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South African banks set for low returns, but may see impairment reversals

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South African banks set for low returns, but may see impairment reversals

South Africa's big four banks could yet receive an earnings boost this year as they reverse some of the 75.4 billion rand — roughly $5.27 billion — in impairments they took in 2020. Yet their return on equity will likely remain lackluster due to the country's prolonged economic malaise.

Nonperforming loans at the major banks — Standard Bank Group Ltd., FirstRand Ltd., Absa Group Ltd. and Nedbank Group Ltd. — have steadily increased over the past half-decade, during which unemployment hit a record high and electricity blackouts became commonplace.

Standard Bank's NPL ratio was 6.21% in 2020, up from 4.22% a year earlier and nearly double that of 2016, according to data from S&P Global Market Intelligence. FirstRand's NPL ratio rose 109 basis points in 2020 to 5.04%, while Nedbank's surged 189 basis points over the same period.

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"While the South African banking system remains relatively robust, the key shorter-term pressure relates to the trajectory of credit losses that will materialize," said Meyrick Barker, an investment analyst at Kagiso Asset Management in Cape Town.

Credit impairment development

Over the longer term, the main headwinds for banks include competitive pressures eroding certain profit pools, and poor political decisions continuing to hamper South Africa's growth prospects, he said.

In 2020, credit impairment charges at Standard Bank and Absa each nearly tripled, to 20.59 billion rand and 20.57 billion rand, respectively, while FirstRand's increased 59% and Nedbank's rose 41%.

"The big theme is what's happening around credit losses from COVID. Banks' most recent results showed things weren't as bad as initially feared, so the question is, have banks over-provisioned?" said David Talpert, an analyst at Johannesburg-based Avior Capital Markets.

"Writing back provisions will be the theme that drives bank earnings for the next year or two."

Yet it is too early to assume there will be a substantial reversal of provisions, warned Ilan Stermer, a bank analyst at Renaissance Capital in London.

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"Banks appear to have provided adequately; delinquencies are stable for now. The biggest concern is that the expected fall-off in impairment charges doesn't happen, or takes place more slowly than anticipated," said Stermer. "There might be new loan delinquencies — not necessarily in consumer lending, but in SME and business banking. I'm not convinced NPLs have peaked."

The major banks are adopting markedly different strategies in terms of new lending.

"FirstRand is the most conservative, pulling back across the board in terms of risk exposure. Absa is the opposite and has been aggressive in trying to gain market share," said Talpert. "Standard and Nedbank are somewhere in the middle. The big question is whether this is the right time to be lending and whether more conservative banks will find it harder to win back any lost market share."

Following the global financial crisis, Absa — then owned and run by Barclays PLC — was wary of lending and lost considerable domestic market share to rivals that were less cautious. Now, Absa has refrained from paying a dividend for 2020 in order to boost capital and expand lending, which could mean its domestic fees and commission income growth outperform, said Stermer.

Fall in income, margins

Credit losses hammered banks' bottom lines in 2020. Standard Bank's net income halved year over year to 13.2 billion rand, FirstRand's dipped 41% to 18.2 billion rand, Absa's dropped 59% and Nedbank's plunged 71%.

"Where is growth going to come from? Where are volumes going to come from? These feed into revenues and profits, and if the economy is stuttering then so will bank profits," Stermer said.

"The impairment story will almost drown out any other noise in the numbers because the changes are so big. In terms of impairment charges being much smaller than last year, banks will move in concert."

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Net interest margins also slid to their lowest levels in at least five years as South Africa's central bank slashed interest rates steadily to 3.5% currently from 6.5% at the start of 2020. The four banks' margins dropped by between 16 and 35 basis points year over year.

"We could see a gradual increase in interest rates in late 2021, but we're not getting back to 2019 interest levels anytime soon, so margins will remain compressed," said Talpert.

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Absa and Standard Bank's greater exposure to the rest of Africa, where rates have remained higher, has lessened the impact of shrinking domestic NIMs.

"It seems NIMs have bottomed out," said Stermer. "If the cycle turns like we've seen in other emerging markets and interest rates start increasing then banks' NIMs will improve, but a meaningful improvement is not my base case scenario at this stage."

Return on average tangible equity has also plunged since 2019.

"From an investment perspective, you're looking at who can return nearer yesteryear ROEs soonest," added Stermer. "A three-year recovery seems plausible — it will be gradual and lukewarm, and I don't see ROEs returning to near pre-COVID levels."

"FirstRand has the strongest franchise, especially in retail, which enables it to have a higher ROE, while the likes of Absa and Nedbank are structurally lower ROE businesses and, because of that, will probably continue to trade below book value for the foreseeable future," added Talpert.

As of April 28, US$1 was equivalent to 14.28 South African rand.