Are South African banks still a safe bet?

South Africa’s financial system has been nothing if not resilient in the past few years. Its lenders cruised through the global crisis of 2008 and 2009 without experiencing much stress beyond their earnings falling slightly. By most measures, their sophistication rivals or beats that found anywhere else in the world, let alone Africa. In September, the World Economic Forum said the country had the second safest banking sector globally.

South Africa’s fiscal and monetary authorities can take much of the credit. They have long kept a close watch over the banks and ensured they adhere to stringent regulation, sometimes even to an extent that bankers feel is stifling. “It’s a common complaint from the banks that they are very highly regulated,” says Roy Havemann, chief director at South Africa's finance ministry. “But we did get through the financial crisis without problems. Of the G-20 countries, we were one of a handful that didn't have any issues with our banking sector, and that was largely due to a very strong regulatory framework.”

Primed for change

Policy-makers are determined that local lenders, as they did with Basel II, implement the Bank for International Settlements’ third framework for regulatory standards smoothly. “I think we’ll be among the fastest banks in the world to meet Basel III requirements,” says Jacko Maree, chief executive of Standard Bank, the biggest lender on the continent.

Doing so should pose little difficulty. The majority of South African banks already have capital adequacy ratios of at least 13%, which is above the minimum stipulated by Basel. And in May the central bank, in a move similar to that carried out by Australian regulators, said it would create a short-term lending window to enable commercial banks to meet the liquidity coverage ratio, which states they must have enough liquid assets to survive a month-long funding squeeze.

A bigger problem, however, will be Basel’s net stable funding ratio (NSFR), which forces banks to match closely the tenor of their liabilities with that of their assets. South Africa’s big banks, which are largely reliant on short-term deposits for funding, but which have hefty mortgage portfolios, say they will not be able to meet the NSFR requirements as they stand, given their inability to source enough long-term liquidity from the local bond market. “It’s all very well to talk about matching assets and liabilities if you’re operating in a country with deep bond markets,” says Mr Maree. “In South Africa, the situation is not so simple.”

The central bank has helped by allowing pension funds to invest up to 75% of their assets in bank bonds, up from 25% previously. But even the central bank admits this will be insufficient. Worried that the mortgage sector might suffer, officials are lobbying with counterparts in other major emerging markets for changes to the current NSFR proposals, which do not have to be implemented until 2018. “The net stable funding ratio is not doable in any emerging market with a developed mortgage sector,” says Mike Brown, head of Nedbank, a large local lender. “Most people believe it will be revised totally by Basel.”

Growth worries

More worrying for the banks than new regulation is a sluggish economy. South Africa’s gross domestic product (GDP) will rise about 2.6% in 2012, which is viewed as too little to reduce its 25% unemployment rate and high level of poverty. It is also a far cry from the growth of 5%-plus experienced in the few years before its recession in 2009.

The biggest four banks – a group that includes FirstRand and Absa, as well as Standard Bank and Nedbank, and which account for 85% of South Africa’s banking assets – are struggling to maintain the same profitability they enjoyed in the pre-crisis era. Nedbank now has a return on equity (ROE) target of its cost of equity plus five percentage points, compared with plus 10 percentage points five years ago.

Bank bosses say their loan books, which they used to be able to grow at 15% to 20% annually, are unlikely to expand much faster than nominal GDP, today rising at about 8%, for the next few years. “We’re in a difficult cycle at the moment,” says Mr Maree. “We had become used to many years of rapid expansion – from 1987 to 2007 Standard Bank’s earnings per share compound annual growth rate was 20%. It’s hard to see those days returning.”

Corporate and investment banking revenues have come under strain. Few businesses are willing to carry out debt-funded expansion amid a weak local macroeconomic environment and with Europe – the biggest export market for manufacturers – teetering on recession. Widespread labour unrest in the minerals sector, particularly in the two months after police shot dead 34 strikers at a platinum mine in mid-August, has only exacerbated the situation, and potentially deterred foreign direct investment. “Corporates are generally nervous about the global environment,” says Mr Brown. “They are cautious and they are waiting for more certainty before committing to projects.”

Destination Africa

One of the main ways the big local banks are trying to make up for this is by expanding in to the rest of sub-Saharan Africa, which is growing far quicker than South Africa. “Most of them have identified Africa as their new frontier,” says Cas Coovadia, head of the Banking Association of South Africa.

A large part of their strategy involves providing corporate and investment banking services to South African companies, which are increasingly looking to the rest of Africa and are now the biggest investors on the continent outside the oil and gas sector.

They also want to grow their African retail operations. Standard Bank has made the most progress. It has licences in 17 sub-Saharan countries outside South Africa, including the biggest banking markets of Nigeria, Angola, Kenya and Ghana.

Nedbank has no direct foothold beyond southern Africa, but in 2008 signed an alliance with Ecobank, which has subsidiaries in 32 African countries, including all those in west and central Africa. While still a fairly nascent partnership, this has enabled Nedbank to win mandates from companies that Togo-based Ecobank, which has a much smaller balance sheet, cannot lend to or execute deals for on its own.

Absa is considering merging its African businesses with those of Barclays, its majority shareholder. This would give it major retail networks in Kenya, Tanzania and Ghana, but not Nigeria or Angola.

FirstRand, meanwhile, has been expanding quickly in Africa via its investment banking arm, Rand Merchant Bank. But it has no consumer banking presence beyond southern Africa and Tanzania. It has long said, however, that it would like to move into Ghana and, in particular, Nigeria, a huge market of 160 million people and which has an economy growing at nearly 7%. Some commentators think it will bid for one of three nationalised Nigerian banks expected to be privatised in the next two years. 

Long-term process

Despite Africa’s buoyancy, analysts warn that it will be hard for South African banks to make high returns there in the short term. Not only are operating conditions tough – few countries on the continent have financial sectors, legal systems or infrastructure anywhere near as developed as South Africa’s – but venturing abroad, whether organically or via acquisitions, is expensive. Moreover, all sub-Saharan banking sectors, including Nigeria’s, are dwarfed by that in South Africa. “Moving more into the rest of Africa will be long-term process,” says Ilan Stermer, a banking analyst at Renaissance Capital. “Africa isn’t an easy place for banks to make money. And given the size of South Africa’s market, local lenders would have to [be confident of] generating big profits to make going abroad worth their while.”

As a result, South African lenders will probably prioritise their home market for the foreseeable future. Their challenge is to try to generate new sources of revenues while their traditional ones remain lacklustre. “It’s one thing to cut costs and increase efficiency,” says Mr Maree. “But sustaining revenue growth is what you’ve ultimately got to focus on.”

Not only has corporate banking activity slowed, but secured personal lending has, too, in particular in the form of home and vehicle loans. There have already been signs of stress. Absa shocked the market in June when it issued a profit warning in response to increasing bad mortgage debt. Analysts think this was an isolated problem, but nonetheless say that most banks will see their mortgage portfolios expand by no more than 10% this year, compared with levels of up to 30% in recent years.

With loan growth difficult, several banks are trying to raise income from elsewhere. Nedbank managed to build its non-interest revenues by 16% year on year in the first half of 2012, which it did in large part by cross-selling insurance and other products to its account holders. But given that lenders in the country already charge for the majority of their services, there is limited scope for commissions and fees to go up.

Cost-cutting would help. South Africa’s banks are already fairly efficient, cost-to-income ratios among the big four averaging about 55%. But analysts say more could be done, including, for example, upgrading IT. “It might not be easy for them, but they’re still very far away from being lean,” says Mr Stermer.

Unsecured lending boom

One banking activity that is not slowing is unsecured personal lending. Driven by robust consumption, this has increased substantially in the past few years, but has largely been the preserve of lenders other than the big four. Two in particular, African Bank Investments (Abil) and Capitec, have based their businesses on the provision of personal term loans. Both now rank among the continent’s biggest banks, despite being little more than a decade old.

Abil and Capitec typically target poorer South Africans and junior government workers who have traditionally struggled to get credit from the larger banks. Abil provides loans from as little as R1500 ($178) to R180,000. Annualised interest rates are high, ranging from 462% for three month debt to 31% for a seven-year facility (the riskiest borrowers tend to be offered the shortest tenors, hence why those loans have higher interest rates than the longer ones). Tami Sokutu, Abil’s chief risk officer, says that while it is difficult to monitor what the loans are used for, many go towards housing renovation or school fees.

South Africa’s big four have started to follow suit, though the borrowers they cater for are still higher earners than those that go to Abil or Capitec. “This is a structural growth opportunity,” says Nedbank’s Mr Brown. “If you look at South Africa’s unsecured lending-to-GDP ratio, it is lower than in other emerging markets. And we’ve got a rising middle class looking for credit to improve their lifestyles.”

Plenty of commentators have criticised this trend, with some stating that a bubble has already formed. The authorities are watching closely. Pravin Gordhan, South Africa's finance minister, met bankers in late August specifically to discuss the rise of unsecured credit.

But most bankers are sanguine for the moment. They say that while the government is correct to be prudent, the unsecured market will merely decelerate in the medium term, rather than implode, and does not pose systemic risks. Such loans still make up a small proportion of the portfolios of the big banks, which insist that they are well aware of the risks and happy to drop their market share if they think that it is over-heating. “Overall unsecured lending has been growing at 30% to 40% annually,” says Mr Brown. “That is unsustainable in the long run. Yet, while there is lots of froth, I don’t think there is a bubble just yet.”

Some concerns surround Abil and Capitec. The latter spooked investors by announcing a R2.2bn rights issue in late September. Yet both lenders are well capitalised, with CARs of above 30%. And their risk management is highly regarded. Mr Sokutu says Abil has managed to stick to its target of limiting delinquent loans to 10% of its portfolio. He adds that while its customers may not be high earners – more than half have salaries of below R7000 a month – their credit-worthiness is enhanced by the fact they usually have little debt when they first approach Abil, given their inability to afford mortgages or other asset-backed loans from the big four. Moreover, government officials would much rather South Africans borrow from regulated institutions such as Abil and Capitec than the informal loan sharks who operate on street corners throughout the country.

Financial inclusion

Many bankers also see the presence of unsecured lenders as helping to broaden financial inclusion. “It is a good thing for the customers and the financial sector,” says Mr Coovadia at the Banking Association of South Africa, who reckons that 35% to 40% of the bankable population remains unbanked. “It has released the competitive juices that are necessary. The big four are responding and looking at what sort of products they can offer instead. Their dominance of the retail banking market cannot be good for this country. We need more diversification.”

In the coming five years, banks will probably do much more to target South Africa’s large number of informally and self-employed people. Abil and Capitec currently insist on their borrowers being employed in the formal sector and having bank accounts. Abil is tempted, however, to start providing small loans to the likes of street vendors. “It’s definitely a growth area for us,” says Mr Sokutu. “We just have to fine-tune the model.” 

It’s the economy, stupid

Regardless of whether unsecured lending continues its rise, banks’ profitability will come under strain if the economy slows further. Of particular concern would be a slump in the property market. “It has stabilised, rather than fallen,” says Mr Stermer. “But it is quite fragile. And if the economy takes a turn for the worse – which is not the base case – we will see property prices come down. That would mean higher impairments for all the banks.”

Yet most banks, including the big four, are expected to make healthy profits if GDP growth remains about 3% for the next two years, even with all the pressures they are under. “ROEs should trend up,” says Mr Stermer. “We are not going to reach 25% again, given the backdrop of Basel III and the economy. But we should be heading towards 20%.”

Those are levels that most European or US banks, struggling to make even double-digit ROEs, can only dream of. And they are all the better for the fact that South African lenders are achieving them in what is regarded as one of the world’s safest banking systems.