/ 17 May 2012

Marcus gives big five banks a hand

Registrar of banks René van Wyk says the facility should not affect the cost of funding in normal times.
Registrar of banks René van Wyk says the facility should not affect the cost of funding in normal times.

In an unprecedented move to bombproof the country’s major lenders, South African Reserve Bank governor Gill Marcus has set up a R240-billion facility to help the big five banks to meet the tough global liquidity requirements of Basel III.

The facility was approved this week after an 18-month investigation exposed a 32% “shortfall” by the big five to meet the liquidity coverage ratio, which requires them to hold sufficient liquid assets to cover net cash outflows for 30 days in a crisis.
Of the seven banks that underwent the liquidity stress tests, only the two smaller lenders, Capitec and African Bank, passed. Standard Bank, Absa, FirstRand, Nedbank and Investec met only 68% of the liquidity coverage ratio and were deemed unable to make up the shortfall because of structural challenges in the South African funding market.

Although the facility is not in the same class as the European Central Bank dishing out €1-trillion in long-term refinancing options to struggling eurozone banks to avert a collapse of the system, it is a lifeline to the larger players and amounts to a subsidy of sorts or, as some analysts put it, “cheap insurance”.

The liquidity facility, which will come into effect in January 2013, two years before the Basel III compliance date, will set the tone for other emerging nations that need to boost the liquidity of their banks in the event of a financial disaster or losses.

Guaranteed stability
Liquidity is the availability of cash to meet immediate obligations and the global rules force banks to have sufficient quality liquid assets to see them through a month-long shock to the financial system that would dry up interbank funding.

Standard, Absa, FirstRand, Nedbank and Investec will have to fork out about R700-million as a commitment fee – about 2% of their collective earnings – even if they do not draw from the facility. It is a small price to pay for an emergency fund, although it is unlikely that the banks would run into difficulties because, unlike most of the eurozone banks that have required bailouts, the local banks are overcapitalised and healthy.

All the banks welcomed the news and were unanimous that it guaranteed the stability of the system.

In a confidential report commissioned by the Banking Association of South Africa, the banks warned this week of a R900-billion liquidity gap if they were to adopt the Basel III rules in their existing form, which they said would push up the cost of capital and borrowings.

The treasury still has to work out a national discretion. But the Reserve Bank’s registrar of banks, René van Wyk, said the current shortfall for the liquidity coverage ratio was about R240-billion, although final numbers were not yet available.

“The rules will be phased in over a two-year period during which the shortfall may change,” he said. “It is not yet certain how much of the shortfall banks will cover through the facility. They may choose to increase their liquid assets during the phase-in period.”

He said the maximum size of the facility would be 40% of the banks’ requirements. “This is expected to be in the region of R220-billion, but the onus is on banks to apply for specific amounts. That statutory cash reserves can now be included in banks’ high-quality liquid assets for the purposes of calculating the liquidity coverage ratio.”

Charles Russell, an analyst at Macquarie First South Securities, said it meant that, despite severe liquidity shortfalls in South Africa, the local banks would most likely be able to meet the requirements of the liquidity coverage ratio.
But Van Wyk said South Africa had a limited pool of the highest quality liquid assets required by Basel III and almost none of the next tranche liquid assets.

The facility would carry a tiered commitment fee of anywhere between 15 and 45 basis points.

“In addition, should the facility be drawn upon, the drawdown rate will equal the Reserve Bank’s repo rate [now 5.5%] plus 100 basis points,” Van Wyk said.

Logical outflow
“The facility is limited to 40% of net cash outflows, meaning that it will likely be used as a substitute of level two assets only, leaving banks to meet the level-one requirement on their own. Our estimation is about R600-million if they use the full facility.”

Russell said, if this cost was to be passed on to customers, it would add a mere 3.5 basis points to the overall lending rate. However, should drawdown be required, the big banks would incur the draw-down rate of 6.5%. “This is significantly higher than the average cost of funding of anywhere between 3.6% and 4.6%, depending on the bank,” he said.

His calculations are based on the biggest four banks’ full-year figures of interest expense divided by the interest-bearing liabilities, which gives the actual cost of all funding. It is a lot less than the overnight Jibar (interbank agreed rate) of about 5.3% and the three-month Jibar of 5.6%. It does mean that it will be expensive to access the liquidity facility, the point being that banks would go to the window only when there is a disruption of funding elsewhere.

Although the facility is positive for South African banks because they will now be able to meet the liquidity coverage ratio, Russell said it would be negative on margins because it would push up funding costs. “The logical outflow of this is that lending rates to customers will increase as banks seek to protect current margins.”

But Van Wyk defended the facility and said it was not a normal source of funding and should therefore not have an impact on the cost of funding in normal times.

How will this facility be funded?  A great deal of money is placed on deposit in the Reserve Bank and it has about R100-billion of statutory cash reserves.

“The point is, if one bank was to face a run the Reserve Bank, as the lender of last resort, would easily fund it,” said Russell. “But if two banks ran into difficulty, then this facility is available. It’s an emergency facility and I doubt it will be used. South Africa is an early adopter and other jurisdictions are sure to follow.”

South Africa’s limited savings pool presents dilemma
Basel III is meant to make banks safer and prevent a replay of the 2008 financial crisis. When financial systems collapse, the cost to society is generally higher than the collapse of other industries and the risk of destruction is greater because banks span many segments of the real economy, as is evidenced by the eurozone crisis.

Basel III forces banks to hold higher capital buffers to counter unexpected financial shocks or losses and, in terms of the net stable funding ratio, to fund assets maturing after a year with stable funding sources. This ratio, which only comes into effect in January 2018, reflects the banks’ longer-term liquidity and requires them to match longer-term deposits against long-term loans.

Stable funding is defined as deposits held for one or more years. Put simply, the longer the fixed deposit, the more the banks have to pay for it. For example, banks are financing home loans with cheap short-term savings. Basel III will force them to source longer-term funding for longer-term loans, which will be more expensive.

The large South African banks are already overcapitalised in terms of the Basel III rules and hold high-quality tier-one capital, a core measure of a bank’s financial strength. Although the majority of global banks are reporting big losses on the back of subdued market conditions, locally the major banks are relatively healthy, having increased their tier-one capital from 12.5% to 12.7% at the end of the December financial year, thanks largely to strong earnings growth.

Given the structure of the South African market, where banks borrow in the short-term market to fund long-term assets such as 20-year mortgages, the big banks would struggle to meet both the liquidity coverage ratio and the net stable funding ratio. As the graph above shows, the banks’ biggest funding source is from the wholesale and retail markets.

Covered bonds
In its definition of short-term liquidity, the Reserve Bank counts only sovereign bonds and public-sector paper, but the banks would like to see covered bonds and high-grade corporate debt in that mix. Covered bonds are low-yielding securities issued by banks and backed by a pool of loans, often high-quality mortgages, that remain on the issuer’s balance sheet.

Bank chief executives have reiterated that profits would be hit hard by liquidity rules unless the structure of our markets was reformed. The treasury is working on new financial sector reforms that could result in the restructuring of the shadow banking sector, such as money markets, which the banks now use to access cheaper short-term funding. The treasury indicated in its February Budget Review that several new pieces of legislation would come before Parliament this year.

Fitch Ratings, in its outlook for banks released this month, emphasised the need for structural reform of South Africa’s funding markets to allow the sector to meet the enhanced liquidity requirements.

Part of the problem is that South Africa does not have a large enough savings pool from which to draw quality long-term liquidity and local banks are too reliant on volatile wholesale funding to finance long-term lending (see graph). This shows up the mismatch of banks’ funding cycle, which analysts blame on the absence of stable funding such as savings.

The banking sector is characterised by several structural features, such as a low discretionary savings rate and a higher degree of contractual savings that are captured by institutions such as pension funds, provident funds and asset managers.
PricewaterhouseCoopers, in its latest banking analysis report, noted an increase in long-term wholesale funding as banks responded to the net stable funding ratio requirements.

Fitch said that although households’ discretionary savings were low, a material portion of their assets were invested in contractual savings instruments. Statistics showed that in 2010 the household sector invested almost 37% of its assets in pension funds and insurers, compared with less than 9% in financial institutions. In turn, pension funds and insurers invested these deposits in financial institutions. “In other words, banks access most of the savings of the household sector via intermediaries such as professional money managers,” Fitch said. “In line with the structure of the domestic funding market, South African banks are reliant on the corporate sector for most of their funding.”

Russell added: “The South African consumer is the net borrower. I can’t see where the liquidity will come from. It will take a generation to change structurally.” – Sharda Naidoo