.