South African banks have exhibited resilient performance in a context of ongoing regulatory changes, notably the implementation of Basel III capital and liquidity buffers, and the adoption of International Financial Reporting Standard (IFRS) 9 provisioning rules.

The South African Reserve Bank (SARB), the central bank, remains resolutely independent and its oversight of banks is in line with global best practice. The year 2018 was a regulatory milestone: Banks fully implemented Basel III standards and the SARB introduced "twin peaks" regulation. Financial sector regulation is now split between two bodies, the Prudential Authority, whose job is to maintain the stability of the financial system, and the Financial Service Conduct Authority, responsible for market conduct and consumer protection. While the transition will take some time, the adoption of twin peaks underpins the SARB's commitment to a more integrated financial supervision model. We also expect the regulator will make some tangible progress on the resolution regime over the next 12-18 months.

We expect South African banks' good earnings resilience will continue, despite muted lending prospects in 2019. The South African economy is struggling to grow in 2019 amid power shortages and upcoming elections, which will in turn constrain credit and revenue growth. Nevertheless, banks in South Africa have historically displayed strong and resilient returns, resulting from good recurring fee income, and generally good risk controls. We expect this trend to continue through the uncertain year ahead (chart 1).

Chart 1

Nonperforming loans are not declining and cost of risk will increase marginally as a result of new provisioning rules under IFRS9. We view the major banks' generally low credit losses through a protracted weak economic environment as a sign of low risk appetite. Overall, we expect credit losses for the top-tier banks will range between 1% and 1.2% in 2019. Structural imbalances to banks' funding and liquidity profile remain, but they are largely mitigated by the closed rand system, which means that rand liquidity will remain in the country because of exchange controls that limit resident outflows for corporates, including banks.

Ratings On Top-Tier Banks Are Capped By The Sovereign Rating

We have a stable outlook on all our South African bank ratings, largely reflecting the outlook on the sovereign and our expectation that banks' financial profiles will remain stable over the next 12 months. We believe that top-tier banks' intrinsic creditworthiness is better than that of the sovereign, as reflected by their higher stand-alone credit profiles (chart 2). We do not rate South African banks above the sovereign rating because of the likely direct and indirect influence of sovereign distress on their operations, including their ability to service foreign currency obligations.

The creditworthiness of the local big five banks is supported by their dominant market share at home (chart 3), stable competitive dynamics, and high barriers to entry.

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Credit Growth Is Muted

Private sector leverage is higher in South Africa than in most peer countries (such as India and Turkey), and likely to remain stable in the next 12-18 months (chart 4). This has implications for banks' credit profiles, given the high household indebtedness in a context of low wealth levels, as well as for economic growth as consumer credit growth is a key economic lever. We forecast GDP will grow to about 1.5% in 2019 amid power shortages and still-low investor confidence.

We expect modest growth in retail lending over the next 12-18 months. Overdrafts and credit cards supported the trend in consumer credit, while leasing financing has fallen over the past 10 years. Growth in mortgages has stagnated at an average of 3.25% per year since 2009. Corporate lending, which has been the engine for banking sector growth since 2013, also slowed down in 2018 (chart 5).

The sluggish economic environment in South Africa will encourage banks to continue their push into Africa and other key markets to increase growth and revenues in 2019.

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Economic Imbalances Are Rising Slightly From Low Levels

In contrast with other emerging markets, economic imbalances have remained low. Commercial real estate continues to exhibit lower credit losses than we would normally expect in a muted environment, partly because leverage is low for such exposures. That said, risk may be building, given the rise in commercial office vacancy rates and lower consumer spending. We see signs of stress in the construction and retail industries, but still expect the quality of the corporate loan book will outperform that of household loans in 2019. Domestic household leverage is the most significant source of risk for the sector because of low wealth levels in South Africa compared with other emerging markets (chart 6).

The risk of capital outflows persists on the funding of the current account deficit, which we forecast will stabilize at about 3% of GDP (chart 7). Foreign investors hold nearly $20 billion in government local currency debt. Portfolio flows can be susceptible to changes in foreign investor sentiment, and an increase in U.S. interest rates.

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Banks' Financial Profiles Are Holding Up

We expect provisions will increase mildly and average 120 basis points (bps) for the sector, after the adoption of IFRS9 in 2018. This compares well with most peers (chart 8). Most banks have adopted the three-year transitional arrangement that will allow them to reduce the impact on their common equity Tier 1 (CET1). On average, the impact of IFRS 9 on top-tier banks' CET 1 ratios has been less than 50 bps and neutral to our measure of banks' risk-adjusted capital (RAC) ratio. Top-tier South African banks remain well capitalized against Basel III capital ratios (chart 9), but we assess their capital and earnings as moderate under our risk-adjusted capital framework. This stems from the application of higher risk weights to exposures in South Africa, which reflects our view of higher economic risks of operating in the country.

Foreign currency lending is not a key risk for South African banks. We expect it to remain below 8% of total loans in 2019-2020, compared with 13% in 2015 (chart 10). South African banks have had a lower appetite to lend in foreign currency compared with some of their peers. They have also reduced their share of foreign currency lending over the past few years to maintain their net interest margin, given the differential of interest rates, which favors local currency loans. While South African households have been affected by the volatility of the rand through inflation, the currency movements have not affected banks' overall asset quality, since major banks rapidly exited the unsecured credit class, which is the most vulnerable to shocks.

South African banks generally display strong and stable returns, resulting from good recurring fee income and generally good risk controls (chart 11). They have been trying to improve their cost base as pressure on revenues has been increasing. We expect banks will continue to invest in their digital platforms and capabilities and rigorously control costs. In our view, banks' success in managing their transition to agile credit organizations by controlling operational and credit costs will be a key differentiator of their creditworthiness over the medium term.

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Stable Funding Profiles, Despite Some Inherent Domestic Constraints

Despite the constraints of their funding profile, which is one-third short-term wholesale funding, South African banks met the Basel III liquidity coverage ratio ahead of schedule, partly thanks to the SARB's provision of a committed liquidity facility. In addition, thanks to the domestic exceptions that the regulator introduced, banks were all compliant with the minimum net stable funding ratio of 100% that was first implemented in 2018. Still, the closed rand system mitigates systemwide liquidity risk in our view. More positively, there is little external debt and some capital and loans in foreign subsidiaries. Consequently, major banks are not exposed to large-scale refinancing risk or a reversal of investor sentiment since they have little exposure to international wholesale market-based funding. This is a positive differentiator over some other emerging markets (chart 12).

Regulatory Progress Continues

Two major regulatory milestones were met in 2018: The introduction of two new regulators (the Prudential Authority and the Financial Services Conduct Authority) and the completion of the phased-in adoption of Basel III rules.

The South African regulator continues to be an early adopter of global best practices. South African banks have successfully implemented Basel III capital ratios (with the exception of the countercyclical capital buffer, which is not required in South Africa) and liquidity ratios. We expect the SARB's committed liquidity facility to fall away by the end of 2022 as banks have fully complied with the liquidity coverage ratio ahead of schedule. IFRS 9 came into effect on Jan. 1, 2018, for banks with a fiscal year end in December. We expect that an additional pack of reforms will be introduced gradually to meet Basel IV requirements.

Furthermore, we continue to believe that deposit insurance, and ultimately an effective resolution regime, will be introduced over the next 12-18 months. At this stage, we do not apply extraordinary support in the form of additional loss-absorbing capacity to South African bank issuer credit ratings.

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