The investment case for SA banks remains especially compelling. A combination of strong balance sheets and cheap valuations could provide investors with an attractive entry point for generating solid long-term returns, writes Sean Neethling.

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The failure of three US regional banks as well as the collapse of global investment bank Credit Suisse has sparked fears of a looming global banking crisis in the first half of the year. Concerns around a run on bank deposits and a contraction in lending have contributed to relatively widespread pressure on global banking stocks as investors consider the risk of contagion spreading across the sector.

South African banks have also come under pressure as investors have generally sold down holdings of perceived risk assets during a turbulent time for capital markets. A systemic banking shock would have especially adverse implications for markets with the experience of the 2008 financial crisis providing a gloomy backdrop for a potential fallout.

Is this a repeat of 2008?

The global economy is currently going through one of the fastest interest rate hiking cycles in history as more than a decade of easy money has come to an end. This has contributed to a highly uncertain market environment characterised by extreme bouts of volatility as investors reprice assets and demand higher returns on capital. Markets are also grappling with rate tightening in this credit cycle taking place when government balance sheets are at excessively leveraged levels.

Viewing the recent stress in the banking sector through this lens instinctively draws parallels with the 2008 financial crisis. While the current banking fallout does potentially pose pronounced short-term drawdown risks for markets, comparisons to 2008 appear somewhat misplaced.

The previous banking crisis was marked by extreme levels of systemic risk-taking as banks took on low-quality mortgages and collateralised debt obligations (CDOs) underpinned by questionable credit ratings and significantly overstated asset valuations. Regulation has significantly improved the integrity of the sector since then.

Aggregate levels of risk-taking are significantly lower than in 2008, with bank balance sheets holding stronger capital adequacy, liquidity, and leverage ratios. There does, however, appear to be pockets of idiosyncratic risk building up across the global banking sector, the most notable of which is in US Regional Banks where liquidity and credit metrics are showing some signs of early stress.

Narrowing in on US regional banks

The trend in deposit and lending growth is especially important to monitor when measuring the health of both the banking sector as well as the broader economy. The graph below shows a sizeable contraction in US bank deposits over the last two years.

The more recent accelerated flows into money market accounts suggest investors are especially nervous about broader market prospects. While rising interest rates do improve the relative attractiveness of cash over listed securities, the accelerated trend of money market inflows being funded by bank deposits could potentially signal a loss of confidence in the banking system.

The additional consideration is that deposit losses could trigger further increases in bank funding costs as affected banks may need to offer higher rates to both retain and attract new deposits.

The anecdotal evidence suggests that deposit stress is largely contained to smaller banks where risk management practices have been exposed by rapidly rising interest rates. The FDIC (Federal Deposit Insurance Corporation) stepped in to take over two US regional banks, Silicon Valley Bank and Signature Bank, following a run on deposits, while JP Morgan has offered to acquire the deposit book of First Republic when the bank came under pressure.

These interventions are exceedingly important to maintain confidence in the banking system, as they signal both the willingness and ability of central banks and corporates to step in when needed. If investors lose confidence in backstop measures to protect the integrity of the system and perceive slack risk controls to be more endemic, then a more widespread liquidity and potential credit crisis could follow.

In addition to near-term pressures of deposits, US regional banks are also particularly exposed to commercial real estate (CRE). The graph below shows the CRE exposure for US regional banks and the contrast between smaller and larger US regional banks.

Smaller US regional banks are shown to account for an outsized percentage of commercial property funding relative to larger US banking peers, with an acceleration in this trend evident since 2015. Managing this exposure could prove to be especially challenging in the current environment.

The combination of higher funding costs, as well as an inability to pass those costs on to struggling borrowers would adversely affect net interest margins. A potential write-down of overstated property values could also further pressurise margins and impair the banks’ ability to operate as a going concern. These banks may contract lending if there are material concerns about exposure across their asset base which could potentially choke off credit supply to important parts of the US economy.

How do South African banks stack up?

It’s important to disentangle the global banking story from the fundamentals of the local South African banks.

The trends in SA commercial banks suggest that the domestic banking sector has not experienced any meaningful squeeze on either deposit or lending growth. Banks are also holding capital and liquidity buffers well ahead of mandatory regulatory requirements.

The graph below shows that deposit growth appears relatively healthy with current growth rates of around 9.5% well above the average since 2010.

The underlying data shows that SA corporates are in an especially good position and are largely responsible for providing a solid deposit base. Financial companies, in particular, have allocated cash to longer-term deposits as interest rates have increased.

Household deposits are still showing positive growth, but the data shows a declining trend over the last five years. With households having relatively low aggregate levels of savings, these deposits could come under pressure as individuals draw on short and medium-term cash pools to manage living costs in a higher interest rate environment.

Another positive local development is that the South African Reserve Bank (SARB) has proposed a deposit insurance scheme to improve the ability of the banking system to manage shocks. While the regulator has shown a willingness to intervene to protect depositors when system integrity is compromised (most recently with African Bank in 2014), the commitment to advancing a more formal framework further enhances the SARB’s credibility as a leading global central bank.

Lending trends have also been maintained at relatively stable levels over the last 10 years. On average, South African banks have continued extending credit to both households and corporates.

The graph above shows that general credit extension dropped off significantly in 2020 but has rebounded since the post-pandemic lows. Within mortgage advances, commercial property has grown significantly, but off a relatively low base. Banks have shown an increased propensity to finance higher quality commercial properties after applying stringent lending standards and pulling back exposure during the pandemic. Growth rates have been maintained approximately in line with average inflation over the last 10 years.

Local banks have been also relatively prudent in terms of managing lending exposure across their asset base. Given the relatively weaker state of household balance sheets, the latest data shows that banks have more appetite for lending to corporates. There is, however, a general slowdown in advances to small and medium enterprises (SMEs) where the sustainability of the business is more closely linked to local consumers exposed to the squeeze of falling real incomes and higher interest rates.

Bank balance sheets are in especially good health. The main SA commercial banks are currently operating with capital adequacy levels well in advance of regulated minimum requirements which provides a strong buffer against potential operating losses. The graph below shows these ratios for FirstRand, Standard Bank, Absa and Nedbank.

Capital adequacy has increased substantially since the 2008 financial crisis and has been maintained in line with leading global peers. Regulatory capital has also been supported by strong earnings growth and prudent risk management after emerging from the Covid-19 pandemic.

Not new territory for emerging market banks

Emerging market central banks are relatively more experienced than their developed market peers in managing both idiosyncratic and systemic risks in both high-interest-rate and high-inflation environments.

Global developed markets are expecting the level of inflation to mean revert from abnormal highs to more normal lows. Elevated inflation combined with higher interest rates has pushed developed market banks into relatively unchartered waters. More importantly, the speed of those rate hikes has pushed up the cost of capital to levels that many management teams would not have encountered in their banking careers.

By contrast, higher inflation and interest rates are the norm in emerging markets like South Africa. Interest rates were abnormally low coming out of Covid-19 and have now increased to levels that can be considered somewhat more normalised. While the drivers of inflation may be different in this cycle, local regulators and management teams have a relatively better understanding of operating in higher interest rate environments than their developed market counterparts.

In conclusion

Banking crises are very rarely simply about the banks. Credit plays an important role in the real economy and any material disruption in the ability or willingness of banks to lend can have particularly adverse effects for both households and corporates.

The direct fallout from the current dislocation appears to be mostly contained to US regional banks. Rising interest rates and relatively poor internal risk management have forced these banks to consider options to restore depositor confidence. There does not appear to be compelling evidence of systemic risk taking with tighter regulation ensuring systemically important banks are holding higher capital and liquidity buffers than during previous financial crises.

The caveat is that markets tend not to be especially rational in the short term and investors should expect markets to trade with relatively extreme bouts of volatility that are likely to be more about fear than fundamentals.

The main risk to SA banks is the contagion of an exaggerated and sustained period of global investor risk aversion where a loss of confidence in the banking system spills over into emerging markets. Local banks are well-capitalised and have been relatively prudent in terms of managing risk-weighted asset exposure, as well as the composition and maturity of their deposit and lending books.

Most importantly, regulators and management teams have experienced similar conditions in previous credit cycles and have a relatively more tested playbook than their developed market peers for navigating through both sector and market uncertainties.

The investment thesis for SA banks remains especially compelling, where the combination of strong balance sheets and cheap valuations provide investors with an attractive entry point for generating solid long-term returns.

Sean Neethling is a senior portfolio manager at Morningstar Investment Management SANews24 encourages freedom of speech and the expression of diverse views. The views of columnists published on News24 are therefore their own and do not necessarily represent the views of News24.