Banking: Signs of danger

African Bank's recent profit warning has thrown the spotlight on bad debt as the National Credit Regulator becomes stricter amid fears that the problem may spread. Maarten Mittner looks at how prevalent debt arrears are in SA's banking system.

Bad debts are threatening a seizure in SA's lending system.

First it was Absa. After reassuring the market at the end of 2012 that there was no problem with its bad debt and no need to increase its relatively modest provisioning, three months later it had to make available R1,35bn to cover newly discovered mortgage debt. This led to earnings falling 9% for 2012.

Two weeks ago African Bank shocked investors with a warning of extensive new provisions for worse-than-expected bad debt emanating from its unsecured lending business. Earnings are expected to drop by up to 28% for the six months ending March 2013.

But at the beginning of the year CEO Leon Kirkinis was positive about provisioning levels and did not expect bad debt levels to deteriorate. He disparaged reckless lending charges from the National Credit Regulator's (NCR) Nomsa Motshegare, which appear now to have been timely.

Last week Transaction Capital was the latest player in the micro-lending market to announce a significant deterioration in its lending book. The credit loss ratio increased to 9,5% from 8,6% with nonperforming loans at its Bayport franchise - loans that have been inactive for three months - amounting to 29,9% of advances. Though much smaller in scope than African Bank, and reporting a profit due to its diversified income stream, Transaction Capital's figures show a similar trend to African Bank's.

This begs the question: how many more financial institutions will report worsening bad debt this year? And what does this say about the banks' lending criteria and loans granted in the light of reassurances from most players that they are responsible lenders and that the borrowers are applying for debt in a mature fashion? Is the bad debt problem systemic?

Most of the big banks, notably Standard Bank, First National Bank (FNB) and Nedbank, entered the unsecured lending market comprehensively after 2008. The spree in unsecured lending dates back to the 2008 global financial crisis. Local banks clamped down heavily on traditional mortgage lending as huge debts had built up among consumers. Banks had been lending injudiciously.

But the demand for loans persisted and as general and disposable income levels in the economy increased, unsecured lending became the mantra. Kagiso Asset Management investment analyst Simon Anderssen says that in three years personal loans rocketed from R41bn in 2008 to R140bn in unsecured liability against the balance sheets of SA households. This is roughly a 40% annual increase and comparable in value to the outstanding debt supporting all the financed cars on SA's roads.

"Yet, unlike vehicle finance, there are no assets backing this liability should borrowers run into financial difficulty." African Bank has the most exposure to unsecured lending and is regarded as a relatively small player in SA banking. However, the facility is more in use than generally understood. For instance, FirstRand, through WesBank and FNB, has run a highly profitable unsecured lending business for years, mainly for middle- and higher-income customers who own a house.

What has changed is that unsecured lending had been extended to vulnerable sectors of the economy?

A large proportion of this segment do not have assets such as a house, shares or a pension fund to back up loans. Moreover, there has been a tendency for lenders to increase loan amounts and the repayment term. For instance, it is now possible to repay a R220000 loan over 84 months at a rate of 21,6%/year, Anderssen says.

This opens a Pandora's box and lenders are saying they have no idea of the eventual outcome of their lending as such large amounts have never been extended over such long repayment periods to the lower-income market before. The banks justify the lending spree as catering to demand from a growing middle-income market.

In the past, microlenders usually made money by charging high rates on relatively small amounts, payable over short terms such as a month or, at most, three months. By extending the payback term, the risk of the borrower defaulting increases exponentially, especially in the lower-middle income market. To a degree, this problem can be masked by extending new loans on existing, consolidated amounts, which is what the lenders have been doing.

But at some stage the brakes have to be applied. This is because microlenders are dependent on increasing loans for inordinately long periods to justify their strong interest income and earnings growth, and to take care of rising bad debts, the inevitable scourge of increased lending.

A failure at African Bank need not infect the entire banking system, even though, on average, every African Bank customer also has three or four loans running simultaneously at other institutions. This could affect more players, including the bigger banks.

Banks registrar René van Wyk would not comment on the implications of African Bank's bad debts but in its most recent "Financial Stability Review", the Reserve Bank paints a relatively benign picture of the unsecured lending market, describing it as a somewhat limited segment of the overall credit market.

Total banking sector assets increased by 6,9% to R3,6trillion at end-December, with the contribution of the sector to GDP, together with real estate and insurance businesses, amounting to around 10%. Growth has clearly levelled off from an average 23%/year experienced in the boom years between 2006 and 2008. Unsecured credit exposure amounted to R441bn at end-December, up from R381bn in June 2012.

Almost half of the banks' exposure to unsecured lending comprised revolving credit, in effect credit cards, making pure unsecured lending products an even smaller part of the total. Therefore the potential for a systemic problem seems remote, even though runs on banks are rarely based on facts. Sentiment and emotion play a much bigger role. A positive for the Reserve Bank has been a decline in impaired advances to gross loans and advances in 2012 from R116,8bn in June to R112,05bn at end-December. As a percentage, impaired advances fell from 4,43% to 4,07%.

Though positive, it should be noted that these figures could be misleading if advances grew rapidly over the period, possibly masking a developing bigger bad debt problem. The impaired advances of the smaller players such as Capitec and African Bank increased by 33,3% in the year to end-December, while those of the five largest banks decreased by 11%.

African Bank's recent woes could be seen as a repeat of what happened in the early stages of the demise of microlender Unifer more than a decade ago. Unifer had to close its doors in 2002 due to a huge bad debt hangover after strong growth in advances.

However, African Bank will not necessarily go the same way. Unifer was then in the Absa stable and began curtailing advances when bad debt began to grow uncontrollably. A decade later, its former CEO Bert Griesel told the FM that bad debt was always underestimated at some point when it came to unsecured lending.

In October 2012, African Bank, together with other banks and loan providers, met with finance minister Pravin Gordhan about concerns that a bubble was developing in the sector. The lenders committed themselves to responsible lending and to relief measures for distressed borrowers. African Bank later told the FM that it had given treasury its reassurances.

By the end of 2012 it had cut back noticeably on lending and advances. But then bad debts spiked, leading to a crunch on income. When it issued the profit warning two weeks ago, African Bank's share price plunged more than 27%, indicating nervousness among shareholders.

It was a far cry from when the stock was favoured for its big dividend payouts. After the trading update, the share was down more than 40% over a year. As the stock lost value, Kirkinis hastily arranged a conference call to allay investors' fears which, sources say, was done under pressure from the Reserve Bank.

Kirkinis says the group's income yield declined, partially as a result of the suspension of interest and fee income due to the growth in non performing loans. A large part of this was related to credit cards and reduced profitability at the Ellerines furniture business. Insurance claims and provisions increased by about 1% of advances, as the group broadened the range of insured events.

Some analysts believe this is related to African Bank charging less for insurance products as regulators plan to cap interest on these, as with "normal" loans. Insurance products fall under the National Credit Act (NCA), but fees are not capped, meaning that African Bank could charge much higher interest for insurance than on a loan. Kirkinis's update helped the share price recover, apparently benefiting investors who effectively shorted it. But the recovery has proven to be tepid with investors unsure of its prospects.

Imara SP Reid research head Steve Meintjes believes conditions deteriorated measurably in March, resulting in additional nonperforming loans having to be written off. "Fundamentally the company remains sound, but there are many questions, including those regarding true profitability."

The delay in providing additional information after the trading update forced analysts to deduce what went wrong. Citigroup says in a research report that lower margins - the difference between funding rates and those lent to customers - and higher debts were the main cause of the earnings fall.

Lower margins are usually indicative of lower income. Before 2008 African Bank's margins were consistently above 40%, meaning hefty profits were made on money the bank borrowed and then advanced to customers. In 2010 its margin fell below 40% for the first time; last year it was 34,1%. Citigroup believes that the margin fell to below 30% in March and could be as low as 24,6% for the full year.

Bad debt impairments, meaning actual write-offs, are now at 11,5% of advances, double that of the major banks, but are still in an anticipated range, Citi says. But that is not the case with the margin decline, as African Bank had to pull back advances more than it would have preferred. "We think the unexpected poor performance was due to worse-than-expected margin declines and not unforeseen bad debts," it says.

A big discrepancy is that African Bank and Capitec use different definitions of a bad debt. If a borrower has defaulted for three months at Capitec, the loan is classified as nonperforming and written off. However, African Bank writes off a loan only after 17 months of nonperformance.

Kirkinis defends this as fruitful, saying many loans are recovered and that the bank often converts a nonperforming loan into a new loan. African Bank therefore has more nonperforming loans than Capitec.The system is further complicated by customers who only "half default". A widespread practice is for borrowers to pay back only a small amount every month. According to research done by Citi, this is when a customer borrows R1000 on a repayment basis of R100/month, but pays only R40/month for three months and then defaults.

Citi says that at African Bank such an account would be classified as non performing, while at Capitec it would be written off as Capitec does not have the extensive resources African Bank has to recover loans. Whatever the bad debt method used, the African Bank meltdown prompts the question: can it happen to others, particularly Capitec?

Capitec's stock was initially knocked down around 7% but later recovered. Though not strictly comparable with African Bank, as it accepts deposits and earns transactional income, Capitec has much the same lending structure. It also lends bigger amounts over longer repayment periods.

CEO Riaan Stassen shies away from elaborating on this aspect, preferring to emphasise the differences between Capitec and African Bank. "Almost half our 4,7m active clients use our banking platforms and not only our credit offer; and we do not carry the same insurance risk as African Bank."

Stassen points out that Capitec is not in the furniture business and that it has been open with the market, predicting tougher conditions at recent interim results . "We have approached provisions for bad debts extremely conservatively."

However, in a recent research report, Renaissance Capital asks if this will be enough if Capitec's bad debt on its longer-dated loans starts to spike. It calculates that half the growth in net interest income in the annual results to end-February was swallowed by impairments.

Its other worry is the longer-dated loans. Despite Capitec's book being 60% the size of African Bank's, it has put more assets on its book in the six months to January 2013. The value of loans sold by Capitec amounted to R25bn in 2012, of which R11bn (or 44%) was in new and longer-duration loans of between 61 and 84 months.

A significant 35% of the outstanding book of R31bn is in these loans. Already there has been a deterioration in the longer maturities, as indicated by the bank's own vintage charts. Renaissance Capital says it is uncomfortable with the increase in longer-term loans.

Nevertheless, many still believe in the Capitec growth story. Meintjes says though bad debts are "horrendously high", management is addressing the problem and has indicated it will take two years to trim it down. All the major banks expanded into the unsecured lending market in the past two years, with Nedbank and Standard Bank growing this aspect of their business faster than the others. Though their lending books are also problematic and experiencing similar bad debt increases, the bigger banks have more resources to cushion themselves.

In contrast to its upmarket image, Nedbank increased its unsecured lending rapidly after 2008 and grew personal unsecured loans by 29% in 2012. Its unsecured nonperforming loan ratio of 12,7% is the second highest after African Bank's. Nedbank experienced a scare last year, reporting a spike of 51% in this category for the year ending December. This trend continued in the first quarter of this year with the overall credit loss ratio rising to 1,22% from 1,05% at end-December.

But analysts at Deutsche Bank say this deterioration at Nedbank is in line with the higher risk associated with unsecured lending products. "Though we remain cautious, it is not indicative of a collapse within the broader unsecured lending sector."

In Standard Bank's campaign to win the retail war since the beginning of 2012, it grew its unsecured lending book by R10bn to R29,6bn by end-December. But this forms only 4% of the total local loan book of R671,96bn. Standard Bank SA personal & business banking head Funeka Montjane says it has reduced its risk in unsecured lending to the low-income sector to R3,7bn. "Growth in this book slowed down significantly in the second half of 2012."

At the same time Standard says it is experiencing a significant decline in the loan appetite of consumers and lenders. This places the more marginal borrowers under strain as they are finding it difficult to refinance their debt.

At end-December the impairment charge in personal unsecured lending (excluding card) had already increased to R3,2bn from R1,3bn a year ago. This was the result of the increased incidence of defaults in the R3,7bn category, with the ratio of nonperforming loans to the total unsecured book rising to 6,4%.

"We have planned for an increase in personal unsecured loan impairments for this year, given the growth in the book in prior years," Montjane says. She says the bank has also tightened origination criteria in most areas of unsecured lending and expects this cautious approach to continue for much of the year.

FNB SA, a division of FirstRand, has had strong demand for unsecured credit but, since June 2012, has been following a deliberate strategy to curtail lending. Its credit loss ratio was 1,28% at end-June, higher than Standard's or Nedbank's, indicating the group experienced higher debt at an earlier stage. But its nonperforming loans have declined to 5,26% of advances from 6,42% in 2011.

However, that does not mean the FirstRand group is out of the woods yet. SBG Securities says in a research report that its credit mix is a higher risk compared with that of the other banks. Though it has superior income-generating capabilities, as proven by its higher margins, it has a greater proportion of personal and vehicle loans in its portfolio, which traditionally cause cyclical high debts. Motshegare and the NCR's offices in Midrand are only a few blocks from African Bank's head office. But the views of the two players about the troubled unsecured lending market are much further apart.

Motshegare won't admit she feels vindicated by African Bank's recent earnings downgrade. She has accused the microlender of reckless lending but is hesitant to single it out as similar charges have also been made against Capitec and other smaller lenders, many of which have been raided by the NCR and police.

But she is clearly not surprised at African Bank's bad debt situation; nor does she buy Kirkinis's excuse that customers default on their loans after they take on additional debt from competitor lenders when African Bank does not extend them further credit. "If a customer has three or four loans, this is already indicative of an overindebted situation," she says. In that case a credit provider should not extend any more credit.

The NCR has referred the charges against African Bank to the national consumer tribunal, which could fine it up to R300m. Motshegare's tough stance signals a stricter approach by the NCR since the end of last year. She says more credit providers are guilty of reckless lending. "We are not saying the credit tap must be closed, but credit must be extended responsibly."

Nor is it for the NCR to say if there is systemic risk, she says, but she believes the system is stable: "We are more involved on the consumer protection side." Motshegare's new target is the National Debt Mediation Association (NDMA), an organisation of credit providers, mostly the bigger banks, formed under the auspices of the Banking Association. The NDMA has worked directly with consumers in dealing with debt defaults.

That means the banks devise new payment arrangements with consumers, without necessarily involving debt counsellors, causing unhappiness in the debt counselling industry. The NCR has withdrawn its recognition of the NDMA and some other organisations, which means they have no legal backing for their work. Motshegare says this was necessary as the NDMA ignored the act.

"We still see a role for the NDMA, but only as an alternative dispute resolution mechanism." This could result in protracted dispute resolutions, adding another cost to the already cumbersome debt counselling process. Banking Association CEO Cas Coovadia says the association is engaging with the NCR about resolving the issue and will ask for recognition in terms of the code of conduct.

But its chances of success are not great as Motshegare blames the banks and the bigger credit providers for the heavily indebted situation many consumers find themselves in. "We cannot have those institutions that caused the higher indebtedness to now come forward and say they are part of the solution."

She says there is a conflict of interest between credit providers lending money and then also acting as dispute interlocutors. "We cannot endorse the NDMA, especially if its aim is to control the debt counselling industry." The NDMA says worthwhile work has been done. It has handled more than 6000 complaints since 2010, and in the first quarter of this year had 453 cases resolved, 72% of them in favour of consumers.

Some banking executives have said that removing the NDMA from the debt resolution processes will make it more difficult for consumers and could make them vulnerable to the unscrupulous, notably those involved in the issuing of garnishee orders.

The office of the credit ombud finds itself in the same position as the NDMA as its recognition was retracted by the NCR. Credit ombud Manie van Schalkwyk says the NCR has left credit providers confused as debt counselling complaints must now be sent to the NCR. That is despite the fact that the ombud's mandate was approved by the Financial Services Ombud Schemes Council. In the past financial year the ombud dealt with 5506 cases, 9,1% of which were related to debt counselling disputes.

Motshegare is also focusing on smaller lenders, especially in rural areas. She says there have been some successes, referring to 10 cases involving microlenders in the Marikana area transgressing NCA conditions.A proposed credit amnesty is another contentious matter the NCR has to tackle. A report on how the amnesty will work will be presented to parliament at the end of this month.

Proposals include that judgments granted between 2006 and 2011 on amounts less than R10000 be removed from credit bureau records, irrespective of nonpayment. But they will not be written off. Motshegare says the amnesty is necessary to help indebted consumers. She does not expect it to lead to another spike in lending, as happened with the previous amnesty in 2006/2007. She says the purpose of the amnesty is to provide a new credit opportunity for consumers and to reduce the cost of credit.

However, there is growing uneasiness in the industry. "If the amnesty is approved by government, we will have absolutely no idea of who we are dealing with," one debt counsellor says. Privately, some CEOs have said the NCR's "high-handed" approach is damaging the industry and that more self-regulation is required.

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