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We’ve recently seen the failure of African Bank, rising concerns about Capitec and other lenders, and the credit rating downgrade of the Big-4 South African Banks. In this Q&A, Futuregrowth Asset Management offers some context to these events.
Is Capitec the next African Bank?
While Capitec is facing the same macro-economic headwinds and consumer strains as African Bank, Futuregrowth’s view is that Capitec is not another “African Bank disaster in the making” for the following reasons:
- Capitec is still 1st generation owner-managers with their “hands on the tiller”. African Bank’s management (with the exception of the previous CEO Leon Kirkinis) was largely 2nd or 3rd generation, and the shareholdings more widely dispersed. Capitec’s management is more risk averse than African Bank’s.
- Capitec has more honest and robust provisioning for bad debts in their asset book than African Bank had, as well as more conservative treatment of rescheduled loans.
- Capitec had taken the strategic choice to run a service providing bank and thus has a better customer relationship model, and alternative fee and funding sources.
- Capitec was therefore slightly less driven to chase market share in lending than African Bank.
- Importantly, Capitec’s loan collection model is better than African Bank’s: Capitec generally gets their customers to open bank accounts and deposit their paychecks, while African Bank relied on debit orders.
- It appears Capitec has a less expensive branch infrastructure and therefore has better economies of scale than African Bank.
- Capitec has a reported capital adequacy ratio of 39%, which is considered robust.
- Finally, one can’t help but notice that Capitec’s largest competitor has just been hampered, which should reduce competitive pressures.
Capitec’s institutional funding has an average term of 36 months, and they receive over 60% of their funding from retail deposits: This means the destructive power of nervous institutional investors is muted, but (in a country without deposit insurance) a skittish consumer could cause large withdrawals. We think that is one reason for Sarb’s extraordinary and (to our memory) unprecedented public statement of support on the weekend of August 16, 2014 following Capitec’s downgrade by Moody’s.
What are the implications of Capitec’s credit rating downgrade?
We saw the Capitec downgrade as the thin-edge-of-the wedge for all South African banks to be downgraded - Capitec was first merely because of its exposure to the unsecured lending market.
The fact is that the African Bank restructuring (bail-in?, bail-out?, resolution?) is a template for future bank failures. The notable points are that:
a) A South African bank has essentially been allowed to fail, and banks in the future will likewise fail. In fact, Sarb’s statement said “a bank should be able to fail without affecting the system.”
b) All investors, save for individual/retail depositors, suffered losses. Equity, preference shares, and subordinated debt appear to have been entirely denuded, while senior debt suffered a 10% haircut. The taxpayer, through Sarb’s purchase of African Bank’s “bad loan book” for R7bn, is taking risk with capital, but also has a first lien on the “bad” assets purchased for a discount. Further, it’s noteworthy that the other banks in the system have been tapped (strong-armed?) to underwrite the equity in the new African Bank: This signals that SARB and the banks all knew the systemic risks of an African Bank collapse.
In short, the perceived probability of default of banks has now de-facto risen, and the recovery rate after default has de-facto dropped. This is a recipe for higher credit risk and rating downgrades.
Was Sarb’s response to African Bank appropriate?
Bank failures are not new to South Africa: In a 2012 review Futuregrowth was able to anecdotally recall over 17 bank failures or near-failures in South Africa during the previous 20 years.
But in almost all cases depositors and senior lenders were protected by some sort of bailout or “arranged marriage”. However, once one added the global experience of 2008-2009 and regulators’ response to the massive bank bailouts, the writing has been on the wall: Banks will fail, and governments won’t bail them out.
We think the Sarb’s response to the African Bank problem was predictable, well timed, rational, and justified.
While it’s unlikely that anyone – Sarb or investors – accurately predicted the cascading losses of African Bank, we are conscious that Sarb had been monitoring the situation for a long time. Had Sarb not stepped in quickly and decisively after the African Bank share price collapse we could have seen:
- African Bank branch closures with immediate job losses;
- An irrational undermining of confidence in the banking system, with accelerating withdrawals from all other banks;
- Chaos in capital markets as players scrambled to manoeuvre in an illiquid, fear-based environment;
- Large withdrawals from money market funds and other unit trusts; and
- A “reverse run” wherein people who have borrowed from African Bank simply stopped paying en-masse, causing even greater losses.
We believe that Sarb’s response was the correct balance of timeliness, cost sharing, systemic stability, and loss prevention.
What are the investment implications of all this?
Futuregrowth has been taking a jaundiced view of unsecured lenders and banks for the past few years. As a consequence we have expressed strong public views on a range of related topics, such as the risks to investors of the advent of covered bonds, the unsustainable practices of the micro-lending industry, and the lack of clarity about South Africa’s bank resolution regime.
We have taken the view that the investor market has not been adequately pricing for the evolving risks in this sector. While as a large institutional investor in South Africa it is exceedingly difficult to completely avoid exposure to the banking sector, in order to mitigate risks Futuregrowth has been:
- Keeping clients’ bank exposures shorter-dated (e.g. avoiding bank debt with more than 5 year terms);
- Avoiding bank subordinated instruments (including subordinated debt, hybrids and preference shares);
- Reducing exposure to personal unsecured lenders, particularly African Bank; and
- Allowing such historical exposures to run-down over time.
We will retain this stance until such time as the market reprices yields for the risks.
While credit spreads on bank debt will widen, the losses will arise only from mark-to-market changes (and not defaults). The scale of potential losses will be much less than the African Bank haircuts and losses.
What other key lessons can investors take away from the African Bank collapse?
The micro-lending industry’s and African Bank’s troubles were visible well in advance, and some portfolio positioning was possible. This case shows that good, forward looking credit analysis can add value for client funds.
Further, the changes to Regulation 28 in 2011 introduced the requirement for a wider range of investment analysis tools, notably environmental, social and governance (ESG) screening which focuses on business sustainability.
The practices of the micro-lending industry were visibly unsustainable and that led Futuregrowth to implement suitable investment views. Unfortunate though it is, African Bank’s demise is a strong endorsement for incorporating sustainability screens into investment processes.
*Andrew Canter is the chief investment officer at Futuregrowth Asset Management.
