Major Factors

Rationale

S&P Global Ratings classifies the banking sector of South Africa (foreign currency BB-/Stable/B; local currency BB/Stable/B) in group '6' under its Banking Industry Country Risk Assessment (BICRA). Its closest peers are Brazil, Morocco, Bahrain, Oman, Russia, and Thailand (see chart 1). India and China, which we also consider to be major emerging national economies, are also in group 6.

Chart 1

We use our BICRA economic risk and industry risk scores to determine a bank's anchor, the starting point in assigning an issuer credit rating. The anchor for banks operating only in South Africa is 'bb+'. South Africa's economy faces a sharp contraction in 2020 due to weak economic prospects and global market dislocations because of COVID-19, which led to significant portfolio outflows in the first quarter of 2020 and a depreciated South African rand. We estimate that the South African economy will contract by 6.9% in 2020, largely due to the pandemic, before rebounding to 4.7% in 2021. The combined effect of COVID-19-related uncertainties and the expected exit of South African bonds from the FTSE Russell WGI index in May 2020 will likely create portfolio flow volatility throughout 2020. We anticipate total private sector credit (defined as total household debt, corporate debt from the banks, and capital markets) will contract to about 80% of GDP through 2021 because of the current recessionary conditions across the globe. We forecast credit to the private sector will shrink by about 5% in 2020, followed by low-single-digit growth in 2021. We expect sector credit losses will rise to about 1.8% in 2020, mostly affecting retail and small and medium enterprise (SME) loans. Households pose a material risk for banks because of their relatively high leverage and low and declining wealth levels. Household leverage (defined as household debt to disposable income) averaged 72% over the past three years. Household debt metrics, including affordability, will come under pressure in 2020 despite lower interest rates. In addition, we expect stress in the commercial real estate sector due to a prolonged economic lockdown and the gradual reopening of the economy in 2020.

The South African Prudential Authority, in line with other G-20 regulators, has been proactive about restructuring, capital relief, and liquidity measures to support banks in their payment relief efforts in 2020. We expect banks' regulatory capital will remain strong, despite marked strain on revenue in 2020-2021. The South African banking sector has made progress in restructuring its funding base, but continues to be exposed to concentrated short- and medium-term wholesale funding from nonbank financial institutions. The South African Reserve Bank's liquidity support via the repurchasing market will ease pressure on banks and asset managers' liquidity requirements, with depositors and investors continuing to favor cash. Furthermore, in a crisis, rand liquidity will remain in the country because of resident exchange controls, which mitigates banks' exposure to institutional funding. Additionally, major banks are not exposed to large-scale refinancing risk or a reversal of investor sentiment thanks to their limited exposure to international funding. This positively differentiates the South African banking sector from other emerging market banking sectors. We continue to believe that a deposit insurance scheme, and ultimately an effective resolution regime, will be implemented over the next 12-18 months.

Until we have more clarity on the resolution regime implementation, we do not apply extraordinary support in the form of additional loss-absorbing capacity (ALAC) to our issuer credit ratings on South African banks.

Economic And Industry Risk Trends

The negative economic risk trend incorporates our expectations of a sharp economic contraction in 2020, exacerbated by volatile portfolio flows. We expect credit losses to reach about 1.8% of total loans in 2020. That said, there is material risk to our base case as the crisis unfolds in 2020. Although not our base case, credit risks could exceed our expectations if the implementation of the land reform infringes on enforceability of contracts and property rights, potentially undermining banks collateral.

Our view of stable industry risk trend is underpinned by an effective and proactive regulation and supervision, as well as good capitalization across the South African banking sector. The recent regulatory measures toward capital relief and liquidity support are positive and in line with measures taken by European regulators. This will in turn support the stability of the banking sector funding and capitalization, despite pressure on profitability from higher impairments.

Economic Risk  |  7

Economic resilience: High risk assessment reflects expected sharp economic contraction and lower wealth levels in South Africa

Economic structure and stability.  South Africa's already contracting economy will face another sharp COVID-19-related downturn in 2020. In the second half of 2019, the economy shrank partly due to a set of severe rolling power blackouts. The COVID-19 health crisis will create additional headwinds to GDP growth, owing to a strict domestic lockdown and gradual opening of the economy in 2020, the markedly weaker external demand outlook, and tighter credit conditions. We forecast a sharp economic contraction of 6.9% in 2020, followed by a rebound of 4.7% in 2021 (see chart 2). South Africa is a middle-income country; we estimate GDP per capita at about US$5,000 in 2020, a sharp fall from about US$6,000 in 2019. The economic underperformance of a rather diversified economic base stems from structural constraints, spanning from infrastructure gaps to social inequalities and rigid labor market that are yet to be addressed through reforms. The country faces considerable challenges, including a wide fiscal deficit recently worsened by the coronavirus pandemic.

Chart 2

Macroeconomic policy flexibility.   We consider the South African Reserve Bank (SARB) to be independent, transparent, and credible. We expect the SARB to maintain policy and operational independence over the forecast period. The recent portfolio outflows and other constraints have led to a pronounced steepening of the domestic yield curve. In the backdrop, lower oil prices in 2020 and lower inflationary pressures have given the SARB room to cut rates swiftly in order to ease credit conditions as the economy faces a sharp contraction. The SARB targets inflation between 3% and 6%. Inflation has been on a steady downward path since 2017, landing at 4.1% in March 2020 from 6.7% at end-2016. Inflation will remain well within the SARB's target range of 3%-6% over 2020-2022. The repurchase rate, which is the bank's most important monetary policy instrument, has been cut twice by 100 basis points at its March and April meetings; it was dropped another 50 basis points in May to 3.75%. We believe inflation will remain largely within the target range for the rest of our forecast period through 2023.

Year-to-date capital flight out of emerging markets (EM) has been particularly acute in South Africa, which has been partially reliant on non-residents to fund material current account deficits over the years. The outflows, among other factors, have led to a meaningful depreciation in the South African rand, which has lost about a quarter of its value in 2020, one of the largest moves of any major EM currency.

The notably weaker macroeconomic environment will weigh heavily on fiscal revenues. We expect a double digit headline fiscal deficit digit in 2020. COVID-19 fallout is likely to translate into a far higher annual interest bill for South Africa, with interest expenditure increasing above 20% of government revenue. In these stressed market conditions, the government will continue to rely on the depth and liquidity of the South African capital market to meet its financing needs, but at a higher risk premium.

Political risk.   South Africa's response to the evolving global health crisis has been strong, characterized by very strict mobility restrictions. The subsequent economic impact will likely be equally deep. In the meantime, decisive leadership actions have garnered political and social support, at least for the short term. That said, the medium-term effects are less certain.

Table 1

Economic imbalances: Credit losses will rise in 2020 amid a sharp economic contraction and market volatility

Private sector credit growth.   Given the high levels of economic uncertainty and recessionary conditions stemming from COVID-19, we forecast total private sector credit (defined as total household debt, corporate debt from the banks, and capital markets) will shrink by about 5% in 2020. We estimate that the banking sector will contract over the next two years since credit growth and profitability will be weaker through 2021. The economic crisis brought on by the pandemic has led to global market dislocations and massive portfolio outflows in March 2020. This, combined with the anticipated drop of South African bonds from the FTSE Russell World Global Index in May 2020, provoked a steepening of the government bond yield curve and tighter credit conditions. The South African rand (ZAR) depreciated to about ZAR20/$1 in first-quarter 2020 from an average of ZAR15/$1 in 2019. In this context, the SARB cut its benchmark rate three times between March and May to 3.75% amid a moderate inflation target. We anticipate that portfolio flows will return eventually, on the back of lower valuation of assets in South Africa. Nevertheless, investors will likely weigh the attractiveness of these asset prices against rising economic risks in a context of lower returns.

Credit conditions will remain tight despite lower interest rates. We include in our lending growth forecasts the uptake of ZAR100 billion bank loan guarantee program to SMEs. The sector was in a weak expansionary phase until recently. Credit to the private sector has increased by less than 1% of GDP over the past three years. Banks have been extending credit slowly and with increasing conservatism amid challenging economic conditions. Household lending growth, which is generally more cyclical and susceptible to the macroeconomic environment, was stable at 6% in December 2019. Corporate lending, which had propelled growth for the banking sector prior to 2018, grew moderately in 2019 (4.1%) thanks to low business sentiment and economic challenges.

Signs of stress will increase on the fringes of the commercial real estate sector, amid strict economic lockdown and working from home measures. Office vacancy rates have risen in recent years and construction sector growth has slowed significantly since the last wave of projects in anticipation of the 2010 football World Cup. We expect higher credit losses will stem from banks' income-producing real estate exposures despite the relatively low leverage. A proactive policy response, including the decision to go into one of the world's strictest lockdowns relatively early, will be detrimental to consumer spending. As a result, pressures on retail companies will likely hinder commercial properties performance in 2020. SMEs will also be affected by the long interruption of their business activities. Banks' exposures that were already vulnerable prior to the pandemic will likely be recognized as such. We believe that banks will support existing clients to the extent that they can safeguard the stability of their balance sheet and good capitalization levels.

Real estate prices.   The South African residential market has recorded flat growth in real terms over the past four years (see chart 3). It has been sustained by historically modest interest rates and slow growth in housing supply. We assume the residential market will contract in 2020 as affordability and income pressures will likely affect more severely the lower income segment, which has been growing faster in the past few years. Commercial real estate's performance in the capital markets has fluctuated, but leverage and credit losses in the banking sector have remained low. However, gradual economic opening following weeks of a strict lockdown will likely intensify pressures for income-producing real estate exposures and office space already suffering from rising vacancy rates.

Chart 3

Equity prices.   The EM sell-off in March 2020 resulted in the JSE FTSE All Share index shedding 23% in the first three months of 2020 (see chart 4) after finishing 2019 with an 11% increase. We expect the rand will remain volatile through 2020 as flight to safety continues amid global uncertainties and domestic investors stay liquid despite lower asset valuations.

Chart 4

Current account and external debt position.   South Africa's external assets (stock of assets) are overwhelmingly denominated in foreign currency, whereas its external liabilities are predominantly denominated in local currency. A weakening of the rand therefore improves the country's net external creditor position vis-à-vis the rest of the world. The return on South Africa's investment in companies abroad largely offsets the foreign currency payments the government makes to non-resident holders of its domestic debt, and on balance, we forecast South Africa will maintain a small net-external-asset position of 13% of current account receipts by 2023.

As an energy importer, the drop in oil prices will ease some of the external pressures, but the closure of the export sector amid COVID-19 restrictions, including most mines, will dampen the positives. Overall, we expect the current account will narrow sharply this year to -0.7% of, on the back of a timely depreciation in South Africa's real effective exchange rate as well as weak growth, and will average -1.9% in 2020-23.

Table 2

Credit risk in the economy: Declining wealth levels and high household leverage are key risks

Private-sector debt capacity and leverage.   The South African private sector has a lower debt absorption capacity due to lower wealth levels and wide income disparities compared with peers. We estimate South Africa's GDP per capita at close to US$4,800 in 2020, a sharp fall from about US$6,000 in 2019. Real GDP per capita has been shrinking since 2014, exacerbated by the depreciation of the rand. Overall, private sector leverage (including total household debt, corporate credit from the banks, and internal and external capital markets) to nominal GDP compares adequately with most peers, averaging 86% over the past three years (see chart 5). We forecast that this metric will trend below 80% of GDP in 2020-2021 as we foresee a contraction of lending for the same period.

Chart 5

Domestic households pose a meaningful risk for banks because of their relatively high leverage and low wealth levels compared with other EMs. Household leverage (defined as household debt to disposable income) averaged 72% in the past three years. Household debt metrics, including affordability will come under pressure in 2020 due to external shocks and the economic crisis. Lower interest rates on the back of moderate inflation in 2020 will alleviate debt service somewhat against income pressure. We forecast South African household net assets as a share of GDP will remain above 100% through 2020.

Banks' risk appetite has moderated over the past decade in the aftermath of the global financial crisis and prolonged sluggish economic growth that restricted access to long-term secured credit due to changes to affordability guidelines in favor of shorter-term, higher-margin loans. The trend in mortgages has stabilized after a rapid deleveraging in 2008-2011. The nature of household leverage has changed since the last global financial crisis, with unsecured lending and installment credit growing faster as households experienced income pressure.

Corporate lending growth, which drove banking sector growth since 2013, has decelerated since 2015 amid low business confidence (see chart 6). This trend will likely persist amid the global economic contraction and a lack of reform momentum in South Africa. We foresee a deterioration in the quality of the corporate loan book as a result of these adverse trends, due to the high leveraging of recent years. It is still early to determine the reach and impact of the government support package to SMEs (with a maximum turnover of ZAR300 million) as the scheme entails a small first loss portion for banks.

Chart 6

Public sector lending (including the embattled state-owned enterprises [SOEs]) accounts for less than 3% of direct lending from the banking sector. Overall, we expect credit losses to increase to about 1.8% for the sector in 2020, versus 0.7% for top tier banks in 2019. Our current assumptions entail material risks.

Lending or underwriting standards.  We view major banks' reduced appetite for unsecured credit as appropriate for the level of economic risk in the country. Rated top-tier banks have historically maintained relatively low single-name and industry concentrations, while their exposure to the more risky commercial real estate sector averaged 7% of total loans in 2019, stemming largely from income-producing assets. We estimate that approximately two-third of outstanding mortgage stocks have a loan-to-value (LTV) below 80%. However, more recent LTV ratios for residential mortgages have been more aggressive, especially for prime real estate, with new mortgages often receiving LTVs above 80%. Foreign currency lending is limited compared with most peers and has been stable, accounting for 9% of total loans in 2019 (see chart 7). The banking sector primarily operates with rather simple and straightforward products, and there is currently limited use of securitization and derivatives to shift risk off balance sheets.

Chart 7

Payment culture and rule of law.   The political discourse regarding corruption and state capture at the very highest levels has tested the strength of South Africa's institutions. This is shown in the average corruption and rule of law indices, which have decreased steeply in the past few years, as published by the World Bank. South Africa ranked 73 out of 180 countries in terms of corruption perception index. Important reforms aimed at restoring the credibility of South Africa's weakened institutions have started, thus strengthening governance at SOEs and reinvigorating the National Prosecuting Authority (NPA) to act swiftly against corruption. Despite these efforts, we do not rule out strain on South Africa's rule of law, particularly in the context of the land reform without compensation if it undermines the enforceability of contracts and property rights.

Table 3

Base-case credit losses.  We expect credit losses will increase to about 1.8% from an average of 0.7% for top tier banks in 2019. There is a material downside risk to our current base-case scenario as the crisis continues to unfold in 2020-2021. We expect significant migration from stage 1 to stage 2 loans due to the pandemic and migration to stage 3 for distressed exposures. That said, South African banks' loan loss experience compares adequately with its peers(see chart 8). There is a pronounced distinction between top-tier banks' and second-tier banks' credit losses due to the unsecured lending exposures of the latter's.

Provisioning levels have improved across the system since 2017, partly due to the change in the nonperforming loan mix toward unsecured from secured lending, and IFRS 9's new impairment charges rules. Historic provisioning levels of the major banks were too low for the level of economic risks and the high household debt metrics, and the credit losses emanating from secured lending during the 2008-2009 downturn.

Chart 8

Table 4

Industry Risk  |  5

Institutional framework: South African regulation, supervision, and transparency are in line with international best practices

Banking regulation and supervision.   The SARB remains resolutely independent and its oversight of banks is at par with global best practices. In line with other G-20 central banks, the SARB cut its benchmark rate several times between March and May 2020 to ease credit conditions due to the global health and economic crisis. It has also provided additional liquidity in exchange for repos on an intraday basis to banks and asset managers who hold government bonds to ensure the normal functioning of the money markets. It lowered the standing facility borrowing rate to support the flow of money market liquidity in the interbank market and will also intervene in the secondary bond market on a case–by-case basis.

The Prudential Authority (PA) 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). To alleviate COVID-19 fallout on banks' capitalization, the prudential authority provided capital relief measures, which lowers temporarily the Pillar 2A capital requirement to zero and allows banks to use the capital conservation buffer if needed. These measures are temporary and we expect the PA to reinstate them through 2022.

Furthermore, we continue to believe that a deposit insurance scheme, and ultimately an effective resolution regime, will be introduced but timeline has become uncertain in the wake of the current global crisis. At this stage, we do not apply extraordinary support in the form of ALAC to our issuer credit ratings on South African banks.

Regulatory track record.   The SARB continues to support liquidity in the repo market and protects the sector against external shocks, through the exchange controls limits. The central bank provided significant interest-rate cuts to support the economy and households when the cycle turned in 2009. It did so again in 2020 as the EM outflows tightened credit and liquidity conditions. The SARB's independence is a key pillar to robust, transparent financial institutions. Any erosion of this independence would weaken our view of the institutional framework.

Governance and transparency.  The major banks' early adoption of both the IFRS and Basel accords has increased the depth and quality of accounts disclosure and means annual reports conform with international standards. Furthermore, listing on the JSE requires high levels of transparency as well as rigorous and timely disclosures.

Competitive dynamics: High barriers to entry and strong profitability underpin stability

Risk appetite.   South African banks generally display strong and stable returns, resulting from good recurring fee income and generally good risk controls. The return on equity (ROE) for top-tier banks averaged 16.6% in 2019, despite persistent challenging economic environment. We expect the banking sector's ROE to deteriorate sharply, reaching an average 10% in 2020 due to higher cost of risk and lower net interest margin. That said, we view the major banks' generally modest credit losses through a protracted weak economic environment to be a sign of proactive risk management and low risk appetite.

Industry stability.   The oligopolistic nature of the banking sector, with the five major banks accounting for over 90% of total system assets (see chart 9), underpins market stability and creates high barriers to entry.

Chart 9

We believe the entrance of digital banking solutions will accelerate the cost optimization of the large banks. Leading banks have embarked on technological transformations to improve efficiency and meet changing customer needs in response to increasing pressure on revenue. In our view, banks' digital capabilities will serve as a catalyst in managing their transition into agile credit organizations by controlling operational and credit costs; and will be a critical differentiator in their creditworthiness over the medium term.

Furthermore, we expect banks to remain well capitalized above minimum regulatory ratios (see chart 10), despite the economic downturn and higher credit losses.

Chart 10

Table 5

Systemwide funding: Short-term wholesale funding mitigated by the closed rand system and SARB's liquidity Support

Core customer deposits.   The South African banking sector continues to derive funding predominately from short-term deposits. In addition, the banks are exposed to concentrations from nonbank financial institutions since contractual savings tend to be dominated by professional money managers. The majority of this funding is short term (less than 12 months). To reflect this, we stripped financial institution corporate funding from our core funding metrics, which are lower than most peers (see chart 11). We also believe that this source of funding is stable given the structure of the South African financial system with a matured asset management industry, which funding is denominated in local currency.

Chart 11

Furthermore, we believe this risk is mitigated by exchange controls that mean rand liquidity remains in the country. These controls limit resident outflows to ZAR2 million per person, or 25% of total liabilities (excluding equity) for corporates, including banks. In addition, exchange controls have helped limit overall nondomestic risk, such as exposure to risky structured products and sovereign foreign debt. Consequently, outside of idiosyncratic events, a systemwide liquidity issue is less likely in normal times. Moreover, banks' liquidity position is supported by the mechanics of domestic settlement and the clearing of payments, dominated by the major banks.

The EM sell-off triggered significant outflows in March 2020. This comprised ZAR90billion ($4.8bil) leaving the bond market and ZAR30billion ($1.6bil) selling from equities. Almost 40% of government bonds were held by non-res investors prior to the crisis. This materially set back the system's liquidity, since fund managers had to meet investors' redemptions and depositors converted their term deposits into cash. The global market dislocations and the anticipated exit of South African bonds from the FTSE Russell WGBI prompted the SARB to provide liquidity support to the banks and the asset management industry through the repo market on an overnight basis. The volume of these windows have reduced significantly by mid-April, which is a sign that liquidity has been restored in the market as capital flows started to return in April. We expect more adjustment in the next few months after the new calibration of the WGBI took place in May and the the global economic crisis unfolds.

Similarly to peers like in Thailand, the SARB's approach to intervene in the secondary bond market aims at alleviating the liquidity stress. The SARB is not increasing the amount of bond purchased, but rather temporarily providing liquidity by purchasing government securities in the secondary market. Meanwhile, the SARB also lowered the Liquidity Coverage Ratio (LCR) to 80% from April 2020 in anticipation of potential volatility of this ratio if outflows and uncertainties persist. They opted for the measure in line with other regulators actions as opposed to granting liquidity through the Comitted Liquidity Facility (CLF) that they decided to wind down through 2022. The introduction of a national discretion on the net stable funding ratio (NSFR) and banks' progress in restructuring their funding profile has helped the sector meet the Basel III funding and liquidity ratios ahead of schedule.

External funding.   The South African financial sector has a neutral external position, with very little external debt and some capital and loans in foreign subsidiaries. Consequently, the major banks are not exposed to large-scale refinancing risk or a reversal of investor sentiment due to their lack of exposure to international wholesale market-based funding (see chart 12).

Chart 12

Domestic debt capital market.  A credible and effective monetary policy framework supports South Africa's moderately broad and deep debt capital markets. The South African Rand is free floating and is an actively traded currency among emerging markets currency. About two-thirds of the bond market is dominated by government issuance, with private-sector issuance dominated by bank borrowers, blue chip corporates, and SOEs. Year-to-date capital flight out of EM assets has been particularly acute for South Africa, which has been partially reliant on nonresidents to fund material current account deficits over the years. The outflows have led to a significant depreciation in the rand, which has lost about a quarter of its value this year.

Government role.  The SARB introduced a national discretion for banks to meet a modified Basel III NSFR. In addition, the SARB's ZAR240 billion (about $13 billion) CLF, facilitating the phase-in of the LCR. We believe that the central bank stands ready to introduce other funding mechanisms along with the new regulation. Equally, given the progress that leading banks have made in restructuring their funding profiles, and the compliance with Basel III funding and liquidity ratios ahead of schedule, we anticipate that the winding down of the CLF by 2022 will not jeopardize their ability to comply with the LCR going forward.

Table 6

Peer BICRA Scores

Our view of the banking sector in South Africa compares better than peers while our assessment of economic risks compare less favorably.

Table 7

Government Support

We consider South African government support toward the banking sector to be uncertain. In our view, the resolution of African Bank, and associated bail-in of its subordinated note holders and haircut of senior creditors' claims, demonstrates that the authorities have the appetite and ability to address future bank failures. Furthermore, the SARB recently published a proposal on its resolution framework, further supporting our view that this is at the forefront of the regulator's agenda. We will be looking for clarification of a few elements including the finalization of creditor hierarchy by establishing the sequence of holding company versus operating company in a bail-in scenario, the applicable loss-absorbing instruments, and the ratios for loss-absorbing capital. Until these are clear, we do not apply our ALAC criteria for issuer credit ratings on South African banks.

Table 8

Related Criteria

• General Criteria: Group Rating Methodology, July 1, 2019
• General Criteria: Hybrid Capital: Methodology And Assumptions, July 1, 2019
• General Criteria: Methodology For National And Regional Scale Credit Ratings, June 25, 2018
• Criteria | Financial Institutions | General: Risk-Adjusted Capital Framework Methodology, July 20, 2017
• General Criteria: Methodology For Linking Long-Term And Short-Term Ratings, April 7, 2017
• Criteria | Financial Institutions | Banks: Quantitative Metrics For Rating Banks Globally: Methodology And Assumptions, July 17, 2013
• Criteria | Financial Institutions | Banks: Banks: Rating Methodology And Assumptions, Nov. 9, 2011
• Criteria | Financial Institutions | Banks: Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011
• General Criteria: Use Of CreditWatch And Outlooks, Sept. 14, 2009

Related Research

• Banking Industry Country Risk Assessment Update: June 2020, June 26, 2020
• South Africa, May 22, 2020
• Various Rating Actions Taken On South African Banks Following Sovereign Downgrade, May 7, 2020
• South Africa Ratings Lowered To 'BB-' From 'BB' As Covid-19 Further Impairs Fiscal And Growth Prospects; Outlook Stable, April 29, 2020