A View of South Africa’s Financial Market Liquidity and Funding
Banks all over the globe have suffered mightily over the last six months as they have had to absorb increasingly levels of distress in all sectors of their client base.
A first response by most banks is to start raising the drawbridges by ensuring that they have access to ample amounts of liquidity, so that each and every maturing liability may be serviced without delay and in full. That dedication to maintaining surplus to requirements often extends way after the triggering factors for the crisis have long melted away.
South African banks have to date in 2020 not revealed any appetite in expanding the credit-risk exposed portions of their balance sheets. As deposits have surged so the banks are stuffing virtually all of that flow into short-term high-quality liquid assets. At the same time lending standards have inevitably tightened, so even if the banks were intent on increasing lending many clients would no longer qualify for any of the facilities.
The South African government has been dramatically exposed as an emperor without clothes in the first half of 2020. They are no longer the borrower of choice for lending institutions. In many the game is up as a short case on asset swap pricing illustrates.
The old yarn about banks being as scarce with lending facilities when you really need them as the South African Police Service at scene of a crime is probably going to play out as wholly true this next financial year.
A Bank for International Settlements (BIS) research paper suggests that bank lending behaviour is highly procyclical. A new hypothesis may help explain why this occurs.
The Institutional Memory Hypothesis is driven by deterioration in the ability of loan officers over the bank’s lending cycle that results in an easing of credit standards. The effects of this process may be compounded by simultaneous deterioration in the capacity of bank management to discipline its loan and credit officers.
To be fair the current credit crisis for the South African banks may be characterised as a complete shot out of the blue. Nevertheless, it would be unreasonable to expect anything other than lending standards to tighten for some time to come in response to unparalleled increases in impairments over the last six months.
Non-financial corporates and households will bear the brunt of the banking sector’s thrift this year and next.
Credit officers will not get fired for not growing the balance sheet. The risk of being terminated for new loans going the same way as the recent credit performance is a non-trivial issue for these bank employees.
Already there is considerable evidence that banks and the South African banking system as a whole is continuing to hoard liquidity.
The latest monthly report from the South African Reserve Bank (SARB) shows that South African banks are holding well in excess of minimum Basel III requirements for the short-term Liquidity Coverage Ratio (LCR) and the medium-term Net Stable Funding Ratio (NSFR).
We have definitions for and examples of how these ratios are calculated and regulated on the website.
Additionally, SA Banks’ current contingent liquidity position is close to 30% of total funding-related liabilities. Contingent liquidity is an expensive resource to maintain, but the collective balance of risk judgement by the banks demonstrates that this cost is worth bearing for the moment.
To support our analysis of the current liquidity system in the South African economy we have included a multi-month table of the consolidated SARB’s BA900 report.
Since February, the collective size of the South African banking system’s Balance Sheet has grown from ZAR 6.07 trillion to ZAR 6.55 trillion, or 7.34% by the end of June.
At the same time total placed Deposits, Loans and Advances have increased from ZAR 4.30 trillion to ZAR 4.42 trillion or only 2.73%
The banking system’s enhanced liquidity position is being preserved and therefore not yet flowing through to South African commercial and corporate entities, and households.
What line items speak for the majority of the increase in South African bank assets if it is not from credit asset growth?
Investments in very short-term and liquid government assets have increased from ZAR 1.36 trillion to ZAR 1.74 trillion or 24.76% in the period under review (Item Number 195). Very simplistically additional liabilities may be channelled into either risk-less government securities or credit-risky facilities to the private sector.
South African banks are clearly in a state of de-risking their balance sheets until the fog of the Covid-19 war has lifted.
The most startling change in the structure of bank’s balance sheets is the explosion in ‘Derivative instruments issued (Item Number 237). Derivatives underwritten have risen from ZAR 317 billion to ZAR 556 billion, or a 56,29% increase.
In point of fact derivatives exposure for the banks was as high as ZAR 617 billion in April. Clearly some short-dated trading and products have already rolled off the books. For additional focus Standard Bank’s derivatives exposure rose from ZAR 82 billion in February to ZAR 116 billion at the end of June.
Exposure well worth taking as in the first six months of 2020 SBG made ZAR 8.10 billion versus ZAR 5.81 billion in same period of 2019.
Summary BA900 return for the South African banking system February – June 2020
Source: South African Reserve Bank
The Inter-Bank Funding and Swap Curve
In the wake of the South African Reserve Bank aggressively cutting the short-term policy repo rate from 6.50% to the current 3.50%, the JIBAR swap curve has also fallen hard. Naturally, short-term swap rates have fallen the most, however term rates, 5 years and above have also done their fair share on the downside.
When describing the South African swap curve, it is much flatter in shape than the South African government bond curve. The short end of the bond curve has collapsed in line with other debt and money market rates while the longer end has remained stubbornly higher.
In previous notes, we have alluded to our view that the upward stickiness of term government rates is largely due to the considerably worsening state of public finances in the country. Our note published last week covers that set of issues in some detail.
Perhaps the most illuminating feature of the relative rate movements in the swap and bond curves is that at some points the swap curve is trading at almost 250 basis points below the bond curve on a semi-annual equivalent basis.
Conventionally interbank curves have traded above the government curve due to the inherently higher credit risk embodied there.
To witness a swap curve trading so far and consistently below government rates is stunning. Another indictment of the state of government finances if one is even needed.
Asset Swap Representation South African Bond – Swap Curve Spreads
First, let’s price the South African government R186 Bond, which is currently yielding 7.35%. The bond pays a 10.50% semi-annual coupon and matures in December 2026. We can use two strands of analysis to understand the asset swap however the end investment result will be similar under virtually all circumstances.
First, an unleveraged investor has ZAR 100 000 000 to invest in a fixed income security, in our example the R186 bond. The alternative to the choice of a R186 investment is to let the money sit in bank call account which today is a relatively unrewarding affair.
Second a leveraged, a hedge fund or similar entity, wants exposure to the South African government market. The hedge fund is able to fund itself on a floating rate basis, flat to the JIBAR curve i.e. no margin, also in a nominal size of ZAR 100 000 000. Since both the liability and the asset are a function of the floating rate index, JIBAR, interest rate risk is fundamentally eliminated.
However different our starting point, real money versus leveraged trader the end point will be the same.
R186 Bond Price Calculation Details
Since the R186 bond is trading @ 117.61617% of nominal, (YTM of 7.35% vs. 10.50% coupon the investor who wishes to have a ZAR 100 000 000 nominal exposure will have to structure the trade to incorporate this reality.
Asset Swap Mechanics
- Bank lends an additional ZAR 17 616 170 to both classes of ASW investor to buy ZAR 100 million R186 nominal
- Bank recovers this outlay by charging the ASW counterparty 2.721% S/A running until R186 maturity on a ZAR 100 000 000 principal amount (An example of the methodology for arriving at this rate resides on our website)
- ASW investor pays over R186 coupon of 10.50% to the bank until bond maturity date
- In return the ASW investor receives JIBAR (S/A) + 2.35% to own credit risk-free South African government debt
- This outcome is extremely beneficial position for both :
- A cash investor who will be rewarded for rates rising even moderately and not being locked into a 7.35% fixed rate and;
- A leveraged hedge fund who through accessing a competitive floating rate funding structure, will under any JIBAR index outcome, will be paid 2.35% for holding South African government risk.
In conversation with some of our colleagues at the major banking institutions, the effective credit spread being charged the government, exceeds that which would be charged of quite a broad swathe of corporate clients.
National Treasury have their work cut out for themselves over the next decade.
Is there a difference between ample liquidity and the cost of funding?
The evidence we have presented above, emphatically supports the hypothesis the quantum of available funding capacity, in the banking sector, does not always readily convert into the provision of liquidity for the bank’s clients.
Also, the brief case study that we have presented on an Asset Swap for the R186 bond reveals that lower rates in the short end, effected the SARB’s repo market operations does not convert into cheap funding alternatives for National Treasury. Up some creek or other without a paddle is a phrase which springs to mind.
South African banks are to a greater or lesser extent, hoarding liquidity, amply provable in the surplus they are holding beyond what is required by international regulatory standards. We expect this focus on liquidity to persist, while the banks grapple with the catastrophic impact on capital ratios by soaring loan loss rates.
Not even government is immune to the forces we have set out above. In fact, government finances may prove to be one of the largest causalities from the economic disruption caused by the global Covid-19 pandemic.