South African banks have a long history of impressive stability, successfully navigating EM crises, a domestic A2 banking crisis and the GFC without too much difficulty. The reasons for this are numerous, but would include the diversity of their income streams, the consolidated oligopolistic structure of the industry, good management teams with a culture of sound risk management, and a strong regulator who successfully prevented them from reaching anything like the levels of gearing that were commonplace in European banks ahead of the GFC.
The long-term dividend paying history of Standard Bank would attest to this resilience, with only the GFC causing any notable, yet still minor, damage to its track record:
Along comes COVID-19…
Bank share prices have fallen sharply in this crisis as the market has shunned leveraged entities, fretting over whether banks will be left holding the can amid escalating consumer and business bankruptcies. The market has targeted Nedbank and ABSA for special treatment. This is because Nedbank has the largest exposure of the big four banks to commercial real estate at 22% of the loan book, which is second only to Investec at 28%. This sector is seen as exceedingly vulnerable given highly leveraged balance sheets and the well-publicised phenomenon of retail tenants refusing to pay rent to landlords. ABSA is being targeted partly because it is seen as the least resilient bank. Together with Nedbank, it has the lowest capital ratios (even though only marginally lower than peers do), and it is perceived to have had the highest credit appetite since the exit of Barclays allowed them to loosen lending criteria. The market’s concern is that this acceleration in asset growth will prove to be ill timed. Another factor affecting both companies is the greater sensitivity their interest margins have to interest rate cuts relative to peers.
Ironically, in a revenue context, banks are in fact partially shielded from this crisis relative to more exposed sectors like apparel retail. While apparel retail revenue has fallen to zero during lockdown, banks are still open for business. They continue to accrue interest on loans (although margins will compress), generate fee revenue on essential goods and online transactions (although volumes will decline), and are likely to have a significant increase in demand for loans going forward (albeit some of that demand will be from distressed borrowers). However, the huge unknown is the extent of loan losses that they will have to bear. This is the key investment point. We think it is unavoidable that the banks will experience material earnings pressure from this line of the income statement through this year, at least, and probably next. However, the question an investor needs to ask is whether the scenario being priced by the market is overly pessimistic or not.
Dissecting Nedbank to gauge industry value
Let’s take Nedbank as an example, since it has been the “lightning rod” in the sector. Compared to 2019 profitability metrics, the bank is currently trading on 3.5x earnings and a 16% dividend yield. Evidently, earnings and dividends will fall this year, making these ratios meaningless in the short term, but the more important issue is to what level earnings will rebound to after the crisis. A common valuation “rule-of-thumb”, the price/book ratio, gives us some clues about what the market is thinking in this regard. Banks typically trade at premiums to their book value, as their sustainable ROEs are above their cost of equity, mostly somewhere around 15%. FirstRand is the outlier with an ROE at closer to 20%. Nedbank is currently trading at a price/book ratio of 0.57x compared to a 10-year average around 1.5x. This suggests that the market expects a permanent haircut to capital. If the stock returns to only 1.0x book, then this implies the ROE falls towards the cost of equity and capital declines by 43%. A return to 1.5x book would require capital to drop by 62%. In other words, the market believes earnings will be lower in future as the E in ROE is permanently impaired.
A quick “back-of-the-envelope” calculation may help us understand what this would look like. Let’s assume the crisis lasts two years. In 2019, Nedbank had pre-provision operating profits of around R24bn. If, hypothetically, that falls to R15bn p.a. over the next two years (i.e. a 37% fall in profitability before bad debts and tax), then the bank would still have around R30bn of profits on a cumulative basis over two years to absorb bad debt losses. To write off 43% of capital (as discussed above) we would require after tax losses of R32bn (equivalent to R42bn on a pre-tax basis), which taken together with the estimated R30bn of profits over two years means you would need loan losses in the order of R72bn over the period. Nedbank has an R800bn advances book, so you would need to write off 9% of the book over two years. Using the 1.5x book assumption would make increase this to 12%.
That seems high to us. Nedbank’s credit loss ratio peaked out at 1.5% of advances in the GFC. The above (admittedly simplistic) calculation suggests we are pricing for an event far worse than the GFC. The loss ratio was 2.9% in aggregate over two years in the GFC, so we could simplify and say we are pricing for losses three times the size of the GFC, or four times using the 1.5x book assumption. This is certainly possible given that we are facing an unprecedented sudden economic stop, but we think valuations have skewed the odds in favour of the investor.
Mitigating factors when looking at potential Covid-19 credit losses
One of the reasons SA banks have never before produced losses of this magnitude is that most of their lending activities are collateralised (Capitec would be an exception to this with an entirely unsecured book). Nedbank had R28bn of Stage 3 (i.e. credit-impaired) assets at the end of 2019, with an R11bn provision against these loans, leaving a net exposure of R17bn on its balance sheet. However, it holds R27bn of collateral against these balances in the form of claims against properties (with cession of leases) for commercial mortgages, claims on specific assets financed in the case of instalment debtors, or guarantees such as personal sureties or even government guarantees in the case of loans to certain SOE’s, like SAA. Moreover, falling inflation, lower interest rates, the fiscal stimulus package, and the R200bn credit guarantee scheme should give banks’ clients some support. Importantly, there is some comfort that the government is not coercing banks into making risky loans without providing an incentive. With only a limited increase in overall capital at risk (the banks bear only 6% of the losses on the scheme), the guarantee scheme enables the banks to underpin their existing SME books by providing additional liquidity support to highly impacted businesses, hopefully allowing them to trade through this period..
Nevertheless, it is sensible to assume that bad debts will rise sharply, even if somewhat less than the market may be fearing. In this context, it is worth noting how balance sheets have been bolstered in recent years to allow banks to absorb this. The GFC exposed several weaknesses in global banks, most notably too much leverage (not enough capital to support their asset bases), excessive reliance on short term funding and insufficient internal liquidity to cater for short term stress events. The response was Basel III, a wide-ranging reform of global banking regulations that was implemented starting in 2013. In essence, banks have spent the past seven years strengthening capital levels, reducing reliance on short-term funding, and increasing their stock of high-quality liquid assets.
To continue with the Nedbank example, it came into this crisis with a CET1 (core equity) ratio of 11.5% of risk-weighted assets, which is significantly higher than the 8.2% with which it entered the GFC. Its short-term funding proportion has declined from 61% in 2008 to 47% now, and it has built up significant holdings in high-quality liquid assets, which it can turn into cash quite readily if needed. In addition, the SARB has temporarily reduced certain capital and liquidity requirements during this crisis. This effectively lowers the overall regulatory capital requirement through the removal of capital buffers built up in calmer times for occasions exactly such as this, as well as softening constraints over the need to hold excess liquidity for stress events. Furthermore, the Prudential Authority has created space for banks to support customers through this crisis without any adverse regulatory consequences by allowing for the restructuring of customer loans without those loans migrating into higher risk-weighting categories that may put pressure on capital ratios.
Short-term caution but long-term value
Nedbank is a specific case, but the story is similar for the other banks, albeit with varying degrees of pessimism priced in by the market. FirstRand is seen as best placed to weather the storm given its higher starting profitability, highest diversification, and lowest exposure to commercial real estate. This makes it a core bank holding with attractive valuations in absolute terms, even if not as cheap as its peers, which have higher levels of risk. Standard Bank has some similarities to Nedbank in that the market is concerned about a specific factor, which is its exposure to Africa, in particular to corporates in the oil industry where prices have fallen to twenty-year lows. At closer to 5% of its book, this exposure is significantly smaller than Nedbank’s commercial real estate exposure and is offset by other positives, such as the highest capital levels in the sector and low commercial real estate exposure. It has also reduced exposure to smaller players in the oil industry, increasing the likelihood that its existing clients can ride out the storm. ABSA undoubtedly has many “balls in the air” with the Barclays separation and retail turnaround projects having required inward focus for some time. Unfortunately, the economy we now face is likely to deprive them of a valuable tailwind that would normally support these efforts. Even so, ABSA’s price implies a similar scenario to that being discounted into Nedbank.
In conclusion, we think the banks are reasonably placed to weather this storm from a solvency perspective, but earnings pressure will be acute and investors should expect a bumpy ride. We think you can commit capital to opportunities where the market is being too pessimistic, but overall exposure should be restricted given the inherent uncertainties of the situation (fatter tails than usual) and expected poor short-term results that will very likely depress market interest for some time. The other issue that needs to be watched is confidence. Banks go out of business far more regularly from liquidity crises that stem from confidence crises than they do from solvency crises. The loss of confidence in a bank is difficult to predict. However, for the systemically important banks we think this current risk of a confidence crisis low, partly because of healthy capital levels (as discussed above), a stable rand funding pool underpinned by exchange controls, and the likelihood that the central bank would be quick to underwrite liquidity should the need arise.