South Africa's banks face higher costs and increased liquidity risk after the country failed to meet all the requirements of an international financial crime watchdog.

The Financial Action Task Force, or FATF, on Feb. 24 added South Africa to its so-called gray list of countries that are subject to increased monitoring. The FATF said South Africa should, among other things, improve information-sharing, do more to prosecute suspected money laundering and terrorism financing cases, and implement penalties more strictly.

FATF decisions can strongly influence investors' perceptions of a country's risk. The gray listing may cause foreign investors to downscale exposure, which could generate funding difficulties for banks and their customers, according to a report by S&P Global Market Intelligence analysts. It will also lead to higher transactional and administrative costs as correspondent banks require tighter screening, and to higher operational requirements for international transfers, the analysts said.

The main consequence of the gray listing is that it will be "much harder" to attract foreign capital, Jee-A van der Linde, a senior economist at Oxford Economics in Cape Town said. "The reputational damage is quite regrettable, and the gray listing just adds to the prevailing negative sentiment surrounding South Africa."

Cost concerns

South Africa's largest banks, Standard Bank Group Ltd., FirstRand Ltd., Absa Group Ltd. and Nedbank Group Ltd., already have a high cost burden. As of June 2022, their cost-to-income ratios ranged from 54% to 59%, compared to an average of 40% at banks across the Middle East and Africa region.

"For a corporate in a graylisted country, everything slows down, gets more expensive, and more uncertain," a spokesperson for Standard Bank told S&P Global Market Intelligence before the grey listing. "They face a lot more red tape — higher compliance costs, more audit requirements, and longer delays — in what should be simple matters like getting letters of credit, clearing foreign payments, and even just establishing relationships with would-be foreign suppliers of inputs and purchasers of their products."

The FATF action will raise the cost of transactions as some foreign financial institutions will apply additional controls to transactions involving South African entities and individuals, Absa said in a statement on its website in the wake of the graylisting. It "will likely increase the cost of compliance for all South African banks and make it harder to access international financial markets and facilitate cross-border transactions," Absa wrote. The bank declined to comment further to Market Intelligence.

A Nedbank spokesperson said the graylisting may hamper investment and international financial transactions due to reputational damage. The country's banks count many foreign investors among their shareholders, including BlackRock Inc., Vanguard Group Inc. and Norges Bank Investment Management.

The graylisting was "avoidable" and relates to a part of South Africa's economy — its banking and financial services industry — that is "world-class in its composition and performance," said Adrian Saville, Professor at Johannesburg's Gordon Institute of Business Science and Investment Specialist at Genera Capital. "The sector has been a real standout feature in a sluggish economy."

South Africa's economy shrank 1.3% in the fourth quarter of 2022 as seven of the country's 10 biggest industries contracted, official data shows. This was a steeper decline than economists' consensus forecast of a 0.4% contraction, according to an Oxford Economics report. Six sectors remain smaller than they were before the pandemic, although the financial, real estate and business services industry has grown 8% over the same period.

Solid revenues

The FATF sanction will not necessarily impact business within South Africa, since most banks already operate in jurisdictions that have been graylisted and, therefore, have the risk management systems in place to cope, said Van der Linde.

Furthermore, banks are benefiting from rising central bank rates. Most corporate and retail loans are on variable interest rates, meaning lenders can reprice loans upwards, boosting lending income and margins. Net interest income at Standard Bank is projected to increase by 15% year over year in 2023, and by nearly 10% at FirstRand, according to analyst consensus estimates compiled by Market Intelligence.

"With [this] endowment effect and non-interest revenue also growing quite strongly, banks' cost-to-income ratios are falling," Adrienne Damant, an equity analyst at Avior Capital Markets in Johannesburg, said. "We're still bullish on banks," Damant said, highlighting lenders' "relatively manageable" credit loss ratios.

Grayed out

The CEO of Investec Bank Ltd., South Africa's fifth-largest bank by assets, said in a statement that the consequences of graylisting would be limited in the short term, but felt more keenly if the country does not get off the list by 2025.

FATF removed Mauritius from its graylist in October 2021, 20 months after the island nation was added. Mauritius implemented various reforms requested by FATF.

"If a country gets its act together, it can leave the graylist swiftly, but comparing what South Africa has delivered in terms of important structural reforms versus what it promised would indicate that we're unlikely to implement the necessary changes as quickly as Mauritius did," said Saville.