The outcome of the global financial crisis of 2008 - 2010 led regulators and central banks the world over to re-look at the way banks are regulated and governed. So what exactly has changed in the South African context?
Basel III requirements: The Basel Committee on Banking Supervision now imposes the following requirements:
- the Liquidity Coverage Ratio which requires that a bank holds enough liquid assets to cover its outflows during a 90-day liquidity stress scenario (i.e. a run on the bank);
- the Net Stable Funding Ratio which aims to address the term maturity mismatch between assets and liabilities;
- Capital Adequacy Requirements to ensure that there are sufficient levels of loss-absorbing capital to take losses before senior funders and, particularly, depositors take losses; and
- the Leverage Ratio which limits the amount that a bank can gear itself.
National Credit Act: This is aimed at curbing reckless lending. More stringent regulations now govern affordability assessments that must be performed by credit providers and restrict the interest rates and fees that credit providers can charge. Banks and other credit providers are less incentivised to write excessively risky loans if they aren’t able to earn risk-adjusted returns for such business.
Bank Resolution Framework: The South African Reserve Bank is currently in the process of finalising this framework, which is intended to address ways and means to recapitalise or reorganise distressed banks before they reach a point of insolvency. The expectation is that by imposing losses on investors, rather than relying on implicit government support, the Resolution Framework should reduce the moral hazard typically associated with banks and impose discipline on investors.
The Depositor Insurance Scheme: This is envisaged as part of the new framework, is further expected to increase the stability of the financial sector. This will ensure that the costs of failed banks are borne by the banking sector rather than by taxpayers (as banks themselves will have to fund the deposit insurance). This will hopefully also reduce the likelihood of a panicked run on a bank.
This is all good, but it does not obviate the core concern: Banks are geared, cyclical entities which operate in highly competitive, changeable markets and are prone to risk taking.
So, how should investors approach their exposure to banks?
Rather than viewing banks as “too big to fail”, investors should endeavour to understand the risks associated with the banking sector (both macroeconomic; structural and bank-specific) in order to assess which risks have been adequately mitigated; which risks can be priced to achieve an appropriate risk-adjusted return; or which, if any, should be avoided outright.
Investors should not simply view all of the large South African banks as homogenous entities. Whilst, there are certain overarching themes such as the macroeconomic and regulatory environment, investors must also perform rigorous analyses at an individual bank level:
- Look at the financial performance of each bank, how its key ratios have changed over time, and how it compares to its peers within the banking sector. This includes understanding the organisational structure and capital structure of each bank relative to the regulatory requirements and the capital structure of peers.
- When assessing the governance structures, assess whether the board has an appropriate balance of power and skill-set to govern the highly complex operations of a bank, and that it has appropriately delegated powers to suitably sized and skilled sub-committees. This is benchmarked against King IV and the practices of peers.
- These assessments can feed into a scoring model that allows investors to quantify the degree to which, on a balance of quantitative and qualitative factors, they may prefer one bank over another.
We believe that this approach to analysing banks, which combines both macro (system-wide) and micro (bank-specific) factors to form a differentiated view on each bank within the broader South African banking system, can enable investors, as best as is possible within an ever-changing environment, to make informed decisions about where to place their funds.
Ultimately, whilst banks remain highly cyclical, highly complex, highly geared entities, they are now also more highly regulated than ever. Does this mean they are too regulated to fail? Certainly not. Investors must remain aware and alert to the ever-changing risks inherent in the banking sector, as they would for any other sector, so that they can make informed decisions and ensure appropriate protections and risk-adjusted returns for themselves or their clients.