Banks make sense of more stringent and changing rules

After the 2008 global financial crisis, the G20 group of countries – of which South Africa is a member – saw the need to reinforce a stable financial system and asked the Basel Committee on Banking Supervision to create a new banking regulation framework.

Basel III, the committee’s current standards for bank soundness, has called for more stringent capital and liquidity requirements, with the latter due to follow a staggered implementation timeline from 2015 to 2019. While South African banks are already well-capitalised, new requirements on the quality of short- and long-tem assets and funding are posing challenges.

Well Capitalised

Under Basel III, higher and better-quality capital is being promoted to prevent another crisis. But the new standards in many ways target weaknesses of banking sectors in Europe and North America, such as problematic capitalisation or a high level of toxic assets. Johannes Grosskopf, banking industry leader at PwC South Africa, notes that South Africa’s banking system was largely unaffected by the 2008 global financial crisis, in part because the closed rand system restricted liquidity leakage. “Exposure to risky assets was limited since many of the toxic products did not exist here. South Africa had no property bubble, and banks were highly capitalised,” he said.

Overall capitalisation is not a concern. “Unlike Europe, our banks are meeting their capital requirements and are not overly leveraged,” Rene van Wyk, registrar of banks at the South African Reserve Bank (SARB), told OBG. “South African banks are capitalised at around 11-13%, while some banks in developed markets have a rate of 1-2%,” said Warren Watkins, head of private equity markets at KPMG, adding that the average in developed markets is half of South Africa’s.

Unbalanced Under Basel

Yet while capitalisation levels will not pose a problem, specific changes required under Basel III have prompted concern – particularly the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). The LCR requirement is aimed at improving the quality of liquid assets needed for short-term obligations, while the NSFR promotes more stable long-term funding sources. The LCR results in more onerous liquidity requirements whereby banks need high-quality liquid assets to cover possible net outflows over a 30-day horizon. Since almost two-thirds of South Africa’s deposits are short-term (one month or less) – a trend mirrored in most of Africa’s banking markets – banks need a substantial amount of high-quality liquid assets, steering banks away from productive assets and lending. The problem is that insufficient instruments of this nature exist in South Africa, according to Mark Brits, general manager of strategic projects at the Banking Association of South Africa, a trade association. Konrad Reuss, managing director for South Africa and sub-Saharan Africa at Standard & Poor’s, told OBG that in South Africa banks offer short-term transactional accounts, whereas money market funds, insurers and pension schemes provide savings products. Under current Basel III requirements, he noted, this funding model will have to change. The NSFR requirement is designed to encourage long-term deposits of over one year, on the grounds that long-term lending should be matched by long-term funding. Under the new ratio, stable funding must exceed 100% by 2018. Since wholesale funding will be deemed unstable, this could prove hard to meet for South African banks. “The challenge of Basel III will be liquidity in the long-term under the LCR and NSFR,” Donna Oosthuyse, director of capital markets at the Johannesburg Stock Exchange, told OBG. “Since around a third of bank’s assets in the country are long-term mortgages and most of their funding comes from the wholesale market – which is mostly short-term – there may be a structural liquidity gap in the future. From a regulatory perspective, this will be a concern, possibly leading banks to lengthen maturities of their liabilities.”

Structurally Sound, But Different

Simply put, the structure of South Africa’s banking sector is not conducive to implementing some of Basel III provisions. The best way to obtain high-quality long-term liquid assets is through government paper, which is a cause for concern in itself after the credit ratings downgrades in 2014 (see overview). According to Van Wyk, those individuals who do have surplus funds either use it to repay bonds or put it into annuities because of tax breaks, leaving little in long-term deposits.

South Africa is not the only country likely to find the new NSFR requirements challenging. “In emerging markets, depositors typically hold money in shorter-term deposits, and mortgage loans are generally longer-duration assets unless securitised, causing banks generally to run larger liquidity mismatches in emerging markets than in developed ones,” explains Mike Brown, CEO of Nedbank. Van Wyk, who also chairs a Basel subcommittee, agrees: “South Africa’s risks are fundamentally different.” Brits told OBG, “Solutions for developed markets are not always the best solutions for emerging ones.” He believes that the regulators are pressured into adopting best practice and thus “tick the box” at the expense of sufficient national discretion to enable the optimisation of the framework for domestic conditions. There is general agreement in the industry that there should be flexibility for emerging markets. “While benchmarking regulations against developed countries is beneficial in the long run, there should be some scope for flexibility as South Africa is still a developing country,” said Roland Sassoon, CEO of Sasfin Bank.

Latest Changes

To address these concerns, many changes to the proposed Basel III framework have been made. In 2012 the SARB approved a “committed liquidity facility” which, for an up-front fee, provides banks access to liquidity lines that count toward their stock of liquid assets. In 2014 the leverage ratio framework was revised to reduce near-term uncertainty by taking a more pragmatic approach. The main changes since 2013 are that under certain conditions banks will be allowed to net cash payables against cash receivables from multiple trades with a single counterparty. There will be a reduced recognition of off-balance sheet items through the application of risk-based credit conversion factors subject to a 10% floor. Pre-settlement payment can also be offset against gross derivative exposure under the cash-variation margin, trade exposure to derivative transactions may be excluded and exposures on written credit derivatives will be capped at a maximum potential loss. The impact of NSFR has lessened for retail, because there are more stable funding factors and fewer requirements. Operational deposits have been recognised, there is more granularity in the treatment of funding and assets with residual maturities of less than a year, and there is better alignment with LCR requirements. The LCR has become more versatile, as central bank facilities can now be included in high-quality liquid assets. However, there are more disclosure requirements, as banks must report quarterly on the main drivers and composition of their high-quality liquid assets. According to PwC in its “Executing on African ambitions: South Africa – Major banks analysis” (March 2014), the new framework is more favourable to retail banking activities, and South African banks in general should gain from these revisions since most liabilities held are short-term.

Growing Burden

Beyond changes under Basel III, all financial services providers are coming to terms with South Africa’s switch to a twin peaks model of regulation, where the prudential and market conduct pillars are being separated (see overview). While banks are generally supportive of the new regulation as a way to improve bank soundness, the additional changes will take time to settle. “With a combination of a domestic agenda that includes twin peaks, the post-crisis Basel banking regulations, FSB requirements around over-the-counter derivatives and central counterparties, shadow banking, recovery and resolution , deposit insurance and more, the heavy regulatory agenda is a lot for an emerging market to implement,” said Brits.

The Banking Association gives examples of the increasing burden passed on to banks over the years. The Home Loan and Mortgage Disclosure Act of 2000 made banks responsible for collecting information on human settlements. The Waste Act of 2008 has pushed the onus of compensation for pollution to titleholders – typically banks – if the offenders are unable to pay. In its Annual Review 2013 the Banking Association cites more recent regulations related to activities such as gambling that give banks reporting obligations that are unrelated to the business of banking. Understanding new regulation and fulfilling requirements have been diverting management from business. “These days bank CEOs are spending more time worrying about compliance than innovation,” said Brits.

For its part, the SARB says its approach is risk-based. “We do not employ an army of people to sit at a bank for months, but not a week goes by that I don’t talk to the banks,” said Van Wyk. Through structured mechanisms such as monthly returns from banks, the SARB analyses data and discusses options with bank CEOs, board members, and audit and risk committees, said Van Wyk, who describes a healthy tension between the banks and the regulator. “When banks are fined, the emphasis is not on the fine but on fixing the problem.”