Can SA banks ride out the global fallout?

After strong growth in 2011, bad debt, rising costs and subdued income are starting to affect SA banks’ earnings. Maarten Mittner looks at some of the challenges they face.

While global banks have lurched from one crisis to the next, SA's big banks have again bucked the trend: two have reported double-digit earnings growth for the six months to June.

Nedbank led the pack at 25,1% headline earnings growth and Standard Bank came in at 11%. The only problem was Absa, which reported 6% lower earnings for the period. FirstRand is expected to outperform forecasts when it reports annual results on September 11.

Compared to international banks, which are collectively heading for their worst annual results since 2008, even Absa's setback doesn't look too bad.

But it would be naive to think that local banks could entirely escape the global fallout. Strategic and competitive pressures are building up. These may have a serious impact on SA bank results in the coming years if not managed adroitly.

SA banks escaped the worst of the global financial crisis, such as government bailouts and huge management reshuffles, but bad debt, cost pressures, and a slowdown in income may not leave them unscathed.

Probably the biggest challenge is an expected decline in income because of low economic growth, higher unemployment, rising debt levels among consumers and a lack of disposable income which will affect banks' earnings in future. These problems have not yet manifested themselves, but Absa could be an early example of the trouble a bank can experience if it neglects a key income-generating segment such as retail.

The market clearly expects great results from FirstRand, thanks to the retail performance at FNB. The group's share price rocketed to R29 early in August and has risen 50% over the past 12 months. An outperformance of the 26% interim growth reported for the six months to December will largely depend on investment banking activities at Rand Merchant Bank (RMB).

Retail earnings are expected to be higher, but overall growth could be muted by lower investment banking and trading income at RMB.

Bruce Gordon, a partner at Capco, a consultancy, says SA's stricter regulatory environment has helped banks up to now. "The downturn in the European economy meant, however, there was a downturn in demand for SA products, affecting local banks negatively."

Fabrice Franzen, a banking analyst at Bain & Co, says the prospects of local banks are mixed at best. "SA banks have not increased their net income growth of less than an annual 1% since 2008, given a 9% growth in operational costs." Banks will struggle to replicate the good results of 2011 as impairment levels (actual write-offs of debt) are already rising at an annualised 6% so far in 2012, he says.

It is not expected that an improved international banking scene will provide relief in the foreseeable future. Emilio Pera, financial services director at Ernst & Young, notes that the eurozone crisis is far from resolved and has affected local banking confidence levels. Though it should be expected that local credit growth will accelerate as interest rates remain lower, there's a mixed picture for growth in interest revenue. "While credit growth is supportive of earnings growth, credit impairment costs have started ticking upwards again in the second quarter," Pera warns.

The traditional growth levers of banks, such as mortgages, mainstream loans and credit cards, will be hard to extend in the coming years, partly explaining the banks' foray into unsecured lending. This sector has grown strongly since 2010 but still forms a small part of total lending.

Though analysts do not expect a bubble in unsecured lending, there could be a concentration risk developing because unsecured lending is focused on a small market. Between 50% and 75% of loans are extended to existing customers.

Customer growth at the lower end of the market is under pressure and banks are struggling to increase cross-selling volumes. The option of increasing fees and commissions is limited because fees are already high.

Capitec has to a degree presented a successful new model for entry-level banking, but could be stymied by the concentration of products in one income sector. Pera is optimistic about unsecured lending and expects the sector to grow strongly.

"But credit losses at retail banks are expected to increase," he says.

Gordon notes that smaller players have poached customers from the bigger banks, adding another threat to their income base. "The rise in mobile banking, along with legislative and regulatory impacts on the SA market, will shape the industry over the next few months."

While it is generally recognised that SA banks have strong capital levels (assets after liabilities), the higher requirements of the Basel 3 rules and the need to increase provisions are added pressures.

Contrary to perceptions, research by Bain & Co shows local banks have made rather low provision for nonperforming loans. It is a real worry as banks have not been conservative with provisioning, Absa being the obvious example. Rising bad debt in mortgages forced the bank to increase its nonperforming loans coverage ratio to 22,6% at the end of June after reducing the rate from 19,1% to 17,1% at the end of 2011.

Market cap leader Standard Bank's interim results to June indicate the pressures building up. Though total income grew by a relatively strong 13%, headline earnings growth was lower than expected at 11%, dented by credit impairments rising 35% and costs climbing 17%. The cost-to-income ratio has again increased from 58% to 59,1%, threatening to cross the crucial 60% level.

CEO Jacko Maree has warned the challenges are building up. "It has become clear that 2012 has developed into another difficult year for the global economy, resulting in a very challenging operating environment for all banks."

The corporate and investment banking division is already feeling it, with an earnings drop of 7%, in contrast to the sterling performance at the retail personal and business banking division, where earnings climbed 33%. Personal and business banking noninterest revenue grew strongly at 9%, even though prices were not hiked at the beginning of the year and the group expected fee losses of around R500m after unveiling its new, cheaper cost structure in April.

But is it is unlikely that this growth at personal and business banking will be sustainable. Together with a deteriorating picture at the corporate and investment banking division, Standard Bank could be heading for single-digit or even flat growth for the year.

Probably the main worry is that costs are increasing. Standard Bank had to embark on an unplanned cost-cutting exercise two years ago. The bank justifies the higher costs as part of its African expansion strategy, but growth in operating expenses of 19% has already surpassed total income growth of 13%.

Financial director Simon Ridley admits costs cannot keep growing at the present pace and expects it to level off to 14% for 2012. A lot hinges on curtailing African expenses, where US$75m in savings have been earmarked. But this could be difficult to achieve as Standard Bank is still in an investment phase in many African countries, notably Angola. It is also clear that credit impairments in the rest of Africa are growing at a faster rate than in SA. Lending has increased markedly to the more than 1m new customers (mostly in SA) the group gained in the past year.

Standard Bank is clearly winning the retail war against a weakened Absa, increasing income from its greater market share in mortgages, instalment sales, card products and transactional income. But the question is the sustainability of the retail net interest income growth on loans of 17% and on noninterest revenue (mainly fees and commissions) of 9%.

Standard Bank SA CEO Sim Tshabalala sees some levelling off of growth in the second half. But he foresees further margin expansion, even after interest rates have been lowered. Average margins swelled from 3,81% to 4,08% thanks to higher customer numbers and better pricing in the half-year to June. "Revenue growth at retail is expected to be more subdued in a more difficult economic environment."

With costs growing, and compliance with Basel 3 requirements looming, the pressure on capital was already felt in the half-year to June, which coincided with the implementation of the Basel 2,5 requirements by end-December 2011. It cost Standard Bank R40bn to adhere to these capital adjustments, pushing core tier 1 capital adequacy down from 11% of assets to 10,3%.

Ridley says tier 1 capital would fall further to 9,5% if Basel 3 were to be implemented in its present form. "It would also cost Standard Bank a further R65bn, which will present a significant challenge to the bank."

But he is hopeful the requirements will eventually be watered down.

Compared to the results at Standard Bank and Absa, Nedbank has been a star performer. From being the laggard in the local banking sector, it has polished up its act and the market has taken notice.

Its share price has grown by 31% over the past year. It is trading at 1,9 times NAV or tangible book value, already passing the 1,7 times at Absa and within striking distance of Standard Bank's 2 times. FirstRand at 2,6 times is the market leader at present.

Delivering interim earnings growth of 25,1% to June, Nedbank has shown better noninterest revenue growth of 15,8% than the 11% for Standard Bank's SA activities. But in net interest income Standard did better with growth of 17%.

Group impairments actually continued to fall from 1,21% of advances to 1,11% at Nedbank while they grew from 0,81% to 0,98% at Standard Bank.

There have been persistent questions about where Nedbank's future growth will emanate from. CEO Mike Brown dismisses the view that its customer base of 5,5m is too small to support meaningful growth. "Customer growth is not necessarily our focus as we have made progress in all our other targeted strategic focus areas."

This includes expansion into Africa, growing noninterest revenue and increasing profit. But the main focus has been on retail, where a loss of R69m in the first half of 2009 has been turned around to a R1,194bn profit at end-June. Though return on equity has increased to 11,8% at the division, it is still less than the cost of equity.

"We recognise that more needs to be done at retail and are by no means saying we are where we want to be," Brown says.

Future retail growth is projected to come from income related to transactional volumes, which at R158m for the half-year is already a large chunk of present total retail noninterest revenue growth of R389m. This is to a degree augmented by higher card and personal loan revenue growth of R134m and R131m respectively.

Total client numbers have grown strongly by over 500000 over the past year. The entry-level market has grown from 1,6m to 2,9m at end-June. This has been the result of the unveiling of the Ke Yona and Savvy account products, which clearly have resonated among customers. It is therefore possible that Nedbank could prove the pessimists wrong again by further capitalising on its strong retail thrust. But that will largely depend on improved economic conditions and increased cross-selling from the bank to customers, mainly with insurance and motor financing.

Nedbank is a firm favourite at SBG Securities, where analysts have set a target of R200/share from a present R187. The target price is R120/share for Standard Bank, compared to a present trading price of R112.

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