<strong>By: Jeremy Gorven, Senior Analyst at Stonehage Fleming Equity Management South Africa</strong>

<h2><strong>How Prepared is South Africa’s Financial System for COVID-19 shocks?</strong></h2>

The unique economic challenge posed by the coronavirus crisis raises important questions around the preparedness of South Africa’s financial system: How ready is it for economic shock and what support is expected to help navigate the ensuing impacts of the crisis?

After the Global Financial Crisis (GFC), the G20 nations called for financial reforms to make the global financial system more resilient to shocks and reduce the likelihood and severity of future crises.

Prior to the current crisis, South African banks built up strong capital and liquidity buffers, as intended by the reforms, and they appear to be more resilient and better prepared for economic shocks. The financial sector is made more resilient by more constrained levels of risk taking in recent years, as reflected by muted credit growth, equity price growth and housing price growth.

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The six largest banks have been declared Systemically Important Financial Institutions (SIFI’s), strengthening the SARB’s ability to prevent a disorderly bank failure due to insolvency or running out of cash. Although South Africa does not have a formalised deposit insurance scheme, there remains an implicit assurance from the SARB that deposits will be covered up to R100,000 per depositor, per bank.

A key component of South Africa’s G20 reforms is the Financial Sector Laws Amendment Bill 2018 (FSLAB), which is at an advanced stage of being passed into law. FSLAB would give the SARB crucial resolution powers to restore solvency and liquidity in systemically important banks as well as to create an explicit deposit insurance scheme.

Despite a high level of readiness in South Africa and abroad, the nature of the shock at hand has central banks around the world referring to their most recent financial system stress tests in order to provide an answer.

The result of the South African Reserve Bank (SARB)’s 2018 stress test of the six largest South African banks was encouraging. Accounting for 92% of sector assets, all banks maintained capital ratios above the minimum under adverse test scenarios. Similarly, their liquidity remained sound and overall, they remained profitable despite a decline in profitability from pre-stress levels. It is clear now, however, that the current expected GDP contraction   -7.0% (SARB, 2020) is likely to exceed that of the stress test -4.8%, and this gap is at risk of widening even further under some scenarios.

<strong>Uncharted Territory</strong>

The pandemic has affected the economy in a unique way. There has been a severe dual contraction of both demand and supply, which is different from demand driven crises of the past. Further, the crisis requires a medical solution to achieve a full recovery. This is likely causing a GDP contraction of unprecedented speed and scale. The duration of the crisis and recovery period remain unclear.

According to the SARB, the actual GDP level in 2022 is now expected to be lower than 2018, meaning that the Covid shock could result in nearly half a decade of stagnant output.

As a result, the ultimate impact on the financial sector is still uncertain. Banks will likely face higher credit losses and a reduced value of some balance sheet assets. As expected credit losses rise, loans on banks’ balance sheets will be regarded as riskier and will require higher levels of capital cover. Insurance companies may also suffer higher than expected policy cancellations.

Bank exposure to sovereign credit risk has been flagged by the SARB as an increasing risk to financial stability. This is due to sovereign assets accounting for a growing proportion of bank assets, currently at 15%. Furthermore, government creditworthiness has deteriorated in recently years. Should gross government debt to GDP reach 85.6% in 2021 as estimated by the IMF, it would have trebled since 2009. As sovereign borrowing costs rise, so does cost of funding for financial businesses.

Beyond this, risks may develop that would make the recovery more difficult. Such as the possible health-related disruption to business operations, the question of what happens once banks are beyond payment holidays, whether there will be permanent loss of demand in some sectors and whether large corporates might have difficulty restarting operations and returning to full capacity. There are also unknown unknowns which have the potential to impact on SA’s highly integrated Financial System.

<strong>SARB Response</strong>

A number of urgent actions have been taken in support of the financial system. The Prudential Authority, the bank regulator, reduced both capital adequacy requirements and liquidity coverage requirements. This provided banks with a greater buffer to absorb losses before being required to raise additional equity capital, thus enabling them to continue to extend loans to customers. This measure also allowed liquidity levels to fall to lower than usual, but safe levels, without banks being in regulatory breech. Banks have also been allowed to restructure loans in good standing and provide payment holidays without recording accelerated credit losses, which protects the value of their loan assets and encourages continued lending.

To further ease strain on the system, the SARB has cut the repo rate by 2.5% to 3.75%, taking the prime overdraft rate to 7.25%, its lowest level since 1965 (Trading Economics). This significantly improves affordability of loans, reducing the current burden of debt to society. It also has the effect of increasing the value of assets in the economy, which is supportive for financial institutions. The SARB has also conducted asset purchases to provide liquidity and thereby stabilise the fixed income market. And the treasury has set up a R200 billion loan guarantee program for SMMEs, which is providing critical support to this sector, also to the benefit of banks and other financials which service this sector.

<strong>Commercial Bank Prime Overdraft Rate in South Africa</strong>

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The SARB has highlighted that the SA financial sector is experiencing an extraordinary shock. Fortunately, SARB policies as well as prudent risk management by financial firms have helped the sector weather the initial phase of this shock. South Africa is fortunate to have a developed-world financial system that will benefit from recent proactive reforms, ongoing collaboration with government, and an SARB with a broad set of policy tools to protect our currency and maintain stability in our financial system. The SARB views South African banks to be more resilient than European banks given our large capital buffers, but cautions that no bank is immune.