Home Articles BANKING AND THE ECONOMY: A thought leadership issue

BANKING AND THE ECONOMY: A thought leadership issue

The global financial crisis, which came to the fore in August 2007, has led to a worldwide recession, the consequences of which have been of an unprecedented magnitude and scale. This has included rapid decline in international trade volumes, increased risk aversion, reduced liquidity and heightened market uncertainty. In the main financial centres of the world, regulators and policymakers have implemented massive fiscal and monetary policy responses to improve liquidity, and re-establish consumer confidence consequential and spending. More recently, there has been increasing evidence that these interventions are starting to bear fruit, with a better than expected trend in corporate earnings, and the stabilisation of the US housing market improving consumer confidence. Despite these initial corrections, there is no doubt that the recovery will be protracted. The IMF is forecasting that global growth will recover to 2.5% in 2010 from the 1.4% contraction forecast for 2009.

South African economy – a casualty of the global downturn
Although initially not directly impacted by the global financial markets crisis, the South African economy has suffered the indirect impact of the fallout and is now officially in a recession. The economy contracted in two consecutive quarters (-1.8% q/q Q408 and -6.4% q/q Q109) and is expected to contract by 1.9% on an annualised basis for 2009. Two of the major credit rating agencies, Standard and Poor’s and FitchRatings have revised the economic outlook of the country from stable to negative. Figures released by the South African Reserve Bank recently reveal that the country’s current account deficit has now reached 7% of Gross Domestic Product (Q408: 5.8%) while manufacturing output, which constitutes 15% of the economy, declined by 22% in the first quarter of 2009. Moreover, the official unemployment rate increased to 23.5%, while vehicle sales declined by 34% and inflation remains consistently above the 8.0% level, despite interest rates having been reduced by 450 basis points since December 2008.
Conversely, the All Share Index is now 35% off its low while the volatility of the Rand has diminished since Q108.. Moreover, while volumes in rand-denominated debt markets have decreased by two-thirds this year, South Africa’s sovereign issue in May 2009 had an order book of USD7 billion, and the size of the issue was subsequently increased from a planned USD1 billion, to USD1.5 billion which demonstrates the confidence of international investors in South Africa’s economic future.

However, despite the aforesaid negative global economic outlook, there are increasing signs that the rate of contraction is slowing down, and that a gradual recovery is imminent. South Africa too is expected to return to a positive growth trajectory in 2010 on the back of an improving global outlook. The IMF is forecasting in its latest world economic outlook that global growth will return to 2.5% in 2010 from -1.4% in 2009.

South African banks remain resilient despite the global financial crisis
Amidst the global financial turmoil that led to banking failures and unprecedented write-downs by a number of international financial institutions, the South African banking sector has proved itself to be resilient, and has succeeded in escaping the worst of the crisis. This resilience is exceptional, as it should be noted that South Africa was already experiencing a cyclical economic slowdown ahead of the global financial crisis. The deteriorating economic environment has no doubt lead to a decline in bank asset growth and a sharp increase in credit impairments, which have in turn impacted earnings growth. Despite this, banks remain profitable and adequately capitalised relative to their international counterparts.

There are a number of factors that have differentiated South African banks from their international counterparts, and insulated them from the toxicity of the fallout. Some of these factors are discussed below.

• All registered banks in SA are rigorously regulated by the South African Reserve Bank (SARB) irrespective of the nature of their business model. In the United States, for example, investment banks were not subjected to the equivalent banking regulations applicable to commercial banks in that country. In the absence of appropriate supervision, these entities engaged in excessive risk-taking activities, which placed the entire economic system at risk in the event of default.
• Although local foreign exchange regulations instituted by the SARB have prevented South African banks from investing in US Dollar denominated assets such as CDOs (collateralised debt obligations) and SIVs (special investment vehicles) on a large scale, South African banks have always adopted a strong culture of risk management that is embedded in the sector. This strong culture of risk management has prevented significant investment in these vehicles – CDOs and SIVs.
• Exchange controls and the structure of the domestic money market have prevented an exodus of liquidity from the country. In the event of a liquidity shortage, domestic banks are therefore able to satisfy their funding requirements through the interbank market.
• The SARB has furthermore been prudent in adopting the more conservative capital adequacy requirements of Basel II on 1 January 2008. These requirements have not yet been widely adopted in the United States, and investment banks were able to grow their balance sheets without the need to increase the capital levels of the banks.
• Early implementation of the Basel II requirements by South African banks has resulted in improved risk management in terms of capital adequacy, liquidity risk, market risk, credit risk and operational risk, well in advance of the crisis having an impact. Domestic banks are nevertheless expected to continue focusing on improving the embedment of risk management and risk management systems in their businesses.
• The SARB has proven to be more conservative than its global counterparts from a solvency perspective by requiring local banks to be capitalised at higher minimum levels compared to their international counterparts. The four major South African banks are required, at a minimum, to be capitalised above a minimum total and tier 1 capital adequacy level of 9.75% and 7% respectively. The actual capital adequacy levels of the four major banks have exceeded these minimum levels with core tier 1 levels above 9%, tier 1 levels above 10% and total capital adequacy levels between 12% and 14%.
• The early introduction of the King 2 Code on corporate governance has created substantial focus on the governance of companies and banks in South Africa. The emphasis placed on corporate governance has contributed to limiting governance failures in the country.
• The conservative nature of the capital adequacy requirements of the SARB has resulted in relatively low leverage levels of the local banks. The leverage levels of the major banks in South Africa was less than 20 times, while international banks were operating at levels of more than 30 times for commercial banks and more than 50 times for investment banks at the time of the crisis.
• The timely promulgation of the National Credit Act has also served to moderate the supply of consumer credit, having commenced approximately two years prior to the global financial crisis.

SA banks face a number of challenges emerging from the crisis
Although the country’s domestic banks have been able to access local funding sources successfully, the cost of funding, especially for longer holdings, has become more expensive. It is worth noting that, given the structure of our money market, less than 10% of bank funding is raised internationally. This has required that local banks focus on reducing liquidity risk by lengthening the maturity profile of their funding base.

In addition to the aforementioned, the other major challenge that domestic banks will face in the current economic environment is maintaining balance sheet growth and profitability. The global financial crisis coupled with domestic economic conditions in South Africa is causing a decline in aggregate demand, leading firms to cut investments and working capital and, ultimately, bank credit. The ongoing market uncertainty is resulting in firms delaying investment and borrowing decisions. Moreover, banks have had to take cognisance of change in the credit quality of their customers, and have responded by reducing credit.

At a recently held Group of 20 (G-20)1 forum in November 2008 to discuss the crisis and its origins, finance ministers of member countries were requested to focus on a number of key aspects, as follows, are likely to strengthen the functioning of financial markets. These aspects, as follows, are likely to guide the approach of banking regulators and supervisors, and increase oversight and regulations of banks in future.
• Mitigating against pro-cyclicality – banks will be required to hold more capital during periods of high economic growth and to maintain prudent lending criteria. A larger capital buffer will sustain lending during more challenging periods.
• There is a need to review and align global accounting standards, specifically with regard to complex securities in times of stress.
• Given that the origins of the credit crunch lay in derivative instruments, there has been a specific request to improve transparency of the credit derivatives markets, particularly the over-the-counter market.
• One of the major drivers of the crisis was compensation practices and the fact that excessive risk-taking led to excessive short-term rewards and incentives. As a result, there has been a call to review compensation practices and their relationship to risk-taking and innovation.
• The systemic nature of the crisis has also renewed calls for a focus on the systemic influence of individual organisations over and above the organisation specific risks.

The synchronicity of events that led to this crisis produced a far more severe and sudden downturn than most in the industry anticipated. The systemic nature of the crisis has further reinforced the interconnectedness of the world’s economies, and the need for global co-ordination of regulation and oversight. The crisis has also without doubt exposed weaknesses and re-emphasised the need for scenario planning, ongoing stress testing of key performance measures and sound embedment of operational, credit and market risk frameworks and practices within banks. South African banks remain in good health, despite the impact of the recent cyclical economic downturn, having embraced a prudent risk management approach and aided by a rigorous regulatory authority. Despite successes in this regard, the banking industry needs to remain open to embracing global best practices and vigilant to emerging risks, which must be proactively addressed.

1. http://www.g20.org

Maria Ramos, CAIB, BCom (Hons), MSc, is the Group Chief Executive of Absa Group Ltd.