IN SOUTH AFRICA
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First published 20H,
Bank M1111a9e111ent in South !\Ji-irn - 1\ risk•bascd perspective
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2.1
INTRODUCTION .........................................................................................31
PART TWO - THE SOUTH AFRICAN BANKING LANDSCAPE .......................... 29
CHAPTER 2: THE COMPETITIVE AND OPERATING ENVIRONMENT OF
THE SOUTH AFRICAN BANKING INDUSTRY ..............................31
LEARNING OBJECTIVES .....................................................................................31
1.2
INTRODUCTION ...........................................................................................3
FINANCIAL INTERMEDIATION THEORY ...................................................... 3
1.2.1
The heart of it all - financial intermediation ....................................... 3
1.2.2
Failure of the general equilibrium framework and the
information asymmetry paradigm ...................................................... 6
1.2.3
First generation: are banks special? .................................................. 8
1.2.4
Second generation: are banks still relevant? ................................... 11
1.2.5
Third generation: are banks still banks? .......................................... 14
1.2.6
The functions of a bank ................................................................... 17
1.3 THE BUSINESS OF BANKING ................................................................... 20
1.3.1
Types of banks ................................................................................. 20
1.3.2
How do South African banks compare internationally? .................. 23
1.4 THE FUTURE OUTLOOK FOR BANKS ...................................................... 24
1.4.1
Risk versus uncertainty .................................................................... 24
1.4.2
Global policy co-ordinatio n .............................................................. 24
1.4.3
Non-traditional sources of competition ........................................... 24
1.4.4
Consumerism and the client of tomorrow ....................................... 24
1 .4.5
Regulation and risk management .................................................... 25
1.5 CONCLUSION ............................................................................................25
REFERENCES ......................................................................................................25
1.1
PART ONE- INTRODUCTION TO BANKING .......................................................1
CHAPTER 1: FINANCIAL INTERMEDIATION THEORY ........................................3
LEARNING OBJECTIVES .......................................................................................3
Permission acknowledgements ........................................................................ xviii
Preface ................................................................................................................. xv
Acknowledgements ........................................................................................... xvii
About the authors .................................................................................................xi
Foreword ............................................................................................................. xiv
2.4.1
Return on average assets (ROM) ................................................... 58
2.4.2
Return on average equity (ROAE) .................................................... 58
2.4.3
Net interest margin (NIM) ................................................................. 59
2.4.4
Cost-to-income ratio (CTI ratio) ....................................................... 59
CONCLUSION ............................................................................................60
2.5
3:5
3.4
THE FINANCIAL REGULATORY AND SUPERVISORY FRAMEWORK
IN SOUTH AFRICA .....................................................................................69
3.3
The international money laundering control framework .................. 87
The Financial Intelligence Centre Act (38 of 2001) .......................... 88
Legislative developments ................................................................ 90
Deposit insurance in South Africa .................................................... 91
Dealing with SIFls and the too-big-to-fail issue ............................... 91
CURRENT REGULATORY TRENDS AND DEVELOPMENTS ..................... 90
3.6.1
3.6.2
COMBATTING MONEY LAUNDERING IN SOUTH AFRICA ....................... 87
Current legislative framework for consumer protection ................... 77
The proposed new approach to market conduct regulation
under the Twin Peaks framework ..................................................... 83
FINANCIAL INCLUSION AND THE FINANCIAL SECTOR CODE ............... 86
3.4.1
3.4.2
MARKET CONDUCT REGULATION IN SOUTH AFRICA ............................ 76
The current regulatory framework .................................................... 69
Prudential regulation of banks in South Africa ................................. 70
Prudential supervision and the SREP .............................................. 72
Proposed prudential regulation under the Twin Peaks model ......... 73
THE RATIONALE AND LIMITATIONS OF FINANCIAL REGULATION
AND SUPERVISION ....................................................................................64
3.2
3.3.1
3.3.2
3.3.3
3.3.4
REFERENCES ....................................................................................................123
INTRODUCTION .........................................................................................63
5.3
REFERENCES ....................................................................................................154
5.6
INTERNATIONAL INSTITUTIONS: THE ROLE OF THE IMF AND THE
WORLD BANK ..........................................................................................148
5.5
5.5.1
The International Monetary Fund ................................................... 148
5.5.2
The World Bank ............................................................................. 151
CONCLUSION ..........................................................................................152
THE ROLE OF SOUTH AFRICAN BANKS IN THE AFRICAN CONTEXT .. 143
5.4
Origins and progression ................................................................. 131
A new emphasis: financial inclusion .............................................. 136
Dealing with the GFC ..................................................................... 138
THE HISTORY AND DEVELOPMENT OF THE SOUTH AFRICAN
BANKING ENVIRONMENT .......................................................................131
5.2
5.3.1
5.3.2
5.3.3
INTRODUCTION .......................................................................................125
THE INTERNATIONAL BANKING ENVIRONMENT ................................... 127
5.1
LEARNING OBJECTIVES ...................................................................................125
CHAPTER 5: THE DEVELOPMENT AND INTERNATIONALiSATION OF
SOUTH AFRICAN BANKING ....................................................... 125
4.5
LEARNING OBJECTIVES .....................................................................................63
4.4.1
The life-cycle phases of relationship banking ................................ 105
4.4.2
The two dimensions of relationship banking ................................. 11 O
4.4.3
The drivers of bank relationships ................................................... 111
4.4.4
The seven relationships of relationship banking ............................ 112
4.4.5
Relationship-based strategies ....................................................... 120
CONCLUSION ..........................................................................................123
TRANSACTIONAL VERSUS RELATIONSHIP BANKING ............................ 99
A MODEL FOR RELATIONSHIP BANKING .............................................. 105
Personal interaction distribution channels ....................................... 96
Remote interaction distribution channels ........................................ 97
4.4
4.2.1
4.2.2
DISTRIBUTION CHANNELS IN BANKING ................................................. 96
INTRODUCTION .........................................................................................95
4.3
4.2
3.1
CHAPTER 3: FINANCIAL REGULATION IN THE SOUTH AFRICAN
BANKING INDUSTRY .....................................................................63
REFERENCES ......................................................................................................61
PERFORMANCE VARIABLES ....................................................................57
4.1
LEARNING OBJECTIVES .....................................................................................95
Pricing strategies in the banking industry ........................................ 51
Merger analysis ................................................................................ 54
CHAPTER 4: RELATIONSHIP BANKING IN SOUTH AFRICA ............................ 95
REFERENCES ......................................................................................................92
3.8
2.3.1
2.3.2
Structural variables .......................................................................... 34
The nature of the products .............................................................. 47
Barriers to entry ............................................................................... 48
Complex monopoly .......................................................................... 50
v
3.7.4
The implementation of TCF ............................................................. 91
3.7.5
Proposed reform of the ombud system ........................................... 92
CONCLUSION ............................................................................................92
Contents
CONDUCT VARIABLES .............................................................................. 51
2.2.1
2.2.2
2.2.3
2.2.4
AN SCP ANALYSIS OF THE SOUTH AFRICAN BANKING INDUSTRY ...... 32
Bank Management in South Africa - A risk-based perspective
2.4
2.3
2.2
iv
Contents
vii
A TYPICAL INTEGRATED REPORT OF A BANK ...................................... 172
6.3
6.4
CONCLUSION ..........................................................................................176
Net interest income ........................................................................ 191
Net non-interest income ................................................................ 192
Loan impairments .......................................................................... 192
7.5.1
Fair value vs historical cost accounting ......................................... 192
7.5.2
The use of annual financial statements ......................................... 193
CONCLUSION .... ......................................................................................194
OTHER ISSUES IN FINANCIAL REPORTING ........................................... 192
7.4.1
7 .4.2
7.4.3
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME ....................................................................................................191
REFERENCES ........... .........................................................................................194
7:6
7.4
7.3
Assets of a bank
183
Liabilities of a bank
187
Capital and reserves of a bank ...................................................... 189
FINANCIAL REPORTING IN SOUTH AFRICA .......................................... 179
THE STATEMENT OF FINANCIAL POSITION ........................................... 181
7.2
7.3.1
7.3.2
7 .3.3
INTRODUCTION .......................................................................................179
7 .1
LEARNING OBJECTIVES ...................................................................................179
CHAPTER 7: FINANCIAL REPORTING FOR BANKS ....................................... 179
REFERENCES ....................................................................................................177
6:5
6.2.1
Integrated reporting as a basis for organisational risk assessment ... 161
6.2.2
The structure and content of integrated reports ............................ 162
SUSTAINABILITY REPORTING ................................................................ 170
Introduction and general overview ................................................. 173
Director and executive management reports ................................. 173
Corporate governance report ........................................................ 173
Risk management report ............................................................... 173
Capital management report ........................................................... 174
Divisional (operational) reviews ...................................................... 174
Annual financial statements and notes .......................................... 175
Definitions and abbreviations ........................................................ 176
Shareholder information ................................................................ 176
Sustainability report ....................................................................... 176
ORGANISATIONAL REPORTING FRAMEWORK ..................................... 161
6.2
6.4.1
6.4.2
6.4.3
6.4.4
6.4.5
6.4.6
6.4.7
6.4.8
6.4.9
6.4.1 0
INTRODUCTION .......................................................................................161
6.1
8.2.1
The elements and difficulties of effective performance management. 198
8.2.2
The role of performance measures in a bank ................................ 201
8.2.3
Understanding financial performance measures ........................... 202
CONCLUSION ..........................................................................................222
BANKING PERFORMANCE AS A STRATEGIC BANK RISK
MANAGEMENT TOOL ..............................................................................198
Evolving nature of risk .................................................................... 244
Innovation and new risks ............................................................... 245
Complexity and the modelling versus judgement issue ................ 245
Regulatory know-how and resource allocation ............................. 245
Policy and regulatory responses .................................................... 246
The incentive-governance dilemma ............................................... 246
CONCLUSION ..........................................................................................246
9.5.1
9.5.2
9.5.3
9.5.4
9.5.5
9.5.6
THE OUTLOOK FOR RISK MANAGEMENT IN BANKING ........................ 244
Product- and service-mix diversification ....................................... 243
Geographical diversification .......................................................... 243
Inter- and intra-market diversification ............................................ 244
Workforce diversification ................................................................ 244
10.1
INTRODUCTION .......................................................................................249
LEARNING OBJECTIVES ...................................................................................249
CHAPTER 10: THE IDENTIFICATION AND MEASUREMENT OF RISK IN
BANKING ...................................................................................249
REFERENCES ....................................................................................................247
9.6
9.5
9.4.1
9.4.2
9.4.3
9.4.4
ENTERPRISE-WIDE RISK MANAGEMENT IN BANKS ............................ 237
HOW DO BANKS DIVERSIFY RISK? ........................................................ 243
9.3
9.4
Risk management versus risk measurement .................................. 230
Risk versus uncertainty .................................................................. 231
Risk versus reward ......................................................................... 233
Contextualising the organisational risk philosophy ....................... 234
9.2
9.2.1
9.2.2
9.2.3
9.2.4
INTRODUCTION ....................................................................................... 229
SELECTED CONCEPTS IN RISK MANAGEMENT ................................... 229
9.1
LEARNING OBJECTIVES ................................................................................... 229
CHAPTER 9: ESTABLISHING A RISK PHILOSOPHY IN BANKS ..................... 229
PART FOUR - RISK MANAGEMENT IN BANKING ..........................................227
REFERENCES ....................................................................................................223
8.3
8.2
LEARNING OBJECTIVES ...................................................................................161
INTRODUCTION .......................................................................................197
LEARNING OBJECTIVES ...................................................................................197
8.1
CHAPTER 6: INTEGRATED REPORTING FOR BANKS ................................... 161
CHAPTER 8: MEASURING THE PERFORMANCE OF A BANK ....................... 197
Bank Management in South Africa - A risk-based perspective
PART THREE- REPORTING IN BANKING ....................................................... 159
vi
Bank Management in South Africa - A risk-based perspective
EVE and Basel ............................................................................... 316
ix
12.2.1 Exchange-traded derivatives ......................................................... 322
12.2.2 OTC derivatives ............................................................................. 339
12.2.3 Alternative risk management instruments ...................................\.. 347
12.3 CONCLUSION ..........................................................................................349
REFERENCES ....................................................................................................349
Risk-weighted assets optimisation ................................................ 272
Compliance with LCR and NSFR. .................................................. 272
Unsecured lending ......................................................................... 273
Other smaller risks ......................................................................... 27 4
10.5 CONCLUSION .......................................................................................... 274
INTRODUCTION ....................................................................................... 277
The loanable funds theory and components of interest rates ....... 280
The yield curve ............................................................................... 282
The relationship between interest rates and inflation .................... 288
The relationship between interest rates and the business cycle ... 291
The impact of SAAB announcements ............................................ 294
The measuring of interest rates and the management of
interest rate risk ............................................................................. 295
........ c..c·--_--0:>~--"c<+.=-«.rv=_\'l"'~~
11.7.1
11.7.2
11.7.3
11.7.4
"···SA= ....
,.--~~~-
EVE and the gap (repricing) analysis .............................................. 314
EVE and the duration gap analysis ................................................ 315
EVE and the discount cash flow method ....................................... 315
EVE and the simulation approach .................................................. 316
MANAGING THE ECONOMIC VALUE OF EQUITY (EVE) .......................... 312
11.6 DURATION GAP MANAGEMENT ............................................................. 305
11.5 INTEREST-SENSITIVE GAP MANAGEMENT ........................................... 300
11.4 THE ASSET-LIABILITY COMMITTEE (ALCO) .......................................... 297
11.3.1
11.3.2
11.3.3
11.3.4
11.3.5
11.3.6
11.3 THE CONCEPT OF INTEREST RATES, THE YIELD
CURVE, INTEREST RATE RISK AND EXPECTATIONS ............................ 280
11.2 ASSET-LIABILITY MANAGEMENT: THE BALANCE SHEET
PERSPECTIVE ..........................................................................................278
11.1
LEARNING OBJECTIVES ...................................................................................277
CHAPTER 11: THE MANAGEMENT OF INTEREST RATE RISK: ASSETLIABILITY MANAGEMENT ........................................................277
REFERENCES ....................................................................................................275
10.4.1
10.4.2
10.4.3
10.4.4
INTRODUCTION .......................................................................................319
INTRODUCTION .......................................................................................353
Managing cash .............................................................................. 355
Managing loans .............................................................................. 356
The investment book ..................................................................... 367
Other assets ................................................................................... 369
INTRODUCTION ....................................................................................... 371
Deposits ......................................................................................... 372
Non-deposit borrowings ................................................................ 37 4
Capital ............................................................................................ 375
14.3.1
14.3.2
14.3.3
Extending loans
Reserves
Interbank lending
375
378
379
14.3 USES OF BANK LIABILITIES ................................................................... 375
14.2.1
14.2.2
14.2.3
14.2 THE LIABILITIES OF A BANK .................................................................. 372
14.1
LEARNING OBJECTIVES ...................................................................................371
CHAPTER 14: MANAGING THE LIABILITIES OF A BANK ...............................371
REFERENCES ....................................................................................................370
13.4 CONCLUSION ..........................................................................................370
13.3.1
13.3.2
13.3.3
13.3.4
13.3 MANAGING THE ASSETS OF A BANK .................................................... 355
13.2 BREAKDOWN OF THE ASSET BOOK: A RECAP .................................... 353
13.1
LEARNING OBJECTIVES ...................................................................................353
CHAPTER 13: MANAGING THE ASSETS OF A BANK ..................................... 353
PART FIVE - MANAGING THE SOURCES AND USES OF FUNDS IN
BANKING ......................................................................................351
12.1
LEARNING OBJECTIVES ................................................................................... 319
12.2 DERIVATIVE INSTRUMENTS ....................................................................320
CHAPTER 12: MANAGING RISK IN BANKING ................................................. 319
REFERENCES ....................................................................................................317
11.8 CONCLUSION .......................................................................................... 317
11.7.5
Contents
10.3.1 Value-at-risk ................................................................................... 258
10.3.2 Risk-adjusted performance measures ........................................... 269
10.3.3 Distress-based performance measures ......................................... 271
10.4 RISK PERCEPTION - SOUTH AFRICAN BANKS ..................................... 271
10.2.1 The challenges of risk .................................................................... 249
10.2.2 On-balance-sheet risk ................................................................... 250
10.2.2 Off-balance-sheet risk ................................................................... 258
10.3 RISK MEASUREMENT TOOLS ................................................................. 258
10.2 WHAT IS RISK? ........................................................................................ 249
viii
Bank Management in South Africa - A risk-based perspective
The liquidity gap ............................................................................. 380
Methods for estimating liquidity needs .......................................... 382
INTRODUCTION .......................................................................................387
Calculating the capital adequacy ratio under Basel I .................... 393
The 1996 Amendment to Basel I: explicit market risk capital
charge ............................................................................................ 398
The purpose of bank capital .......................................................... 388
How much capital does a bank need? .......................................... 388
Capital adequacy standards: global reform and South Africa ....... 391
I .................................................................................................... 393
The three pillars of Basel II ............................................................. 403
The definition of capital and capital charges under Basel II .......... 405
The operational risk capital charge ................................................ 409
The market risk capital charge under Basel II. ............................... 413
Basel II capital adequacy requirements in South Africa ................ 414
The definition of capital under Basel 111. ......................................... 416
The major contributions of Basel 111 ............................................... 418
The implementation of Basel Ill in South Africa ............................. 426
INDEX .................................................................................................................433
REFERENCES ....................................................................................................431
15.7 CONCLUSION ..........................................................................................430
15.6.1
15.6.2
15.6.3
15.6 BASELlll ..................................................................................................416
15.5 BASEL II½ ................................................................................................414
15 .4 .1
15.4.2
15.4.3
15.4.4
15.4.5
15.4 BASEL II .................................................................................................. .403
15.3.1
15.3.2
15.2.1
15.2.2
15.2.3
15.3 BASEL
15.2 REGULATION FOR BANK CAPITAL ......................................................... 388
15.1
LEARNING OBJECTIVES ...................................................................................387
CHAPTER 15: BANKS AND CAPITAL ADEQUACY ..........................................387
REFERENCES ....................................................................................................385
14.5 CONCLUSION ..........................................................................................385
14.4.1
14.4.2
14.4 LIQUIDITY MANAGEMENT ......................................................................380
x
Dr Arno van Niekerk - Department of Economics, University of the Free
State
Dr van Niekerk has a PhD in Economics and a Master's degree in Money and
Banking from the University of the Free Stale (UFS). He worked for an auditing
company, after which he pursued a career at the UFS where he is currently a senior
Dr Jesse de Beer - Department of Economics, University of the Free State
Dr de Beer is a senior lecturer in the Department of Economics at the University of
the Free State, specialising in investment management and financial regulation. She
has 21 years of lecturing experience, lecturing Economics and Financial Economics
at undergraduate and postgraduate level. She has published in local and
international academic journals and presented papers at local and international
conferences in the areas of consumer decision-making in retail financial markets,
capital flows, investment management, behavioural finance and financial literacy,
as well as several topics related to financial regulation in South Africa. She has also
acted as a referee for several academic public<1tions, including the Journal <!f
Economic and Financial Sciences (JEFS), the South African Journal of Economics and Die
Tydskrif vir Geesteswetenskappe. Dr de Beer has been an external examiner for
Master's and PhD degrees (University of Johannesburg, PUK campus of the
University of the North West, University of Pretoria and Rhodes University).
Dr Johan Coetzee - Department of Economics, University of the Free State
Dr Coetzee has a PhD in Economics from the University of the Free State (UPS). an
MBA (Chartered B,mker) from the University of Bangor in Wales and a Master's
degree in Banking from the UPS. He worked for Nedbank in the Retail Division as a
branch manager, and later as an analyst in the Sovereign and Institutions Risk Unit
in the Corporate Credit Division. Since leaving the private sector, he has pursued a
career in academia and is currently the Deputy Chair of the Department of
Economics at the UPS and a board member of the School of Investment and Banking
al the Milpark Business School. Dr Coetzee has also been an external course
evaluator and presenter in the Risk Management course presented by the South
African Reserve Bank Academy, and teaches Macroeconomics in the MBA
programme at the UFS Business School. He has been a visiting external seni.or
lecturer in Bank Management at the Salzburg University of Applied Sciences in
Austria, where he teaches Master's students specialising in Financial Risk
Management. He has been an external course evaluator for several courses at NWlJ
and Rhodes University and has published in both local and international academic
journals in topics related to banking. specifically in the South African banking
industry.
••.•.• ,+~~!"??_ .~/Y/FC~-->>
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Shaun Watson CA(SA) - School for Accounting, University of the Free State
Mr Watson is a qualified Chartered Accountant and also has an HDip in Tax and a
Master's degree in Accounting at the University of Pretoria. He currently lectures
Financial Management to both under- and postgraduate students specialising in
Accounting at the University of the Free State. He has also lectured Financial
Management at the University of Bremen in Germany. Mr Watson has presented
and published research papers at both national and international conferences and
in journals respectively. He has extensive private sector experience at major
accounting firms. as well as being contracted to the Auditor General.
Cornelie Crous CA(SA) - School for Accounting, University of the Free State
Ms Crous obtained her CA qualification in 2005 after completing her articles at the
international auditing firm PriccwaterhouseCoopers (PwC). After a nine-month
secondment to the USA in 2004/2005, she joined the University of the Free State as
a senior lecturer in June 2005. beginning to specialise in auditing in 2006. She
obtained her MCompt degree (cum laude) in auditing in 2013 and received the
Dean's Medal for the best Master's dissertation in the Faculty of Economic and
Management Sciences in the same year. Ms Crous has been involved in the training
and assessment of prospective chartered accountants in South Africa for the past:
decade. She is a board member of the University of the Pree State Enactus
(previously SIPE) chapter and has served on several professional committees and
bodies in her field. She is specialising in South African corporate governance with
focus on higher education institutions in South Africa. She has also co-authored
several books focusing on the audit profession and the Company's and Close
Corporations Acts in South Africa and has presented several peer-reviewed papers
in her field at international conferences.
··------~~-··---~~-~~
Dr Ja 'nel Esterhuysen - Standard Chartered Bank South Africa
Dr Esterhuysen is currently a Senior Director at Standard Chartered Bank in
Johannesburg. He has a well-established background in the South African banking
industry with companies such as Standard Bank. Investec and Barclays. His
experience covers a wide range of topics, including credit risk analysis. quantitative
market risk analysis. updating and implementing market risk methodology, and
quantitative input for joint probability of default methodology. He is currently
extensively involved in structuring project finance, leverage finance and structured
equity finance transactions. He holds two PhDs, has authored 11 internationally
published research papers, and co-authored 15 research papers. He is also the
author of The Management of Operational Value at Risk in South African Banks.
Prof Andre Heymans - School of Economics, North-West University
Prof Heymans has a PhD in Risk Management from North-West University. Before
returning to academia. he was employed at the Bank of New York Mellon in London
in corporate banking. After the credit crisis of 2008 he moved back to South Africa
to take up a position at a local financing firm as Head: Research and Development
on their trading desk. Since leaving the private sector, Prof Heymans has been
employed at North-West University where he is the head of the Risk Management
programme. Prof Heymans also served on the Board of the Economic Society of
South Africa and is a board member of the School of Investment and Banking at the
Milpark Business School. He is an external course evaluator for several finance
courses at WITS. UNISA, UFS and UKZN. regularly publishes in both local and
international academic journals in topics related to investments and banking. and
supervises several Master's and PhD students in finance.
xiii
Karlien Stemmet- Department of Economics, University of the Free State
Mrs Stemmet obtained both her BCom (Hons) and MCom with distinction in Economics
from the University of the Free State (UPS). During her studies she was awarded the
Dean's medal for the best Master's student in the Faculty of Economic and Business
Sciences. and obtained academic honours colours from the university. She is employed
by the UPS and teaches Economics for Managers in the MBA programme, PGDip and
BML programme at the UPS Business School. She specialises in microeconomics,
industrial organisation. competition law and complex network theories.
About the authors
Dr Chris van Heerden - School of Economics, North-West University
Dr van Heerden is currently a senior lecturer and programme leader of Economics
at the North-West University's Potchefstroom Campus. After completing his PhD in
2011 he accelerated to a well-established specialist in performance evaluation and
risk management in under three years. He is the section editor of the South African
Journal of Economic & Management Sciences (SAJEMS) and of the International
Business and Economics Research (IBER) journal, and a regular peer reviewer of
several nationally and internationally accredited academic journals.
Bank Management in South Africa - A risk-based perspective
lecturer .in the Department of Economics. Dr van Niekerk teaches International
Economics and is also an external moderator to postgraduate courses in
International Trade and Finance. He has been a visiting external senior lecturer in
linancial markets and institutions at the Salzburg University of Applied Sciences in
Austria for a number of years, as part of their Master's programme. He bas
published in academic journals, both local and international, focusing on global
economic governance, international finance and trade. He has also been a reviewer
for a number of journals.
xii
Helena van Zyl
Professor in hanking and Director at the UF'S Business School
It is a notable achievement that a younger generation ol' academics have contributed
in this way to the field of risk management in banking.
Given the above brief background, and despite the ongoing transformation and
development of academic material and theory, there is a permanent need for quality
handbooks in the field of risk management - not only for students in banking,
but also for banking practitioners. I would like to commend this handbook, which
provides a theoretical basis for financial intermediation and an overview of the South
African banking landscape, with a specific focus on risk management in the banking
environment- the first of its kind to have an exclusive focus on South African banks.
The management of risk has become critically important in all facets of the financial
services industry. Banks are considered to be the fundamental pillar of a financial
system and. therefore, clarity on the meaning and management. of risk is nonnegotiable. Financial instability in any financial system is dangerous and cannot be
tolerated, especially since 2008.
Globalisation has become a reality for the South African financial markets since the
democratic elections in 1994. Although we can highlight a few delining events, the
2008 Global Financial Crisis completely changed the landscape of risk management
for financial markets and financial institutions. Whereas the earlier focus had been
on the solvency of banks using the Basel Accords by the Bank for International
Settlements (BIS), the crisis provided a rude awakening for the local and
international tinancial world. It showed that rules and procedures alone are not
sufficient to prevent a '2008' from occurring: proper and rigorous implementation
of these rules and procedures is needed.
Part 4 is the heart of the text, as the focus is on risk management in banks. The
institutional risk management philosophy sets the tone for how banks identify,
measure and manage the wealth of risks they face on a daily basis. Part 4 answers the
question: How do banks establish an organisational philosophy that identifies, measures
and manages risk?
Part 3 considers the reporting environment that banks are faced with, specifically
integrated reporting, financial reporting and performance measurement. Part 3
answers the question: How do hanks report their conduct and performance to stakeholders?
Part 2 deals specifically with the South African banking landscape and includes a
comprehensive overview of the structure, regulatory environment. relationshipbased environment and the development and internationalisatio n of South African
banking. Part 2 answers the question: What does the South African industry look like
and how has it developed through the years?
Part l introduces the theory of financial intermediation. It takes a historical view of
the evolution of the theory and explains what makes banks unique. Part l answers
the question: Are banks (still) special?
The book is divided into five parts:
This book deals with how banks manage risk and it takes an explicitly South African
perspective. This, in my experience, has been a void for local bankers and students
when trying to understand how the South African banking environment functions.
As a result, the need arose for a one-stop reference guide on banking in South Africa
that was both reader-friendly and technical enough to address the needs of all
interested parties.
The first notion of writing a book on bank management occurred whilst: I was still
an undergraduate student. The lecturer would often say things like, 'Leave out the
first three chapters as they do not apply to South Africa'. This always puzzled me why had no-one written a text that focused on the South African situation? When I
later worked for Nedbank in the Sovereign Risk Unit, again I was confronted by my
colleagues asking for 'South African evidence', landing in a situation where the
'evidence' could only be found from many sparse and scattered sources. The tinal
straw was when I entered academia and found myself saying exactly what my
undergraduate lecturer told me: 'Leave out the first three chapters as they do not
apply to South Africa'. At this point a book that focused on the South African
situation became a priority, and what you see in front of you is the result.
A final note on the text. According to the International Accounting Standard 1
(IAS 1) paragraph HJ, the terms 'balance sheet' and 'income statement' have been
replaced with 'a statement of financial position' and 'a statement of profit or loss
and other comprehensive income' respectively. IAS 1 further states, however, that an
entity may use alternative titles for the statements. As such, this book refers to both
interchangeably, but, in most part, still refers to the old terms. The reason for this
is twofold: .first, some of the largest banks in the world still use the old terminology
(balance sheet and income statement). It would therefore be confusing not to refer to
it as such, especially when an objective of this book is to provide a platform for readers
to analyse the financial statements of the largest banks in the world; second, the Basel
Committee on Banking Supervision (BCBS) uses the old terminology in their policy
documents. Given the importance of the Basel capital Accords, once again it would
be better to conform to the international convention at this stage. Although South
African banks use the new terminology as per IAS 1 and the quality of financial
reporting in South Africa is regarded as probably the best in the world according the
World Economic Forum's Global Competitiveness Report, we acknowledge the period
of transition that the global banking community finds itself in regarding the use of
the terms under IAS 1, and adapt our book on these grounds.
For the lecturers or facilitators using this book, we have included PowerPoint slides
for each chapter, along with a set of over 400 multiple-choice questions that test the
content of each chapter, We hope that this will provide a means to encourage young
aspiring bankers to learn more about this wonderful field,
Part 5 provides management with the tools to manage the sources and uses of
funds; that is, their balance sheet. In particular, the final chapter deals extensively
with the evolution of the Capital Accords since Basel I in 1988 until present-day
Basel III extending until 2019, The South African capital requirements are dealt
with and form the foundation for the regulatory and operating environment facing
banks going forward. Part 5 answers the question: How do banks manage their balance
sheets and how must international, and specifically South African banks, comply with the
capital requirements provided by the Basel Committee on Banking Supervision?
xvi Bank Management in South Africa - A risk-based perspective
Johan Coetzee
Bloemfontein
South Africa
December 2015
Finally, to my family, and specifically my wonderful wife Karlien who supported me
endlessly, and son Benjamin, this book is ultimately dedicated to you.
J would also like to acknowledge the input from two professors in banking at the UPS
who inspired me both as a student and later as a colleague. In particular, Prof Helena
van Zy I and Prof Buks Wessels were instrumental in the formative phase of the book.
Their motivation to strive for excellence and to ensure that banking as a discipline
is handled with the respect it deserves has been my underlying motivation for this
book.
Writing a text on the South African banking environment is indeed a daunting task.
I realised soon enough that I would not be able to do it without the help of fellow
academics who specialise in aspects of banking (or economic theory at large). As
such, a book of this nature would not have been possible without the help of my
contributing authors. The knowledge and know-how that my colleagues Shaun,
Arno, Karlien, Jesse and Cornelie at the University of the Free State (UFS); Chris and
Andre at North-West University: and Ja'nel at Standard Chartered Bank have
brought to the table has ensured that the final product is of higher quality than I
could have achieved on my own.
Table 5.5: South African Bank presence in SADC countries in the first decade
since isolation (1994-2 003)
Staff Working Paper ERSD-20 06-03 © World Trade Organization (WTO) 2006
Table 5.3: Foreign assets of South Africa (1996-2 005)
© 2015 ElsevierB.V.
Table 5.2: Foreign banks as percentage of total banks by African region (19982006)
© 2015 Elsevier B.V.
Table 5.]: Impact of the GFC on selected African financial markets compare
d
globally
© 2014-20 15 European Report on Developm ent
Figure 5.2: Bank trading incomes per region as percentage of gross total income
-2011
The Banker Database. Top 1000 world banks 2013. The Banker Research Team.
Financia l Times Ltd
Figure 5.l: Movements in bank loans volumes in Sub-Saharan Africa (SSA)
Bank for Internati onal Settleme nts (BIS). 2010.
Table 4.8: Selected brands in the organisational structures of the big four South
African banks
Barclays Africa Group, Limited, FirstRan d Group Limited, Nedbank Group
Limited, Standard Bank Group Limited
Table 4.6: Sections of the Code of Banking Practice
© The Banking Asso<::iation South Africa (BASA)
Table 3. 7: The six pillars of the FSC and progress made by the Big Four banks
in
South Africa
Dr Arno van Niekerk
xix
15.14: The sources of risk components under the IRB approach
Basel Committee on Banking Supervis ion (BCBS)
15 .13: The five asset class exposures under the lRB approach
Basel Committee on Banking Supervis ion (BCBS)
Table 15.12: Credit risk weights under the standardised approach
Basel Committee on Banking Supervis ion (BCBS)
Table 15 .11: The definition of capital under Basel If
Basel Committee on Banking Supervis ion (BCBS)
Table 15.9: Specification of market risk factors in the IMA according to the
1996 Basel Amendment
Basel Committee on Banking Supervis ion (BCBS)
Table 15.8: Selected standards for qualitative, quantitative, stress testing, and
external validation in the lMA according to the 1996 Basel Amendment
Basel Committee on Banking Supervis ion (BCBS)
. . Table 15.5: CredU conversion factors (add-ons) for off-balance-sheet derivativ
es
according to Basel I
on Banking Supervis ion (BCBS)
Table 15.4: Credit conversion factors for off-balance-sheet instruments and
transactions (CRWA 0 rrr) according to Basel I
Basel Committee on Banking Supervis ion (BCBS)
Table 15.3: Risk-weight categories for on-balance-sheet assets according to
Basel I
•
Basel Committee on Banking Supervis ion (BCBS)
Table 15.2: The definition of capital under Basel I
Basel Committ ee on Banking Supervis ion (BCBS)
Figure 13.1: Moody's KMV. Overview. 2008: Average PDs, 2002-20 09
. © 2015 Moody's Analytics. Inc. Moody's KMV
Table 13.3: Moody's EDf vs Moody's external ratings
© 2015 Moody's Analytics. Inc. Moody's KMV
Table 9.4: The risk statement and risk appetite for Nedbank Group
Nedbank Group Limited
Table 2.5: Net interest margin (NIM) data for South African banks, 2007-20
13
Bankscope © Bureau Van Dijk
Table 2.6: Cost to income ratio: Banks 2007-20 13
Banksco pe © Bureau Van Dijk
Table 9.3: The risk statement and risk appetite for Standard Bank Group
Standard Bank Group Limited
Table 9.2: The risk statement and risk appetite for FirstRand Group
FirstRand Group Limited
Table 9.1: The risk statement and risk appetite for Barclays Africa Group
Africa Group
Permissio n Acknowle dgements
Table 2.4: Return on average equity for South African banks, 2007-20 13
Bankscope © Bureau Van Dijk
''iahknowledgements
,-~--'-
.
'
h
-.
••Oh,
Bank Management in South Africa - A risk-based perspective
m
w•,•r=< >>····="""'·"""•~..,.,_,_..__ _ _ _ _ _~.
Table l 5.27: Basel HJ transition period minimum requirements for LCR in South
African banks
South African Reserve Bank
Table I 5.26: Final Basel III capital requirements applicable to South African
banks from 2019
South African Reserve Bank
Table I 5.2 S: Basel Ill capital framework transitional period: 2013-2019:
South African Reserve Bank
Table 15.24: The twelve principles for the 0-SIB framework
Basel Committee on Banking Supervision (BCBS)
Table 1 S.21: G-SIB score ranges for the HLA buckets until 31 December 20 IS
Basel Committee on Banking Supervision (BCBS)
Table l 5.20: The indicator-based measurement approach for G-SIBs
Basel Committee on Banking Supervision (BCBS)
Table l 5.19: Minimum capital conservation standards for individual banks
when a bank has to comply to a 2.5% CB requirement
Basel Committee on Banking Supervision (BCBS)
Table 15.18: Minimum capital conservation standards for individual banks
Basel Committee on Banking Supervision (BCBS)
Table 15.17: The definition of capital under Basel
Basel Committee on Banking Supervision (BCBS)
Table 15.15: The business lines and beta weights under the standardised
approach for the operational risk capital charge
Basel Committee on Banking Supervision (BCBS)
xx
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INTRODUCTION
The heart of it all - financial intermediation
-~-· ~ - - - v · - ~ - - - ,---- - ~ - ~ - ~ ~ - - - -
In order to understand the importance of banks, a good departure point is to
identify their contribution to an economy. Table ] .l provides the relative
contributions of debt and equity financing (in Rmillion) relative to gross domestic
product (GDP) in the South African financial markets. Loans have consistently been
the preferred source of financing (sec the shaded cells), especially when compared
FINANCIAL INTERMEDIATION THEORY
1.2
1.2.1
Banks are in the business of managing risk. These risks can originate from past,
present or future transacJions and exist in almost every activity in which they
participate and in relation to every market participant with whom they interact:. As
financial markets have become more integrated and global in nature, the types of
risk have changed to include those traditionally banking-related, such as credit and
liquidity, as well as those that are non-traditional in nature, such as off-balance
sheet risk. Banks have had to adapt to this change in ways that have questioned
their identity as being purely banks. This situation has been exacerbated by the
Global Financial Crisis (GFC) which began in 2007. ft is argued by many that the
GFC has changed the banking landscape forever and that perhaps the global
banking environment is entering a 'new normal' post-GFC.
The purpose of this chapter is to provide an overview of the literature
explaining the role of banks specifically and financial intermediaries in general. The
chapter also considers the contribution of banks to the economy and identities the
different types of banks.
1.1
After reading this chapter, you should be able to:
explain why the general equilibrium theory fails to explain the role of banks in
an economy
explain how banks can reduce market imperfections such as moral hazard and
adverse selection
discuss the three generations of financial intermediation theory
identify and discuss the different types of banks
discuss the three phases of the Global Financial Crisis
identify and discuss the main functions of a bank
identify how South African banks differ in size from the largest banks in the world
■
provide a brief commentary on the future challenges facing South African banks.
LEARNING OBJECTIVES
□
ciafIntermediation Theory
T
Bank Management in South Africa - A risk-based perspective
186 513
4.0
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Do the results of Table 1.1 suggest that banks are in some way special, particularly
if alternative sources of debt from financial markets across the world are being
accessed more easily than ever before? Why would economic agents go through the
effort of applying for a loan rather than accessing capital markets directly? Do banks
have features that make them unique? These questions have plagued academics in
the field of financial economics for several decades and have resulted in a wealth of
literature investigating the nature of banks in particular, and linancial intermediaries
in general. The focus of our attention is therefore the evolution of this so-called
financial intermediation (Fl) theory.
At the heart of a bank's purpose is its role to act as an intermediary. This
function eliminates the so-called double coincidence of wants problem by bringing
together different market participants and allocating resources more efficiently
•• between them. This is especially effective because it reduces the search and time
costs associated with two parties finding each other under a bartering system. The
process of financial intermediation is depicted in Figure 1.1.
•Calculated by the author. for the year by South African banks [registered under the Banks Act (94
of 1990)] to the domestic private sector. Source: SARB (2015:Sl0: 20 I 2:Sl0) 1•2
11 Net issues of
marketable bonds for the year. Includes government. local government, other
borrowers and public enterprises. Source: BPA McGrcgorl
'for the year, by companies listed on the Johannesburg Stock Exchange. Source: (201 S:S30:
2012:S30)u
dCalculated by the author. At market prices. Source: SARB (2015:S 108; 20l2:Sl08)u
2005
241 543
297 288
-20 566
2009
2008
289 812
78 213
2007
137 751
2011
140156
202 853
2013
2012
2010
186 033
2014
sector'
Total public
>··
Equity
share capital
raisedc
Bond market
Total value of
Asa%of
GDP"
Debt
Total
Loans
domestic
credit
extensiorrt
2006
-
Year ending
2005-2014
Table 1.1 Relative contributions of debt and equity financing in South Africa for the period
to raising debt in the bond market. What is also noticeable is how the relative
contribution of loans has decreased substantially since 2009, amidst the GFC and
the subsequent squeeze on bank lending.
4
5
Given that a market has several market participants, including households,
governments, foreigners and businesses, an efficient process is needed, firstly to bring
them together and secondly to allocate the available resources efliciently between
them. Fis achieve this by bringing together market participants with excess cash/
wealth who are prepared to lend (surplus economic units) and market participants
with a shortage of cash/wealth who want to borrow (deficit economic units). In
creating this link, Fis reduce information and search costs for the market participants.
In the case of a bank, the effect of this intermediation process is reflected on its
balance sheet. The funds from the surplus units are used as a liability to grant loans
to the deficit units (as an asset) - banks pay interest on the former and use these
funds lo finance lhe latter on which they earn interest. Liabilities are therefore the
source of funds for a bank and assets the use of funds. How a bank is able to manage its
assets and liabilities to maximise the spread between the interest paid and earned is
central to its being a profitable institution. This is the process of intermediation and
serves as the. basic definition of a bank. Put differently:
Figure 1.1 The process and effect of intermediation in banking
Chapter 1: Financial Intermediation
banks have the ability to gather, store and disseminate proprietary information that
reduces information asymmetry between the client and the bank. In doing so, they
are able to make more informed decisions and allocate resources more efficiently
by reducing information and search costs.
Bank Management in South Africa - A risk-based perspective
Failure of the general equilibrium framework and the information
asymmetry paradigm
The literature on Fl theory has grown primarily from the works of Gurley and
Shaw 5 and Benston and Smith.<' Although no single theory exists, formal theories
have been developed as a result of the general equilibrium framework failing to
explain the role of banks in the economy. The subsequent focus on market
imperfections caused by asymmetric information. in particular, became a central
feature in the derivation of FI theory and evolved when the general equilibrium
framework of perfect markets was insufficient to explain the existence of banks.
This framework postulates that information is symmetric (perfect) and complete
across all economic agents. ensuring that all variables affecting their well-being arc
1.2.2
Although in its simplest form intermediati on explains whal a bank does, scholars
have for decades argued whether or not lhis is the dejininu feature that accounts for
their existence. The subsequent rise of FI theory has been characterise d by three
generations, each asking a distinct question. The first generation focused on the role
of a bank and asked the question: are banks special? This generation was
characterise d by scholars questioning the rationale for the existence of banks,
especially with regards to establishing whether or not they had features that made
them special. As llnancial markets became more competitive and global. particularly
in the latter part of the 1990s and early 2000s, the existence of banks was
increasingly under pressure. Non-traditio nal competitors were entering the banking
domain and threatening bank survival and clients were exposed to new ways of
doing business that did not necessarily require the services of a bank. Managing the
risk associated with bank-client relationships became increasingly challenging. As a
result, the second generation of Fl theory emerged focusing on the relevance of
banks. The central question at this time was: are hanks still relevant? More recently, as
a result of global events such as the terrorist attacks in the US in September 2001
and also the GFC, the literature has focused more on identifying the risks faced by
banks and in particular how to manage them in an increasingly complex and
interconnected financial system. The systemic risk associated with bank failure,
especially in the global banking context, has raised awareness of the systemic
importance of banks, resulting in renewed focus being placed on regulation. The
third, and current, generation has therefore been characterise d by risks emanating
from sources that have either been non-traditio nal, or have not been known to the
bank. Consequently, banks, and how we understand them, have been questioned,
with the central question thus being: are /Ja11ks still banks?
FI theory has evolved as the nature of financial markets has changed. The
different theories are therefore considered to be mutually inclusive of one another, 4
and the following section provides a discussion around the evolution of FI theory.
6
7
known. Also referred lo as the Arrow-Dubreu framework, it assumes that all trade
with firms takes place simultaneou sly and before uncertainty is resolved. At
equilibrium, resource allocation is Pareto optimal, meaning that the trading of
contingent commodities leads to efficient risk allocation. Each agent (in this case,
the bank and the consumer) acts optimally as a result of having access to perfect
financial markets and inter-temporal smoothing is assumed to occur automatically.
Transaction costs are also assumed to be non-existent. Since all markets clear
perfectly at equilibrium, banks make zero profits. as all interest rates are equal. no
matter the volume or characterist ics of the securities on the balance sheet of the
bank. In reality. this state of equilibrium is not possible and therefore does not
provide a suitable framework to explain the existence of banks. This resulted in what
•Freixas and Rocbet7 refer to as the 'incomplete information paradigm', which has
led to explanations of the imperfect nature of financial markets and establishing the
rationale for the existence of Fis and thus banks.
Central to the problem of imperfect markets and the failure of the ArrowDubreu framework is the problem of asymmetric information. Asymmetric
information refers to a situation where one party in a relationship /transaction has
different information (defined by amount or quality) from the other party in the
relationship /transaction . This asymmetry whether intentional or nol. will result in
market imperfection as neither party is able to make decisions based on the same
ormano making the information less costly and exclusive to the benefiting
1rty. As.:
party.
As a result of having superior information, one party will be able to make a
ore.informed
r
decision when compared to the other party. In the case of banks that
intermediate, the lack of information results in increased risk, because poor quality
information leads to poor quality decisions.
Imperfect or asymmetric information gives rise to the problems of adverse
selection and moral hazard. Adverse selection occurs when a selection/decision is
made that is not a 'good' decision. Within the context of asymmetric information, iJ
one party in a relationship /transaction bases their decision on less or poorer quality
information, and the decision/selection is a poor one, adverse selection bas been
said to occur. In effect, had there been no asymmetric information and the latter
party bad had all the available information on which to base the decision, adverse
selection would probably not have occurred as a 'better' decision would have been
made given more or better quality information. In the words of Akerlof, 8 'the
difficulty of distinguishing good quality from bad is inherent in the business world;
this may indeed explain many economic institutions. ' Adverse selection is therefore
characterised by increased risk on the part of the party making the decision/
selection, but not necessarily being aware of this risk due to the asymmetric
information. For this reason, adverse selection occurs before (or ex ante) the bad
decision/selection is made.
Asymmetric information also causes moral hazard. which occurs when one
party within a relationship /transaction acts in a risky manner at the expense of the
other party in the relationship/transciction. As the name suggests, there is a moral
• element to the action taken by the party making the decision because they try to
maximise their gains at the expense of the other party. Moral ha;,:ard is thus
Chapter 1: Financial Intermediation Theory
Bank Management in South Africa - A risk-based perspective
First generation: are banks special?
The general equilibrium theory failed to explain the existence of Fis and as a result
scholars have tried to explain the existence of banks based on the functions they
1.2.3
Since the general equilibrium theory failed to adequately explain the role of banks,
the information asymmetry paradigm emerged in the 1960s and enabled policy
makers to identify structural weaknesses within the banking sector. Market
imperfections such as adverse selection and moral hazard were seen as central to
explaining the existence of Pis in general and banks in particular. In a banking
context, these market imperfections would imply situations of information
asymmetry occurring before (adverse selection) and during (moral hazard) a
contract between a bank and its borrower.
By using specialised expertise to evaluate the proprietary information gathered
from clients, banks are able to reduce asymmetric information and generate
information economies of scope. The bank is able to minimise credit risk by being
more informed about the client's ability to service the debt. This is particularly
important because the presence of asymmetric information has profitability
implications and banks act to allocate resources more efficiently when they are
aware of the existence of this imbalance. As suggested by Leland and Pylc. 9
Diamond. 10 Campbell and Kracaw 11 and Chan 12 unless a bank is able to monitor
borrowers, the existence of moral hazard impedes direct information transfer
between market participants and results in the justification of Fls.
The general equilibrium theory was unable to explain the existence of banks
and so scholars have, since the 19 SOs, been trying to establish not only why banks
exist but also whether or not they arc unique. Three generations of FI theory are
identified to explain the evolution of this research.
Abank in its ability to collect, store and disseminate proprietary client irifcmnation
is>bY its very nature, able to overcome, at least partially, the market imperfections
of adverse selection and moral hazard. For example, credit screening js. used to
identify and categorise economic agents according to their risks and characteristics,
thereby reducing the likelihood of selecting a client who is likely to default. Given
lhata bank isprivy tOproprietary and confidential clientinformationandthatit
monitors the behaviour of its clients, it is in an ideal position to identify Situations
where moral hazard may arise. Of course, this is assumed to be true if the bank has
all the information atits disposal. It is clear, therefore, that adverse selection arid
moral hazard cause markets to perform sub-optimally and thus .fail.G~is rn~rket.
failure, more specifically information asymmetry, implies that the gemJral equilibrium
theory of perfect markets does not provide an adequate framework to justify the
existence of banks. tt was with this in mind that the foundation was laid fOrtheoriStS
to establish explanations as to why Fis, and in particular banks, exist.
associated with the incentives of economic agents to avoid costly actions knowing
very well that they will benefit at the expense of the other party. This occurs after
inception (or ex post) of the relationship/transaction.
8
9
Contrary to Benston and Smith, 6 Leland and Pylc 9 discarded the magnitude of
transaction costs associated with the intermediation function and suggested
information asymmetry as the primary reason for the existence of Fis. Their study
indicated that the willingness of a firm to commit equity capital to a project would
act as a signal to the market thereby indicating the quality of the project. If
intermediaries did not exist and firms had to allocate their own resources to enable
them to sell information to investors, Leland and Pyle argue that the information
would then become available to the public in the form of a public good. Fama 14 cites
the ability of banks to generate low-cost financial information by monitoring loans and
creating a comparative advantage as making banks special. He further concluded
that although banks issue certificates of deposit (CDs), that have no apparent
benefits in relation to similar instruments such as commercial paper or bankers
[a] complete theory of the firm, however, should not only provide an integrated view
of the [bank]'s asset and liability choices, but also allow an endogenous
determination of the total scale of operation of the [bank].
perform. The first generation of FI literature made reference, in particular, to
transaction costs and asymmetric information, providing the foundation for
understanding the role of Fis.
Based on works published in the mid-19 SOs, Gurley and Shaw 5 in 19 60
provided the first recognised conceptual framework by integrating the theories of
money and financial institutions. They aimed to explain the relationship between
commercial banks and non-banking financial institutions in the US and identified
the ability to transform assets at a low cost as a central function of a bank. Banks
were seen to exist due to market imperfections and they administered their asset and
deposit portfolios cheaply and on a large scale, which enabled them to gain
economies of scale as the size of the bank increased. This function of transforming
liabilities (primary securities) into assets (secondary securities) was a vital initial
contribution to FI theory.
Based on the work of Gurley and Shaw, 5 Benston and Smith 6 referred to the
reduction of transaction costs as central to the intermediation function. In particular,
they regarded Fis as 'creating specialised financial commodities' that can be sold to
cover the expected costs of production. They viewed these commodities as a derived
demand that enabled both inter- and intra-temporal transfers of consumption by
individuals. Technology and transaction costs borne by consumers determine who
sells the financial commodities and in what manner they are packaged.
Baltensperger 13 identified the main economic function of banks as transforming
risks and acting as brokers in credit markets. According to him, the literature at the
time focused on financial and portfolio aspects such as information, uncertainty
and adjustment costs, but avoided looking at banks as institutions that could
consolidate and transform risk, which in turn would produce and maintain
financial contracts through the use of real resources such as labour. The central
tenet of his contribution was that the financial and real resources of a bank must be
dealt with in an integrated manner. As he states: 13
Chapter 1: Financial Intermediation Theory
I
Bank Management in South Africa -A risk-based perspective
acceptances, they still offer competitive yields, albeit that
CDs require banks to hold
non-in terest bearing reserves agains t deposits - this is referre
d to by Black 15 as a tax
on deposits.
Campbell and Kracaw 11 took a contra ry stance to the view
that Fls focused only
on information costs, the protection of confidentiality
or the production of
information. Rather, they regarded these views as being
complementary and not
independent or stand-a lone explan ations of financial interm
ediation. They suggested,
contra ry to Leland and Pyle, 9 that information asymm
etry and costly information
were not the sole reason s for the emerge nce of intermediarie
s, but rather as a result
of the joint production of both information and the product
s and services for investors.
Diamond and Dybvig 16 highlig ht the ability of banks to
transform illiquid assets into
liquid assets as an import ant function of banks. Therefore,
the provision of liquidity,
transac tion services, confidentiality and the sale of insuran
ce contra cts were cited
as examples of the joint produc tion of information.
This view is suppor ted by
Ramak rishnan and Thako r 17 who regard information
reliability as an import ant
feature of banks. Nayyar 18 goes even further and regards
information asymm etry as
a source of competitive advantage for diversified firms such
as banks.
Delegated monitoring theory. drawn from the seminal work
by Diamond 10 in
1984, argues that because borrow ers want l.o keep
their records confidential,
depositors delegate the responsibility of monitoring to the
bank. The bank then acts as
an agent for the depositors, investing both reputa tional
and human capital in the
process and being able to diversify risk throug h attract
ing large volumes of loans.
As a result of the bank having a superior ability to evaluat
e loans and a cost advantage
to collecting the information, banks are regarded as being special 19
.
Stiglitz and Weiss 20 state that banks perform several
informational roles by
providing a system of accoun ts that enable resources to
be allocated efficiently. This
is done throug h the screening of potential borrowers
and placiny them into risk
categories. The actions of these borrowers are monitored
in order to avoid incentive
problems such as adverse selection or moral hazard. Even
if equity financing is more
desirable. the screening and monitoriny function facilita
tes non-ba nk interac tion
between lirms to make use of bank credit.
Related to the view that banks are produc ers and dissem
inators of information,
is the fact that they provide signals to the market. Centra
l to the signalling effect.
banks provide feedback to the market when supplying
information about their
clients throug h, for example, the annou nceme nt of
ongoing or cancelled credit
arrang ements . The paper by James 21 in particu lar
provides evidence of the
signalling effect by investigating the response of publicl
y announ ced bank loans on
the stock price of a firm. James found a positive abnorm al
response of the stock price
to bank loans, but not for publicly placed debt issues.
He suggested the reason for
this is related to banks being special in some manner. As
he puts it, 'banks provide
some special service not available from other lenders.' 21
Lummer and McConnell 22 provide further evidence that
distinguishes between
new and renewed bank loans. Implicit in their study is
the idea that the information
transmitted to the capital market is based on the ability of a
bank to assess the riskiness
of the borrower both initially when the credit facility is wanted
and through a relationship
10
Allen and Santom ero 23 identified the changi ng global
financial system and the
resulta nt change in the role of intermediaries in the decade
s leading up to the year
2000. Scholtens and Van Wensveen 24 indicated this
by pointin g out that Fis
P() throug h the
information and globalisation revolutions, as well as
the
omo, tition from sources not deemed traditio nal to
compe
the business of banking. This
idea
aea cculmin ated in a shift in the focus of FI theory to consid
er the relevance of
Dd
more closely. The emerge nce of this second genera tion highlig
hted the role of
banks within the contex t of changing financial markets,
and especially within the
context of globalisalion.
As financial markets became more global, risk manag
ement became an
increasingly import ant function within Fl theory. Merton 25
suggested that the
manag ement of risk became particu larly import ant for
banks 'given the centra l role
of creditworthiness in relationships with their custom
ers.' It became clear that
• manag ement needed to actively 'identify, assess. monito
r, and contro l risk' owing to
banks being particularly active in complex markets (specifi
cally derivatives) where
they were encouraged to engage in 'better risk manag ement
(practices] than would
otherwise exist'. 25 •26 •27
28
Allen and Allen and Santom ero 23 have highlighted the
evolution of financial
markets since the 1960s and the resulta nt change in the
role of Fls. A central focus
was on the increasing complexity and range of financial
products banks offered and
used to conduc t risk manag ement of their own daily
operations. The role of
intermediaries to transfer risk and their ability to facilitat
e the participation of complex
financial instruments in complex financial markets was seen
as being absent from the
Jiterat ure and the central tenet of their view. 23 Althou
gh the size of financial
markets and instrum ents had increased, traditio nal interm
ediaries such as banks
were seen to play a smaller role in financial market
s because individuals and
households were using non-traditional intermediaries
and alterna tive investm ent
vehicles such as mutua l funds. 23 The author s provide
d empirical evidence
suppor ting their view that the efficient partici pation of
mutua l and pension funds
along with commercial and investm ent banks had
increased substa ntially in
financial markets and that participation by the individuals
had diminished due to a
1.2.4 Second generation: are banks still relevan
t?
built up when the credit facility is renewed or extended. Their
findings indicate that the
response to loan renewals is significantly larger than lo new
loan approvals. They also
;find that bank loans that are renewed but reduced (or cancell
ed) by the bank result in
a decline in the stock price. They suggest that the reason
for this lies in the continued
]ending relationship between the bank and the borrower.
These studies reflect the endeav our of theorists to define
a bank according to the
functions it performs. It became clear, however, that in
the 1990s and early 2000s
the globalised nature of financial market s played an increas
ingly import ant role in
defining the existence of banks. Competition from
non-tra ditiona l sources in
particu lar placed the existence of banks under threat
and the literatu re began lo
question the relevance of banks especially with regards
to their ability to manag e
risk inhere nt in both traditio nal and non-tra ditiona l source
s.
Chapter 1: Financial Intermediation Theory 11
_____ ,,..,•.,,..-..-~~~:,,;,~-=-~~-"'-·= =---:r--.--~
significant increase in the 'value of people's time'. 23 Technology, they claimed,
reduced the cost of information, leading to a reduction in information asymmetry,
and financial innovation was noted as making a significant contribution to increasing
the breadth and depth of financial markets and instruments. The authors concluded
that financial instruments such as derivatives and securitisation reflected the
growing focus of intermediaries on managing and trading risk and that risk was
allocated where it could best be borne as a result of markets being imperfect. It
follows that previous theories focusing on transaction costs and information
asymmetry do not fully explain this growth of financial markets and instruments
that had emerged at that point in time.
The paper by Scholtens and Van Wensveen 24 regard the study of Allen and
Santomero 23 as incomplete. They postulate that the analysis of intermediaries
should be from a functional rather than institutional perspective, and further argue
that risk management is not a new phenomenon. Rather, the transfer and
management of risk are seen as the 'root' of the existence of Fis as banks have
specialised, over several centuries, in the production and processing of information
to diversify and absorb risk. 24 • 30 Scholtens and Van Wensveen 24 also take into
account the view of Allen and Santomero 23 concerning the idea that participation
costs do not fully explain the drastic changes that resulted in the phenomenal
increase in mutual funds and derivative instruments in the financial industry.
Again, risk is seen to be the raison d'etre of this growth. The authors believe that Fl
theory should 'move beyond its present borders' and 'have the dynamic process of
financial innovation and market differentiation at its basis'. 24
In a classic rebuttal, Allen and Santomero 29 provide empirical evidence existing
in the US which suggests that there has been a decrease in the share of bank assets
and directly held assets relative to non-bank intermediaries such as pension and
mutual funds. 29 More importantly, they claimed that the activities of banks had
significantly changed to include non-interest related activities so as to move away
from merely traditional intermediation and to include fee-producing activities. 29
Evidence is provided citing studies confirming similar trends in France, Germany
and the UK. They draw on the conclusions of Allen and Gale 31 and provide evidence
suggesting that the risk appetite of banks is indicative of economics that are market.based, such as the UK and US, as opposed to being bank-based, such as Japan,
France and Germany. They conclude that in being more market-based, risk
management would reflect the usage of derivatives and similar instruments more than t.he
financial systems of less market-based economies. 29
Oldfield and Santomero 32 also highlight the importance for financial
institutions to manage risk. They identified five generic risks applicable to all
financial institutions, namely systematic, credit, counterparty, operational and legal
ri.sk and concluded that commercial banks are active managers of these risks. 32 The
uniqueness of banks, they claimed, was that actively managed portfolios
characteristic of banks imply that information and investor actions are opaque due to
investor interests. As a result, this feature requires banks to conduct 'discretionary
risk management' activities across the firm. 32 They acknowledge, however, that even
_ /the most stringent application of risk management will not eliminate all risk faced
12 Bank Management in South Africa - A risk-based perspective
13
--•,-,.-..-.-----------~---.,
----.-,--~>-~---------·~ ~----~~~-----·
by a bank. Moreover, Allen and Gale 31 argued that traditional theory lacked t.he
explanation of non-diversi{iable risk. As standard theory postulated that risk is
exchanged and traded across agents with different risk profiles, their model
incorporated the effect of intertemporal smoothing on welfare and asset pricing and
came to the conclusion that intermediaries will improve the welfare of yenerations. As
they explained 'an intermediated financial system can make every generation better
off than it would be with financial markets alone.' 31 As suggested elsewhere, the
29 32
resultant use of risk management techniques will also become more important. financial
of
nature
evolving
and
dynamic
t.he
that
suggest
strongly
papers
These
markets and the concomitant proliferation of risks had a noticeable effect on how
theorists viewed the role of banks. Innovation was rife during this time of
globalisation, but so too were the risks attached. Finnerty 33 for example, regarded
innovation as a process that signified I.he profit-driven response occurring because of
unexpected changes in the tax, economic and regulatory environments, both nationally
and internationally. Mcrton 34 similarly regarded the tax and regulatory
environments as major drivers of innovation /Jy banks. The jurisdiction of the
regulatory environment expanded amidst globalisation, as did the risks. ln further
research, Mertun 35 suggested that while the functions performed by the financial
system (and thus Fis) had been relatively constant since the 1970s, how they were
performed had not been. Citing several examples indicating the rapidly changing
financial markets, he highlighted the increasing competition between Fis and the
financial markets. Merton argued that opaque institutions such as banks could.
become less important as financial innovation increased and new products were developed,
unless they were able to quickly adapt to the change. He argued that intermediaries
'serve an important latent function of creating and testing new products as part of
. ·the general financial-innovation process' and regarded the competitiveness between
Fls and financial markets as ultimately resulting in the improvement of the functions
of each other. 3 5
Coupled with innovation, the rapid advancement of technology has in[luenced
banks to such a degree that the technological revolution has effectively reduced the cost
information, and thus the presence of information asymmetry. 23 As early as 1996,
Llewellyn 36 regarded this as a 'powerful force as it both reinforces and challenges
of the banks' major core competencies: information.' He argued that the
technological revolution would eventually transform the banking and financial
services industries in reducing the barriers to entry /Jy increasing the availability of
information to competitors. 36 Technology was therefore seen as an important feature
that would revolutionise how the world viewed a bank. On a practical level, this
• resulted in banks expanding the choice of service delivery channels to include virtual
structures such as automated teller machines (ATMs), telephone banking, call
centres, and internet banking. 26 •37 The proliferation of financial services had
. further resulted in banks offering a 'one-stop' universal financial service: not only was
• it easier to interact with a bank, but when clients did so they were also able to
purchase products and servjces that insurance companies traditionally offered. 37 •38
Adding value to clients, particularly through what they offered and how they offered it
became a central theme in explaining the role of banks.
Chapter 1: Financial Intermediation Theory
Bank Management in South Africa -A risk-based perspective
1.2.5 Third generation: are banks still banks?
The third generation of FI theory has signified a new era in our understanding of
banks and the impact of bank failure on, especially, the real economy. If scholars
have explained the existence of banks and argued their relevance, how was it still
possible in practice that there was no effective regulatory and legislative framework
Technology and the internet in particular resulted in information not always being
proprietary due to its ready availability. 23 •24 •29 This suggests that it is not the
information itself that is important. but rather that the value lies in how this
information is used to ultimately benefit both the bank and the client. With clients
becoming more demanding, less loyal and engaging in multiple banking
relationships, 39 •4 o banks are constantly seeking to use the information they acquire
as effectively as possible to create revenue-generating opportunities. It follows that
the quality of the information is paramount to banks. The views of Allen and
Santomero 23 •29 and Scholtens and Van Wensveen 24 indicate the inclination of banks
to innovate and expand their product offerings to include fee-generating operations
on the back of the information at their disposal. This suggests that innovation is
essential to reduced transaction and agency costs. 6 •35 Sinkey 41 indicates that the
modern perspective of banks extends the traditional view of intermediation by
regarding banks as offering 'one-stop' financial services and likens banks to 'factories
engaged in information processing and deal making' in fields such as insurance,
investment banking, corporate finance, and trust and retirement services. rt is clear
that besides improving economic efficiency banks have broadened their business
operations to provide a more diversified product and service mix.
In many ways the second generation of FI theory reflects the initial stages of
literature focused on relationship banking. The paper by James 21 is regarded by many
as the first paper which discusses the importance of bank-client relationships.
Scholtens and Van Wensveen 24 see Fis as providing 'consumers and business
households with a variety of services that fulfil their different needs' and that 'valueaddition should be the focus of financial intermediation.' Customer orientation is
essential and the intermediary should be seen as focusing on profitably selling
financial services. They regard the reduction of participation costs and the expansion
of services as central to ensuring this. Urwitz 42 refers to 'customer relationships' as
the most important source of competitive advantage held by banks. As he states, 'the
most significant competitive advantage possessed by banks is that they are the
institutions which have been most successful in building credible, long-term
relationships with their clients.' 42 He further refers to the branch network as the
'main instrument that enables a bank to establish lasting customer relationships.'
The second generation of FI theory was characterised by the changing nature of
financial markets, both nationally and internationally, the resultant focus on risk
management and the use of ubiquitous information to build and foster bank-client
relationships. Coupled with this, however, was the fact that banks became mega
institutions that did not offer traditional bank-only products and one of the consequences
of this complex environment was that several banking crises, such as the Asian Financial
Crisis, and more recently the GFC, changed the course of banking regulation.
14
15
At the heart of these five focus areas are the proposals of the so-called Basel III capital
requirements 43 discussed in Chapter 15. The management of risk as well as the
actual identification, quantification and mitigation of the risk from both a systemic
and organisational perspective will be a central feature of FI theory going forward.
Five main focus areas reflect the evolution of FI theory in the next generation:
(1) The link between the monetary (especially where banks are involved) and real
economy.
(2) The systemic importance of banks and the interconnected nature of both
national and international markets.
(3) The safety net of bailout provided by central banks to big banks - that is, moral
hazard and the 'too big to fail' issue.
(4) The complexity and innovation associated with Hnancial markets and financial
instruments.
(5) Regulatory and supervisory reforms that incorporate the above four areas.
place to prevent such widespread disasters such as the GFC? In essence, what we
about banks and their role in the economy is being thrown into
At th_e heart of the issue is whether or not they are indeed still banks,
given the fact that the actions of banks were the cause of the GFC. More
specifically. banks were mega financial institutions that engaged in complex
far removed from their traditional role. Are 'banks' therefore still 'banks'
the true sense of the word, or are they more complex tinancial service providers?
the latter is true, does this not suggest that they should be treated differently from
-aditional banks (that is, merely deposit-taking and lending institutions)? And if so,
what extent? Given the proliferation of banking products and services and the
expansion into global markets, the third generation of FI theory has raised many
questions than answers at this stage. Global regulatory reform is a dominant
of current FI theory. In South Africa for example, the proposed Twin Peaks
(see Chapter 3) sets the tone for how South African regulators and
firstly view banks and the functions they perform, and secondly who
regulator will be. Clearly, there is an acknowledgement by regulators that the
role or influence of banks has changed and reforms need to incorporate this.
Chapter 1: Financial Intermediation
.
c•l·..
>
.inte· •·.·•· ·. •r..• ·• .•·b.·• ·•.·.• .· .a·.·ril<
int.·h•····e···•
o.·. f liquidity
to a lack.
risk. Due
to reduce
an attempt
ite.ria inbank
e.. n. ding c·r.central
in an
practice
common
became
intervention
and fiscal
.markets,
>attemptto improve monetary conditions. The Federal .Reserve lowered interest rates ..
Jo record low levels and quantitative easing (QE) was an explicit attempt to stimulate
\~Cdnornifractivity. The initial chain of events of the SPCJncluded thErfail(fre of
~ several financial institutions as a result of panic in financial markets:Oue ·to .liquidity
\effective1yyanishing, Lehman Brothers went bankrupt and AIG \VaShail~? d~\pY .an
\$85 billion.loan from the Federal Reserve, who in turn took over the governmMt
48
5Sponsored~nterprises Fannie Mae and Freddie Mac:
The second phase was the policy response to the initial SPC. Given the systemic
.effects of the SPC and the global reach of securitisation, liquidity quickly
disappeared and the so-called 'credit crunch' emerged as banks tighten!id their .
The complexity of financial instruments used .in the securitisation process
(collateralised debt obligations (CDOs), mortgage-backed securities (MBS) artd the
like), in attempting to be more innovative in order to increase revenue streams,
played a large role in further incentivising banks to increase risk-taking activities.
Subsequently, information asymmetry increased between the actions of the banks
and the ability of the market, whether deliberately or not, to understand and/or
assess the risks inherent in activities conducted by banks. For example, the role
credit ratings agencies such as Moody's, Standard & Poor's and Fitch played when
assigning credit rating to the securitised assets further grossly misrepresented
actual risk - up to 75% of the CDOs received AAA ratings with only 7% rated 81313
and lower. 46 This apparent lack of proper risk assessment On the part of rating
agencies further contributed to a situation of information asymmetry, especially as
ratings formed an integral part of the risk assessment process for investors. Hisk,
.. therefore, was grossly underestimated and the communication of this risk to the
market was grossly misleading. This in turn implied that perverse incentives existed
. in the system; bankers were incentivised to take on more risk with the promise of
excessive remuneration packages and bonuses. The risk~return trade off Was
therefore not aligned in any way to rational decision-making.
The deregulation and thus liberalisation of financial markets and institutions inthe
US, specifically the removal of the Glass-Steagall Act that separated commercial
and investment banking activities, is cited as one of the reasons causing the crisis
although some contend that this was not a major driving force given the highly
regulated banking sector. 44 The more liberated financial sector provided a platfdfrri
for banks as financial institutions exploited market imperfections. In an attempt to
increase revenue because of increased competition, banks provided mortgage loans
to subprime clients who, under normal prudent lending practices, would not
necessarily have qualified for these loans. This in turn increased the risk taken by
banks whichwas exacerbated by the growing competition generated hy
globalisation. 47 These lax lending policies contributed greatly to the deteriorating
asset quality on the balance sheets of banks, but the process of securitisation
enabled them to transfer the risk off their balance sheets to other market
participants. The net effect was that securitisation red~cedcapital requir~'.Jlenfa .~nd
45
the quality of the loan books was inherently poor. Undercapitalised banks were the
bankrupt.
forerunner to these institutions becoming
16 Bank Management in South Africa - A risk-based perspective
-~.::
• ~';:-:~/~~ :j'}}tt>~
17
Given the above discussion the most important functions performed by a bank are:
The intermediatio n (asset transformati on) function
The most obvious function of a bank is to act as an intermediary that accepts
deposits and channels these funds into lending activities. This implies that banks
channel funds from lenders, through deposit facilities. to borrowers, through credit
facilities, and in so doing transform liabilities into assets. Banks therefore play a
major role in allocating credit within an economy and as intermediaries they are
able to perform this function. Without this intermediation , market participants
oHhemajol'Jes sonslearriftrorn lhe GFCtfas been how ifexr,'6sed the
rconnected ~atureotboth t~e real.and financial sectors. ~ow regulators deal
h thiswilLbecentra.l to .regulatory.frameworks going forward .. >
7
po sure to excessive sovereign •detff.levels>As global panic set ir\When .the US
1ari6iaEsysti§h'Fcollapsed, interdatidna1;matket participantswit htJrewtheircap ital
,~ the US ari~_headed to soppgsec!IY,~af?havenssuch·as the-E~rpzone and ·.•·••·
mrnoditi s,~o{~ .• asgold. Jheprobf?n-i,,however, wasthat govet0r'rlents; especially
rope,ran.h~ge budget deficitsonthe back bfthe~FC and ~~l:)sequently
ped· high sovereign debfra.tios'that were;not being absorbed by increased
nor11lfgrov.i!~- ThaMsuing;~oC pa~ic~lattyexpo sed Europe~1}~ountriessuch
reece; lreiand, ltaly,Portugai and Spairr(GIIPS),who had sovereign debt ratios
nexi:e~s gt.JOO%. ~fternptS'byJne Ear6pean Central Ba~k (E~B) .tQstimulate
ta:ycMd_i.!fgns had beenJa'rgelyurtsifocessful by the end •of 2_014; Greece in
ularhasb_een under severe threatof leaving thHuropeari lJnibn albeit having
~t:~siveausteti ty measures irnposed}n an auempt to r:duce,the high levels.of
n~ent debt,TheBasei capitalfrarnewo rk has .also been_revis.ited onthe back
e.G~f· ~~~·resultant.Basel Ill pfovidesiapew setof capit~I, li~~idity and.risk
elin:sJor~anks;.1n addition;capitalbuffers'.hiive·l:)eeripropdsed tnat .account
busi~ess cycles and 'the focus has .shifted to holding good quaHrrcapital along
a sufficfehfquant ityof capital. Chapte;'15 provides anin-depth discussion of
••
'efapilal i'etjuireitlents.i:
~-'ih1,a1J};Ji~·?ft~~~ri~iA~c.~s!isAfAt~'ibeg~ bhJribt~rise~i;~~f~~;~drtd~id;
\\lhich enabled them to purchase}he so--calfEid'toxic assets' off the .balaricesheetsc,f
48
Jailing banks. .At a time when regtilationjn theflnancial sectorwas~!th e forefrontin
th~}hinking _of ~~1icymal<ers, the Eme~gency EconomiCStabilisatio~~ct (EESA) of
.ctobe~.2.ods g~ve theSecretary of the Treasury in the us the right tojnitially either
48
11_r9hase2r in~urethes'ettoubled}issetsop to ari amount of $700 6~1i?n. JARP / >
ns
~?.otherprograr
rketpro'grarns.a
grarns.,iredittna
:lank·supportprg
cluded:?ver!.11
8
ding suppo~for AIG a;nd supj:lortJor\Fi'eUS automobileJndusfry.t The Obama
i~istration_furtherrnore signed .int()laW the Dcidd•Frank 'Wall St~e~t~eform and
risumer Protection Act (Dodd-Frank),which effectivelypfovided the largest reforl'i1
·egolati6n fn'-t~e US financial systeiT,Iiihce0the Great,Depression:j,;{'tnajorchange
posed by D_6dd~Frankwas t~efocbs on i~endfying systemically;risky financial
utio~s,: whi_~.h in tum>Nas helievedtoalfev iate the 'too big _to faWissue. Doddj
•
'arik effectiveryrevarhpt!d thEliJS financial 'iervices inclostry.
f%iu~ government alsOimplerriente!tlthe 'Troubled Asset Relief Pr6§fammEl'(TM~).
Chapter 1: Financial Intermediation Theory
•
■
■
■
•
18
would have to find each other, which is both costly and time-consuming.
information costs and in particular the presence of asymmetric information
explains the rationale behind the intermediation function.
The crediJ (wealth creation) function
Due to intermediation, the provision of credit enables borrowers to create wealth
and purchase goods that would otherwise not be available to them. If managed
responsibly, the provision of credit plays a very important role in enabling the
general population to improve their standard of living by providing them with a
means to accumulate wealth.
The liquidity function
Banks assist clients with liquidity through, for example, credit lines and liquidity
provision to reduce possible losses that they might incur. Banks also manage cash
deposil~ for clients by handling the receipt and disbursement of cash from business
clients in particular. This service provides non-interest revenue for the bank, but also
increases insurance and cash handling fees given the risky nature, from a crime and
fraud perspective. of holding excess cash. Banks also take an active part in interbank
markets by assisting other banks with their liquidity needs. A liquidity shortage on the
money and interbank markets is usually the first sign of liquidity problems within the
market. A major challenge for banks in South Africa is to ensure I.hat they maintain the
regulatory liquidity requirements according to the Banks Act (94 of 1990) while at the
same time meeting the demand for loans and cash withdrawals from their clients.
The payments function
Banks carry out the payment of goods and services for their clients through
services including cheque clearing and electronic transfers. This function facilitates
daily transactions between market participants both locally and internationally.
Given the drive by banks to rednce the use of cash transactions, the payments
function reduces the risk of holding cash by conducting payments through a
centralised and convenient. system.
The risk diversificatio n function
Banks reduce risk by diversifying their exposure to different types of assets and
liabilities. This is achieved by transforming risk when a risk mismatch exists between
the bank and its borrowers. Although borrowers use loans provided by banks to
engage in risky projects, the risk is a component of the collateral pledged against the
loan as well as the degree of asymmetric information between the two parties. To
reduce this risk, banks invest in a vast array of different securities in money and capital
market~ that effectively diversities their risk exposure. Banks also offer products and
services that enable clients to reduce their respective risk profiles. Instruments such as
derivatives and unit trusts are examples of such risk-reducing offerings.
The provision of financial scn,iccs and lower transaction costs
Banks diversify their products and services to include, in particular, insurancerelated offerings. Typically referred to as the convergence of financial markets, it is
also known as bancassurance in South Africa and France and al/finanz in Germany.
This activity has resulted in the increased contribution of non-interest revenue
relative to total operating income as well as the reduction of transaction costs for
clients. From a purely strategic perspective the provision of insurance products
makes sense for banks as the business of banking and insurance are interrelated
and complementary to each other. Banks therefore offer financial services as
opposed to merely banking services.
Bank Management in South Africa - A risk-based perspective
The monetary policy function
Banks play a key role in the transmission of monetary policy as central banks
would not be effective without them - central banks interact with banks that in
turn interact directly with the market. ie households, governments. foreigners and
businesses. Banks are therefore the intermediary between the central bank and the
market. As deposits arc the most liquid form of money, monetary authorities can
change the availability of credit. causing a subsequent impact on money supply
that influences the rate of inllation and economic growth. Monetary policy
instruments such as the repo rate and the minimum cash reserve requirement. are
used to indicate the current policy stance adopted by the central bank of a country.
Without banks, these instruments would have no purpose or effect on the economy.
The trust: and fiduciary function
The proliferation of products and services of banks has resulted in the offering of
trust services to clients where the bank manages these funds on behalf of clients.
This fiduciary !'unction acts as a further generator of non-interest revenue.
The guarantor function
Banks act as guarantors for clients who are unable to settle debt immediately by
offering products such as letters or guarantee, for example, to facilitate trade or
funding activities. This function has grown substantially in recent decades due to the
increase in off-balance-sheet activities and the proliferation of financial services in
specifically international markets. In essence. the bank guarantees the performance
of the buyer by standing in as guarantor should the buyer default on their debt
obligations. These guarantees create an alternative source of non-interest revenue for
banks, while providing an effective and low-cost risk management tool for clients.
fth6Gghth~}1tjencVfonction benefits:cli~fas"and shafeholderi.W~en the agents att
theirrespective best interests, theriskisthat the managementof the bank is
cehtivised not to act ih the b'est interests of the shareholders Ofclients.
symmetric information between sharehci.lders (principal) and martagemen!(agent),
uld result in market failures such as adverse selection and mora/hazard. This is
Stly for the principal as the activities and behaviour of the ageritmust be
dnitored through ensurin•g that governance structures are in plaCe. A case in point
.-Sarings Batik in the UK where Nick Lee-son acted in.total violation of best
practices and/based on his actions, caused the eventual demise of the bank.
i~lth6[JgffCoase50 is credited wrthpior'reering the•litehiture ohiigency theory.the
eminal contribution of Jensen and Meckling 51 develops a more comprehensive
w"ofthe firm by integrating the theories of property rights; agency and finance.
mply referring to a firm as a 'black box' that manages inputs and outputs to
ximise profits does not, as they state, ~Xplain the 'conflicting 6bjectives of the
i\di\iidual participants [that] are brought ihto equilibrium so as tOyield this result.'
The agency function
Given the highly skilled nature of bank staff, they act as agents on behalf of their
clients and shareholders to protect and manage the assets and liabilities. The bank
is therefore delegated the responsibility of monitoring the functions it performs in
the best interests of the clients and shareholders.
Chapter 1: Financial Intermediation Theory 19
/.,
~----
..
___ ,
The advisory function
Given the diverse nature of fiirnncial products and services, banks offer their clients
advice on how best to use these offerings to address their needs. The advice can
range from simple budgeting plans and how lo use a current account in the retail
environment, to more complex advice on structured financing and mergers and
acquisitions in the corporate and investment banking environment. In some cases
banks act as facilitators in this regard. given that advice per se can only be provided
if the commensurate qualifications have been obtained by the banker providing the
advice. In South Africa, the Financial Advisory and Intermediaries Act (3 7 of
2002) provides specific 'fit and proper' requirements for bankers to comply with
before they can offer advice to clients.
The intergeneration al savings function
Banks help clients to improve their standard of living by building. managing and
protecting client savings over different generations. This allows inter-temporal
savings and consumption and ensures intergenerational risk-sharing where the
risks associated with assets are spread across current and future generations.
•
Types of banks
1.3.1.1 Universal banking
Given the pressure on banks to compete with both traditional and non-traditional
competitors, mergers and acquisitions have resulted in banks offering a broader
range of financial products and services. This approach is commonly referred to as
the universal banking approach and is evidenced by banks expanding their
distribution channels, through both virtual and branch infrastructures. as well as
The functions performed by banks are provided through various channels that reflect
the characteristics of the client segment and focus of the bank. For this reason some
banks are more specialised and do not perform all the functions mentioned in the
previous section. Some may specialise in only one market segment, while others will
be more universal and service the entire spectrum of clients. The latter type of banks
will typically have divisions or departments each with their own respective strategy
that fits into the overall strategy of the bank. Universal banking is typical of the large
banks which function internationally and that purposefully adopt this strategy of
being a one-stop financial services provider. ln South Africa, the Big Four - ABSA
(under the Barclays Africa Group). FirstRand (including First National Bank, Rand
Merchant Bank and Wesbank), Standard Bank of South Africa and Nedbank - are all
regarded as universal banks with divisions focusing on specific market segments.
Below is a discussion on the various types of banking.
1.3.1
1.3 THE BUSINESS OF BANKING
Although banks continue to provide less important functions such as the safeguarding
of valuables in high security facilities, the functions listed above reflect the notion
that banks arc highly complex institutions. Convenience for the client is a central
driving force and is manifested in the proliferation of services offered. In many ways,
the word bank could be termed a misnomer - a financial services provider is perhaps
more fitting.
•
Bank Management in South Africa - A risk-based perspective
20
1.3.1.5 Consumer banking
Consumer banking refers specifically to the banking needs of consumers and is usually
segmented according to their respective incomes or net worth. Dedicated business units
Within the bank address the needs of each market segment with bankers that have
specific expertise and skills. Although banks categorise and segment different
consumer markets using different criteria. typical consumer segments include:
Wealth management
Wealth management focuses on the wealthiest clients segmented according to net
worth and usually includes professional and extremely high net worth individuals.
The wealth management business unit provides a comprehensive financial services
solution to these clients including investment management, structured lending and
international wealth management. A dedicated relationship banker is expected to
address the needs of these highly demanding clients. The underlying strategy used
by the bank is•to be proactive to client needs and offer specialised product solutions.
Mutual banking
Mutual banks usually offer simple transaction accounts and minimal loan facilities,
along with attractive incentives for depositors to save with them, for the right to vote
• •as a shareholder. Mutual banks arc also known for their conservative approach to
risk-taking, hence offering few products and services.
••• 1.3.I.4
1.3.1.3 Commercial and business banking
Commercial banking usually includes clients that have businesses. These businesses
can typically be classified as small, medium and large businesses (including
agricultural clients), although small businesses, especially sole proprietorships. are
often included in the retail banking segment. As can be expected, the expertise
•offered by banks to this segment is substantial given the risk attached to keeping
businesses solvent as well as profitable.
1.3. I .2 Corporate, investment and merclianl banking
Corporate, investment and merchant banks typically provide wholesale funding
from capital markets to corporate clients. This enables large corporate clients to
rnise capital through the underwriting function provided by these types or bank.
Given the complexities facing the corporate environment, these banks also offer
expert advice on structured financing and offer complex financial solutions that
would not typically be offered to other clients.
adopting the ba11cassurance model. Globalisation has also caused banks to
cilitate cross-border economic activity through their offerings and the integration
f financial markets is making it increasingly more competitive to do so.
Shareholdings within bank holding groups also rellect a vast array of nontraditional banking activities and banks are able to capitalise on the economies of
ale and scope generated by the differentiated, yet complementary. product and
rvice offerings. If one considers the revenue breakdown of banks. those nonditional banking activities from domestic and foreign sources broaden the
evenue base by contributing in particular to non-interest revenue.
Chapter 1: Financial Intermediation Theory 21
By building mutually beneficial and value-based relationships, the revenue
potenlial in this market is high.
Privafc banking
The private banking segment typically includes the same criteria as for wealth
clients except at a slightly lower level. Banks also target professional high net worth
clients and offer services similar to those offered to wealth management with the
same support staff structure.
Pcr·sonal and retail banking
Personal and retail banking deals with the banking needs of middle to lower income
clients. This is typically the largest consumer segment on the books of a bank and
although relationship bankers are assigned to individual clients. the extent of the
attention given to any one client is much less when compared to the wealth and
private segments. The underlying strategy in this market is to address client needs
through the brnneh network and to do so on a reactive or transactional basis.
Transactional banking driven through high volumes of transactions is the central
driving force in this segment. fn certain banks, small businesses, particularly sole
proprietorships, are included.
Mass-market banking
Since the implementalion of the Financial Sector Charter in 2004, South African
banks have increased their focus on the so-called previously unbanked mass
market. As a result. and given the ensuing uptake of banking products. banks have
established mass-market business units that focus on the lowest end of the retail
banking spectrum. These clients arc often previously unbanke<l and have low if not
zero levels of net worth and income. Predominantly black African, these clients
tend to reside in remote rural areas and require, or can only afford, limited
functionality on their banking products. They are also characterised by having a
lower level of education and linancial literacy. 52 The Mzansi account introduced in
2005 by South African banks is an example of a transaction account that facilitates
limited transactions at a low cost. It is debatable whether or not the account has
been successful given the high degree of inactivity and the subsequent need for
banks to close many of these accounts. Nevertheless, the account is a tangible
reflection of a concerted effort by South African banks lo address the need to
promote financial inclusion in all segments of the population.
Bank Management in South Africa - A risk-based perspective
1.3.1.6 Islamic banking
Islamic banking focuses on providing banking products and services, based on the
principles of sharia law, to predominantly Muslim clients. With the central premise
being that usury is not permissible, Islamic banking challenges the conventional
norm that religion and commerce must be separated and argues that modern
commercial methods are not always ethical. especially with regards to conventional
banking activities. Given the growth or the Muslim faith in Africa. Islamic banking
is a market segment that holds revenue potential for the South African economy
going forward.
•
•
22
23
I
462 282 I
372 321
2 298 031
I
I
41 644
49 259
38 542
88 217
266 000
2 313 14s
30 476 988
241 359
2 684 992
29 771 063
JP
HSBC/
'Morgan
pie'
·chase/
185 000
1317529
29 234 069
123 400
1 187 904
98138
1 030 248
24 455 887 24 041 451
Barclays'· Deutsche
BNP
·Paribas•·;
Bankm
pie'
241 000
2 453 361
21 318 072
Citigtoup"
30 499
70911
809 313
Nedbank'Grc>up'
<
Three indicators are often used to indicate the size of an institution: total assets,
·. total equity and the number of employees. Table 1.2 indicates thHt South African
banks are substantially smaller than their international counterparts. For example,
in terms of assets, lCBC (the biggest bank in the world at the time of writing) is
approximately 20 times larger than the Standard Bank Group (the biggest bank
in South Africa at the time of writing), 18 times larger in terms of total equity
and employs 9.4 times more employees. Jn comparison to Nedbank (the smallest
or the Big Four banks at the time of writing), JCBC is approximately 4 7 times
• larger in terms of total assets, 41 times in terms of total assets and employs over
15 times more staff. The South African Big Four banks are therefore substantially
smaller than the largest banks in the world. (Note: although Barclays Africa Group
includes the ABSA brand and is compared to Barclays pie in Table J .2, the latter
owns 63.2% of the Barclays Africa Group. 54 )
• All group information in Rm ill ion as of the eod of December 2014.
b All figures are converted to rand as per the exchange rate for the respective country on 3 l December
2014 and rounded off to the nearest rand. The exchange rates used are Rll.S7$US, Rl.4,07€.
R18,01£ and Rl ,84¥. Source: SARl3 (2015). 57
Sources: "Standard Bank Group Limited (2014): 51 dBarclays Africa Limited (2014): 54
,, 'Firstrand Group Limited (2014); 55 fNedbank Group Limited (2014); 56 ·'ICBC (2014); 58 "China
Construction Bank (2014); 59 'HSBC Holdings pie (2014): 60 iJP Morgan Chase & Co (2014): 61
kBNP Paribas (2014); 62 'Barclays pie (2014); 63 "'Deutsche Bank (2014); 64 "Cilibank (2014) 65
2844012
90 945
165 367
945 535
Eight ofthe largest banks in the world•
991 414
FirstRand Group" >
Big Four South African banksa
Barclays Africa
Groupd
..
1 906 706
Groupe
Standard Bank \
1.2 Comparison between the South African Big Four and eight of the largest banks
the world, 2014
How do South African banks compare internationally?
l.2 provides a comparison by size of the Big Four South African banks with
of the largest banks in the world at 2014 year-end.
Chapter 1: Financial Intermediation
111
I
r,;;;;i
Bank Management in South Africa - A risk-based perspective
Risk versus uncertainty
Non-traditional sources of competition
The advent of the internet, and onlinc purchasing in particular, has resulted in
consumers being bombarded with choices and the ability to purchase on a much
larger scale than ever before. Clients arc, therefore, better informed and can be more
hands-on in their purchasing decisions. The challenge for banks is to harness this
spending activity and provide products and services that are applicable to client
needs. This will require them to be proactive when engaging with consumers as
their needs are ever-changing. Consumer rights also come to the fore, as banks will
be faced with clients who know their rights and act judiciously (or foolishly) to
protect themselves from seemingly predatory financial institutions. With legislation
aimed at protecting the consumer growing at a phenomenal rate in South Africa
[see the Consumer Protection Act (68 of 2008), the Financial Intelligence Centre
Act (38 of 2001), and the Financial Advisory and Intermediary Services Act (3 7 of
2002)] the pressure will be on banks to ensure they minimise the reputat.ional
effects of non-compliance. To this effect, in a world where social media can be a
strong marketing tool. it is also a channel that easily increases reputational risk.
1.4.4 Consumerism and the client of tomorrow
Non-traditional financial institutions such as retai.lers, and innovative funding
mechanisms such as crowd-funding. will become an increasing threat to banks as
they vie for market share. With globalisation and the internet makjng it easier for
consumers to purchase anything from anywhere, competition will surely intensify.
1.4.3
Given the global aftermath of the GFC and the ensuing effect this bas bad on policies
throughout the world, banks and specifically their regulators will not only have to
monitor but also align themselves to monetary and fiscal policies. The CFC has
revealed the interconnectednes s of financial markets and the systemic importance
of large multinational banks and this will place immense pressure on national
policymakers to ensure that they co-ordinate their policy frameworks with those of
the major global economies
1.4.2 Global policy co-ordination
By expanding into new markets and offering a wider menu of products and services
in these markets banks will be faced with a new set of risks and uncertainty. As
innovati.on intensifies to capture and even maintain market share. the ability of
banks to identify. quantify and mitigate these risks will be crucial to survival.
1.4.1
1.4 THE FUTURE OUTLOOK FOR BANKS
The specialness of banks is constantly under threat. There are several challenges
that banks, and specifically South African banks. will have to be aware of when they
enter the next decade. These arc listed below.
24
25
..,,..,,·.%t
~-~
"'·'"'"-""'
REFERENCES
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CONCLUSION
This chapter has provided an overview of FI theory. At the core of the theory is the
<question whether or not banks are special. Proponents of specialness tend to argue
that banks offer the unique ability to collect, store and disseminate proprietary client
information and that the intermediation function they provide drives the uniqueness
of a bank; opponents argue that given the proliferation of banking products and
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>being able to acquire. store and disseminate information on its clients. it is unable to
ensure that it makes informed decisions as well as addresses the specific needs of its
clients. The challenge for banks, however, is to remain competitive and 'relevant' as
>the literature clearly indicates that the definition of intermediaries as a whole is
constantly under threat due to evolving. globalised and complex financial markets.
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change dramatically on the back of the GFC. Basel III is already being implemented
and with the Twin Peaks framework close to being formalised in South Africa, the
burden placed on banks to be compliant will intensify. Banks will need to ensure
that not only do they hold sufficient quality and quantity of capital. but also that
the risk management practices they have in place identify. quantify and mitigate all
the risks faced by the bank. This is by no means an easy task, especially on the back
of a highly interconnected and complex financial sector that thrives on innovation.
Regulation and risk management
Chapter 1: Financial Intermediation Theory
Bank Management in South Africa - A risk-based perspective
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Boot. WA & Marine, M. 2008. 'The evolving landscape of banking.' Industrial and
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------- -- -.--------~-~------===
5 5. FirstRand Group Limited. 'Annual integrated report 2014.' http:/ /www.lirstrand.
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28 Bank Management in South Africa - A risk-based perspective
·Gt.ANDSCAPE
l}TH AFRICAN
"·/i
·RT-TWO
INTRODUCTION
Assessing the operating environment of the South Afrirnn banking industry should
include a combination of market structure (number of firms and level of
. concentration), contestability and effective competition analysis. This may sound
\ much simpler than it actually is. The b,mking industry is known for its rapid
growth, innovation and the creation of new banking activities in fields such as, but
not limited to, investment banking, vehicle financing and retail banking. The South
• •· African banking industry is dominated by four banks, the so-called Big Four (or four
pillars). namely ABSA (part of the Barclays Group), Standard Bank of South Africa
•.• (part of the Standard Bank Group), Nedbank (part of the Ncdbank Group) and First
National Bank (part of the FirstRand Group), Since the financial sector is at the
f centre of the economy, the high level of concentration and the structure of the
• • industry (specifically the retail industry) often grab the attention of South Africa's
competition authorities. The purpose of this chapter is to provide an overview of the
level of competition and competition policy related issues in the banking industry.
./
Note that care should be taken when using the respective concepts 'sector',
•• 'market', 'industry' and 'firm'. A sector describes the broadest scope of
economic activity categorised by a large group of companies involved in similar
business activities, such as the financial sector. Within the financial sector, lies a
market. A market refers to both the demand and the supply side. Examples are
the capital market, foreign exchange market and derivative market. When only
referring to the supply side of the market, we refer to the industry (an easy way
to remember this is that the market refers to who the firms are supplying to and
the industry refers to who is supplying the good or service). Therefore, an
.tter reading this chapter, you should be able to:
analyse the level of competition in the South African banking industry by using
the structure-conduct-perfo rmance framework
evaluate the structural variables that influence the conduct and performance of
a bank
discuss the different types of barriers to entry that exist in the banking industry
interpret and evaluate the current competition policy issues in the South
African banking industry
compare the most important performance indicators pertaining to banks in
South Africa.
EARNING OBJECTIVES
~thpetitive and Operating
.:<>~Tent of the South African
ngJndustry
Bank Management in South Africa - A risk-based perspective
· · - - .- - ~
----a-,--,~--"'~~~11""~~~":I!•" "~=,._,,.,,_,,_.,_-_-,-__
2.2
AN SCP ANALYSIS OF THE SOUTH AFRICAN BANKING
INDUSTRY
Figure 2.1 provides the outline of the SCP approach that will be used in this chapter
to conduct a competition analysis of the South African banking industry.
industry describes a specific group of rival companies that is involved in high
substitutable (nearly identical) business activities. such as the retail industry or
insurance industry.
The South African banking industry provides a 'textbook' example of an
oligopolistic market. Its market attributes include few firms (between two and
twenty), homogenous/heterogen eous products. high barriers to entry and mutual
interdependence. Mutual interdependence implies that pricing and output decisions
are not so much a matter of cost and revenue. but rather of strategy. The survival of
firms in oligopolistic markets therefore depends not only on their own decisions but
also on the actions and reactions of their rivals.
In general the literature identifies three approaches for measuring the degree
of competition in the banking industry. or any industry for that matter. The most
comprehensive of the three is the neo-classical structure-conduct-performance
(SCP) approach, which postulates that the degree of competition is inversely
related to the degree of market concentration. This approach is the most pervasive
of the three and is regarded by competition authorities as the most important in
measuring the degree of competition. The remaining two approaches are much
narrower than the SCP in that they are more focused on specific variables within
the industry. The contestability approach measures the height of barriers to entry,
as there is an inverse relationship between the strength of these barriers and the
level of competition. This approach, proposed by Baumol1 in 1982. was used as
justification for defending Microsoft in the anti-trust case jJut forward by the
Department of Justice in the US in the early 2000s. Finally, the direct approach
measures competition by computing the reaction of price (or bank interest
revenue) to changes in cost. This measure is called the II-statistic. put forward by
Panzar and Rossc 2 in 198 7. Due lo the restricted nature of the latter two
approaches, they are typically included as part of the more comprehensive SCP
approach. As such. the SCP will be used as the basis for the structure of analysis
of competition in the South African banking industry throughout this chapter.
This is highlighted in the next section in Figure 2.1.
32
33
The SCP paradigm (developed by Mason (19 39) and Bain (19 56))postulatesthatfirm s
who operate in a certain market structure will conduct business in a complementary
way and this will result in a specific level of performance. In other words, there is a
}direct one-way causality between structure. conduct and performance. Within the
SCP paradigm, two competing hypotheses exist justifying the correlation between
industry structure and performance. The first hypothesis - the so-called market
power hypothesis- predicts that high levels of concentration (or few firms operating
/in a market) will encourage co-operative behaviour and reduce competition, thereby
enhancing profits. There is thus a positive relationship between concentration and
profitability irrespective of the level of efficiency achieved by the firms. Contrary
to this view, the efficient market hypothesis suggests that highly concentrated
markets are a result of superior efficiency and not necessarily collusive behaviour.
Therefore. as a bank increases its overall efficiency, its pricing structures will
become more competitive. gain market share and increase profits.
The SCP one-way causality has also been criticised by the so-called New
Empirical Industrial Organisation (NEIO) paradigm. which argues that the structure
>of a market is not endogenous, but influenced by the strategic behaviour of firms.
The NE[O approach thus suggests that there is no direct link between structure,
conduct and performance as the conduct of firms can alter the type of market
tructure. In practice there is no consensus over which of the two schools of
4
3
thought is better. In South Africa for example. Prager and Hannan, Falkena et al
5
the
that
conclude
(or Falkena II) and Okeahalam all used the SCP framework to
banking industry was highly concentrated and in favour of the market power
Figure 2.1 Structure-conduct-perfor mance paradigm
The Competitive and Operating Environment of the South African Banking Industry
•·: --~---~?
;j ~ =t Li=1~- -
'.
'
11.
,:-::
:c2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
·''!'.
y,_rywc7.>u<<Y~
_>----~ ~-
v ...- - , - - - - - -
Source: South African Reserve Bank, Bank Supervision Department. various annual report.s 6
Figure 2.2 Number of banks in South Africa, 2000-2013
O
:~ :.~_:_:_u:~i::-.·~_:_-i+Yf--r; _
'
/
20
~-
if-: · ; ; t - - F . 3 ~ : r - ? ? ~ - ~ , - - - - - - - - - - - - - - - - ~ 20" 1~ 1~- ~19 19
1§ 17 17 17 17
- ,
'.,r,; 1-
E
.0
~ ~~
~
~
50 . - - - - - - - - - - - - - - - A'>
45 _ '-...~
40 · , : ~ - 1 ' l - - - - - - - - - - - - - - - - - - - - - _ __
35 :- --·-- /,,_"'-.
Registered banks in South Africa
2.2.1.1 Tl,e number of firms
Since the beginning or the new democratic South Arrica in 1994, the number of
small and medium local banks (or A2 banks) increased steadily over the years until
1999 when the number started declining on a consistent basis. (A2 banks refer to
smaller banks, based on ratings by credit rating agencies, and this name is applied
here to all local banks except the Big Four and Investec in South Africa.) In the
artermath or both the global emerging market crisis or 199 7 /98 and the 9/11
terrorist attacks in the US in 200], poor financial management (driven especially by
liquidity pressure) led to many of these A2 banks either merging or being taken over
by Al banks. This factor, as well as exits from the market due to licences not being
renewed, was a precursor to Saambou Bank being placed under curatorship in
February 2002 due to reckless mortgage lending and fraud. In the following
months. BOE Bank was integrated into Nedbank. During the period between
September 1999 and March 2003, a total of 22 banks exited the South African
banking system. This resulted in there being no meaningful 'second-tier' banking
institution left. The number of registered banks further decreased to 19 in 2005 as
Peoples Bank Limited was deregistered. Figure 2.2 indicates the dramatic fall in the
number or registered banks in South Africa from 2000 to 2013.
2.2.1 Structural variables
The first step in the SCP analysis is to identiry the structural variables in the
industry. Structural variables refer to the exogenous factors that place a competitive
constraint on a linn's ability to set price and output. These variables are: the number
or lirms and the level of concentration; the nature or the product and the barriers_ to
entry.
hypothesis. Irrespective or the link between the SCP variables. the framework will be
used in this chapter to analyse the degree or competition in the South African
banking industry.
34 Bank Management in South Africa - A risk-based perspective
1.i.a.20
mcmocs active banks and Jthala Limited, exempted by sectioo l (c)c) of the Banks Act (94 of
1990) and Meeg 13ank Limited exempted by the Registrar of Banks (with effect from J July
1996) in terms of the Supervision of Financial Institutions Rationalisation Act (32 of 1996).
South African Reserve Bank, Bank Supervision Department. annual reports. various
editions"
2.3 Number of banks in South Africa, 2000-2013
-in
"'
,,-
,,, Local branches of foreign banks
Registered banks*
Representative offices ■ Controlling companies
· 11.•1
!'~;I
!1
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
.
■
m 2005 the number of banks remained constant at 19 until ABSA Group Limited
quired all the shares in Meeg Bank Limited during 2009, reducing the total number
.banks to 18. During 2010. the number was reduced further to 17 as the assets
d liabilities of Imperial Bank Limited were sold to Nedbank Limited. After the
ajority of the A2 banks were integrated with the leading A 1 banks, South African
thorities adopted the so-called four pillar policy. (Australia and New Zealand have
lied on the four pillar policy since 1990.)This policy refers to the minimum number
f locally owned banks (called 'pillars') that the domestic banking industry relies on
nd explicitly discourages any merger between them in the interests of promoting a
&mpetitive environment that reduces the adverse effects of systemic risk. However,
,e Banks Act (94 of 1990) does not disqualify international ownership of a bank
Br a bank controlling company). thereby ensuring that the acquisition of ABSA by
arclays in 2005 and that of Standard Bank by the Industrial and Commercial Bank
f China in 2007 did not infringe the four pillar policy.
In 2013 the South African banking industry consisted of 17 registered banks,
4 local branches of foreign banks, two mutual banks and 43 foreign banks with
cal representative offices. or the total registered banks. six were controlled by
reign companies and nine by local companies. 6 This is shown in Figure 2.3.
The Competitive and Operating Environment of the South African Banking Industry 35
.%·~ ••....-.-.··•'-
•.
2000
~
rn rn rn
rn rn rn
0
0
rn
rn
rn rn
rn rn oo
o
o
a
o
---0-
o
o
o
o
o
o
o
o
~
o
o
00
o
o
rn
a
o
Total assets as % of GDP
O
N
N
N
N
N
N
N
N
N
N
N
o
~
~
N
o
~
N
N
o
~
M
N
o
~
I 0%
- : - , - : • ~ . - ? / . W o ' . ~ - - . .:,---.-_,-_.,_, ____ ,c.v..··-,,
*The calculatio ns of the concentra tion and market shares are based
on the Dl900 total asset
returns provided by the SARB on December 201 3, To express total
assets as a percentag e of GDP,
the nominal value of GDP !as published in the SARE Quarterly Bulletin
(201 3 :S-108)] was used.
given that the nominal value of assets is reported,
Figure 2.4 Total assets as a percentage of GDP for banks in South
Africa, 1994-2013.
0
500
1 000
1 500
2 500
3000
3 500
4 000
,,,, GDP
11 (,,, I ,,.,, I 1·1 I 1·•1 I 1--1 I ,,., I ,-,-, I I 'I I IH I Fl
) 1-:11 I r:-j I Ml t Pl I 111'1 I r~, I -Ml t r·1 I PI j l'N
~
~
©
~
00 rn O
~
N
M V
~
~
Total assets
4500
~
C:
In 1991 Allied Bank, United Bank, Volkskas and SagifBanks merged
tc:icreatethe
Amalgamated Banks of South Africa (or ABSA as it is known). As
of July 2013, and
because of a majority ownership by Barclays Bank pie in the United
Kingdom, the
group name changed to Barclays Africa Group Limited. Although
the ABSA brand is
still functioning in South Africa, suggestions are that it is merely
a matter oftime
before it falls away entirely.
Bank Management in South Africa - A risk-based perspective
The sharehol ding structur e of the South African banks at the end of
2013 consisted
of 47. 7% foreign shareho lders (measured in nominal value of South
African banking
sector shares). 24.3% domestic sharehol ders and 28% minority sharehol
ders. The
main reason for the large foreign percentage is due to the majority sharehol
ding that
Barclays has in ABSA. Minority sharehol ders refer to both domestic
and foreign
shareholders who respectively own less than 1% of the total nominal
value of shares. 6
The financial sector plays a vital role in economic growth as it typically
contributes
between 10% and 11% of South Africa's gross domestic product (GDP).
As of 2012.
banking sector assets represent over 50% (R3.5 trillion) of the R6
trillion financial
services sector assets. 7 Since 200 l, growth rates in banking assets have
exceeded that of
the annual nominal GDP growth rate. As illustrated in Figure 2.4, the
ratio of assets-toGDP by banks exceeded the 100% mark in 2001, reaching a peak of 140%
in 2008 and
falling in subsequent years, mainly as a result of the Global Financial Crisis
(GFC).
36
Market share and concentrati.011 ratios
Before regulators can calculate the market share and assess the level
of competition in
an industry, the relevant market in question should be defined. The relevant
market is a
/concep t used in competition analysis that refers to drawing a
boundar y around
products or services that are truly substitutable. This determines
which financial
institutions are genuinely competitors. Defining the 'relevan t market'
answers the
question, for example, docs beer compete with wine? Or does brandy
compete with
whiskey? In other words. by defining the relevant market, it can
be established
•• •2.1.2 The level of concentration
ncentrat ion indices measure the number and size distribut ion of
firms in an
dustry, These structur al indices are used by competition authorit ies
worldwide to
ssess the degree and/or change in the level of competition. Various
indices exist to
• easure the degree of concent ration in the banking sector. These
indices include
arket share, the Herfind ahl-Hirs chman index (HHI), concent ration
ratio (CR) and
'he Lerner index. It is importa nt to note that when assessing
the degree of
ompetition within a particul ar market, especially a complex environ
ment such as
banking, other factors should also be considered. These include
the size of the
Incumbe nt firms, the geograp hical constrai nts of custome rs, custome
r interest and
heeds, switching costs. the level of contestability, regulato ry requirem
ents and
product differentiation. Note that custome rs and clients arc used intercha
ngeably as
they refer to both consum ers (people) and entities (companies). Consum
ers simply
refer to the final user or purchas er of a good or service.
In general. competition theory identifies a positive relations hip
between
concentr ation and financial margins (or profits) in banks. There
are three main
argumen ts for this. The first. argues that as a bank's market share
increases (and
therefore concent ration levels increase), the degree of market
power the bank
possesses also increases. Firms with market power are prone to - either
unilatera lly
or co-operatively - increasi ng their prices. This leads to higher margins
between
ending and deposit rates. which in turn implies higher profits. The second
argume nt
suggests that banks arc more efficient and consequ ently more
prolitable, thus
obtaining a larger market share. The third argume nt maintain s that
markets are
concent rated as a result: of barriers to entry. High barriers - especiall
y regulato ry
barriers - result in fewer potentia l entries. These high barriers result
in firms being
able to charge high prices, maintai n high margins and make excessiv
e profit without
fear of new competition,
The following section deals with several measure s that assess
the level of
concent ration and therefore competi tion .
iJNeclb'ahkGroup was foUritledlh Arn'sterdam in1888 and
ederlandsche Bank en Credietvereeniging voor Zuid Afrika. In
ha~ged to Nedbank Limited and on31 March 1992 it
(January 2003,Nedcor Umited absorbed ·BOE Limited and
h:inged its·name to Nedbank Group Liniited.
The Competitive and Operating Environment of the South African Banking
Industry 37
f
= ·-,-,-, ••·.•-• ·••
-· ····-~ ./.•·-
"'""·""'·=----~- -~-
?-V.,111""-"II"!,~-' /V';·.~"""-n/ .-."'.:".Z?..
whether or not we are dealing wilh. in this case, the beer market. wine market, spirits
market or alcoholic beverages market. Only once the competitors have been identified,
can the applicable market share be calculated. It should, however, be mentioned that
depending on the availabilily of data or the research question that needs to be
answered, economists and regulators use different proxies to calculate market share.
Jn the banking industry, for example, assets, deposits or liabilities are often used as
general proxies. Furthermore, different approaches are followed to classify the
substitutability of products. Literature tends to use the cluster approach (or define the
relevant rm1rket more broadly). whereas competition authorities follow the segmented
market approach. The cluster approach combines products into bundles - for example a
banking account consists of savings. cheque and credit card accounts. Consumers are
then free to choose a bundle of banking products given the specific needs of the
customer. Conversely the segmented market approach considers each product in a
separate market. Using the same example, credit cards, savings accounts and cheque
accounts are all viewed as being in separate market segments. The total market share
of the bank is then calculated by the average of all the different products.
Another reason for the importance of market share is its role as an indicator of
market power. The larger the market share a firm possesses, the stronger the degree
of market power. Economists define market power as the ability of a firm to set price
above marginal cost. As firms in a perfectly competitive market act as price takers,
price is set equal to marginal cost. The Competition Commission in South Africa
uses two approc1ches to define market power - the structural approaclr and the
behaviour approach. The structural approaclr focuses on market share. Section 7 of the
South African Competition Act states that: ·a firm is dominant in a market if (i) it
has at least 45% of that market, (ii) it has at least 35%, but less than 45%, of that
market, unless it can show that it does not have market power and (iii) it has less
than 3 5% of that market but has market power'. 8 The behaviour approach determines
market power by assessing the conduct of firms - market power is defined as 'the
power of a firm to control prices; to exclude competition or to behave to an
appreciable extent independently of its competitors, customers or suppliers'. 8 The
Competition Act directly infers that if a firm has above 35% market share. it has
market power and is classified as a dominant firm.
Although market share can provide an indication of who controls how much of
the total market, it is not always a true indication of market power. The main
limitations of using market share as an indication of dominance (or market power)
include:
•
The area or geographical scope in which a firm competes. A firm might hold a
large market share for the domestic market. but actually competes in
international markets. This will overestimate the level of concentration and the
degree of market power a firm possesses.
•
A firm may hold a large market share. but the degree of market power is
constrained by an elastic demand. This can be attributed to ractors such as the
luxury nature of the product, close or available substitutes, dynamic
innovation and constant product differentiation that renders dominant market
share tempornry.
38 Bank Management in South Africa - A risk-based perspective
39
Equation 2. 1
CRs are commonly used by competition authorities in merger or acquisition cases
where the comparison of the pre- and post-merger ratios are used to ascertain
whether or not the merger will result in the creation of a dominant bank and as ,1
result enhance the market power of the bank.
As indicated in Table 2 .1, the South African banking sector is dominated by four
full-service banks, namely ABSA, Standard Bank, FirstRand and Nedbank. These
banks account for at least 80% of the total market assets. Standard Bank, the largest
bank in terms of assets in 2012. had a market share of 26%, followed by ABSA and
FirstRand with approximately 20% each. The smallest of the four banks, Nedbank,
had a market share of approximately 16%. The largest increase in the CR took
4
place in 2002/2003 (refer to highlighted sections in the table) as a result of the
Nedcor/BOE merger. At the end of 2001. the CR was 69%, whereas at the end of
4
2003 it had increased substantially post-merger to 80.66% (Nedbank's market
share increased from 14.60% to 20.29%). Another reason for the escalation of the
k is 4. Z; represents the total value of the assets held by the individual bank
21 the total industry assets. Depending on how the market shares are distributed
between the firms, the concentration ratio for the three, five or ten largest firms is
commonly used. By way of an example, if the CR.1 = 80% it means that the largest
three banks are responsible for 80% of the total banking assets. The higher the CR,
the higher the level of concentration and the more the market is dominated by a
few banks. [n the Merger Guidelines of 1968,Y the US Department of Justice and
the Federal Trade Commission provided a rule of thumb for the interpretation of an
industry structure using the CR 4 . Jf:
CR 4 = 0: perfect competition
0 < CR 4 < 40: effective competition or monopolistic competition
40 < CR 4 < 60: loose oligopoly (where the market share between the largest
four firms is distributed evenly) or monopolistic competition
CR 4 > 60: tight oligopoly (where the market share between the largest four
firms is distributed unevenly) or the presence of a dominant firm with fringe
firms
CR 4 > 90: effective monopoly or a super dominant firm with competitive fringe.
ZI
CRk= l:/=,Zi
the market shares of the firms are determined. the concentration ratios can
be calculated. Concentration ratios indicate the extent to which a relatively small
number of firms control or dominate the total industry. Tt therefore focuses on the
egree of inequality in a market by emphasising the share of the largest firms. The
R4 (fou~-firm concentration ratio) for the South African banking industry would
hen be calculated by dividing the assets of k number of banks by the total assets of
banking industry:
Market share docs not. provide an indication of the level of barriers to entry as
lower barriers can constrain a dominant firm's ability to abuse its market power.
er 2: The Competitive and Operating Environment of the South African Banking Industry
Bank Management in South Africa - A risk-based perspective
83.78
90.99
91.53
84.11
0.65
7.42
1954
17.16
26.11
21.30
2011
91.59
84.68
0.41
6.91
19.75
17.55
25.90
2008
89.77
84.42
0.14
5.36
19.19
15.92
27.20
22.11
90.84
85.09
0.11
5.75
19.34
17.14
25.87
22.73
2007
89.72
84.04
0.09
5.68
18.70
18.27
25.57
21.50
2006
0.05
4.83
17.56
20.61
25.69
19.73
19.55
20.64
0.30
6.06
18.48
5.80
19.26
20.29' 44'60
2303
18.86
5.99
18.63
13.75
17.58
19.27
2001
6.16
11.26
13.83
18.38
20.69
2000
89.52
88.42
86.73
79.85
75.24
76.32
O.o3 O.D3 0.04
83.74 83.59 80.66, '74:05 69.24 70.16
0.07
5.79
18.31
18.01
25.99
21.37
2005 2004 2003 2002
Equation 2.2
where n is the number of firms. Z; is the value of the respective firm's
assets and z,
is the total value of all assets in the industry. When the market share
is expressed as
a percentage, the HHI ranges between 10 000 (100 2 for a monopoly)
and IO 000/11
(for a minimu m value). where n represents the number of firms in the
industry. Note
that if market share is expressed as a decimal, the maximu m value
of the HHl is l
and the minimu m value is 1/n. The higher the value of the HI-II,
the higher is the
level of concent ration.
The HHI is used to measure the level of concent ration and competi
tion in an
industry and specifically assists competition authorities in merger
analysis. South
Africa has adopted the US Departm ent of Justice and the Federal Trade
Commission's
Horizontal Merger Guidelines of 2010 10 as the guideline to assess
the level of
competition for firms in South Africa. If:
1
,,, (~)2
HHI = l:;=
z,
2.2.1.2.2 The Hc1finda/Jl-llirsc/1man index
The Herfinda hl-Hirsc hman index (HHI) is the most widely used index
for measuri ng
the degree of concent ration. It is calculat ed by squaring the market
share (expressed
as a percenta ge of total assets) or each respective firm competing in
the market and
then summin g the resulting squared numbers . As this measure takes
cognisan ce of
both the market share and the number of firms in the market,
it is generally
preferred over other indices by economists and competition authorit
ies:
The CR is nol without limitations. Its major disadvantage is that it
does not give an
indicatio n of the total number of firms in an industry and how the
market share is
distributed amongs t the leading (or largest) firms (refer to the explanat
ion box in the
section below for an example). To overcome this hurdle the HHJ is also
calculated.
90.74
84.64
0.29
6.10
18.50
17.13
27.10
21.90
2010 2009
21.47
Source: Author's own calculations
83.40
90.52
116
CR 5
7.21
7.12
Investec
Capitec Bank
CR4
16.86
20.11
17.15
20.46
Nedbank
FirstRand Bank
1.03
26.14
25.53
Standard Bank
20.66
20.26
ABSA Bank
2013 2012
Table 2.1 Market share and concentration ratio of leading banks
in South Africa,
2000-2013
concent ration ratios was attribute d to the 22 banks that exited the industry
between
September 1999 and the end of March 2003. The highest CR was
reached in 2007
4
(85.09%), with the CR5 peaking in 2010 at 91.59%. It is interesti
ng to note that
since 1994, only Capitec bas manage d to enter the deposit-taking retail
market and
survive. Given that Capitec caters for the lower income level custome
r, it has in
recent years been a worthy competi tor to the Big Four in the rel.ail banking
space.
40
Equation 2.3
--------"""""'~
-------_ .....-== -="",____ ____ ____ ____
____ ____ ___
t/suB/>o§e'tf-,ii'(;R/=80% for•·bbthfndu!H~•~a:nHjfitfustryB resJjettiJe
1y.ir·•··
A/,discussed above,theCRJails!Oi~di~atepow.the markeF~har~:,s
distributed .• •
':!1/{een.th!f?U~jeading firms: If ~oulc:ih~Fth,at industry A's rnar~':ts~
are .is equal(Y
ist~.ibtite_a·betweeh}heJour firtns ~f~b%f iich••WMreas •industry.~•s
market·shar~ is<•.
t5t~i.buted respectively 50%,20 ~{5~-~ d . 5%;.v.J_e aSSUlll!! inf~C}•th
at this ·.is the__ •
tfa~'7· l~}ncfil5!r/t/ao utie of co~operatf~e market powei'/or.collu~i~n)··is
.more l_ik~ly
ta_~_e· ~1ace,cWhereas the··abuse~f u~il~t:Yal 111arket pdwerfs.mor~'li.k
elytotakek
1:cewhen a large dominantfirii'ti.s preseryt;~uch)asJhefa~ewit~indust
ry 8. (}- ••
t~olighth e9~4equ alling 80%;indi?atesthat Jhere are _moretha~Jourfirm
S/\. D • • ••••
p:rating in the market~the'.questi6il;that;~eeds cto be asked· is how
mailyfirm s are
there exactly? It can ·be anything from five to literally hundreds or
thousands.
<,
advanta ge of the HIII over the CR is that it gives proporti onately greater
weight
the larger market shares and it includes all the banks in the industry
. As a result
the HHI provides us with both informa tion of how the market share
is distributed
between the firms and reveals market dominance.
following general benchm arks 10 for merger analysis are applied:
If the HHI is less than 1 500 the merger is less likely to cause competi
tive
concern and requires no further analysis.
If the HHI is between 1 500 and 2 500 and the increase is greater than
100, it
is likely to have adverse competitive effects and warrant s further scrutiny
.
If the HHI is greater than 2 500 and the increase is between 100 and
200, it
potentially raises significant competitive concerns and often warrants
scrutiny.
However, if the increase is greater than 200, the merger will enhance
the market
power of the post-merger entity and strengthen its ability to abuse its market
power.
(Abuse of market power is classified as either exploitative or exclusio
nary abuse.
Exploitative abuse refers to the direct exploitation of market power, where
conduct
of a dominant firm directly causes harm to the consumers by either charging
a high
price to its consumers, or by limiting its development of new products
(innovation).
Exclusionary abuse refers to any conduct by a dominan t firm that either
puts rivals
at a disadvantage or prevents firms from entering or expanding within a
market. The
aim of exploitative abuse, is to extract a greater amount of consumer
surplus and
increase profits, whereas the aim of exclusionary abuse is to strengthen
or maintain
the market power of the dominan t firm by distorting or eliminating competit
ion.)
Increase in HHI = market share ol' Ax market share of Bx 2
ompetition authorit ies use the HHI to consider both the pre-mer ger
level of the HHI
nd the increase in the HHI resulting from the merger. Assumin g firm
A and tirm B
to merge the increase in the HHI as a result of a merger is calculated
as follows:
HHI < 1 500: indication of low levels of concentration and high levels of
competition
1 500 < HHI < 2 500: indication of moderate levels of concentration and
competition
HHI > 2 500: indication of high levels or concent ration. When the index
exceeds
1 800, oligopolistic markets usually exist.
The Competitive and Operating Environment of the South African Banking
Industry 41
+
Therefore, if industry A has, for example, five firms with equal marketshare,
HHI = (20 2 202 + 202 + 20 2 + 202) = 2 000.
Bank Management in South Africa - A risk-based perspective
~
~
~
~
ro
m
~
N
N
oo
o
rn m
m m
m m
rn
rn m
rn m
rn oo
N
oo
N
N
~
ao
N
~
oo
N
~
oo
N
oo
m
N
~
oo
N
oo
oo
N
oo
rn
N
o
oN
oN
N
o-
N
o
~
C')
In comparison to other international banking industries, South Africa has a high
level of concentration. Figure 2.6 shows the HHI for several foreign countries in
order to provide a benchmark for international comparison. South Africa has a high
level of concentration, as do Israel and Finland. Low levels of concentration exist for
Germany, the UK and France. The main reason for the lower level of concentration
Source: South African Reserve Bank. Bank Supervision Department, various annual reports"
Figure 2.5 HHI figures for the South African banking industry, 1994-2013
I
:i:
2000
1 800
1 600
1 400
1 200
1 000
800
600
400
200
0
The Herfindahl-Hirschman index for the South
African banking industry, 1994-2013
As depicted in Figure 2.5, the HHI for the South African banking industry declined
steadily from 1995 to 1998, mainly due to the increase in the number of A2 and
foreign banks. Following this period, the HHI remained stable between 1998 and
2001. From 2002 it deteriorated as a number of registered banks collapsed (43
banks in 2000 and 17 in 2013) ,md exited the market for the reasons discussed
above. Since 2003, the index has further increased reaching a high of 1 900 in
2007. This can be attributed to the increase in the market share of the Big Four
banks and the reduction in the overall number of registered banks. The biggest jump
in the HHI was between 2001 and 2002, from 1320 to 1750, mainly due to the
Nedcor/BOE merger.
This example shows thaflf a dominant
this case 3 030 is greater than 2 000), suggesting that the level of concentration
higher in industry 8 than in industry A.
·• Moreover, if industry B consisted of, say, nine firms the HHI
42 + 42 +4 2 + 42 + 42 ) = 3 030.
42
.......
~~·~•
...
(/)
~~
0
O
~
al
N
u
.C
~
International comparison of the 2012 Herfindahl-Hirschman index
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00 &w(/)-~
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ifri tlie baffltregulat'ory agericies}atboth fecleral and state •
ide·s·selett!?f~!!dx~bo·ut tti~,p~ ~~:~~ingJn~?s!rY- Here .it,is
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it . b~~!i1l~~f!!i;re~~l!~~~i,j6h~ii~ fi~;i~:ddt~=~Y
Adapted from the Israel Banking Supervision Department, 2013. 11 The figure for Israel is
December 2013, is calculated based on the total assets of the commercial banks, and docs not
activity of foreign banks in Israel. Figures for other countries are for December 201 2, and
activity of foreign banks in each country.
0
500
International comparison of the 2012
Herfindahl-Hirschman index
's that the markets consist of many firms that are characterised by monopolistically
features.
The Competitive and Operating Environment of the South African Banking Industry 43
Merged/Closed
Failed""
441
856
854
1 056
2.2.1.2.3 The Lerner index
The Lerner index is used as a measure of market power and the degree of
competition. As mentioned above, market power in economic terms refers to a firm's
ability to set its price above its marginal cost. As the price of a product is equal to
marginal cost in perfectly competitive markets, a value of zero indicates no market
power. Conversely, the closer the value is to a maximum of one, the higher the
degree of market power and the lower the degree of competition in a market. The
Lerner index is especially useful when working with mnltiple products. but requires
accurate and costly information regarding the marginal cost and price of a product.
The formula to calculate the Lerner index is thus:
As indicated at the beginning of the chapter, the SCP paradigm states that there is a
direct link between concentration, profits and price margins. The more concentrated
the market is, the higher the prices and therefore the higher the profit margins arc.
Related specifically to the mark-up factor (the extent to which a firm can sel its price
above its marginal cost), a further tool used in an industry analysis to determine the
degree of competition is the Lerner index.
• • Adjusted for mergers. **Excludes open bank assistance transactions.
-·Note: Data for records processed until 4/ 312015.
Source: US Federal Deposit Insurance Corporation 12
-"
Newly established
From January 1 2015 - March 5 2015:
Total FDIC Insured Institutions
us branches of foreign banks
Total commercial banks and savings institutions
FCIC super~sed
OCC supervised
Federal Reserve supervised
'Financi~I data•:;s of 31/12/2014' ($million)
3 687
Bank Management in South Africa -A risk-based perspective
- _··r:oiC insurecl'lnstliutl6ris as of 5/3/2015 .
44
45
-]
=-~:;
Equation 2.5
X
MC= [-2.5/(l - 2.5)]
X
R3 = RS
Equation 2.6
2.2.1.2.4 Mark-up
Now that the Lerner index has been dealt with, we can derive the exact extent to
which the marginal cost exceeds the price (hence the mark-up). The mark-up
measures the extent to which a firm can set a profit-maximising price above its
marginal cost. This is also called the price margin. Given that no profit-maximising
firm will operate along the inelastic part of its demand curve, the Lerner index can
never be greater than 1. (A firm will never operate at the inelastic part of a demand
curve as its marginal revenue will be negative, ie the revenue that the firm receives
This example suggests that the optimal pricing strategy will be to charge a lower
• price for low-income consumers because their demand is more elastic. In the South
African situation. this example supports the reason for the creation of the lowincome Mzansi account (see Chapters 3 and 4) and the endeavour of banks to attract
the unbanked population.
the profit maximising price for highincome customers will be:
Ph;gh = [E/(1 + E)] x MC= (-1.5/(l - 1.5)] x R3 = R9
Plow= [E/(l + Ed)]
the profit maximising price for the low-income consumers will be:
F
Profit maximising price= ( 1 ;"E,
x MC
l
Elasticity of demand refers to the responsiveness (or sensitivity) in the amount
consumers are willing and able to buy (expressed as a percentage change in quantity
demanded) for a specific percentage change in the price of that good. An inelastic
demand indicates that the percentage fall (or rise) in quantity demanded will be
ess in relation to the percentage increase (or decrease) in the price of a good. For
ample, if the bank increases its credit card fees by 10%, the quantity demanded
will only fall by 2%. On the other hand, if the percentage fall (or rise) in quantity
demanded is more in relation to the percentage increase (or decrease) in price, let's
say by 20%, the demand is said to be elastic.
Elasticity (or E11 ) is also used as a tool to determine the optimal profit maximising
price, as low-income consumers are more sensitive to price than high-income
consumers are. To illustrate this, suppose the elasticity of demand is - 1.5 for a
high-income consumer and -2.5 for a low-income consumer. If the marginal cost
(MC) of a transaction is R3. the profit maximising price can be calculated using the
following formula:
Lerner
Pis the price and MC is the marginal cost of the product or service. The Lerner
ndex is also related to the price elasticity of demand as it is expressed as the negative
inverse of the elasticity of demand (Ed) at profit maximising price such that
Equation 2.4
The Competitive and Operating Environment of the South African Banking Industry
Bank Management in South Africa - A risk-based perspective
Equation 2. 7
2.2.1.2.5 The Ii-statistic
The H-statistic (based on the Panzar and Rosse 2 methodology) measures how either
price or output responds to cost changes (input prices). ft is computed by the
summation of the elasticity of revenue relative to the factor price. The H-statistic has a
value that ranges from negative oo to l. In a perfect competitive market, firms face a
perfectly elastic demand curve. Therefore, an increase in input prices will increase
both marginal cost and total revenue by the same amount (ratio of 1:1). The
II-statistic in a perfect competitive market will therefore be equal to 1. On the other
hand, a monopoly's demand curve has a negative slope, and as a result an increase in
input prices will cause marginal costs to rise, output to fall and revenue to fall. (Note: a
monopoly always produces on the elastic part of its demand curve where marginal
revenue is positive.) The H-statistic in a monopoly will hence be less than or equal to 0.
Conversely, the closer the value is to zero, the higher the degree of concentration and
the lower the level of competition. In monopolistic competitive firms, the rise in output
price as a response to input prices will depend on the elasticity of demand. The higher
the degree of elasticity, the higher the degree of competition and the lower the degree
of market power. A monopolistically competitive market therefore exhibits an
H-statistic value between 0 and 1 .
Calculating the II-statistic involves complicated econometric modelling. Sludies
conducted in South Africa have found the H-statistic to indicate that competition and
efficiency in the banking industry resemble that of monopolistic competition: 0.85 by
Claessens and Laeven; 13 0.75 by Greenberg and Simbanegavi; 14 0.46 by Bikker et
15
al; and 0.53 by Simbanegavi et al. 16 These results suggest that the South African
banking industry has become more concentrated and less competitive over the years.
A few words of caution when interpreting concentration indices, especially
regarding the banking industry:
■
Banks produce multiple product lines - when interpreting these indices one
should be careful not to assess the total level of competition in the industry by
treating all the different products as one single product. Therefore, the relevant
product market should be clearly defined in order to avoid overestimating the degree of
market power.
■
The proxy used to measure concentration should be specified and clarified.
Academics tend to use data on a national level, such as the total assets for
banks. Competition authorities. on the other hand, tend to define a market
By way of an example, ff the price of a product is RS and the marginal cost of
producing the product is R2, then the Lerner index= 0. 75. Therefore the mark-up
factor will be equal to [1/(l - 0.75)] = 4. The price is therefore four times that of the
marginal cost.
P=(~)xMC
from the sales of a good will be negative. This is because marginal revenue is
calculated as: price x (1 + 1/El) As such, the larger the Lerner index becomes, the
greater lhe mark-up will be. Therefore:
46
47
e nature of the product (or service) produced by a firm plays a major role in the
etermination of the market structure. Perfectly competitive markets consist of many,
ny firms who supply consumers with identical (perfect substitule) goods. Accordingly,
'ms have no control over the market price of the goods (hence these firms are facing a
rfectly elastic demand curve). Although, monopolistically competitive markets are also
haracterised by many firms operating in the market, they differ from perfectly
ompetitive market.~ in the sense that consumers view products as differentiated yet close
bstitutes. As consumers can easily switch between the substitute products, firms face a
gative, yet elastic demand curve. Monopolies produce goods for which there are no
bstitutes and hence the market demand is equal to the firm's demand curve. Therefore,
can be deduced that the availability and closeness (similarity between goods) or
ubstitutes contributes to the type of market structure a firm operates within.
As mentioned previously, the South African banking industry represents an
,ligopolistic market. Products in oligopolistic markets can either be homogcnous or
eterogeneous. As firms in oligopolistic markets are mutually interdependent. price
nd non-price competition are tactical or strategically based decisions. Given the
eve! of uncertainty and fear of a price war, firms usually tend to focus more on nonPrice competition such as adverlising and marketing differentiation strategies. As
such, banks spend millions on advertising and marketing, and employ two main
types of advertising. The first is informative advertising that aims lo inform the
consumer of new or existing products or services. Il is for this reason that banks
provide a vast variety of products that include, to mention a few, savings accounts,
credit cards, loans, mortgages, vehicle and assets finance. The second type of
advertising is convincing advertising, aimed to convince the consumer that a
particular bank's product or service offering is superior to that of its rivals. The
tationale behind this is to create the perception of a unique product or service,
ereby making the consumer demand less elastic (or more inelastic}. This creates
rand loyalty and strengthens the degree of product differentiation.
Further to identifying the nature of products and services. microeconomic
theory distinguishes between two major types of product differentiation. These are:
) . Horizontal product differentiation
When the prices of two products are the same, some consumers will prefer one and
others will prefer the alternative. In this case, the products differ only in their
i2.2 The nature of the products
ore narrowly, focusing on, say, the number of deposits or loans within a
province or specific region. The geographical boundaries should therefore be
specified very clearly. In other words, it must be very clear whether or not the
data being used is local. regional. national or international.
Concentration indices are only a useful departure point in the assessment of
competition within a specific industry. Variables such as rapid innovation,
technology and so forth should also be considered to assess the true nature of
competition between the firms. Given the rapid advances made by banks to
innovate in terms of products and modes or inleraction with clients all over the
world, this is an important consideration to keep in mind.
The Competitive and Operating Environment of the South African Banking Industry
Bank Management in South Africa - A risk-based perspective
Barriers to entry
The following are some of the general barners identified in the banking industry:
Regulatory barriers: these are prominent in industries where an entrant needs
•
permission from regulatory authorities to enter a market, such as the banking
industry. In South Africa the Banks Act (94 of 1990) requires a bank to obtain
a banking licence from the Registrar of Ranks and register with the SARB.
Since 2002. no new bank licences have been granted, thereby emphasising the
lack of entry into the market. The banking industry is also regulated by a
number of different Acts. Refer to Chapter 3 for further discussion on these.
Advertising and/or product differentiation: South African banks spend heavily on
•
One of the major determinants of market structure and the inherent degree of
competition in an industry relates to the barriers to entry into the market. Barriers
to entry refer to any variable that binders or prevents a new firm from entering or
expanding a particular market. In other words, it refers to any variable that allows a
firm to make an economic profit without attracting new entrants.
As such, the literature generally distinguishes three main types of barriers to entry:
l . Exogenous barriers
Structural characteristics of the market over which an incumbent firm has no
control, including economies of scale, economies of scope, natural product
differentiation, absolute cost advantage and capital requirements (as in the case
of banks).
2. Endogenous barriers
Barriers that are strategically created by the existing firms in the market in order to
either eliminate or slow down the process for a new entrant to enter the market. The
extent and success of the deterring strategy depends on the size and degree of market
power the incumbent firm has relating to, but not limited to, brand proliferation
(brand loyalty), limit pricing, predatory pricing and price discrimination.
3. Government and regul"tory barriers
Barriers that are erected by government or regulatory agencies.
2.2.3
For a bank to maintain its market share and survive in a particular market, it is
important that products are developed to best match the behaviour and preferences
of its consumers. The advancement of technology (especially the internet) and
the frequency with which consumers are bombarded with information, result in
constant changes in consumer preferences. A case in point is the rapid evolution of
online banking and mobile banking, and more recently, smartphone apps that allow
a consumer to perform these same transactions.
characteristics. For example, some consumers will prefer using a debit card to a
credit card, or vice versa.
2. Vertical product differentiation
When the price of two products is the same, all consumers prefer the same product.
In this case, products differ with regards to quality. For example, consumers prefer a
colour television to a black-and-white one.
48
49
Contestability therefore relates to the level of barriers to entry. Barriers play an
important role in the analysis of competition as they protect the abusers of market
The level of barriers translates to a further measure of competition, that of con testability.
It can be argued that strict regulation deters entry into the banking industry and as the
industry becomes less contestable, the banks abuse their market power by setting higher
margins and enjoying excessive profits. A market is therefore said to be contestable if
entry conditions are low. The result of contest.ability is therefore:
Markets can be dominated by a Jew Jinns {IS long as there are no significant barriers to
entry. The threat of potential entry will constrain any abuse of market power. That
is, should a firm act. in an anticompetitive manner and subsequently make excessive
profit from this action, new firms will enter the market and enhance competition.
Sunk costs should be low for entry to occur. The level of sunk costs in a market is
also determined by the conduct of the incumbent firms. When sunk costs are
low, this opens the market up for a 'hit-and-run' entry, thereby further
constraining the behaviour of firms.
advertising. One of the major spheres of advertising includes the sponsoring of
popular sporting and cultural events. The Big Four banks in South Africa, for
example, have been major sponsors of sports such as cricket, rugby, soccer and
golf. In doing this, each bank connects to the national identity - read patriotic
psyche - of a certain market-specific demographic. As banks spend heavily on
advertising they also reap the benefits of scale economies from advertising. New
firms must therefore spend proportionately more on each consumer lo convince
them to switch.
Switching costs: this barrier not only refers to the monetary cost of changing or
switching between banks, but also the opportunity cost of such a switch. In
retail banking, for example, switching costs are high as consumers are not
17
responsive to price changes because of the inherent inertia they exhibit.
Sunk costs: sunk costs refer to those that a firm incurs which cannot be
recovered. This is particularly applicable to industries with massive lixed costs
such as infrastructure. In addition, advertising expenses are a good example of
sunk costs.
Economies of scale: this barrier is achieved when the cost of production (the
long-run average cost curve) falls as output increases.
C"pital requirements: refers to buildings (setting up of branches and agency
networks), technology (such as electronic banking facilities, access to payments
and deposits systems) and equipment that new entrants must acquire to enter
the market. In the South African banking industry, banks have to comply with
minimum capital requirements as stipulated in the Banks Act. See Chapter 3 for
further discussion on this.
Cost advantages: refers to the ability of the incumbent firm to produce each level
of output at a lower cost than the entrant firm. Cost advantages are obtained
through, for example, superior skilled personnel, vertical integration, superior
technology and better geographical location.
The Competitive and Operating Environment of the South African Banking Industry
Bank Manage ment in South Africa - A risk-bas ed perspec
tive
Complex monopoly
To date no case related to complex monopolies has been brought
. to the attentio n
of the Competition Commission. When interpre ting comple
x monopolies, one can
expect certain complications:
•
The concep t of complex monopolies is unique to the South African
Competilion
Act. No other jurisdiction includes this concept. As a result,
investigations into
A comple x monopo ly will be deemed to exist where: (i)
two or more firms supply or
are supplie d with at least 75% of a market's goods or services
, and (ii) such firms
conduc t their respective business affairs in 'a parallel conscio
us or a coordin ated
manner', whether or not they do so voluntarily or with explicit
agreement.
Participation in a comple x monopo ly conduc t is prohibit
ed where it prevents or
substantially lessens compet ition within the relevant market
and the conduc t
resulted in:
■
high barriers to entry to the relevant market
• exclusion of firms
• excessive pricing
• uniform or exploitative pricing, similar trading conditio
ns or other indicators of
parallel conscious conduc t
• refusal to supply other firms within the market
• other market characteristics that indicate co-ordin ated
conduct. 8
In a further study Napier 18 also found that South African
banks operate as a
complex monopoly with barriers to entry perceived to be high.
These findings led to
the inclusion of a section on complex monopolies in the Compet
ition Amend ment
Act signed in August 2009. Specifically section l OA 8 states that:
The concep t of comple x monopo ly should become part
of the general remit of the
Compet ition Commission. A comple x monopo ly occurs
when firms, whethe r
voluntarily or not and with or without agreement betwee
n them, so conduc t their
business that it prevents, restricts or distorts competition.
This would give the
Compet ition Commission scope to investigate anti-com
petitive behaviour even
where it does not involve proven collusion. 4
Althou gh the South African banking industr y operates in
an oligopolistic market
structu re, the conduc t of the banks could fall under the definitio
n of a complex
monopoly. Complex monopolies exist in markets where (i) there
is little or no price
competition, (ii) firms segmen t their custom ers in order to
price discrim inate and
(iii) firms change prices excessively. Referring to the South African
banking industry,
4
the Falkena II Report found that:
• 2.2.4
power as well as enhanc e market power. Given the high barriers
that exist in the
banking industry, compet ition authori ties are typically concern
ed with conduc t that
strategically creates barriers as this lowers the degree
of compet ition and creates socalled complex monopolies.
50
51
For example. should Bank A increas e the price of its product s
or services, consum ers
will simply switch to the rivals. However, should Bank A lower
its prices, the other
Oligopolistic conditio ns that reduce any incentive to lower
price, reinforce the
confidence of each bank in the expecte d reactions of its
rivals, engend er price
rigidities, and produce a tendenc y toward upward price
followin g behaviour. 15
In the absence of a price war or collusive price-tixing, the
kinked- demand curve
theory explains why prices in oligopolistic markets are relative
ly stable. This theory
is based on the behavio ural assump tion that rivals in an oligopo
listic market react
asymmetrically to a change in the price of anothe r firm. This
means that should one
firm increas e the price of the good, its rivals will not match
the price increas e.
Consequently the firm will lose market share as output signific
antly falls because
Consumers will simply switch to the lower price rivals. Therefo
re. the firm faces an
elastic demand curve for prices above the current market price.
On the other hand,
should one firm decide to lower its price, rivals will typicall
y match the price
decrease to protect and mainta in their market share. ln this
case, the firm faces an
inelastic demand curve for prices below the current market
price. The net result of
this behavio ur is that a firm demand curve has a kink (ie
the firm faces a dualdemand curve) at the current market price.
Pricing strategies in the banking industry
COND UCT VARIABLES
Conduct variables refer to how firms behave in a certain market
structur e and also how
hey interact with their rivals (either competitively or collusiv
ely). Variables include
pricing strategies, mergers, acquisitions, product range, advertis
ing and marketing,
tesearch and development. It should be stressed that as banks in
South Africa operate in
an oligopolistic market. the characteristic of mutual interdependence
limits one bank's
ability to act independently. Banks are therefore constantly aware
of what their rivals
are doing as this can have an impact on the survival of the bank
in the long run.
analysis of the structu ral variables in the SCP paradig m
is now complete
·nd leads us to the next part - the conduc t variables that identify
the competitive
nvironm ent in which a firm operates.
complex monopolies will be difficult withou t previou
s compar ative
jurisprudence.
It is in the very nature of oligopolistic firms to closely monito
r the pricing
strategics and policies of its rivals. It will therefore be difficult
to distingu ish
between parallel (or symme trical) behavio ur and collusive
(or co-ordi nated)
behaviour.
Oligopolistic firms typically avoid price competition and focus
rather on nonprice competition. This is specifically evident in the banking
industr y as banks
focus on advertising, market ing and other selling instrum
ents to attract
customers.
Compet itive and Operating Environment of the South African
Banking Industry
Bank Management in South Africa -A risk-based perspective
... there is no uniformity in the manner in which the packaged offerings are
structured and priced. It is therefore impossible to make direct price comparisons
between the offerings without having to input derailed information about the
transactional behaviour of the prospective customer and then perform fairly lengthy
calculations based on the different price formulas of the banks. 15
uniformity (that is, bank products and services that are not uniform across all banks)
made it difficult to compare bank products as banks did not only bundle their products
into different packages, but the number of services or transactions allocated per
product bundle also differed:
The Competition Commission's Enquiry PaneP 5 into banking fees found that non-
The banking industry is classilled as a multi-product business since banks provide
a vast variety of products and services that include current accounts, credit cards,
overdraft facilities, electronic banking, insurance, home loans, foreign exchange,
business banking and investing. As a result, a number of different pricing and
packaging options are offered to their customers. The major three types are:
•
Pa!i-as-you-transact: a single fee is levied for every individual transaction.
•
Fixed monthly fee: the customer pays a fixed monthly fee for a limited number of
bundled transactions. Once the customer exceeds the number of transactions.
the pay-as-you-transact principle applies. This is known as 'second degree price
discrimination'. In this case, a bank will provide the customer with a variety of
price-product or service packages and allow the customer to self-select the one
that best suits their needs .
• Rebate option: if a consumer keeps a certain amount or balance (for example
Rl 5 000) in a particular bank account for. say, a month, certain pay-as-youtransact fees will be credited (or not, in some cases) to their account.
Instead, banks rather make use of different types of pricing strategics such as
bundling or tying:
•
Pure bundling: the consumer is forced to buy a bundle of identical goods as a
unit (an all-or-nothing approach).
•
Mixed bundling: the consumer has a choice of either buying the goods as a
bundle or separately. Here, goods are usually complimenary in nature.
•
Tying: the consumer is forced to buy an unrelated product. For example, in
order to obtain a student loan from Bank A, the customer would also be
required to have a savings account at this bank.
The Panel found that the complexity of products and prices, inadequate
transparency and disclosure and the costs associated with switching - combined
with the reluctance of banks to price compete - creates customer inertia which
enforces the banks' market power. 15
banks will simply follow the price change. As a result, banks try to avoid price
competition:
52
The Falkena II Report4 in 2004, the FEASibilitY Report 19 in March 2006, and the
Banking Enquiry 17 launched by the Competition Commission in August 2006 all
identified several anticompetitive outcomes within the South African banking
industry. These included high fees, poor quality service, high barriers to entry, lack
of innovation in the national payment system, ineffective competition in retail
banking and financial exclusion especially of the poor. Further to this the Banking
Enquiry argued that although no single bank has a market share exceeding 30%,
each bank has market power, which is obtained and maintained by product
differentiation, asymmetric information, high switching costs and fee complexity.
In total 28 recommendations were made by the Panel of the Competition
Commission's Banking Enquiry 17 . These recommendations were classified into five
main groups:
Penalty fees: banks were found to charge excessively high penalty fees - as high
as RllO per rejected debit order. This was found to contribute to the vicious
cycle of consumer indebtedness. Furthermore, these penalties were levied
disproportionately onto lower-income customers. The Panel recommended a
cap of RS per rejected debit order and also that banks make it easier for
customers to cancel a debit order.
ATM carriage fees: the Panel found that the manner in which banks set the
carriage fee (commonly known as Saswitch fees, which are payable between
banks when a customer uses the ATM of another bank) was problematic and
complex. To achieve greater price competition between the ATM services, it was
recommended that a direct-charging model that offers full disclosure and
transparency at the start of the transaction be adopted.
Access to the National Pa!iment System (NPS): in order to enhance competition,
the Panel recommended open access to the NPS by broadening the regulatory
environment, as the current system makes it difficult for potential new
innovative competitors to enter the market.
•
Payment cards and interchange fees: the Enquiry revealed that potential abuse lies
within the interbank arrangements and the costs associated with branded
payment cards (Visa and MasterCard). This is because banks charge the
maximum price that merchants are willing to bear, resulting in higher prices
·</fdniggingtheLIBOR rate (London Interbank Offered Rate) from2005 to
irrJuhe2~12/Batclaysp1cJthehofdi2g~ompahyofABSA)'iJ~~~ned
anks generally levy fees in three ways:
The /Jase fee per transaction is a fixed fee. For example, a RIO Saswitch fee to
withdraw cash from a rival bank's ATM.
Expressed as a percentage of the value of the transaction. For example, 5% for
every Rl 000 cash withdrawal from an ATM.
The maximum payable fee. For example. 5% is levied for every Rl 000
withdrawal, but not exceeding a maximum of R2 50.
The Competitive and Operating Environment of the South African Banking Industry 53
and 'unfairly punishing lower income customers who pay with cash.' As a
result, it was recommended that an independent, objective and transparent
regulatory process for the setting of interbank fees should be established and
certain rules that were made by MasterCard and Visa should be abolished.
Products and pricing: the Panel round that the complexity of products and prices,
inadequate transparency and disclosure, and the costs associated with
switching (combined with the reluctance of banks to price compete) creates
customer inertia that enforces the market power of banks. Recommendations
included (i) amending the Banking Association's Code of Banking Practice to
develop a minimum set of standards for disclosure of product and price
information, (ii) the standardisatio n of terminology, (iii) a fee calculator and
(iv) marketing generic customer profiles aimed at improving comparability. 17
Bank Management in South Africa - A risk-based perspective
Merger analysis
A merger is not likely to create or enhance market power or to facilitate its exercise,
if entry into the market is so easy that the market participants, after the merger,
either collectively or unilaterally could not profitably maintain a price above premerger levels. Such entry likely will deter an anticompetitive merger in its incipiency,
or deter or counteract the competitive effects of concern.
Given the high level of concentration and concern with already high banking fees
and barriers to entry in the banking industry, the Competition Commission is very
cautious of approving mergers in South Africa. The rationale for this is rooted in the
US Horizontal Merger Guidelines of] 992 20 that state:
2.3.2
The Competition Commission did not only create headlines with the Enquiry into
the Banking Industry, but also in its investigations into proposed mergers within the
industry. The first bank-proposed merger between Nedcor and Stanbic in 1999/2000
created friction between the Competition Act and the Bank Act. specifically regarding
the jurisdiction of the case (that is. who had the final say in the outcome thereof).
This resulted in the first amendment of the South African Competition Act in 2000
to include financial institutions under the concurrent jurisdiction of the Competition
Commission. (Section 3 of the Competition Act of 1998 stated that 'This Act applies
to nil eco11omic activity within. or liaving an effect within tlie Republic, except (d) Acts
subject to or authorised /Jy public regulation.' It was this section that resulted in jostling
between competition authorities and bank regulators. On appeal, the Supreme Court
held that Section 3(1) precludes the Competition Authorities from exercising its
jurisdiction upon all regulated sectors. As a result, the Competition Act was amended
by removing (d) and replacing it with '(a) /11 so Ji1r as tliis Act applies to an industry, or
sector of an industry, that is subject lo the jurisdiction of another regulatory authority,
which authority has jurisdiction in respect of conduct regulated in terms of Chapter 2 or 3
of this Act, this Act must be construed as establishing concurrent jurisdiction in respect of
that conduct.') Nevertheless, the Minister of Finance still has the sole jurisdiction on
bank merger, but can call upon the Commission for assistance if required.
•
54
55
Nedcor/Starrb icin 1999
Corporate, investment and merchant banking servias
The Competition Commission identified 12 products in this market.: cash,
cheque and transmission accounts; deposits; loans, advances and overdrafts;
leases and instalment sales agreements; treasury services; international
banking services; international business centres; custodial services; asset
management (unit trusts); project/structu red finance; corporate finance; and
stockbroking.
If the merger were approved, the post-merger entity would have a market
share greater than 50% in five of these twelve markets and in four additional
markets, a market share of between 29% and 42% over its closest competitor.
Pre-merger, the HHI already exceeded 1 800 in six of the twelve categories.
Thus although the market was highly concentrated, the Commission found that
the merger would not. substantially lessen or prevent competition due to low
barriers to entry, countervailing power and increased foreign competition. 12
The main concern was with the retail banking segments, where the merger would
have enhanced the market power of the 'new· bank and lowered the ability of the
remaining banks to compete effectively. Using the three categories identified by the
Competition Commission, below is a brief summary of the reasons why the merger
was prohibited:
The Competition Commission argued that if the merger were approved, the new
-combined CR (Nedcor!Standard, ABSA and First National Bank) would be 77.7%. 22
3
The Commission segmented the relevant market into three separate categories
because the competition takes place therein:
corporate, investment and merchant banking services
retail banking services: personal banking services
retail banking services: small business banking services. 22
n November J 999, Nedcor (the fourth largest bank at the time) attempted a hostile
akeover of Stanbic (the second largest bank al the time). In order to assess the level
f competition of this bid, South African competition authorities adopted the earlier
''ersion of the US Merger Guidelines of 1982: 21
HHI < l 000: indication of low levels of concentration and high levels of
competition
1000 < HHI < l 800: indication of moderate level of concentration and
competition
HHI > 1 800: indication of high levels of concentration . When the index
exceeds 1 800, oligopolistic markets usually exist.
;3.2.1
ce 2000 there have been three proposed mergers in the South African banking
ustry - one was prohibited by the Competition Commission, one was approved,
d one was not scrutinised by the Commission. Below follows a brief explanation
each and the rationale for their respective outcomes.
The Competitive and Operating Environment of the South African Banking Industry
Retail banking services: Small business banking services
In the third category identified by the Competition Commission, the CRl and
HHI would respectively increase from 78% and 2 496 pre-merger to 96% and
3 720 post-merger. This strongly suggested the dominant position and
enhancement of market power by the proposed new bank. Other than the
increase in concentration, the Commission concluded that the merged entity
would be able to exercise market power as, (i) there was no import competition
in the market, (ii) the market was characterised by high barriers and (iii) clients
had no countervailing power in the market. 22
3
Nedcor!BOE in 1.001.
The ripple effect of the demise of Saambou in 2002 was felt by BOE. Large withdrawals
by wholesale depositors caused BOE to approach the SARB for liquidity assistance as
confidence in the smaller banks was falling rapidly. This resulted in a merger between
Nedcor and BOE (the sixth largest bank at the time) in 2002. This caused the HHI to
increase from 1 470 to l 750 (a 33.4% increase) and the CR 4 to increase from 69% to
81 %. This further reduced the number of major banks from six to five in an already
heavily concentrated market. The merger was not assessed by the Competition
Commission owing to time constraints and the urgent nature of the transaction systemic risk was rife given the collapse of the A2 sector during this time and the
authorities were determined to act swiftly in order to avoid further systemic panic. As
the Registrar of Banks and the Minister of Finance authorised the merger.
1..3.1..1.
Given the discussion above, the Competition Commission recommended that the
merger be prohibited. The removal of an effective competitor (especially given the
four pillar policy), the enhancement of market power and the lessening of competition
(in the retail banking service industry in particular) were at the centre of the
Commission's recommendation.
Retail banking services: Personal banking services
The Commission identified five submarkets in which both Ncdcor and Stanbic
competed. These were cash/cheque and transmission accounts; deposits;
overdraft facilities; mortgages; and credit cards. Concerns were raised about the
level of concentration and competition in this particular market as all the
submarkets had a CR 3 > 6 5% and the lowest HIII pre-merger (in terms of total
deposits) was 2 118. The post-merged entity would have a market share
exceeding 38% in all five markets and have the largest volume of middle- and
upper-market customers in the cheque account market in South Africa. The
Commission also found that there was little threat of import competition and
high barriers to entry (specifically significant investment in ATM facilities and
branch networks). Standard Bank was also found to be an effective competitor
with a high rate of innovation. Given this evidence, it was concluded that there
were no factors that would constrain the ability of the new entity to abuse
market power. As a result, the Commission ascertained that the merger would
significantly reduce competition in the personal retail banking market. 22
Bank Management in South Africa - A risk-based perspective
2
56
57
goal of a firm will therefore be to maximise all three of these efficiencies in order
lower its cost components, and thereby maximise profits. The purpose of this
is to provide a general overview of the performance of the South African
industry by using four select performance indicators generally considered to
PERFORMANCE VARIABLES
he performance of firms is measured in terms of profitability and efficiency.
Caution should be applied when comparing data before 2009 to that after 2009, as
structural break occurred due to the implementation of Basel II.) Even though
fficiency' is a commonly used term in business, from a micro-economic
erspective. it is divided into three categories:
Allocative efficiency; refers to how the economy distributes its resources and is
achieved if resources are allocated to the production of goods that yield the
value to the consumer. This is measured by the relationship between
price and marginal cost - price expresses the value of the consumption of the
product and the marginal cost the opportunity cost of using the product - in the
production of-that specific product. Allocative efficiency is achieved in perfectly
competitive markets as demand equals supply at equilibrium, and as a result
the sum of the total consumer and producer surplus is maximised.
Production efficiency: refers to being able to produce at the lowest: possible average
total cost - that is, the ability of a firm to exploit all economies of scale in the long
run. This is important because there is a direct link between cost and price; the
higher the cost of production, the higher the price needed to cover the cost.
Dynamic efficiency: refers to the incentive to innovate new technology and
research and development.
the ABSA/Barclays pie merger to be approved. recommendations from the
istrar of Banks. the Competition Commission and National Treasury were
uired by the Minister of Finance, who had the final say in the matter. As such,
Competition Commission recommended the merger without any conditions. The
in reasons were that it would not lessen or prevent: competition in the market (as
te was no removal of an effective competitor) and thus no change in the market
cture or level of concentration. Therefore, the Minister of Finance approved the
rger with certain conditions that were primarily aimed at maintaining the
undness of the financial system. Further to this, the Minister, in accordance with
tion 3 7(2)(a)(iii) of the Banks Act, approved the acquisition on the basis that
relays would hold more than 49% but less than 74% of the ABSA shares. As of
13, Barclays owns 62.3% of ABSA.
,2.3 ABSA!Barclaus plc in 1.005
Competitive and Operating Environment of the South African Banking Industry
P!I
l<i~II
Bank Managemen t in South Africa - A risk-based perspective
Return on average assets (ROAA)
~
Average total assets x 100
475
4.92
0.70
1.43
1.03
1.25
0.99
2012
5.10
0.82
1.12
0.93
1.08
1.15
2011
3.94
1 09
1.01
0.68
0.98
1.00
2010
4.91
1 06
0.73
0.74
0.96
0.82
2009
8.27
1.18
1.37
1.26
1.09
1.34
2008-
7.
7.91
1.16
1.26
1.40
1.48
200
Return on average equity (ROAE)
Equation 2.9
tNote on the calculation s: For comparative purposes, the financial statements of
the holding
.. companies (which integrate the statements of the controlled subsidiaries or branches
with an
unconsolidated companion) were used. except in the case of Capitec and Nedbank, which
have no
unconsolidated companion.
The denominato r of the performance variables was calculated using the averages of the variables,
·as provided by Bankscope. As mentioned earlier, caution should be taken when comparing
data
before 2009 to that of data after 2009. as a structural break occurred due to the implementa
tion
_.of the Basel IL Only from January 2009 could the weighted moving average be calculated.
Table 2.4 shows the ROAE for the six largest banks in South Africa. The highest ROAE
was recorded in 2007 by Standard Bank. with a value of 31.25, and the lowest by
Investec in 2012 of 8.45.
ROAE = Net income after tax..,. Average total equity capital x 100
The ROAE is a measure of the return on average shareholde r funds. The higher the
ratio, the better the return shareholde rs receive relative to their equity investmen t in
the bank. The ratio should however be used with caution as it may be at the expense
of an over-leveraged balance sheet. The formula for the ROAE is:
2.4.2
Table 2.3 indicates the ROAA for the six largest banks in South Africa for the period
2007 to 2013. The lowest ROAA was recorded by Nedbank in 2010- 0.68, whereas
the highest ROAA was listed by Capitec in 2008 - 8.27.
Source: Bankscope
. Capitec Bank
0.74
1.49
•..•
FirstRand Bank
Investec
1.07
1.05
,'•
Standard Bank
Nedbank
1.13
ABSABank
2013
Table 2.3 Return on average assets for South African banks, 2007-2013
ROAA = Net income after tax
The ROAA compares the efficiency and operational performance of banks as it
considers the return generated from the assets financed by the bank. The higher the
ratio, the higher the income earned relative to the asset investment. The formula for·
ROAAis:
2.4.1
be those most important to the industry. These are the return on average assets. th
return on average equity, the net interest margin and the cost-to-income ratio. t For
a more elaborate discussion on performan ce indicators refer to Chapter 9.
58
17.13
20.71
8.45
23.17
21.12
8.76
22.16
24.07
9.85
13.53
14.28
18.35
14.89
2011,
14.44
18.96
12.65
14.78
14.04
_::://2012:,
,,,•2013
on averaoe eo
19.73
12.93
16.34
9.70
17.16
13.51
,,2010
24.11
13.09
13.08
10.33
19.66
1,.42
,:)2009
25.74
15.21
25.62
17.75
24.35
22.16
2008
18.34
15.62
23.14
19.59
31.25
24.45
2007
59
Equation 2.10
22.30
22.00
22.44
2.06
2.13
3.19
2.59
3.44
j,:,:,; 2011/
23.43
2.03
2.23
3.06
2.68
26.42
2.25
2.26
3.04
2.73
2.96
.. - ~ ri:r£¥009
3.31
I
34.52
2.70
2.27
3.30
2.93
3.21
,2008\':
32.48
2.43
2.72
3.43
2.87
3.51
2007
CTI ratio= Total operating income..,. Total operating expenses x 100
Equation 2.11
The CTI ratio measures how efficient (hence its sometimes being referred to as the
,efficiency ratio) a bank is by expressing its overheads (or costs) of running the bank
as a percentage of the income it generates (before provisions):
2.4.4 Cost-to-income ratio (CTI ratio)
oo•
2.90
2.00
2.01
3.23
3.26
3.60
2.82
3.35
3.13
3.50
:2013/\Jt ~::i,2;;c;.
able 2.5 Net interest margin (NIM) data for South African banks, 2007-2013
NIM implies a low cost of funding- that is, the higher the NIM, the higher the
argin the bank is commandi ng. Higher margins and profitability are preferred as
ong as the asset quality is being maintained. Table 2.5 indicates that among the five
eading banks, First Rand Bank had the highest NIM at 3.60 in 2013, with Investec
ording the lowest of 2 in 2012. Capitec achieved an extraordinarily high 34.52
h- -2008.
-- -
NIM= Net interest revenue~ Total assets (or earning assets)
.3 Net interest margin (NIM)
he NIM expresses the value of the bank's net interest revenue as a share of its total
ssets as follows:
omot:i
32.67
Capitec Bank
39.15
54.82
59.03
07.74
54.51
53.91
47.02
52.71
61.86
58.18
54.ffl
57.97
2011
55.26
49.34
63.35
57.77
56.65
58.61
2010 .
58.60
47.00
61.17
54.86
48.41
52.03
2009
52.81
48.26
5701
51.78
46.17
53.28
2008
60.39
48.22
61.29
56.13
51.30
~
~'
Since 2002 concentratio n in the South African banking industry has increased as
indicated by the HHI, CR 4 and CR . Furthermore , it is clear that the banks possess
5
market power, charge high fees and exhibit high barriers to entry. Going forward,
2.5 CONCLUSION
Johannesburg stock exchanges .
dtial-lisled corhpany (DLC) structu
. .1KJJ(y 2002,lhvestec became·t
The CTI ratios for the South African banks are provided in Table 2.6. With the
internationa l benchmark regarded to be 60%. the banks in general perform around
or substantially below it. Given that values in excess of a 60% benchmark are
considered to be inefficient. FirstRand was the only bank in the period provided to
exceed the threshold, albeit only marginally (61.17, 63.35 and 61.86 in 2009, 2010
and 2011 respectively). Of the leading five banks listed, Standard Bank provided the
lowest ratio of at 46.17 in 2008.
A word of caution when interpreting the CT[ ratio; although a bank wants to be as
'efficient' as possible a potential problem arises when the ratio is too small. If the ratio is
small because costs are particularly low, it could mean that the bank is not spending
enough to ensure that the revenues are maintained over time. In other words, revenue
(or income) growth usually needs to be 'fuelled' by some sort of cash injection in order
to make it sustainable over the longer term. Added to this, a CTI ratio could be lower
even if costs are actually being contained. which is what managemen t would want.
This is exactly what happened to Nedbank in the period 2002 to 2003 as a result of the
BOE merger - although the merger and consequent restructuring costs were to some
extent contained, the revenue generated was not growing as desired. For this reason, it
makes more sense to consider the trend over time of CTI ratios rather than the absolute
figure for one period. An improving (decreasing) err ratio over a period of time says
more about improved efficiency than docs a low (or high) figure in one particular year.
For that reason, the analysis of trends rather than one-period ligures should be the
norm for any ratio analysis. This must be coupled with a thorough understandi ng of
the operational issues causing those ratio changes.
Source: Bankscope
58.24
57.00
FirstRand Bank
Investec
57.88
57.92
Standard Bank
Nedbank >
57.63
ABSA Bank
2012
Baumol, W]. 1982. 'Contestable markets: An uprising in the theory of industry
structure'. American Economic Review 72(1): 1-15.
Panzar, JC & Rosse, JN. 1987. 'Testing for Monopoly Equilibrium.' The Journal of
.Industrial Economics 3 5(4): 443-456.
• Prager. RS & Hannan, TH. 1998. 'Do Substantial Horizontal Mergers Generate
Significant Price Effects? Evidence from the Banking Industry.' Journal of Indust.rial
Economics 433-452.
. Falkena, H, Davel. G, Hawkins. P, et al. 2004. 'Competition in South African
banking.' Task Group Report for the National Treasury and the South African Reserve
Bank. http://www.finforum.co.za/fininsts/ciball.pdf (Accessed 18 October 2012) •
Okeahalam, C. 2001. 'Structure and conduct in the commercial banking sector of
South Africa.' TIPS 200 I Annual Forum. Presented at TIPS 2001 Annual Forum.
University of Witwatersrand. http://www.tips.org.za/files/499.pdf (Accessed I 8
October 2012).
South African Reserve Bank. Bank Supervision Department. Various Annual
•Reports. 1994-2014. Pretoria. https:/ /www.rcsbank.co.za/Publications/Reports/
.•Pages/BankSupcrvisionAnnualReports.aspx (Accessed 2 3 September 2014 ).
The Banking Association of South Africa. 2012. South African Banking Sector
Overview for 2012. http:/ /www.banking.org.za (Accessed 18 October 2012).
Competition Act (89 of 1998) ss 7. 1. lOA. http://www.compcom.co.za/thelaw/
TheNewAct.doc (Accessed 23 September 2014).
Shepherd, WG. 198 5. The Economics of Industrial Organization. Englewood Clift'.~. N.J:
Prentice Hall.
US Department of Justice, Anti-trust division and Federal Trade Commission. 20.l 0.
Merger guidelines of 2010. http:/ /www.justice.gov/atr/public/guidelines/hmg20l0.pd( (Accessed 19 August 2010) .
Israel Banking Supervision Department. 2013. http:/ /www.boi.org.il/en/
NewsAndl'ublications/RegularPu blications/Pages/FigureSkira2013 .aspx.
US Federal Deposit Insurance Corporation. htt.ps://www2.fdic.gov/idasp/
KeyStatistic s.asp?tdate- 3/5/201S&p Date-3/4/20 15 (Accessed l3 March 2015 ).
Claessens, SA & Laeven, L. 2004. 'What drives bank competition? Some
international evidence.' Journal of Money, Credit and Banking 36(4): 563-583.
Greenberg, J & Simbanegavi, W. 2009. Testing for competition in the South African
banking sector. http:/ /www.commerce.uct.ac.za/economics/
seminars/20 09 / 20091106% 20 Simbanegavi%20Measuring%20competition%20
in%20Banking%20sector.pdf.
Bikker, JA. Shaffer. S & Spierdijk, L. 2012. '.Assessing competition with the PanzarRosse model: The role of scale, costs, and equilibrium.' Review of Economics and
Statistics. 94( 4): 102 5-1044.
Simbanegavi, W. Greenberg, J & Gwatidzo, T. 2013. 'Testing for competition in the
banking sector.' Economic Re.~earch Southern Africa. http://www.econrsa.org/
system/Ii les/ workshops/ papers/ 2013 / gwatidzo presentation .pdf.
a competition point of view it will be interesting to see how competition
orities apply the inclusion of the complex monopoly provision in the South
an Competition Act as, in this regard, the South African banking industry is
only one of its kind in the world.
2013
Table 2.6 Cost-to-incom e ratio for South African banks, 2007-2013
61
Competitive and Operating Environment of the South African Banking Industry
Bank Management in South Africa - A risk-based perspective
60
Bank Management in South Africa - A risk-based perspective
17. Competition Commission. 2008. Banking Enquiry Report to the Competition
Commissioner by the Enquiry Panel. Pretoria. www.compcom.co.za (Accessed 18
October 2012).
18. Napier. M. 2005, 3-4 February. Country Case Study Provision of Financial Services of
South Africa. Services Expert Meeting. www.finmark.org.za (Accessed 23 October
2014).
19. FEASibilitY. 2006, March. The National Paymrnt System and Competition in the
Banking Sector. A report prepari~dfor the Com11etition Commission. Pretoria. http://
www.feasibilitv;co.za/research.htm (Accessed 18 October 2012).
20. US Department of Justice. Anti-trust Division and Federal Trade Commission. Meraer
Guidelines of J 992. http:/ /www.justice.gov/atr/hmerger/l 12 50.pdf.
21. lJS Department of Justice. Anti-trust Division and Federal Trade Commission. Merger
Guidelines of 1982. http://www.justice.gov/atr/hmerger/ 11248.pdf.
22. Competition Commission of South Africa. 2000. Competition Commission Report to
the Minister of Finance. The proposed merger between Nedcor and Stanbic. Pretoria.
62
Financial institutions in general and banks in particular are traditionally regarded
as existing in one of the most regulated industries in the world. As such. the
financial sector plays an important role in supporting the real economy through
credit provisioning and facilitation of transactions through a national payments
system. The behaviour of financial institutions can potentially introduce several
risks to the system. The main policy objective of tinancial regulation, therefore, is to
limit these risks in order to ensure financial stability.
The Global Financial Crisis (CFC) that commenced in 2007 triggered substantial
global financial regulatory reforms on the back of the fundamenta l weaknesses that
were arising in internationa l financial markets. Internationa l standard-set ting bodies
such as the Financial Stability Board (FSB), the G-20 and the Basel Committee on
Banking Supervision (BCBS) announced various initiatives, strategies. and new or
revised requirements and standards. These included a renewed focus on managing
system-wide risk across the entire financial sector, both locally and internationally.
This has become known as the macroprudential approach to regulation which focuses
on analysing how macroeconomic events and trends affect the stability and
soundness of financial institutions. In addition, it attempts to identify and control the
links between financial institutions, given the systemic and interconnected nature of
the financial systems around the world.
INTRODUCTION
After reading this chapter, you should be able to:
explain the rationale and objectives of regulation in the banking industry,
especially in the South African context
explain the importance of prudential regulation and supervision in the South
African banking industry
discuss the relevance and applicability of the prudential requirements
applicable to South African banks under the Banks Act
discuss the relevance of market conduct regulation and supervision in the
South African banking industry
assess the proposed Twin Peaks framework in the South African financial
sector
provide an overview of the legislative landscape· applicable to South African
banks, including NCA, FAIS and FICA
discuss the relevance of financial inclusion as a policy objective in the South
African banking industry.
LEARNING OBJECTIVES
!iarRegulation in the South
i"t!Alteanking Industry
I
I
Bank Management in South Africa - A risk-based perspective
THE RATIONALE AND LIMITATIONS OF FINANCIAL REGULATION
AND SUPERVISION
....
E
~
is
]?
GJ
Q.,
.2
.. "'
N .~
~
f~
~
~
~G
.•••.· .. ·
MACROECONOMIC HIRN
Reduced demand for propert10s
Reduced liquidi!y in financial markets
Increasing lnflation
Neutral monetary policy
Reduced llsca! tax revenues
Failing consumer confidence
PROFIT GROWTH
Increasing revenue growth
High demand for credit
MACROECONOMIC UPSWING
Property market boom
liquid financial markets
Expansionary liscal policy
Expanskmary monetary policy
Current account deficits
Growing consumer credit
High consumer confidence
BUILD·UP or RISK
!ncreasing revenue growth
Excessive credit-granting
Increasing loan impairments
Lax credit risk mitigation
lax corpora1e governance
Excessive usage of liquidity
Deposit growth
Low loan impairments
Excessive liquidity availability
Internal organisational
environment
External macroeconomic
environment
Increase
(moderate)
Increase
Increase
(high)
Liabilities
(moderate)
Increase
(high)
Assets
=
Increase
(moderate)
Increase
(high)
Capital
Typical balance sheet effects•
Table 3.1 The phases of a banking crisis and the effect on bank balance sheets
In its broadest sense, financial regulation is a form of control by financial regulators
over the activities and behaviour of financial institutions. This 'control' consists of
financial requirements, restrictions and guidelines aimed at maintaining the
integrity and safety of the financial system. Financial regulation can take many
forms, including (but not limited to) capital requirements, mandatory information
disclosure, minimum requirements for the start-up of a bank, or rules about the
way financial products are marketed. This implies that financial regulation refers to
specific rules of behaviour. Financial supervision on the other hand refers to a more
general observation of the behaviour of financial institutions in order to establish
the extent to which they implement the relevant regulations. 2
The main aim (or policy objective) of financial regulation is to ensure the safety
and stability of the financial system in order to reduce the chances of systemic risk,
which is usually the forerunner of a banking crisis. Table 3.1 provides an outline of
the typical phases that occur in a banking crisis and the resultant effect on the
balance sheets of the banks.
3.2
South Africa has committed itself to a global financial regulatory reform agenda
aimed at strengthening financial stability. 1 The Basel III framework and the
subsequent move to the so-called 'Twin Peaks' regulatory framework (which
proposes among other things a macroprudential approach to banking supervision)
arc the most important regulatory changes expected in South Africa in the
foreseeable future. This chapter explores the current regulatory environment in
South Africa specifically related to banks. (Note: an in-depth discussion on the Basel
Accord is reserved for Chapter 15. J
64
! -~
MACROECONOMIC TURN
Fiscal consolidation
Expansionary monetary ix>licy
Recovering property market
Improving liquidity in financial markets
Improving consumer confidence
RISK ANO RETURN CONSOUOATION
Slabilising revenues
Slabilising impainnenls
Liquidity injeclion
Improving risk miligation
RISK SPILL·OVER
Falling revenue {losses)
Poor quality assel book
Poor Quality collaleral
Shor1age of liquidity
Credit squeeze
Excessive loan impairments
Stabilise
Oecrease
(high)
Stabilise
Decrease
(high)
Stabilise
Decrease
(high!
65
There are both external macroeconomic and internal organisational events that
can trigger the onset or a banking crisis. In phase one times are good. The external
macroeconomic environment is flourishing and macroeconomic policymakers
provide policies that are conducive to economic growth. Consumer confidence is high,
asset markets are thriving and liquidity is easily available. Within a bank, revenue
and profits are growing, as is the loan book on the back of a vibrant consumer credit
and lending market in general. As a result or the expanding economy, banks typically
do not have excessive loan impairments as borrowers are able to service their debt.
If loans are non-performing, banks arc able to absorb these losses because of their
upside growth po ten ti a I. As such, balance sheets are growing (especially on the asset
side), along with revenues.
Although times are good in phase 1, this environment has all the makings of a
potential crisis. At the heart or it is the fact that because times are so good, the bank
becomes lax in the mitigation or risk. For example, given the favourable growth on
the lending book (and the concomitant growth or revenue), the processes put in
place to mitigate risk do not comply, as they did before, with what would be expected
from a bank. Therefore, in addition to poorer risk mitigation and corporate
governance practices, phase 2 is characterised by the bank's use of excess liquidity to
fuel the excessive growth from phase one. There is a strong probability that this buildup of risk could become systemic and consequently result in a full-on banking crisis.
Following phase two, the banking industry collapses due to the excessive buildup of risk. Phase 3 is initially characterised by an immediate drying-up of liquidity
in financial markets. This is a consequence of the so-called '!light-to-quality'
mentality - market participants will move their funds (or exposures) from a place
of risk that is perceived to be excessive to one where the perceived risk is lower,
mainly because or the underlying quality of the new destination. Due to liquidity
drying up, the payments system collapses and banks are less willing to provide
loans. Borrowers default on their loans, impairments increase and revenues fall. In
effect, the quality of the loan (and asset) book deteriorates, not only because of
their non-perf;rming nature, but also because the value or the underlying
collateral is deteriorating on the back of a collapse in the property asset market.
The balance sheets of the banks deteriorate to such an extent that insolvencies
•Rate of change in parenthesis: high, moderate, low.
u
a.-~
..
1G
~
~
.s::. .SQ
.i
mo
co
NeutraVexpansionary monetary policy
Flight-lo-quality
low consumer confidence
MACROECONOMIC DOWNSWING
Property (and assets) market collapse
51 Uquidity shortage in financial markels
f_ §
M
Chapter 3: Financial Regulation in the South African Banking Industry
ao--,•~-.- · ·_ _ • : ~
.
Bank Management in South Africa - A risk-based perspective
•. __ ,, .. -~,;"_S-,5 _~i/'.(<'\~:- ~.{.._ • .).0=···:·
.«; ... ,...
increase - the collapse of the banking industry leads to nationwide collapse as the
economy heads towards a recession.
Intervention by policy authorities to resolve the banking crisis occurs in phase
This may involve explicit intervention by the government and central bank to act as
lender of last resort and bail out the troubled banks. The primary motivation behind
the intervention to reduce the systemic risk is to protect the deposits of consumers.
The central bank is most likely to inject liquidity into financial markets through its
open market operations, or it could purchase the non-performing assets on the books
of the failed banks. Of course, whatever its actions, it has to be wary of the moral
hazard implications - that is, by acting as lender of last resort, it does not want to set
a precedent of bailing out banks and thus encourage risky behaviour in the future.
Needless to say, phase four is characterised by explicit intervention by policymakers
in an attempt to resolve the crisis by stabilising conditions in financial markets and in
the operations of the banks and industry as a whole. (See Section 3. 7 for the proposal
that banks should have recovery plans in place in case they should fail.)
Although the four phases are useful when explaining the general progression of
a banking crisis, it is by no means meant to reflect the highly complex nature of
banking crises. In fact the GFC was characterised by its extensive global reach.
Although it started as a subprime crisis in the US. to date it has evolved to be a
sovereign debt crisis across the world. This is on the back of banking practices that
have evolved lo maximise returns by innovating and transferring risk to market
participants across the world. The complexity of innovation in banking products
has brought with it a new set of rules regarding the management of risk.
The regulation of risk i.s more important now than it has ever been as it not only
ensures financial stability but it reduces the burden on governments (and thus
taxpayers) to bail out the banks and save the economy. A 2013 study undertaken by
the IMF indicated that banking crises since 19 70 have in some cases resulted in
fiscal costs (as a percentage of GDP) being as high as 57% in Indonesia in 1997,
44% in Iceland in 2008 and 41 % in Ireland in 2008. 3 In certain countries the
ensuing banking crisis resulted in an increase in debt of more than 100% of GDP in
Guinea-Bissau (1995) and Congo (1992) and output loss as a percentage of GDP
exceeding 100% in Kuwait (1982). Congo (1991), Burundi (1994), Thailand
(1997), Jordan (1989), Ireland (2008), Latvia (2008), Cameroon (1987) and
Lebanon (1990). 3 Although output loss (to GDP) for the Euro area and the US
amidst the GFC are somewhat lower at 2 3% and 31 % respectively, the Dallas Federal
Reserve Bank estimated that the GFC had cost the US economy upwards of $14
trillion by mid-2013. 3.1 Clearly fiscal costs incurred by either the non-regulation or
poor regulation of banks are excessive and should by no means be taken lightly.
Financial stability is however not the only policy objective. In South Africa, for
example, it is recognised that the financial sector as a whole is vitally important to
advancing socio-economic transformation that improves the living standards of all
South Africans. As a result, the National Treasury has identified the following four
policy objectives: 5
■
financial stability
The South African Reserve Bank (SARB) defines financial stability
66
Chapter 3: Financial Regulation in the South African Banking Industry
67
four policy objectives loosely reflect the format of this chapter.
Whereas the objectives of financial regulation refer to the outcome of what
ulation is trying to achieve, the rationale for regulation refers to why regulation is
essary if the objectives are to be achieved. Therefore, the ultimate rationale for
ancial regulation is to correct market imperfections (or market failures) that can
ve devastating consequences for the financial system. consumer·s and the real
homy. 2
·At the heart of these market imperfections lies the problem of asymmetric
"rmation. As discussed in Chapter 1, this refers to a situation in which one party
transaction has more (or superior) information compared with another and
equently acts on this advantage. This advantage is potentially harmful because
party can take advantage of the other's lack of information. In the case of a
k (or lender), a high-risk borrower (or client) is more likely to apply for a loan
h a low-risk borrower. The bank, however, cannot always distinguish between
two. Should the bank grant the loan to a borrower it would normally ,wt lend to,
as a high-risk borrower on its books and is unaware of the extent of this risk.
is known as adverse selection and occurs ex ante as the bank is not aware of all
ttributes of the borrower before a transaction is concluded. Conversely, upon
duding a transaction with a borrower, a lender may be incentivised to misuse
funds acquired through the loan. If the bank is unaware of this, moral hazard
rs. This moral hazard occurs ex post - that is, after the transaction. Regulation
hlpts to reduce these problems associated with asymmetric information.
Expanding access through financial inclusion
The third policy objective ensures that all South Africans have access to financial
services to help them manage their money better and to improve their opportunities
to save through appropriate savings products.
Combat1ing financial crime
The final policy objective attempts to combat money laundering and terrorism
financing.
Consumer protection and market conduct
The second policy objective ensures that consumers of financial products are
treated fairly and vulnerable consumers are not being exploited by financial
~i-;:
stability
of key financial institutions and the markets in which they operate - in
other words, individual banks are safe and sound and they operate in a safe banking
system. Financi;il stability also implies the absence or financial crises and thus
requires effective prudential regulation and supervision by the regulator. This
includes both micro and macroprudential regulation and supervision:
microprudential regulation refers to maintaining and enhancing the safety and
soundness of individual financial institutions: macroprudential regulation refers to
the analysis of vulnerabilities of financial systems as a whole. In addition to the
financi;il soundness of financial institutions, macroprudent:ial assessments also
cover aspects such as overall credit growth in the economy, unemployment and
GDP growth rates. Currently the focus is on microprudential regulation in South
Africa, -but macroprudential regulation is envisaged as playing a bigger role in the
-
Bank Management in South Africa - A risk-b
ased perspective
Ther e are several reaso ns justifying the
ratio nale behin d regul ating the financial
system and bank s in parti cular :
1. Regulation prom otes confidence in
the financial syste m by ensu ring that
it
operates in a mann er that is consi stent
with soun d governance and practice.
This promotes consumer confidence and
trust, which is vitally impo rtant to
ensu re the integ rity of an efficient econo
my.
2. One of the uniqu e aspects of the finan
cial system is that bank s lend to each
other and if one bank fails, it has the poten
tial to unde rmin e the other banks.
This interconnected (or systemic) natur e
of the system may lead to panic by
mark et parti cipan ts that results in a bank
run (or several bank runs) that
potentially cause s the collapse of both
the financial system and the real
economy. A gene ral regul atory response
to this social exter nality is deposit
insur ance and mand atory capital requi reme
nts.
3. Moral hazard implies that ,banks are
incentivised to take on excessive risks
know ing very well that they will be bailed
out by the gove rnme nt shou ld the
risk-taking resul t in failure of some sort.
Regulation attem pts to reduce this
incentive by eithe r forcing more strin gent
risk-negating meas ures (such as
highe r capit al requi reme nts or bette
r quali ty collateral agree ment s) or
incentivising bank s t.o take on less risky
activities. Of course, how bank s
themselves moni tor and cond uct their micro
inter nal review process over their
borro wers is just as impo rtant for ensu
ring the quality of the bank 's balan ce
sheet as it is for retain ing the macr o-reg ulato
ry perspective.
4. Regulation ensu res that. the regul ators
are more responsive to risks in the system
(be that for specific bank s or the system
as a whole). By const antly moni torin g
the activities and infor matio n provided
by mark et partic ipant s, regul ators can
identify early warn ing signs and be proac
tive rathe r than reactive to impe nding
mark et failures, or at least the possible
cause s thereof. The chall enge for
regul ators is to respond accordingly whils
t keeping in mind the global and
inter conn ected natur e of financial mark
ets.
5. Globalisation has forced bank s to be
dyna mic and responsive to a const antly
chan ging mark et envir onme nt. Regulatory
autho rities need to ensu re that
regulatory and legislative structures respond
accordingly. If one merely considers
the numb er and exten t of global financial
crises since the 1980 s, a quest ion
can be asked as to whet her or not regul
ators have adapted their frameworks
enou gh to address the chall enge s they
are faced with. In other words, being
responsive is one thing - havin g the
appro priate regul atory and legislative
framework is quite anoth er.
6. Specifically in South Africa, redistributi
onal considerations provide an additional
rationale for bank ing regulation. Given
the massive disparities in the South
African economy as a result of apart heid,
and the fact: that most problems in the
financial sector have a larger impa ct on the
lower end of the consu mer spectrum,
regulation and specifically its effectiveness
ensur e that the poorest of the poor are
protected from mark et failure. Regulation
also addresses problems related to
financial education, sophistication and litera
cy of the poor in South Africa.
68
The financial regulatory framework refers
to which regulator oversees which type of
financial institution. or which aspect of
a financial institution is regulated and
supervised by which regulator. Currently,
the type of business conducted largely
determines the regulator in South Africa:
the Bank Supervision Depa rtmen t (BSD)
within the SARB (headed by the Regis
trar of Banks) prudentially regulates and
supervises banks and the Financial Servi
ces Board [FSB(SA)] curre ntly prudentiall
y
regulates and supervises most non- bank
financial institutions (which include
financial advisory and interm ediar y servic
es, long- and short -term insur ance and
collective investment schemes). The Natio
nal Credit Regulator (NCR) is responsible
for
• the implementation of the National Credi
t Act (NCA) that regulates the mark et
cond uct of all credit providers (banks and
non-banks).
The curre nt regul atory framework in South
Africa is based on a range of different
-· laws and regulators at indus try level.
For example, different laws and regulation
s
apply to the banking. insur ance and
collective investment schemes' industries
respectively. In practice, this mean s that South
African bank s are subject. to a numb er
of regulators including the Registrar of Bank
s at the BSD (as prude ntial regul ator of
the banks), the Insur ance Registrar withi n
the FSB(SA) (as prude ntial regulator of the
insur ance business) and the NCR (as regul
ator of their respective mark et cond uct as
credit providers). This silo appro ach to finan
cial regulation (where different. stand ards
and legal requirements apply to different
sections within one financial institution)
is
one of the main reasons for the drive towa
rds the so-called Twin Peaks framework of
financial regulation. Ultimately the inten
tion of Twin Peaks is to provide a more
streamlined system of financial regulation
and supervision for the South African
financial sector. 6 This will be discussed in
more detail later in the chapter.
The current regulatory fram ewor k
THE FINANCIAL REGULATORY AND
SUPERVISORY
FRAMEWORK IN SOUTH AFRICA
Chapter 3: Financial Regulation in the South
African Banking Industry 69
!though regulation and supervision are
vitally impo rtant as a means of ensur ing
ancial stability. their effectiveness is costly
. For instance, it is possible to reduce the
obability of financial instability for any bank
to almost zero by imposing high capital
equirements. However, this would raise the
cost of financial services to the detriment of
onsumers. Thus regulators need to balance
the benefits of a higher degree of achieveme
nt
f objectives (effectiveness) with the costs incur
red in this pursu it (efficiency). Other
amples of a similar trade-off between linan
cial stability and competing objectives
nclude access to credit and consu mer prote
ction. While credit growth migh t appear
esirable, excessive lending may create instab
ility when borrowers fail to service the debt.
'o combat this in South Africa, the Natio
nal Credit Act (34 of 2005 ) prohibits exces
sive
ending and reinforces the financial stability
objective. At the heart of the issue is the role
,f the regulator to ensure that balance betwe
en regulatory objectives and consumer and
arket protection are achieved. As such, differ
ent financial regulators and supervisors
are tasked with achieving the four broad
policy objectives outlined in this section. The
division of responsibilities amon g different
regulators is referred to as the regulatory
framework and is the topic of the next sectio
n.
~--~-
•.. . - , ; - = ~ ~ ~ ~ ~ ~ - = ~ - - . , . . · - · · · - ·
The submission of information related to the business systems, business plans.
auditors and financial projections for an applicant bank are all part of the registration
approval process.
Chapter VI of the Banks Act includes the prudential requirements for banks.
Briefly, these are: 9
•
Minimum capital rc<1uircmcnts
As stipulated in section 70. the minimum start-up capital for a bank is R2 50 million.
Prudential regulation aims to ensure that financial institutions are financially sound
and capable or meeting their obligations to their clients. As mentioned previously. in
South Africa the BSD at lhe SARB is responsible for the prudential regulation of banks;
firstly issuing banking licences that meet specified requirements and then monitoring
their activities in terms of the prudential requirements and regulations set out in the
Banks Act. Prudential regulation 1Jlso refers to the imposition of penalties in cases of
noncompliance and crisis management and resolution in the case of bank failure.
The legal framework for prudential regulation and supervision of the banking
sector in South Africa consists or lhree tiers.7Tier one includes the Banks Act (94 of
1990). the Co-operative Banks Act (40 of 2007) and the Mutual Banks Act (124 of
1993); tier two refers to all the regulations applicable to the acts in tier one; and tier
three includes all the Directives. Circulars and Guidance Notes related to the three
acts in tier one. (The Directives. Circulars and Guidance Notes provide banks with
more detailed information on how they should comply wilh the requirements of the
Banks Act and its regulations.)
Further to the above, banks have to comply with the King Code on Corporate
Governance as well as the Basel Capital Accord (except for the two mutual banks). The
BSD models ils regulatory and supervisory framework on internationally recognised
key supervisory methodologies and principles including the 25 Core Principles for
Effective Banking Supervision thal was developed by the Basel Committee on Banking
Supervision. The Banks Act and the prudential regulations arc frequently reviewed by
a Standing Committee for the Revision of the Banks Act to ensure that it remains
relevant in an ever-changing global financial environment.
The Banks Act defines the business of a bank as 'the soliciting or advertising for. or
the acceptance of. deposits from the general public as a regular feature of the business
in question'. 8 In other words. all deposit-taking institutions in South Africa must be
registered as a bank and obtain a licence. In order to get a licence and register as a
bank. applicants must lirst obtain authorisation from the Registrar of Banks who will
only grant a licence when satisfied that a set of conditions specified in section 13 of the
Banks Act is fullillcd. A few of the most important conditions are that: 9
•
the Registrar must be convinced that the applicant will be able to meet the
requirements of the Banks Act on a continuous basis
•
the Registrar will evaluate the shareholding structures and sources of capital
before registration
•
the Registrar will evaluate the suitability of directors and senior management.
including an assessment of their knowledge of the proposed bank's operations.
Prudential regulation of banks in South Africa
Bank Management in South Africa - A risk-based perspective
3.3.2
70
71
ction] OA of the South African Reserve Bank Act (90 of 1989) further requires banks
hold a minimum cash reserve requirement of 2.5% at the SARB. Three other sections
f the Banks Act that are of particular interest with regards to prudential or riskelated requirements are: 9
Section 60B requires that the Board establishes and maintains a suitable
corporate governance process. This implies that a bank must achieve its
strategic objectives in a manner that is efficient, effective. ethical and equitable.
As stipulated in section 64, a bank is required to appoint a risk and capital
management committee that assists the Board to: 9
- ensure that sound corporate governance practices are adhered to
- evaluate in-house risk policies. procedures and practices on a daily basis
- identify and forecast various risks exposed to the bank
- develop suitable risk mitigation strategies to manage risks
- conduct a formal risk assessment al least once a year
- identify and monitor key risk indicators to ensure risk decision-making is
accurate and optimal
ensure that reporting structures are effective at communicating risk-related
developments between management and the Board
- establish a risk management function that is independent
- introduce measures that will improve the risk management policies.
practices and controls
globally monitor and co-ordinate risk management practices
- implement risk management processes and controls thal improve overall
risk and capital management
ensure that all material risks are properly identified, measured and reported
- ensure that the amount of capital held corresponds to the level of risk taken
- incorporate risk and capital adequacy goals into the strategic and business
focus of the bank
- perform risk- and capital-based functions as prescribed by the Registrar of Banks.
On an ongoing basis banks must hold a minimum capital of the higher of
R250 million or a certain percentage of risk weighted assets. (Capital adequacy is
dealt with in more detail in Chapter 15.)
Minimum liquid asset requirements
Section 72 requires that a bank must hold a minimum 'average daily amount.' of level
one high-quality liquid assets that exceeds 5% of its liabilities. This applies from the
15th business day in a month to the l 4th business day of the following month. At the
close of any business day. the high-quality liquid assets must: exceed 75% of the average
daily amount and may not be below 50% during the course of any business day.
Furthermore. a bank may not hold liquid assets of more than 20% of ils liabilities.
Conccnh·ation risk requirements
According to section 73, a bank needs approval from its Board of Directors (the
Board) to grant loans or make investments to any person or entity for an amount that
is more than 10% of its capital and reserves. Furthermore, a bank is not permitted to
grant loans or make investments for an amount that is more than 25% or its capital
and reserves to any person or entity without permission from the Registrar of Banks.
Chapter 3: Financial Regulation in the South African Banking Industry
The Directives under Regulation 38 in the Government Gazette of 2012 refer in
detail to the capital adequacy and leverage requirements for banks (this is dealt
with further in Chapter 15). Regulation 39 also stipulates the process of corporate
governance within a suitable risk and capital management environment. 10
Sect.ion 69 deals with the appointment of a curator to a bank. A curator is
appointed by the Minister of Finance (under the recommendations of the
Registrar) if it is deemed that a particular bank is unable to meet its contractual
obligations and in so doing affects the interests of the general public. The
curator must be someone who has relevant experience in the activities of the
respective bank and is remunerated by the bank under curatorship.
Bank Management in South Africa - A risk-based perspective
Prudential supervision and the SREP
The FSB(SA) is currently responsible for the prudential supervision of non-banks in
South Africa. For banks, the key function of prudential supervision is to assess their
individual performance based on their risk profile, corporate governance structures
and risk management processes in order to ultimately assess how the risks impact on
capital and reserves.7 More specifically, prudential supervision is about monitoring
and enforcing compliance with both the legal prudential requirements and best
practices whilst taking into account the risk profile. risk management and risk
mitigation systems of the bank. Ultimately the bank's Board is the most important
player in the supervisory process and accepts ultimate responsibility for its risk profile.
Regular meetings (usually annual, depending on the risk profile of the
particular bank) between the Board and the BSD are an important part of the
prudential supervisory process. Such meetings are used to obtain directors' views
and perspectives on the relevant risk profiles, risk management and risk appetite of
the bank. The BSD also gives feedback to the Board on current supervisory issues.
This process of meetings and feedback is structured around a supervisory
framework known as the Supervisory Review and Evaluation Process (or SREP) that
was implemented at the beginning of 2008 by the BSD. The SREP cycle is a
'continuous process involving supervisory planning, gathering information,
forming a view on the main risk areas, undertaking focused reviews and providing
feedback to the bank's management' . 11 Based on the findings of a SREP, the BSD
may require remedial act.ions that could include increasing the minimum capital
requirement for a respective bank.
As part of its planning process, the BSD classifies all banks on a quarterly basis
as being either high-risk, medium-risk or low-risk. 11 This risk classification
determines both the length of the SREP cycle and the supervisory resources to be
allocated. The size of the bank, and thus its systemic influence should it fail, is an
important criterion for it to be classified as being high-risk. Such a large systemically
important bank (or SIB) may have low bank-specific risk, but have a SREP cycle of
3.3.3
Prudential regulation of the South African banking industry is very advanced and
in line with international best practices. The prudential requirements of the Banks
Act in particular have ensured that the industry as a whole adheres to regulatory
requirements that promote financial stability.
3.
72
73
Proposed prudential regulation under the Twin Peaks model
Market conduct regulation
National 'rreasury (2014b:25) 13
The proposed new regulatory architecture under Twin Peaks in South Africa
Prudential regulation
--------►
2011 the National Treasury published a policy document containing proposals to
engthen financial sector regulation in South Africa. 12 This was in response to both
e lessons learnt from the 2007 /08 GFC and the challenges facing the South African
onomy. For reasons mentioned in the previous section, the regulatory framework of
ancial institutions in South Africa is highly fragmented and interconnected,
pecially given the bancassurance model adopted throughout the industry. By
plication, financial institutions were able to sell complex products to clients where,
many cases, they themselves were unaware of the risks involved. The main proposal
om the National Treasury, therefore, was to move to a 'Twin Peaks' model of
nancial regulation - that is, one regulator is tasked with prudential regulation of the
sector (called the prudential authority or PA) and another tasked with market conduct
regulation (called the Financial Sector Conduct Authority or FSCA).
A further purpose of the Twin Peaks model is to ensure that consumer
rotection receives sufficient priority and is not presumed to be secondary to
prudential concerns as, it can be argued, is currently the case. As such, the FSCA
will be a stand-alone authority with the PA to be established within the SARB. The
Twin Peaks model also places a separate focus on financial stability, giving primary
egulatory responsibility to the SARB. A Financial Stability Oversight Committee
6
FSOC) will also be created, which will be chaired by the Governor of the SARB.
3.4
year, the same as a smaller (and thus low systemic risk) bank with high bankcific risk. Owing to the potential systemic repercussions of the failure of the large
nk, however, a large high-risk bank will always be allocated more supervisory
sources than a small high-risk bank.
Chapter 3: Financial Regulation in the South African Banking Industry
Bank Management in South Africa - A risk-based perspective
FSCA
NCR
FAIS
(37 ol 2002)
NCA
(34 ol 2005)
Standards issued by PA and FSCA
wiU apply to entities licensed by
lheNCfl
Slandards to be issued in
consu!tation with the FSCA and PA
•
New standards may be issued by PA
and FSCA
■
■
ExisHng legislation responsibility of
the PA
•
PA and FSCA supervise, enlorce
requirements of standards they issue
NCR remains responsible tor
supervising, enforcing the NCA
FSCA supervises and enforces
existing legislation and new
standards and legislation ii issues
PA supervises and enforces existing
legislation and new slandards and
legislation It issues
Continu ous consult ation and co-ordi nation between the
different regulat ory
authori ties form an integra l part of the Twin Peaks model.
fncluded in this is the
require ment to draw-u p a memor andum of underst anding
between the different
regulat ory authori ties. As such, the FSR Bill also makes provisio
n for a Council of
Financi al Regula tors (CFR) that will provide consult ation on
matters of commo n
interest , raise issues and concern s and co-ordi nate actions
between different
■
•
•
•
Proposed Twin Peaks model
Subordina ted legislation
Source: Adapted from National Treasury (2014.a: 20) 3
PA
Licensing authority
Banks Act
(94 ol 1990)
Current existing
law
Table 3.2 Existing legislation and proposed Phase 1 reforms under
Twin Peaks in
South Africa
The implem entation of the Twin Peaks model will take place
over a numbe r of year
and in two phases. 6 The llrst phase, essentially divided into two
sub-pha ses, name!
la and lb, is set to be implemented by 2015/1 6 and phase
two during the perio
2016-2 018. Phase la deals with the creation of the Twin Peaks
authori ties (the R
and the FSCA) under the Financi al Sector Regulation (FSR)
Bill proposed in 201
and Phase lb covers the establis hment of the powers of these
authori ties to mee
their statutor y objectives. Althou gh the BSD and FSB(SA), as
they are known today,
will cease to exist, very few change s will be made in Phase
1 to existing industr y
specific legislation such as the Banks Act. Rather. the authori
ty responsible for the
existing acts will change . For example, the PA will become the
authori ty responsible
for the prudential provisions of the Banks Act as well as the Long-te
rm and Short-t erm
Insuran ce Acts (current ly the responsibility of the Registrar
of Banks and Registrars
of Short-t erm and Long-te rm [nsuran ce respectively). For
most other pieces of
legislation, the primary responsibility will move to the FSCA.
During Phase 2, the legal frameworks for pruden tial and market
conduc t will be
developed and harmon ised. This implies that existing financia
l sector legislation will
be amende d or replaced to establish a new regulat ory framew
ork where institut ionspecific laws will be replaced by new overarc hing laws. 6 The
Twin Peaks model is
therefore intende d to provide a streaml ined system of licensin
g, regulat ing and
supervi sing financial institut ions, whilst at the same time providi
ng a new approac h
to the enforce ment of financial regulat ion, supervision, client
compla ints (including
a revised om bud scheme), client advice and financial (literacy
) educati on.
74
··•""'"
■
Industry-specific laws
Requires co-ordination
authority
l::xisting ombuds remain
in place
Repeat FSOS Act
fSOS Cou~il to
s1reamli.1e and consolidate
arrangements
Exptorn potential 'Chief
Ombud'
Exibiing powers remain,
but additional enforcement
actions in FSR Bill
supervisory powers
Retain existing powers, but
add overlay of additional
Existing subordinate
legislation (bank regulations,
FA1S General Code) continue
to apply
FSCA and PA will be able to
issue new standards
between authoritif!s
■
■
•
•
•
•
Review of existing system
witl determine the way
forward
Aim to ensure consolidated
approach to alternative
c!isputc resolution
Exisling laws repealed and
replaced, especially new
market conduct lramework
Phase oul existing
subordinate legislation and
replace wilh standards
Existing licences repealed
and to be replaced
Musi get licence from PA
and FSCA
Phase 2:"f'argett iigulato,y
framewoik (201 &-2018)
he second draft of the FSR Bill was released in December
2014 and makes the
ollowing proposals: 6
Licens ing
Where financial institutions arc currently licensed according
to industry-specific
law. the Twin Peaks framework aims to streamline licensing significa
ntly. Financial
institutions will receive one licence from the FSCA if they provide
financial services
and a separate licence from the PA if they provide financial product
s. In the first
phase of the reform process, existing licensing requirements such
as those under
the Banks Act or FAIS will remain in place.
Setting standa rds and regula tory requir ements
Standards are regulatory instruments used by regulatory authorit
ies and include
capital adequacy and solvency standards. Seen as a 'minimum
benchmark', these
standards can be formulated as a combination of' rules-based and
principles-based
documents or policy. Since they are issued by a regulatory authori
ty as subordinate
legislation as opposed to legislation by a government departm
ent, it means that
they can be modified relatively easily and quickly. For this reason,
it is expected that
ource: Adapted from National Treasury (2014a: 13-14)"
■
■
Existing taws •·• FSOS Act and FAJS I ■
Act, Pension Fund Act. Different
laws for different ombuds
■
■
■
•
•
Tl1rough powers provided for in
industry specific laws
lnclustry-speci1ic laws (such as
regulations and board notices)
regulatory framework
,lli 3.3 The proposed pillars of the Twin Peaks regulatory
framework and the current
B amongs t others.
lators. The CFR will include represe ntatives from the PA, PSCA,
NCR and the
Chapter 3: Financial Regulation in the South African Banking Industry
75
-=---~-----,
current prudential and market conduct subordinate legislation will be replace,
with standards over time, whilst any new subordinate legislation will summarily
issued as standards.
Supervision (induding information-gathering, on-site inspectjons an
invest:igal,ions)
lnformalion-gathering and on-site inspections refer to routine supervisory actio
while investigations refer to actions over and above the routine supervisory actio
specifically in cases where breaching of the law is suspected. These powers at,
already part of the existing regulatory framework, but will be centralised
harmonised and strengthened under the Twin Peaks framework.
Administrative/enforcement actions
Enforcement powers refer to those remedial or punitive actions in the case where t.
breach of financial regulation law is detected. Once again, these powers (including
the issuance of Directives, interdicts, debarment orders and administrative penalties)
are not new to the existing regulatory framework, and will similarly be centralised,
harmonised and strengthened under the Twin Peaks framework.
Consumer recourse - reform of the ombud system
The current ombud system is regulated under several different laws and there
uncertainty about the jurisdiction of the different ombuds. This has in many cas
led to consumer confusion. As with the other pillars of the regulatory framewor
mentioned above, under the Twin Peaks framework the ombud system will also be
centralised, harmonised and strengthened.
Bank Management in South Africa - A risk-based perspective
<-----~-+~ J-'.5-'.??.c:<+_._.ssp. .. -.v, . . z~•~•.•••· ... •.
~- - - ~
3.4 MARKET CONDUCT REGULATION IN SOUTH AFRICA
Within the financial sector, consumer protection aims to ensure that
institutions behave appropriately towards their clients by treating them fairly.
Therefore, the common rationale for market conduct regulation in the financial
services industry is that the complex and opaque nature of financial products
suggest that generic consumer protection regulation is not enough to protect
consumers. Because they have credence characteristics, the quality of financial
services can often only be judged at considerable cost and time to the consumer.
Market conduct regulation attempts to address this imbalance of power between
consumers and financial institutions. More specifically, it aims to prevent consumer
detriment by: lJ
providing rules on how financial services are sold
•
prescribing who can sell financial services
•
requiring mandatory information disclosures
•
All indications are that industry-specific prudential legislation (most notably the
Banks Act) will remain relevant for at least the first phase of the Twin Peaks reform
process. Ultimately the Twin Peaks framework will have a single prudential regulation
authority (namely the PA) that will be responsible for the prudential regulation of
both banks and non-banks. The PA will also be mandated to play a broader linancial
stability role that includes the consideration of 'risks that are external to individually
supervised institutions' 13 and be able to deregister banks if it deems the risk to
financial stability in the system is threatened.
•
•
•
76
77
Tlte Financial Advisory and Inwrmediary Services Act (.J7 of 2002)
e PAIS Act is currently the major regulatory law applicable to consumer
otection in the South African financial industry. It aims, through the FSB(SA), to
otect consumers by regulating the financial institutions, or more specifically the
nancial service providers (FSPs), that sell financial products. In addition, the PAIS
ct regulates the way in which financial products are sold - that is, it makes
rovision for the contents and structure of any _financial advice given. The Act further
eks to ensure that clients are able to make informed decisions about financial
:ervices and that their reasonable financial needs regarding financial products are
ppropriately and suitably satisfied. 15 Section 14 of the J:<'AIS Act further stipulates
he debarment of representatives who fail to comply with the duties of the Act. As
ch, the Act is mainly applicable to divisions within banks that sell and provide
dvice on insurance and investment products.
In terms of the Act, FSPs cannot operate unless a licence is issued to them by the
Registrar of Financial Service Providers. FSPs and specilically their representatives
must meet the following so-called fit and proper requirements before they can be
registered as an authorised FSP: 15
exhibit character qualities associated with personal integrity and honesty
be competent to fullil the requirements of PAIS
exhibit the operational ability to fulfil the requirements of PAIS
be !inancially sound
.1.1
e Financial Advisory and Intermediary Services Act (3 7 of 2002) (FAIS) and the
tional Credit Act (34 of 2005) (NCA) arc examples of current market conduct
gulations that are applicable to banks. PAIS mainly protects consumers from
ying investment products, while the NCA provides protection for consumers from
dit products.
Current legislative framework for consumer protection
bnsumer detriment does occur, however. consumer protection regulations also
:ompass certain recourse measures. In South Africa, consumer recourse has
eral different channels through which it can be initiated. The most significant
:1udc internal dispute resolution mechanisms such as the comphiints department.
thin a financial institution. courts and the various ombud schemes. There are
·era! ombud schemes in South Africa including the Ombudsman for banking,
dit information, short-term insurance and long-term insurance respectively, as
II as the Pension Funds Adjudicator (PFA), the Registrar of the Council for Medical
emes and the Financial Advisory and Intermediary Services (PAIS) Ombud.
prescribing requirements regarding the honesty and integrity of institutions
nd their employees
requiring guidelines for the quality and objectivity of advice
promoting financial literacy and educating consumers about the costs of credit
enforcing credit cost disclosure regulations to protect them against over
indebtedness.
Chapter 3: Financial Regulation in the South African Banking Industry
have a minimum formal academic qualification
have a minimum number of years of appropriate experience
pass prescribed regulatory examination s (RE exams)
meet continuous professional development (CPD) requirement s to ensure that
knowledge is current
be able to operate as an ongoing business concern (that is, have a fixed business
address, adequate communica tion facilities and an appropriate money
laundering control system in place).
■
Reference to the Code as being the short name and the date of its commencement under
seclion 7(1) of !he FAISAcl.
Source: Adapted from the General Code of Conduct for Authorised Financial Services Providers
and lheir Representatives (2003) 1"
Short title and commencement
'tJV
The rights of the client wilh regards to the Code
Guidelines for the terminations of contractual obligations.
Termination of agreement or business
Waiver ol rights
XII
XI
XIII
Guidelines and obligations for FSPs for cllent complaints and relating to internal complaint
resolution systems and the Ombud lor Financial Services Providers.
f,omplaints
X
The requirements to ensure "Sound risk management protocol. for both the FSP and clients
Guidelines for FSPs regarding advertising and direct marketing campaigns.
Risk management
Advertising and direct marketing
IX
The guidelines lor holding and administering financial products and funds
The guidelines to provi~e advice to clients, including a Record o! Adv1ce.
Furnishing of advtce
Cuslody of financial producls and lunds
VII
VIII
The features of lhe financial service provided to clients
lnformalion aboul financial service
The requirements of FSPs to provide clients wlth information about the respective FSP.
The guidelines to use when communicating with dients.
lnlormation on providers
Contacting of client
IV
VI
The requirements ot FSPs lo provide clients with inforrm1tion about the suppliers of financial
services
The genera! and specific duties of FSPs.
Information on product suppliers
General provisioos
Description
General definitions and the applicability of the Code in conjunction with the FAIS Act
Introductory provisions
I Heading
Ill
Part
Table 3.4 Basic outline of the General Code of Conduct for Authorised Financial Services
Providers and their Representati ves
All FSPs must comply with various codes of conduct, depending on the type of
financial products they arc registered to sell. These different codes deal with aspects
including, but not limited to, the disclosure of information about the risks associated
with various products, record-keeping practices, the avoidance of misleading
advertising and the protocol for the safe-keeping of funds and documentat ion.
However, all FSPs must comply with the General Code of Conduct for Authorised
Financial Services Providers and their Representatives (or simply the Code). The Code
stipulates that the general duty of an FSP is that it 'must at all times render financial
services honestly, fairly, with due skill, care and diligence, and in the interests of
clients and the integrity of the financial services industry' . 16 The parts of the Code
with brief descriptions of each are provided in Table 3.4 below.
■
■
■
■
Bank Management in South Africa -A risk-based perspective
78
79
of 200 5)
nder section 12 of the NCA, the National Credit Regulator (NCR) is the regulatory
ilthority responsible for the implementa tion of the Act. The NCR is an independent
nd impartial body that has full jurisdiction to enforce the requirement s of the Act
king into account both national and internationa l developments in consumer
edit. The NCR is ultimately responsible for developing an accessible credit market
South Africa by ensuring that it abides by the objectives of the NCA set out
ove. Of specific interest is the focns on the low-income historically disadvantaged
ople in remote and isolated communitie s in South Africa. In addition, the NCR is
ponsible for conducting research and disseminating data related to credit trends
d developments in the South African consumer credit environmen t. The NCR is
visaged to continue to play an important role in market conduct regulation and
ilpervision and will continue to operate as a separate regulatory authority under
he Twin Peaks framework.
The NCA also aims to protect consumer rights. Chapter 4 of the Act refers to the
ights of consumers when applying for credit. These include: 17
the right to apply for credit
e NCA became effective on l June 2007 and replaced the Usury Act of 1968, the
edit Agreements Act of 1980 and the Exemption Notice (which regulated micronding transactions). According to section 3, the purpose of the NCA is to 'promote
d advance the social and economic welfare of South Africans, promote a fair,
ansparent, competitive. sustainable, responsible, efficient. effective, and accessible
edit market and industry' .17 The Act also promotes the protection of consumers
sfollows: 17
accessible credit markets especially to the historically disadvantaged
consistent treatment of credit products and providers
encourages responsible borrowing
discourages over-indebtedness by consumers
discourages reckless lending by credit: providers
promotes equity between consumers and credit providers
.addresses imbalances related to credit and consumer rights, disclosure and
informed decision-making, and deceptive conduct by credit providers and credit
. . bureaux
improves the administrati on of credit bureaux
promotes a system of consensual resolution arising from credit-related
contractual disputes
promotes a system of debt restructurin g.
The National Credit Act (3 4
-summary, the FAIS Act was promulgated in order to protect the rights of the client
hen dealing with FSPs. This is especially so when financial advice is given. By providing
lient with the proper advice the FSP itself is also protected, especially in cases where
putes (and even legal actions) arise related to information supposedly not being
ovided to clients. The FAIS Act, or at least legislation explicitly protecting clients from
ploitation by financial institutions, is therefore long overdue in South Africa.
Chapter 3: Financial Regulation in the South African Banking industry
proteclion against discrimination in respect of credit
the right to reasons for credit being refused
the right to information in the official language of the applicant
the right to receive copies of the documents relating to the credit agreement
the right to have personal information treated as confidential
the right to have a clear outline of all applicable costs related to the credit
agreement
the right to access and challenge credit records and information.
•
•
•
•
Reckless lending
Capped interest rates and other fees and charges
As stipulated in Chapter 5, the NCA effectively caps the total cost (interest rate
charges, fees and other charges such as credit life insurance premiums) of credit
agreements. The maximum permissible interest rate that may be charged to
clients is based on a formula calculated via movements of the repo rate determined
by the SARB. The in duplum rule (literally meaning 'double the amount') applies a loan will no longer accumulate interest when the total amount of arrears
interest is equal to the outstanding principal debt. According to Section 103(5),
'the amounts that accrue during the time that a consumer is in default under the
credit agreement may not, in aggregate, exceed the unpaid balance of the
principal debt under that credit agreement as at the time that the default
17
occurs' • Table 3. 5 provides the maximum permissible fees and interest rates
allowed under the NCA.
3.4. 1.2.2
The provisions of the Act related to over-indebtedness and reckless lending require
that clients should not be misled into taking up credit that they cannot afford. This
implies that banks should conduct a proper and thorough credit assessment of each
client to determine their ability to meet the contractual obligations of the credit
agreement in a timely manner. The ability and willingness to service the loan is a
vital underlying intention of this assessment and failure to conduct it in such a
manner may lead to a suspension of the credit agreement. ff. however. the client
fails to fully and truthfully disclose relevant information to the credit provider, a
credit agreement will not be declared reckless. These provisions also have
implications for credit marketing practices. Phrases such as 'low cost credit' might
be interpreted as being misleading, and therefore the Act requires that such phrases
be explained and justified by providing complete information regarding the true cost
of the credit.
3.4.1.2.1
Chapter 2 of the Act also makes provision for the National Consumer Tribunal (NCT)
which acts to adjudicate on matters related to the NCA put forward by those affected
by the Act. Below follows a brief overview of selected provisions within the NCA.
•
Bank Management in South Africa - A risk-based perspective
80
0
Marketing practices
The NCA does not allow credit providers to conduct marketing practices such as
door-to-door selling and uninvited canvassing at a workplace or home. Rather, the
Act requires that marketing communication must be clear, simple and
understandable. This implies that advertisements should not be misleading and
must disclose all relevant costs related to the credit agreement. An advertisement
that makes reference to, for example, the cost of credit must disclose the instalment
amount, number of instalments, a breakdown of the costs involved (including the
interest rate, fees and compulsory insurance), the applicable interest rate (indicating
whether or not it is variable or fixed) and the final residual or 'balloon' amount
payable (if applicable). Where phrases such as 'cheap credit', 'affordable credit' or
'low-cost credit' are used, specific information related to the total cost of the credit
should also be provided. 18 The NCA also contains a provision that clients are
entitled to receive a detailed written quote which is valid for five business days to
enable them to compare quotes from different credit providers.
3.4.1.2.3
In addition to the interest rate, credit providers are allowed to charge an initiation
fee that covers the cost of loan origination. This is permissible in order to prevent
the credit provider from recovering this cost from the interest charged to the client.
A monthly service fee that covers ongoing administration and collection costs may
also be levied. In the event that a credit provider requires a loan protection policy,
clients may cede existing insurance cover. If this is not owned. the charges for a loan
protection policy must be reasonable.
a
F6f Ceftainlypes of credit agreeriienfthl'ihiaximuiri permissible iHterest rate is
spe?.ified as·a;~ercentage perll'l?~.th.·fCJ~efample, . •in ·the·,case·of}~9idental credit
agreements (such as school fees; overdue bills frommunicipalitiesand doctors) the
murnperrnlssible interest rat:is?'¾,permonth.}n addition,f?r~.hort-term loans
.to 6 months \'l.ith value of less than R8 Q0O the maximumpermissible interest
rate is 5%permohth, 18
Minimum Ice R150
Maximum fee R23 500
A150 1- (10% of any amount larger than R10 000, to a
maximum of Al 000)
(Reporate x 2.2) + 10%
(Repo rate x 2.2) + 20%
Rt50 + (10% of any amount larger than R10 000, to a
maximum of R1 000)
R1 000 + (10% of any amount larger than R10 000, to a
maximum ot R5 000)
Maximum oridiriatidtff88
(Repo rate x 2.2) + 10%
(Repo rate x 2.2) + 5%
urce: Adapted from NCR (2007:30) 18
Small and medium business loans and low
income housing loans (developmental credit}
Credit facilities (store cards and credit cards)
Mortgage agreement
MaximUrriirit8resfftite
Table 3.5 The maximum fees and interest rates permitted under the NCA
Chapter 3: Financial Regulation in the South African Banking Industry 81
-~~--- - - - - - - - - ~ ~ · -
3.4.1.3 Recet1t changes to the NCA
ln response to certain issues in the South Afrirnn credit market, ongoing changes
and refinements have been made to the NCA. relating mainly to reckless lending
provisions, affordability assessments and the information provided by credit
bureaux. These changes are contained in the National Credit Amendment Act (19
of 2014) (NCAA). Most notably, the NCAA contains certain provisions regarding
credit information amnesty, suggesting that credit burec1ux must remove adverse
credit information from their records in order to allow consumers with impaired
credit records a proverbial clean slate to apply for new credit. Further to this, the
draft National Credit Regulations for Affordability Assessments was promulgated on
5 August 20.14 and stipulates legally binding criteria for affordability assessments.
At the very least, the NCA is complex and comprehensive and a major
improvement on the outdated legislation preceding it. Many commentators believe
that the very nature of the Act in focusing on affordability when assessing
creditworthiness was one of the reasons that the South African financial sector was
not affected by the GFC as badly as other economies. The reason for the existence of
the Act is to avoid excessive and reckless lending and if a bank is found to have
3. 4.1. 2. 5 Debt counselling
The NCA gives clients who are unable to service their debt obligations the right to
apply for financial management and debt counselling in order to assist them with
restructuring their debt repayments. This process cc1n be either voluntary or
mandatory by order of the court.
An agreement entered into as a result of negative option marketing is unenforceable
according to the NCA. By implication, this means that the credit provider has no
legal basis to enforce any provision of the agreement - it is as if the agreement was
never entered into in the first place.
In addition to the marketing practice provisions above, the NCA prohibits negative
option marketing. Prior to the advent of the NCA banks would for example, without
informing clients, increc1se overdraft facilities automatically. This is now not allowed.
Furthermore, negative option marketing occurs when a credit provider makes an offer
to a client (whether prospective or existing) on the basis that the offer is deemed to
have been accepted unless the client declines the offer. ln other words. unless the
client formally declines the offer. they are contractually bound by it. Section 74 of the
Act prohibits negative option marketing in the following three instances: 17
•
a credit provider makes an offer lo enter into a credit agreement that comes into
effect unless the client formc1lly declines the offer
■
a credit provider increases a credit facility (with or without the client's
knowledge) that comes into effect unless the client formally declines the
increase
•
a credit provider alters or amends a credit agreement that takes effect unless the
client formally declines the alteration or amendment.
Negative option marketi11g
Bank Management in South Africa - A risk-based perspective
3.4.1. 2.4
82
83
--.----- -
------
order to ensure that these eight principles are embedded into Twin Peaks,
the National Treasury has recommended that the new legislative framework be
consolidated into i:l so-called 'conduct of business [ramework'. 14 Currently ten Acts
(namely the Long-term Insurance Act, Short-term Insurance Act, Pension Funds
Act, Collective Investment Schemes Control Act, Friendly Societies Act, Financial
Advisory and Intermedic1ry Services Act, Financial Markets Act, Credit Ratings
Services Act, Banks Act and the National Payments Systems Act) rall within the
ambit of market conduct.regulation and the proposal is that this be consolidated into
two Acts, namely the Financial Sector Regulation Act and the Conduct or Financial
Institutions Act. The benefit of this consolidation is that it reduces compliance costs
The National Treasury put forward eight principles upon which the proposed market
conduct framework should be based. These are: 14
The FSCA must be transparent and consultative in its decision-making process.
The framework must be comprehensive and the underlying principles must be
applied consistently.
The framework must be appropriate to the particular sub-sector or activity it is
being applied in, whilst being intensive and intrusive enough to ensure that
regulation and supervision is rigorous.
Regulated institutions must be outcomes-based - that is, client outcomes must
be based on both principles- and rules-based standards and be clearly evident
throughout tbe institution.
Regulatory requirements must be risk-based and proportional - those
institutions that consistently comply with market conduct requirements and
outcomes will be under less regulatory scrutiny from the FSCA.
The FSCA must be pre-emptive and proactive in order to swiftly negate any
misconduct by financial institutions.
The FSCA must be seen as an effective and credible deterrent to market
misconduct.
The framework must adhere to international standards regarding market
conduct.
sdiscussed in Section 3.3.4, the Twin Peaks framework will ensure that market conduct
egulat.ion will be more prominent than under the current regulatory structure. As such,
e FSCA will replace the FSB(St\) and have a new mandate with a new regulatory and
upervisory framework. The FSR Bill provides three objectives for the FSCA: (i) fair
treatment of financial clients; (ii) efficiency and integrity of the financial system: and (iii)
financial literacy and capability within the financial system. 14 It is envisaged that the
FSCA will co-operate with the PA to achieve these three objectives.
.4.2 The proposed new approach to market conduct regulation under the
Twin Peaks framework
isrespected these guidelines, the consequences thereof lie with the bank. So although
e NCA may not have explicitly protected the financial sector per se, it did contribute
0 a national philosophy of credit granting that is more risk-averse than risk-taking.
Chapter 3: Financial Regulation in the South African Banking Industry
Bank Management in South Africa - A risk-based perspective
A clear definition of the regulatory perimeter
Licensing and authorisat.ion
Outcomes-based supervision
Setting regulatory standards (conduct standards)
Information gathering
\ G ~ _ x f _ ~ ~ ?90, ..,...,.f.--~~.,.,...
Greater emphasis will be placed on factors that have in the past not been part of the
more traditional information gathering function of financial regulators. The aim is
to obtain better and pre-emptive insights into conduct risks including. for example,
understanding business models, incentives and drivers of conflict. This suggests that
the FSCA may need to rely on sources of information beyond that supplied by the
regulated entity.
5.
The FSCA will be mandated to set flexible and broad subordinate legislation or
standards. Examples of these conduct standards include (but are not limited to)
standards of business conduct. flt and proper person requirements, disclosure
requirements. remuneration practices and preventing abusive market practices. In
effect, over time the FSCA will replace the powers of the current FSB(SA) to issue
Notices, Board Notices and Rules with regards to conduct standards.
4.
Outcomes-focused supervision will not only test FSPs on their delivery of TCF
outcomes and pricing efficiency, but also on their effectiveness in supporting the
financial sector which in turn supports the real economy. Thus the FSCA may be
required· to consider macroeconomic problems such as the extent to which the
financial sector supports the average South African in saving for the future. By
implication. the FSCA will be a considerably more proactive and pre-emptive
regulator, acting to prevent consumer detriment from occurring.
3.
An activity-based system of authorisation is proposed with tough fit and proper
standards. It is proposed that the FSCA will issue FSPs with a single licence that
authorises them to propose specified products and services to specific types of
consumers. This implies that the FSCA will not license an institution such as a bank. for
example, but rather a typical bank would be licensed as an FSP that is authorised to sell
certain types of financial products to certain types of consumers (see Section 3.4.2.1).
2.
Market conduct regulation should cover all financial products, whether or not the
arc provided by traditional FSPs. The idea i.s that market conduct legislation should
be able to respond to all sources of conduct risk in a way that is flexible, complete,
consistent and necessarily proactive and intrusive. As a result of this, all institutions
that are regulated by the PA will also need to be regulated by the FSCA. As
mentioned before, the approach will be risk-based. where the law will be applied
proportionately to the potential conduct risk of a respective institution.
1.
associated with fewer acts whilst reporting to a single market conduct regulato,.
Following on from Section 3. 3.4 above, this proposed legislative framework should
comprise the following six key components: 14
84
85
Description
lhere must be no lllreasooablc post-sale barners hirxiefing climts to change prro.x:ts, switc::t1 l)"ovioc'fs, submit claims Of make compk1ints.
Financial prOOucts and services musl perform as clienls expect them to and the level of service provided by lhe financial institution
mus! be ol an acceptable standanl
Where clients receive actv1ce, it musl be suitable and take accounl of lhelr persona! circumstances.
Clients must be given clear infonnalion and be kepl appropriately informed before, during and atter purchasing a tinancial procluct
or service.
Financial products must be designed to meel the needs of identified client groups and targeted accordingly.
Clients must be confident that they are dealing with inslitutions that have their lair treatment embedded in their organisational culture
Source: National Treasury (2014b:5J) 14
· Outcome
Table 3.6 The six fairness outcomes of the TCF approach
3.4.2.1 Treating c11stomersfairlu
Currently the PSB(SA) uses the so-called treating customers fairly (TCF) principles to
regulate non-bank institutions. Once the Twin Peaks framework is fully implemented,
the TCF framework will form part of the regulatory framework for banks, with TCF
forming an important foundation for the new market conduct authority (FSCA).
TCF is an activity- and outcomes-based approach to regulation and supervision. The
former refers to those institutions that will be regulated according to the type of financial
services they provide - that is. all institutions that provide the same type of financial
services will be regulated in the same way, regardless of what type of financial institution
they are. The latter refers to a situation where institutions must demonstrate that they
have delivered specified fairness outcomes to their consumers. TCF supervision will also
be risk-based, meaning that the intensity of supervision will be determined by the risk
that a bank will not treat their customers (clients) fairly - that is, the higher the risk for
not treating clients fairly, the more intensive the supervision. The vulnerability of clients
to potential abuse will also determine the intensity of supervision.
The final desired outcome of TCF is to ensure that the financial services needs of
clients are appropriately met. As such, the TCP approach centres around six fairness
outcomes that have to be achieved by financial institutions. These are provided in
Table 3.6. 14
should be clear that the proposed Twin Peaks framework is ambitious to say the
ast. The challenge for the South African authorities is to consolidate an existing
gulatory framework that is by no means poor, with a proposed framework that is
e natural result of gross misconduct in the lead-up to the CFC. The irony is that
e current framework to a large extent protected the South African financial system
om the adverse effects of the CFC. Yet in order to ensure that the framework docs
lag behind its international peers. it has to adapt accordingly. This is definitely
not an easy task and requires a concerted effort from all stakeholders involved.
e FSR Bill introduces several new enforcement actions for the FSCA, including
lowing the FSCA to enter into leniency agreements. whereby, in exchange for coeration in an investigation, certain actions will not be taken against a person. The
CA will increasingly not only focus on breaches of specific rules-based standards.
t also on breaches of principles-based standards. such as failing to provide TCF
tcomes. This means an increased reliance on judgement-based decision-making.
Enforcement and administrative actions
Chapter 3: Financial Regulation in the South African Banking Industry
I
1
;
~
t
i
;!
I
l,1
t
!I
I/i
Bank Management in South Africa - A risk-based perspective
Encourage shareholder awareness through rriple-bonom-line
reportrng on performance in implementing the FSC.
Encourage tram1ng and awareness programmes for
shareholders
The target that was set by tne FSC was 25% tor black
ov•merShip, measured at the holding company level, by 2010
Promote increased levels of influence ol direct black owners at
board level
Ownership and control
.This includes targeted !nw,5tments in low~income housing,
transformational infrastructure. agricultural development and
black SMEs and BEE transaction financing
Empowerment financing
Provide firsl-order retail financial services such as attordable
banking services (for transac!ioos and saVfngs), contractual
savings schemes and credit for small and microenterprises
Develop sustainable inslilutions to serve poor communi!ies.
Regulation of credit bureaux.
Access to financial services
Financial institutions were expected to meer a target of 50% of
the value of al! procurement from BEE-accredited companies
by 2008
The large! should have increased to 70% by 2014.
Preferential procurement of goods and services
This alms lo redress disparities in lhe Soulh African workplace
and broaden the skills base, especially by promoting b!ack
participation.
Human resource development
.Targeted areas (pillars)
FNB
n/a
20
nla
nla
20
20
nla
11.94
nla
12.44
2011
nla
19.50
nla
19.37
2011
FNB
ASSA
Nedbank
23
23
23
23
Available points
for: ownership
n/a
n/a
,va
20.07
2012
nla
22.77
nla
20.18
2011
rransformational mfrastructurc- over R12 bil!ion
Sid Bank
•
14.0~
n/a
nla
20.00
2010
~
Access to branches and ATMs within 10 km radius is over 80%
SME finance - over A16 billion
•
Agricultural linance -- over R3 billion
Access of living slandards measure (LSM) group 1-5 to bank branches
witl1in a 15 km radius is over 75%
1t
¥!
Mzansi accounts - over 6 million
New, more cost-eHective financial inclusion accounts by the Big Four
banks
15.42
n/a
n/a
20.00
2010
9.24
n/a
nla
12.54
2010
Iii
Access to housing finance - over R65 mil!ion
ABSA
Nedbank
19.46
20
2012
n/a
n/a
nla
9.96
2012
•
•
18
ABSA
Available points
18
NedlJank
Std Bank
18
18
fNB
Available points
11 Std Bank
I
j Progress
Table 3.7 The six pillars of the FSC and progress made by the Big Four banks in
South Africa
FINANCIAL INCLUSION AND THE FINANCIAL SECTOR CODE
In order to increase financial inclusion. the South African financial secto
committed itself to promoting Black Economic Empowerment by voluntarily
drawing up the Financial Sector Charter (FSC) at the Financial Sector Summit in
19
August 2002. The FSC came into effect in January 2004 and aims to provide
increased access (and thereby inclusion) to financial services for previously
disadvantaged households and communities. The FSC is based on six pillars which
are highlighted in Table 3. 7. The table also highlights the progress made by the Big
Four South African banks for the period 2010 to 2012. The Charter Council
established as an independent body to oversee the implementation of the FSC.
3.5
86
•
11
ABSA
n/a
9.19
nla
8.46
2011
7.6
nla
n/a
8.25
I 2010
ABSA also sponsors the Klein Karoo Nasionale Kunstefecs and sporting
events such as the Currie Cup, Premiership soccer and Cape Epic. Other
Big Four banks are similarly active in taking up their social responsibility
In civil society.
The international money laundering control framework
A money laundering offence occurs when the origin of funds (or proceeds) obtained
from illegal activities is disguised. This usually takes place in three stages: 25 the placement
stage occurs when the illegal funds are placed in the formal financial system; the layering
stage occurs when the source and ownership of the funds is purposefully concealed or
disguised; the integration stage occurs when the first two stages are successful and the
funds are integrated into the legitimate economic and financial system. 25 Money
lannderers often receive prolessional assistance to carry out these activities.
Combatting money laundering requires a global policy response because of its ability
to adapt to changing business and legal jurisdictions. To this end, the Financial Action
Task Force (FATF) was established in 1989 by the G-7 summit held in Paris. In 1990 the
FATF issued a 40-point list of recommendations that prescribe a range of actions
designed to strengthen international co-operation against financial crime. After the
terrorist attacks on 11 September 2001, the FATF expanded its mandate beyond money
3.6.1
COMBATTING MONEY LAUNDERING IN SOUTH AFRICA
a process of negotiations from 2007 to 2011, a Financial Sector Code was
published in theGovernmenlGazette in November 2012. As a result, the FSC, a voluntary
agreement, was transformed into the legally binding Financial Sector Code under the
Broad-Based Black Economic Empowerment (BBBEE) Code. 24 The BBBEE scorecard
forms an integral part of compliance and provides a set of indicators to measure the
success of empowerment initiatives in the banking sector. The scorecard is used by
banks for self-assessment and the Charter Council to evaluate the implementation of
BEBEE. The government also uses the scorecard when awarding contracts, since banks
must receive a certain minimum score in order to be awarded government contracts.
The scorecard is based on the six pillars identified in the original FSC except that
the preferential procurement of goods and services pillar is split into a preferential
procurement and enterprise development respectively to form seven pillars in total.
0:Pollowing
n/a
nla
n/a
8.32
I 2012 I
87
ASSA spent R60.9 minion in CSl-profects in 2007, focusing on educalion,
entrepreneurship, health and disabitiry, and the environmenl.
11
Ne{lbank
Compiled by Dr Arno van Niekerk.
.'Source: BASA: 20 Moya & Rohan; 21 Finscope (2012); 22 DTI (2012) 23
should be aimed mainly at black groups, namely: education,
taming, development programmes, job creation, arts and
'.culture, health and sport.
•
II
11
Sid Bank
FNB
Available
points for:
management
control
Black Enterprise Empowerment Trusts own 9.5% ol FirstRand's slack
Chapter 3: Financial Regulation in the South African Banking Industry
Bank Management in South Africa - A risk-based perspec
tive
The Financial Intelligence Centre Act (38 of 2001)
7
:.~ice.,._.·:- __
• ··- ·,•.
-
•
•
• .. -·-··.--,:--:cc·:.-.c·-.•-,·c•.-.-------, ••. ,., .•. ,.,:••·:-cc.-·•·
bave•• ~·ina§ ituation where youyisfted y6tir.6a~~.anff~~~~~6
yet1,~Y .•;
/heiraski2gYou teJ~~ntifyyourself even though the ban.kc
!;~ ktiowsx;rvW;flY"~O you
Oare",fl?.JX ~qbites tfa~ks to yerify the identity of the client
ittr~~sacts With ~ypr;se2ti2g
fr'validgoverl'lment-iss~~djD . documents,.Frustr~tion·arises
.•when . the~a2~·cJ~f~t~s~s·you
?>f~.i~~ritlfy yeu';l~lfJhenext;time you.visit the batik. "fhis
may)t,e for ~ev~~ ~,~~ns .first:
•"f°t!ie.recefcJ~~~ping#yStems of the bank are not4ntegrated,
soalthough)'o~fi~~ti~.m~y
[, ~~V;~ riy~rlfi ed .iP !~epast,6ne system . maypot 'talk.to
anether' sy~tem .~e.2a , . ~he
•·:c:fa ti?ns.en~!'barikcl~rk·•3rE!.aUdited in·.accordi31'1cewit~tt?
~Be.t.~~
C-://i:}/.C:"'.?·?,°'
·naseve
ry.righttoaskyoufoidentify yourself every time you vislt it. ti~s·it.m~y,?\~~2k(
.c'/ .. . • ...
Jfl~&~11y
South Africa's anti-m oney launde ring legal framework
is based predom inantly on
the Financial Intelligence Centre Act (38 of 2001) (FICA)
and the Prevention of
Organised Crime Act (121 of 1998) (POCA). FICA focuses
on providing detailed
money launde ring contro l obligations for so-called
'accou ntable institu tions'
whereas POCA defines the general money launde ring offence
s. For purposes of our
discussion, however, reference will be made to FICA and
its applicability.
In 2008, the Financial Intelligence Amend ment Act (11
of 2008) came into
being and made several change s to the original FICA.
The amend ments became
effective on 1 December 2010 and focused predominantly
on providing for greater
penalties upon contra ventio n of the Act. For example,
certain offences stipulate
impris onmen t for up to 15 years or fines of up to Rl 00 million
.
At the heart of FICA is the require ment to 'know your
client' (KYC). This KYC
principle is established in section 21 of the Act whereby
'[a]n accountable institution
may not establish a business relationship or conclude
a single transaction with a
client unless the accountable institution has taken the
prescribed steps to establish
and verify the identity of the client'. 25 Section 21 also
stipulates that clients of the
bank before the implementation of FTCA need to be verified
before further transactions
may take place. The BSD enforces all FIC-issued Guidan
ce Notes, Circulars and
announ cemen ts to be made to banks and also conduc
ts proactive assessments of
whethe r or not they comply with money laundering provisi
ons.
3.6.2
laundering and issued the Eight Special Recommendations
on Terrorist Financing. South'
Africa became a member of Ri\TF in 2003 and committed
itself to implementing and
complying with the international standards to combat money
laundering and terrorist
financing. Subsequently, the FATF created Financial Intellig
ence Units (or F!Us) for
member countries that are designed to attack financial crime
through various forms of
co-operation including the exchange of information and sharing
of expertise. With this
in mind, the Financial Intelligence Centre (FIC) was establis
hed in 2002 to act as the
regulatory body in South Africa to enforce anti-money launde
ring practices. The FIC
conducts itself under the auspices of the Financial Intelligence
Centre Act (38 of 2001) ..
In addition, the Money Laundering Advisory Council (MLAC
) was established to advise
the Minister of Finance on best practice regarding anti-mo
ney laundering activities, to
act as a forum for debate on combalting money laundering
and to advise the FIC on its
performance with regards to its functions vis-a-vis FICA. 25
88
e
At the heart of FICA is the assura nce that banks are dealing
with clients who are
they say they are and have funds from sources that are legitim
ate. This is a very
import ant principle in the realm of manag ing risk within
a bank. If a bank is not able
I
the identity of their clients. Thus the higher the risk that
a client might be involved
in money launde ring activities, the higher the intensi
ty of the method s the bank
can use to verify the identity of the client. In this regard,
the FIC has issued a General
Guidance Note Concerning the Identification of Clients
that identifies a numbe r of
further risk indicators that may suggest possible money
launde ring activities. Some
of these risk indicators include: 26
a client has several bank accoun ts with different banks in
one geographical area
a client makes large cash deposits into an accoun t of a foreign
correspondent bank
a client wishes to have credit and debit cards sent to
destinations other than
their address on record
a client has numer ous accoun ts and makes or receives large
cash deposits
a client frequently exchanges curren cies
a client wishes to have unusua l access to safe-deposit facilitie
s
a client receives and disburses from their accoun ts large
cash amoun ts which '
are seemingly unrela ted to norma l business activities.
lri South Africa.banks are allowed to follow a risk-based approa
ch when verifying
!!;e¼~xi~~le§.?f~~~ria·~~~~J~igbi~'?fa~6ffen?e•·.J.nderFl~~;~eW
.it:JailS.tdi.'
lde~~ify pers?fisandkeepsina:deciuater~ords; fails.to··giVe'~S
sist~~Seto /.•·· )
•pre~.ent~tiv~~'.cif the~IC;cfai1s1o;reportgashtr.a~sa~ti(lr1sao()ye
,fit~cribed. 1i111its:;;; /•.•·•·•
ilflo.i.reportfifapid()U~pruti~ftianra~;~etlbns;Iampersviffn9~.~e~troy
ssonryde.~tiiil.·.•··
,terrnaiion:failsfoiofrn.ulate ancfi§,plerq'.e-ritifitf!rii!liri.ltes;\~
P~lic~~
··1point•aniriterifal (;0111pliary<5e~~b~~'failtt6.provi~Ji=tc~.~laf li3!ot<Y?; failst~•x•/
~;y~iningt6 its staff;· •••·
structs an"official in the perfotma~ce2tif'!hl'lir duties vis-a•Visthe~c 26
t.
1
control measu res under FICA essentially focus on suitabl
y verifying the identity
clients, establishing the source of the funds in questio n
and reporti ng to the FIC
y suspicious activity believed to relate to money launde ring or terrorist
activities.
such, FICA requires banks to:
implement an interna l framework (policies and proced
ures) that enables them
to identify and verify the identity of their clients. This
applies to both new
clients and those already on the books of the bank.
ensure that records of business relationships (for at
least five years from
termin ation of this relationship) and transac tions (for
at least five years from
the date when a respective transac tion was concluded)
are kept and stored in
either paper or electronic format
develop an interna l system to identify suspicious,
unusua l or irregul ar
transac tions that must be reporte d to the FIC
provide anti-money launde ring trainin g for its staff
appoint a Compliance Officer that ensures compliance with
the provisions of FICA.
Chapter 3: Financial Regulation in the South African Banking
Industry 89
Bank Management in South Africa - A risk-based perspective
Legislative developments
CURRENT REGULATORY TRENDS AND DEVELOPMENTS
Several laws have recently been passed to improve the existing financial regulatory
framework in South Africa. Most of these aim to (i) bring the regulatory framework
into line with international developments and (ii) cater for the implementation of
the Twin Peaks framework. For example. the Financial Markets Act (19 of 2012)
(FMA) aims to regulate South African financial markets by ensuring that they are
fair. efficient and transparent. In doing so, the Act increases confidence and
minimises systemic risk in the financial markets by protecting its participants and
promoting both national and international competitiveness. The FMA makes
provision for formal exchanges (such as the Johannesburg Stock Exchange). the
custody and administration of securities. clearing houses, trade repositories, market
abuse (such as insider trading) and auditing standards.
Complementary to the FMA. the Credit Rating Services Act (24 ol' 2012) provides
for the registration or credit rating agencies, and specifically for the reduction of
systemic risk by being responsible and accountable. providing credit ratings that are
reliable and transparent and improving investor protection, fairness. efficiency, and
transparency in financial markets. This is particularly relevant given the role that
rating agencies played in the lead-up to the CFC of 2007 /08.
The Financial Services Laws General Amendment Act (45 of 2013) came into
effect on 28 February 2014 and aims to ensure that South Africa has up-to-date
financial sector legislation during the transition to the Twin Peaks framework.
Thirteen financial sector laws were amended under this Act including the South
African Reserve Bank Act (90 of 1989), the Financial Services Board Act (9 7 of
1990). the Financial Markets Act (19 or 2012) and the Financial Advisory and
Intermediary Services Act (3 7 of 2002). As an example of the extent or change in
3. 7.1
3.7
In April 2014 the SARB fined four SoutfrAfricaifbai\ks fotalarn6unt of
R125 million ,as a result of shortcomings irithelirmeiney laun~efing and terrorist
financing combatting systems. The fines.did notfdllow any explicit ·money
laundering transactions, but focused on insufficierit processes arid systems
regarding the verification Of client details, record..keepirig and the mariagirig and
processing ofsospicidus transactions. In_ Februaryi20) 5 Jwo furtherbanks .were
fined RS millio'l'l and R10 million respectively for similar deficiencies intheir money
laundering·detectiori frameworks.
a
to properly assess the source of funds and the true identity of a client, how will it be
able to properly assess legitimate information based on the client? This raises serious
information asymmetry concerns for the bank especially with regards to the adverse
selection issue. Further to this. if funds have terrorist-related sources, concerns are
raised that may lead to political or sovereign risk implications. FICA has therefore
been a vital addition to an already well-regulated South African financial sector.
90
Deposit insurance in South Africa
Dealing with SIFls and the too-big-to-fail issue
TCF is an evolving framework that the FSB(SA) plans to implement on an
incremental and risk-based basis. This means that the higher the perceived risk, the
more intensive the supervision. The vulnerability of clients to potential abuse will
also determine the intensity of supervision. At the moment TCF is not legal. yet it is
a vital next step for the implementation of the Twin Peaks framework. Therefore,
the FSB(SA) is currently emphasising the importance of embedding a TCF culture in
financial institutions, starting with the business leaders and senior managers. It is
hoped that by doing this rather than adopting a 'tick box' compliance approach will
embed TCF principles more implicitly. The FSB(SA) believes that if this is achieved,
then the remaining five fairness outcomes will follow as a matter of course.
3.7.4 The implementation of TCF
The regulation of systemically important financial institutions (SIFis). or global
SIFis (G-SIF!s) in the case of banks that operate internationally, is one of the biggest
issues in the current debate on regulatory reform. Despite several proposals by
international bodies such as the FSB, much uncertainty still surrounds the
regulatory treatment of SIFis. At the heart of this issue is the so-called too-big-tofail argument that states that certain financial institutions are so large and
interconnected that in the event of one failing it runs the risk of causing severe
systemic risk. Regulators thus face a dilemma - on the one hand if they do bail out
the financial institution, they prevent significant systemic failure; on the other, if
they let if fail they set an example of market discipline for the industry as a whole.
Clearly. moral hazard is at the heart of this debate. Different measures to deal with
SIFis are part of the proposals in Basel III that arc discussed further in Chapter 15.
The FSB also requires member countries (including South Africa) to have
recovery and resolution plans in place for all SIFis. More specifically, these S!Fls, and
banks in particular, are required to develop recovery plans detailing how the bank's
management plans to recover from severe financial stress. Moreover, the SARB will
also have to develop resolution plans in situations where the recovery plans do not
have the desired impact, such as failure of these S!Fls. The aim of these resolution
plans is to minimise the cost to taxpayers in the event of bank failure.
3.7.3
n explicit deposit insurance scheme (DIS) is seen to be a main requirement for
ternational best practice in financial regulation. Although not formal (or explicit).
South Africa adopts an implicit DIS - deposits are protected by the intervention of
the National Treasury and the SARB in the case or bank failure. The process for
launching an explicit DIS in South Africa has been revived on numerous occasions,
but the SARB remains or the opinion that the cost of having such a scheme will be
excessive and outweigh the bencfits. 27
.7.2
nancial sector regulation in South Africa, it should be noted that this Act also
eludes amendments to the above-mentioned Financial Markets Act (19 of 2012)
nd the Credit Rating Services Act (24 of 2012).
Chapter 3: Financial Regulation in the South African Banking Industry 91
l.
National Treasury. Republic of South Africa. 2013. 'Implementing a Twin Peaks
model of financial regulation in South Africa.' www.treasury.gov.za (Accessed 2 3
April 2013).
REFERENCES
Banks are traditionally regarded as one of the most regulated industries in the
world, and banks in South Africa are no exception. While the main aim of financial
regulation is to maintain the integrity and soundness of the financial system, an
additional important aim in South Africa is the advancement of socio-economic
transformation that improves the standard of living of the people. This chapter
explored the current regulatory and supervisory environment in South Africa
related specifically to banks. Financial regulation refers to specific rules of
behaviour that banks must adhere to while financial supervision refers to a more
general observation of the behaviour of financial institutions in order to establish to
what extent they implement the relevant regulations. The current regulatory
structure, where South African banks are regulated by several different regulators,
was contrasted with the proposed Twin Peaks regulatory structure. where banks
will be regulated by two main regulators, namely the PA, tasked with prudential
regulation of the sector and the FSCA, tasked with market conduct regulation.
It is clear that financial regulation in South Africa is in a state of flux and
several laws have recently been passed in order to improve the existing financial
regulatory framework. Most of these aim to bring the regulatory framework into
line with international developments after the GFC, as well as to facilitate the move
to the Twin Peaks regulatory framework. Ultimately the intention of Twin Peaks is
to provide a more streamlined system of financial regulation and supervision for the
South African financial sector. Although Twin Peaks is a very ambitious framework.
the successful implementation thereof will require a concerted effort from all
stakeholders involved. The move to the Twin Peaks system also poses specific
challenges for banks. Most specifically, banks will be subjected to more intrusive
·market conduct regulation than is currently the case.
3.8 CONCLUSION
A further aspect of the envisaged improved consumer protection framework is the
enhanced effectiveness and accessability of the current ombud system to consumers.
In this regard, the FSR Bill has proposed that the Financial Sector Ombud Scheme Act
(FSOSA) should be repealed and that the provisions of the Act be incorporated into
the FSR Bill. In the interim, all existing ombud schemes will remain in place.
The FSR Bill also proposes to establish a FSOSA Council that will serve as a
single point of entry into the ombud system. This council will focus on
consolidation of the ombud system and ensure that consistent approaches are
applied to dispute resolution across different ombuds. Although all financial
institutions will be compelled to belong to an ombud scheme, how the ombud
system will look and how a consolidated approach to alternative dispute
resolution will be achieved, is still uncertain.
Proposed reform of the ombud system
Bank Management in South Africa - A risk-based perspective
3.7.5
92
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Chapter 3: Financial Regulation in the South African Banking Industry
Bank Management in South Africa - A risk-based perspective
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Southern Africa 23(2): 289-303.
22. Finscope South Africa. 2012. Consumer Survey. Johannesburg: Finmark Trust.
23. Department of Trade and Industry. 2012. Amended Broad-Based Black Economic
Empowerment Codes. www.thedti.gov.za/economic empowerment/docs/bee
launch.pdf (Accessed 16 September 2013).
24. Banking Association of South Africa. Financial Sector Charter Code. http:/ /www.
banking.org.za/index.php/consumer-centre/financial-sector-charter-code
(Accessed 23 September 2013).
25. Banking Association of South Africa. Financial Intelligence Centre Act. http://www.
banking. org .za/ in <lex. ph p/ co nsu mer-centre/ financial-in telli gence-cen tre-act
(Accessed 23 September 2013).
26. Financial Intelligence Centre. 2005, July. Guidance Note 3 Guidance for Banks on
Customer Identification and Verification and Related Matters. https://www.fic.gov.
za/ •./] 30328%20GUIDANCE%20NOTE%203A.pdf (Accessed 7 March 2015).
27. Pinancial Stability Board. 2013. Peer Review of South Africa Review Report. http://
www.financialstabilityboard.org/publications/r 130205.pdf (Accessed 3 March
2014).
94
Building mutually beneficial bank-client relationships is an important strategic
, driver for any bank. To ensure mutual benefit, however, takes time and results in
banks having a strain put onto their resources, especially at the beginning of the
relationship. For this reason, banks must try and make the transition from
>transactional to relationship banking as seamless as possible so that the client
makes more transactions through more products, but via facilities that are cheaper
to operate - that is, electronic banking facilities. The purpose of this chapter is to
introduce a model for relationship banking that addresses this migration. It also
provides a discussion on the major relationship-b ased topics bankers deal with in
their day-to-day activities. Finally, the chapter provides a brief overview of how
South African banks manage their relationship-ba sed operations.
INTRODUCTION
er reading this chapter, you should be able to:
explain the difference between personal and remote interaction distribution
channels
identify the different types of personal and remote interaction distribution
channels
differentiate between transactional and relationship banking
explain why relationship banking places more strain on branch resources than
transactional banking does
explain why it is important to migrate relationship banking clients to electronic
banking facilities
define the relationship banking paradox
discuss the impact of the life-cycle of relationship banking on the revenue of a
bank
discuss and illustrate the relationship banking model
discuss the relevance of the two dimensions of relationship banking
discuss the four drivers of relationship banking
discuss the seven relationships found in the relationship banking model
identify the main features of a formal lending policy
explain the steps in the lending process
discuss client-centricity and relationship banking as two relationship-based
strategies used by banks
discuss the main characteristics of the South African distribution channel and
slogan strategies respectively.
RNING OBJECTIVES
1ea
:t!tti.dnship Banking in South
DISTRIBUTION CHANNELS IN BANKING
Bank Management in South Africa -A risk-based perspective
Personal interaction distribution channels
There are several types of personal interaction distribution channels, differing in
terms of the type and number of services they offer:
•
Full-service branches offer the entire spectrum of facilities ranging from sales
consultants to tellers and ATMs. These branches are normally situated in areas
where the number of walk-in clients is substantial and given their size, they are
operationally expensive to run.
•
Banks can also use limited-service branches that do not include all the facilities of
a full-service branch. Rather, the facilities are a function of the demographic
characteristics of the area where the branch is situated.
•
In-store branches offer very limited facilities and are normally situated within a
supermarket store. Their primary purpose is to address the needs (especially
those that are deposit-related) of clients who are unable to visit a branch during
normal working hours. For this reason, in-store branches operate during
similar hours to the supermarket.
•
Some banks offer loan kiosks in stores such as furniture stores, where a client
can apply for a loan on the spot to purchase the product. So, instead of visiting
a branch of the bank, a client has the convenience of applying for a loan at the
store itsel[ This convenience has in recent years resulted in an increase in
popularity of such channels.
Personal interaction distribution channels are those where there is some form of
physical human interaction between the client and a staff member of the bank. A
branch is the most utilised personal distribution channel and usually offers all the
necessary banking facilities available to clients. From a sales point of view.
consultants and financial planners offer products and services to clients and
facilitate the approval process. From an operations point of view, tellers, automated
teller machines (ATMs), internet banking kiosks and the enquiries desk facilitate the
processes and procedures that support the sales environment. The branch
environment therefore provides a platform where clients can be attended to by staff
who have a specific understanding of their banking needs. This is considered to be a
competitive advantage for a branch . 1
4.2.1
which to access the products.
Relationship banking deals primarily with how a bank interacts with its clients.
departure point for these interactions is the distribution channels because these
provide the means to distribute the products and services of the bank and in so
doing, contribute to building mutually beneficial relationships. While banks have
expanded the number of products on offer, they have also been forced to expand the
way in which they distribute these offerings. Convenience is a major driver of
service proliferation and has resulted in banks establishing a diverse network of
distribution channels ranging from personal face-to-face options such as branches
to remote interfaces such as internet banking. Convenience is therefore associated
both with what the products are able to do and with what facilities are available from
4.2
96
97
Banks also offer mobile branches (or mobile /Janks). These are branches that are
literally mobile and arc often used to test the viability of remote areas without
committing to the construction of a brick-and-mortar branch. In South Africa
this has been particularly popular on the back of the drive to focus on banking
the unbanked market in often very remote areas. These branches offer limited
services, but are sufficient to address basic banking needs.
National head offices usually include a full-service branch, but primarily employ
the administrative, credit, treasury, IT, retail, commercial and corporate staff
along with their respective senior line management. Furthermore, they are the
decision-making hub from which all national strategy is disseminated. Regional
(or provincial) head offices provide similar structures, but are more aligned to the
services offered in the region (or province).
Chapter 4: Relationship Banking in South Africa
Remote interaction distribution channels
emote interaction distribution channels refer to those where a client is able to use a
latform (or facility) to conduct their banking from a remote place, and there is no
human interaction between the client and bank staff. There are several types
remote interaction distribution channels:
il.utomated teller machines (ATMs) are electronic terminals that dispense cash to
clients at any time of the day. Clients access the ATM with a bank card and use
a personal identification number (PIN) to access their account from which the
cash is withdrawn. ATMs normally offer basic transactional functionality and
in some cases allow deposit-taking. The benefit for the client is that ATMs are
situated all over the country, especially in shopping centres, petrol stations and
near supermarkets. Banks also offer mobile ATMs that are vehicles with an ATM
on board. These can often be seen at sporting events or festivals. Some banks
have self-service terminals (SSTs) that offer additional transactional functionality
such as transfers and account statements.
Electronic banking refers to the use of the internet to conduct banking
transactions. Clients use the internet to log in to their accounts and then
conduct the transactions at a much cheaper cost than would be the case had
they done the same transaction in a branch. Besides being the cheapest way of
doing transactions, this has the added benefit of convenience because the only
requirement is an internet connection to an electronic device such as a
computer, tablet or cellphone. This facility can therefore be used anywhere in
the world.
Banks make extensive use of call centres, which are centralised offices that
receive large volumes of telephone calls dealing with queries or requests from
clients regarding the bank's products. A client phones a call centre number
where they are electronically prompted to make keypad selections to direct
.2.2
mpirical evidence suggests that personal face-to-face interaction especially with
oorer and financially illiterate clients fosters trust with the bank. 2 The challenge for
anks is to balance the cost associated with establishing a branch with the revenue
nerated from the clients who use the facilities.
-
them to a call centre operator who deals specifically with the product that the
client is enquiring about. These operators are assigned to dealing with specific
queries and requests from specific client segments. For example, if a client has a
query about their cheque account, they will be directed to an operator who
deals exclusively with cheque accounts. Likewise, if a client is unable to access
their internet: banking account, they will deal specifically with an operator
allocated to internet banking.
Telephone banking enables cli.ents to use their phones to conduct banking
transactio ns via a dedicated telephone banking call centre. Given the likelihood
of fraud, the authentica tion process is rigorous and the functionality offered is
usually quite limited. This facility does, however, offer convenience to the client
as transactio ns are merely a phone call away.
Mobile apps via iOS or Android platforms can be downloaded and used to
conduct banking transaction s. All the major banks provide these apps that
usually allow additional services such as share trading and ATM locators.
Banks also provide merchants (such as supermark ets and departmen t stores)
with point-of-sale (POS) devices which enable them to accept immediate
payment from their clients. The client is asked to present their (debit or credit)
card and key in a PIN, and thereafter the transactio n is either approved or
declined instantane ously based on the amount of available funds in the client's
account. A benefit for the client is that the device reduces the need to carry
cash. However. if there are connection problems with the server, the device will
not be able to conclude the transactio n.
Bank Management in South Africa - A risk-based perspective
table'4.1.proviaesthe points of represMtation (l:,rant;hesandATMS) andriurriher
. of clients in five of the major client-facing banks in°South ·Africa.
South Africa is known for its high crime rate and ATMs are often targets of this
crime. The number of ATM bombings and scams have increased sharply in recent
years as a result of criminals attempting to access the cash held in the ATM. Banks
have subsequently increased the security measures at ATMs in an attempt to reduce
this crime. 3 The South African Banking Risk Information Centre (SABRIC) has
indicated that although bank-relat ed robberies decreased by 23% in 2015. there was
an increase of 30% in 2014. 4 The environme nt within which banks operate in South
Africa needs to consider these crime figures and address them accordingly. Another
way in which banks have tried to minimise the losses associated with ATM crime
is to limit the amount of cash that can be withdrawn per client, Internet crime is
another reality for banks, hence the stringent entry controls in place for accessing
internet accounts. A multiple login process, SMS notification, virtual keypad (that is,
touchpad-based), multiple firewalls and encrypted software are only a few measures
used by banks to provide a secure electronic banking experience.
•
•
98
In order to have a mutually beneficial relationship, banks must ensure that they
create value for themselves as well as the client when they interact with each other.
The interaction itself is therefore vitally important in this context. There are two
overarching modes of interaction with clients. First, transactional /Jankin{J is based on
engaging with clients quickly and does not require excessive resource allocation on
the part of the bank on a per-client basis. It is therefore less hands-on due to limited
.commitment and contact. As the needs of clients are homogeno us (standardised)
and consistently repeated, they are more easily serviced by the operationa l function
or a bank. For this reason. the operations or administrative function (for example,
tellers in a branch) can usually deal fully with these clients.
TRANSACTIONAL VERSUS RELATIONSHIP BANKING
<+,,~-•bankWiiht11itRo~fATJiagtl··•c:1lJii+kiiStand~id•·sa~k/bdfSAaSA hasthirfios
t·•
. ATMs. Whafis. particularly notic•eable Js the growth in the representation of Capitec
Bank ih Corr!parison tocwe ~ig Four. -E~fablished in 2001, this bahk has beco~e a
.majorcomp~titor intli'ifretailenvironment because it offers simple banking products
_,that are cheap and Which are offered throu·gh an extensive and-rapidly growing
branch network.
•0
,:3,7
4.7 I
5.4
All figtitesitidu de S6uthAfritt iri ttiitl Alt1dm Operations, eiccept fot2012 which is 16rtly for
south Afril:a under'ABSA Gtotip-Llrii:ltefl;Source: ABSA Group Lifllited (2012); 5 B'arclays
.A.frica Liinited(20 l3); 6 Barclajsii:rrica'Limited (2014) 7 /
> ·:.._. ..,. . · > ,
hAlJfigures}~cludeSou th Afrktnifoid African operations: ATM flgu'..resinclude autorilhti!d
• dcposittellers·{ADTs). Source: FirstRand Group Limited (2012): 8 _FirstRand Group Limited
9
. J2014) <> •-C"• '; _.. , .. ,, .... ,,,.•. :;;"e, .. ,,.<,.·:·••••C•• > ,.,,·:,. :< •·•· • ·;;. ·.:•
••·<The branches iiichide stiiffed outlets and excltide personal Ioart·kiosks. Including
the
, .personal l6afi kiosks. the figur€s are l199.1 185 and 118Sfor 2012. 2013 and 2014
respectively. All figures include South African and African operations. Source: Nedbank
. ·····"::Group (2014:49) 10 ., . , "' . < . : < . ••'<.·
':;,All figuresinclu deSotithAft ican andAfricaiiopertilfons':Briincht!'kfrtdud~ servicec~htr
es:
•.. Source: Stiiridard Bank Group{20l3 );ll-Standar d Bank Group (2014) 12
1Capitec only has South
African opetatioils.T he ATMs refer to only thbse ()WfleifbYCapitec.
>IfATMs in partnership s arejndud~d , 'the'.humber increases to 2 '918. 2 s54 anir2 07
6
• for 2014, 2013 and 2012 respec:tivel:iisourcc: Capitec Bank Holdings Limited (2014); 1
.1
i) ,Capitec Bank Holdings Limited(20 15) 14• • fro Rmillion.
Points of represeritati6frahclnumber of clients of thi five major client...
\,facing banks in S6uthAfrica ,
Chapter 4: Relationship Banking in South Africa 99
!~:,
m
i~
:rn
Bank Management in South Africa -A risk-based perspec
tive
Transactional
Operations
Umiled/hands-otf
Limited
ltttle emphasis
I lornogenous/standardlsed
Short
Product lealures and lunclional
Client acquisilion: quantity-driven
•••.
?
Relationship
file concern of au in the bank
High/personal
Hiyh
High emphasis
Helerogeoeo11s/customised
Long
Product benelits and value-driven
Client retention: quality-driven
Given that a transac tional approa ch focuses more on
the short-t erm acquisition
of new clients, it is no less import ant than a relationship-ba
sed approa ch. Indeed,
transac tional bankin g is a vitally import ant source of
revenue for banks as the
administrative function of a branch (especially a large
branch that services many
clients) is primarily focused on meeting transac tional needs.
Figure 4.1 provides a visual represe ntation of a typical
branch with an
enquiries counter, two person al bankers, a financial planne
r, six tellers, an interne t
bankin g kiosk and two ATMs. In this instance, relatio
nship bankin g occurs when
Client A interacts with and does their bankin g with the
Enquiries Desk, Personal
Banker l, the Financial Planner. Teller 2 and finally the
Interne t Banking Kiosk.
This transac tion is time-c onsum ing and reflects the heterog
eneous and personalised
bankin g needs of the client. Alternatively, in a transac tional
bankin g context, Client
B walks into the branch and goes directly to Teller 1
after which they leave. The
nature of the engage ment with branch staff is minimal
and substantially less time
consum ing than it would be for the relationship
bankin g transac tion. The
homog enous need of this client (say, to make a cash deposit
) is standa rd (making a
- deposit follows the same operati onal process whethe r
it i.s for RlO or RlO 000) and
can be performed by a teller in a consist ent and predictable
manner.
Source: Adapted from Little & Marandi (2003); 15 Peck ct
al. (1999) 16
Custodian
Client contact
Client commitm ent
Client service
Client needs
Timescale
Orientation
Focus
Characte ristics
Table 4.2 Transactional versus relationship focus
in banking
The second type of interac tion is relationship-based. These
clients want to intera
with someone personally due to their unique and heterog
onous needs. Due to t
value-driven orienta tion, the commi tment between the
bank and client is high an
contac t is frequent. This suggests that service quality is
an import ant require men
to ensure that the relationship is quality-driven. The custod
ian of servicing thes
clients is not limited to operations only, suggesting a more
inclusive focus centred o
a dedicated personal banker. Mutua l trust. commi tment
and loyalty are central t,
the relational focus. Table 4.2 provides an overview
of the major difference
between a transac tional and relatio nal focus in banking.
100
._,,
..
~
101
irony of transac tional and relatio nal bankin g is that banks
are moving towards
couraging clients to visit branch es less given the growth
and availability of
ectronic bankin g facilities. By encour aging clients to use
electronic bankin g, they
ecome less reliant on branch staff for their bankin g busine
ss and only visit the
'ranch in situatio ns where their needs are unique or require
customised solutions.
Visual representation of transac tional and relation
ship banking in a brarich
--------►
._EriiPaiiciI;g
Chapte r 4: Relationship Banking in South Africa
Internet Banking Kiosk: paid three beneficiaries R300 each
Transfer fee payable per transaction: R5 (total transfer fee: R15)
Amount of time: 1 0 minutes
Bank Management in South Africa -A risk-based perspective
I
20
10
10
60
400
15
600
15
100
25
.··•
•. ·.·.··••···
15'
350
10
50
10
_These two scenarios reflect the trade-off for bahksiwheffc6nsiderihg iifriinsa6tiOn':or relationship-based approach: the revenue generated via transactional biinking is··•
/lower per unit, but the branch visiting time is also lower. Conversely, the revenue
generated via relationship banking is substantially higher.per unit, bufthe branch•·
'.yisiting time is also higher. Therefore, although relationship banking generates more
. ·revenue per unit, it places a larger burden on the resources of the branch; and,
.'_.although transactional banking generates less revenue per unit, it places less
/pressure on the resources of the branch.
The time (60.niintites)·and cost (R600)to· ·c1ientAib r]]ting¾;tJ ictid~1nth e
. branch are both high. The actions of Client A reflectrelationshipbankihg ";the level
•. of personal interactiorris high, it is time-consumingartd needs are heterogeneous.
However, the time (10 minutes) and cost (R100) for CliehtH are substantially lower'
--_ and reflect a transactional banking approach -the le\lel ?fpersonal .inlera?tion is·•
low, transaction times are quick and the needs are'homogenous (or standardised).
100
-
100
In the branch
Time(min)
Cost(R)
5
• •Anew cheque book order onlinc costs RS.
bDebit order fees are standard at R5 each.
; 'Transfers made between personal
·the 3% commission fee is payable in this case.
: dTbe school fees are paid online as a beneficiary
• 'All beneficiary payments cost RS each.
Manual 1/ansler of RIO 000 to
an investment account
cash wilhdrawal or A1 000
Pay three beneficiaries R300
each
Totals
the current account
60
Cost(R)
Client A
Tabi~4.3 Cosf~~d time trade0 offs per bl"arich a~d internet h,..hkin,,.
•• The tot~I fees paya~IE! and time spent bf each client resP§tively is reflected (rtTabfe~.3.
Also indicated are the costs and time spent by Clienrn ~ad they done exactly the same
/transactions that Client A did in the branch.except viaari intemetbankingaccount.
•.·.·.·.•..· ·.·····.i:::: -:i::.•··.·.•.
•
0
fees. This transaction at Teller 1 took 1o minutes and also incurred a cash handlin
(fee ofR100.
AS;llfl1~ forthefthat Client B also madeifcash WittidraWg1.ofR1 bOotb 6aVsth6
u
102
)D .
103
>
:>:-.--C~--•-
··-
•
•""
~i~1~t,0~;~8§tl6JAJritfdfpit~i\¥?$iiA't~J bFaridtiii• i*gd\iyt6f1J~rtieasfdr. •di~nfs
.irtlhe.brandl(R1?7rnin):;l"his1ug'§estsfthat•although Client Agli'iieriited R500 .n;.ore
•
re~enue for;~e bank, he·or~heused ~ore time (and thus resoo(ces) to generatl:l
:tryatrevenu~.ClientH generated:tss tev.enoe, but usad fewer.r,~sources to do~tr). Relativ~ly S~ElaKinp;,ho\Vev:r• thetare;bo th eqoallyprofjtableJb'\he bank ·per / •;
••anocatedt~s60rce.:n,~traiis~i:d6~s ot;enent·s over .t~e interiie\,however, retqrr\a
valuEl ~f..app~cii<i~ately ~22/~h'\. ThiS _llieans that the rntei"nettri~sactions weri;
,stantiall9°.moi'eprofitablef6i'.t~~:b~n.~.·onatelati,;,eoasist~1i~1:)othof!h.El~f.~nt:h
..... transactioM,tort~.errrtore no'Strai~wiis.placed on thebranch+~soorces-·only'?n
/
. • :theinternet>\'.>ankingtesoor6'e.X::1eady)fmakes more senseto~,ipourage efectto~ic
••
y. ~a~ki~gttansactfomi rather1ryiin t:!ran?~transactions .on a per6est basis•. :niis<
i;Lsuggests that the btisierbran~hes be~onie; the more ~rsources.\'/iH have .to ~~ made
(~yaHa~IEltO~~rvfc~}he·cnen~s:-u11.~ss~t~e bank generates . ~u~iittntially highe~.\ee
•revehUep'e(cliehtduring thesef viSitS/the·hranch will not beosing its resources.;
•'optirnany.,]"
•
> .•, j,-s
••
•
•
i~2iJi •I!€!e,!;s ·ag~fn;;F6r db?ioii;, r~a§(j;;;th e reJ~nu~ forltie
> corredbyt'i'~}C:lient,Theaniourit of time spent in the bran_chor
orithginte~a!tis}~proxytotJ.rye'st~~iri'fpl~ced on .the tiank's re.so?rces. Clearly,Jf the
c,li.!n,t s~en~'s'rrior!iim"e in th.~;Br!n~h 'f~!E!i'actrng·\Vith more .st~ff./the strain on.• •
·e.sources is\t,igheribei:ausei~'drejs'allocatedloservici~g this ~'6e client.,·.SO, ih.
rder to nie~~?re.ttfe. re~.ehu:tge~!;~t:~Per.use _trffesour6'e,~e'.sc:a~ . calculate {~e
UEl•pe(?~it 6Ilitri~.~is ·mfiiStire js in'effec! a type·of co.st~benefit.ah~lysis .as
behe~t ~eyengeJ is.?oml3~redff~th~coi1:(a'mo~rifof !ime ~9~.thus strain on !he
::h'~r&strofoes)rThe.revenile;per:~nifof tirnefor·C.lient··~iiifhebranch•·is i:i.101
./~tpli~~!~ i~.thebrancffjt'tsf~ls~~)o/~in;_and f~r..ciienfSyia internet •••
nking it is almost R22/rnih:•.Wiiat do'thesevaluesmean1 ••
-• ·:,.__
•
:;c:-.-;:•.
7
nt;a b'nl<;ghts to Mve th~het1rbgeneous prodoctne edlof Client A (thafi~•
products sold to .the client);but have the transactions made(through .internet
ng IacHities insteiidof In.a l:l~anc~;Hadclient B dohe this, they would have
he banR~350(instead ?f•R6~0)·an? spent 16 minutes (ihst~ad of 60 minutes)
:l8in'g tnetransactiohS':Tne behefitfot'the client is clearly to make transactions··.•.
H!6Ughintefn:t banking asJ~is savesib?th time arid money. Fot;the bank, the
eriefitJSflof~s cleirr-cut: Mariag~rneht.needsto balance the .cdst of usingmor~
·ces With higheri'everti.legeriefated 1rom the multiple transactions in the ii
h.. 1.nftt!teal ~?rl~; MW:~,;,er;.the !~tal revenue generated fr?m . branch visit~by
s1sn8tash ighfdr eachtesped1\le.vis'it because ,a client can only have so
pro~uctS:andto?duct~n·rrr~ny ~!nsactions, Fol'. this reas-on, an optimal . /
gy is fot!r'IC?Uragebbththexotufne ofJransactionalbranchwisits (which .are
) and the e/ectfohic6a~1'I'g~.,fins!~tiohs (which .~re·inoreip't?fitable.relativi!tb
••
••
al,~n6,)ih't d6irigS'o;\ brah hefarere~s cmwded andthe
ct~~rrs .i!JoiJ~f:]f clIElnt~feso~10 c?n~.~7ti.ng·their.
.,
Bartking;Jn~~b:!irtk carireduce the ri'l§6urcesin·the
t,of.th~;ero.scenario·s•··i•s o~tlmalfor th.e bank a:d cli~nt/!tec tively?./
Chapter 4: Relationship Banking in South Africa
Bank Management in South Africa -A risk-based perspective
Short
High
Long
Low
Low
High
When a client is new to a bank, their needs are substantial. Practically speaking
this means that the client is sold several products. This also means that the client
needs a lot of attention initially as the banking products need to be customised to
meet their specific needs. As a result of not knowing how the products work, a new
client is more inclined to visit their personal banker in the branch. The cost (and thus
strain) on the resources in the branch is therefore higher at the beginning of a new
relationship. This is depicted at A. As the client becomes more accustomed to how
the products work, they feel more comfortable in making the transactions online
rather than during a visit to the branch. Only on occasion where they need to clarify
a problem with the personal banker do they visit. This is at B. Finally, the client is fully
comfortable with the new bank and how it operates and hardly ever visits the branch
(C). The strain on the resources in the branch is minimal and the need to customise
banking solutions at this stage of the relationship is low. The client is therefore fully
'self-sufficient' and the benefits of being in this relationship are mutual: the client
uses the bank products at will through cheaper and more convenient electronic
banking facilities; the bank generates revenue when the transactions are made
Figure 4.2 The mode of interaction migration matrix
Number of branch
transactions: Low
Number of electronic banking
transactions: High
Number of branch
transactions: High
Number of electronic banking
transactions: Low
The above example suggests that banks would prefer clients to have several products
with the bank, but do transactions electronically (such as over the internet in this
case) rather than in the branch. In order to do this. banks need to migrate clients
from the branch to electronic banking facilities. Figure 4.2 provides an explanation
for this migrntion.
104
105
....
Before we deal with the model for relationship banking, it is prudent to ask the
question, what motives do banks have to engage in banking relationships over time?
Figure 4.3 provides the life-cycle of relationship banking. There are two overarching features of the life-cycle: first, the four life-cycle phases and how individuals
earn income, consume and accumulate wealth over time; second, what banks offer
individuals during the life-cycle phases in order to capitalise on patterns of income
earned, consumption spending and wealth accumulation.
The life-cycle phases of relationship banking
A MODEL FOR RELATIONSHIP BANKING
associated w1tn-acquiririg newclfents-ani:t ·subseqoentlS,migrating them to electltinic
banking.
T/( <c/:/
/C2f
electronic facjlities,thestrairi ifn:brarich:r0S'our'c~soutweighs thepotentiaJ•benefit
tacilities .. Soii.ttelationsliip ba~~inge'.i:n~foftenbsebraft?hf.!!Cilftiesrather.thaii · •·
b~nkresour~~sJ~~(jth: client ~ig~te~todoing bu~im1sstfirbd~h:lectronic .• ;;:;.
-rHe"abovel?!amplehighlight§;th~rii,JHo'nship··ba?kihgparadox: .•~lthough········
relationshipbankingfs more pfofitabre'fthan tra/\saclional banki~g per client, it
''p~tsiliore str~inon the·resources.1lfthe.~ank".• Therefore-relationship banking is.?nly
~table prop~Jition1f t~e teveh~eperflient indeases overtime((?ra given use of
]ectronically and the branch is less crowded due to the lower frequency of visits.
his entire strategy is reflected by a move from A to B to C.
Complementary to this strategy is the movement of clients from transactional
anking to relationship banking. As these are existing clients who already have
omogenous product needs, this approach requires selling them more products and
eventually migrating them to electronic facilities as well. This would entail moving
the clients from D to B to C.
The migration of clients from branches to electronic-based banking facilities
is an explicit strategic objective for retail banks. If migration is successful, the
branch is used as a channel to attract new clients and cross-sell as aggressively as
that eventually these clients also migrate to electronic banking
Chapter 4: Relationship Banking in South Africa
C
(/)
C
Phase 2:
Growth
Saving
Phase 3:
Maturity
!~
!
\
""' '' ' '
\
\
\
~
' '
Phase 4:
Retirement
•
:
-
Yo1
': C
~
21
80
The four phases of the life-cycle phases of relationship banking are drawn from
the
life-cycle hypothesis that reflects the relationship between disposable income (Y
0) and
consumption (C). Consider the following hypothetical example of Benjamin. In phase
1,
heis born and under the care of his parents. Assuming this dependency continues through
school and university, it is characterised by dissaving, as he does not yet have a job,
but,
still spends. Assuming at the age of 21 he leaves the home of his parents and
starts a
job. He starts earning an income and wealth starts to accumula te (taken as the net
asset
value (NAV), which is basically his assets less liabilities) as he buys his first house.
During
this time, he could also get married, which further increases the household income
and
subsequent wealth accumulation. Although additional expenses are incurred due
to the
birth of, say, two children in Benjamin's household, this growth phase is character
ised
by increasing household income and wealth accumulation, and thus saving. The
third
phase occurs around the age of 40, where Benjamin has almost paid off his major
debts
and is now investing all his excess income in preparation for retirement in twenty-od
d
years' time. This maturity phase is pre-retirement and is characterised by moderatin
g
consumption patterns for the intention of temporal consumption during retiremen
t.
At age 65 Benjamin enters retirement and exits the job market, thereby not earning
a
salary anymore. Benjamin and his wife are now dependent solely on their accumula
ted
wealth and consumption peters off compared to pre-retirement.
Three broad possibilities exist as to how his household consumes during
the
retirement phase. First, he made provision for retirement income by investing in
assets
65
NAVYD3 NAVYD2:
or==::::::::__:____ __;____ ___i__
_~_
_i___
0
Phase 1:
Dependency
Bank Management in South Africa - A risk-based perspective
40
Age of client
Figure 4.3 The life-cycle phases of relationship banking
~6
~:i'
0"'
g.
"'
(/) 0
0 -0
-.0
0
o:.::::
E o
a.
-~
E
a, ::,
a, C
;2'g:
106
107
Growth
I
✓
I
I
I
I
✓
✓
-
-
, II'. .>' 4JE' .c/ }',NII',,
-
✓
I
I
'
I
✓
✓
✓
I
I
-
-
I -
I
I
I
✓
✓
✓
I
I
-
I
✓
✓
✓
I
I
I I I I I I I I I
✓
NII'+. 'LJI' ••:t •i;;, IE',!;;\ ;,,,Nlf_,.'\
✓
✓
✓
"II equals interest income, which is generated from the interest earned from the loans
provided to clients.
'IE equals interest expense, which is paid on the deposits (liabilities of the bank)
that clients take
out at the bank
'NII equals non-interest income, which refers to the commissions and fees
banks earn when
offering a service that is. typically, transactional. commission or investment related,
Retirement '
Phase 4:
Phase 3:
Maturity
✓
·4;,cU~};i'i ···,AE' ,r
\Table 4.4 Bank offerings and earnings during the life-cycle of relationsh
ip banking
c·+ '"'\\-flV"'cfCredlL,:.,w?;;icc ¢:\1,.s lransactlonats0,,
'"'is.sJnsurance;JJJXt I
lnvesttilent
··ng pre-retirement that pay out over the retirement phase (Y ). This income partly
01
,sidises retirement consumption and requires less reliance on wealth for retiremen
t
sumption (NAV YD!). Second, Benjamin provided as for the previous example. except
t the income received during retirement is less (Y ). This implies that wealth is depleted
02
a faster rate during retirement (NAV vo ). Third, no provision is made for retiremen
t
2
me (Y01 ) and Benjamin and his wife live solely on the wealth accumulated during
pre• ·ement to subsidise consumption during retirement. In eflcct, this results in the wealth
g depleted at an even faster rate (NAV YDJ) and may lead to Benjamin running out
of
Ith reserves if he (or his wife) live beyond an age that they are expected to.
How does a bank capitalise on these phases? Based on Chapter I, banks offer four
ad categories of products or services to clients in a relationship with them. The
first
ates to credit and is facilitated through the different types of loans banks provide.
is is by far the major product offering by banks, especially those focusing
on
aditional banking activities. The second refers to the so-called transactionals,
which
fer to the products that facilitate transactio ns between clients and their beneficiar
ies.
hese include, for example, current accounts or electronic payment platforms
and
able clients to engage in the payments process. The third category refers
to
surance. Given the bancassu rance model adopted by banks (see Section 4.4.5),
they
flcr both traditional banking and non-tradi tional financial products and services.
he latter includes insurance for both short- and long-term needs and serves to
insure
lients from adverse events where losses are incurred. The final category refers
to
vestments. These refer to the investment opportunities banks offer clients and
is
Ultimately encapsulated by the asset managem ent function where banks manage
asset portfolios (such as unit trusts) and offer clients the opportunity to earn superior
returns. Although this category also includes your typical 'bank' investment products
_(such as fixed deposits and notice deposits, which arc typical liabilities to a commerc
ial
bank), the broader connotat ion to investments imply an active managem ent approach
by the bank (as opposed to passive approach) in financial markets such as the
money
and capital markets, both nationally and internationally.
Table 4.4 provides an overview of how banks capitalise on the life-cycle
by
. providing their products and services.
Chapter 4: Relationship Banking in South Africa
Bank Management in South Africa - A risk-based perspective
Benjamin and his wife retire in phase 4. The couple do not need any more
loans as they have built up and paid for their assets during pre-retirem ent,
transact occasionally and rely on the insurance policies they have taken out and
the return on the wealth accumulate d over time. Although fees are still paid to
the bank, these are lower than they were before retirement. Finally, because the
couple completed the will and testament at the bank, it is entitled to a
commission on the estate upon death.
During phase 3, the status quo is maintained, except that the twins are older
now and preparing to leave their parents and start their own careers. Benjamin and
his wife continue accumulatin g wealth and preparing for retirement, and the
investments that they started saving from the time their twins were born, start
paying out. This enables the twins to eventually leave their parents' house and
become self-sufficient. Things start slowing down for the couple as they enter
retirement.
During phase 2, Benjamin starts earning a salary, and subsequently, buys a c
and furniture. His social life starts picking up. He therefore needs credit to mainta
this lifestyle, and the bank provides vehicle finance and an overdraft facility
'emergency' liquidity. They also offer him a personalised credit card that allows hi
to enter the lounges at any airport for free when he travels across the country and
other countries. As time passes, he meets a girl and they get married and they deci
to buy a house for their family. Their cumulative income increases and they ca
afford the mortgage loan that the bank offers and earns interest income on. Th
also need to take out insurance as guarantee to the bank should they default for an
reason. The bank thus provides the mortgage loan and the insurance on th
mortgage. A few years later, the couple give birth to twins and decide to start savin
early for their tertiary education in 18 years' time. They also invest all excess cash i
unit trusts so as to build their personal wealth when they retire. As the twins grow
up, their needs change and the couple spend exorbitant amounts of money on
birthday parties, school sports tours and hobbies to name only a few. This results in
the couple sometimes running out of cash, so they use the credit card and overdraft
facility in times of liquidity shortages. All these services the bank provides and in
return earn commissions and fees reflected via non-interest income when
transactions are done, and interest income when credit cards and overdraft facilities
are used.
Going back to our example with Benjamin. during phase I he is highly depend
on his parents. At birth, he became a prospective client for the bank. As he n
21 years of age, his parents open a transactiona l account (such as a savings
transmission account) where they deposit his monthly pocket money. Although
fees on this type of youth account are minimal (if any). Benjamin may use his d
card to transact at, say, the movies or a toy store. In phase 1. therefore, the b,
only generates fees (although negligible) and possibly, pays a low interest rate
the savings that he has accumulated through the pocket money he receives. T
intention of the bank is ensure that Benjamin is a client of the bank so that they c
cross-sell additional products and services as he enters the next two phases in
life-cycle.
108
109
:=
Figure 4.4 The relationship banking model
.---.·~•~»-~,«=4 ='-~M~~•"'"<'h<
•
•
net effect of the bank's involvement over the entire life-cycle of Benjamin (and
'amily) is clearly illustrated. The intention of the bank is to 'lock-in' (see, for
pie, Section 4.4.4.1) Benjamin by selling him as many products and services as
ble and in so doing, create a disincentive to move to another bank. All this is
to simultaneously earn both interest-related income and non-interest related
;me. The potential revenue earned does not necessarily stop at the death of
jamin. For example, if he dies and his wife inherits the assets (wealth) of the
te, the bank earns further income for as long as his wife lives. Further to this,
n his wife dies, the estate would pass on to the twins (assuming the NAV is at
er NAVy 01 or NAVy 1J2). If Benjamin opened a bank account for the twins when
ey were, say, five years old, there is a good chance that they would still be clients of
'e bank and thus the entire life-cycle would continue, but from the perspective of
e twins. In addition, if the twins inherit the NAV of the estate, they are in fact
tter off than Benjamin was at the same age. This would probably result in them
1plying for bigger loans and spending even more, which in turn results in further
terest income and non-interest income received by the bank.
The life-cycle of relationship banking sets the tone for why banks want to
gage in a relationship-based approach. In the long-term it is profitable and, if
anaged properly during the lifetime of the client, may be so for several generations
ing forward.
We now turn our attention to a model for relationship banking. Figure 4.4
rovides a model for relationship banking, with two overarching dimensions and
even explicit relationships.
Chapter 4: Relationship Banking in South Africa
The two dimensions of relationship banking
Bank Management in South Africa -A risk-based perspective
Economic.dimension
Obtiyatory revenue
Con~istency in process delivery
Benefits to bank
Risk reduction
Security (collateral) benefits
Functional benefils
Persona/ interactions with the bank defined along economic
The result of these interactions is legally binding in nature.
Benefits to client
Pricin9 benefits
The social dimension is characterised by the personal interactions between the ban
contact staff and the client. These interactions create a non-binding relationship bas
on benefits such as the promotion of confidence in each other. special treatment a
better service quality. A further benefit is that the bank is able to customise banki
solutions to client needs due to the more intimate social and informal relationshi
For the bank, a social relationship that is mutually beneficial creates word-of-mou
benefits and identifies cross-selling opportunities that would otherwise not have be
apparent. Ultimately the social dimension is revenue-enhancing.
The economic dimension of relationship banking is characterised by interactions tha
have a specifically economic purpose and are defined by the contractual responsibiliti
between the two parties. These relationships are therefore legally (or contractually)
binding. The economic dimension of relationship banking benefits the client through
better fee or interest rate related pricing. more lenient collateral requirements and the
functional benefits that the products provide. Furthermore. if the bank has a sound
contractual framework for its products, it is better able to provide processes that are
consistent and predictable. This further promotes organisational efliciency in the way the
bank deals with its clients. For the bank. the legally binding contractual obligations reduce
the risk of default or any other material risk. which in turn secures an obligatory stream of
revenue for the bank. Ultimately the economic dimension is cost- (or loss-) restricting.
A major benefit of the social dimension in particular is that a relational contract
(as opposed to a legal contract in the economic dimension) is generated that enables
the bank to acquire information that it would not otherwise be able to obtain from a
purely economic relationship. By implication, the relationship between the bank
and client is enhanced by the bank gathering 'soft' information (behaviour-related,
based on mutual social exchanges) and 'hard' information (performance-related,
based on financial statements used by the credit department). In addition. a social
(or non-economic) obligation that promotes integrity and mutual co-operation
Cross-selling opportunities
Word-of-mouth promotion
Benefits to bank
Service quality benelits
Customisation benefits
Special treatment benefits
Confidence benefits
Personal interactions with the bank defined along social dimensions
The result of these interactions is non-binding in nature.
Benefits to client
Social dimension
Table 4.5 The two dimensions of relationship banking
The relationship model depicted in Figure 4.4 has two overarching dimensions!
that is social and another that is economic. These two dimensions explain
underlying nature of the bank-client relationship. The main features of the
dimensions arc provided in Table 4. 5.
4.4.2
110
111
The sales driver refers to both the sales and marketing approaches of the bank and the
banking needs of clients. This driver specifically includes the extent to which the bank
focuses on selling the products it offers, and simultaneously, the extent to which clients
want to purchase the bank's products. An aggressive sales approach would be at A,
whereas a conservative approach would be at C.
Contractual driver
The contractual driver refers to the amount of contractual (legal) documentation the
bank requires to conclude the sale of a product. Although the contractual burden may
1. Sales driver
four drivers of the bank-client relationship are sales, governance, contnicts and
nnovation and are discussed below.
4.5 The relationship driver matrix
Innovation driver
~-
Q.
~
~
3
a;
0
G)
ition to the two overarching dimensions of relationship banking, there arc
rivers that either encourage or discourage the extent (or success) of bankrelationships. These four drivers answer the following question: Which factors
Jhe success of a bank-client relationship so that it can eventually become
lilly beneficial? Figure 4.5 provides the relationship driver matrix.
The drivers of bank relationships
the two parties will develop. These are benefits that have been shown to
e client loyalty and encourage repeat purchases. When a legally binding
tual obligation exists between the two parties. the risk arises that the client
icular loses the liberty (or willingness) to exchange information that would
ise be exchanged in a more informal social setting. Ironically, it is for this
son that contracts are drawn up in order to protect the rights of both parties
ither one decides to renege on their obligations.
Chapter 4: Relationship Banking in South Africa
The seven relationships of relationship banking
4.4.4.1 The client-cm,tact staff relationship
The client-contact staff relationship is based on interactions between the staff 'of the
bank who are client-facing and the clients themselves. This relationship typically
occurs in a retail branch environment. but may also take place in banking suites or at
head or regional offices in the case of higher net worth clients. The initial meeting
usually begins in an informal sense and moves towards the contact staff member
identifying the specific banking needs of the client. Once the needs analysis has been
Based on the model depicted in Figure 4.4 and the relationship drivers in Figure 4.5/
there are seven relationships in a relationship banking context. These are as follows:
4.4.4
The challenge for a bank is to find a balance between the four drivers of relationship
For example, it does not help the sales environment if there are excessive contractu
and legal requirements for each sale they make (B). The more inclined a bank is t,
aggressively drive sales through innovative products or processes, the more like!
they are to take excessive risks at the expense of risk-mitigating governance an
contractual obligations (C). Similarly, the more innovation allowed by managemen
the more likely secure governance structures will be threatened as the very nature
of innovation is one where conventions are challenged (A). Conversely, where more
rigid internal structures are driven by burdensome contractual requirements, the
less innovative the bank will be (B). From an organisational point of view, it does
not make sense to be at D where the bank has low sales due to a lack of innovation
and poor risk-mitigating contracts. This is typically a situation where the bank
would stagnate or where growth would be slow. Ideally, a bank must work towards
balancing the sales thrust with contractual and legal requirements that are fair and
reasonable, while at the same time ensuring that the policies and procedures are
efficient and innovative enough to enable the sale of the product (E).
The innovation driver refers to the extent to which bank staff are allowed and
encouraged to innovate in their immediate working environment. The higher the degre
of innovation, the more likely the bank will develop new and innovative ways to offer
their products. This may be with regards to new products or new processes.
Encouraged innovation is at C and discouraged innovation at 0.
4. Innovation driver
The governance driver refers to the policies and procedures that drive the operations
a bank. The higher the degree of governance, the less leeway staff have to manipulate
internal policies and procedures. This can be found at 8. Conversely, the lower the lev
of governance, the more able staff are to manipulate policies and procedures, which
may result in fraudulent and corrupt internal structures. This can be found at 0.
3. Governance driver
be large, it improves the quality of contracts and reduces organisational risk through ·
potential losses that may occur due to a failure to comply with the contracts.
Conversely, the smaller the burden, the easier it is to provide clients with products, b
at the risk of losses given the poorer quality of the underlying contracts. Therefore, a
burdensome but risk-mitigating degree of contracting can be found at 8 and less
burdensome but risk-enhancing contracts at A.
112 Bank Management in South Africa - A risk-based perspective
113
dJpa1~~ht);i!responsiblef§rN;Y
therefoi%!i;fflutual lJenefit .fof.bOth
cohsultafat,isq~.:~i~?~;~~r
,tis'6ftenifor\nulate
,nsibilitfesbet.,,.;,~2~opi~i~i?~·~;.1f
early outlineti:'A'~~~j~J:l~irt \Yelll~ be, if
• :ts to,be 86,1~/~s~ra\Y~~~~t~e
. If the ATfv1}i!;rotfo?etio~ig~,lhe
an8e;wtterea:ihhe
pprcia8n;prear1y,
• for the simplerea~dh
'•:,~~f1tiBBifepa1111enfis~~~
.4.4.2 The co11tact staff--administraiive staff relationship
nee a client decides to use the products of a bank, the application documents are
mpleted and the administrative staff have the responsibility of authenticating and
oring the documents. The relationship between contact staff and administrative
aff is one where the latter facilitates the processes required to make possible the
entual sale of the product to the client.
)le pr6d~~tsf()rt~·eir~ah~in9'heeds. This·envi~()~n,ent n,ust be ii
'eririgsuperi?r!=l'lli?:~?alityifo that fhecli':'nt i~~atisfied and e?gages
es.•The~a?~Y"!nt~!~~ellJ~~•martyprodtrct~.!()fhe •client.as po~sible
:lie/itrev.~~?~~s~lgh'~: po:s1~1e;A·side'aff=~ei!~aving many (if •not
·5f!iafbne!J!~~'.i~t~t;~o~~lled /6ck0.in.'e~ec.t,. [his•occurs wh~?<•i.•···••••··•••
.r\y pr&tucfav.iithtibarildhtitjt becdri\es ~xtre111:lydifficult.,t().n'lOVe··to
"fi high 15:!irrierstoexitthatthe Clienfis
•• '
,_
positive arid affegativ1¥c6r\sequerice;if
'lhtenfion of movln~f,Jfiira
,,,._~--~--~"..-" jiscoufaged,due to
'
ativew'dn:1°of-
viron~e~!ot~'~ta:~clf!~Johaafuental to ehsririig]~atBient§pufc:~·a·s·· >·e· ·
ucted, products are proposed to address client needs. This interaction is the first
call for the ensuing economic relationship between the two parties.
Chapter 4: Relationship Banking in South Africa
a i,vell formulated and explicit risk appetite
organisational objectives
• clear guidelines specifying the preferred loan portfolio in
•.maturity,.quality and market segment
•the quantitative metrics to assess loan applications in terms of type, size,
maturity, quality and market segment
the flexibility ailowed regarding the use of judgement in loan assessments
• explicit exposure limits per market segment (retail, commercial, c
an exposure limit for the overall loan portfolio along with guidelin
the portfolio nearing this limit
clear mandates for credit managers and their line managers reg
size, maturity, quality and market segment of a loan
explicit lines of authority regarding the approval of loans that are above cert
mandate thresholds
a clear policy regarding the approach to attract, assess and manage the loan
portfolio
an explicit description of the required documents in a loan application
a policy regarding the storage of loan documentation, especially that of a
sensitive nature
explicit guidelines regarding the collateral requirements for each loan assess
per type, size, maturity, quality and market segment
guidelines regarding the fee and interest rate structure a
specified degree .of risk
guidelines for the repayment structure of anterent loans
an·indication of the geographical areas (towns, cities, pr,
continents) in which the bank is willing to grant loans
a clear framework for dealing with distressed loans.
Without a sound corporate governance structure in place to support the
the integrity of the lending process is in danger and this may result in substantial
organisational risk, The management of credit risk through the requirements stip
in the loan policy is paramount to ensuring that the loan book is one of quality.
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
A policy framework gives guidance to staff as to how they must conduct
themselves: In a bank, the credit lending policy is one of the most important gi
that lending is the primary business of a bank. A formal lending policy must hav,
following features: 17
The relationship that the client-facing staff and the administrative staff have with
organisational custodians or corporate governance is referred to as an institutio
relationship. This corporate governance environment refers to the institutional buy
and control framework regarding the processes and procedures that govern a
facilitate the functioning of the bank whether sales-related or operational in nature.
TIie institutional relationship
Bank Management in South Africa -A risk-based perspective
4.4.4.3
114
TIie sales relationship
'°i'ikii'ig Practice
a
··a.··.··.·
..
0
nd remittances,
ancial
· t•. ·. h· .·• .· e· .· .· · •. ·.•.·.·T.ie.••·. ·g.· ·. ·. · ·, · o· .· .· ·.•.·•."•· •.· ·.• ·.o•·.•. .•·•. ··r.••.·.•.·.·.• •.•·.·h•.· i.·•s· .•·.•·.t••.· .o.·.•·•.•·.r· · · .·•i.·c.•.··.a
· .• .• ·. •·l.·. · ·.·•.s·• 1.e· · •· .s·•.·.· ·p· ·. .·e.· ·. · .· •·rf.· .·•.·.o.·.·.·.·.·.r.·.n,a· ·•· ·.·.".·. ·.· ·.•.•·.c••.•·.e
.•·.••. ·.• .·• of. the branc. h·' pne
.lestargets;tobeachieved;theremay be cases where .< /• i
1JCtSI~~!lhecl1eQtdoes n<:Jt.necessarilyg;ed .•• This .expl<:Jitation
'fthep~?P!toye~:ightgovern.sthe,ict.io~:lnd motives<:Jfthe
t0!3ay,?fhefinanciaL.A.dvisory and 1nterrt1e?iaryService: .A.ct
>··•·· ·. · ~ptcifica11ile:ta~lished.to ensureth.at.sucr.exploitation • doe:inot
FU~'!-re~:!8.t~.is,the.•~aQkirilJj.A.ssoci.ation.~outr/.A.fri.ca(~.A.SA) •.formulate?ia
.?fI~an~iQ?\Et~cticeJtre,~p?e)ain,;? at.a.d.dressing•h.o.':".'?.bank conducts
towardsper:8~.a.,.i~":dtsipall ..~usi~ess.c.lien.ts,[h.eemprasjs js·••on. the
anktlaswitliit~•clieQ!S;ron, Pl'<:Jductan? ser_11ice point Of View
is:!~i~ne.ss, t~an.sparency, acc<:JUQ!abilityand
an overview ofthe rnain sections in the Code.
'c8tisurta~!~(btpeili~~a1 ~a~~!f~) ~a~tfatria?~ale ielI .bank products
ey.areinC;Q!iYi:;dJ<:Jdo;:o:i~dih~r.e explic.it.:ales target.s. th~t are
t8
sales relationship is characterised by the sales and marketing requirements that
d to be fulfilled by the contact staff. As such. this relationship is between the clientng sales staff and their immediate sales manager to whom they are accountable
a sales point of view. Central to the sales relationship is the in,centive for contact
to increase sales in order to achieve organisational targets set by the sales
nagement team. These incentives may encourage risk-taking on the part of the
tact staff in an attempt to achieve their targets. In order to facilitate the sales
cess, the sales staff must cross-sell as many products as possible .
.4.4
Chapter 4: Relationship Banking in South Africa 115
Bank Management in South Africa -A risk-based perspective
.?~;
~ssJg~ing,t:~~~rtlirig~~is/>flhic1iJntJsJ~&fi!~l!i?Gtt. .~6~ey~ras/;·,
• • • • tionf~echaracterof the client)INhic:h is .n.?t.~straightf()~afi:J' ex~tdise.
n as~?lients.to 'put equity .into me loan'.;---t~at is, requ;st.i dep'5sit.
heJactJ.hat the·bank 1Nill not beprepa~ed.t()~n.g t~;l.()~n.a.rn.?~.?.fi.ntutl,
·•· gness/tnd ability of the ·client to pay a ct;positjs
v.r~y t();;as.s.;Sfthe
•,••of t?;.cli.ent·.to service·the·· loan.>~anks· c:~n.·.~.IS() consid;rpr~vi'5US..g;l:>t
•.·. ts via,cr;dit bureaux in order to.assess thetrack record.?!i~ebfpa~Tents.
:re~.ifbureaUK-flso indicate whether or.not the clie9ti.slikely topaY.pn tirn;()t Will
-n!k~{~tepa:yh'!ents.,This information indicates .ifa clientis alatepayerornot
fa
···•lrirird~ficfi1ds~si'.I1;~lbmtyf6.iJb~yato!ih·,,1i~~~r~4&ifi~a:
of inc:orne and ;xpenditure,as Well as)t~;1r fjriariCia,1..eosition (a~ets,a
·cash'.7low \Vitally imp()rtantwhen ass;ssing a.bili!Yitt1pay.po~~rrl~9ti
salary;slip;thr;;.ITlo~.t~s ·•Of ba~.~ .•. statern;n.fs; ~ .'.i5.t?ft7;}assetsi()Vllh;d
accurri(Jli!ted W()Uld typically determine:"'hether(()~n()tJhediElntjs abtef§/~f~i
loan. Jhe pricing of the loan is also important to g;termine theabHity to repay .... th
)'higher the interest rate or fees, the less likely the client will be able to repay,
•
evalualirig w~;Wer or not the clienUs b()th able a~g}wi/fing to.s;ryice theJ~~h.
: "doing this,the:J;a9k assesses the crMitworthinessof...the client~htl manages th
·::·credit risk,iriherent to'the loan book.
Secd'nd,'·ihe~~hffrfost forrnallY'•assess the··a~~lic.ati§.1•*0firt. THis.titillif,~s
First/the clienFm(Jst bbmplete··a ·fotrna1'applic~ti6h·tdft11.fhls~tepi~ £/e[ulfbif • • •
sales and marketing drive the bank has enacted i9. or.der to a~~acffhe C'i.;nt. It
-:requires the client to provide adequate proof thro.~ghthe relevantdocum~ntation
that they are able to service the loan and are not:an undue riskto the •bank
The life•cycle of a loan can be explaihed throl.ighseven steps:
4.4.4.5 The credit relationship
The credit relationship is between the client-facing sales staff and the credit departrri
who makes the credit decision based on the application collected by the form
Depending on the outcome of the decision, the contact staff member needs to ensu
that it addresses the concerns of the credit department so that all available informati
is used. The credit department is commissioned to look at the 'hard' information
identify any material risks that may occur if the application is approved. Coupled w
this are the requisite contractual obligations that the bank requires from the client. T
credit relationship is ultimately risk-mitigating and acts to reduce any potential los
(or costs) that could occur when the product is approved.
Given the incentive to achieve sales targets, consultants needto ensurethat they.:',
conduct themselves not only within the ambit of the Code, but also within the
explicit ethics and value system of the bank that employs them. Avoiding
reputational risk as a result of clients logging cases at the OmbudsmanJotBa:nki
•• Services should be avoided as far as possible.
116
:c-
-~--
0
.,,.,,
···'· ··._
• ·-
·"
•••
117
,fac6mpariy
rnployed,~re
cli:?t'sJ~~rklhg
,tentiahifta
eabiHty &fthe
Thisb~:~fldw
#Eiri6d ofti~e.tf•
ility to{;P~Y the
• indic:atibnof
toprov/~ean
eii..m6rti111y
blenesstif
• • • • 1talso•be6ased
,iibank"'""'.
gthe legal
!,!~f
?~1T;i\~{~fftY>.. i~ ?rdeFt&• ~~~ure••·
• ~ciua:tl'!l'al fnust not;~ryly be .bas;d g~;the
::·:.:-J>~sf)~~-ddisclds;
1~'tf11.1~Fassl!s~;~;!~gal.capacityi~f;~
:'(legalrfsk gbingforWard,
,•••
-
:lt~~~;ry?nes!?,il9;tf!~!~gtity ..................... \
h~1T1ayr,eqi.li~)~flie9!J6listallt?e:~~~ff1tey
e~it ~?:6k, lfie~~~19~.,bletoi?e!~ririi.1~
•a:rly assessingcharac'terJsdifficult~s'it
'''···c"-;;,, .C:j,';;:,
•lf74~
ai~ us&'8'to as§ess tff~ abiiity fiA'd~illirighessOf aiwil'lt
,: _ ~1~,t~e0~ii•a1\l.~l'.~~\Vtte;i1,thaF¥~~'8ti~hf6,,~~,~hddet~frr1i~~
"Wht'!fhl!rilrnbtad~itl6nal.pOllat;ra1,re-qi:liretn.ent•i·mustb~;pri:ivided.I~.e·qiia.li!Y
er~l.\h~sfa.tliritffb~ri~g 01:fhl/1.rnderlyingrisk'th; t5a.nkfaces;§~ouid
: >.· .·. efau.lt()2_thekia~.·~l!o..lheji1e~er;~~e~~a:lifyo(fhecollateral,;the
'i!ttert11e priding coridii16flS1JSUa11y a:re onthEfid~n.
•
.~{JS-i:iirf~d sclbfcredit
Chapter 4: Relationship Banking in South Africa
The profit relationship
The profit relationship is more intangible in nature. All staff in a bank will have an
acute organisational awareness of the fact that their actions arc ultimately aligned
to achieving organisational objectives. in this case maximising returns. There are
therefore organisational ethical connotations to the profit relationship.
4.4.4.6
Seventh, should a loan 8ecome a problem tit disffasSed loan, tt,e nece§sary steps
> . must be taken toavoid excessive losses to the bank. ln~ost cases the Ioan)s
'quarantined' and active steps are taken to try and assist the client. For example, the
terms of the loan can be adjusted to make .the instalments more affordable. This can >
be done by increasing the payback period from.say; 20 to 30 yearsinthe case Of a
- home loan •. Be that as it may, the onus to repay the loan isfheresponsibility of the
client. As a last resort the Joan is sent to the legal department for legal action against
the client. Ultimately this results in the bank laying Claim to the collateral in Order to
cover its losses.
Sixth, the bank monitors the payment activity of the client. This monitoring primarily
entails identifying warning signals that may result in defaolfon the part bf the Client.
· ·•·.•·.•· Usually a loan review process occurs one year aftefihe §igning bf the f6an
agreement where the bank reassesses the willingness arid ability bf
service the loan:· However, if the monitoring processes .iii place thfoUghout the
•_ are adequate,.any problem loans will be identified prior to the loan review.
Fifth; theloan agreettfoht is drawn up wherein the forrris •arid Cbhditiodsdf the loan
are specified •• lfthe client accepts the loan agreement itis signed and possession iS
taken of the underlying asset. A debit order is loaded so that monthly paymEints can
be secured by the bank;
.· . f.·•.t
·•.··a..·. 1.•·.• u.··. ·.•·•.•e. •.· ·. ·. • •. •.o
c:rea.sii,]~e. v. .·•.a
.· · .·.•'.n.
.·.·.t. ·.·.·o
P.ll. c.•.·.·.·.·e.·•s.• •.the
.• P.• roperty
fo.r·.For
th.· e propensity
fiue to.at.least,
f?t·m.er,
For theitself
bank,through
.this reason
constant.
remains,.
house
mortgage, is more willing to offer finance for longer periods (up to 30 years). For a
vehicle financing loan,·however, the value of the vehiele itself depreciates as ·imon
it leaves the vehicle dealership. For this reason, the bank requires payback for
usually no more;than six years. Second-hand vehfofos usually have even .,hnrtc.payback periods due to their lower second 0 hand values.
<
In sbftieTnsfant~s no 2611ateral is requiredper s~~~cauJi·thel!s~~tbeing
is the collateral. Two examples of this are a home loan and a vehicleJiriancing roa
Fourth, the risk (likelihood of default) of the client is detiirmined and a/iapi:frbpriati:!
pricing structure is proposed. The basic principles behind the pricing bf risk into a
loan agreement are reflected in four basic ways:
1. The higher the risk, the higher the interest ratifand/or fees thatged (and
.
versa).
2. The higher the risk,lhe larger the depositreqfiifement (and \iiCe\ietsa}.
3. The higher the risk, the more or better quality collateral is required
Versa) •.··· <>
4. The higher the risk/the shorter
Bank Management in South Africa - A risk-based perspective
The external relationsl,ip
119
.za: bw~,cipffiEH'ank.co::ia\'W'W\\'.fnKcd:ig:dwww.ihvestiiticO.za:
:gi:'8ii.if;t6.za:f~;nn.6,ca':za: owww.stan'dardliank:cb.ia,
actesseclpfil,Augirst 2015,';;Hc:'"
nt toitfmMt~tfiiajo~.sootftAfri8in'banks
!~e~rtal pa/tje~p~~;e~#act Wh~n~~-~·l·i~g~!!~1,!~,~bank,••l"able.t7
·offJihes and{rn~mar~ef'.segm~ntfeE~sfo~,sev irafof the major
ds-iiiiSoUth"Afiic:a,·· :o',<•<i>i>•· "'•';3
t~~,i!;t!Jt~ll'gh
•
he pe'f{€ptic>tra~trank porff1fy~t611iimarket'i§Yifailyifuporta ~t tc>attrat:ffng-new ...
•
the adverti~i~g campaigns they ~un.·on
nis.. 2~!}'taY~!2~s do
1si6nor'.in·•m~in,~ffeaFT1,J'if~i~'.i~R'atbffline.(?r~IRg~~));refl~c[~Jthebusines.~/f•···•
d on all the above relationships, the bank is able to increase its client base by
oting its products to the external market. The external relationship is therefore
en the bank and society as a whole. The better the perception created by the
, the more inclined potential clients will be to deal with it and ultimately want
become actual clients. Perceptions of achievement (related to awards or
ievements) and corporate social responsibility (CSR) initiatives contribute to the
ernal relationship.
4, 7
Chapter 4: Relationship Banking in South Africa
Bank Management in South Africa -A risk-based perspective
Relationship-based strategies
Client-centricity
The existence of a client-centric approach changes the departure point for banks
when dealing with clients: where product-centricity focuses on first developing
products and then segmenting clients according to the features of the products,
client-centricity focuses on initially identi{ying the needs of a client and then offering
products that address each specific need. Client-centricity is therefore more aligned
to personalising and customising banking solutions. Figure 4.5 compares productcentricity with client-centricity.
Adopting a client-centric approach has several benefils: 2
■ It encourages banks to be sensitive to the banking needs of clients.
•
ft provides a holistic approach to client needs.
•
It creates cross-selling opportunities.
•
ft offers customised banking solutions.
•
It creates value for the client through superior levels of service, which in turn
promotes loyalty to the bank.
Banks compete aggressively for the business of clients. So much so that in recent
years they have adopted an overarching strategy that focuses more explicitly on the
needs of the client. This client-centric approach places the needs of the client at the
centre of all bank activities. Client-centricity refers to 'what products and services
must be offered, how they are delivered. and to what extent the needs of clients are
consistently being met by doing this'. 2
4.4.5.1
This chapter has highlighted the importance of building mutually beneficial ban
client relationships. We now turn our attention to two strategies used extensively by
banks to build and enhance these relationships.
4.4.5
~
The payoff lines for the banks in Table 4. 7 reflect Rdiverse ~ange dfltl~~~eting strategi
Whatis particularly interesting is how the payo~liryes align the1TJ~;lyes to the ITlarket
Seg!Tlent focus of eachrespective brand.~niyers-af banks sucry;!~~~SA, Nedb
•Standard Bank reflect_.relational, innovatiye ~ndferward-lookingn?~ri~~s reSP,
'.t3iver'rtheir t1ryiyersal nature, they are in positioryio capitalise ?Q .?Q?"~t?p fi_~an
serviceoffefi~gs, ~is too can be said ?f.FirstR_ar1_d ..~~~~f~~i~.h.i.ncl?~:sFi.~!)
<•eank_and HarydMEirchant .BanK) Niche ?an_kssuch asp~pit~/~~rl~~r1~;19Y.~~t~1
._•••• on.the·low-;artd:high-iand _of the rnarketr?spectiY:'Y.ffhiS}s_ •.refl~S~~.•ir1 their"payoffli
Simple banking Jar Capitec Bank; extraordinary and ·unexpectea.tor.Jnvesfec..
120
Bancassurance
121
n order to offer a broader spectrum of products and generate additional revenue,
anks have expanded their business operations into non-traditional banking
activities. This expansion into complementary financial services industries such as
insurance is the endeavour of banks, and financial institutions in general, to become
more integrated and client-centric. The heart of the bancassurance model is lo
become a one-stop financial services provider that caters not only to specific banking
heeds, but to the larger more general financial services needs which include
insurance-related products. Such an approach provides a bank with the opportunity
to offer a wider range of financial solutions. which in turn addresses the client-centric
and relationship-based approach adopted by banks.
A bancassurance model is usually implemented through strategic alliance
agreements or subsidiary cross-holdings between banks and insurance companies.
To illustrate this point. Table 4.8 provides selected brands in the organisational
structures of the Big Four South African banks.
Table 4.8 indicates that each bank, in some form, has a link to either a wellestablished insurance company or has a division that explicitly focuses on insurance.
These 'banks' are therefore actually financial services providers that offer a wide
spectrum of financial products .
.4.5.2
191.ire 4.6 Product-centricity versus client-centricity
Chapter 4: Relationship Banking in South Africa
As of 2013, three
divisions were
established replacing
the rormer divisions:
Retail and Business
Banking, Corporate
and Investment
Banking and
Wealth, Investment
Management and
Insurance
Ashburton Investments
{A separate listed investment
holding company called Rand
Merchant Insurance Holdings
(RMI) holds stakes ,n
Discovery (25%)
MMI Holdings including
Momentum and Metropolotan
(25%)
Outsurance (83%)
RMB Structured Insurance (76%1)
First National Bank
RamJ Merchant Bank
WesBank
I
FirstRand Group
FirstRand Bank•
Neaoa, ,1\ -
Old Mutual
Nedgroup Trust ltd
{formeJy Fairburn Trust
Company lid\
Local subsidiaries
inlcude Nedhank ltd,
BOE Investment Holdings
lid and Nedbank Group
!nsuracne lid.
Nedbank
BOE Private Clients
Old Mulual Life Assurance
Company ltd (55.5%)
~1an<1
Btmk
or so
liberty Holdings ltd is a
separate entity of wh~h ii
owns 53.6%
Diners Club Soulh Africa,
Blue Bond Investments,
and Standard Bank
c11n.;e BroKers are d
Dan or Ine ~tandard Ba
Africa
Stanbic
Standard
Standard B
•
■
increased agency costs due to either a lack of synergy or strategic incompatibility
between the bank and insurance company
added pressure to train and upskil/ staff to be competent in both banking- and
insurance- related products
The challenges facing a bane.assur ance model include:
•
regulatory discrepancies given the different regulators for banking and insurance
respectively
•■
The benefits of a bancassur ance model include:
Increased revenue (specifically non-intere st revenue) for the bank that is
generated from both traditional banking (such as lending) and non-tradit ional
banking (insurance ) activities.
■
Increased product diversificalio11 as the bank offers products that have different
cash flow characteris tics, product features and revenue correlation s.
■
Economies of scale as the bank is able to offer more products at a lower cost.
•
Economies of scope due to more products being offered at one contact point. This
in turn generates cross-selling opportunit ies.
■
Clients receive customised financial solutions that incorporat e insurance
products.
■
There is a greater degree of geographical diversification if the subsidiarie s
originate or do their business in different markets or countries.
• Barclays Africa Group Limited owns l 00% of ABSA Bank Limited. Barclays Bank
plc owns
62.3% of Barclays Africa Group Limited. Source: website (http://www.barclaysafr
ica.com/
barclaysafrica/ About-Us/Who-we-are/Our-Group-legal-structure)
"Sources: FirstRand website (http:/ /www.tirstrand.co.w/ Aboutlls/Pages/ ownersbip-structure-,md
operaling-model.aspx). RMI Holdings website (http://www.minsurance.eo.za/about_struclure.as
p)
'Sonrces: Nedbank (2014):lll Old Mutual. (www.oidm utual.com/d ownload/18 732/0ld%20
Mutual%20Group%20legal%structure.pdl}
dStandard Bank Group (2014) 12
All accessed on l August 2015
Insurance brands
or subsidiaries
within group
I
ABSA
Banking brands
within group
Barclays Africa Group
ltd(100%)
Major
shareholder
Absa Bank"
Table 4.8 Selected brands in the organisational structures of the Big Four South
Africa
banks
122 Bank Management in South Africa - A risk-based perspective
Urwitz, G. 1993. 'Who needs banks?' in Operation and Regulation in Financial
Intermediation: A Functional Perspective. edited by P Englund. Stockholm: The
Economic Council: 7 5-81.
Coetzee, J, 2014. Client-Centricity in South African Retail Banking. International
Business & Economics Research Journal 13(4): 997-1016 .
Sewpersad, S & Minnaar, A. 2010. The bombing of ATMs in South Africa. Acta
Criminologica 2: 169-188
South African Banking Risk Information Centre (SABRIC). 2015. lndustry pleased
by decrease in associated robberies. https://www.sabric.eo.za/media-and-news/posts/
industry-pleased-by-decrease-in-associated-robberies (Accessed 6 August 2015).
ABSA Limited. 2013. Integrated Report for the period ended 31 December 2012.
http://www. barciaysa frica.com/ deployed files/ Assets/Richmedia/PDF /
Reports/20 12/2012 Integrated report.pd[ (Accessed 16July 2015).
Barclays Africa Group Limited. 2014. Integrated Report for the period ended 31
December 201 3. http://www.barclaysafrica.com/deployedfiles/ Assets/Richmedia/
PDP/Reports/2013/Barclays Africa Group integrated report 2013.pdf
(Accessed 16 July 2015).
Barclays Africa Group Limited. 2015. Integrated Report for the period end1!d 31
December 2014. http://www.barclaysafrica.com/deployedfiles/ Assets/Richmcdia/
PDF/Results/Annual/2014 full year results booklet.pdf(Accessed l6July
2015),
FirstRand Group Limited. 2013. Annual integrated report 2012. http://www.
fir strand .co.za /InvestorCentrc/ Annual%2 0Reports%20Archives/2012 %20
This [bank-client] relationship is not simply a one-way process. An effective banking
relationship requires a positive contributio n from both parties. The ability of the
bank to meet client needs requires that the owner/man ager provides the bank with
appropriate and timely information and is receptive to suggestions and advice
provided by the bank. 19
.k-client relationshi ps are undoubted ly important. Banks have acknowled ged
sand adapted their strategies accordingl y to promote an environme nt of trust.
ving said this, relationshi ps are complex and change continuou sly and the onus
ts with the bank through its contact staff to be sensitive to these changing
namics. This is especially the case when considerin g that not all relationshi ps are
'Ually profitable and committin g resources to less profitable clients requires an
"tive focus to migrate them to electronic banking platforms. If mutual benefit is
nsidered to be the core rationale behind a relationshi p, it follows that identifying
ient needs and addressing them will create a better understan ding of the nature of
lationships. As suggested by Ennew and Binks:
CONCLUSION
cassurance as a strategy is therefore more pervasive than a purely banking-o nly
el and has resulted in revenues expanding to include non-intere st activities as a
or source of operating income.
Chapter 4: Relationship Banking in South Africa 123
,,-=--•o-... -•-·~•••
Bank Management in South Africa -A risk-based perspective
..• •
--
~-•···•
••··••
/~k
•••·
FSR%20annual%20integrated%20report.pdf (Accessed 16 July 2015).
9. FirstRand Group Limited. 2015. Annual integrated report 2014. http:/ /www.
firstrand .co.za/InvestorCen tre/ Current'Yr,20PSR %20a nnual%20report/ 2014 %2
FSR %20annual%20int egrated%20report. pdf (Accessed 16 July 2015).
10. Ned bank Group Limited. 2015. Integrated report for the year ended 31 December
2014. http:/ /www.nedbankgroup.eo.za/linancial/Nedbank ar2014/downloads /
NedbankIR2014.pdf (Accessed 16 July 2015).
11. Standard Bank Group Limited.2014. Sustainability Report 2013. http://
sustainability.standardbank.com/wp-content/uploads/ 2014/04/2013Sustainability-Report-final.pdf (Accessed 16 July 20] 5).
12. Standard Bank Group Limited. 2015. Sustainability Report 2014. http://
sustainability.standardbank.com/downloads/finalsdr2014.pdf (Accessed J 6 July
2015).
13. Capitec Bank Holdings Limited. 2015. lntegrated annual report 2014. https:/
/www.
capitecbank.co.za/ resources/2014 Annual Report.pdf (Accessed 6 August 2015)
14. Capitec Bank Holdings Limited. 2015. Integrated annual report 2015. https:/ /
commondatastorage.googleapis.com/groovy-util-configobject60bclfce/annual
report.pdf (Accessed August 2015 ).
15. Little, E & Marandi, E. 2003. Relationship Marketing Management. London:
Thomson
Learning.
16. Peck, H, Payne, A, Christopher, M & Clark. M. 1999. Relationship Marketing:
Strategy and implementation. Oxford: Butterworth-Heinemann.
17. Rose, PS & Hudgins, SC. 2010. Bank Management 6 Financial Services.
8th ed. USA:
McGraw-Hill.
18. Banking Association South Africa (BASA). 201 l. The Code of Banking Practice.
https:/ /www.fnb.co.za/downloads/legal/Code-of-Banking-Practice-2011.pdf
(Accessed 3 August 2015).
19. Ennew, CT & Binks, MR. 1996. 'The impact of service quality and service
characteristics on customer retention: Small businesses and their banks in the UK.'
British Journal of Management 7(3): 219-230.
124
:Iobally, the banking environment is becoming more dynamic. competitive, diverse,
omplex and integrated. This description reflects the multi-faceted changing nature of
lobal banking, as it requires banking services to become much more client-orientated
ccording to different national contexts and needs. Even small community banks are
eing challenged to rethink their service delivery as a result of the influences of the
lobal banking environment. ln South Africa, local banks are being challenged by
reign banks, which are offering local clients access to international sources of funds
nd unique global investment opportunities. This has in turn led to South African
anks enlarging their international footprint, especially in Africa.
South Africa has, especially in the post-apartheid era, distinguished itself from
any other emerging market countries - and even many advanced economies - by
establishing a first-class banking system. As part of its deregulation reforms since
the late 1980s, South Africa has opened itself up to more international competition
by allowing foreign banks to enter the market. It has, as Tito Mboweni [a former
INTRODUCTION
reading this chapter, you should be able to:
understand the interrelationships between financial globalisation, systemic risk,
contagion and convergence in the context of both the South African and global
;financial systems
interpret the historical and theoretical roots of contemporary global financial
market integration
differentiate between the diverse types of international bank representation
comprehend the origins and progression of the South African banking industry
how it relates to the post-1994 era
interpret how the new emphasis on financial inclusion has added value to the
South African banking industry and prepared banks for African markets in the
era
understand how the opening up of the South African banking industry to
foreign entry was a stimulus for international expansion by South African
banks, especially into Africa
outline the complementary relationship between African economic integration,
the internationalisation of South African banks into Africa, and the deepening of
African financial markets
differentiate between the roles of the IMF and the World Bank in the
international financial system and monetary order.
RNING OBJECTIVES
-~~Jlopment and
1ationalisation of
Jt"ftican Banking
Bank Management in South Africa -A risk-based perspective
By drawing attention to the internatio nal context, this chapter provides an overview
of the development of the South African banking industry and its role and influence
in internatio nal monetary relations. More specifically, it deals with the various types
of internatio nal bank representa tion, the historical development of the industry
if11~f~16ba1 Fi~~nciarprisis ·(GF9>·refeffto.'the.ri'.Ri11~1al8r,J1~i6t~68~i;tH~t/ttis
.;?eenlr?ced to.!he··~o,.lapse·of the housing•.rriark~}i~.t~~ ~~it~~.i~t.~!f~{LJ~yan.d the
dc?nsequences ofJtiiS ~ollapse on the market for ri,ortg?ge•r~late~ se~~rities),8 This ·•
· •· has Men~idely tiewed as the greatest global .cri~is ?rre~essi?~ ~in~;th~iP~~at
Depression of 1929-1933 , hence its oftenbeingrefetredfoasthe.•GreatReceSSion ..
Governor of the South African Reserve Bank (SARB)] summarise d it, 'become much
more mature, with a moderate level of private sector indebtedness and a respectable
and first-rate regulatory and legal framework'. 2 As indicated in Chapter 2, South
Africa's banking industry is known to be highly concentrat ed and it is dominated by
four large banks resulting in its having reached a level of saturation . 3 As a result,
the move to consider other markets, especially in sub-Sahar an Africa (SSA), has
been a natural strategic progression.
A development in recent decades that has weighed heavily in Africa's favour in
terms of attracting capital has been that financial systems across the continent
(albeit not in every country) have deepened and become more stable and efficient. 4
Today Africa is in a better position than it was in the past to weather turmoil
engendere d by global crises and can even help ease the effects of a crisis in host
economies. There is certainly more optimism about finance in Africa today than
there has been in the past. This is largely due to banks around the world that have
penetrated African markets and contribute d to improvements in banking efficiency
and profitability. 5 The downside of this financial market integration, however, is
that it exposes Africa's previously isolated markets to global risk. This was
particularl y evident during the 2008 Global Financial Crisis (GFC) when emerging
market economies - including several African economies - were severely affected by
risks emanating from global banks. 6
Coinciding with banks becoming more globalised are shocks that originate in
host and home markets. As much as global banks offer liquidity and risk-sharin g
benefits to host markets when they experience negative shocks, they also become
prime catalysts for the transmissi on of risk across internatio nal markets. As an
example, in the period leading up to the GFC total loans from global banks to
emerging markets rose from roughly $200 billion to over $500 billion (2006 to
mid-2007).7 A prominent feature of financial globalisation since 2000 - and even
after the GFC - has been the incredible rise in these cross-border links. especially
among emerging markets. Moreover, the impact of globalisation and the current
transition of the national and internatio nal financial regulatory environme nts are
altering banking structures and affecting bank profitability in diverse ways. The
landscape of global banking is certainly changing. making the manner and timing
of internatio nal expansion vitally important .
126
While financial globalisation increased it also led to the proliferation of systemic
risk, as the number of financial crises started to increase from the l 990s. Inherent
to this was the increased securitisation of markets (where debts are pooled together
and sold to third parties), which 'reduced the need for a direct relationship between
borrower and lender, and the systematic treatment of large amounts of data on the
'a{~;!~~j;~ t~)~~~~c Jt~~::·of't he
·e past twoaeMaes,
i.11.ion P:t~~y, IN~ipif~~.oanannua!ise?
}iitWtJihk irl§(hdd[t ~l{[~:[~'.l fGin~f,gf
;r;t~d~~~,t~ir~::it~~ej;;I
THE INTERNATIONAL BANKING ENVIRONMENT
Internatio nal banking suffered a serious setback during the 19 70s and 19 80s
mainly as a result of the internatio nal debt crisis and the global economic turmoil
that preceded it. Since then financial firms - especially US banks - have experienced
a resurgence in global activities in the wake of the collapse of communis m in
Central and Eastern Europe and the unification of Europe. 9 This continued until
2007 when the first effects of the GFC brought an abrupt end to this revitalisation.
The 20-year period leading up to the GFC also witnessed an extraordin ary
acceleration of all aspects related to contempo rary globalisation.
Contemporary globalisation could be described as 'a process of interaction and
integration among the people, companies, institution s and governments that
involve different nations. a process driven by internatio nal trade and investmen t
and aided by information and telecommu nications technology.' JO The informatio n
revolution. which has been a major driving force behind globalisation, has led to a
remarkable expansion in global banking activities as it has placed a premium on
innovation and the ability of banks and corporates in general to adapt to change.
Breaking down barriers between geographically dispersed markets since the 1980s,
the information and communic ation revolution has given rise to virtually
instantane ous electronic trading in financial markets. 11 As a result, financial
globalisation has shaped up to be a particularl y dynamic dimension of globalisation
as the financial sector started to influence all other sectors. Financial glo/Jalisation
can therefore be described as 'the integration of financial institutions, instrumen ts
and markets into an internatio nal financial systcm'. 8 Two developments that have
reduced barriers and opened the way for financial globalisation to flourish arc
regulatory liberalisation - especially regarding internatio nal capital !lows - and the
use of technological innovation in the financial sector as a whole. and in the
banking industry in particular.
and the expansion into global markets, specifically on the African continent. Lastly,
the chapter considers the role of the key internatio nal institution s in the global
financial system, namely the Internatio nal Monetary Fund and the World Bank.
Chapter 5: The Development and Internationalisation of South African Banking 127
Bank Management in South Africa -A risk-ba
sed perspective
The ongoing consolidation of the financial system
contri butes significantly to
the systemic risk of the global financial system
throu gh its potential conta gion
effects. Contagion in banki ng occur s when 'a
deposit run at one bank spreads to
other banks, resulting in a liquidity crisis for
the financial system'. 9 Arising from
globalised, networked and integr ated financial
systems, these effects are multiplied
in a global conte xt by the trend of convergence
in the global financial sector where
different financial services industries join
forces and consolidate to become
diversified mega-financial multi nation al service
providers.
The historical roots of these developments can
be traced back to just after the
collapse of the Bretton Woods mone tary system
and the crisis-ridden years of the
19 70s, which ended a period of relatively stable
world order. l 5 New and more liberal
intern ationa l financial arran geme nts and practi
ces emerged in the 1980s , makin g
financialisation the domin ant mode of capita
l accum ulatio n, as the focus of banks
shifted from asset mana geme nt to active liabili
ty mana geme nt in order to increase
return s from their deposit bases. These new shoots
of capitalist renewal were later
under pinne d by the neoclassical economic theory
of neoliberalism and also created
the global ideological context for globalisatio
n to thrive upon. The theory of
creditworthiness of individual firms made it
possible for more geographic
dispersed borrowers to enter the marke t' 11 The
twin effects of vigorous deregula
of banks since the 1980s and the growing
interdependency amon g fina
markets globally, has led to increased and preca
rious levels of systemic risk. Syst
risk refers to 'the risk that an event (shock)
will trigger a loss of economic value
confidence in, and conse quent increases in uncer
tainty about, a substa ntial porti,
of the financial system that is large enoug h,
in all probability, to have significa
adverse effects on the real economy'. 12
In the context of an increasingly complex and
interd epend ent intern ation
banki ng enviro nmen t systemic risk has specifi
c significance. This risk entails t
probability of the breakdown of an entire system
and is evidenced by co-movemen
amon gst most or all parts of the system. As such,
the size of financial institution
interdependencies (instit utiona l systemic risk)
and the degree of global financi
marke t integr ation (market systemic risk) becom
es critical. 13 Institu tional failu
can arise from either direct interdependencies
(inter-firm on and off-balance-she
exposures) or indirect interdependencies (expo
sures to the same or similar asse
such as loan conce ntrati ons in the same indus try
(similar risk profile), for example)
In view of this, strong contra ctual interdepend
encies are inher ent to system·
risk. For example, the Bank for Intern ationa l Settle
ments (BIS) defines systemic r·
as 'the risk that the failure of a partic ipant to
meet its contra ctual obligations ma
in turn cause other partic ipants to default with
a chain reaction leading to broade
financial difficulties' . 14 This implies that a sort
of 'domino effect' or contagion occurs
where negative externalities 'spill over' from one
financial institu tion (or market) to
anoth er at a potentially rapid pace. This conta gion
even affects economically solvent
(innocent) and economically insolvent (guilty
) parties and offers little protection
and no way of limiting its dama ging effects
once it gets into motion. The real
economy also suffers throu gh unem ploym ent.
substa ntial reductions in outpu t and
price volatility.
128
deregulation.
=--~- -,~·"" "-~""- '·-'="• "~-•-· ~~'"--
'"'_ _ _ _ _ _ _ _ _ _ _ _
_
liberal norms and doctrines starte d to gain
worldwide acceptance after the
shington Consensus and afterm ath of the Cold
War. 16 This resulted in a high
rec of policy convergence as intern ationa l
institu tions strongly endor sed
liberal reform guidelines to their member
countries. Arguably, the most
ificant effect of this was rapid global financ
ial marke t integr ation. Hence
,ntemporary globalisation came to be a compl
ex multidimensional process of
:bordering and despatialisation, on the one
hand, and of consolidation and
iterconnection on the other. This was especially
so in the financial sector. As a
nsequence of neoliberalism. the process of globa
lisation has been facilitated by
:celerated regula tory and super visory harmo nisati
on. result ing from significant
regulation in the global financial sector. 15 This
generic liberalisation of banki ng
ulation throu gh progressive relaxa tion was an
attem pt to 'level the playing field'
intern ationa l banks throu gh the 1988 Basel
Conco rdat and subse quent
omme ndatio ns from the so-called 'Basel Comm
ittee' (see Chapter 16 for an inepth discussion on this). This ongoing financ
ial liberalisation significantly
ncouraged the entry of foreign banks into domes
tic banki ng markets.
International banking essentially refers to the
cross-border and cross- curren cy
cets of banki ng business. It can be classified
into two main activities, namely,
aditional foreign banki ng (trans action s with non-r
esidents in domestic curren cy)
nd euroc urren cy banki ng (trans action s in foreig
n excha nge with both residents
nd non-residents). The provision of eurom arket
loans, trade finance and foreign
chang e are activities in which intern ationa l
banks are commonly engaged.
nterna tional banki ng also includes multinationa
l banking (MNB) where banks own
nd control branc hes and/o r affiliates in more
than one country. This typically
nvolves an eleme nt of foreign direct investment
(FDI).
sh by mean s of liberalisation, privatisation and
129
eralism is essentially marke t funda menta lism,
causin g competitive marke ts to
Chapt er 5: The Development and Internationalis
ation of South African Banking
_ _ _ _ __
Bank Management in South Africa -A risk-based perspective
•
.■
•
Correspondent bank relationships (or affiliate banks): a smaller global bank that
stands in relationship with a large domestic or foreign correspondent bank,
providing a full range of banking services without sizable investment (only
paying fees for services it wants). It is the most inexpensive way to provide
international services as the cost of the fees (plus markup) can be transferred to:
the client.
Shell branches: an office space occupied by a global bank to record the receipt of
deposits and other international transactions. Its aim is to avoid costs and the
burden of regulation and usually contains little more than a telephone, fax
machine, desk and computer to book deposits from global eurocurrency markets.
They are also called ojf.~hore banking centres dealing with external accounts.
International departments: an international department within a bank is a basic
requirement for banks to expand globally and to offer a general package of
services to multinational clients.
As banks expanded their business activities in the international domain, sev,
networking relationships in different global financial sectors occurred. For exam
banks expanded globally to offer international banking services to existing die
and/or to gain market share in foreign markets for growth purposes. This has led
immense growth in the market share of banks with sizeable foreign positions. 17
recent times the globalisation of banking has been moving away from a system wi
predominantly cross-border flows to a system with both cross-border transactio
and more internationally diversified ownership of banks. While banking globalisati
is still evolving. the different types of international bank representation in countri
around the world are primarily: 9 •18
•
Foreign subsidiaries: an international bank that has acquired majority ownersh
of a separate, legally incorporated foreign bank, which has an established clie
base. Such a subsidiary has its own charter and capital stock. When a
international bank holds a minority ownership, it is called an affiliate bank.
•
Joint ventures (or 'Greenfield' developments): a foreign bank that enters into
joint venture with a financial firm in a country with a market that is familia
sharing both expenses and profits, thereby shielding its risk exposure.
•
Agreement corporations: subsidiaries of a bank that focus specifically o'
servicing international clients.
•
Representative offices: a limited-service facility that markets the services offer,
by the home office of the international bank (the parent bank). which identifi
new clients but does not make loans available or take deposits.
•
Agency offices: a foreign bank that extends commitments to make/purchase loans
issues letters of credit, administers the cash accounts of clients, and offer
assistance with their security trading. They do not take deposits from the public.
•
Branch offices: an overseas branch of an international bank operating as a local
bank in a foreign country to attract new investment. It offers the full range of
services, including accepting deposits subject to host country regulations
(trying to escape regulations faced by its branches in the home country).
Sometimes they are subject to dual regulation by home and host countries.
Foreign branches only represent a single large global bank and are not separate
legal entities.
130
131
riginally, the creation of banks in South Africa was entirely focused on meeting
gricultural needs through the provision of credit to farmers. In 179 3 the Bank
an Leening was established and in 1808 its subsidiary the Lombard Discount
ank came into existence. Both were government-back ed banks. 20 The era of
anking not backed by government only came into being when the Cctpe of Good
ope Bank was estc1blished in 1836. By 1861 the Cape Colony was serviced by 28
rivate or district banks.
With financial expertise somewhat limited, these small banks became part of a
tocess of consolidation to improve their competitiveness as foreign banks started to
ter the market. British banks penetrated the local market in 18 61 when the London
South African Bank (LSAB) was established, followed soon afterwards by the Standard
Bank of British South Africa (SB) in 1862. 21 The discovery of gold led to growing
immigration into South Africa and profit opportunities for foreign banks. In 1888. the
Netherlands Bank of South Africa Ltd (renamed Nedbank Ltd in 1971) was.
Origins and progression
THE HISTORY AND DEVELOPMENT OF THE SOUTH AFRICAN
BANKING ENVIRONMENT
iiite early on. South Africa's banking industry was integrated into the global
onomy and became orientated mainly towards corporate financing. This was
imarily due to the industrialisation of South Africa. particularly through its
ining industry. This strategic twin industry (!.hat is, banking and mining) created
legacy of high-level capability in financial services as South Africa's banking
dustry benefited from the international influence of advanced banking practices.
owcver, the divergent dynamics behind the historical progression of banking in
,uth Africa is quite intriguing. In an attempt to gain a competitive advantage. the
creased competition. market saturation and social responsibility led South African
auks to explore both the low-income and previously unbanked markets. This in
rn led to their being better prepared for their eventual African expansion.
incorporated foreign bank branches and foreign hank representative oflices. 19 In
African context. international banking in virtually all of its forms has consisted
African banks themselves entering other African markets. SSA in particular has
en a major focus for South African banks expanding into Africa. This has however
it happened overnight and the expansion outside the borders of South Africa has
en gradual.
uthree broad categories of bank: incorporated banks (domestic and foreign),
South Africa, these various types of international representation are divided
be a US-chartered bank) that holds computerised account records of deposits
. and transactions that focus on international commerce.
Loan Syndications: a vehicle that enables new banks to establish themselves in
the international loan market by providing an opportunity for loan expansion
without large-scale foreign investment.
:Jrrternational Banking Facility (IBF): a foreign bank operating in the US (or it can
Chapter 5: The Development and Internationalisation of South African Banking
Bank Management in South Africa -A risk-based perspective
In 1926 Barclays National Bank entered the country by taking over De Nationale Ban
and also merging with the Colonial Bank (of the West Indies) and the Anglo-Egypti,
Bank. During the l 930s the South African banking industry was dominated by th
duopoly of Barclays and SB, while they also had extensive networks in other parts o
Africa. Through correspondent banks, they offered sophisticated international services
to South African clients. In 19 34 Volkskas Bank was established (it started to do
business as a commercial bank in ] 941) to compete with the British banks. 24 With most
of the smaller private banks having been taken over by the large foreign banks at that
stage, there existed only five commercial banks in South Africa, making its banking
environment highly competitive. With the JSE also progressing well, an active market for
corporate control emerged after 194 5.
After the Second World War, with Afrikaner sentiment climaxing as the National
Party ascended to power in 1948, aversion to British banking capital increased and
banking at Volkskas helped to undermine British dominance as Volkskas rapidly
became a large bank. 25 With high international commodity prices, South Africa's
persistently good economic growth and risk diversification opportunities provided
strong impetus for foreign interest in the local banking industry. More foreign banks
banknotestolhe public in the absenceof uniformlegislation. 23 The
requirementwas that when banknotes were tendered at their branches, th"'""'"''"
obliged to convert them into gold.
Prrdr.·is·•theSA~·~•s establiShri1ent.••cdrnm~rcial bahks•i~·•·sduth.Afriba.•,~sued
The SAAB.was established in 1921 udder a special Act OfParliartlen(the\<i/
Currency anctBanking Act (31 of} 920).This actwasteplaced in 1944byJhe $A
Act.(29 of 1944); by the SAAB Act{90 ?f1989)in}989, and the Banks Act(94 Of
1990) in 1990.%;1neseactswere incor-porated i~J994 into the.E?nstituti?n?f.th
Republic ·of SouthAtrica (200 of 1993),}he SAAB Act .~as been al'\'lended from)i
to time, with the latest being in 2010 (SAAB Amendment Act 4 of 2010).
established. SB expanded into the Transvaal while De Nationale Bank was formed
1890. The latter, backed by a London-Amsterdam-Berlin syndicate, absorbed t
Bank of Africa and the small Natal Bank by the year 1914.
As concerns about monetary and currency stability escalated in South Afri
after the First World War, the Currency and Banking Act, established in 192
initiated uniform reserve requirements for banks. Through this, the South Afric
Reserve Bank (SARB) was established following the examples set by the cent
banks of the Netherlands and the island of Java. 22 The Johannesburg St
Exchange (JSE) came into existence in 188 7 as the corporate sector developed ea
to help finance gold mining by directing capital into the mining industry at first a
later into secondary industry. 5
132
133
·-----~-----·
-----------
ted to establish subsidiaries and associate companies. Examples of these include
Southern African Bank of Athens in 194 7 and the French Bank of Southern
ca (initially Banque de l'Indochine SA) in 1949. In 1958 and 1965 respectively,
First National City Bank of New York SA Ltd and the Bank of Lisbon and South
ica were also registered as deposit-receiving institutions. During this period Chase
nhattan Bank acquired an interest in Standard Bank Ltd in London, resulting in
SA Chase subsidiary merging with the Standard Bank of South Africa. In 19 70
ndard Bank merged with Chartered Bank (a British MNB) to form Standard
artered. 26
Federal Trust was established in 19 5 5 (later renamed Trust Bank in 19 5 6) and
\Ted to advance the Afrikaner cause further. The extensive capital requirement for
ep-level mining in South Africa was predominantly satisfied by the wellitalised imperial banks, thereby giving them a superior capital advantage over
national banks.2 1 By the end of 1970, 73.2% of all commercial bank deposits in
nth Africa were controlled by foreign banks. 20 Because this was considered
ceptional by western standards, the political economy restricted competition in
·e market by limiting foreign banks from 19 70 onwards. There were 5 6 registered
nking institutions active in South Africa by the 19 70s. Between then and the
980s, however. foreign banks - especially from the UK and the Netherlands ithdrew for political reasons, selling their shares to local shareholders. 5
This was also a time when South Africa became a major sovereign borrower as
I became more crucial for manufacturing development. Even after foreign
ithdrawal. South Africa's integration into international financial markets
ontinued into the 1980s as domestic banks had a continued presence in global
nancial centres. Based on findings by the Franzsen Commission's 19 70 Report,
outh African authorities phased in policies to restrict the entry of new foreign
anks and prohibited representative offices of foreign banks from taking deposits.
iven international pressures, this was done to keep control over the local banking
dustry, which was viewed as being a strategic industry in the economy.
Amongst others, three leading foreign controlled banks disinvested from
South Africa in 1986 and 1987 after being restricted by the Franzsen
Commission's recommendations. These were the two British banks, namely
arclays National and Standard Chartered (selling its stake in Standard Bank of
South Africa), and the American owned Citibank. The recommendations of the
Commission were later incorporated into the legislation or the Banks Act of 19 7 2
(for example, that the combined shareholding of foreigners in a bank in South
Africa should not exceed 50%) and was only scrapped in 1992 under the Deposittaking Institutions Act (94 of 1990) amended as the Banks Act l 994. 20 By 19 8 5
there were 47 active banks in South Africa - 22 general banks, 10 merchant
banks and 15 commercial banks.
The restrictions imposed by the 1972 Banks Act went against the international
trend of liberalisation in the 1980s and the internationalisation of banking (in the
sense of privatisation). In fact, such state intervention played a key role in
facilitating the introduction of foreign sanctions and excluding South Africa from
benefiting from the liberalisation of international capital markets. 21 This, together
Chapter 5: The Development and Internationalisation of South African Banking
with increased disintermedi.alion, proved to be particu
larly counterproductiv,
personal savings in South Africa declined and foreign capital
dried up, subseq u
constra ining economic growth even more. South African
banks were fur
constra ined by exchan ge controls (as the curren cy deprec
iated by 50% bet
1983 and 1990) and monet ary policy based on direct
controls failed to slow do
rapidly rising inflation.
The turning point came after the De Kock Commission rejected
direct controls in
1985 report and advocated monetary policy geared toward
s market effectiveness. 2
was observed in similar findings from other inquiries
(for example the Australi
Financial System inquiry of 19 79 and the Knight Group
of 1982) that regulati
caused inefficiency by segmenting financial markets. As
the Commission's report
'pragmatic monetarist', however, its market-orientated approa
ch to monetary poli,
was incompatible with government legislation that restrict
ed foreign participation.
The constraining economic conditions, coupled with the debt
standstill of 19 8 5 cau
by international banks (led by Chase Manha ttan Bank)
not wanting to release m
than US$10 billion in payments, resulted in a crisis situatio
n. Ironically, the cri
provided a stimulus for financial liberalisation (deregulation)
and internationalisati
to dovetail as South Africa's economic policy regimes were
reversed.
When the political climate began to change radically after
2 February 1990,i
was followed by reforms leading the way for a new wave
of foreign banks to enter th
country. As financial globalisation gained momen tum
after the Washingto
Consensus, dozens of foreign banks opened representative
offices in South Africa
with some even establishing locally incorporated subsidi
aries. 20 These foreign bank
mainly concentrated on corporate and investment (or wholes
ale) banking as oppose
to retail banking, given the high infrastructure costs
associated with setting u
branch networks. Since most of them were backed by their
parent banks and therefor,
had sufficient funding to cover deposits, it was made easier
for the SARB to act a
lender of last resort for domestic banks during the l 990s.
As a result of the influx o
foreign banks and increased competition, the merging
in 1991 of Volkskas, United
Bank, Allied Bank, Trust Bank and the Sage Group to form
the Amalgamated Banks
South Africa (ABSA) ushered in a move towards consoli
dation. Building societies
became takeover targets for large banking groups as distinc
tions between deposit
taking institutions were removed by the Banks Act 1990
(as amended in 1994).
In terms of capital requirements, the 1988 Basel Accord
prescribed that by 1995
a capital ratio of 8% should be achieved by banks. Endors
ing the Basel Committee's
principles for supervision of foreign establishments,
South African banks were
required to include returns for foreign branch es and
subsidiaries in consolidated
prudential returns . 21 This resulted in more deregulation
in South Africa's banking
industry and more competition, which ultimately increas
ed the concen tration of
banks in the industry. In 1998, the FirstRand Group was
established throug h the
merger of First National Bank, Rand Merch ant Bank and
Momentum Insura nce &
Asset Management. Between 199 5 and 2000 the numbe
r of foreign banks with a
market presence nearly doubled. 5 The resulta nt increas
e in capital inflow to most
industries of the economy contributed towards the JSE being
rated, in the late l 990s,
among the top 20 globally in terms of market capitalisation
.
134 Bank Management in South Africa - A risk-based
perspective
135
2000 there were 34 banks in South Africa that offered
a variety of financial
ices and by the end of 2001 there were 39 registered banks
and 15 local branch es
foreign banks. In early 2002, Saambou and Regal Bank
were placed under
atorship, causing shock waves throug hout the South African
banking system and
!ting in a run on BoE Bank and a numbe r of smaller banks,
which were forced lo
financial assistance. Due to high concen tration and consoli
dation, the numbe r of
stered banks fell to 15 by the end of 2003. 20 This concen
tration and consolidation
nsilied even more with the re-entry of Barclays Bank
in 2005, acquiring a
ority stake for £2.6 billion (56.4% and then increasing
to 62.3% in 2013) in
SA Bank. This was Barclays Bank's largest FD! outside
the UK. Relaxing the
riction on foreigners, who were only allowed to acquire
up to 10% of shares in a
th African bank just before the Barclays takeover, strengt
hened the role of foreign
nks in the banking industry on an unprecedented scale
and opened the way for
er MNBs to obtain large shareholdings.
One such development was the acquisition of a stake of
20% in Standa rd Bank
i 2007 by Industrial and Commercial Bank of China (ICBC) for
US$5. 5 billion.
his further contrib uted to global ratings agencies re-rati
ng the South African
anking industr y since large foreign banks could count
on the suppor t of their
rent banks, thereby reduci ng systemic risk. Hence in
line with the four pillars
mnk policy (see Chapte r 2), the South African bankin g industr
y in the 2000s came
o be dominated by the so-called Big Four: ABSA (the
group was rename d to
"arclays Africa Group Ltd in 2013); Standa rd Bank
of South Africa (Stanbic);
irstRand Group; and the Nedbank Group (initially Nedcor
Group after the mergin g
''1 2003 of Nedcor, BoE, Nedcor Investm ent
Bank and Cape of Good Hope Bank).
ignalling the impact of foreign entry into the South Africa
bankin g industry, by the
nd of 2012 there were 17 registered banks (of which 11
were locally controlled),
3 mutua l banks, 14 local branch es of foreign banks, 15
controlling compa nies and
41 foreign banks with approved local representative oflices. 23
At the beginn ing of
2012, foreign shareh olding in the bankin g industr
y comprised 43% of total
nominal bankin g shares in issue, while domestic shareh
olding comprised 28% and
,minority shareh olding (those with less than 1% shareh
olding ) 29%. 29 A result of
the foreign bank presence was that South African banks
were to a large extent not
/promi nent in corpor ate bankin g activities. This was primar
ily due to the economies
of scale and scope that the foreign banks brough t to
the fore. As a result, these
foreign banks (typically US and European-based) asserte
d themselves by being more
aggressive in their priciog. 27
Chapter 5: The Development and Internationalisation
of South African Banking
Bank Management in South Africa -A risk-based perspective
A new emphasis: financial inclusion
A further way in which the South African banking industry has transformed is in the
number of institutions - especially microfinance institutions - that have targeted
financial services at the low-income and previously unbanked market. After 1994,
financial inclusion has gradually become a central aim for domestic banks as the
national policy to bank the so-called unbanked, underbanked and financially excluded
5.3.2
Results from a Panzar-Rosse estimation in 2011 suggested that the structute of the
South African banking industry is by nature monopolistic competition. 30 This
confirms the domination of the Big Four banks and is in line with the 2008 Report
by the Competition Commission on Banking, which found that the large banks tend
to avoid outright competition against each other. This, together with most banking
efficiency being generated from cost efficiency, made expansion into the
,international (especially African) market particularly attractive to South African
banks in the 2000s, The Big Four banks gained substantial market share, especially
from the strong market growth between the 1950s and 1980s, which could
ironically be associated with severe income inequalities resulting from apartheid.
Although sophistication and product innovation improved vastly after 1994, the
market may have reached saturation point, despite the potential of the 'bottom of
the pyramid' (low-income) market growth. 5
About half of the adult population in the lower income group has no access to
finance in South Africa. 30 In 2001, for instance, between 60% and 80% of the
country's economically active population was found to be unbanked. Estimations
suggest that in 2013 about 67% of South Africa's adult population was unbanked,
In the post-GFC era, South Africa's banking industry is seen as setting a glo
standard, distinguishing it from many other emerging market economies. With
of the largest capital markets amongst these economies, the depth of South Afri
financial sector is nearly three times that of India and the SSA average, and ne
four times that of Brazil.3° In the past 20 years it has become characterised h
first-rate regulatory and legal framework, adequate capital and a moderate level
private-sector indebtedness. South African banks are well managed and ha
become known for utilising sophisticated risk management practices and corpora
governance structures in conducting their business. 2
The banking industry has transformed through consolidation, cutting-ed
legislation and technologically advanced systems. Having said this, with the tar
market mainly the middle to upper income groups even after apartheid ended, lo
banks found themselves quite underdeveloped in serving low-income clients in th
home and foreign host markets. Indicative of a dualistic credit-granting indust
this led to a move towards greater 'financial inclusion' by the Big Four banks, whe
in 2004, they teamed up with the Postbank to assist, by means of Mzansi accounts/
those with no access to banking services. By the end of 2008 more than six million
Mzansi accounts had been opened.
136
137
·ovide access to 1he previousiy unbanked community by addressing
eeds in a low0 cost and or.complicated manner. 'Afi.thin six years of
.t of the tier-one banks ft:>ond the Mzansi too co~tly arid subsequently
n branded initlative's.which-tried to offer low-cost banking for less
___ ,th.39 First National Bank.(FNB),forinstance, launched EasyP/an in
July.2011 Nedbimk launched its Ke Yona account; comprising a pay-astransactional _account; Joneral cover, personal loan, JuitSave account arid a
n M•Pesa moneytransfer.riptlon. ASSA, continuing with its Mzansi account,
ended its Transact accour\t across all its branches in February 2012,
d Bank-announced its Access account in March 2012 and expanded its
•
s) in townshfps and underserviced
tial
:i account is an affordable and readily availabletransaction account
emerged. Principles of financial inclusion in South Africa typically refer to issues
as affordability, access, usage, appropriateness, consumer financial education,
ation, diversification, product quality and simplicity (see also Chapters 3 and 4).
Chapter 5: The Development and Internationalisation of South African Banking
Bank Management in South Africa - A risk-based perspective
~!r,,
•
Although by no means limited to these, the main causes of the GFC were: 39
Securitisation fostered the 'originate- to-distribu te' model. which reduced
incentives of lenders to be prudent, particularl y in the face of enormous
investor demand for subprime loans packaged as AAA bonds.
•
Financial innovation through new instrumen ts in structured finance developed
so rapidly - leading to increased capital flows - that market infrastruct ure and
systems were unprepare d when these instrumen ts came under stress.
•
Risky financial activities once confined to regulated banks (use of leverage,
borrowing short-term to lend long, etc) migrated outside the safety net provided
5.3.3 Dealing with the GFC
The globalisation of financial markets and the size of private capital flows have
drastically increased the interdepen dence of economies around the world. Starting
in the US subprime crisis in 2008, the GFC quickly spread to the rest of the world,
putting the global financial system under enormous pressure. Since the 1930s, it
has become the first truly 'global' crisis in the current era of globalisation. 38
The growing microfinance industry plays a critical role in improving access
financial services in Africa. As the ability of South African banks to increase thei
influence in this market improves, it enhances their ability to expand thei
operations into Africa. The microfinance industry also appears to have the added
benefit of being quite insulated from the contagion effects to which banks and
capital markets are exposed during a financial crisis. 33 This provides further
motivation for developing this industry.
san~
\'~a~~;i~so~f1~~61i's rt1ibrofl11 1n2~iR~u§ t111e!~~!i; !~;l?s!~fu;! !,i,rr,!
Instance; establishe!d in•:1~98 astheBa~ko!Transkei;~eE!g
is•·~~!h
}.temai~ing,black~o\\lnecJ)~ank.~hd . is . .part,?f,the,tEl~~ . et<5p~-/f~b~·•.~a~~i~sjfg~
•.. 1975 and rrrainlffocuses on the .mining sec!or an~fowe~income·C>~biu~;collar~
"'"AfricanBank and Capltec Bank were resp&ctively established in J 993 and 2d01;
Key microfinance institution s (who can take deposits), apart from microlend
(who may not take deposits), include: member-based organisati ons (stokvels, viii
banks, mutual banks, etc); non-gover nmental organisations (such as Mara
Beehive and FINCA); Ithala; Land Bank; and the Postbank. It also includes tier
banks (Capitec Bank, African Bank and Teba Bank) and tier one banks t
collaborated to offer, in line with the FSC, Mzansi accounts. 19
J
Although comprising only about 4% of.total co2surn~rcredifexteh.si6h;c(
•• microlenders have, in most cases,. beehJhe prim~ry??~rcepfacces.sto predff
the unbanked Iow-income individuals; CurrenUy, there are toughly 3 n,illion
;/borrower s, ~00 registered microlender.s With a ~r~~?h outreach of7 000
:microlending outlets in all nine South African provinces. 27
138
139
_______ .,.,.....,.,.
-7------
.-------~~
nregulated institution s offering mortgage lending. which led to unsupervi sed
risk-taking.
World financial flows have been characterised in recent years by an unsustaina ble
Pattern where some countries (such as China, Japan and Germany) run large
surpluses on their current accounts every year, while others (the US and UK) run
deficits. The external deficits of the US have been paralleled by budget deficits in
the household and government sectors. Their borrowing, though, cannot
continue indefinitely. Although the remedy was initially focused on failures in
regulation and supervision, it later became clear that there were root global
macroeconomic causes of the GFC that supported these global imbalances.
,y deposit insurance. This shadow hanking system included, for instance,
Chapter 5: The Development and Internationalisation of South African Banking
: ·:_:·:_~~--~---•.,/.,;,:c~.,.,..
0,,,___ ___
I
I
---'"'--
"'_,., .. ,,." ..
', --~•-•·-,••
....... ,. 'l"V
,0·<
= • ,,
mark:etsdBrnparedgl
Bank Management in South
Africa - A risk-based perspect
ive
-·-- - -·. ·--·r --· -· ···GFC on selectedAfricanfinar\c:
-~---"-- L•.,.~
:ial
140
Financial globalisation has mad
e cross~border cap ital flows
high ly mobile, whi lst
also allowing toxic assets (illi
quid assets tha t have no read
ily available seco nda ry
market and are therefore difficult, if not
impossible, to sell) to move instantly fi
one financial centr e to another. As a resul
t, this mobility has heightened syste
risk and regul atory arbitrage opportunities. 40
The GFC showed that capital mar
and specifically capital flows well excee
ded 'conventional' commercial ban
operations in size and influence on the
performance of overall financial mar
Essentially, it was global bank ing flows that
determined the geographical reac
the GFC. 41 Particularly after the collapse
of Lehman Brothers, it became evid
how global in scope large financial instit
utions are with regards to their operati
and that they effectively link together the
fortunes of financial markets worldwi,
This has led to the now globally used conc
ept of interconnectedness. 42 Alarmingly,
also became clear that natio nal governme
nts and centr al banks were inade quate
meas uring and captu ring (and thus fully
addressing) financial risk, which is eas
trans mitte d globally irrespective of how
effective national regul ators are. 40
response to the GFC, the G20 - of whic
h Sout h Africa is a mem ber - formal
endorsed the Basel Committee on Banking
Supervision's proposals for capital a
liquidity requirements for bank ing instit
utions, resulting in Basel III. This accor;
albeit not legally binding, stren gthen ed
the capital requirements for banks a
introduced new regul atory requi reme nts
for liquidity and leverage (see Chapter 1
In addition, prior to the GFC. deregulation
and liberalisation of the financial servi
sector aroun d the world brou ght abou t an
unprecedented flow of capital moveme
Financial globalisation contr ibute d to the
widespread abolishment of restrictions
capital acco unts and also on capital flows
in the form of exchange controls. 43
While South Africa and other countries in
the south ern African region had a
introduced deregulation initiatives in their
financial markets to increase capi
inflows, they were less severely affected by
the GFC. South Africa's financial sector
particular was significantly shielded from
the GFC - especially from direct exposure
the troubled securitised debt market in the
US - because of the effective financial
reforms it introduced prior to the crisis. In
fact, the Saambou liquidity crisis in 2002
ushered in new regulatory reforms by South
African regulators. The instability caused
by the Saambou problem resulted in a threa
tenin g loss of confidence as it also affecte the so-called tier two banks and especially
BoE Bank, the sixth largest bank at th
time. 2 The other large banks were in a healt
hy condition. but still benefited from t
reform. Legislation such as FAIS, FICA and
the NCA (sec Chapter 3 for a thoroug
discussion) further ensured that Sout h
African banks adopted risk manageme
practices. Moreover, after the SARB dealt
with the collapse of Saambou in 2002 , th
Registrar of Banks reviewed the statu s of
compliance to sound corporate governan
practices within Sout h Africa's five largest
banks. They were found to be applying big
standards of corporate governance.
Prud ent macroeconomic policies, unde rpinn
ed by a consistent and transpareri
policy framework, furth er helped cush ion
the impa ct of Sout h Africa's larges
recession since the lifting of sanctions
in the early 1990 s. 44 Furth ermo re, loca
banks (except for the mutu al banks) were
subjected to the King Code on Corporat
Governance and various ombudsmen provi
ded the indus try with fast and effectiv
dispute resolution for bank s that ensu red
a fair, impartial and confidential way o
dealing with clients. 29 Lastly, with the
comm itmen t of Sout h African regul ator
142 Bank Management in South Africa
-A risk-based perspective
143
··••··• ··•·••~ ••"~'= ·•·-~- --
<THE ROLE OF SOU TH AFRICAN BAN
KS IN THE AFRICAN CON TEX T
end of apartheid not only unsh ackle d South
Africa's political envir onme nt. but
its economic relations with coun tries in
the Sout hern African Development
munity (SADC). In light of increased
globalisation, regional economic
ration. led by South Africa, reshaped
economic struc tures in Africa as
beral reforms and the New Partn ershi p for
Africa's Development (NEPAD) took
t:1 8 Prior to 1994 . Sout h Africa had limite
d bank ing operations outside its
ders. Most of the focus had been on
Namibia, which was historically and
inially part of South Africa. 49 The open
ing up of the Sout h African financial
or and chan ge in political regime resul
ted in. several bank s establishing
rations globally, including the easte rn and
south ern African regions. The new
th Africa certainly heralded the opening
up of new horizons for banks, and the
"rest in the local mark et shown by globa
l bank s also grew rapidly. The big five
th African banks in parti cular expanded
their networks in Africa, and played a
role in financing large domestic business
ventures in Africa. In their ques t for
eased global competitiveness, Sout h Afric
an banks have gone throu gh a period
exceptional inter natio nalis ation , also expa
nding into Europe and the Far East to
low their clients as foreign trade opportuni
ties opened up for local companies. 19
. South African bank s and financial instit
ution s in general have followed three
iitegies with regards to inter natio nalis
ation . First, the strategy adopted by
dbank. ABSA and FirstRand has been
to main tain the mark et-su stain ing
,proach of earlier years: that is, to finance
much of the inter natio nal trade and
vestment pursuits of curre nt Sout h African
corpo rate clients. 5 The second strategy
that followed predominantly by Stand ard
Bank (and partly by Sanlam) that
uses on seeking new markets with an emer
ging mark et focus. Stand ard Bank
ms to be a 'mini-network' bank that provi
des services across a vast numb er of
obal markets with the goal of offering the
full spect rum of financial solutions,
.pecially across Africa. The third inter natio
nalis ation strategy is that followed by
vestec. Old Mutual, Discovery and Liber
ty Lile, which is to transfer the firm's
. imary stock market listing abroad. They
have also furthered their strategy
·rough acquisitions, rathe r than looking
for organic grow th based on Greenfield
try or joint ventures with local partn ers. 5
orities to the Basel Accord, the banks have
main
d a level of soun d capital
ts management. With Basel III being phased in taine
since 2013 and the proposed
Peaks regulatory model (which is based
on a macr oprud entia l appro ach to
ing supervision) in the pipeline, the regul
atory envir onme nt for Sout h African
sis, to all inten ts and purposes, in a good
state.
Chapter 5: The Development and Intern
ationalisation of South African Banking
The financial sector of most African countries during the 19 70s and
experienced considerable government intervention as governments often ha
majority ownership of banks. Interest rate controls (resulting in higher spreads)
credit allocation quotas, high barriers to entry, limited institutional capacity,
inordinate risk-taking and a lack of capital created shallow financial markets. .~
5
This led to high default rates as funds were not channelled to the most profitabl
deficit units. This changed during the l 990s as many African countries embrace
neoliberal privatisation programmes in varying forms. The primary purpose was t,
enhance the banking industry's efficiency. In line with the international
liberalisation of the whole financial sector, African countries opened up to foreign
competition, which led to positive spillover into domestic banks and an influx of
cross-border capital flows. As can be expected, this was not without increased risk.
Just as a large part of the South African population today remains unbanked, the
rest of the continent is unbanked to an even greater degree. Given that finance plays
•a critical role in economic development, there is considerable scope for expansion of
52
the financial system in Africa. As such, in the post-1994 era, South Africa is often
described as an 'engine for growth' in Africa as its economic growth has a
considerable effect on other African countries. Apart from technological spillover,
one way in which the effect of this growth is transmitted is through financial sector
links, given that South African investment plays a large role in the banking systems
and capital flows of numerous African countries. 52 The investment of South African
banks in African countries has coincided with the growth in trade and investment
Bank Management in South Africa - A risk-based perspective
145
44%
22%
40%
22%
26%
44%
50%
50%
29%
44%
51%
51%
29%
43%
52%
50%
,2002
29%
48%
54%
50%
2003
34%
54%
54%
51%
2004·
34%
56%
54%
56%
37%
56%
54%
56%
2005, '2006
- - .. , ••••,..,~..,."~?
-«•---------- - - - - - - - - - -
ber of South African banks have made considerable inroads into Africa and
cially SSA. 53 They have concentrated mainly on financing trade and investment
ities as opposed to retail banking. By the early 2000s most SADC countries
host to at least one South African retail or merchant bank with subsequent
stments in progress. 48 With financial systems in southern Africa (except South
ica) generally characterised by low levels of sophistication and intermediation.
s created opportunities through either opening branches, representative offices
reenfield investments. Leading the charge for South Africa's 'invasion' of Africa,
ndard Bank (through Stanbic Africa) and ABSA have been vigorously pursuing
ective, active, acquisition campaigns across Africa. In fact, Stanbic is considered
be a full-scale regional multinational bank, having representation through retail
nking operations in 1 7 African countries outside South Africa. It has, for instance,
offshore unit in Mauritius. 54 Other banks with African operations that are less
isible are Rand Merchant Bank, Nedbank and the insurer Alexander Forbes.
Between 1996 and 2004, investment in Africa increased more than fivefold,
ith SSA the region in which south-south banking (among developing countries)
Was relatively the largest (43% of all foreign banks in 2006). 55 For the first time
South African firms had more than 10% of all their FDI foreign assets in Africa.
Table 5.3 provides the foreign assets in South Africa for the period 1996 to 2005.
African FOi in banking for the period expanded dramatically in 2001 and 2002,
comprising 2 3% and 19% of all African FDl foreign assets respectively. 56
Dominating the African banking landscape, South African banks accounted for
40.4% of total banking assets among the top 200 banks in Africa in 2008, 34.6%
of net earnings, 49. 9% of bank credit, and 42.4% of bank deposits. 30
48%
43%
51%
1999- _2000': ;2001
• the rest of the continent. This has been assisted by an economic and
l 'renaissance' in many African countries. which in the pre-GFC period, was
ble to that in Asian countries during the 'East Asian miracle'. 17 Foreign
1ave been instrumental in banking development in Africa as their share of
ican banking has increased substantially. Table 5.2 illustrates this increase,
buld mainly be attributed to significant financial sector reforms in which
ountries have engaged. Notably. the banking industry in most African
·es is either dominated by state-owned banks or by a few large, often foreign,
:hapter 5: The Development and Internationalisation of South African Banking
NIA
African banking
reinvested earnings
NIA
NIA
NIA
NIA
1.3%
121
9 117
5.8%
6 538
4.2%
157 385
1998
0
323
3.2%
323
9 971
4.9%
8 543
4.2%
203 036
I
3461
105
86%
1 051
12 265
5.0%
14 277
5.8%
244 653
1 868
I
1 343 I
22.9%
1 406
1 299
19.0%
2705
7.5%
3 211
14 234
6.6%
I
I
3 411
1.8%
189911
I
I
631 I
1 362
126%
1 993
15 837
8.8%
3 758
2.1%
180 507
··2002 • c.·2003·
14 031
7 284
3.4%
213184
,,,999_. ,,·2000 '· ;.2001
384
896
5.4%
20%
Botswana
76%
Namibia.•c•
Source: Adapted from lkhide & Yinusa (2012): 58 Wang et al. (2007) 57
Market share of Sooth Afr~n banks
Total number of banks
of which South African
66%
Table 5.4 Banking industry indicators of selected SADC countries in 2005
82%
As Table 5.4 indicates, by 2005, there were already a significant number
South African banks operating in neighbouring countries, accounting for bet.we
66% and 82% of their banking industry (except for Botswana). In Namibia, Lesot
and Swaziland, First National Bank, Nedbank and Standard Bank have created
virtually unified banking system within the Common Monetary Area (CMA).57
further indication of high levels of integration in the banking industry is t
homogeneous financial soundness indicators across the CMA. However, as far
financial market development and depth across the CMA is concerned, South Afric
is at a much more advanced stage, followed by Namibia, Swaziland and Lesotho.
The main reason for South African banks expanding northwards into Africa
naturally to broaden revenue bases through market seeking, efficiency seeking
resource seeking. In addition to this, the most important factors/risks conside1
when investing in SSA are: country governance and political risk; market size a
demand conditions; infrastructure considerations; and economic environment
macro-economic performance. Research suggests that South African financial fir
in general are most strongly influenced by the political and economic stability oft
respective SSA country, along with the profitability and long-term sustainability
its specific markets. 56
Source: Luiz and Charalambous (2009) 56
NIA
5.6%
4.7%
African banking
equity capital
358
6 374
5.6%
2 484
2.2%
113170
1997
217
4 659
4.1%
Tolal Afrlc;an FOi
%oltolalFOI
Tolal Alrican banking
FOi
% of total African
FOi
1 772
16%
Total banking FOi
% ol total FOi
·1996·
114 013
.~.
Total overall direct
investment
(RmllliOii)
Table 5.3 Foreign assets of South Africa, 1996-2005
146 Bank Management in South Africa - A risk-based perspective
147
NIA
NIA
NIA
11
82
NIA
18
30
12
21
72
NIA
72
e advantage that South African banks have over non-African MNBs when doing
siness in Africa is that they adapt more easily to local conditions and given their
frican heritage, they have lower transaction costs when overcoming the rigidities of
aditions and customs. 60 This lends itself to being better accustomed to evaluate and
pervise local borrowers by adopting, with good discretion, soft lending techniques
at overcome informational ambiguities inherent to African business practices.
Banks in African countries are therefore able to compete with their international
counterparts as they have a high absorptive capacity, thereby attracting new clients
and assimilating information efficiently. Conversely, however, if the technological
and expertise gaps are too large, these banks struggle to compete with large foreign
banks and are subsequently pushed out of the market. This is particularly the case
With corporate and investment banking activities.
NIA
80 (5)
46(3)
82 (4)
95 (5)
87 (3)
14
urce: Jansen & Vennes (2006) 51
96 (5)
90 (4)
0
I
15
21
24
0
NIA
6
17
3!>-40
87
22
South African
bankS' share,
%6f:tiSsets
(2003)
90(4)
NIA
0
0
South'African
barikS\:s:hare,
• % of _iissets
(1994)
66 (2)
NIA
NIA
NIA
0
15
76 (3)
90 (5)
NIA
._.:banks)
Nll.~berot' g .,.•· Concentration,
~..a~ch··.·.·.~:0!/·•.•.·.·.·•.•.•.·.• • :,o/o(numbenif
fomlgn bank"'' •
isolation, 1994-2003
•s.5 South African bank presence in SADC countries in the first decade after
;5 shows how South African banks made significant inroads during the
(years after 1994 in the South African Development Community (SADC)
es. The non-CMA countries in which South African banks have enlarged
fotprint the most are Mozambique. Mauritius, Tanzania and Malawi. This
as contributed considerably to regional integration within SADC. 51 One of
in obstacles that needed to be overcome was the difference in host-country
fig regulations. These sunk costs placed greater emphasis on harmonising
hg regulation across the region as part of the regional liberalisation process.
foresting international comparison is that by 2006 South Africa, Panama and
owned the highest number of banks in other developing countries (28% of all
oping country banks). 55
·hapter 5: The Development and Internationalisation of South African Banking
Bank Management in South Africa - A risk-based perspective
INTERNATIONAL INSTITUTIONS: THE ROLE OF THE IMF AND
THE WORLD BANK
The International Monetary Fund
Considered to be the institutional nerve centre of the global monetary order,
mandate given to the IMF by its member countries includes the promotion
international co-operation in monetary and financial affairs through collaboration
and consultation and assuring members of temporary access to its general
57
resources if necessary.
By being primarily responsible for macroeconomic
assessments, the IMF is the only international organisation whose mandate requires
that it becomes involved in active dialogue with practically all countries. 62 It has
become the principal forum for discussing both the global context of national
economic policies and issues that are vital to ensuring the stability of the
international monetary and financial system. The official responsibilities and
5.5.1
Since South Africa became a member of both the International Monetary
(IMF) and the World Bank in the 1940s, these two international institutions ha
played a significant role in the development of South Africa's banking industry. It
would be meaningful to examine the growth of these two institutions and also
gain an understanding of how they have progressed to their current influential
in the South African financial system. Although there are still deficiencies
in these institutions, their role in stabilising financial systems is important.
5.5
Finally, perceptions about Africa's capacity (both economic and human)
changing for the better throughout the world. Foreign investors are reconside
the latent potential of this vast. untapped African market of 850 million p
given that the returns on investment compete well with most other countries.
crucial trend is also emerging: the risk associated with doing business in Africa
declining markedly as the institutional environment becomes more familiar a
predictable (especially as a result of increased generic financial regulations after
GFC). as evidenced by investment in Africa increasing in absolute terms from
average of US$1. 9 billion during the 1970s to US$5. l billion in the 1990s and o
US$30 billion in the 2000s. 56
Notably, since 199 3 a number of African countries have collaborated with the
Committee tel harmonise their regulatory frameworks through the Easter
Southern Africa Banking Supervision group (ESAF). 51 Extending beyond
membership, this group developed a memorandum of understanding that st
harmonising and aligning national regulations with internationally ac
standards. Examples of these include bank licensing and regulation, on- and o
supervision, supervision of cross-border operations, and accounting rules.
subsequently played a key role in attracting more capital to the region. The E
however dissolved in 2004 to form a bank supervisory body confined within S
known as the SADC Subcommittee of Bank Supervisors (SSBS). Based on the
Basel Principles for Effective Banking Supervision, their aim is to further harmo
banking regulations, supervisory systems and business practices across the w
of the SADC region.
148
149
liant with an amended Article IV Section 3 of its statutes, the IMF was from
outset principally tasked with overseeing the international monetary system.
icularly since the l 990s, its main focus of activity has shifted from exchange
surveillance to the stability and integrity of the international financial system. 64
n attempt to achieve its economic reform objectives more readily, the IMF started
ntervene to a greater degree in member countries. Apart from the Structural
justment Programmes (SAPs), conditionality was further expanded when the
F together with the World Bank insisted on stipulations on domestic governance
d the institutional framework of economic policymaking. 65 Accordingly, the TMF
tiated major training and technical assistance activities and tools for countries
at struggle with the policy reform challenges in an era characterised by intense
obalisation. Furthermore, the governance structure and decision-making
cesses of the IMF are the result of agreements embodied in the quota regime
r the allocation of funds), with the size of quotas determined by each country's
lative economic weight in the world economy. Alt.hough each member receives a
sic number of votes, a country's relative voting power in the IMF is decided by the
ze of its quota. 61
In effect. the IMF's quota regime functions as the basis for determining (i) the
quired size of each member's capital contribution, (ii) the extent of access that
ch member country has to the IMF's resources, and (iii) the distribution of voting
ghts within the institution. The body that governs the IMF is the Board bf
overnors, who control but do not manage it - a function that is rather performed
,y the Executive Board. Decision-making at the IMF is based on a rule that is not
one-country-one-vote, but roughly 100 000 SDRs (Special Drawing Rights) to one
vote. On this basis, the IMF is officially controlled, in terms of decision-making, by
its wealthiest member states by means of weighted voting. Probably the most
significant WjlY for developing countries to have some meaningful influence in the
• IMF is through the constituency system, where a group of countries - a
constituency - join to elect an Executive Director. 66 This person then represents the
interests of these countries through casting the constituency's votes as a unit in
Executive Board decisions.
As the GFC has revealed, there are serious weaknesses in the current financial
architecture that need to be corrected through radical reform. There needs to be a
of the IMF are determined by its Articles of Agreement. As its most
nt constitutional instrument (since 1944), the Articles of Agreement state
IMF's primary objectives are: 63
mating foreign exchange stability
ating a multilateral system of payments between members
mating international monetary co-operation
ducing the duration and severity of disequilibria in members' balance of
yments, and enhancing current account convertibility
cilitating the expansion and balanced growth of international trade
the correction of maladjustments in members' balance of
5: The Development and Internationalisation of South African Banking
Bank Management in South Africa -A risk-based perspective
enhancing the regulation of collective investment schemes to attend to the gaps
in disclosure and valuation
•
■
improving the surveillance of over-the-counter derivative markets
introducing deposit insurance to reduce systemic liquidity risk
breaking down existing silos and enhancing group-wide supervision to manage
credit, concentration and cross-border risks
■
•
more orderly liberalisation of capital controls. 42 Countries· capital account regi
need to be tnore integrated wi.th the domestic financial supervisory framework, a
at the global level the IMF should be more empowered to monitor the strength
these systems. This would help foster global economic and financial stability.
bilateral and multilateral surveillance function of the IMF (that is. assessing t
risks of countries, regions and the entire global financial system) needs to
drastically improved. By establishing the Financial Sector Assessment Progra
(FSAP) after the East-Asian financial crisis in 1998. there has been a push
enhance the various standards and codes that guide the operations of bo
supervisory authorities and financial institutions. In this. the IMF has work,
closely with the relevant standard-setting bodies, as well as the World Bank,
conduct the FSAP exercises in individual countries. This remains an effective way
tapping into the expertise of the various standard-setting bodies. The formation
the Financial Stability Forum (FSFJ in 1999 (and strengthened in 2008) provide
for the first time a forum for regulators and supervisors to meet with those takin
responsibility for macroeconomic policy. In 2009, the successor to the FSr'. th
Financial St.ibility Board (FSB) was established at the G20 London Summit an·
included members of the G20 that previously were not part of the FSF.
As a G20 country, South Africa is expected to undertake an FSAP every fiv,
years. In the December 2014 report. the IMF made a number of key findings an
74
recommendations . While recognising that South Africa's financial sector operat
in a challenging environment, the IMF has commended the country for it
remarkable progress since 1994. Concerns were raised that as a consequence of
high unemployment, stagnant disposable income and households' high
indebtedness, banks are increasingly exposed to credit risk. Firms and households
are also vulnerable to increases in interest rates. The IMF was also concerned about
contagion because of the reliance of South African banks on money market funds
for short-term wholesale funding, as well as their active trading in the over-thecounter derivatives market. Furthermore, the susceptibility of South Africa towards
contagion has been exacerbated not only because of the high level of concentration
in the market, but also the extensive expansion into SSA. These vulnerabilities were
confirmed when African Bank was placed under curatorship in August 2014 after
record losses from unsecured lending. While the systemic implications were not
disastrous, this still had a significant impact on the financial system as a whole,
resulting in a downgrading by the major ratings agencies. Nevertheless, the FSAP
report confirmed that stress tests to severe shocks resulted in good capital resilience
by both the banks and insurance companies, albeit that the tests also indicated a
vulnerability to liquidity shortfalls. In its recommendations, the 2014 FSAP report
placed emphasis on:
150
151
ough the World Bank was established to fill the financing disparities left by
1vate capital markets, it is at present primarily responsible for structural and
,verty assessments in member countries. 67 The very core of the World Bank's
ission is to reduce global poverty and increase economic growth. It is therefore its
sk to finance growth-enabling investment in poor countries. Roads, bridges, wells,
mmunication systems and health systems are all typical projects that are funded
part of its quest to reduce worldwide poverty. 68 The World Bank is also concerned
ith debt relief, the transfer of financial resources and general economic
evelopment. particularly in developing countries.
As a result of several economic crises experienced by a number of countries
ring the 1980s. World Bank loans started to move beyond the Jinancing of
ecific development projects and it directed the majority of its efforts towards the
ontentious activity of policy-based lending (that is, attaching conditions to loan
isbursements). Similar to the IMF's economic austerity conditions, this gave the
'orld Bank influence over how loans were spent and consequently put them in a
rime position to ordain the conditions of development policy discourses. 69
urrently the World Bank officially offers investment loans and development policy
oans. with the former meant for economic and social development projects and the
atter to provide fast disbursing financing to support policy and institutional reforms
within countries. 70 Both types of loan have conditions and requirements for
omestic economic restructuring. Its track record shows that the World Bank's
main intervention has been long-term loans and technical assistance which is
intended to enhance the financial sectors of various developing countries. 71 In the
recent past, the Bank's policies and programmes have chiefly been aimed at sector
restructuring, privatisation and legal reform .
The World Bank's decision-making procedures are officially determined by
article V, section 3(6). which decrees that all matters will be decided upon by a
majority of the votes cast by its 182 members. This is based on the 250 votes held by
each member plus an additional vote for each share of stock held. Formal power at
the World Bank rests in the hands of its member states, which are represented on
the Board of Governors, the ultimate policy makers at the World Bank. This body
delegates decision-making to its Executive Board, a 24-member body that decides on
project proposals and reviews the World Bank's policies. 71 The president of the
World Bank chairs both the Board of Governors and the Executive Board on which
.2 The World Bank
ould be noted that the FSAPs consider the stability of the financial system as
ole and not that of individual institutions. Through its FSAP assessments and
~ssisting with financial policymaking, the IMF contributes to make its member
ntries' financial systems more stable by identifying key sources of systemic risk
acilitating the implementation of policies that enhance their resilience to shocks,
.cmic risk and contagion effects.
uthoritics needing to promote a more competitive financial system for greater
efficiency.
Chapter 5: The Development and Internationalisation of South African Banking
Bank Management in South Africa -A risk-based perspective
CONCLUSION
The South African banking industry has had an astounding evolution fro
primitive agricultural financing-orientated beginnings in the late 1700s to a first
class financial system with sophistication and depth that has played a leading role in
the global banking environment since the 1990s. It was significantly tested by the
GFC and proved to be surprisingly resilient when many other advanced economy
financial systems imploded. The initial influence of international banks translated
into establishing a financial system where leading South African banks became
globally competitive, despite the isolation years during apartheid. With economic
liberalisation in the early 1990s, different types of international bank
representation have emerged as part of the globalisation of banking, which has
created a range of approaches for South African banks to internationalise their
, banking operations. This eventually ranged from foreign subsidiaries and Greenfield
developments to shell branches. Rapid acceleration in financial globalisation and
the ensuing GFC has created both challenges and opportunities as South African
banks were exposed to an interdependent financial world of financial innovation,
securitisation, systemic risk, contagion and convergence as neoliberalism
, proliferated. All this happened while they were dealing with a new domestic context
5.6
they have the casting vote in case of a tie. As the live largest shareholders of
World Bank, the US, UK, France, Germany and Japan each appoint an Execu
Director and the rest are elected by the other member governments every two ye
The reason developed countries hold a clear majority within the World Ban
because the amount of stock depends on a member's relative economic
financial strength. Thus, as with the IMF, the World Bank is also controlled by
wealthiest member states through weighted voting.
The World Bank currently funds four large operations in South Africa: the Esk,
Investment Support Project (US$3.75 billion); the lsimangaliso Wetland Park proj
(US$9 million); the Renewable Energy Markel Transformation project (US$6 milli
and the Clean Technology Fund of the World Bank (US$250 million). 75 It also fu
more than 20 smaller projects across South Africa. The World Bank (together wi
the Basel Committee) shares the G20 leaders' endorsement of financial inclusion a
pillar of the global development agenda. Hence enhancing financial inclusion is hi
on the World Bank's priority list for South Africa's banking industry. It provid
assistance to banks with regards to creating synergies between financial inclusio
financial stability, financial integrity and financial consumer protection (or its s
called I-SIP objectives). In its view there can be no long-term stability witho
76
inclusion. As such. a more diversified, stable, retail deposit base increases system
stability. It further adds to greater political legitimacy and thus decreases the risk
political and social instability (by improving general economic stability). Becau
there are also very often trade-offs between inclusion and stability (and integrity an
consumer protection), the World Bank assists banks in creating positive synergies an
helping them develop policies that facilitate this objective. It also plays a key role a
mediator between banks and the government as far as financial policy formulation i
concerned.
152
153
e greater emphasis had to be placed on financial inclusion and banking the
nked. Demonstrating the efficiency and forward thinking ability of the South
an financial sector, they proactively engaged government on this matter, which
'1tually culminated in the drawing up and implementation of the Financial
or Charter.
'
The 'invasion' of Africa by South African banks continues to this day at a steady
particularly since local banks are more familiar with local circumstances than
-African foreign banks, and also because they view African markets as being truly
pped. While their operations are certainly profitable, such investments are also
al to revitalising the continent within the context of the African Renaissance, the
an Union and the integration and deepening of African financial markets. 54
arch confirms that the presence of foreign-owned financial institutions has the
ntial to enhance the efficiency of the local banking system. It often leads to riskring, liquidity provision and the improvement of the quality, pricing and
ilability of financial services, both directly by service providers and indirectly,
ough heightened competition. 72 This, however, needs to be balanced by the fact
1t although greater competition will increase cost efficiency, constraints imposed on
,nks to take part in alternative investment decisions might increase cost inefficiency.
Moreover, the globalisation of banking also contributes profoundly to the
nsmission of shocks across markets and on the effectiveness of policy tools
plied at home and abroad. 6 As was seen during the GFC - even in Africa - foreign
uidity conditions impact on both foreign-owned banks and local stand-alone
nks. but in differing degrees, This typically depends on their exposure to crossorder funding and to the capital markets that include the MNBs (or network of
anks) wherein they operate.
Key developments and dynamics in African banking are the growing presence
China and India, not only as trade and investment partners, but also as financial
rvices providers - either through direct branches or in acquiring stakes in leading
frican banks (as seen with Standard Bank). Another development is the rapidly
iminishing credibility of neoliberal economic policies and approaches after the
FC. 70 The past decade has evidenced a radical shift in the world economic and
olitical order as China has surged forward despite the GFC. The rise of East-South
'elationships in preference to North-South relationships, and more precisely the
emise of Europe and North America's domination over Africa. presents a new era
f how Africa will open its markets to foreign participation. This is something South
frican banks have to take cognisance of, especially in view of the emerging search
or a stable. post-liberal world and the liquidity requirements of Basel III.
Given the South African banking industry's progress with regards to black
conomic empowerment, a number of smaller banks have emerged as key players
that cater for the needs of entry-level banking. These banks might be the 'next big
inove' for South African banks northward as they are fittingly geared for Africa's
unbanked and favourably raise the competitive stakes in African banking. Overall,
South African banks have ample opportunity to expand into Africa, particularly
with the contribution that technology can make to efficiency and to expanding their
reach through mobile banking, thereby improving market accessibility.
Chapter 5: The Development and Internationalisation of South African Banking
Bank Management in South Africa - A risk-based perspective
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Chapter 5: The Development and Internationalisation of South
African Banking
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Integrated reporting as a basis for organisational risk assessment
ORGANISATIONAL REPORTING FRAMEWORK
iven the current turbulent and dynamic economic times that banks have both caused
and been a part of in recent decades, the management of risk from an organisational
rerspective has become an extremely important area of focus. As a result, the concept
adopting an enterprise-wide risk management (ERM) framework has become an
tegral part of organisational structure design. ERM refers to a holistic and integrated
anagement and reporting approach that recognises the interconnectedness of
',2
information era in which we live has changed the way the world gathers
rmation. This information, however. is not always credible given the proliferation of
ns of contributing to the information highway. Society on the whole is therefore
with the problem that the integrity of information cannot be verified, as it has not
ys come from credible sources. For this reason, and in the interests of protecting all
evant stakeholders, the quality of reporting for companies has become an important
d comprehensive source of information. Reporting requirements are becoming more
;orous and companies are increasingly being forced to be transparent about their
ancial and environmental impact.
,
This chapter provides a discussion on the integrated reporting frameworks
mpanies have at their disposal and applies it to the South African context. Following
is is a discussion on the typical integrated reporting frameworks within a bank.'
INTRODUCTION
reading this chapter, you should be able to:
entity and discuss the relevance of integrated reporting to enterprise-wide
isk management
discuss the three main sections of an integrated report
name and discuss the seven main disclosure categories in integrated reports
identify the standards and guidelines related to sustainability reporting around
the world
establish the relevance of corporate social respof)sibility to integrated reporting
identify and discuss the main differences that a bank's integrated report has
compared with other companies
identify and discuss the main disclosures found in the integrated report for a bank
. identify and discuss the main disclosures found in the notes of financial
statements for a bank.
NING OBJECTIVES
Reporting for Banks
6.2.2 The structure and content of integrated reports
6.2.2.1 The three main sections of integrated reports
The main source used for the content of an integrated report in South Africa is found
in the King III Code on Corporate Governance and the Global Reporting Initiative
different risks and establishes clear organisational reporting structures that are ai
providing processes and policies to manage these risks.
Although ERM is discussed in detail in Chapter 9, it is important to under
at this stage, that the risks faced by a bank are interconnected. This means
management is required to adopt an organisational approach that takes
account the interconnected and thus integrated nature of risk. It is important
the reporting of risk be as comprehensive as possible so that the public is awa
the risk exposure faced by a bank. Integrated reporting encompasses a ho!
approach that covers the entire operations of a company and the report ai
integrate all the facets of the business in which a company is involved in ord
provide a comprehensive source of information to stakeholders such as invest,
analysts, employees, clients and governmental organisations. It is not uncom
for banks to publish an integrated report of several hundred pages. However, in
day and age where information is ubiquitous, it is common practice for compa
to place their annual reports on their websites for interested parties to down!
rather than publishing such large and costly documents. The integrated report o
major bank is typically found on the company website under the 'Investor Relatio
section along with several other sources of bank information. These sources
include the financial results and annual reports which are listed separately alo
with information on the bank's credit ratings, its compliance to the latest Ba
Capital requirements, its sustainability reports and its BEE efforts to name a few.
Integrated reporting covers more than the elucidation of performance via t'
financial statements and accompanying notes. In recent times, investors have be
increasingly more concerned with the impact of a bank's operations on t
environment and in particular on the society in the broader context it operat
within. When a modern investor evaluates a company for possible investment, th
need to be assured that the bank conducts itself in an ethical manner, is driven by
sound value system and strong corporate governance structures. Triple bottom Ii
reporting that focuses on environmental . social and financial issues is an importan
element for inclusion in an integrated report as it allows the bank to indicate, on a
annual basis, how it plans to maintain or improve the positive effects its operation
have on society and conversely, how it plans to reduce the negative effects. A
important feature of any reporting is its forward-looking nature.
At the heart of integrated reporting is the notion that stakeholders are provided
with a comprehensive overview of the operations of a company in order to assess
the organisational risk environment. Given that investors in a particular company
were traditionally only interested in the economic value of that company, the
statement of financial position (balance sheet) and the statement of comprehensive
income (income statement) served as the main source of information.
What is included in a typical integrated report?
162 Bank Management in South Africa -A risk-based perspective
163
3 guidelines launched in 2006. With increased international focus on
tability. the G3 guidelines have been adjusted to place more focus on the
tires of an organisation's impact on its environment and its sustainability. This
d to the development of the G4 guidelines. which are applicable to all
nability reports after 31 December 2015. Where traditional annual reports
e only the directors' report and the audited financial statements, an integrated
includes a third component. which focuses on non-financial information.
·n general the three main components of an integrated report are:
be directors' report
he directors' report should be seen as a commentary on the economic value of
e company and allows stakeholders the opportunity to gain insight into the
ompany's plans to create value for the stakeholders. The Chief Executive
fficer (CEO) usually provides a brief overview of the company and its
chievement over the year. The directors' report can also include an assessment
f the key risks faced and how the directors plan to remedy or mitigate them. In
:a·ddition, the report needs to disclose whether or not the company is expected to
l,e a going concern in the coming financial year. If there is a question about the
going concern status of the company, the Directors should disclose their plans
"to rerrtedythe situation in the coming financial year.
•• The audited financial statements
The audited financial statements typically include the statement of financial
position (formerly the balance sheet). the statement of comprehensive income
(formerly the income statement), and the cash flow statement, along with the
accompanying notes of each of these. These are the requirements as stipulated
by the International Financial Reporting Standards (IFRS) (refer to Chapter 7).
Non-financial . and sustainabilit y reports
The remainder of the integrated report focuses on non-financial information
and sustainability. Non-financial information is typically part of the
sustainability report and should include information about the company's
plans to improve the positive aspects and remedy the negative aspects of its
business operations in the coming year. This allows the stakeholders to make
informed decisions based on the economic value of the company and typically
includes the following: 1 •2
The disclosure of how the company generates its income from both
favourable and unfavourable factors that impact on business operations.
This is done by addressing the strategy, organisational profile and reporting
parameters of the company.
Reporting should be done across all areas of the organisation and include
the choices that the Board of Directors (Board) has made to reach the
strategic objectives.
The disclosures must reflect the impact of decisions on the triple bottom line
- that is, the economic, social and environmenta l.
In compiling the integrated report the Board must keep I.he principle of
transparency in mind. This includes non-financial information that is
critical to the stakeholders' understanding of the key issues affecting the
Chapter 6: Integrated Reporting for Banks
company. These key aspects include governance of
commitments to sustainability and stakeholders and
stakeholders and the environment.
The integrated report must address the key performance indicators o
company. These indicators address economic performance, environm
performance, social performance, human rights, and society and pr
responsibility.
Bank Management in South Africa - A risk-based perspective
Tl,e se11en mai11 disclosure categories in integrated reports
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6.2.2.2.2 Organisational profile
Table 6.2 contains a list of all disclosures relating to a company's operationa
profile. It may be that the operational profile is shown with the strategic aspect
mentioned above. Reporf:ing on the organisational profile typically includes th
name of the company, the distribution networks (branches), descriptions of suppl
chain management, markets served, location of the company headquarters and s
on. The information presented in the organisational profile can be used by investor
to gain an understanding of the company within the industry in which it trades.
Source: Compiled from GR! G3 Guidelines (2006) 3 and GR! G4 Guidelines (2013) 4
Key outcomes in terms of capitals
Key outputs
Key business activities
Key inputs relating 10 capitals
Key impact ol risks and oppor!unities
Overall vision and stralegy for ShOft, medium and long term
Statement from most senior decision-maker of organisation
about the relevance of sustainability
:.:.Strategy, analysis and business mode
Table 6.1 Strategy, analysis and business model aspects in an integrated report
6.2.2.2.1 Strategy, analysis and business model
Table 6.1 contains a list of all disclosures that relate to the strategy and busi
model of a company. The reporting on these aspects typically includes
management, vision, key business activities, outputs and a statement by the
senior decision-makers, such as the CEO and CFO. on the sustainability of
company.
6.2.2.2
When providing an annual report, there are seven main categories of disclO
that are typically included. Although there is no stipulation as to the location
these disclosures in the report, the following tables indicate where the informatio
most likely to be placed. From a reporting perspective, what is important is that
information is included.
164
ol abovementioned
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Reporting parameters and material aspects
'he reporting parameters and material aspects contained in Table 6.3 provide
formation related specifically to the annual financial reporting year, the list of
tities which form part of the group (if group structure applies), the process that
e company follows in order to identify what to include in the integrated report,
ow the company goes about identifying which entities to classify as joint ventures
r subsidiaries, and any other material aspects that the company may deem
.important to investors. These other aspects cover items within and outside the
immediate control of the company.
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-lntegm!ed report
>Financlalstatements
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165
\Directors' report
urce: Compiled from GRI G3 Guidelines (2006) 3 and GRI G4 Guidelines (2013) 4
of Iota! employees covered by coHer:tive bargaining
ion of employees are
sell-employed
,n
1n broken down in terms of debt and equity
lnaFprofile·
Chapter 6: Integrated Reporting for Banks
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Financial statements .
Governance, com111itme11t and engage111ent
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, •• , • • • .-...
The governance structures of the company, along with the purpose, values and
.strategies are important given that investors are becoming increasingly interested in
the highest decision-making and governing bodies within organisational structures.
6.2.2.2. 5
Source: Compiled from GR! G3 Guidelines (2006) 3 and GRI G4 Guidelines (2013) 4
Key topic and concerns raised through stakeholder
engagf!ment
Approach lo stakeholders engagemenl
Basis far identification of stakeholders groups
Lisi of stakeholder groups
Stakeholder engagement
Table 6.4 Stakeholder engagement aspects in an integrated report
With the increased international focus on stakeholders during the Global Financia
Crisis (GFC), it has become crucial for companies to maintain and foster thei
stakeholder relationships. The importance of these relationships is recognised in the
King III Report on Corporate Governance Principles, which requires that
stakeholder relationships (and their management) be a permanent item on all Board
agendas. Table 6.4 contains the requirements that need to be disclosed in the
integrated report in terms of the management of stakeholder relationships.
6.2.2.2.4
Source: Compiled from GRI G3 Guidelines (2006) 3 and GRI G4 Guidelines (2013) 4
Materiality of aspect oulside \he Ofganisauon
Material!ty of aspect within the organisation
Significanl changes to previous financial statements
Explanation of effect of res1a1ement of previous financial
statements
Basis fOf reporting on subsidiaries, joint ventures, etc
Boundary of the report (countries, divisions, subsidiaries, etc)
Process for delining report contents
List material aspects identified in the process ol delining
content
Cootacl point for questions regarding reporting
Reporting cycle, ie annual
Date of most recent re(X)rt
Reporting period
Explain implementation of Reporting Principles Jor Defining
Aepon Content
Any entities not included in the integrated reJ)Ol1
List of entities included in consolidated financial statements
Directors' report . I Financial statements •
Reporting parameters and material aspects and boundaries in an integrated
report
Reporting parameters and identified material
aspects and boundaries ••
Table 6.3
166 Bank Management in South Africa -A risk-based perspective
amg co
onmental and SOC1d
The mle ol the highest governance body in sustainability
reporting
Frequency of gOV1:!rning body's review of risks
management processes
Governing body's role in reviewing effectiveness of rtsk
Stakeholder consultation in identification in risks
of risks
Governing body's role in idenlification and management
The role of the nighest governance bOdy in risk management
Actions in response to evaluation
Processes ol evaluation ol pertormance in terms of
eoonornie, environmental and social topics
Measures taken to develop and enhance goveming body's
collective knowledge
Competencies and pertocmance evaluations ol the highest
governance body
Governing body and e)(ecutives role in development,
approval and uixtattng of purpose, values, mission
statements, strategies and goats
Role of the highest governance body in setting purpose, values
and strategy
Report on ensuring conflict ol interest are avoided and
managed
and committees
Report on the nomination and selection processes ol board
ts the Chair of the governing body also an executive officer?
Composition of the highest governing body including
executive vs non-executive, independence, tenure, number
of other significant positions held, gender, membership
of underrepresented social groups, competence and
stakehotder representation
Process for consultation between stakeholders and the body
responsible for social. economic and environmental topicS
Appointment of executive-level positions responsible foc
social, economic and environmental topics
Process of delegation for authority in terms of economic,
environmental and social topics
'impacts
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Pltld
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""Diti!Clors'repott:_I FIHarieiiiHltatements 11nte!)rat!ld report •.
Governance, commitments and engagement aspects in an integrated report
:disclosure gives rise to transparency as well as trust in the management. The
petence of the members of the governing body as well as the role they play in the
management process of a company are the main drivers in the decision-making
i;ess of investors. Table 6.5 contains these aspects as well as additional information
ut the company's involvement in sustainability and its remuneration policy.
Chapter 6: Integrated Reporting for Banks
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~rectors' ;~P~rt :,-1 •Financial_statements ~
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6.2.2.2. 7 Management approach and performance indicators
The final category in the integrated report deals with the company's performance
indicators for sustainability. This section usually includes a discussion on economic
performance, environmental sustai.nability and performance. social and human
rights, societal impact, product responsibility and labour practices. The majority of
sustainable disclosures forms part of this section and often stipulates management's
approach to ensure that sustainable practices will be followed. Table 6. 7 contains.
examples that management can consider when reporting on their management
approach and the sustainability of the company.
Source: Compiled from GR! G3 Guidelines (2006) 3 and GR! G4 Guidelines (2013) 4
Internal and external mechanisms fOf' re~ing concerns in
terms of unethical or unlawful behaviour
Values, principles, standards and norms of organisation.
ie codes of ethics
Ethics·and integrity
Table 6.6 Ethical and integrity aspects in an integrated report
6.2.2.2.6 Ethics and integrity
Good corporate governance principles require management and the Board of
company to be model corporate citizens and manage the business with integrity and it
an ethical manner. 3 Ethical leadership is important to invest.ors and a company need
to disclose its commitment to such behaviour. Table 6.6 contains examples of aspect·
that a company might include in the integrated report in terms of ethics and integrity.
Source: Compiled from GRT G3 Guidelines (2006) 3 and GR! G4 Guidelines (2013) 4
to median of compensalion for all employees
Ratio of annual total compensation al highest paid individual
Stakeholders' view in determining remuneration
Process in determining remuneration
PerfOl'mance criteria in terms of remuneration policy
Retirement benefits
Clawbacks
Termination payments
Sign-on bonuses
Fixed and variable pay
Remuneration policies for governing board
Remuneration and inceittives
Nature and total number of concerns tile were
communicated
Process for communicating critical concerns
The role of the highest governance body in evaluating
ecooomic, environmental and social performance
sustainability report
Highest committee or position who review and approved
Directors' report
Bank Management in South Africa -A risk-based perspective
Governance, commitments and engagement
168
169
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Child labour
Forced and compulsory labour
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Grievance mechanisms for impact on society
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Custom~r health and safety
Product and service labelling
Marketing communicalions
Product responsibility
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Anti•competitive behaviour
Supplier assessment for impact on society
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Compliance
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Corrupl~n
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Supplier human rights assessment
Human rights grievance mechanisms
Community
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Indigenous rights assessment
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Freedom of association and collective bargaining
Security practices
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Investment and procurement practices
Diversity and equal opportunity
Noo·discrimination
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Training and education
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=
.Financial:statements Jntegmted report
Occupalional health and safety
•it' ,;Directors'.report
Labour/management relations
Env\ronmental grievance mechanisms
nt approach to malerials, energy, water,
emissions, waste, prollucts and services,
~~nee, transport, etc
·::';':a~...
Management approach and performance indicator aspects in an integrated report
Chapter 6: Integrated Reporting for Banks
Compliance
Customer policy
Employrnenl
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SUSTAINABILITY REPORTING
In addition to these, Germany issued the German Commercial Code in 2013 and
revised it in 2015, 9 Norway issued a White Paper on CSR in 2009 10 and Denmark
passed a law on CSR in 2012. 11
In keeping with international trends, the Johannesburg Stock Exchange (JSE)
launched the SRI index in 2004. This index was the first of its kind and allowed both
current and prospective investors listed on the JSE to judge the integration of
international principles of corporate social responsibility in the policies and
procedures of listed entities and to assist investors in looking at non-financial risk
variables in the decision-making process. 12 The index is based on the concept of
Several standards and guidelines exist across the world for sustainability reporting
These include:
■
the Global Compact and Principles for Responsible Investment (PRI) focusin
on ESG, supported by the United Nations in 2006 6
■
the Green Paper for Corporate Social Responsibility issued in 2001 7 by th
European Union
■
Organisation for Economic Cooperation and Development (OECD) published the
Guidelines for Multinational Companies in 2006 18
■
the Swedish government issued the Global Reporting Initiative's (GRI) G3
guidelines in 2006 9
The concept of sustainability has been relevant for several years although in
times there have been significant international changes and developments in th
reporting thereof. Sustainability reporting and corporate social responsibility (CSR
are so intertwined that the terms are often used interchangeably.
6.3
Tables 6.1 through 6. 7 can also be used as a checklist to determine which aspe
are applicable to a company and should therefore be included in the integrat,
report. Some of the aspects may not be applicable, but as part of being a responsi
corporate citizen, comprehensive disclosure is better than being sketchy.
Source: Compiled from GR! G3 Guidelines (2006) 3 and GRI G4 Guidelines (2013) 4
Labour practices grievance mechanisms
Supp!ler assessment for labour practices
EQUal remuneration for woman and men
Diversity and equaJ opportunity
Training and educalion
Occupational health and safety
Lalxlur/management relatioos
Directors'}'8po,t_j_!l_nanci81:_statements}:
Bank Management in South Africa - A risk-based perspective
labour practices and decent work
170
171
6.1 The impact of business on society
bottom line reporting, as introduced by the King II Report in 2002.13 The
bottom line concept is also referred to as the 'people planet profit' concept,
r implies that a balance be struck between the interests of the community
le), the company (profit), and the environment (planet). According to the JSE
ndex the best performers, as far as sustainability reporting for 2012 is
rned, include companies such as the Bidvest Group, Santam Ltd, Old Mutual
nd Standard Bank Ltd.1 4 The 2013 list of best performers includes Anglo
rican Platinum Ltd, Illovo Sugar Ltd, Nedhank Ltd, Standard Bank Ltd,
nhoff International and the Vodacom Group Ltd. 15 The 2014 list includes Anglo
erican· Platinum Ltd, Standard Bank Ltd, Barloworld, Ilovo Sugar Ltd, Lonmin
'Netcare Ltd, Royal Bafokeng Platinum and the Vodacom Group Ltd. 10
Corporate social responsibility (CSR) refers to how ethically companies are
naged when creating wealth, not only for the company itself but also for all
keholders of the company. Companies are required to report on the quality of
ir management (see Figure 6.1) of both people and operating processes. They
d to report on the nature and extent of their impact on the market, workplace,
ironment and community, as well as including a plan for bow they aim to
hieve this element of the overall strategic and risk management practices of the
tnpany. Upon achieving this, companies are seen to be good 'corporate citizens'.
Chapter 6: Integrated Reporting for Banks
Bank Management in South Africa -A risk-based perspective
Although there is no officially accepted framework or structure that banks must us
when compiling an integrated report, there are similarities in what type of material i
included in the report. That means that one might come across the integrated report
of two different banks that do not necessarily have the same structure. Where the
are located on the bank's website is also not always consistent. For the most part,
however, there is some conformity regarding the content.
The following section provides an overview of the typical elements reported on
·by South African banks, with a brief description of what is included in each section.
6.4 A TYPICAL INTEGRATED REPORT OF A BANK
Given the discussion above, what information is actually included in the inte
reports of banks? This is a particularly pertinent question given the unique n
of banking and the specific regulatory requirements according to the Banks Ac
of 1990) and the Basel Capital Requirements (see Chapters 3 and 15 respective!
The information disclosed in the integrated report provides stakeholders
an opportunity to assess the environment facing the operations of the bank.
better the quality of information the better the assessment of risk faced by the
There are several benefits for banks (and companies in general) that use integr,
reporting including:
■
The risk environment within which the bank operates is reflected through
operational and organisational structures, which are organised to iden
assess and manage risk.
■
Shareholders can compare annual reports of different banks in order to ch
the best investment opportunity.
■
Equity analysts consider sustainability and integrated reporting when valu'
and rating banks.
■
Higher credit ratings are normally given to banks that have sustainabili
strategies in place.
■
It improves transparency and promotes a more effective risk management (a
assessment) environment.
■
Integrated reporting allows banks themselves to identify sustainability-rela
opportunities for growth and cost containment.
■
Stakeholders are better able to holistically assess the future growth pat
envisaged by the management of the bank.
■
A properly prepared integrated report holds compliance benefits to banks such
complying with environmental laws and 'green' product development. This i
turn has positive reputational effects, especially with regards to environmen
lobby groups.
In order to be a good corporate citizen a company is required to disclose
items on sustainability as part of the integrated report. This disclosure will
less litigation, less resistance from stakeholders and a better public image an
in turn, will streamline processes and thus improve the operational efficien
companies.
172
173
Risk management report
he risk management report is usually one of (if not the) most comprehensive
ection in the integrated report of a bank for several reasons:
Risk management is the core business of banking.
The GFC starting in 2007 has changed the risk landscape, especially with
regards to the reporting thereof.
Basel II and III require banks to disclose their risk identification, quantification
and mitigation more comprehensively than ever before.
Banks are required to be more transparent about how they deal with risk.
.4.4
n the problems related to corporate governance in the lead-up to the GFC, the
ality of governance within a bank has become a priority for both regulators and
cutive management. The corporate governance report provides a detailed overview
the processes and structures the bank has in place to ensure that sound corporate
ernance occurs. The integrated report would typically elaborate on the structure
within the bank in terms of lines of authority and reporting, from the Board to
various custodians of corporate governance within the bank. For example, the
ort typically provides brief commentaries on the role and performance of the
uneration, audit and ethics committees and the policies they enforce.
A thorough description of the members of the Board is often provided as well as
e identification of non-executive directors, executive directors or independent
n-executive directors. A list of the year's Board meetings and attendance registers
included as well as the qualifications and internal and external directorships
eld by the various Board members.
,3 Corporate governance report
integrated report is usually followed by a report from each of the respective senior
'tors within the bank, typically including the Chairman of the Board of Directors
oard) and the Chief Executive Officer. It is not uncommon in recent years for
members of executive management including the Chief Financial Officer, Chief
ations Officer and the Chief Economist to provide their assessment and
ctions for the banking environment. The commentary provided is an extremely
ibrtant section of the report as it gives a sense of the issues the Board and executive
nagement are dealing with, specifically from a strategic point of view.
Director and executive management reports
troduction section usually provides a brief overview of the bank in terms of
nd and general operations, whether domestically or internationally. The
n and vision of the bank are provided within the context of its strategic focus.
he bank will include human resource or operational highlights (such as
s) in this section. Usually there is a select list of salient performance indicators
rovide a brief analysis of how well the bank has performed during recent
. Often these performance indicators are benchmarked according to a
termined target or projection previously imposed by the bank.
Introduction and general overview
Chapter 6: Integrated Reporting for Banks
Capital management report
Divisional (operational) revi
ews
Wh ethe r or not the ban k is part
of a group, the different division
s functioning
within the ban k are discussed.
This would typically include a
brief com men tary of
the year's performance and futu
re outlook by the divisional head
. The different
divisions usually include retail,
commercial and corporate ban
king. This section is
6.4.6
Complementary to the risk man
age men t repo rt is the capital man
age men t repo
According to Basel III, banks are
required to provide their Common
Equity Tier
(CETl), Tier 1 (Tl) and Total Cap
ital ratios (TCR) and these mus t
be above min imu
pre-specified values set by the
SARB in accordance with the
BCBS requ irem en
Excluding the bank-specific indi
vidual capital requ irem ent (wh
ich may not b
disclosed publicly), the min imu
m capital ratios for CETl, Tl and
TCR at the end o
201 5 were 6.5%, 8% and 10%
respectively (see Chapter 15). The
ability of the ban
to meet and exceed these (alt hou
gh not too excessively) is discusse
d in the capita
report. [n addition, the repo rt con
tain s details of the methodologies
used to quantify
these ratios and risk-weighted asse
ts are also provided.
6.4.5
The first part of the risk man age
men t repo rt usually highlights
the risk a
cult ure and strategic app roac
h to risk and is usually acco
mpanied by
governance stru ctur e that delineat
es the organisational lines of auth
orit y rega
the man age men t and own ersh ip
of the various risks. This is an imp
orta nt depa
point as it provides the read er
with an idea of the degree and
willingne
man age men t to engage in risky
activities. [t sets the tone for the
philosophy of
man age men t. Banks typically
follow a risk governance fram
ework that has t
levels (or lines of defence) of con
trol (see Chapter 9 for a furt her
discussion on t
■
Lev el one con trol : bus ines s
uni ts
The various business units resp
ectively take ownership of the
risk environ
they face .
• Level two con trol : risk man age men t pol icie s
The business unit man age rs are
supported by the various risk
man age
processes and policies in place
and typically adopt an enterpri
se-wide appr
to risk man age men t approach.
• Level thr ee control.: aud it and exte rna l
The aud it function and inde
pendent exte rnal assessments
are essential
ensu ring that the risk man age men
t in place is effective and adequate
.
Following this, ther e may be the
inclusion of a thor oug h discussi
on on the performa
of the bank with regards to the
various risks to which it is expo
sed. These typica
include interest rate. credit, cou
ntcrparty, strategic, reputational,
market, fore·
exchange (and sovereign), equi
ty, operational, liquidity and regu
latory risk. The r
man age men t repo rt sets out in deta
il how these risks are man age d and
quantified a
provides the latest figures that have
to be compliant with min imu m
requirements
by the Sou th African Reserve Ban
k (SARB) and /or the Basel Com
mittee on Banki
Supervision (BCBS).
174 Bank Management in Sou
th Africa - A risk-based perspect
ive
175
Inte rest inco me and inte rest
Interest income includes all the ex1>ense
activities in which the ban k gen
erates interest
income and would typically high
light. the loan (or advances) mix
to which the
ban k is exposed. Similarly, inte
rest expense includes all the
activities that
generate interest expense and
would provide all deposit (and
non-deposit)
borrowings to which the ban
k is exposed. Analysts are able
to get a good
indication of the inte rest con trib
utio n of the various types of loan
s and deposits
to the overall net interest income
of the bank. These activities typi
cally reflect
the activities inhe rent in the ban
king book and specifically the
intermediation
function of the bank.
.Loans (ad van ces)
The assets include all cash, inve
stments and non-movable prop
erty, but by far
the largest com pon ent is the loan
book, which is usually broken dow
n into four
categories:
segment, such as retail. commercial
. corp orat e banking, etc
product, such as overdrafts, mortgag
e loans, term loans, etc
sector, such as retail, agriculture,
min ing
geographical location, according to
either cou ntry (South Africa, Afri
ca, North
America, etc) or region (Gauten
g, Western Cape, Kwazulu-Natal.
etc).
For an analyst, the breakdown
of the asset book is essential to
assessing the
quality of the loan book, espe
cially with regards to the like
lihood of non performing (impaired) or deli nqu
ent loans going forward. For
this reason a
breakdown of impaired loans is
usually also provided in the note
.
Lia bili ties (dep osit s)
The deposit book reflects the fund
s the ban k acquires in order to
make the loans
it provides. As with the loans,
they arc usually disclosed in the
four categories
segment, product, sector and geo
graphical location.
tiancial statements include the
stat eme nt of financial position
(SFP, previously
n as the balance sheet), the stat
eme nt of profit or loss and othe
r comprehensive
·. e (SPL. previously known as the
income statement), the stat eme
nt of changes
ity, the statement of cash flow, and
notes on each respective financia
l statement.
uditor's report and secretary cert
ification report is also usually
found in this
n. For a thor oug h discussion on
these financial statements, refe
r to Chapter 7.
otes on the SFP and the SPL are
particularly informative as they
delve deeper
the detail of the respective item.
For banks in particular the note
s in the SPL and
provide a lot of valuable info
rmation that can assist stakeho
lders to better
stand the environment in which
the ban k functions.
:Annual financial statements
and notes
ant in establishing the business
model of the ban k and in part
icular,
ring how different divisions arc
performing relative to one another
.
Cha pter 6: Integrated Reportin
g for Banks
Non-interest income and non-intc1·cst expense
The non-interest income includes all those activities that generate re
from sources that are neither lending nor deposit-taking in nature. In
words, non-interest income includes the income generated from activities
as fees and commissions (cash deposit, brokerage, bank charges, know
fees) and income derived from insurance-rela ted activities. The acti
highlighted in the non-interest income note reflect the intent of bank
diversify into revenue streams that are non-traditiona l, especially those rel
to insurance. The non-interest expenses refer to those typically found in
organisation including salaries, stationery, maintenance, etc.
Bank Management in South Africa - A risk-based perspective
6.5
CONCLUSION
This chapter has highlighted the fact that integrated reports provide a wealth o
information to stakeholders that allow them to make informed judgements about th
bank. One only has to compare an annual report of two decades ago with one of toda'
• and you will notice that. in its published form, it has increased in size, in most cases b
more than ten times. This is the result of an ever-changing economic and operatin
• environment that has both domestic and international clements. By implication, ris
on':lt
6.4.10 Sustainability report
Although often produced as a document separate to the actual annual report due
its sheer size, the sustainability report provides an assessment and overview of t
bank's CSR and sustainability initiatives. In particular, banks will publish t
impact their operations have on the economic (profit-related), environmen
('green'-related ) and social (impact on people, including employees, clients an
communities) spheres of society. National and
n.,:,
standards are often used to gauge their effectiveness.
6.4.9 Shareholder information
The shareholder report provides all the shareholders of the bank as well as on whi
stock exchanges the bank is listed. The notice to the most recent annual gener
meeting is also included and any resolutions decided upon.
6.4.8 Definitions and abbreviations
A list of definitions will be provided if a bank feels that it needs to clarify its mean
of a certain concept. An example of this is reputation risk. Given the fact t
reputation is very company-specific, the business activities that lead to reputati
effects can be totally different from one bank to another. For this reason, it m,
sense to provide a formal definition from the viewpoint of the bank that clari
this. Abbreviations used by the bank can also be included for ease of use.
The breakdown of the bank's revenue sources in the notes is vitally importati
understanding the business model of the bank, especially with regards to the stra
to focus on traditional banking activities (net interest income) and non-traditio
banking activities (those related to insurance as part of non-interest income).
..
176
177
stitute of Directors. 2014. 1'he King III Report and Code on Governance in South
ifrica. Johannesburg. LexisNexis.
he International Integrated Reporting Council (IIRC). 2013. The lnteruationa/
'ramework. http://integratedreporting.org/resou reel in ternational-ir-framework/
Accessed 11 May 2015).
,lobal Reporting Institute (GRI). Sustainability Reporting Guidelines (G3 ). https:/ /
ww. globalreporting. org/ standards/G 3 andG 3-1 / g 3-guidelines/ Pages/ defau lt.aspx
(Accessed 16 February 2015) .
:Global Reporting Institute (GRI). Sustainability Reporting Guidelines (G4). https://www.
globalreporting.org/standards/ g4/Pages/ default.aspx (Accessed 11 May 2015).
Institute of Directors. 2014. King lI1 Report on Corporate Governance Principles.
LexisNexis: Durban.
Principles for Responsible Investment (PRI). 2012. The six principles. hltp:/ /www.
>unpri.org/about-pri/the-six-principles/ (Accessed 16 February 2013).
• Green Paper for Corporate Social Responsibility. 2013. http://europa.e u/
legislation summaries/employment and social policy/employment rights and
work organisation/n 26039 en.htm (Accessed 16 February 2013).
OECD. nd. Better policies for better lives. http:/ /www.oecd.org/corporate/mne/
. {Accessed 16 February 2013).
• • Deutscher Nachhaltigkeitskodex. 2015. The Sustainability Code. http://www.
deutscher-nachhaltigkeitskodex.de/en/application/downloads.html (Accessed
11 May 2015).
United Nations Global Compact. 2009. White Paper on Corporate Social
Responsibility. https://www.unglobalcompact.org/newsandevents/ncws
archives/2009 07 02.html (Accessed 16 February 2013).
Corporate Social Responsibility and Reporting in Denmark. 2013. http://
samfundsansvar.dk/file/358879/csr rapport 2013 cng.pdf (Accessed 16
February 2013).
2. Johannesburg Stock Exchange. 2014. SRI Index: Backyround and Criteria. https://
www.jse.co.za/content/TSERulesPoliciesandRegulationitems/13ackground%20
and%20Criteria%202014.pdf (Accessed 11 May 2015).
South African Institute of Chartered Accountants. nd. Executive Summary of the
King Report of 2002. https://www.saica.co.za/Portals/O/documents/executive
summary kingll.pdf (Accessed 16 February 2013).
Johannesburg Stock Exchange. nd. SRT Index Best Perjormers. https:/ /www.jse.
co.za/services/market-data/indices/socially-responsible-investment-index
(Accessed 16 February 2013).
Johannesburg Stock Exchange. nd. SRI Index Best Performers. https:/ /www.jse.
co.za/services/market-data/indices/socia]ly-responsible-investment-index
(Accessed 1 May 2015).
reased due to the complexity and innovation within financial markets and
have had to comply with regulations and legislation in both traditional and
ditional banking sectors. An integrated report therefore fulfils an extremely
nt role in ensuring adequate disclosure and transparency regarding the
operandi of a bank.
Chapter 6: Integrated Reporting for Banks
Bank Management in South Africa - A risk-based perspective
~ " - ~ - - - - ~ , - - c c . , 1 / _ f l.. ~ - - V
_,._
... ' . > .. :.-.-"< _ .• ,
16. Johannesburg Stock Exchange. nd. SRI Index Best Performers. https:/ /www.jse.
co.za/content/
TSEin dex Cons ti tuentsa nd Weightings Iterns/ 20 14S RIIn dexConstituentsbest
performers.pd[ (Accessed 11 May 2015 ).
178
2 FINANCIAL REPORTING IN SOUTH AFRICA
ior to the adoption of International Financial Reporting Standards (lFRS),
imparing financial statements posed major challenges to users from both a
mestic and a global perspective. Financial statements were prepared using
fferent accounting principles, measurement, recognition, disclosures and
gulatory requirements. In response to the need for a global accounting standard,
e International Accounting Standards Board (IASB) was established in 200 I. The
,jective of the IASB was to 'develop, in the public interest, a single set of highuality, understandable, enforceable and globally accepted financial reporting
andards based upon clearly articulated principles' . 1 South Africa formally adopted
e IFRS as its financial reporting framework in January 2005, becoming one of the
rst countries to adopt it. Subsequently, South Africa has played an important role
the evolution of these accounting standards.
The adoption of IFRS was believed to bring about conformity by harmonising
'egulations, accounting standards and financial statement disclosures for all countries
INTRODUCTION
e purpose of this chapter is to provide an overall understanding of the composition
a bank's financial statements. It is not intended to be a comprehensive analysis,
ly an overview. It outlines the reporting framework for both listed and unlisted
panics and provides a brief comparison between fair value accounting and
torical cost accounting. It also includes a brief overview of the typical items found
the linancial statements of a bank, specifically the statement of financial position
FP) and the statement of profit or loss and other comprehensive income (SPL).
reading this chapter, you should be able to:
identify the components of financial statements
identify and discuss individual items within the statement of financial position
of banks
identify and discuss individual items within the statement of profit or loss and
,Other comprehensive income of a bank
discuss the relationship between the statement of financial position and
statement of profit or loss and other comprehensive income of banks
discuss the accounting reporting framework that South African banks are
required to comply with
discuss the major differences between fair value accounting and historical cost
accounting.
ll.1""-0
"':ialReporting for Banks
Bank Management in South Africa -A risk-based perspective
The SCF provides invaluable information about the cash movements resulting
from operating, investing and financing activities. rilustrating this point, research
has consistently shown that the relationship between cash flow and total debt is
often a useful indicator of the financial health of a firm. However. for purposes of
this book the SCP will not be discussed; this chapter will focus primarily on the SFP
··and SPL.
The International Accounting Standard 1 - Presentation of Finan
Statements (generally referred to as IAS1J prescribes the basis for the presentat
of general purpose financial statements to ensure comparability both with
entity's own financial statements for previous periods and with the finan
statements of other entities. IASI sets out the overall requirements for
presentation of financial statements, with guidelines for their structure and
minimum requirements in respect of their content. IASI describes finan
statements as being 'a structured representation of the financial position
financial performance of an entity'. It further states that the objective of tin an
reporting is to 'provide information about the financial position, financ
performance and cash flows of an entity that is useful to a wide range of users
making economic decisions'. lt therefore follows that a typical set of financi
statements consists of the SPP (previously referred to as the 'balance sheet'), t
SPL (previously referred to as the 'income statement'), the statement of changes i
equity (SCE). the statement of cash flow (SCP). and notes to these stutements. 2
While the SFP is essentially a snapshot of the assets. equity and liabilities of th,
company at a specific date. the SPL, the SCE and the SCP present the financia
transactions for a period of time, normally a year. Financial statements provide a
account of the year's transactions and the financial position of the company at th
end of the year in question. While it is acknowledged that financial statements ver
often report extremely complex transactions, they do provide the user with crucial
information about the financial position, performance and cash flows of a particula
company, From a brief study of the finuncial statements, an inexperienced user
should, for example. be able to determine whether or not the assets exceed the
liabilities. the company has made a profit or loss, or cash flows for the year were
positive or negative. Further detailed analysis may provide the user with greater
insight as to the operations of the company and even possibly a prediction of its
future.
that applied them. Realising the potential advantages that the adoption of IFRS h
listed companies. the Johannesburg Stock Exchange (JSE) amended its
requirements to oblige all listed companies to apply IFRS in the preparation o·
financial statements. Following the ulmost worldwide adoption of IFRS
recognised accounting reporting framework, the IASB developed und published a
for Smull and Medium Entities (IFRS for SMEs) on 9 July 2009. South Africa was
again a forerunner by being the first country to adopt IFRS for SMEs as a rep,
framework. Although very similar to full IPRS. IFRS for SMEs is less complex and
cost effective for the SMEs to apply. Regardless of whether un entity is applying for th
IFRS or IPRS for SMEs. the basic accounting principles and content of the fina
statements remain the same.
180
---
XXX
XXX
J(J(J(
18
20
Trade receivables
Other currenl assels
Gash and cash equivalents
XXX
XXX
24
25
Retained earnings
Other components of equity
Non-controlling interests
XXX
XXX
IO()(
22
23
Share capital
XXX
-
-
XXX
XXX
15
16
Inventories
XXX
XXX
12
Investments in equity instruments
XXX
-"'
XXX
-
=
ROO0s
XXX
I
11
Notes
Investments in associates
Olher intangible assels
Goodwill
Property, plant and equipment
1n•current assets
ment of financial position as at 31 December 2015
mtted
Statement of financial position of AB Bank Limited as at 31 December 2015
Equity attributable to owners of the parent
-
181
fHE STATEMENT OF FINANCIAL POSITION
the SPL reflects a summary of the income and expenditure for a period of
normally a year). the SFP presents a 'snapshot' of the assets, liabilities and
of an entity at a specific date. As such, the SFP and its uccompanying notes
e valuable information about the financial position of the particular
tion. Information such as the composition of the funding of the entity (equity
1bilities), the investment allocation of such funding and the cumulative result
rrent and prior operations are all presented in the SFP.
Chapter 7: Financial Reporting for Banks
Bank Management in South Africa -A risk-based perspective
35
31
25
27
30
29
26
ASSETS
Investments in associates
Accounts receivable
Commodities
Investment securities and other investments
Advances
Derivative financial instruments
Cash and cash equivalents
Statement of financial position as at 31 December 2015
BC Bank Limited
XXX
XXX
13
14
XXX
12
XXX
XXX
11
9
XXX
XXX
7
8
ROOOs
Notes
Table 7.2 Statement of financial position of BC Bank Limited as at 31 December 2015
IASl prescribes the minimum information to the presented in the SFP and furthe
requires entities to 'present additional line items, headings and subtotals in th
statement of financial position [SFP] when such presentation is relevant to a
understanding of the entity's financial position', 3 The line items in the SFP may
vary from company to company depending on their unique reporting needs. The
SFP in Table 7.1 is the format generally used for non-banks. Given that the business
operations of financial institutions (or banks) vary from those of non-banks, the
presentation of specific line items presented in the SFP of banks may vary from the
abovementioned example. It should, however, be noted that the basic accounting
principle of assets= equity+ liabilities still applies regardless of whether the reporting
entity is a financial or non-financial institution. For comparative purposes, Table 7.2
below provides the typical SFP for a bank.
Total equity and liabilities
Total liabilities
Total current liabilities
Short-term provisions
Current tax payable
Current portion of long-term borrowings
Short"term borrowings
Trade and other payables
Current liabilities
Total non-current liabilities
long-term provisions
Deferred tax
Long-term borrowings
Non-current liabilities
182
XXX
-
m
XXX
7.3.1 Assets of a bank
It is important to note that although each bank groups its assets according to its
reporting needs, the asset section of the SFP consists primarily of five major
categories:
The most notable differences between the non-bank and bank SFPs are within the
asset and liability sections. Given its very nature, the SFP of a bank consists primarily
of financial instruments. To this end, the composition of the assets and liabilities of
a bank are discussed next.
Total equity and liabilities
Total liabilities
~
Long-term liabilities
m
m
17
m
m
Deferred tax liability
~
Provisions
m
m
~
Creditors and accruals
m
N
8
Derivative financial instruments
m
Post-retirement liabilities
~
Short uading positions
m
XXX
Tax liability
m
Deposits and current accounts
~
m
V
Other components ol quity
Non-controlling interest
m
~
m
XXX
XXX
XXX
~
19
Tax asset
XXX
Share capital
18
Intangible assets
XXX
XXX
XXX
183
Retained earnings
24
Post ·retirement benefil asset
17
16
Property and equipmenl
Deferred tax asset
15
Amounts due by holding company and fellow subsidiary companies
Chapter 7: Financial Reporting for Banks
cash and cash equivalents
derivative financial instru ments
investment securities and other investments
loans and leases grante d to custom ers
government and intere st bearin g securities
sundry assets.
Bank Management in South Africa -A risk-based
perspective
7.3.1.2 Derivative financ ial instru ments
Derivatives are financial instru ments or contracts,
the value of which chang es i
response to chang es in the underl ying items; they
require little or no initi
investment: and they are settled at a future date. 4 Given
that the fair values or cas
flows of derivatives chang e in this way, they are used
as risk manag ement tools
offset the chang es in fair values or cash flows of the
assets that are at risk.
Banks generally use derivatives for three main
purposes: to package ri
manag ement solutions for clients; for trading purpos
es; and to manag e their own ri
exposure. Derivatives packaged and sold to clients
as risk manag ement solutioninclude the structu ring of various products to enable
the customers to manag e o
hedge their own risk exposure. Trading activities in
derivatives are entered into with
the objective of generating profit from short- term price
lluctuations in the underlying
asset. Although these activities may expose banks to
significant open positions in thei
portfolios of derivatives, they constantly manag e or
hedge their exposure to ensure
. that they remain within acceptable risk levels. Hedgin
g instrum ents may contai n a
combination of several different financial instrum
ents such as shares, exchangetraded funds, insurance, forward contracts, swaps,
options and futures contracts. As
the hedging activities contin ue to grow and evolve,
the volume, variety, and inhere nt
complexity of derivative contra cts have also increased.
For accou nting purposes, derivative instru ments are
recorded at their respective
fair value at report ing date. Changes in the underlying
items such as marke t interes t
rates, foreign currency, marke t share prices. credit
ratings, the price of underlying
7.3.1.1 Cash and cash equiva lents
Cash and cash equivalents include coins and bank
notes held in the vault, de
deposits invested at other financial institutions, balanc
es held at the South Afr
Reserve Bank (SARB) and interb ank balances held
at other banks. A statuto ry Ii
deposits requir ement stipulates that South Africa
n banks should maint a
minim um deposit with the SARB - see Chapt er 3 for
more details. Althou gh st"
asset of the bank itself. these deposits are not availab
le for daily use by the ban
updated month ly and earn very little or no interest.
Cash and cash equivalents
as the prima ry source of funds for custom er deposi
t withdrawals and loan reg
Given that cash and cash equivalents earn very little
interest, if any, South Afri
banks, similar to the intern ationa l trend, strive to
keep the level of cash and c
equivalents as low as possible. The cash and cash
equivalents as a percentag,
total assets for the 2012 financial year for ABSA
Bank Limited, FirstRand B
Limited, Nedbank Group and Stand ard Bank of South
Africa Limited amoun ted
2.68%, 4.57%, 1.95% and 3.97% respectively.
■
■
■
■
■
■
184
185
corporate and consu mer overdrafts
specialised finance loans
credit cards
foreign curren cy loans
The loans and advances portfolio generally includes
items such as:
.1.4 Loans and advances
ally accounting for up to 70% of the total assets held
by universal South African
ks, loans and advances constitute the largest asset found
in the SFP. These loans are
refore regarded as the use of funds at the bank's dispos
al to perform its intermediation
ction. The interest charged on these loans is includ
ed in the interest income
mponent of the SPL and is a function of the risk associa
ted with the borrower and the
pe of loan. The higher the assessed risk. the higher the
interest rate charged on the
,an. The risk/return trade-off is therefore central to pricing
the loans.
According to its relative size in terms of IFRS, banks
are required to provide
tensive information about each type of loans and advan
ce in the SPL. The detail
f the loans and advances provided in the accom panyin
g notes typically include a
ectorial analysis, geographical analysis. matur ity
analysis and a classification of
oans by type, such as overdrafts, finance agreem ents,
person al loans. etc. These
notes provide an extensive breakd own of the nature
of the loans, which in turn
provides a more comprehensive assess ment of the
underl ying risk and quality
inhere nt in the loan book •
Investment securities and other invest ments
ient in securities and other produ cts is generally
one of the larger assets
ing on the SFP of banks. The notes accom panyin g
the invest ment securities
provide valuable information such as wheth er the
securities are listed or
d and wheth er they are equity investments, unit trusts
or Treasu ry bills. Of
tar impor tance is wheth er or not the note disclos
es that any of the
ent securities serve as part of the required liquid asset
portfolio. (Please refer
government and other security investments section
below for a detailed
ion of the liquid asset portfolio.)
e accounting for and disclosure of financial instru ments
varies depending on
,ype of instru ment and the accou nting standa rds
applied. The accou nting
ards include: IFRS9 Financial Instruments; IFRS7
Financial Instru ments :
sures; IAS32 Financial Instru ments : Presentation;
and IAS39 Financial
uments: Presentation. Althou gh the decision is contro
versial. the majority of
cial instrum ents are fair value accounted in terms
of IFRS. It is prude nt to
hasise that the accou nting for and disclosure of financ
ial instru ments remain a
ly complex and technical aspect of accounting. The topic
of fair value accou nting
iscussed further in Section 7. 5.
ities and so on may result in derivative instru ments
either being favourable
or unfavourable (liabilities). Changes in the values
of the derivatives
in the SFP are accordingly recognised in the SPL.
Chapte r 7: Financial Reporting for Banks
~
]l
t
t.!
~
!;:
~
'"'·
t
'
.
'l
Ii
f
l
ti
fil
ek
~;
w::
I\
instalment credit agreements
loans to associates and joint ventures
micro loans
mortgages
other advances
overnight finance
personal and term loans
wholesale overdrafts.
Bank Management in South Africa - A risk-based perspective
An associate is defined as 'an entity over which the investor has significant influence'. 6 It
is important to note that the percentage shareholding does not necessarily indicate
whether or not an entity has significant influence over another. The concept of
'significant influence' is best described as the authority to participate in the financial
and operating policy decisions of the investee. 6 In general the equity method is used to
account for the investments in associates. In terms of the equity method the bank will
initially record the investment at cost and subsequently include a portion of the
7.3.1.6 lllvestmeHts ill associates
The SARB expects banks to maintain a liquid asset portfolio that complies wi
statutory requirements. The liquid asset portfolio serves as an additional source
funds to cover customer deposit withdrawals. Government and other securit.
investments often form part of tbe bank's liquid asset portfolio requirement. Thes,
investments typically include government bonds, Treasury bills. Land Bank bills
SARB debentures and various other short-term government securities. Althoug
the application of these resources is regulated in terms of the prudential
requirements set out in the Banks Act, these investments have the potential to earn
more income than cash and cash equivalents.
With the accounting standard IAS 1 permitting an entity to report information
according to its unique reporting needs, some banks disclose the liquid asset
portfolio as a separate item on the SFP while others disclose it in the notes
accompanying the financial statements. For example, in their respective 2012
financial statements, Nedbank Group and ABSA Bank Limited present the statutory
liquid asset portfolio as a separate line item in the SFP while FirstRand Bank Limited
and Standard Bank of South Africa Limited disclose this as part of their security
investments or trading asset notes.
7.3.1.5 Government and other security iHvestment
Financial institutions are required (in terms of IFRS7 Financial instrume
Disclosures) to disclose information about the significance of financial instrum
for an entity as well as the nature and extent of the risks associated with tbe respec
instruments. Given that loans and advances are financial instruments with ere,
risk. banks are required, from a financial reporting perspective, to evaluate t
collectability of loans and advances, write off non-performing loans (or impairmen
and disclose such information in their annual reports. 5 These impaired loans a
advances are reflected as an expense on the SPL. The amount reflected on the SFP
thus the net amount after accounting for uncollectable loans and advances.
•
•
•
•
■
•
•
■
186
187
Liabilities of a bank
While shareholders collectively control the bank through their voting rights, lenders
of capital have a limited right to their capital and any interest earned on that
capital. As such, banks have two sources of capital, namely own capital (or share
7.3.2
An intangible asset is defined as an 'identifiable non-monetary asset without
physical substance'. 8 With banks relying extensively on information technology, a
significant portion of the intangible assets often relates to computer software.
Goodwill also constitutes a large portion of the intangible asset amount. It is
however important to note that in terms of IFRS, a company may not recognise
internally generated goodwill. The goodwill amount therefore relates to investments
made by the bank where the consideration paid exceeds the net asset value of the
company in which the investment is made .
7.3.1.10 lntangibleassets
'he post-retirement benefit asset represents the amount invested on behalf of
employees who have contributed to the pension or provident funds over the years.
While the bank discloses this amount as an asset, the bank also has a corresponding
liability to pay such benefits to members upon retirement. A corresponding liability
for the amounts payable to the funds' contributors is also disclosed under the noncurrent liabilities section of the SFP.
.3.1.9 Post-retiremeHt benefits
ith the accounting principles differing from the tax rules applied by the South African
·enue Service (SARS), timing differences arise between the accounting and tax
ounts. These timing differences result in income tax either being paid in advance
eferred tax asset) or income tax being payable in the future (deferred tax liability).
though these two items are very often disclosed separately under the asset and liability
tions respectively, the net effect of the two is the true representation of this item.
'!3.1.8 Deferred tax
erty and equipment includes tangible items that are held for use in the
uction or supply of goods or services, for rental to others, or for administrative
poses and are expected to be used during more than one period.7 Given the
ure of bank operations, the property, plant and equipment line item is generally
expected to constitute a significant portion of the assets as most properties tend
e leased. To illustrate this point, the property and equipment amount for each of
respective Big Four South African banks averaged around 1 % of their tot.al
sets in 2012.
J.7 Property and equipment
fates' profit or loss annually in the SPL and SCE. These earnings are therefore
ded under the Common Equity Tier 1 capital of the bank in terms of Basel UL The
ccompanying the investment in associates generally provides information such as
er or not the associate is a listed entity, providing a breakdown of the profit or loss
associate as well as the fair value of the investment.
Chapter 7: Financial Reporting for Banks
Bank Management in South Africa - A risk-based perspective
7.3.2.2 Trading portfolio liabilities
The trading portfolio liabilities item is also referred to as derivative financia
instruments on the SFP. This liability includes transactions that have been entere
into during the normal course of business and are carried on the books of the ban
at fair value. The principal types of derivatives include:
•
Swaps
These are over-the-counter (OTC) agreements between two parties to exchang,
periodic payments of interest, changes in value of a commodity, or a related inde
over a set period based on notional principal amounts. Swaps include interest ra
swaps, credit swaps, commodity swaps and equity swaps, to name but a few.
■
Options
Options are contractual agreements under which the seller (writer) grants th<'
purchaser (holder) the right, but not the obligation, to either buy (a call option
or sell (a put option). at or by a set date during a set period, a specific amount o
a foreign currency or a financial instrument at a predetermin ed price. The seller
.· receives a premium from the purchaser in consideratio n for the assumption of
foreign exchange or interest rate risk. Options may be either exchange-traded o
negotiated between the bank and a customer.
7.3.2.1 Deposits
From an accounting perspective, deposits represent the capital amounts that individu
other banks, government, companies and various other entities (collectively referred to
surplus economic units) have deposited or lent to the bank for safe-keeping until a fu
date when they will be withdrawn. These deposits are therefore regarded as the 'source'
funds that the bank uses to perform its intermediation function.
Should the bank be liquidated, the shareholder s will receive what remains aft;
the deposit holders have been refunded their money. Although various types
deposit exist, they are generally classified as being current or cheque accoun
saving deposits, fixed or notice deposits, foreign currency deposits and repurcha
agreements. Banks pay depositors interest to use these deposits as loans, which
recorded as interest expense in the SPL. Typically, the cheapest types of deposit a
cheque and savings accounts given that a very low interest charge, if any,
attached to them. As with loans, the pricing of deposits follows the typical ris
return trade-off; the higher the risk that the deposit can be withdrawn from t
bank, the lower the interest paid to the depositor and vice versa.
In keeping with internationa l trends, deposits constitute by far the large
liability of South African banking institutions. The deposits expressed as ,
percentage of total liabilities for the 2012 financial year for ABSA Bank Limited
FirstRand Bank Limited, Nedbank Group and Standard Bank of South Afric
Limited amount to 66.52%, 79.09%, 90. 78% and 78.36% respectively.
capital) and borrowed capital, more specifically referred to as liabilities. The liabili
of a bank are regarded as the 'source' of the funds that it channels to its 'use'
funds on the assets side of the SFP. The most typical types of liabilities of a bank a
given below.
188
Capital and reserves of a bank
Equity is often referred to in annual reports as owners' equity, shareholder s' equity
capital and reserves. Equity, which includes share capital and various reserves, is
7.3.3
7.3.2.4 Tar liability
In terms of the South African Income Tax Act, companies arc required to pay a
financial year's estimated tax in two instalments. The first provisional tax payment,
representing half of the expected tax, is due within six months from the beginning
f the current year. The remaining estimated tax liability is then due before or on
he last day of the financial year. Following this, the income tax returns are
ubmitted a number of months after the financial year-end. It therefore follows that
t the financial reporting date, the provisional tax paid during the year may have
been underpaid or overpaid. Any underpayme nt of provisional tax will be reflected
as an amount still payable to the SARS. If the provisional tax paid exceeds the final
tax liability, this amount will be disclosed under current assets.
.3.2.3 Creditors and accruals
reditor and accrual includes amounts payable at year-end. Simply stated, these
terns represent both the short-term portion of long-term liabilities payable and
ormal trading debts payable within one year from the reporting date. The items
ormally included under creditors and accruals are, for example, trade and other
reditors, outstanding audit fees. accounting provisions for amounts payable and
outstanding dividends payable to shareholder s.
futures and forwards
Short-term interest rate futures, bond futures, financial and commodity futures
and forward foreign exchange contracts are all agreements to deliver, or take
delivery of, a specified amount of an asset or financial instrument based on a
specified rate, price or index applied against the underlying asset or financial
instrument at a specified date. Futures are exchange-tr aded at standardised
amounts of the underlying asset or financial instrument. Forward contracts are
generally OTC agreements.
Although very similar to futures, forward contracts are not exchangetraded at standardised amounts. Forwards contracts are considered OTC as
there is no centralised trading location and transactions are conducted directly
between the banking institution and its customers via telephone and online
trading platforms. Similar to other derivative securities, forward contracts are
often used to hedge risk - typically currency, interest and exchange rate risk as a means of speculation or to allow a party to take advantage of the quality of
the underlying instrument which is time-sensitive.
Collatei-al
Banking institutions may require collateral in respect of the credit risk present in
derivative transactions. The amount of credit risk is principally the positive fair value
of the contract. Collateral may be in the form of cash or in the form of a lien over a
client's asset~. entitling the bank to make a claim for current and future liabilities.
Bank Management in South Africa -A risk-based perspective
• Reserves form part of the equity of the company and include prior and current
profits retained in the entity, revaluations of i:lssets, mark-to-mark et (available for
sale) reserves, cash flow hedge reserves, share-based payment reserves and foreign
currency translation reserves. Companies constantly have to balance the need to
retain profits for future operations against the shareholders dividend expectations
7.3.3.2 Reserves
7.3.3.1 Share capital
There are several types of share capital including ordini:lry shares, preference shares;
participating shares and redeemable shares. The classification of these shares as
equity depends on the rights associated with the shares. The holders of equity share
capital are in essence the owners of the company. Their return on investment includes
both the dividends received as well as any growth in share price.
defined in the TASB's Conceptual Framework as the residual interest in the en
assets after deducting all its liabilities. 9 We can therefore apply the traditi
accounting principal of assets= liabilities+ shareholders equity to explain the con
of equity and reserves. For purposes of a bank however, the term 'capital' is used.
A company has two means of financing its assets: own capital (share capi
and/or borrowed capital (liabilities or debt). Own capital refers to the shares th
company issues to investors in exchange for cash. Borrowed capital refers to
funds that companies borrow from financiers. The shareholder' return on t
investment is in terms of dividends received as well as the growth in value of t:
shares held. The financier's return on their investment is limited to the interest th
they charge on the capital provided.
Regarding the amount of capital South African banks must hold, the minim
capital requirements are explicitly set out in the framework developed by the B
Committee on Banking Supervision. The SARB, as the custodian of monetary pol
ensures that the requirements are adhered to and in certain cases even adapts
requirements to the South African situation. The most recent adaptation of
Basel Accord (commonly referred to as Basel HI) requires more restrictive capi
definitions, higher risk-weighted asset requirements, increased capital a
minimum capital buffers and stringent liquidity requirements. Essentially, given t
adverse effects of the Global Financial Crisis, banks have to retain a larger a
higher quality amount of capital than previously required under Basel IL At th
point Basel III distinguishes between two tiers of capital: core capital (Tier 1 capita
and supplementary capital (Tier 2 capital). The stricter definition of capital requir,
that Tier 1 instruments must predominantly consist of common share capital art
retained earnings. Share premiums, accumulated other comprehensive income art
other reserves may however also form part of Tier 1 capital. Tier 2 capital serves t
purpose of ensuring loss absorption in case of liquidation. Tier 2 capital includ
undisclosed reserves, revaluation reserves, hybrid debt instruments an
subordinated term debt. For a more comprehensive discussion on the Basel capita:'
requirements refer to Chapter 15.
The typical primary components of the equity section in the SFP typically.
190
'he primary source of a bank's income is generated from the interest earned
ncluding fair value adjustments) on the cash and cash equivalents, the loans and
dvances made to customers and other banks and its statutory liquid asset portfolio.
imilar to the interest income portion, the interest expense normally represents the
rgest individual line item in the SPL. Although the interest on debt securities
Ssued and fixed deposits constitute the largest amounts of interest paid, interest is
aid on all forms of debt held by the banking institutions.
,c. Banks usually disclose the interest income and interest expense items together
with the net interest income total. It is important to note that fair vi:llue adjustments
are often included in the interest and similar income line item. While it is
acknowledged that the fair value adjustments result in the assets and liabilities
being stated at their fair value in the SFP. it also leads to unrealised profits being
included in the SPL. This very concept caused accounting and accounting standi:lrds
to be harshly criticised during the recent Global Financial Crises. As such, the fair
value adjustment income amounts expressed as a percentage of total interest
income as reflected in the 2012 financial year for ABSA Bank Limited, FirstRand
Bank Limited, Nedbank Group and Standard Bank of South Africa Limited amount
to 4.47%, 10.68%, 14.49%, and 5.31 % respectively. Similar to the interest income,
fair value adjustments to financial instruments are also included in the total interest
expense amount disclosed in the SPL.
Net interest income as reflected in the 201 2 financial year for respectively ABSA Bank
Limited, FirstRand Bank Limited, Nedbank Group and Standard Bank of South Africa
Limited amounted to Rl7 684 million (48.80% of total income), RlO 331 million
(27.55%), RB 559 million (48.93%) and R25 249 million (53.40%).
Net interest income
STATEMENT OF PROFIT OR LOSS AND OTHER .
COMPREHENSIVE INCOME
the SFP presents a 'snapshot' of the assets. liabilities and equity of an entity at a
c date, the SPL reflects a summary of the income and expenditure for a period of
(normally a year). Simply put, the SPL provides an overview of how well or poorly the
and liabilities of the banking institution were managed in order to generate profit.
A bank's income consists of two major categories, namely, net interest income
net non-interest income. The former is calculated by subtracting interest
nses. generated from the interest-paying liabilities, from interest income,
erated from the interest-bearing assets; the latter is calculated by subtracting the
-interest expenses, typically generated from the operation and functional activities
'ormed by the bank, from the non-interest income, including predominantly feecommission-based revenues. The contribution of net interest income and net
.-interest income to total income is usually approximately a 50:50 split. This of
1urse varies depending on the type of bank, commercial or investment, the level of
terest rates and the general level of economic activity in an economy.
:roviding the capital. Reserves play a crucial role in maintaining the minimum
equity requirements in terms of Basel III.
Chapter 7: Financial Reporting for Banks 191
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Bank Management in South Africa -A
risk-based perspective
Loan impairments
Fair value vs historical cost accountin
g
OTHER ISSUES IN FINANCIAL REP
ORTING
fair value is defined in IFRSl 3: Fair Valu
e Mea surem ent, as being 'the price that
would be received to sell an asset or
paid to trans fer a liability in an orde
rly
trans actio n betw een mark et parti
cipan ts at the meas urem ent date' 10
.
Dete rmin ing the fair valu e of a finan
cial instr ume nt is however not alwa
ys as
simple as refer ring to a listed price,
and very often dema nds extensive resea
rch,
valu ation models and costs.
The concept of fair value accountin
g, also know n as mark -to-m arket
accounting, was first intro duce d in 19
7 5 when the IASB required that mark
etable
securities be reported at cost or fair
value, whichever was the lower. Desp
ite
7.5.1
7.5
Given that the non- perfo rmin g natu re
of loans and advances is an inhe rent
when providing credit, the probability
that some of the loans will not be colle
c
cons tantl y mon itore d and mana ged by
the bank 's credit depa rtme nt. Impa ir
repre sent man agem ent's best estim ate
of the total amo unt of loans and adva
no
the repo rting date that may not be recov
ered in the future. According to the SA
(and many global regu lator y bodies),
a loan is regarded as being impaired if
it
not been paid fully or in part within 90
days of the paym ent due date.
Man agem ent is required to exercise trem
endo us care and judg emen t in ma
assumptions and estim ation s abou t loan
and advance impairments. Banks a
various statistical meth ods and mode
ls when calcu latin g impa irme nts on
b
individually and collectively assessed loans
and advances. Given that it is simply n
practical to identify and assess loan
and advance impa irme nts on an indiv
idu
basis, the models and statistical techn
iques used are all subject to a degre
e
estimation uncertainty. The methodolo
gy and the assum ption s used in calcu
lati
impa irme nt losses are reviewed regu
larly in light of the fact that differ
en,
between loss estimations and actua l losse
s will vary. It should also be reme mber
that the impa irme nt of loans and adva
nces is expensed in the SPL and there
fo
impacts directly on the reported profit.
These impa irme nts also played a cruci
al ro!,'
in the recen t financial crises and the loan
losses incu rred by banks.
7.4.3
The second majo r category of incom
e for a bank is the net non- inter est i
whic h consists primarily of portfolio tradi
ng profits (such as bank charges an
commissions earn ed, dividends received,
fees charged and fair value adjus t
Similar to inter est revenue, non- inter
est items also include unrealised fair
adju stme nt income resul ting from
the fair value acco untin g of fin
instr umen ts held by the bank ing instit
ute. The grow th in non- inter est i
reflects the strategic move of bank s
in recen t decades to diversify their re
strea ms to non- tradi tiona l bank ing activ
ities. This convergence, especially wi
insur ance industry, has resulted in noninter est income becoming a muc h I
comp onen t of total bank revenue and
in some cases, such as with investment
If'
even exceeding net-i ntere st income.
7.4.2
192
193
effective use and inter preta tion of finan
cial state ment s requ ire the user to have
a reasonable unde rstan ding of acco
untin g principles and the roles
and
'7.5.2 The use of annual financial
statements
ury furth er argu ed that fair value acco
untin g resulted in bank s facing solvency
es whic h forced them to sell assets at
discounted prices. This, in turn , furth
er
'ed the crisis. Persuaded by such argu ment
s, some politicians in the United States
Europe have called for the susp ensio n
of fair value acco untin g in favour of
:orical cost acco untin g, whic h requires
that assets are generally valued at origi
nal
,tor purc hase price. 11
Critics of fair value acco untin g furth er
argu e that by recognising unrealised fair
ue adjus tmen ts in income and/ or expe
nses, an entit y may be misr epres entin
g its
fit. While it is acknowledged that an
entit y may recognise fair value incom
e
justments in times of inflation, the oppo
site is also true. An entity will, in term s
of
r value acco untin g, recognise fair
value expense adju stme nts when price
s
crease. The inclusion of fair value adju
stme nts therefore induces a degree of
,latility in the SPL. Critics furth er argu
e that the unce rtain ty and subjectivit
y
.valved in deter mini ng the fair value may
rend er the practice as being unreliabl
e
d therefore not relevant.
It is interesting to note that the main
argu ment s against the use of fair value
ccounting are the exact coun ter argu
ment s against the use of historical
cost
ccounting. Critics of historical cost acco
untin g argu e that a historical cost from
veral years ago may not necessarily be
relevant to curre nt financial reports. They
rther argu e that given the degree
of estimation involved in determini
ng
epreciation, both the expense and the carry
ing amo unt of the asset may accordingl
y
be unreliable. The fact of the matt er
is that no matt er how imperfect fair
value
acco untin g may seem, it must be ackn
owledged that historical cost acco untin
g is
likewise imperfect and has over time earne
d its rightful place in financial reporting.
For further reading on how fair value amou
nts are meas ured refer to IFRSl 3.
are still
'orming. But beca use the market is
frozen, the prices of these assets have
fallen
market acco untin g rules have turne
d a large prob lem into a humongou
s
. A vast majority of mortgages, corporate
bonds, and struc tured debts
rk-to-
:ble resistance from all sectors of the
financial repo rting community,
-setting bodies such as the IASB and
Fina ncial Acco untin g Stan dard s
:ASB) cont inue d to develop and impl emen
t fair value acco untin g. As this
,'gained mom entu m, it beca me the topic
of many conflicting argu men ts in
ncial world. One of the driving forces
behin d this disag reem ent is the belief
r value acco untin g may have initiated
and aggravated the recen t Global
al Crisis. Whe n credit mark ets seized
up and clearing prices for key assets
banks fell to unpr eced ented lows, fair
value acco untin g was being blamed
king an already bad situa tion even
worse. Economist Bria n Wesbury
nting the views of a grou p of bank s state
d that:
Chap ter 7: Financial Reporting for Bank
s
CONCLUSION
International Accounting Standard
s Board. 2001 . http:/ /www.ifrs.org
/Theorganisation/Pages/IFRS-Foundationand-the-IASB.aspx (Accessed 4 June
2. International Accounting Stan
2013).
dards Board. 2012 . lntenrational Acco
unting Standari
I - Presentation of Financial Statement
s. London: International Accountin
g
Standards Commit.tee Foundation.
3. International Accounting Stan
dards Board. 2012 . International Finan
cial Reporting
Standard 9- Financial Instruments. Lond
on: International Accounting Standard
s
Committee Foundation.
4. International Accounting Stan
dards Board. 2012 . International Finan
cial Reporting
Standard 7- Financial Instruments: Discl
osures. London: International Acco
unting
Standards Committee Foundation.
1.
REFERENCES
Fina ncia l repo rting plays a significa
nt role in the bank ing sector. Whi
le financ1
services repo rting rem ains a spec
ialised field, a basic unde rstan ding
of the maj
com pone nts with in the repo rts
is essential for those who wish
to use them .
financial repo rt typically consists
of the SFP, the SPL, the SCE, the SCP
and the not;
acco mpa nyin g the financial state
men ts. An unde rstan ding of
wha t ea
com pone nt represents and how
they relat e to each othe r shou ld
enab le user s
assess the profitability and finan
cial position of a bank. Given
the exte nsii
involvement with financial instr ume
nts, fair valu e acco unti ng plays an
importari
role in financial insti tutio n repo rting
and the unde rlyin g ratio nale to eval
uati ng th
items on financial reports.
7.6
responsibilities of thos e involved
in the prep arati on and audi ting
of them .
requires companies, and therefore
thei r man agem ent, to prep are gene
ral pu
financial state men ts. IAS l furth er
defines general purp ose as financial
state
that are inten ded to mee t the need
s of user s who do not requ ire an enti
ty to pre
repo rts specific to their needs.
Fina ncia l state men ts are thus
man age
repr esen tatio ns abou t the finan
cial position and perf orm ance of
the com
inten ded for a wide variety of user
s. In usin g the annu al financial state
men ts u
mus t recognise that the prep arati
on of the annu al financial state
men ts
requ ires man agem ent to apply
complex acco unti ng principles
that req
significant estim ates and judg men
t.
By cont rast, the audi tor's responsi
bility is to express an opin ion on
whe
man agem ent has fairly pres ente
d the com pany 's financial info
rma tion )
acco rdan ce with IFRS and has com
plied with relative legislative requ
irem ents .
audi tor's findings arc sum mar ised
in the form of an audi t repo rt to be
included
the annu al financial state men ts.
The fact that they are audi ted adds
credibility
man agem ent's financial state men
ts. The audi tor also eval uate s the
entit y's abilit
cont inue as a going conc ern in the
future. In placing relia nce upon the
audi t rep
it is imp orta nt to rem emb er that
the audi tor is expressing an opin ion
based on
work they performed. The audi t repo
rt shou ld not be regarded as a guar
ante e t
the opin ion is perfectly corr ect. The
long list of failed com pani es with
clea n au
repo rts pays testa men t to this.
194 Bank Management in Sout
h Africa -A risk-based perspecti
ve
195
ternational Accounting Standards Boar
d. 20.12. International Accounting Stand
ard
8- Investments in Associates and Joint
Ventures. London: Inter natio nal Acco
unting
andards Committee Foundation.
nternational Accounting Standards
Board. 2012 . International Accountin
g Standard
6- Property, Plant and Equipment. Lond
on: Inte rnat iona l Accounting Standard
s
ommittee Foundation.
nternational Accounting Standards
Board. 2012 . International Accountin
g Standard
8- Intangible Assets. London: Inte rnat
iona l Accounting Standards Committe
e
Foundation.
-International Accounting Standard
s Board. 2012 . Conceptual Framewor
k. London:
Inte rnat iona l Accounting Standard
s Committee Foundation.
International Accounting Standard
s Board. 2012 . International Financial
Reportirt/J
Standard 13- Fair Value Measurement.
London: Inter natio nal Accounting
Standards
Committee Foundation.
Pozen RC. 2009 . 'Is It Fair to Blame
Fair Value Accounting for the Financia
l Crisis?'
Harvard Business Review. http :/ /hbr .org
/200 9/ l 1 /is-it-fair-to-blame-fair-valu
eaccounting-for-the-financial-crisis (Acc
essed 6 June 2013).
Chap ter 7: Financial Reporting
for Banks
INTRODUCTION
South African banking industry is regarded as being well developed and
histicated in international terms. 3 With the required systems, regulations and
ctures in place, it is difficult to envisage a reason as to why South African banks
uld not be efficient and outperforming international competitors. However,
th African banks are still struggling with a number of challenges, which include
suring that the South African financial sector remains systematically stable in a
idly changing technological environment with sharply increasing competitive
nditions. Especially after the 2007-2009 Global Financial Crisis, banks all over
• world have been challenged to increase their capital requirements from 8% to
proximately 14% in order to be Basel TII compliant. Other challenges attached to
suring banking services are delivered to the broader unbanked community whilst
suring that costs are minimised also place pressure on the performance of banks.
These challenges validate the requirement for banks to have a devoted
anagement team that has a thorough knowledge of both strategic risk
anagement and the financial health and viability of a bank. Both executive and
on-executive management must recognise the opportunities for improving bank
erformance in the ongoing changing financial environment. This emphasises the
portance of using performance measures to ensure that the desired goals and
bjectives are achieved over both the long and short term.
This chapter provides the necessary background and knowledge required to
understand the management of bank performance from a strategic risk perspective.
This will be followed by a discussion on the difficulties of bank performance analysis
and the role of performance measures in a bank. The next section discusses the
different financial performance measures available and will make use of financial
he different types available.
ing this chapter, you should be abie to:
erstand the concept of performance from a strategic bank risk
nagement perspective
erstand the difficulties of measuring bank performance
derstand the role of performance measures in a bank
imate and interpret financial performance measures for banks such as
stock valuations, market value ratios, profitability ratios, liquidity ratios, asset
'-anagement ratios, and debt management ratios
nderstand the use of non-financial performance measures and to elaborate on
\ing the Performance of a
Bank Management in South Africa - A risk-based perspective
BANKING PERFORMANCE AS A STRATEGIC BANK RISK
MANAGEMENT TOOL
The elements and difficulties of effective performance management
Bank performance should be measured against an objective because without such an
objective the bank will have no criterion on which to select the correct investment
strategies or projects. 10 Bank performance evaluation can, therefore, be used as a
guideline for keeping a bank on track in achieving its objectives. 11 This implies that a
continuous bank performance evaluation process ensures that a bank can overcome
the gap between actual and desired performance. Managing banking performance can,
-however, become very complicated, as illustrated in Figure 8.1. Management has to
incorporate a number of controllable and non-controllable factors that can influence
the overall performance of individual branches and the company as a whole. The bank
8.2.1
During the l 980s banks became more performance-orientated, which highli
an era in which management was driven by pre-determined objectives. 4 Ho
during this time and specifically up until 1994 the South African banking ind
had been deteriorating due to restrictions on bank branching and poli
isolation. 5 Nonetheless, the South African economy recognised the increasing
for specialised expertise in banking, including expertise in international ban
cash management and lending. As a result, banks have begun to speciali
different product lines and have organised themselves as a collection of diffe
lines of business, each with different customers, products, risks and distribu
channels. Greater competition in domestic and international markets
continuous fundamental structural changes have forced banks to be rtii
productive ·and flexible, implying a greater focus on providing customer servic
This development in the banking industry has given rise to new issues concerni
performarice measurement, resource allocation. risk management. and the need
applying suitable distribution channels as a strategic tool to increase market sha
In addition, resource allocation based only on gross profitability was no long,
sufficient and management had to become more aware of the need to measu
returns on a risk-adjusted basis 6 (see Chapter 10).
This implies that effective performance management has become more comp!
and that referring to traditional measures of profit exclusively is no longer appropri
in the evaluation of desired objectives related to productivity and custom
satisfaction. 7 Management has realised that there are no longer boundaries f1
selecting main performance measures and that effective management includes t
use of a combination of performance measures such as financial. market/custome
human resources, competitor, internal business processes and environment,
indicators. 8 It has also become important to combine cost efficiency estimates wit
profitability evaluations to ensure a more comprehensive evaluation of ban
performance. 9
8.2
statements to enhance the understanding and interpretation of some of
performance measures. The chapter then concludes by elaborating on the
non-financial performance measures in addition to the common financial mea
198
199
--- ·"""" ... ~···-·~--
-----
__ ___..,.____
~
---
Recognising that the controllable and non-controllable influential factors are
important only forms the first step of the performance evaluation process. The second
step is to have a framework in place for developing a performance model. In order to
ensure effective bank performance evaluation the following steps must be followed to
develop a reliable performance model: 12
Source: Avkiran (1997) 12
Figure 8.1 Bank performance framework
ve's decisions involve a trade-off between mm1m1sing risks and costs and
ising returns, which can also be influenced by a number of factors. Some of
factors include the regulatory and economic environment, shareholder
ces and feedback on the performance of personal banking, business banking
rations. Figure 8.1 illustrates that non-controllable factors that influence
performance outcomes include the catchment-area-specific potential variables.
types of variable focus on the area from which the bank attracts customers,
implies capturing both socio-economic and demographic information. It also
cts with branch specific controllable variables such as the qualification and
ledge levels of employees and the functions they fulfil in the company. Overall
performance can also be assessed by the capital market, depending of course on
objectives of the company and the bank's managerial actions and asset pricing
•niques in terms of the market price of the bank's shares. 12
Chapter 8: Measuring the Performance of a Bank
Bank Management in South Africa - A risk-based perspective
The use of historical data and traditional bank performance measures can be
misleading. Examples of this are when expense ratios mislead trend analysis if the
product mixes change over time or in cross-sectional analysis if the banks being
In addition, the greatest problems in bank performance evaluation arise due to the fa
that virtually all performance evaluators make use of accounting data as well as othe
data to help estimate the financial condition and the level of management in the bank.
Financial performance measures alone can have serious limitations due to their: 14 ·15
•
backward-looking nature
■
limited ability to measure performance and
■
tendency to focus only on the short term.
If the performance analyst does not illustrate a proper understanding of the great varie
of performance measures and the impact of uncontrollable environmental changes, t
performance measures can be misinterpreted, which can lead to strategic risk.
The influential factors highlighted in Step 8 that can cause problems during
evaluation process include:
■
the unreliability of some performance measures and of management
■
changing definitions of success, bias instruments and evaluators
■
a lack of understanding and communication
•
a lack of commitment and participation by the employees
■
a lack of trust and managerial support
■
socio-psychological factors
■
the role of capitalism. 1 l
Step 1: review the bank's objectives and strategies
Step 2: define branch performance in terms of these objectives,
that are critical to the bank's success must be identified
Step 3: identify the potential variables that can be associated with
performance, and which are controllable by management
Step 4: determine the sources of data for performance and potential variables
Step 5: develop multivariate measures for data collection
Step 6: analyse the data through the use of multiple regression and other techni
where the sets of potential variables that explain each of the perfor
variables must be determined
Step 7: examine the results found and increase performance through the reconfigur,
of branches
Step 8: overcome the influential factors that can jeopardise the implementati
branch reconfiguration.
200
201
ow performance is measured, however, still depends on each individual bank and is
based on its unique statement of financial position (SFP) structure. the regulatory and
economic environment 19 and the strategic objectives and goals set by the Executive
Committee (ExCo). 8 An effective performance evaluation report should consist of
results of both financial and non-financial performance measures. Combining these
measures increases the effectiveness of compiling short- and long-term evaluations,
which can be used as benchmarks to improve the bank's overall performance and
decision-making processes.
part from these requirements, a good bank performance measurement system
1ust be:
supportive and consistent with the institution's culture, employees, goals,
actions and key success factors
driven by the customer, appropriate to both the internal and external
environment, developed by a combination of bottom-up and top-down efforts
communicated and integrated throughout the whole bank
focused on the effective management of resources, inputs and costs
committed to providing action-orientated feedback and
supportive of institutional, branch and individual learning. 6
tated previously, the understanding of and the choice between the variety of
erent performance measures is crucial to ensuring effective bank performance
nagement. The selection of performance measures must also be driven from the
Ilk's strategies, providing a link between the strategic plans and business unit
ions. Furthermore, the selection must be hierarchical and integrated across all the
·erent business functions, must be supportive of the institution's multidimensional
ironment and must be based on an understanding of the cost behaviour and cost
ationships in the institution. 18
.2 The role of performance measures in a bank
theless, a successful bank depends upon the decision-making abilities of its
agers with their success depending on the availability of useable information.
financial and non-financial performance measures must. therefore, be applied
:yas a monitoring, assisting mechanisms in the decision-making process to ensure
t the bank remains on track to achieve its short- and long-term objectives.
ted have dissimilar product mixes. 16 Traditional bank performance analysis
s of three additional basic flaws: 17
ignores the wide diversity of strategies that are pursued by different banks
'he analysis provides no direct information regarding how and which bank
ctivity contributes to the creation of shareholder value. This implies that it
gnores other performance benchmarks that consumer-focused managers
nsider to identify the best for future strategies.
bank's total assets can no longer serve as a meaningful benchmark if banks
articipate in off-balance-sheet activities .
Chapter 8: Measuring the Performance of a Bank
I
-f
Understanding financial performance measures
8.2.3
8.2.3.J Ma:rimisir19 share value
A fundamental objective of financial management is to increase the institution
share value 10 in order to ensure the ability of raising capital in the future to promo
institutional growth. This implies that banks have to improve their intern
processes. thus increasing the level of bank performance in order to generate high
expected earnings. This in turn will result in higher dividend payouts that make t
institution's share more attractive. As more investors buy this share, the high
demand will cause the share price to increase, thereby exemplifying a mor,
profound market image to other investors and potential customers.
A key consideration within these internal processes includes the manageri
decisions of the bank, which produce six key activities that can influence the sha
price: 23
1. Spread management: includes managing the spread between interest income an
non-interest income and interest expenses and non-interest expenses.
2. Control of overheads: refers to the ability to minimise overheads (or non-interest
expenses) while maintaining a high spread between these and non-interest income.
3. Liquidity management: converting short-term assets into cash in order to comply
with liquidity requirements. funding needs and meeting unexpected deposit
withdrawals.
4. Capital management: managing the level of regulatory capital in such a manner
that asset and liability growth can be accomplished without any decrease in
public confidence or prolitability.
The American Accounting Association 20 defines financial measures as a too
evaluate and interpret economic information, which enables management to m
more informed judgements and decisions. By combining the information of a ba
Statement of Profit or Loss and other Comprehensive lncome (SPL) and the SFP,
first step in bank performance evaluation can be initiated by means of r
analyses. Ratio analyses can be applied in three ways: a cross-sectional analysi
time series analysis and a combination of these two analyses. A cross-sectio
analysis makes use· of financial ratios to provide a performance comparison
different banks at a certain point in time. A time series analysis. on the other ha
makes use of financial ratios to evaluate the performance of a bank over a cer
time period, thus enabling the analyst to assess and compare past performance
current performance levels. The combined approach is considered to be the
comprehensive approach given that financial ratios are used to compare the t
banks over a certain time period. 21
The analyst must ensure that if one of these approaches is applied the finan
statements must be dated at the same point in time in order to avoid the biased
results that seasonality can cause. The analyst must also ensure that the finan
statements are audited and that there is no room for distortion by inflation. 22
order to initiate a bank performance evaluation the analyst must also h
knowledge of the different variety of financial ratios available and understand ho'
to interpret each one.
Bank Management in South Africa - A risk-based perspective
202
203
Equation 8.2
Besides max1m1smg the share value by improving the bank's performance and
efficiency levels. bank management must also consider the market perception of the
and future performances of the bank.
here D represents the constant expected dividends over period l; r is the cost of
1
pita!; and g is the expected growth rate. The cost of capital entails the minimum
uired risk-free rate and the risk premium.
P0 =D 1 ~(r-g)
ere Dt represents the expected dividends by the shareholder and r is the cost of
ital that entails the minimum required risk-free rate and the risk premium. From
s equation it is evident that there are four different situations that can cause the
re price to rise. First, if the stream of expected dividend increases, due to growth or
increase in the bank's profitability level the share price will increase accordingly.
ond, the share price will increase if the perceived level of risk decreases, which
JI lead to a lower required risk premium. Third. if the minimum required risk'e rate decreases, investors' acceptable rates of return will also decrease which
'II cause the share price to increase. Finally, a combination of an increase in the
pected dividend with a lower risk premium (decrease in perceived risk) will cause
'e share price to increase.
The equation does, however, make the assumption that the share will pay varying
iOunts of dividend over the time period t. However, if it is expected that the dividend
ill grow at a constant rate over time, the Gordon growth equation can be used: 25
Equation 8.1
her factors that can influence the share price include the attitude of management,
reference of the share owners, the regulatory and economic environment and
bank's primary objectives (vision and mission). 24 fn addition, the price of a share
can be estimated as follows: 25
Tax management: minimising the bank's tax liabilities.
The management of off-balance-s/Jeet activities: incorporates the management of
ctivities such as letters of credit, lines of credit and loan commitments in order
Chapter 8: Measuring the Performance of a Bank
Market vafoe ratios
=NIS-;- N
=Market price per share -;- Book value per share
Market-to-book ratio
In Equation 8.5, N is the number or common shares outstanding. Three additional
market value ratios that can be considered are the earnings yield ratio, the dividend
=Common equity -;- N
Book value per share
In the equations above. NIS signifies the net income available to common sharehold
(net income minus dividends on preferred shares) and N is the number of comm'
shares outstanding at the end of a certain period (sometimes the weighted avera
for the estimated period is used). This estimate from Equation 8.3 can also serve
a profitability measure. That is, it illustrates what portion of the bank's profit
allocated to each of the respective outstanding common shares. Remember t
a bank that uses less of its capital (equity) to generate a certain EPS level will
considered more efficient and attractive than a bank that uses its capital to genera;
the same level of EPS, ceteris paribus.
A second market value ratio that can be applied to provide additio
information regarding investor perceptions of the bank as an investm
opportunity is the market-to-book ratio. This ratio compares the share's marke
price to its book value. Banks with relative high rates of return on equity (ROE) ar,
considered to be able to sell shares at higher prices than their book values suggest. 2
The inverse of this ratio, namely the book-to-market ratio, can also assist investor
in identifying an overvalued or undervalued share. If the book-to-market ratio i
above 1, the share is considered to be undervalued, while with a ratio of less than 1
the share is considered to be overvalued. In order to estimate the market-to-book
ratio the book value per share must first be determined as follows: 26
P/E = Market price per share~ EPS
The PIE can then be calculated:
EPS
By applying market value ratios in the performance evaluation process the bank
able to determine the investor's perception regarding the available pros
investing in a particular bank. Besides these ratios, a more common indic
incorporates overall market perception is the trend of a bank's share price. Th
the share price the better investor perceptions towards the bank's overall
promote future growth. Nonetheless, there are a number of alternative market
ratios that can be used. The first is the price-to-earnings (PIE) ratio which repor
much an investor is willing to pay per rand or reported profits. A high PIE ratio si
that the bank has high growth prospects. If the PIE of a particular bank is lower
that of a competitor, it is considered to be a riskier investment opportunity. In or,
estimate PIE the ratio the earnings per share (EPS) must first be calculated as folio
8.2.3.2
204 Bank Management in South Africa - A risk-based perspective
Equation 8.9
=Earnings per share ~ Dividend per share
fdend cover ratio
(%) - - - - -
Price (R)
I
0
24
12
iii
!1!
i'1i'.
Il ~
rtf.·
,,I
:!!
4'
36 ~
48
£
60
84
72
.2.3.3 Profitability ratios
rofitability ratios provide more insight into a bank's ability to generate revenues given
he cost constraints in the provision of financial services. Basic profitability ratios are
the net interest margin (NfM), the net non-interest margin (NNIM) and the net
bperating margin. The NIM ratio (Equation 8.10) reports on the size of a bank's spread
between the interest revenues and the interest expenses achieved by controlling its
earning assets (or total assets) and the pursuit of acquiring the cheapest source of
funding when necessary. The NNfM ratio (Equation 8.11), on the other hand, reports
on how effectively the spread is being managed between the non-interest revenues
gore 8.2 Relationship between share price and growth in earnings
~~~~~~,~~0~8~~~~~~,~~0~8~~~~~~-~~0~8
cn~n~c~~nu>ucnro~~ cs~nu>ocnan~c~~no> o
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
000000000000000000000000000000000000
000000000000000000000000000000000000
~~~~~~~~~~~~NNNNNNNNN NNNMMMMMMMMMMM M
1-- Earnings growth
Equation 8.8
=Dividend per share-;- Price per share
vidend yield ratio
:ggested above, for investors to be interested in investing in a bank, banks must
ce them by making their shares very attractive. This can be done by ensuring
rofitability, sound liquidity levels and debt management are well managed over
the long and short term. Figure 8.2 provides an example of the relationship
en the share price and earnings of a typical bank, and suggests a strong positive
ionship between earnings and share price in the long term. Profitability analysis
erefore, an important aspect of performance management.
Equation 8. 7
~
Price per share
nings yield ratio = Earnings per share
'o and the dividend cover ratio. The earnings yield ratio illustrates the yield
stors are demanding from the bank; the dividend yield ratio indicates the
that investors will obtain on their investment in the bank in the form or
ds; the dividend cover ratio indicates the extent of earnings that the bank will
in the form of dividends. A high dividend cover ratio will signal that a large
' of earnings is being retained and reinvested within the bank. 22
Chapter 8: Measuring the Performance of a Bank 205
Bank Management in South Africa - A risk-based perspective
The two most popular profitability measures include the return on assets (ROA
and return on equity (ROE) ratios. The equations for ROA (Equation 8.15) and RO
(Equation 8.16) are as follows: 25
NIE is the non-interest expenses; NI is the non-interest income;
average total assets.
Burden ratio= (NIE - NI) -;- ATA
In Equation 8.13, IC is the interest income; AEA is the average earning assets; IE is t
interest expense and AIBL is the average interest-bearing liabilities. The burden rat'
on the other hand, measures the amount of non-interest expenses that include fe
service charges, security gains and other income as a fraction of average total asse
A bank with a lower burden ratio is considered to be better off, while an increasi
ratio illustrates a lack of a burden bearing capacity. 17
Earnings spread ratio= (IC-'- AEA) - (IE-;- AlBL)
Two alternative traditional measures for profitability efficiency are the ear
spread ratio (also known as the spread ratio) (Equation 8.13) and the burden r
(Equation 8.14). The earnings spread ratio measures the bank's effectivenes:
performing its intermediation function of lending and borrowing money. This ra
can also be used to measure the competitive intensity in the financial market.
25
;
~spaff
theNNliVI and'NIM ratios/whilst others
when tneseratios are consulted tnafdo
&,hsider~Eitr.rrity 9 ains'•(or_tosse~}
prefer to:incorporate itas part of ttie pre-tax:operatiha i
;;There'_are·-severat ·banksttfattise tota1· ea
In the equations above, NPA is the difference between interest income and i
expenses; NIR is the total non-interest income; PVLL is the provision for loans an
losses; NIE is the non-interest expenses: and NP is the difference between op
income and operating expenses (also referred to as pre-tax operating income).
Net operating margin = NP ~ Total assets
NNIM = (NIR - PVLL - NIE) ~ Total assets (or earning assets)
NIM= NPA-;- Total assets (or earning assets)
as wages, maintenance, and loan loss expenses). The net operating margin ref!.
effectively the bank is managing the spread between operating income and o
expenses relative to its total assets (Equation 8.12). 25 The NIM ratio, the NNI
and the net operating margin can be estimated as follows:
(origi~ating from service fees) and non-interest expenses (which include expen
206
~
Total equity capital
Equation· 8.16
Equation 8.15
207
,.,......•=•-·'·
~ Total
~=··'""'·"'.~.--''" 1 / r : < Y .
equity capital
==•·•""•-•~C_.0_~
P.M = Total assets
AU= Total operating income -;- Total assets
PM= Net income after tax -;- Total operating income
. •-=-•
YI, . .+. YS.-·,.•Y~•W:• , ... ,
,,\\Ill'""'''"
Equation 8.19
Equation 8.18
Equation 8.17
1A ratio serves as an indicator for managerial efficiency. which entails the
'anagement's ability to convert assets into earnings. The higher the ROA the
ff the bank because more money is being earned from less asset investment.
IA, however, provides no direct information concerning how or which or the
activities contribute to the creation of shareholder value. It also ignores other
ance benchmarks that customer-focused managers must consider to identify
long-term strategies.
e ROE measures the rate of return that shareholders will receive. The DuPont
·is enables an analyst to break the ratio down into three components, namely, the
,fit margin (NPM). the degree of asset utilisation (AU) and the equity multiplier
Splitting the ROE ratio into these three components (see Equations 8 .17 to 8 .19)
s it easier to understand any changes in the ROE ratio over time and to direct
le management energy to addressing problems in that specific area. 25
Net income after tax
;: Net income after tax -;- Total assets
Chapter 8: Measuring the Performance of a Bank
Bank Management in South Africa -A risk-based perspective
Source: Koch & MacDonald (2003) 17
Figure 8.3 The decomposition of ROE
The NPM reflects the operating efficiency in terms of effective cost manageme
service pricing policies. The AU, on the other hand, reflects asset-use efficie
terms of effectively managing portfolio policies and focuses especially on the yiel
mix of assets. Finally, the EM reflects the bank's financial leverage, which illu
the effectiveness of a bank's financing policies regarding which sources (equ
debt) were chosen to fund the bank. Increasing financial leverage can imply th
bank is using more debt financing relative to equity financing. 25 A higher propo
of debt in the bank's capital structure can lead to a higher ROE, however, only i
bank's ROA exceeds the interest rate on debt will the increase in debt make a p
contribution to the bank's ROE. The EM can also be applied as a risk measure,
can be used to indicate how many assets can default before the bank will bee
insolvent. In addition to the abovementioned decomposition, the DuPont analysis
divides the ROE into the components illustrated in Figure 8.3. 17
208
209
ese ratios lack the ability to account for any risk adjustments. As a result,
ept of risk-adjusted performance measures was developed to overcome these
ks and this is why banks began to move to economic values (mark-to-market
et-to-model values) because these are both risk- and revenue-adjusted 27
10 elaborates more on risk-adjusted measures).
ite setting profitability as a long-term strategic goal, the one factor that
ot be dismissed by a bank is liquidity. The level of effective liquidity risk
ent describes the bank's ability to meet uncertain cash flow obligations and
ncreases in assets without the possibility of incurring losses. 25 Liquidity risk
rincipally assigned to a flawed SPL structure, the product mix offered by the
d its cash flow profile of both off- and on-balance-sheet obligations. 28 Also, a
nation of an inability to generate the necessary liquidity buffer, misconduct of
g bad loans that can reduce cash flow and mismanagement of funding costs
lethal to even the largest banks.
e lack of effective liquidity management. can lead to the deterioration of
confidence, thus leading to a bank run. Analysing a bank's level of effective
·ty management is, therefore, crucial to establishing the current market's
tion of the bank's liquidity management abilities.
h the ROE and ROA are considered to be highly dependable profitability
Chapter 8: Measuring the Performance of a Bank
Liquidity ratios 12,26
Quick ratio
= Total quick assets -;- Total current liabilities
Current ratio = Total current assets ~ Total current liabilities
Liquidity ratios are used to assess a bank's ability to meet obligations and, w
necessary, be able to quickly convert assets into cash. 29 These obligations specifi
refer to being able to accommodate withdrawals by depositors, maintaining
viability of meeting the loan demands of customers, ensuring feasible m
expectations and ensuring the effective performance of typical daily activities. Th
are two common liquidity ratios used by bankers: the current ratio and the quick ra
The current ratio is a measure of the bank's liquidity health. It indicates whether
not a bank is able to pay its current short-term obligations. which include payables a
debt, with its short-term assets that include inventory, cash and receivables. A b
with a current ratio below 1 suggests that the bank is currently unable to pay off
obligations. The quick ratio, on the other hand, can be regarded as an acid test fi
liquidity. This ratio illustrates whether or not a bank is able to meet its current sho
term obligations (liquid obligations) with its most liquid assets including cash, prepai,
and notes receivable, accounts receivable and Treasury bills. The quick ratio exclud
inventory from the total current assets because inventory can become difficult to tu
into cash. The formulae for these respective ratios are as follows:
8.2.3.4
210 Bank Management in South Africa -A risk-based perspective
it~~•.
• - - - - - - - - ~ - •W
=.-0.--S-· ◄ •,.•-·~.V.
r_,c_v
Y . . · = 0·=-···-~.--:_. _. •• ,_ •• ,._._ .•\.,\'{11, •• '>l''-'..'",,-.
~,fJiioifi,§lihghtffa'J tiilm.f!~C:/.prijl:Jl!~s tBr!~~jsC>ot
~fryd~'r,inga2010.!tudy.ahd,~afistilLguarantee~•.nu1
ertions;,Sinceohly cash rese1Ves;aridcgoverntner11,.aebt at~f~!tfasifiedas hfg~
J~lilyfiqUid.assets; ItleSoutfj~frican l:)On-d markef(1as'·c~rifipered·.to(j·. .~m~ll}o
·•comrriod:Methe arno~T)l .of. a~yernr:nentpa\:lenha(r1!ede~tp:pe pough!.·.~yfoUth·
iban\:Jahks.in order toacqoir~t~thighq uality liquid asse;!•~eedetl,}he'.;\'
LicturafHquidffy mismatch b'etween local banksJ~consider, ,to bethe greatest
r\Jrega[din? thetw(j liejoi~1tyJitiosfor.,sotftH ~f~itan~a~B~·V!.i.th·.~·•.larg~
1t;6ff~ndirig ·afi~ingfr6r1'.'V/.~ofii'satesources, priniarilytorn the money l'!larket,
nt1:i,ecau'~<; rnost'South·.i\fril'fan bartltassets have lohgmat~!iti.es, .~ rrtisleadirig·•••···
ni~gegtthe$OUth African:b-irrikfrrg.Jridustry is portrayed .. Dh~f)theliquidity < • • •
i~rnatd, i~}heSoutt,African'.~a~~ingJndustry,;as 'll/ell•as t.hilfinited •.size ot;2.e
6rnestic bond .marketolocal IlafikSJ.vilfonly be able to gefrert!e an approximate
O'?l~f?dHe~CR and 60WJor t~e·~sFRreqiJired bYjhe BasEi.fJH Accord. These
• proxirnatihns can generate unce~iinty and·COncemtor rnarRetparticipants
regarding,the future direction O'f barikin•g liquidity managemenf.2, •
0
-..gti~r~>: "t _.•.;;,., .;;;,;, . , .....>·.•••··· , ..•••. < • .
sfable flirids -~?Requiredsfable funds >}00°,
.
/ i. . •••• ••'~••· ,
liquid assets +'.;Net 30•day cash outflow~ 100%;
, 1i<s; 1ge ra*id:/. • ;·-:<>·• /
in
'SsRfi!~f}:~fi;;~~ :~il~;lit~~~;~t~i jt~;:~~~1h!sle:!t 1l~a£1e
lin:g o~er(alonget.!ini~'r:fe'r[<,i:T;,J.cf~E!I~£~.i~~ll.~~;tha:t.the•.ban~ List·•
.•.····•·.<.•··'tPuffer~f~l~hc'~g~tiiy,lia?1~~ssst~;Iei.~6Vtit.!9;etJiq\Jidity6utf!eiY.,S•.• >•
~p'~y;stress.peric>ct'Tpese,~.lgfi.\<1?ality-liqoldass~tsi~bouldpr1l.iquiqi<f?ring
f~~S..-lS~ou.ltf;i~~~ ;fii~JI;&~ditt~?llfty, ;friclJ~ei~ltf~~~,,t\~B eligible,!~•~ 7
str~st~cen~t!6'~~l~Htlih~ea to estfrnateJhenetCpash.ouUfbW~A
bdthsystemicaridiristitulicin-specific shcit~S. 47 ~epigh quality liq?id
•••••• 6olated"bf.viulfipl!iHg'theJrrfar~et v?l~e\With-.!h~l:lssetfactor for
}vithten.tral;bAn.k.reserves,mar~etab.le .se~?tittes }ssued or••·
.·.;.,,sovefeigns;"hashtcehtralbankand.tfomestic~oveteign.aebt
a f?ctor of 100'¼~46 Th!NSFR,'.pnthe otherhMd,pafines the type et
?d)\at,1Ht.ies expected 'tgbearelitble .so~rce?f .fun~12g'Under.a stress
>'of?>neyeafJhe feq(jired fdh'ding amount depeiids gnthe instrument's
:whicH~lso determin€s;he'available·or required stable:tactor. These jactors
ipliicfbyJhe availabfe ;Ori'eq·uired stable fundihg iteniJi.o ,estimate the
• • • falue\J~eavallableStablejactbr defines theariJoi:mt of assets(partly
ts\Wit~an'effectiv~rriatutity?f leSs}h.an oneyefr) that would remain
g(im exfendecf~t~i<5tfdo.rinira St~es!tvent/"fti~ required stable
is}he am(j~nt Bf,~t,lirtlcularasset tHaf c6uld b?!:Pe monetised durihg
sfress'SVent of cineyear. 46 Theformulae of the LCR and the NSi=R are asfollows:
i(y'~~~!~{!;~t;f?~ =~~~~}~~~~~ft! ~td~8~~:rfu•~@ ·ihg
tfje·1i9.~idity~gyetag~r~!£<i<LS§tt';):irC>l'Yl.~f~~. s~o~~ter.ryi.ff~xibiijty···•
··•4(iJhtah'd:@tfc.Kf?t[~sf th~t~!!!,tw~~.~~itional liqui.di~>tatios
tuatihg1fjEl.,,tiffiic!i~rnes~i?,{!'ibank.'s.liq~ldi!Y9iven•
Chapter 8: Measuring the Performance of a Bank 211
••• •••••••"'"•• /2
00 M.-•--•-••••
••• •• ~ .•0'""'••••
Bank Management in South Africa -A risk-based perspective
Leverage ratios
Operatin g and prod11cti vity efficiency ratios
8.2.3.6.1 Cost management ratios
One of the most common cost managem ent ratios is the cost-to-income ratio,
whic
provides an investor with insight regarding the overall efficiency of a bank (hence
its
Estimates that could provide a substantial contribution to the overall bank performa
n
evaluation process include the efficiency and productivity ratios of day-to-d,
operations. This category of ratios is divided into three subgroups that include
co
managem ent ratios, customer-related ratios and other ratios (which include
capit
adequacy, asset quality, liquidity standards, user standards and other growth ratios).
8.2.3.6
In Equation 8.24, EBIT is the bank's earnings before interest and taxes. The
to-equity ratio illustrates the bank's ability to leverage its debt against the
c
that is employed by its sharehold ers. 22 A high debt-to-equity ratio illustrates tha
bank follows an aggressive strategy in financing its growth with debt. This aggre·
strategy implies that additional interest expenses will have to be paid on the debt
is being used. This implies more volatile earnings for the bank. Total debt in the
d
ratio includes both current liabilities and long-term debt. Creditors prefer a
ban
have a low debt ratio, meaning that the bank has a greater cushion against credi
losses in the event of liquidation. 26 The interest coverage rate, on the other
ha
indicates the portion of debt interest that can be covered by the cash flow
of t'
29
bank. The lower the interest coverage ratio, the more the bank is burdened
b§
debt expenses. For example, if the bank has an interest coverage ratio of 0.5 itsugg
that the bank is not generatin g sufficient cash flow to pay the interest expenses.
such, an interest coverage ratio of, for example, 2 would be more desirable.
Apart from evaluatin g a bank's share price, market value, profitability, liquid
and leverage, a financial analyst must also consider the operation al efficien
within the bank.
Interest coverage ratio = EBIT ~ Interest expenses
Debt ratio= Total debt~ Total assets
Debt-to-equity ratio= Total liabilities~ Total equity capital
The leverage ratios of a bank provide the analyst with an idea of the
financing that is used or can be used to measure a bank's ability to meet fin
obligations. 26 The three most commonly used leverage ratios are:
8.2.3.5
Besides making use of highly liquid assets the bank can also use debt fina
perform certain daily operations and to maintain a certain capital structu
therefore, importan t to evaluate a bank's level of leverage in order to determ
to compare the type of financing that is used. If the returns on assets, whl,
financed with borrowed funds, exceed the interest paid on the borrowed fun
returns on sharehold er capital arc considered to be amplified or leveraged. 26
212
213
Equation 8.28
Financial expense ratio= IFEL-;- Total gross loan portfolio
Equation 8.32
Cost per active customer ratio = Operating expenses~ TNC
the equation s above, FEL is the financial expenses on funding liabilities; IFEL is
the
interest and fees expenses on funding liabilities; TIED is the total interest expenses
on deposits; DI is the direct and indirect operating expenses allocated to deposits
and
TNC is the total number of active customers. 30
Operating expense of deposits ratio= DI
Equation 8.31
Equation 8.30
~ Average deposits
Operating efficiency ratio = Operating expenses .;- Total operating income
Equation 8.29
Equation 8.27
Cost of funds ratio = FI'L-;- Total deposits and borrowings
~ Average deposits
Equation 8.26
Interest margin= Interest income -;- Total income
Financial expense of deposits ratio = TlED
Equation 8.25
Cost-to-income ratio = Total operating income~ Total operating expenses
eferred to as the efficiency ratio). The lower the cost-to-income ratio (where the
ational benchma rk is 0.6 or 60%) the more profitable the bank will be. If this
ndicates an unexpected increase, it could mean that the expenses are growing
at
er rate than income, thus suggesting that the bank is failing to function cost
ively. Equation 8.26 provides additional information about a bank's revenues
es: it illustrates to what extent the total income is generated from interest income
n-interest income. The cost of funds ratio. on the other hand, provides an estimate
,w interest rates are managed given the total number of deposits and borrowings.
financial expense ratio provides an estimate of how much interest rate expenses
• been paid to fund the bank's total gross loan portfolio. In order to directly compare
ost of funding to all the possible future borrowing opportunities, the financial
nse of deposits ratio can be applied to provide such an estimate. An alternative cost
agement ratio includes the operating efficiency ratio, which provides an indication
ow effectively the personnel and administrative expenses are managed relative
to
total operating income. Also, the operating expense of deposits ratio provides
the
lyst with an indication as to whether the deposit mobilisation costs are managed
ctively. Finally, the cost per active customer ratio determines the cost of maintain
ing
active customer. 30
Chapter 8: Measuring the Performance of a Bank
~
TNAC
Capital adequacy, asset quality, liquidity and user standards, and other growth ratios
One of the most common ratios to consider is the capital adequacy ratio (CAR),
which presents the level at which the depositors are protected. (Chapter 15 provides
an extensive discussion on capital adequacy and the CAR). This ratio also illustrates
8.2.3.6.3
For the equations above, NAB is the number of active borrowers; TNLO is the total
number of loan officers; TNAC is the total number of active customers: TNP is the
total number of bank personnel; NNAC represents the number of active customers
at the beginning of the period plus the number of new customers during this period
minus the number of active customers at the end of the period: NOA is the number
of deposit accounts; ND is the number of depositors; NL is the number of loans
disbursed; and NLO is the number of active borrowers. 30
Average outstanding loan size ratio= Gross loan portfolio-;- NLO
Average loan disbursed ratio= Value of loans disbursed~ NL
Portfolio-to-assets ratio= Gross loan portfolio-;- Total assets
Loans-to-deposits ratio = Gross loan portfolio -;- Deposits
Average deposit account balance per depositor= Total deposits~ ND
Average deposits account balance= Total deposits~ NOA
Customer turnover ratio= NNAC
Active customer per staff member ratio = TNAC -;- TNP
Rorrowcrs per loan officer ratio = NAB -;- TNLO
The first customer-related ratio that is considered is the borrowers per loan offi
ratio. which measures the average number of borrowers that are managed by ea
loan officer in the bank. An alternative ratio to consider is the active customers
staff member ratio that measures the overall productivity of the bank's personnel
managing their customers. The customer turnover ratio, on the other ha
calculates the net number of customers that are continuing to obtain access to t
bank's services over the estimated period. Equation 8.36 provides a measure
customer loyalty to the bank and Equation 8.3 7 provides an indication of custom
outreach. Furthermore, the loans-to-deposit ratio can be used as a proxy to measur,
the intermediation function of a bank, where it determines the role of deposits as
funding source. The portfolio-to-assets ratio measures the level of allocation of asse
to the bank's lending activities and the average loan disbursed ratio can be used t,
project possible future disbursements. Finally. the average outstanding loan size rati
measures the average outstanding financing that was accessed by customers. 30
Customer-related ratios
Bank Management in South Africa -A risk-based perspective
8.2.3.6.2
214
~
Total loans
Total assets
~
=Loans to the private sector ~ Total loans
Equation 8.48
Equation 8.47
Equation 8.46
Equation 8.45
Equation 8.44
Equation 8.43
Risk-adjusted performance measures are additional performance measures that
should also be considered by financial analysts and especially by investors (see
Chapter 10). Besides the fact that traditional profitability ratios such as ROE and
ROA lack the ability to account for any risk adjustments, risk-adjusted measures
allow financial managers and investors the opportunity to determine which business
operation is profitable by comparing the risk-adjusted returns against a measure
of cost of capital (also called a hurdle rate). These types of performance measures
provide additional valuable guidelines for performance evaluation, effici~nt asset
allocation and capital structure decisions in multidivisional banks. Risk-adjusted
performance measures are, however, difficult to construct because of the lack of
precise information on the profitability and risk of. in particular, branches.
To conclude, the final and most important factor that must be considered by
financial analyst and investor is the possibility that the bank may become
bankrupt. This leads to the next section which deals with the different ratios that
can be applied to determine the possibility of bankruptcy. These ratios can also be
TOE denotes the sum of total deposits and total shareholders' equity.
User standard 3 = Domestic credits-;- TOE
User standard 2
User standard 1 = Loans lo the private sector -;- Private sector deposits
Liquidity standard = Liquid assets
Asset quality standard 2 = Loan provisions
Asset quality standard 1 =Non-performing loans-;- Total loans
or~
Capital adequacy ratio (CAR)= Tier 1 and Tier 2 capital~ Risk-weighted assets
Equation 8.42
level of stability and efficiency of the bank in terms of complying with the
latory capital requirements set by the SARB in accordance with the Basel
cord. Alternative ratios to consider are the asset quality standard ratios that
borate on the bank's financial viability over the estimated period. In turn, the
uidity standard ratio provides an indication of the bank's high quality liquid asset
sition, which serves as a buffer to comply with unforeseen obligations. Finally, the
er standard ratios indicate the level at which the bank is providing loans and
ditional credit lines to the private sector. Furthermore, general growth rates in
rms of total assets, total customer deposits, total credit facilities and the growth
ate of the bank's financial asset portfolio can also provide evidence of an efficient
nd growing bank. 31 The 'general' CAR is:
Chapter 8: Measuring the Performance of a Bank 215
Bank Management in South Africa - A risk-based perspective
These ratios do, however, have the same shortcomings, as do all the other financial
ratios discussed throughout this chapter. As a result of being based on accounting
data they are backward-looking. This in turn limits their use in strategic decision-
• Retained earnings+ Total assets
Market value of shares ~ Book value of debt
Working capital + Total assets
Total debt+ Total assets
Earnings before interests and tax + Total assets
Net income + Total assets
Cash flow + Total debt
Cash flow + Long-term debt
8.2.3.7 Predicting insolvency (Bankruptcy ratios)
In the event of filing for bankruptcy, all the debtor's assets are evaluate.d
measured to be used to repay a portion of the outstanding debt. At this stage, ho
some of the debt can still be outstanding. This can further amplify future liq
problems of the debtor. Should a bank go bankrupt, there are severe consequenc
the employees, who lose not only their jobs, but also their source of income. Espe
in financial sectors that are highly concentrated, the bankruptcy of a major bank
have severe negative spillover effects. This in turn can affect the earnings of ot
banks, the trust of customers and investors, and possibly lead to the bankruptcy
other banks that are compelled to pay outstanding debt that is owed to the bankr
bank. This systemic risk was one of the major drivers of the global nature of
financial crisis. Some of the most profound international announcements
bankruptcy that had immense spillover effects on the world included Northern Ro
(22 February 2008) and Lehman Brothers (15 September 2008).
As such, when analysing the overall performance of a bank, an analyst has.
be able to identify early signs of possible banking problems. There are nine rati
(including the current ratio from Section 8.2.3.4) that can serve as an effecti
overall evaluation of the possibility for a bank to go bankrupt. These ratios inclu
the following: 32
defined as thelllgal~tatiiSot,a oan~~n~~ltlS unao11
',E3ankfuptey
outstantling debtowect to creditors arid is also.unable to perfomi.ffs.,
ca.Abe
used as benchmarks for other banks to increase the overall level of performanc
216
217
g by the senior management within a bank. 14 Accounting ratios also provide
r no indication as to the specific reasons for 'good' or 'bad' pcrformance. 12
portant thing to realise, however. is that by combining both financial and
nancial performance measures the financial analyst is provided with a more
ive evaluation of the overall performance and efficiency of the bank.
Chapter 8: Measuring the Performance of a Bank
218
Bank Management in South Africa A risk-based perspective
Chapter 8: Measuring the Performan
ce of a Bank
219
220 Bank Management in South Africa - A risk-based perspective
221
nderstanding non-firiaricial performance measures
ing non-financial performance measures in a bank's evaluation process
e several benefits for strategic decision-making as these measures can
te customer satisfaction, on-time delivery, market share, innovation
and product/services quality and productivity. 7 Non-financial performance
are perceived to be better indicators of managerial efforts, 33 of long-term
ce 34 and also provide more information on the causes of firm failures. I 5
rtcial measures are also used to measure the changing technological
ent and the key leverage capabilities in order to achieve key competitive
ges. 35 More importantly, non-financial measures arc less prone to
Jation than accounting ratios. 36 They also have the ability to provide more
e efficiency measurements, compared to that of traditional financial ratios,
form only one aspect of the bank's overall performance. 10 This entails
ining a bank's ability to use resources effectively in delivering products and
(cost efficiency), by using the lowest levels of input (technical efficiency) and
k's skills at generating income from these services {profit efficicncy). 9
ere are several non-financial measures that can be applied to the performance
at.ion process. These include approaches such as benchmarking, total quality
gement {TQM), European Foundation for Quality Management (EFQM),
ced scorecards (BSC), data envelopment analysis (DEA), stochastic frontier
sis (SFA) and multilateral total factor productivity (MTFP) indices. The three
common approaches used are balanced scorecards, DEA and SFA. The BSC
ibutes operational components to the traditional financial measures 37 - it
!es management to link performance measures to their vision and strategies and
s to channel the bank's resources, abilities and energy to achieve its long-term
s. 38 The BSC also allows the bank to pinpoint its strategic objectives by using the
,wing four pillars: financial perspective, customer perspective, internal business
cess measures and learning and growth measures. 37
Financial perspective includes financial measures such as those discussed in
tion 8.2.3. Customer perspective includes indicators such as customer needs, the
1 of defects present in incoming and on-time delivery of required products and
vices. 37 These measures can be calculated with information that is gathered from
tomer surveys, repeated sales to customers and from respective customer
ofitability analysis. The value of customer perspective is crucial because it helps
e bank to connect its internal processes to improved outcomes with its
stomers. 38 •39 The internal business process measures are based on the objective of
ost efficiently produced products and services that meet customer needs. For
,xample, on-time delivery from suppliers, cost of non-conformance and lead-time
eduction. 38 Finally, the learning and growth measures focus on developing the
capabilities and processes needed for the future. This can include the speed of
transactions or the number of people involved in a transaction. I 5
The DEA and SFA models, on the other hand, are used to measure the efficiency
of a bank. They measure, taking into account the bank's overall objectives, the
maximisation of output, the maximisation of profits or the minimisation of costs. 10
The DEA model determines the bank (best-practice) that produces outputs with the
Chapter 8: Measuring the Performance of a Bank
Bank Management in South Africa - A risk-based perspective
8.3 CONCLUSION
Performa nce measurem ent is not an easy task because of the variet
performa nce indicators. Financial accountin g ratio measures are not
al
appropria te for measurin g the bank's performance, because a bank may
perfi
differently with different ratios and data can become difficult to interpret. It
ca
misleading if the product mix changes over time and in cross-sectional analyses
the banks being compared have dissimilar product mixes. Also, financial measu
are backward-looking and do not reflect the long-term and future conseque
nces
manageri al actions. Furtherm ore, one of the most problema tic drawback
s
financial accountin g ratios, such as ROE and ROA, is that they do not include
a
risk adjustme nt or risk exposure measurem ents, which will be discussed
in mo
detail in Chapter 10.
Additionally, using financial indicator s as the sole measure for incenti
•
purposes may encourag e manageri al focus only on the short-ter m strategy
and ma'
distort the decision-making process. Financial accountin g ratios are not an
effecti
means of represent ing the many facets of performa nce and are unable to
captu
the interplay between multiple resources and outputs. Also, the required financial
data is not always available and sometimes the required financial statemen
ts are
impossible to obtain. This has led to the development of non-finan cial measures
,
least inputs by using data on input prices, costs, and outputs. 40 It involves
linear programm ing methods to construc t a non-para metric piecewi
across the data. This is used to measure the relative efficiency or prod
terms of the inputs and outputs selected by the bank. 41 Also, the prob'
measurin g bank efficiency is data availability. Typically the databases of ba
accommo date accounti ng procedur es and not combined analysis of ope'
marketin g and financial data. The DEA model is considered to be an ap
method for overcoming these problems because of its modelling flexibilitI
ability to address qualitativ e and quantitat ive data, and non-discr etion
discretion ary inputs. 42
The SFA model incorpora tes the costs of different financial prodti
services of the bank. This model allows the financial analyst to evaluate the
cost efficiency in more detail, whilst simultane ously determin ing standar,
efficiency and alternativ e profit efficiency. 43 The major drawback of the SFA
when compared to the DEA model is that the former requires more assu
about the form of the frontier and the errors, which makes the cost fronti
flexible. 44 •45
Nevertheless. even with the different shortcomings associated with non-fin
and traditional financial measures (accounting ratios) they are the only infor
sources that are available in order to construct a proper platform for manage
make long-term decisions. It is, therefore, important for a financial analyst and
Ii
management of a bank to determine the most effective combination of financi
non-financial measures. Doing so will generate the most comprehensive and trans
information to help a bank overcoming the gap between their actual performan
ce
their desired performance.
222
223
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borporate more performa nce-relat ed aspects, such as customer satisfaction.
delivery, market share, innovatio n measures and product/s ervices quality
'uctivity. This means that an effective bank performa nce evaluatio n process
to include a combinat ion of non-finan cial and financial measures to
anageme nt to plan for and adapt to both short- and long-term objectives.
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224 Bank Management in South Africa - A risk-based perspective
erman, D & Ladino, G. 1995. 'Managing bank productivity using data
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are, R, Grosskopf, S & Lovell, CAK. 1985. The Measurement of Efficiency of
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olany, B & Storbeck, J. 1999. 'A data envelopment analysis of the operational
f6ciency of bank branches.' Interfaces 29(3): 14-26.
erger, AN & Mester, LJ. 1997. 'Inside the black box: what explains differences with
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ester, LJ. 1994. 'Ejficiency of banks in the third Federal Reserve district.' Federal
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Risk Regulatory Review BASEL III May2013.pdf (Accessed 12 September
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SiteCollectionDocuments/PDF/ Accenture-Basel-III-Handbook.pdf (Accessed 12
September 2013).
Chapter 8: Measuring the Performance of a Bank 225
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9.2 SELECTED CONCEPTS IN RISK MANAGEMENT
At the outset, it is important to take cognisance of the fact that risk managemen t as
• a practice is not limited only to banking or finance. It can apply to any sector that
experieric'es risk - to name a few, the medical, IT and energy sectors and even to
• certain functions within project managemen t. 1 The list is to all intents and
· purposes, endless, which is a very real problem regarding the use of risk terminology
because reference to something in one context may not mean the same in another.
An attempt to standardise risk language has been a priority for risk practitioner s
INTRODUCTION
'he -business of banking is synonymou s with risk. Risk is pervasive and part of
very business activity in which the bank is involved. In recent years and especially
ollowing the systemic effects of the Global Financial Crisis (GFC). the pressure
placed on banks to identify, quantify and manage risk is more pronounced than ever
before. Banks have therefore placed increased pressure on internal organisation al
structures to adopt an all-encompassing risk managemen t approach.
This chapter provides the backdrop for the remainder of the book in that it sets
the tone for the organisation al philosophy vis-a-vis risk managemen t, specifically
: via the enterprise-wide risk managemen t (ERM) approach.
reading this chapter, you should be able to:
explain why banks must manage risk
differentiate between risk management and risk measurement
>differentiate between risk and uncertainty
discuss the trade-off between risk and reward in the management of risk
explain the difference between risk appetite, risk tolerance, risk capacity and
• risk attitude
name the five principles of risk appetite
explain how banks apply risk governance through the three lines of defence
model
identify and apply the steps that banks can follow when adopting an
enterprise-wide risk management approach
discuss the six driving forces leading to the use of enterprise-wide risk
management within banks
discuss the four ways banks diversify risk
discuss the future outlook regarding risk management for banks.
a Risk Philosophy in
~
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11·•.1._
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'!
Risk management versus risk measurement
There are five principles of risk management within an organisation: 1
1. The activities used in risk management must be proportionate to the overall level
of risk.
2. The risk management activities must be aligned to the other operational and
functional activities.
3. The risk management approach must be as comprehensive as possible.
4. The activities used in risk management must be embedded within the operations
of the organisation.
5. The activities used in risk management must be as dynamic and responsive as
possible to the impending risk environment.
There are two components of the overarching risk management paradigm that nee
to be considered within an organisation: managing risk and measuring risk. Risk
management refers to managing and leading people, processes and structures within
an organisation to identify and mitigate risk. 3 This implies a co-ordinated effort from
management to align activities with organisational strategy (or goc11s). 1
9.2.1
Managing risk is an important management function that not only ensures th
survival of a bank, but also the stability in the economy at large.
The following section provides an overview of some of the most importa
concepts relevant to risk management in the field of banking (commonly referred t
as financial risk management).
ff risk is so ubiquitous, why should banks manage it?
•
Banking is all about risk-taking, which is part of the everyday operations in
•
Failure to identify and manage the risk facing banks will result in bank fa
and a possible run on the bank's deposits.
•
Risk management in banks ensures that financial markets are stable, w
promotes consumer confidence and trust in the system.
•
Banks are exposed to both local and international financial markets with t
own set of common and unique risks.
•
The interconnected nature of financial markets in a globalised world r
systemic risk and contagion effects.
• The interrelated and co-ordinated nature of monetary (usually the custodi
of managing and regulating banks) and fiscal policy cannot be sustainable '
banks do not manage their risk.
•
The intrinsic mismatch in the maturity profile of a bank's balance sheet - th
is, short-term liabilities fund long-term assets.
•
As the name suggests. risk management implies the management of risk, ri
the avoidance thereof. Risk-taking can be profitable, which potentially protec
and maximises shareholder wealth. The opposite is also true.
and the International Organization for Standardization (ISO) has published th
Guide 73:2009 2 as a reference for standardised generic terms in risk managem
230 Bank Management in South Africa - A risk-based perspective
231
Risk versus uncertainty
Although Chapter 10 provides a detailed discussion of the risks facing financial risk
managers in banks, it is important to make a distinction between risk and uncertainty
because of the application of policies to address these concepts. According to ISO 73.
risk is typically the deviation from an expected outcome and is often described as an
event with either positive or negative effects. 2 Hopkin suggests referring to risk as 'an
9.2.2
ese are by no means the only three measures used by risk practitioners. Risk can
be measured as absolute (the loss as a proportion of the initial value) or relative
easured relative to a benchmark). 4 Within the lield of financial risk management
ere are many tools at the disposal of risk managers. VaR in its various forms is the
iiost widely used measure and can be calculated using the RiskMetrics, Monte Carlo
t historic methods (see Chapter 10). Normal and lognormal distributions are also
sed in risk modelling and distributions, with time-varying volatilities making use
f simple measures like a moving average to more complex techniques such as the
eneralised autoregressive conditional heteroskedastic (GARCH) and exponentially
eighted moving average (EWMA). 4
The problem with risk measurement, however, is that traditional risk measures
re backward-looking and assume outcome distributions that are stable and
pplicable for the future. 3 This is not always the case, as evidenced during the GFC
where outcomes that would have been predicted as being highly improbable actually
·occurred. Risk measurement has to consider these unlikely outcomes and account
for the potentially devastating effect they can have. Furthermore, the reliance on
:models must not be done at the expense of people, especially regarding their ability
.to react at the lirst sign of model weakness. 3 Needless to say, although risk
measurement is vitally important within the ambit of the broader risk management
process, assumptions regarding distribution, volatility and correlation should not be
· regarded as constant over time, especially given the complex, interconnected and
dynamic nature of financial markets.
Risk management and risk measurement are therefore not mutually exclusive,
but complementary of one another. If risk practitioners cannot identify the
magnitude of potential losses by measuring the risk, they cannot align the internal
processes to avoid these losses. As the old adage goes, 'one cannot manage
something that is not measured.'
incurring a greater loss and is characterised by a certain level of confidence
(such as 90%, 95% or 99%).
Value-at-risk (VaR): the cut-off point where there is a low probability of
mean
easurement refers to the numbers - the quantitative measurement of risk using
lex mathematical and statistical models. 3 Risk practitioners typically construct
els reflecting return or loss distributions as the basis for risk measurement. These
4
ibutions reflect three important statistical measures used to interpret risk:
Mean: the average value of the elements used in the distribution
Standard deviation: measures volatility and specifically the dispersion around the
Chapter 9: Establishing a Risk Philosophy in Banks
Bank Management in South Africa - A risk-based perspective
A
JOA
Figure 9.1 Risk versus uncertainty
-
(e)
{c)
{d)
-=--=---~---~----· ~.-----~~·-·--
Lines (a), (c) and (e) reflect outcomes management knows can occur. This
risk. Although management might not know whether or not the outcome will be,
for example, a positive risk outcome (a) or a negative risk outcome [(c) or (e)), it
knows that the outcome could be one of the three. Conversely, (b), (d) and (I) are
outcomes that are not known to management. This implies uncertainty. For lines
Source: Adapted from Laycock (2014: 18) 5
(f)
(a)
-------- (b)
Figure 9. l provides a depiction of risk versus uncertainty.
unplanned event with unexpected consequences' .1 Laycock concludes t
materialisation of a risk event is not guaranteed, it has an effect on the value of
and the consequences thereof are either positive or negative. 5 Uncertainty, on t
hand, occurs where there is no known outcome for an event. 5 Perhaps the mo
known distinction between risk and uncertainty is that provided by Jorion: 3•4
■
J(nown knowns
These are risks that we know that we know.
orooenv
measured and accounted for by management.
■
Known unknowns
These risks are those that have been ignored, measured inaccurate
interpreted incorrectly by management. The issue here is not tha.
organisation does not know about the specific risk (in fact it does), rather, t
has not properly accounted for this risk, either wittingly or unwittingly.
■
Unknown unknowns
Unknown unknowns are risks that an organisation does not know it
know. Because these risks are not known, they cannot be accounted for.
suggests uncertainty. As Jorion states, '[e]valuating such risks will always
challenge but their existence must [first] be acknowledged'. 3
232
233
The risk-reward trade-off suggests thatthe higher the degree of risk taken, the greater
the likely variability in reward. In other words, if more risk is taken, the variability
between earning greater rewards or incurring larger losses simultaneously increases.
This implies that higher risk-taking is more likely to be either very rewarding (with
higher returns) or very unrewarding (with larger losses). Conversely, if less risk is
taken, the variability between earning higher rewards or incurring larger losses
simultaneously decreases. This implies that lower risk-taking is more likely to have a
stable and predictable reward with neither higher returns nor larger losses. In order
to manage the risk-reward trade-off, a three-pronged approach would be to:
1. manage the degree of risk-taking •
2. reduce the likelihood of losses
3. maximise return (reward).
Figure 9.2 The balancing act of risk management in the risk-reward trade-off
RISK MANAGEMENT
Losses due
to excessive
risk-taking
management is not about avoiding risk - it is about managing it. This implies
taking higher risks is a plausible strategy as long as the likelihood of losses are
ltaneously minimised. Risk management is therefore a balancing act for
nisations given that the risk-reward trade-off is part of every risk-related
ity. Figure 9 .2 depicts this trade-off.
Risk versus reward
(d). the outcomes are respectively bound within the positive (a) and negative
outcomes. Line (I), however. is outside the range of possible risk outcomes
nted for by management at that particular point in time. Lines (b), (d) and (f)
,ly to the definition of uncertainty because management is uncertain about the
-range of possible risk outcomes. 5 That is, they do not know the outcomes can
),(d) or (I).
"he ability of management to identify risk outcomes is vital for a successful risk
agement policy as it provides more certainty and clarity with regards to risk
sure faced by an organisation. This has a direct effect on the possible losses and
quent return that is achieved.
Chapter 9: Establishing a Risk Philosophy in Banks
Bank Management in South Africa - A risk-based perspective
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Contextualising the organisational risk philosophy
The risk philosophy of an organisation must represent the instituti
onal ethos·
regarding its approac h to risk. It must be comprehensive, yet specific,
and clearly
delineate its relevance to the various business units. The commun ication
of risk and
the monitoring of its outcomes must be integrat ed into daily working
s. For the risk
philosophy to be inbred in the culture there are a few importa nt concepts
that must'
be clearly conceptualised.
The risk statement specifies the instituti onal risk philosophy and provides
the•
overarch ing risk approac h. This stateme nt is usually part of a larger
docume nt
that incorpo rates various risk concepts and can be as short as one
sentenc e or as
long as a few pages. What is importa nt is that this stateme nt gives
the reader a
good overall impression of the organisa tion's risk approac h.
Once the risk
stateme nt has been determi ned, the Board of Directors (Board) must
determi ne
9.2.4
The matrix indicates that the higher the degree of risk taken (AFG),
the highe
(I) or lower (G) the reward. Conversely, the lower the risk, the lower
the expected
reward (A). The challenge for manage ment is to maximise the trade-of
f such that an.
acceptable degree of risk is taken that minimises losses and maximis
es the reward)
Ideally this would be in the quadran t DEHL The challenge for manage
ment is to find
some sort of acceptable balance between the risk taken and the eventua
l reward
generated from the risk activities. This implies an organisational approac
h toward
managin g risk that reflects its risk manage ment philosophy.
Figure 9.3 Risk versus reward matrix
Low risk
Moderate risk
High risk
Figure 9.3 provides a matrix reflecting the decision to pursue risk or
reward.
234
235
~ - -
~
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~ - " " · · \ .,.r_._,c·_.,/;<(lf, .1 _"" _
""" _ '\\'\ll'1't
... f- • . , ¼-.•·-Y_<W'(ss.W ,_,.¼.'i,11))! .. -.',:.s••·,, ... ;
By clearly defining these four considerations, the overall risk
appetite can
be communicated via the risk stateme nt. The risk appetite can
be stated per
strategic objective and according to the different risk categories. 6
Subsequently,
implementation must be monitored through the audit and compliance
function and
the corporate governance structur es must complement the organisa
tional culture.
Ensuring that organisational behavio ur is directed towards risk-based
decisions is a
vitally importa nt aspect of risk culture due to the fact that not all risk
can be formally
oescribed in policies and procedures. 5
here are four considerations that determine the risk appetite of an organisa
tion: 6
The existing risk profile is 'the current level and distribution of risk
across the
entity and across various risk categories.'
Risk capacity is 'the amount of risk that the entity is able to support in
pursuit of
its objectives.'
Risk tolerance is the 'acceptable level of variation an entity is willing
to accept
regarding the pursuit of its objectives.'
The risk attitude is 'the attitude towards growth, risk, and return.'
SO provides five principles related to risk appetite: 6
It guides organisa tional strategy.
It guides resource allocation.
It aligns people, processes and infrastru cture.
It represents organisa tional risk philosophy, which in turn influenc
es culture
and operating style.
It aligns organisational strategy with risk appetite.
in other words, what is its risk
tite? According to the Committee of Sponsor ing Organis ations
of the
adway Commission (COSO), risk appetite is '[t]he amount of risk,
on a broad
'el, an entity is willing to accept in pursuit of value. It reflects the
entity's risk
nageme nt philosophy, and in turn influences the entity's culture and
operatin g
6
5
le.' Laycock defines risk appetite as 'the amount and type of risk
that the
anisatio n is willing to pursue or retain.' The central characte ristic
of risk
petite is therefore how much risk an organisa tion is willing to take
to achieve its
ategy (or organisa tional goals).
wmuch risk the organisa tion is willing to take -
Chapter 9: Establishing a Risk Philosophy in Banks
"' ., 1\\\6•.'. •
ENTERPRISE-WIDE RISK MANAGEMENT IN
BANKS
RM must be at the heart of the organi sation al approa
ch to manag ing risk and be
cknowledged in every transa ction and process condu
cted by every person or
epartm ent in the bank. It must be all-encompas
sing and explicit. The
organisational struct ure is param ount in ensuri ng
the enterprise-wide nature of
risk manag ement . Figure 9.4 provides an examp
le of such an organi sation al
(organogram) struct ure and highlights the interc onnec
ted nature of the functions
performed by a simple retail bank.
he three lines of defence model provides a framew
ork upon which organisations
an build and align their strategy to the risk manag
ement policies in a struct ured
anner. 11 The ERM approa ch is a natura l outflow of this.
1:it>roa:ch adopted by many organisations and especi
ally financial institu tions is
marcate their risk governance into the three lines of
defence model: 5•11
First line of defen ce: Busin ess opera tions
·• The first line of defence includes the front-line staff
who act in accordance with
)he risk appetite provided by the Board. Also known
as the 'risk owners', the
frisks are identified. assessed, decisions made and report
ed on as part of the daily
business activities.
Secon d line of defen ce: Risk overs ight funct ions
The second line of defence refers to the ri.sk oversight
function and specifically
includes the compliance and risk manag ement
functions within an
organisation. The oversight functions are usually
aligned to the types of risk
the organisation is exposed to within the differe
nt business units in the
organisational structu re.
Third line of defen ce: Indep enden t assur ance
J>roviders
The third line of defence refers to the assura nce
of risk manag ement role
provided by auditors, both intern ally and externally.
The role of the audito rs is
to independently confirm wheth er or not policies
and procedures are being
adhered to, whilst they simultaneously 'stand back
from the detail and assess
the overall shape and configuration of the policies. standa
rds and procedures'. 5
Bank Management in South Africa - A risk-based perspective
The hypothetical retail bank reflected in Figure 9 .4 has five main business units
service retail clients. These are:
l. The sales and marketing unit: the staff responsible for selling and marketing t
products and services offered by the bank - otherwise known as the 'front-office
2. The distribution channel unit: the unit responsible for providing and managi
the physical branch and ATM infrastructure used to interact with clients.
3. The technology and operations unit: the unit that conducts the administrati
function and ensures the functioning of the technology used in normal reta
banking operations - otherwise known as 'back-office'.
4. The credit management unit: the unit responsible for receiving loan application
and making decisions as to whether to approve or decline these applications.
5. The legal and recoveries unit: the unit responsible for taking legal action on behalf
of the banks where clients do not service the loans as per the loan agreement.
Figure 9.4 Organogram reflecting functional and risk integration for a hypothetical ret
bank
238
239
There are no simple answers to these questions and this highlights the fact that
risk integration is commensurate with functional integration. In other words, because
an organisation has different business units that rely on each other to deliver on
their respective function, this shared environment implies that the risks inherent to
arly all five of the units provided in Figure 9.4 are involved in the loan application
ocess but which unit is responsible for the loss the bank incurs?
Is it the sales staff member at the branch who collected the fraudulent identification
document and information provided on the application form?
Is it the administrative staff member at the branch who did the credit and
identification checks on the client but failed to pick up the fraudulent
information?
Is it the credit analyst who approved the loan based on the fictitious information
used to make this decision?
Is it the failure of the legal unit to recover the lost funds because they have no
legal jurisdiction in the neighbouring country?
;sume a client walks into a branch and wants to purchase a new car. The sales
·aff member suggests applying for a vehicle-financing loan, whereupon an
,plication form is completed and emailed to the credit unit after the
"ministrative department completes all the necessary credit checks. A decision
made for the loan to be granted with the condition that a 10% deposit be paid.
ne client pays this and collects the brand new car the next day. For the next three
nonths, however, the client fails to make any instalment payments to the bank.
"eing in arrears, the bank tries to contact him but finds that the contact details
rovided are incorrect. Further investigation reveals that the identification
'ocuments given during the application were fraudulent and all the information
rovided on the application form belongs to an unsuspecting client of another
bank. The bank is unable to get hold of the client and the account is handed over
to the legal department for legal action and recovery of the funds. The legal
department is unable to recover the funds due as their investigation reveals that
the client has fled to a neighbouring country where the bank has no legal
'jurisdiction. Subsequently, the branch is required to write off the loan as a loss.
der the following scenario:
ve units are essential to performing the services to clients that the bank claims
An important feature reflected in the organogram is the integrated nature
ve functions. Without a branch and ATM facility, the sales staff cannot sell
cts; without a back-office to do the administrative function, a loan application
ot be captured for the credit unit; without a decision on a loan from the credit
he sales staff cannot provide a personal loan; without the legal expertise from
gal department regarding loan default, a branch would not be able to recover
funds should the client default. The functions in a retail bank are therefore
bnnected and intertwined. Importantly, so too are the risks.
Chapter 9: Establishing a Risk Philosophy in Banks
Bank Management in South Africa - A risk-based perspective
g;ted::b~h
feater recoghiti
lliikli •are 1116fe't:6111~lic
'Th~if~i~!t•i~ati!~i61";iJ~W~r~Jw
towards q'uatitifyingfisk in
engirleeririg}insurartce, m
0
::g
- ~.. - ~ - = - - - • • •..•••-""'··-
,s-_,.0•"·u-,
Once the organisational structure has been identified and the business units are
aligned to perform their specific functions, the risk management environment must
be contextualised within the ambit of the structure. This is where the steps of ERM
become relevant. Figure 9.5 provides these steps.
revehti~•ginerating oppo'ftunities;
fv.>.~~~!"g,i~r~~sterri~g·e~i,1ct.i.Ye1ypursuin~t¢ertain
z~:}:lttitu~.~t.P.v.>ar~sri,~~t~s~y~ry;~M~·fry,n:-
:;~, ~ii1risseJ~~ser.1epportu,,'.'.!e··;c·c . .
/i
th;·~~~e;pf risk•·.rn~nage~.~:.•·;·---· ....•... :.--r;c.;:;.~.;.·.~.-.-:•·c.<c. •
ban~ing:rel~ted ind.ustries>Gl?bali~at.ip~and·_·interconnected
•
re:~tted in;; ;;'teiGflnform~!ion•sharing With
••
Mva~~'esj~JechnolpgY, riskm.p?e
events;'Md}thejntegration of spe
s: e!~~,~~i~~~~~~~!!~~~!
4;
fraaitiohal'ftnahbiartisks.
t:ahd;iritegra:fetl view,.-especiallywi
3 ••.. ~ifl~!~ffEt~e~tj~I,~11;fi~f1~
.· < Mor& receritly}~e};n~ency to)~
martagingcltgahisatiohal risk,
agfealer··awareriessarid
weti=!S'ilblic:i;eafailurM in
2.~xt~rhal.pr~~sur~~~re i
~ _; :t:acc6~ntiibleJorl'Tla~agi
ti
tlhaddltion f6 rtia'na.girig the
,f8foes:feaclingfothe use of
the functions are also shared. In Figure 9.4, where a risk would normally a
only one unit, it becomes applicable to another because the units are functi
dependent on one another. The ability of a bank to manage both the function
risk integration at the organisational level is at the heart of the ERM risk ma nag,
approach.
240
and Burnaby & Hass (2009)
1
241
Step 2: organise
Once the risks have been identified, they need to be quantified and integrated within
a framework that ensures proper control by a respective business unit. The control
t the heart of ERM lie the basic management functions - plan, organise, lead and
ntrol. ERM builds on these functions and adapts the context to provide a pervasive
d integrated risk management approach that contextualises the identification and
anagement of risk within the organisational framework.
13
The steps of ERM are: 12 •
Step 1: plan
When adopting an ERM approach, planning is essential. Before any policy
framework can be developed there must be a clear and well-formulated risk
mandate from the Board. This framework must incorporate the explicit risk
philosophy and strategic direction the bank intends to take and ensures that an
organisational context is established. This context is both internal and external the former refers to the current status quo within the bank, relating specifically
to the objectives of the bank, the structures in place to achieve these objectives
and the key performance indicators in place to measure the achievement of the
objectives. The external context refers to the environment outside the
immediate control of the bank. This may include the markets that the bank is
exposed to, its biggest competitors and the economic factors that impact on the
performance of the bank and its stakeholders. If the mandate is clear and
articulate, the ERM department is better able to ensure co-ordinated buy-in
throughout management structures. This in turn ensures that the risk control
framework is contextualised for the relevant departments to use as a blueprint
to identify and manage risk on an enterprise-wide basis.
12
9.5 The steps in enterprise-wide risk management for banks
,urce: Adapted from Casualty Actuarial Society (2003)
'.Ure
Chapter 9: Establishing a Risk Philosophy in Banks
~f~'
-_"~ ~iR~ ira2 ~Ji~ iiBG t&'6 i'~sp
~~~ J1JJ ~~,1 ~i~~ r~t~ §,~, ~~ff
!~1? pi;-- •
department~;rnust have a clea
r mandate of th:irr~llc! in the r,rtie
essand th
-• ,be accountability throughout
the organisation. ,1r{bank1-••/the otga~isatiohal· ~tructure·is
·a1ways
,.-- acre.dit card }~j~ U~d toa- clie
nt,th er:a re
_-•- ow~e.rship'.~f;ffje yari.ousscena
rios I.f1-~tpol11H,~R.B~f:CH
;:card.fp~exa~ple,•111e· er.ed
it dep artT :nt,i n tfj~,f~:di\,§ard
-card:then;tfj'e/pard theyissue
-_is deliv:red t~ tfj~br~neh
A.n,ffjisexampl~;;Te~:'Y delivering
thesard_.tp.t~::e11e~_t .iny,
~_depart~ents:tf1:•·-~~~dit • ca~d
_Cextertial)'atidfffe•branch ItseldiVisionot~edeliv:;-yc9un:r(~fi~!ti'er\tgtef1~r
f /They each pefforrri a different
role.(approval/
•
-■
mus t be all-encompassing and
include both inte rnal and exte rnal
comp'
The risk control framework mus
t be seen to incorporate downsid
e risk a
possible opportunities that need
to be exploited and the business
unii
ensu re that they have a clear set
of objectives for whi ch they are
held acco
These objectives mus t be accompa
nied by a clearly defined set of
outco
performance measures) which
can be measured. The quantificati
on and
of the various risks in part icul
ar will require clear guidelines
that are
with the organisational risk phil
osophy and the man date provided
by the
Communication between business
units is vitally imp orta nt and may
requ
establishment of various committ
ees in order to shar e information
.
Step 3: lead.
Once the plan ning and orga
nisa tion al con text uali sati on
has oc
man age men t needs to lead and
motivate the staf f to achieve the
stated obj
In addition to com mun icat ing,
man age men t mus t use thei r auth
orit y b
the head of a business unit and
as the ultim ate cust odia n of the
objectiv,
by the Board. The leaders mus
t supervise the process accordin
g to the
objectives and ensu re that repo
rting syst ems and the inte rpre
tatio n ther eo
as comprehensive as possible. This
may require the prioritisation of
certain
especially given the ever -cha ngin
g dynamics in financial markets
.
Step 4: con trol
The ERM process can be implem
ented, but if it is not effective,
then ther e
need to con tinu e with it. Control
and the monitoring of the process
is thus vi
imp orta nt to ensu re that wha
teve r is not working be revisited
and changei
necessary. Each step in the ERM
process needs to be monitored and
based orfl
repo rtin g systems and the con
textualised framework set out
by the Board
this is not the case, revisions need
to be made. Alth oug h these revi
sions rri
alte r the objectives (or at leas
t thei r application) for each busi
ness unit . it
crucially imp orta nt to ensu re
that the overall man date is
followed. M
importantly. if man age men t does
not con stan tly mon itor and revi
ew the E
process, the ban k run s the risk
of losing touc h with the risk
env iron m
within whi ch it functions. The
challenge is to be proactive and
stay abre ast
new developments in orde r to
foresee future risk implication
s that can ha
enterprise-wide consequences.
242 Bank Management in Sou
th Africa - A risk-based perspect
ive
Ht aa1J\i1e's1··•·
integratedbut
Banks also diversify thei r risk cation
geographically. A com mon way
to do this is to offer
products and services in differen
t countries. A ban k such as Stan
dard Bank has a
strategy that focuses strongly
on repr esen tatio n in Africa. In
addition to Sou th
<Africa, these African cou ntri
es include Lesotho, Swaziland,
Namibia, Bot swa na.
.Zimbabwe, Mozambique, Ang
ola, Zambia, Malawi, Tanzani
a. the DRC, Uganda,
Kenya. Sou th Sud an, Gha na and
Nigeria. 9 Alth oug h the exposur
e to othe r cou ntri es
brings with it risks in othe r form
s (such as foreign exch ang e and
sovereign risk) it is
imp orta nt, given the global natu
re of ban king these days, to avoi
d. whe re possible,
exposure to only one country.
.4.2 Geographical diversifi
cation
rnost obvious way ban ks dive
rsify thei r risk is thro ugh thei
r prod uct- and
-ice-mix. Banks have a wide vari
ety of assets and liabilities that
have different:
values (how muc h they are wor
th)
ima turi ties (how long they
are expected to be on the books
of the ban k)
expiry dates (the date they mat
ure)
. pricing features (the fees and /or
inte rest rate applicable)
-_- functional features (wh at they
can do).
riks have also diversified thei
r reve nue stre ams into non -tra
ditio nal ban king
ctors such as insu ranc e. By offe
ring both ban king and insu ranc
e prod ucts and
rvices they are able to capitalis
e on selling a complete financia
l offering to clients.
,client no longer has to go to eithe
r a ban k or an insu ranc e com
pan y - thes e services
··e offered und er one roof ata ban
k. This model (kno wn as ban cass
uran ce) has thre e
nefits: first, it increases the reve
nue sources of ban ks to include
insu ranc e-re late d
come; second. it offers convenienc
e to clients, whi ch subsequently
improves service
uality and relationship quality;
third, it diversifies the prod uct
and reve nue15base for
e ban k due to the inverted prod
uct cycle of insu ranc e relative to
banking.
Product- and service-mix dive
rsifi
HOW DO BANKS DIVERSIFY
RISK?
dog risk requires diversity. 14
This diversity can come in seve
ral different
, for example, thro ugh its exp
osure to different mar kets or
products. The
ing four are the mos t common.
'beir\cd'MfatitcohfmuriicatioifWit
h•·i>aCh"6ther.
-'"" vu., ___ u~..- ~·--· ·-·--__
Bank Management in South Africa - A risk-based perspective
Inter- and intra-market diversification
Workforce diversification
Evolving nature of risk
THE OUTLOOK FOR RISK MANAGEMENT IN BANKING
it. is constarr
Risk, or at least. what we currentl y know and understa nd about
in the 19&
risk
credit
assessing
evolving. Consider how bankers may have viewed
client w,
the
of
needs
the
1980s,
the
In
today.
it
and how they might assess
also minim
was
There
loans.
ised
standard
for
applied
they
simple
relatively
hips wit
competition from other banks and they relied heavily on building relations
e
bombard
ly
constant
are
ers
Consum
.
different
very
are
things
their clients. Today,
This occurs vi
by financial institutions, not just banks, that vie for their business.
es and so o
channel s that did not even exist in the 1980s - the internet, cellphon
the types o
about
informed
and
ing
demand
more
are
clients
that
Besides the fact
challengec
are
banks
default,
loans, how they work, and the implications should they
This doe
80s.
19
the
in
existed
than
factors
more
to assess credit risk based on many
that a
markets
l
financia
of
world
complex
the
account
into
not take
permea
must
ment
manage
risk
of
interconnected. Carrel argues that the culture
system. 14 Ris
all the sectors and regulato ry environments in the financial
e natur,
pervasiv
the
given
possible.
as
e
pervasiv
as
be
therefore
must
manage ment
conside
also
and
factors
nomic
of risk itself. Moreover, it must incorporate non-eco
15 Risk and how we understa nd it today, wi
time.
to
time
irrational behaviour from
from now.
be understood differently in the future, whether one year or three decades
9.5.1
9.5
is to
A further way in which banks in particul ar have diversified risk
to em
banks
for
on
uncomm
not
is
it
,
example
For
d.
diversifie
is
workforce that
analy
d
advance
have
highly qualified enginee rs or even scientists because they
to the
and problem-solving skills. This brings an entirely new set of skills
num
and
lfinancia
complex
the
ents
complem
turn
in
environm ent, which
itself is
orientat ed world of banking. Having said this, the world of banking
g are also
diverse and university graduate s in general manage ment or marketin
demand, especially in branche s on the sales and marketin g side.
9.4.4
industri e
Banks further diversify their risk and exposure in different sectors or
ca
diversifi
of
type
This
on.
so
as retail, mining, agricult ure, energy sectors and
se
or
markets
different
between
is
it
as
cation
diversifi
called inter-ma rket
by segme
Within these different sectors, banks further diversify their exposure
, in
the client base according to income or net worth. This can, for example
as i
known
is
and
domain
banking
retail
the
in
banking
wealth
or
retail, private
sector.
or
market
ar
market diversification as it occurs within a particul
9.4.3
s. It c
Geographical diversification does not only refer to other countrie
South
major
the
,
example
For
regions.
t
differen
in
within a country but
itself a
banks have exposure across all nine provinces - the branch network
withi
sectors
t
differen
in
and
means of risk diversification across the country
respective province.
244
Regulatory know-how and resource allocation
will regulato rs
Given model complexity and the future outlook for risk manage ment,
ration in the
Remune
ment?
manage
be able to stay abreast of developments in risk
ge and
knowled
l
technica
the
given
premium
a
at
is
field of risk manage ment
remune rate risk
to
willing
are
iven.
profit-dr
are
who
banks,
If
.
required
expertise
to this, if the
analysts attractively, will regulato rs also be able to do so? Further
d market
dedicate
a
towards
moving
is
Africa
South
in
rk
regulato ry framewo
model (see
conduct and prudenti al regulato ry framework under the Twin Peaks
to the proposed
Chapter 3), will regulato rs be able to allocate the requisite resources
9.5.4
of the GFC
le of the major reasons cited as exacerb ating the devastat ing effects
A study by
banks.
by
used
models
l
financia
the
with
ed
associat
ity
complex
s the
as such
ity
complex
not
was
it
that
Financial Services Research Forum found
to deal
ment
manage
of
abilities
and
s
attitude
the
rather
twas the problem, but
16 There is an argume nt that the risk
ity.
complex
the
with
d
associate
risk
the
th
ity and the
d econometric models were not complex enough, given their uniform 14
g. Going
modellin
the
of
nature
rated
concent
and
comitan t intercon nected
be to ensure
ward, the challeng e for both regulato rs and bank manage ment will
and the
at they strike a balance between the complexity of the15 models
ity is
uniform
If
.
humans
by
-making
decision
nt-based
judgeme
scretion ary
t
amongs
(via,
risk
systemic
ursued, it increases intercon nectedn ess and possibly
banks
if
ively,
Alternat
risk).
ce
covarian
and
ion
ther things, increasi ng correlat
ised and this
re allowed more discretion, models and practices are not standard
The irony is
ormity.
non-unif
to
due
ises concern s about informa tion asymme try
be able to
never
will
models
,
markets
l
financia
of
nature
hat given the complex
enough and
fully capture all the risk. In a sense, therefore. models are not complex
y but is a
will probably never be. Human judgeme nt is therefore not only necessar
risk in itself.
~3 Complexity and the modelling versus judgement issue
service
with the evolving nature of risk is the drive to innovate product and
d,
develope
are
products
new
As
sources.
revenue
increase
to
attempt
sin an
l
financia
As
risks.
of
set
will enter new markets that expose them to a new
on
focusing
by
innovate
to
w
know-ho
their
use
ers in the employ of banks
expect to
s or industries that have traditionally not been entered, they can
ily imply
necessar
not
does
this
nter new risks in different ways. Of course,
as easily
just
could
on
innovati
this
risk;
e
downsid
only
have
e new markets
here
t the bank from a diversification point of view. But that is not the issue
risks.
of
sets
new
with
ments
environ
risk
new
. Rather, with innovation comes
ental in
bility of banks to identify these new risks speedily will be instrum
h
approac
g
d-lookin
backwar
al
·ng they innovate successfully and the tradition
looking
forwardwith
ented
complem
be
must
orecasting risk events
with it new
roaches. 15 Risk manage ment as a discipline is therefore set to bring
Ilenges over time.
Innovation and new risks
Chapter 9: Establishing a Risk Philosophy in Banks
ever-c hangin g
risk
9.6 CONCLUSION
The manag ement of risk is by no means a simple
task. Adopting an enterprise-wide
approa ch is vital as all business units must align functio
nal and risk objectives in order
9.5.6 The incentive-governance dilemma
At the heart of the GFC was the incentive to chase
profits at all costs. This plays
the princi pal-ag ent problem where incentives (throu
gh salaries and bonuses) we
at the forefront of encou raging risky behav iour by
the agents (bankers). Regulator
,and banke rs will have to find the balanc e between
remun eratin g banke rs sufficient!
and ensuri ng that the risk they take is in the
best interes ts of the broade r
stakeh older community. There have been proposals
to link the incentive plans
banke rs to the long-t erm perfor mance of banks,
but wheth er or not this is
effective proposal is questionable. 17 Needless to
say, the application of a
corpor ate govern ance enviro nment within the organi
sation al struct ure of banks
vital to ensuri ng that banke rs do not take risks
in excess of the risk
established by the Board.
9.5.5 Policy and regulatory responses
The GFC not only revealed the interc onnec ted nature
of financial markets. b
the devast ating effects that failure in the monet ary
sector has on the real se
an econ'omy. Moreover, the ultima te macro econo mic
effect that predat ory lend(
the US subpri me marke t caused indicates, in this case,
the strong causal relatio
betwe en microe conom ic and macro econo mic enviro
nment s. This spillover
suggests that regula tors must focus their attenti
on not only on microp rud
regula tion, but also macro pruden tial regula tion. 14
This raises two impo
questi ons from a policy point of view. First, to what
extent must global regul
reforms force co-ord ination of both fiscal and monet
ary policies? Considerin
growt h in budge t deficits and the ensuin g sovereign
debt crisis in Europe post-G
strong argum ent exists for more aligned and co-ord
inated fiscal policies acros
world. Is this a viable consideration? In Europe where
monet ary policy is gave
by the Europ ean Central Bank, could there be
an argum ent for a mega-fl
author ity of this nature ? The argum ent persists, but
one thing is for sure: if gl
regula tory reforms move towards more co-ord inated
fiscal policies, it threat ens'
sovereignty of nation s. Could this be a possible
reason for the next global cri·
Second, to what extent will policymakers (and regula
tors) be able to react spee(
to immin ent risk in financial markets? At the
heart of this conce rn is t
bureau cratic nature of policymaking. Policymaker
s must be able to interv ene wh:
necess ary and do so appropriately, especially if there
are systemic implications
play. It can be argued that the more integr ated and
interc onnec ted policymak,
become, the easier it will be to make approp riate
and speedy decisions. Of cour
the opposite also applies - the more integr ated and
interc onnec ted policymak,
become, the greate r the systemic implications.
the
Bank Management in South Africa - A risk-based
perspective
regula tory framework and address
enviro nment at the same time?
246
247
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,
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__
...... .J
0
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,
=eRENCES
/Hopkin. P. 2014. Fundamental Risk M11nageme11t: Unders
tanding. Evaluating 1111d
Implementing Effective Risk Management. 3rd ed. Londo
(ISO Guide 73:200 9. 2009. Risk Management-Vocabu n: Kogan Page.
lary. Intern ationa l Standards
,Organ ization .
·, , Jorion. P. 2009. 'Risk manag ement lessons from the
credit crisis'. European Financial
i Management 15(5): 923-9 33.
Jorion, P. 2011. Financial Risk Management Handbook:
FRM Part I/11. 6th ed, GARP,
Wiley Finance.
Laycock, M. 2014. Risk management at the top: A 11uide
•
to risk and its governance in
financial institutions. Wiley Finance Series.
Rittenberg, L, Martens, F. 2012. Enterprise Risk Manag
ement: Understanding and
Communicating Risk Appetite. Committee of Sponsoring
Organizations of the
Treadway Commission.
Barclays Africa Group Limited. 2015. Risk management
for the period ended 31
December 2014. http://www.barclaysafrica.com/deployed
files/ Assets/Rich media/
PDF/Reports/2()14/]3arclaYS. Africa Grouo. LimitedJU!ik
Management
Report 2014.pdf (Accessed 21 July 2015).
FirstRand Group Limited. 2015. Annual integrated report
2014. http://www.
firstrand.co.za/InvestorCent.r /Current"!. 20FSR 0!. 20annu
al''<,20re ort/2014'Y<>lil
~~.u t t\,.-.u._,.;.;~.:::_: ~- ;-~~- .-..n, c\
fSR%20annual%20integratect"/oL.
Ureporw1u,
vuc··~
n ""v .<.viJ, .
Standard Bank Group Limited. 2015. Annual integrated
report 2014. http://
annua lre ort2 14.standardbank.com/d wnloads/Sta
n ard-Bank-Grouo-Annualintegrated-report-2014.pdl tAccessect lb July 20_ J
Nedbank Group Limited. 2015. Pillar 3 Basel III Public
Disclosure Reportjor the year
ended 31 December 2014. http:/ /www.nedbankgroup
.co.za/pdfs/baselilDisclosure/
isk JllW Capital Management ]koor t as A 31 Decem
ber 2014.pdf (Accessed
21 July 2015).
KPMG. 2015. The three lines of defence. https://www.kpmg.
com/RU/en/
ssuesAndlnsi hts/ Article Publications/ Audit- 'ommi
ttee- ournal /Docu ments /
The-three-lines-of-defence-en.pdf (Accessed 21 July 2015
). Audit Committee
Institute.
Casualty Actuarial Society. 2003. Overview of Enterpr
ise Risk Ma11age111ent.
Enterprise Risk Management Committee.
Burnaby P, Hass S. 2009. Ten steps to enterprise-wide
risk management. Corporate
Governance 9(5): 539-5 50.
Carrel. P. 2014. The Handbook of Risk Management: Implem
enting A Post-Crisis
Corporate Culture. Wit.tshire: Wiley Finance.
one thing that has become increasingly
s after the devastating effects of the GFC it is that
the impor tance of risk
ment as an organi sation al philosophy is more impor
tant now than ever
. Risk manag ers need to realise, however, that
the manag ement and
remen t of risk has limitations. This suggests that it
be approached with a sense
mility given its potentially devastating effects if not
identified, quantified and
ted appropriately. This is especially so if the organi sation
al stance is taken that
manag ement is not about avoiding risk, but rather manag
ing it- which it is.
as integrated as possible. If there is
Chapte r 9: Estab:ishing a Risk Philosophy in Banks
Bank Management in South Africa - A risk-based perspective
----=--Y")"".11\~ ~
,." • .,._-""
!-93;
""-"""""'~""-·~·-=·'-=·="'~"-"·~! II'~"''~'-----~--
15. Lehmann, AP & Hofmann, OM. 2010. Lessons Ieamedfrom the financial eris,
management: Contrasting developments in insurance and banking. The Geneva
63-78.
16. Ashby, S. 2011. Picking up the Pieces: Risk Management in a Post Crisis World:
Management in a Post Crisis World. Financial Services Research Forum.
17. Ayadi, R. Arbak E & De Groen, WP. 2012. 'Executive compensation and risk
in European banking', in Research Handbook on International Banking and Gov,
edited by JR Barth, C Lin & C Wihlborg. Cheltenham: Edward Elgar.
248
WHAT IS RISK?
10.2.1 The challenges of risk
As discussed in Chapter 9, it is very difficult. and in some cases impossible, to
manage something that cannot be defined or measured. In order to measure risk, we
first have to define it. For the average person risk can translate into, for example,
falling terminally ill. or not being able to meet mortgage payments. This can
subsequently result in, say. that person losing their house. For the average business.
risk can translate into the loss of income because of competition or the inability to
10.2
INTRODUCTION
and uncertainty have always been a part of human existence and are a facet of
life. From early ages the occurrence of negative events was associated with the
th of the gods. Since equilibrium could only be restored by appeasing the gods in
e way, the management of risk was deemed necessary. In the middle ages, the
rd 'risicum' was used to depict the possibility of loss and damage that followect
sea trade. By the 16th century the terms 'rischio' and 'riezgo' were used in
mtinental Europe and by the 17th century they had replaced the idea of
isfortune. This development created in people's minds an understanding that risk
different from 'bad luck' and that it is something that can be measured by adding
e concept of probability to it.
Once it was understood that risk could be measured, attempts were made to
anage it. Managing risk, however, necessitates the accurate measurement of risk;
the more accurate the measurement tools. the more effectively risk can be managed.
Before risk measurement can be discussed, risk itself must be defined, thus the first
part of this chapter provides a brief overview of the concept of risk in banking. For a
•more comprehensive overview. consult Chapter 9.
reading this chapter, you should be able to:
dentify the different types of risk facing banks
istinguish between risks that are on-balance-sheet and off-balance-sheet for
anks
alculate the value-at-risk using the RiskMetrics approach
calculate the value-at-risk using the historic approach
explain how the RiskMetrics approach differs from the historic approach
explain how value-at-risk is calculated wh_en using the Monte Carlo approach
identify the various risk-adjusted performance measures used by banks.
NING OBJECTIVES
,.':ctification and
'~ent of Risk in Banking
Bank Management in South Africa - A risk based perspective
a
As mentioned above, on-balance-sheet risk can be defined as the risk that financial
institutions face during the course of their core business operations. Since the core
business of the bank is the provision of financial services, these risks can be
classified under the following broad categories: credit risk, market risk, liquidity risk
and operational risk. Liquidity risk is simply incurred during the financing process,
whereas the other risks can be analysed further. Under credit risk banks pay close
attention to risk caused by a concentration of their assets, risk associated with their
10.2.2 On-balance-sheet risk
pay wages because of cash flow problems. Clearly, risk can mean different thin
different people. Risk should therefore be defined within a frame of reference. B
for example, even though they are businesses, define risk differently from o
businesses.
In order to define risk it would be advantageous to look at its definitions fro
finance perspective. There are many different definitions of risk in finance literat
Valsamakis et al, for example, define risk as 'the variation of the actual outco
from the expected outcome. Risk, therefore, implies the presence of uncertaint
This differs from Luhmann, who defines risk as 'the threat or probability that
action or event will adversely or beneficially affect an organisation's ability·
achieve its objectives'. 2 Denenberg, on the other hand, defines risk as 't'
uncertainty of loss', where the term loss refers specifically to financial loss. 3
The reason for these diverse definitions is attributed to the fact that not'
market participants view risk in the same way. Despite these differences, there
usually three main elements that recur within these definitions. The first element
almost always the fact that there is some kind of uncertainty. The second eleme
found in many definitions is the probability that some kind of uncertain event c
occur, and the third universal element is the fact that the outcome will be negati
When combining these elements, a universal definition of risk could be t
probability that some negative event will ensue. Since it is possible to define risk wi
some kind of probability, it makes sense to include probability in the measuremeri
of risk. Therefore. risk is often measured using the standard deviation of return
around a mean. When considering risk in the broader sense. it is clear that not al
risk can be expressed in terms of a direct loss in returns as there are many aspects t
it. In order to manage risk successfully, it is necessary to measure these differen
aspects accurately. Risk is therefore characterised as either occurring on the balance'
sheet or off .the balance sheet.
Although individual types of risk associated with most off-balance-sheet
business are in principle no different from those associated with on-balance-sheet
business, most banks separate these risks. On-balance-sheet risk can be defined as·
the risks that are taken by the bank when generating profit through their core
business operations. Alternatively, off-balance-sheet risk occurs when the bank is
trading in derivative instruments such as futures, options, swaps and other 'overthe-counter' contracts. Since neither contingent assets nor liabilities are recorded'
on the balance sheet. risks pertaining to these items can also be regarded as offbalance-sheet risks.
250
251
10.2.2.1 Credit risk
When banks lend money to individuals, companies or parastatals. they incur credit
risk. This is the risk that the counterparty to the lending agreement will either
default on interest payments or miss down payments. Since this means that the
counterparty defaults on their obligation, it is also referred to as default risk.
Although companies differ in setting the amount of time which may elapse before
debt is considered as bad, or non-performing, banks usually regard a default on
payments as being those which are 90 days late. In order to assess credit risk. banks
usually calculate the probability that a certain percentage of clients will default.
This probability is then changed based on the characteristics of the bank's lending
book, the macroeconomic forecast for the foreseeable future and other factors such as a change in interest rate - that might influence people's ability to repay their
loans.
Although some of these risks can also be incurred from transactions which are offbalance-sheet, they are mainly part of the core functions of the bank. The following
section describes briefly each of the above-mentioned risks in order to facilitate the
understanding of how risk is measured.
-
Crime
Other risks
nterparties and transactions. Market risk, on the other hand. is a result of
nges in market prices, the most important of these being risk arising from
nges in interest rate and foreign exchange rate, as well as changes in the prices
ocks and commodities. In terms of operational risk, banks monitor internal and
.ernal fraud. the practices of employees. clients and businesses as well as legal
es. compliance issues and the failure of processes and systems. Figure 10.1
ow provides a summary of the different risks faced by banks.
Chapter 10: The Identification and Measurement of Risk in Banking
~
=-~
~
- -~---
---------,-~-, --------
10.2.2.2.1 Interest rate risk
Since banks derive most of their income from loans, interest rate risk is importan
as they could lose money because of a change in the interest rate. For banks, thi
can happen on both the asset and the liability sides of the balance sheet. On t
asset side, banks lend money to individuals and businesses. These loans a
normally granted at the prevailing interest rate, called the prime rate, plus or minu
a percentage which is risk specific to the borrower. The bank can also lend money a
a fixed interest rate. On the liability side banks make loans in the form of short-term
and long-term deposits and alt.hough these deposits can earn different rates, mos
are negotiated at fixed rates. Banks will also lend money in the money market fro
time to time in order to ensure that they adhere to the minimum cash reserve
requirements set by the Reserve Bank.
Thus a bank can easily lose money if one or more interest rates change. Because
banks normally lend money (asset side) at a prime interest rate whilst borrowing
money (liability side) at a money market rate, they run the risk of the lending rate
either increasing more slowly than the borrowing rate, or alternatively decreasing
more quickly than the borrowing rate. This phenomenon is also known as basis risk.
Banks may also lose net interest income if they make loans at fixed rates where the
10.2.2.2 Market risk
Market risk consists mainly of interest rate risk, foreign exchange risk and price
where the changes in prices of stocks, commodities and other asset classes adverse
affects the bank's position. Market risk affects banks on a daily basis; therefore th
use a sizeable portion of their resources to hedge themselves against this.
In the equations above, the non-performing loans are income-generating assets t
have been due for 90 days or more. Net charge-offs are the difference between
value of loans that have been written off in the bank's books and the sporadic inco
that has been generated from these assets. Credit risk can also be exacerbated un
strenuous market conditions if the bank allows its asset allocation to become
concentrated. This is normally referred to as concentration risk. Although ba
take care to spread their asset allocation in various ways, they might still suffer los
when the economy as a whole is under stress. The loss incurred by banks during t
GFC is a good example of this.
Net charge-offs of loans
Total loans and leases
Total loans (or equity capital)
Annual provision for loan losses
Allowance for loan losses
Total loans and leases (or equity capital)
Non-performing loans
Total loans and leases
Non-performing loans
Equily capital
The following five ratios can be applied to determine the bank's credit
exposure:
252 Bank Management in South Africa - A risk based perspective
253
Equation 10.7
Equation 10.6
10.2.2.2.2 Foreign exchange risk
Foreign exchange risk (or forex risk) occurs when a bank holds assets or liabilities in
different currencies. Since the value of currency is constantly changing, in some
cases, for example, South Africa, in an unpredictable manner, it affects the earnings
'',t:e'of
"~~~~~f~Tu1!
Equation 10. 7, uninsured deposits are corporate or government deposits that exceed
e amount covered by insurance and are highly sensitive to changing interest rates.
a bank has more interest-sensitive assets than interest-sensitive liabilities, the bank
ill benefit from increasing interest rates and vice versa. However, if the interestnsitive liabilities exceed the interest-sensitive assets the bank will benefit from
ailing interest rates and vice versa. Refer to Chapter 11 for a more comprehensive
iscussion on interest rate risk.
Uninsured deposits
Total assests
Interest-sensitive assets
Interest-sensitive liubities
larket interest rate is dropping, or if they lent money at fixed rates in a market
here interest rates are increasing.
In order to determine what exposure the bank has to interest rate risk. it can
amine four main relationships. The first two are duration and the adjusted
terest-sensitive gap, and the other two can be expressed as follows:
Chapter 10: The Identification and Measurement of Risk in Banking
''
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and capital of the ban k directly. Fore
x risk can be classified as either tran
saction'·
translational. Tran sact iona l risk
occurs whenever con trac tual
cash
denominated in foreign curr enci
es are subject to unan ticip ated
chang<
exchange rate. In order to reali
se the domestic value of its fore
ign-denomi
cash flows. the ban k mus t exch
ange foreign curr ency for the dom
estic curr,
with a fluctuating exch ange rate.
The ban k is therefore exposed to
the possib
that it might receive less domestic
curr ency than anticipated because
of the vo
curr ency market.
Translational risk is the risk that
money is lost because of the
inco
tran slati on of the assets held in
different currencies. This happens
because
ban k's financial repo rting is affec
ted by exchange rate movements
where it
branches in more than one country.
During the consolidation process,
foreign a
and liabilities, or the financial state
men ts of foreign subsidiaries, are
combin
the bank 's financial state men ts.
This could have a significant imp
act on the ba
reported earn ings and therefore
on its shar e price.
Banks take forex risk in two major
ways. The first is whe n the bank
has asse
liabilities that are deno min ated
in a curr ency different from the
one in whi ch
normally operate. The second is
because bank s actively deal in fore
ign curr e
both for themselves as well as for
clients. Banks are however only
exposed to f,
risk to the exte nt that they have
not hedged or covered their posi
tion.
unc erta inty abou t futu re exchange
rates which will affect the valu
e of finan'
inst rum ents cons titut es risk for
a commercial bank. As such, forex
risk does
exist in cases whe re the futu
re exchange rate is predefined
usin g differ,
inst rum ents and tools.
Trading activities on the forex
mar ket are typical of a com mer
cial ban k a
not all of thes e activities lead
to risk exposure for the bank .
In the case wh
thes e activities are performed by
the commercial ban k on beh alf
of its cust ome
the forex risk is tran sfer red to
the cust ome rs as the ban k take
s an agen cy r
Whe re the ban k uses these tran
sact ions for hedging purposes,
ther e is no ri
either, since the ban k has hedg
ed its risk by pred eter min ing the
exch ang e ra
with othe r financial inst ituti ons
usin g different financial inst rum
ents . The re a
however, inst ance s whe re the ban
k can incu r forex risk exposure;
this may occ
whe n a gain or loss is realised beca
use of an unexpected outc ome or
event. Th
unexpected events can be categori
sed in two ways; principal foreign
exch ang e (F
related con trac ts, for example
spot tran sact ions , forwards and
swaps, and no
trad ed foreign curr ency expo sure
in the form of ban king products
and services
foreign exchange.
Banks also incu r forex risk in
a part icul ar curr ency in othe
r ways.
unh edg ed position, for example,
gives rise to forex risk and this
is said to be a
open position in that part icul
ar currency. If a ban k has sold
mor e foreig
curr ency than it has purc hase
d, it is said to be 'net sho rt'
in
that
curr enc
Conversely, if it has purc hase d
mor e foreign curr ency than it has
sold, it is in
'net long' position. Both of thes
e positions are exposed to risk
as the forei
curr ency may fall in valu e com pare
d to the local or hom e currency,
whi ch in tu
results in a subs tant ial loss for
the ban k if it has a net long posi
tion. If the hart
254 Bank Management in South
Africa - A risk based perspective
255
Price risk
Equation 10.1 O
Equation 10.9
Equation 10.8
Liqu idity rJsk
1or banks, a shor tage in liquidity
can quickly lead to the ban k clos
ing its doors. In
'rder to prevent this from happenin
g, the Reserve Bank forces Sou th
African bank s
keep a min imu m of 2.5% of liabi
lities in cash and othe r liquid asse
ts. The reas on
r the minimum cash reserve requ
irem ent is the fact that banks in
Sou th Africa s in many othe r part s of the worl
d - use a fractional reserve bank
ing system. A
actional reserve bank ing system
is one in which only a port ion of
ban k deposits is
acked by actu al cash reserves. 6
Should a grea t num ber of depo
sitors with draw thei r money at
the sam e time
such as duri ng a ban k run) ,
the ban k mus t have sufficient
cash to pay the
epositors thei r money. The mai n
liquid asset sources that can be
used as reserves
nclude investments in shor t-ter m
government securities. cash and
due from othe r
0.2. 2.3
Equation 10.9 , BF (bond fund)
denotes the value as recorded on
the financial
stitution's books of the sam e bon
ds and assets. An alternative prox
y that can also
considered by a financial anal yst
is the mar ket value per preferred
and com mon
ares. This retlects the investor perc
eption of the financial inst ituti
on's _current
rnings potential and risk exposure
.
Lastly, alth oug h mar ket risk com
prises, as a whole, aspects of inte
rest rate, forex
;nd price risk, these thre e risks
are individually just as importa
nt:
for a ban k to
entify and man age .
Estimated market vctlue of the same
assets
Book value of assets
Market value of bonds and other fixedincome assets
- BF
Book value of equity captial
Market value of equity capital
ket risk exposure entails the poss
ibility of experiencing losses in
investment
rns and in asset or liability valu
es due to decreasing mar ket inte
rest rates.
thou gh price risk exposure is diffi
cult to estimate, a financial anal
yst can apply
·erent proxies to eval uate the pric
e risk com pon ent of mar ket risk.
Price risk
ers to the market value sensitivi
ty of assets, liabilities and equity.
The following
ce risk indicators can be used; the
book-to-market value (Equation
10.8 ) as well
Equations 10.9 and 10.1 0.
2.2.2 .3
a net sho rt position in that curr ency
and the foreign curr ency rises in
value, it
ses losses for the bank . A long posi
tion is also kno wn as being 'ove
rbou
ght' or
ng
a
'net
asset' position and a sho rt position
1
is also kno wn as a 'net liability'
oversold' position. The sum of
all the net asset positions and
net liability
tions is kno wn as the 'net open
position' or 'net foreign curr ency
exposure'.
net foreign curr ency exposure prov
ides info rma tion abo ut the forex
risk that
been assu med by the ban k at that
poin t in time. This figure repr esen
ts the
edged position of the ban k in
all the foreign curr enci es. A nega
tive figure
lws a net sho rt position whe reas
a positive figure shows a net long
position.
Chapter 10: The Identification
and Measurement of Risk in Bank
ing
Bank Management in South Africa - A risk based perspective
prices can move against the institution, forcing it to make crucial adjustments i
performance and policies. As a financial analyst there are a number of proxies that
can be used to determine the progress of the financially distressed bank. These
include the PIE ratio (Equation 10.14), the equity ratio (Equation 10.15), the
capital adequacy ratio (Equation 10.16) and the purchased funds to liabilities ratio
(Equation 10.17):
If a financial institution finds itself in financial distress, the interest rates and securit
Balance at the Reserve Bank
Total assets
Cash assets and government securities
Total assets -
Purchased funds
Total assets
banks, commercial paper, lending in the interbank market, bankers' accept
negotiable certificates of deposits, securities purchased under agreem
repurchase (repos), and other markeable short-term securities. Borrowed Ii_
sources can include securities sold under agreement to repurchase, borrowing
the Reserve Bank, large negotiable certificates of deposits, borrowing on
interbank market, the issue of commercial paper and longer term securities, an
sale of loans and assets.
It should be noted, however, that if a bank were faced with a run on its de
and was unable to meet the cash withdrawals, it does not necessarily mean tha
bank cannot provide depositors with their cash. Rather, given the natu
financial intermediation, these initial cash deposits by clients were pro
transformed into loans or other assets that are difficult to liquidate at a given
in time. Bank runs are a problem because banks are not able to provide liqu
both quickly and cheaply; if they do so, losses are more than likely to result.
It follows that a bank can run into liquidity issues based on the nature .6
assets. Long-term assets, such as home loans and business loans for example,
very difficult to convert into cash. This means that a bank will be unable to
cash deposits if all its money is locked up in such assets. Once banks have liqu
problems they can run into additional liquidity problems very easily. As soo
other banks realise that the problem bank might not be able to repay loans, they
charge more interest on existing loans and might refuse to extend additional er,
The combination of an inability to generate the necessary liquidity bu
misconduct of allowing bad loans that can reduce cash flow and mismanagem
of funding costs can thus be lethal to even the largest financial institutions. W
liquidity is a problem for a particular bank, it is usually the first problem that
evident to the market. This is why the monitoring of the interbank bank by cen
banks is vitally important as it provides an initial indication of any possible mar
disruption that may become systemic and affect the entire system.
The following three proxies can be applied to determine the bank's ability t
effectively manage these funds - the purchased funds ratio (Equation 10.11), th
cash asset ratio (Equation 10.12) and the reserve funds ratio (Equation 10.13):
256
Equation 10.17
Equation 10.16
Equation 10.15
Equation 10.14
Operational risk
hough operational risk can also occur on the bank's trading book, this risk exists
marily as part of the bank's core business operations. According to the Basel
cord, operational risk is defined as the risk that direct or indirect I.asses might
cur because of inadequate internal processes, the failure of people and/or systems
because of external events. It is therefore widely agreed that operational risk is
used by people making mistakes while performing activities in the general course
the bank's activities: that the processes that support these activities are flawed;
at the systems that facilitate these activities are faulty in some way; or that
ternal events have occurred that have disrupted the finalisation of these activities.
The above definition can be expanded to cover seven main event types. Many of
ese event types can be linked to the actions of people: in particular, internal fraud and
,xternal fraud result in losses incurred because of people. Internal fraud includes
,ribery, tax evasion and the misappropriation of assets. External fraud includes
ctivitics such as third-party theft, forgery, hacking into client accounts and stealing
nformation. Other event types include losses incurred because of worker compensation,
nfair employment practices and workplace safety; bad business practices such as
arket manipulation, fiduciary breaches and improper trading; external events like
rrorism and natural disasters; the failure of systems such as utility disruptions,
oftware and hardware failures; as well as mistakes made by people and/or systems data entry errors, accounting errors and the negligent loss of clients' assets.
Note that reputation and strategic risk are not included in this definition
because a minimum regulatory operational risk capital charge must be established
for banks. Each financial institution will have several key performance indicators
(KP!s) that it uses as proxies to determine the level of operational risk exposure. A
financial analyst can choose different groups of KPls, depending on the goals and
objectives of the financial institution. It is, therefore, critical to know the bank's
and objectives before embarking on a performance evaluation process.
.2.2.4
e equations above, purchased funds include uninsured deposits and borrowings
non-bank corporations, from the money market, from other banks or the Reserve
and other government units. A decrease in the estimates in Equations 10.14
10.16 can indicate that the bank's capital risk exposure is increasing, whereas
rease in the estimates in Equation 10.15 indicates that the bank may not have
relative equity funding required to finance its assets. These results can lead to a
hdrawal of equity capital by investors, as the perception of the bank's ability to
mote healthy future growth is being compromised .
ity capital
Price per share
nnual earnings per share
Chapter 10: The Identification and Measurement of Risk in Banking 257
Bank Management in South Africa - A risk based perspective
Value-at-risk
Since the inception of banks, the financial sector bas been plagued by financfa
crises. Although some of these crises could be overcome by simply stimulating th
economy with expansive macroecono mic policies, others pushed countries into
recession for years. In an attempt to escape the negative consequence s of crises,
10.3.1
As companies have different approaches to risk. it follows that there are various
measuremen t tools. Risk also differs in terms of the impact it has on differe
companies. In financial institutions such as banks. risk is mainly categorised
either 'high probability and low impact events', or 'low probability and high impa
events'. The tools that measure these risks and their impact naturally reflect the
characteristics. The following sections take a closer look at the most important rii
measuremen t tools employed by financial firms.
10.3 RISK MEASUREMENT TOOLS
Before the broad deregulation of the financial system in the mid 1980s,
loaned money to borrowers based on strict prerequisites. The initial assess
the borrower was based on their ability and willingness to repay the loan,
deregulation, banks were allowed to resell the loans they granted to borrowers,
transferring credit risk to investors through a securitisation process. Securiti
is the selling of various types of debt, such as loans and credit card obligatio
investors in order to turn an illiquid asset into a liquid asset. It is this proces
allows banks and other financial institutions to remove these assets from
balance sheet. These off-balance-sheet transactions are only disclosed in no
the financial statements.
Since banks and other financial institutions trade with these assets - b
and selling debt in the form of instruments such as collateralised debt obliga
(CDO) and asset-backed securities (ABS) - they take various financial risks i
process. The seller of these instruments could, for example, get rid of credit risk
then runs the risk of selling these assets for less than they are worth incurring price risk. The buyer of such securities would take on credit risk as w,
price risk in that they might have paid more for these securities than they are w
These off-balance-sheet activities can be divided into credit substitutes
derivatives. Credit substitutes include letters of credit (LC) and securities he!
trust by the bank. An LC is issued by a financial institution to assure payment to
seller of goods or services, provided that the seller delivers the goods or provides
service as specified in the contract. Financial institutions also hold various o
derivative contracts off the balance sheet. These include over-the-cou nter (OTC)
exchange-tr aded contracts such as forwards, swaps, futures contracts and opti
Although these off-balance-sheet transactions are often used as part of the hedgi
process, dealing in these contracts exposes the financial institution to market ri
credit risk, operational risk and liquidity risk.
Now that the main risks have been discussed, the following section will furt
investigate the tools used to measure these risks.
10.2.3 Off-balance-sheet risk
258
259
RiskMetrics
he RiskMetrics model was developed in 1989 for the former chairman of JP
Morgan. Sir Dennis Weatherstone. As part of the portfolio evaluation process.
Weatherstone wanted to know what the market risks were across all businesses and·
locations, expressed as a single figure at the end of each business day. This gave him
an idea of the market risk exposure for JP Morgan the next day. This example clearly
reveals the need for, and the objectives of, the VaR measureme nt model. Four years
later (1992) the RiskMetrics methodology was launched by JP Morgan. making the
substantive research freely available to all market participants and by 1994 the
RiskMetrics model was implemented.
atory responses have always been aimed at stabilising the financial sector in
us ways. The most notable of these reforms were introduced during the great
sion of the 1930s. As part of the new requirement s banks were obliged to
egulatory capital in order to ensure that they did not fail because depositors
claiming more cash than the bank had on hand. However. since such
atory capital does not earn any significant interest, banks will try to keep the
um required amount of their assets in this form. To this end. banks have to
that their operations are not at risk and that they will be able to pay out
its at any time.
order to ensure that they hold enough regulatory capital, banks often use
e"at-risk (VaR) models. The VaR model measures the potential loss of income, as
:ult of normal market (risk) conditions, from a portfolio to which a financial
tution or investor is exposed. It is therefore used to describe the magnitude of the
losses in the portfolio on any given day due to possible adverse events. These
ts tmiy include: changes in the price of an asset; changes in interest rates;
rket volatility; and market liquidity. 4 It should be noted that market risk is
valent in financial institutions that actively trade assets, liabilities and derivatives
•opposed to institutions focussing on passive portfolio investment or hedging
tegies. 4
In terms of its usage, VaR is a relatively new concept. It was first introduced by
~ major US financial firms of the late 1980s in order to measure the risks of their
ding portfolios. Since then however. it has expanded in its usage and application.
day VaR is also regularly used by non-financi al institutions. smaller financial
stitutions and institutional investors. Because of its widespread use. the Basel
mmittee on Banking Supervision allows banking institutions to calculate their
'pita! requirement s pertaining to market risk by using VaR models with their own
oprietary values.
In the next section we will be introducing three approaches that are used by
nks to calculate their 'value-at-ris k' although there are numerous variations
thin each approach. The risk measure - VaR- can be computed either by making
rtain assumptions about the return distributions for market risk as well as
tilising the variance in and covariance of each of these risks. Another method is to
enerate hypothetical portfolios by using historical data, or running Monte Carlo
rnulations.
Chapter 10: The Identification and Measurement of Risk in Banking
•••
•·•· .. ··••••••••••.OO-'.
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Bank Management in South Africa - A risk based perspective
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~llP'pose,ct2e_ tund_. _~anagers _ofCci_~?nati?n'~:~.~1.in~e~
';Flf,~illidn(t'rlar~etvalue) invested}i1'a;ero~eoupo~ ~?."'
,,i:~iditac! ()i.~lu~;(jf.• ~1.·;_·~so_oas.i=urth_e~,..as_~~~e.}ti~tto
:o:O?:I16_%_ peryear{fhiSborid.is held a~partef.th ;ir}r~di
x11~edst0•~2~w ~.hatfhe potential ~X£0SUre
p6sitio . > ·;,. :. ...... ./.
{ jrafesi_ncre~?e_{a.njncreaS'e.in _ .~ond r~t.es w_iU!e~dt? .~dro-pi~_.!~;•pri.~;i~tJ~&
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1Jheboni:l's pric(t) volatility.Thiscanbe calculated asJollows:
lf:ixedirfc?'ffrejz··· ,...
Many fund managers have funds that include various asset classes in the
fund. Coronation Fund Managers' Balanced Defensive Fund, for example, con
mainly of bonds, (roughly one-third of the portfolio value), cash (both local
internation al), as well as equities (both local and internation al). In order for th
to assess their daily VaR, they have to calculate the VaR on each of the asset clas
separately before arriving at a single amount. In the next section, the focus will be
how to calculate the DEAR in three trading areas - fixed income, foreign exchang,
(PX), and equities - using the RiskMetrics approach, and accordingly how to estimat,
the aggregate risk of the entire trading portfolio in order to meet the objective of.
single aggregate rand exposure measure.
Assun'l~thatt\financial lnstltt.\ti6hheed§t6 rrieastifo itst\i~rket ti!i'ke
given dat,ond_er•the _RiskMetri_csitipprcrac::friiTti~;fina~cial}§sfi~~t
'to know 20w to preserve the ~rtn'srequityifmarket conditionsw
adverselyfomorrow,which.is:
260
Chapter 10: The Identification and Measurement of Risk in Banking
261
r1
1
I
~I
-.JN
Y9 = R22 950
= (Rand market VaR) x (Price volatility), the next step is to calc
deviation of the R/€ exchange rate over the past year. Let us assu
over the past year.
= R1 000000
Foreign exchange
In order for C:oror,:ation''s
their euro p
be calculate
Assuming th
FX position is calculated as:
In order to calculate the total portfolio VaR, the next example calculates the Va
a foreign exchange position. Here we assume that Coronation's Balanced Defern
Fund has an open trading position of €68 965,52 in spot euros at the close
business day.
In.the above calculations, price sensitivity was estimated usi
However, the RiskMetrics model generally utilises the
changes as price-sensitivity weights rather than than modified durations.
VaR = R7 650 x
Thus the value of the earnings at risk by the fund - due to ad
movements - is a function of the DEAR multiplied by the square r,
of days for which the fund has to hold the security. It should be n
calculation implicitly assumes that there is no time restriction for t
bond, even at the new lower price. In reality, it may take the fund
days to offload the position. This illiquidity exposes the fund to increased I
measured by the square root of N. If, for example, N is 9 days, then:
VaR = DEAR x
262 Bank Management in South Africa - A risk based perspective
263
•with the market - as
ue (undiversifiable) to
described above can
final asset class to be considered by the fund managers at Coronation is equities.
en investing in this asset class, two types of risk are relevant, namely, systematic
and unsystematic risk. The next example will show how DEAR is calculated for
Chapter 10: The ldentificatim1 and Measurement of Risk in Banking
Bank Management in South Africa - A risk
In calculating the DEAR of the entire fund, we cannot simply add the
totals (R7 650 + Rl3 447.50 + R41 250 = R62 347,50), since by
offsetting covariance or correlation relationship between the different asse
is being ignored. If the different asset classes are positively correlated. t
exposure might be bigger than the sum total. However, if negative correlati
among these asset classes, shocks will reduce the degree of portfolio risk.
The individual DEARs were:
5-year zero-coupon bonds= R7 650
Euro spot= Rl.3 44 7, 50
SA equities= R41 250
Now that the various components of the portfolio have been calculated,
to aggregate the different positions in order to calculate a DEAR for Coronf
Balanced Defensive Fund as a whole - the R 1 million in bonds, Rl million in F
RJ million in equities.
264
Historic (back simulation) approacl1
ough the RiskMetrics model is a very good model for evaluating a fund's assets
sk, it is not without its shortcomings. Like many other market evaluation tools,
RiskMetrics approach assumes that all asset returns are normally distributed.
ough returns might be normally distributed some of the time for some assets,
is not a regular occurrence. Certain assets hardly ever conform to this
ribution. Since this is a major drawback, many financial firms also make use of
historic (or back simulation) approach. This approach has several advantages in
t it is simple and requires very few assumptions - including normality - and
re is no need to calculate the correlations or standard deviations of asset returns.
.1.2
lintioned earlier. VaR is widely applied as a risk measure on portfolios .
ing risk managers with a rand amount of the value of the portfolio that is at
:VaR can however also be applied in many other circumstances to indicate the
-at-risk for loans, assets or any other future income stream. This makes VaR a
ble risk measurement tool that has cemented its use in modern day finance.
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266 Bank· Management in South A
"
... .-,~.,-
The liistoric approach versus RiskMetrics
As mentioned before, the main benefit of the historic approach in calculatin g
portfolio risk is that there is no need to calculate standard deviation, correlation s or
assume a normal distributio n of asset returns. Another advantage is that the
historic model provides us with a worst case scenario number - a maximum loss of
Rl6 235,21 in the case of the above example. By contrast, the RiskMetrics model
assumes that asset returns are normally distributed and as such, the returns can
range between positive and negative infinity, therefore providing no such worst case
scenario number. Another constraint with the RiskMetrics model is that while a fair
estimate of downside risk may be produced for financial institution s with highly
diversified portfolios, the same cannot be said for financial institution s with small
undiversified portfolios, where the true risk exposure would be significantly
underestimated.
Although it appears that the historic approach is superior to the RiskMetrics
model, it too has shortcomi ngs. For example, one drawback of the former is the
degree of confidence attributed to the 5% VaR number based on only
500 observations. From a statistical point of view, 500 observations is not a large
number, and as a result the model could suffer from simulation errors, or wide
·""''
perspective
Bank Management in South Africa - A risk based
269
an approximation of
also remains a simulation, with the results being only
value, and indeed, of reality.
of Risk in Banking
Chapte r 10: The Identification and Measurement
Total capital
= OR-OE EL+ IC
Equation 10.20
,.,..,.....~--
··--
ing expenses; EL denotes
denotes the operat ing revenues; OE denotes the operat
is estimated by the VaR
that
loss
ated
anticip
e
averag
the
is
e expected loss, which
e from capital, which
incom
ode! over a specific time horizon; and IC denotes the
rate of return , which
ee
risk-fr
the
with
s
estimated by multiplying capital charge
Total capital. also
bond.
ment
govern
a
on
offered
rate
the
be
normally proxied to
ed as a buffer to
requir
is
that
l
nown as economic capital. refers to the total capita
with the VaR
ated
calcul
often
is
l
capita
mic
Econo
,vercome a worst case scenario.
ional risk.
operat
and
t risk
"model and associated as a function of credit risk, marke
both risk
in
tion
alloca
l
capita
ve
,1'he RAROC ratio is, therefore, used to ensure effecti
tion.
evalua
mance
perfor
bank
manag ement and sufficient
used to evalua te different
The RORAC ratio, on the other hand, is generally
.••
a valuable metho d with
thus
is
It
s.
profile
investments that consist of varying risk
exposure. The RORAC
risk
of
level
able
accept
the
fy
quanti
which to manag e and
the capital assets that
to
ing
'ratio is specifically applied when the risk varies accord
is the capital and not
it
.
model
C
RARO
the
to
d
are being used. Note that as oppose
risk adjust ment of
The
.
model
C
RORA
the
in
risk
for
ed
the return that is adjust
Basel Accord. It
the
by
ed
outlin
capital is based on the capital guidelines that are
to the specific
ting
alloca
is
bank
the
that
l
capita
can be considered as the regula tory
l that is
capita
the economic
investment. The allocated risk capital is, therefore,
adjusted for the maxim um potential loss.
RAROC
.· . Risk-adjusted performance measures
to compare themselves
djusted performance measu res are suitable for banks
intern al depart ments .
of
mance
perfor
of
level
the
re
measu
to
as
",eers as well
tion or individual
institu
each
in
ement
ratios measure the level of risk manag
ine the ability
determ
also
and
vely
effecti
more
l
capita
ssess their ability to use
enviro nment .
risk
t
curren
bank to increase its profit and daily revenue in the
include the
applied
be
can
that
ratios
mance
ost common risk-adjusted perfor
justed capital
risk-ad
on
s
return
the
C),
(RARO
l
capita
on
s
djusted return
capital (RARORAC), the
AC). the risk-adjusted return s on risk-adjusted
(MVA) ratio and the
added
value
t
marke
the
holder value added (SVA) ratio.
omic value added (EVA) ratio.
res the risky return s - the
'RAROC is a risk-based profitability ratio that compa
nt investments. It allows
differe
l
severa
of
return
of
rate
rns above the risk-free
investors and/o r fund
For
analyst to adjust and measu re the return s for risk.
must be above the
ratio
C
RARO
the
asset.
an
nagers to consider buying or selling
on the specific
return
justed
risk-ad
um
minim
the
ents
repres
die rate, which
able proxy for
applic
an
as
(ROE)
stment. Several banks use the return on equity
s:
follow
as
ted
estima
be
hurdle rate. The RAROC ratio can
·""'"-'"'""-.l"----•r~,~-
10.3.1 .4 Monte Carlo simul ation approa ch
historical data points,
In order to overcome the problem that banks have with
entails the building of m
make use of Monte Carlo simulation. This method
- for any factor tha1
ution
distrib
that use a range of values - a probability
of uncert ainty that a
s
source
s
variou
the
that
means
inhere nt uncertainty. This
ted. Following th
simula
are
the value of the instru ment, portfolio or investment
underlying inp
the
of
values
le
possib
the
representative value is calculated given
es within histc
outcom
g
tradin
le
possib
te
simula
to
ideal
it
This attribu te makes
repeated tens
is
s
proces
the
.
parameters. In order to attain robust results
values from .
random
of
set
nt
differe
a
using
time
thousa nds of times, each
outcom e val
of
utions
probability functions. Thus the process produces distrib
a risk anal
to
ning
pertai
les
variab
that realistically describe uncert ainty in
occur,
might
event
what
about
ation
inform
with
user
because it provides the
to
ought
tions
simula
these
the probability of that event occurring. Because
ine
determ
first
will
er
manag
fund
or
risk
the
mimicking real historic values,
es the actual historical data. New observations a
type of distribution best describution.
distrib
that
fit
to
ted
•then simula
tages, including the
Although Monte Carlo simulation offers several advan
optimum solution an
the
s
reache
often
it
run,
to
rd
tforwa
that it is fairly straigh
than a 'what if
results
of
range
er
overcomes local extremes, producing a narrow
Monte Carl
cally,
Specifi
s.
antage
disadv
have
also
analysis. It does, however,
result. This
desired
reach the
simulation requires a large numbe r of samples to
only on a
le
availab
is
data
where
might be difficult in some cases, especially
iterations,
of
s
million
cases
some
in
and
nds,
thousa
the
quarte rly basis. Because of
ds. This
metho
other
to
red
Monte Carlo simulation can be time-consuming compa
is limited by the h
confidence bands, since the numb er of simulations
result in the R 7 9 70,7
period. This means that the one bad day in 20 might
is partic ularly
This
t.
amoun
above example being exceeded by a fair
ial crises
financ
the
with
case
the
was
as
fundamental shift occurs
1997/ 98 and 2007/ 08.
historic observ af
In order to address this shortcoming, the numb er of
SO' h worst case)
(the
000
1
on
VaR
5%
the
g
ulatin
be increased, recalc
th
. However, in ex
ations
10 000 (the 500 worst case) historic daily observ
distan t past
very
the
that
es
assum
also
one
the numb er of observations.
take place ov,
es
chang
ible,
imposs
not
is
this
ugh
Altho
repeat itself.
mic sancti ons are d
countr ies chang e monet ary and fiscal policies. econo
exchange rate sys
fixed
from
moved
greatly
and the world as a whole has
m, there are
proble
s
seriou
a
is
this
gh
Althou
s.
regime
g
floatin
manag ed
te this pr
mitiga
to
used
arc
ches
counte ract these shortc oming s. Two approa
y tha
heavil
more
ations
observ
recent
t
weigh
to
The first solution is
value
actual
the
dictate
observations. This allows recent marke t trends to
w
tions,
simula
Carlo
Monte
use
to
is
ach
assets at risk. The second appro
consis tent with
are
that
ations
observ
ial
artific
nal
additio
te
essence genera
historic experiences.
268
RORAC
d
... --······
ride r;mit;1I
=Allocate
Net income after tax
Bank Management in South Africa - A risk based
perspective
Equaf
Equati6
Equation.
=Bank's marke t value - Invesl capital
Equation 1
... , .c: ... \3/j.1/:-f- .. -~.j'.l. _1":'l'.\I':'"''-' ..\j
f\,\_;_,·y,<.. .
. .-..+
.... ' ... >-
.-~--·•·.• .. ·•-•·-·····.. • ..... ..
EVA = (NO PAT- WACC) x Economic capital
The bank's marke t value represents the marke t value
of the bank debt and equity.
highe r the MVA ratio, the better it is for shareh
olders. A positive MVA ratio imp
shareh older wealth creation, whereas a negati
ve MVA ratio implies the oppos
However, it can become difficult to measu re the
MVA ratio because the marke t val
often chang es for reasons unrela ted to the bank'
s opera ting performance. Applyi
MVA to lines of business can also become extrem
ely difficult with the absence
available share prices or marke t values.
The EVA ratio indicates the absolute amou nt
of share holde r value that w
created. EVA can increase share holde r value by
increasing the return derived fro
assets, by runni ng the income statem ent more efficie
ntly, witho ut additional capit
invested on the balan ce sheet. The formula is:
MVA
In Equation 10.23 , EL is the expected loss; k% is
the hurdl e rate or the required .
of capital; and (k% x Allocated capital) denotes
the cost of the risk-based cap
A positive SVA ratio implies value creation and
a negative SVA ratio implies
destruction of value from a share holde r perspective.
Two additional measures that also make the assum
ption that the objecti
the bank is to maximise share holde r wealth are
the MVA and EVA ratios. The fo
estimates the difference between the marke t value
of equity and debt and the cap
contributed by investors. Remember that the marke
t value implies the estim ation
the present value of all future cash flows. The formu
la for the MVA is thus:
SVA = Net profit before tax - EL- (k% x Alloca
ted capital)
In Equation 10.22 , OR is the operating revenue;
EL is the economic loss; and
the margi nal economic capital.
A furthe r risk-adjusted accou nting profitability
measure is the SVA ratio
estimates the bank' s worth to shareholders. The
term 'value added' impli
value will be added when the overall net econo
mic cash flow that was gener
the bank exceeds the expected loss and the econo
mic cost of all the capital th
required to produce the opera ting profit. SVA can
be expressed as:
RAROR AC = OR - EL
MEC
Furthermore, the RARORAC ratio enables the
bank to assess bank perf1
taking all expected costs and input factors into accou
nt. This ratio allows a do
adjustment, where both the return s and the capita
l are adjusted for risk. RA
can therefore be expressed as:
270
271
RISK PERCEPTION - SOUTH AFRICAN BANK
S
The 2013 PricewaterhouseCoopers (PwC) survey
on banki ng in South Africa
explored the industry trends and identifies severa
l key opportunities and challenges
faced by the banks, group ing them within
four broad themes: extern al
developments; macroeconomic trends; intern
al responses; and stakeholder
include unins ured deposits and borrowings
from non-b ank
"0
rporations, the money market, other banks,
or the Reserve Bank and other
,vernment units. A decrease in the estimates from
Equation 10.26 to 10.28 can
dicate that the bank' s capital risk exposure is
increasing, whereas a decrease in
{he estimates from Equation 10. 2 7 indicates that
the bank may not have the relative
equity funding required to finance its assets. These
results can lead to a withdrawal of
equity capital by investors, as the perception of the
bank' s ability to promote health y
future growt h is being compromised.
Purchased funds
Total liabilities
Equation 10.29
Equation 10.28
Total equity capital
~
Equation 10.27
Equation 10.26
• Total equity capital
Totafassets
Annual earning s per share
Price per share
es risk-adjusted performance measures, a financ
ial analy st must also consider
erceived uncer tainty associated with partic ular
events, including the different
s of bank risk that can threa ten the bank' s day-to
-day performance and longsurvival.
If a bank finds itself in a distressed situation, the
interest rates and security
es can also have a negative effect on the institu
tion, forcing it to make crucia l
ustments in performance and in policies. In the
case when a bank assesses the
vency of its borrowers (see Chapter 9), a financ
ial analy st can use a numb er of
,xies to determine the distressed natur e of the bank.
These include:
.3 Distress-based performance measures
denotes the net opera ting profit after tax and
WACC denotes the weighted
cost of capital. The WACC is the minim um rate that
the bank expects to pay on
e to all its shareholders. The EVA can help identify
improvement opportunities,
better investment decisions and mana ge the shortand long-t erm benefits of
,nk. However, the EVA also has its limitations. For
example, when measu ring the
f the entire bank it is often difficult to obtain the
measu re of the organ isatio n's
f capital. The reaso n is that there are many model
s available to estimate the cost
ital, each producing a different estimate. Examples
include the CAPM and the
end growt h model. Also, net opera ting profit after
tax does not reflect opera ting
t of the curre nt financial state of the organisatio
n. The traditional GAAP-based
'.unting data must be modified to obtain economic
profit estimates •
Chapter 10: The Identification and Measuremen
t of Risk in Banking
Bank Management in South Africa - A risk based
perspective
Risk-weighted assets optimisation
•. :~Y .... / .., ~ ~ · - s . . > A > V . ·"'"'
.. -<· .•••/'" . .
,,., ____ ,..,
The new Basel III liquidity requir ement s have a shortterm (30 day) and a
term (one year) focus. The Liquidity Coverage Ratio
(LCR) (short-term) is design
to ensure that the bank will be able to survive for a
period of 30 calend ar days un
a stressed scenar io such as a run on the bank. As
a result of this, South Afric
banks will see an increase in 'high- qualit y liquid assets'
. Althou gh the majority
South African Banks are well equipped and prepared
for the proposed amend ment
it is clear that they are facing difficulty with these
liquidity requirements.
partic ular conce rn is the net stable funding ratio (NSFR
) (long-term) since it will n
only force local banks to diversify their funding struct
ure towards more long-ter
stable funding, but also increase their margi nal
cost of funding. South Afric
banks mainly use short- term (money market) whole
sale funding as opposed to long
term products such as mortg age loans. With long-t
erm funding costing more tha
short- term funding, the impac t will be an increase
in lending cost and a decrease i
credit availability, which in turn, is an impor tant
catalyst for growt h in emerging
markets. The main reason for the lack of long-t
erm instru ments is that South
African banks do not have access to a large local
base of longer term funding.
Additional operat ional and cost challenges include
developing adequ ate IT systems
in order to access the banks liquidity at any given
time, especially under stress
conditions, as well as additional staff costs, since suitab
ly qualified individuals will
be needed to maint ain the requir ement s of Basel Ill.
There was an indication among the Big Four South
African banks that they
have unique struct ural features that are distinctive
to the South African financing
10.4.2 Compliance with LCR and NSFR
The most significant challenge faced by South Africa
n banks is regula tory
the wake of the financial crisis, slow growth prospe
cts and possible stagfl
Although Basel III only has to be implemented fully
by 2019, its implications
the greate st conce rn. Specifically, Basel III establi
shes more string ent cii
standa rds and requir ement s. Banks ought to hold
4. 5% of comm on equity, 6
Tier 1 capital of risk-weighted assets (RWA) as well
as additional capital buff,
2.5% as capital conser vation buffer and 2.5% in
times of high credit gr,
Althou gh RWA optimisation is of partic ular conce rn
for South African banks, m
do not believe that they have responded too aggres
sively in attemp ting to opti
their RWA levels. This is positive because it has
been indicated that the
optimisation initiatives adopted by various intern
ationa l banks may ca
significant and long-lasting damag e to their busine
ss, the indust ry and the wi:
economy. More specifically the report indicates that
some damag ing responses
include distorted business portfolios, exacer bating
asset price deflation and
cyclicality by selling non-co re assets in fire sale condit
ions with the aim of resto
ROE to as near pre-crisis levels as possible and
closing underp erform ing
fundamentally sound business lines.
10.4.1
expectations. With specific reference to the contex
t of this chapter, the fol
four topics are of partic ular interest.
272
273
Unsecured lending
though it has been monitored within the ambit of
the Nation al Credit Act (34 of
05), the surge in unsecu red lending to a highly indebt
ed popula tion is anoth er
ajor conce rn for South African banks . These banks
indicated that they did not
gard the unsecu red lending enviro nment as being
highly competitive, since there
significant deman d at presen t for these loans in the
South African marke t which
uelate s with the abund ance of business available to
all partici pants. However, the
ponential growt h in unsecu red lendin g exposures
is evident, with bankin g
ecutives rankin g this as a key development in the bankin
g sector. Despite the fact
at the margi ns are appealing and deman d is ample
the degree of exposure for
ach loan is of great conce rn becau se there is no collate
ral in the event of default.
herefore it is not surpri sing that unsecu red lendin
g is seen as the second largest
eakness in the South African bankin g indust ry at presen 4
t.
There are a few factors contri buting to the growt
h in this marke t segment.
actors on the deman d side include: increased consum
erism; a stagna nt interes t
ate environment; and insufficient aware ness among
consu mers regard ing the risk
nd cost associated with high levels of indebtedness
. On the supply side, the main
driving factor is the increased attractiveness of unsecu
red lendin g as opposed to
other credit forms, with banks indicating that unsecu
red personal loans are either
proftable with return s of 10% to 20%, or very profita
ble with return s of 20% to
30%. It is therefore not surpri sing that banks are
curren tly willing to accept and
trade the increased risk for possible increased return
An additional feature of the unsecu red lendins.g segme
nt is the shift towards
higher value, longer term loans to high income
individuals, indica ting that the
lower end of the marke t may have reache d satura tion
point. The impac t of a rise in
interest rates is still of conce rn, however, with
the National Credit Regulator's
indicating that 25.2% (or 17.52 million) of total
active accou nts had impaired
records, and impaired credit records increa sing from
46.2% to 46.8% year-on-year
from December 2011 to December 2012. 7
At the end of 2012, however, the SARB, Nation
al Treasury, the Banking
Association of South Africa and the major banks
reache d agreem ent on variou s
measu res aimed at improving responsible lendin
g and preventing a debt spiral.
Accordingly, the report found that banks rated increa
sed risk of loan defaults as the
.4.3
. A key characteristic. for example, is the low discre
tionary retail savings rate
will force banks to shrink their balanc e sheets. There
was also an indication
ug these Big Four that complete compliance would
increase their bankin g
ges by approximately 20% to 40%. As a conseq
uence the SARB and other
estic banks have argued that the Basel rules should
allow local regula tors to
y nation al discretion in the application of
the funding and liquidity
irements and take the uniqu e features of the South
African financial marke t
consideration. It is also worth mentio ning that the
SARB has made a liquidity
'lity available to South African banks to assist
in the LCR requir ement by
ring up to 40% of bank liquidity requir ement s in the
event of a bankin g crisis.
r to Chapter 15 for more on this •
Chapter 10: The Identification and Measurement
of Risk in Banking
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Bank Management in South Africa -A risk based perspective
Other smaller risks
This chapter has considered the various risks financial institutions face on a
basis. It should be clear that both on-balance-sheet and off-balance-sheet risk
affect the profitability of the bank, and that it is paramount that these risks
managed. Although banks and other financial institutions spend a lot of time a
resources on identifying and managing the risks on their balance sheet, the o
balance-sheet risks are equally important. Various institutions went bankru
through dealings off their balance sheet - Barings Bank and Lehman Brothers a
two examples of this. It is therefore imperative for financial institutions to be awar,
of all the risks that might have an impact on their business.
Being aware that these risks exist is insufficient, however, and in order
manage risk, it has to be measured first. The most prominent and widely used tool
for determining the VaR for a specific fund, subset of assets or specific asset is the
RiskMetrics approach pioneered by JP Morgan. Although the RiskMetrics approach
is very useful for determining market value-at-risk. its main criticism is that it
assumes a normal distribution. In order to obviate this shortcoming, some financial
institutions make use of the historic approach - which makes no such assumptions.
This approach also has its shortcomings, however, one of which is the fact that old
data points may not be valid predictors of current and future events.
10.5 CONCLUSION
South African banks also believe that there is minimal threat from
entrants. both locally and internationally, into the industry. These new entrant
however not expected in the traditional banking sense, but rather in the for
retailers and mobile service providers. The risk has mainly arisen due to
increased usage of technology (lowering barriers to entry), an increase in custo
migrating to electronic products and innovative partnerships between differ
sectors. However they are not overly concerned, ranking this 31 out of a total of
pressing issues. Cybercrime and related fraud is also on the rise, with ba
indicating that internet fraud is a major weakness within the industry. Data securi
is also one of the pressing issues and has increased compared to earlier reports.
The PwC report also indicated various other risks and challenges faced by
African banking community. With the continued state of stagnation of the
African economy compared to other emerging markets, there has been inc
focus and attention from the government on how the local banking indust
play a more active role in stimulating the economy. It is therefore not surprisin
banks view the growing level of government attention as the third most imp
development impacting upon the banking community, especially as Governm
encouraging banks to facilitate major infrastructure projects (funding
urbanisation) and renewable energy projects.
10.4.4
18 most pressing issue out of 32. The report also indicated that banks f;
challenges relating to impairments, with an insufficient amount of
specialist staff present in this area and the operational complexity of si
models and data constraints being of some concern.
th
274
of Risk in Banking 275
EFERENCES
Valsamakis, AC. Vivian, RW & Du Toit, GS. 2004. Risk Management: Managing
Enterprise Risks. 3rd ed. Sandton: Heinemann.
Luhmann, N. 1996. Modern Society Shocked IJ!J its Risks. University of Hong Kong:
Department of Sociology (Occasional Papers 17).
Denenberg, HS. 1964. Risk and Insurance. Englewood Cliffs, NJ: Prentice Hall.
PWC. 2013. Shaping the Bank of the Future: South African Banking Survey 2013.
Saunders, A & Cornett, MM. 2007. Financial Institutions Management: A Risk
Management Approach. 6th ed. Boston: McGraw-Hill/Irwin.
Choi, FDS. 2003. International Finance and Accounting Handbook. 3rd ed. Hoboken,
New Jersey: John Wiley & Sons.
National Credit Regulator. 2012. Credit Bureau Monitor. December. fourth quarter.
are two methods of dealing with this shortcoming. The first is to weight
values so that the most recent data points carry greater weight than older
ints. The other solution is to simulate data points that will conform to the
aracteristics currently seen in the market. For this purpose, most financial
tions make use of Monte Carlo simulations. This methodology allows the user
trnple the historical data, determine what type of distribution it follows, and
rlate new data points that will mimic that distribution. Because of this ability to
ome the shortcomings of the historic approach, many financial institutions
adopted Monte Carlo simulations for market risk analysis.
n terms of the local scene South African banks consider themselves well
ared for the challenges ahead, especially for regulatory changes. Although the
and NSFR requirements will challenge local banks, it is very likely that the
R will go through a number of changes and transitions before being
lemented. Currently LCR funds constitute 85% of the banks' balance sheets but
h the proposed amendments this figure is likely to be reduced to between 2 5 %
30%. The improved liquidity standards may have come at an opportune time:
th a substantial rise in unsecured lending and default risk threatening, banks
ight be compelled to rethink their lending strategy. Other risks include the
creased possibility of new non-traditional competitors entering the lending
vironmcnt, cybercrime and its related fraud.
Chapter 10: The Identification and Measurement
fl,
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•
manage ment process
assist in the measure ment and control of risk in general
assist in the hedging and compliance processes
to address
sset-liability management (ALM) can be defined as a manage rial process
between its
h
mismatc
the
of
result
a
as
on
instituti
l
financia
a
by
faced
.the risk
l instituti ons to
liabilities and assets. 2 The ALM framework, therefore, assists financia
liabilities. It
and
assets
its
of
mix
the
g
managin
while
anticipate future events,
ing bank
maximis
risks,
focuses on managin g particul arly liquidity and interest rate
capital
ng
addressi
and
policy
ALM
the
of
performance within the paramet ers
strategic
a
of
is
rk
framewo
ALM
its
that
ensure
should
bank
Each
adequacy issues.
current existing
nature and is both static and dynamic. Static means identifying
events and
future
ng
identifyi
means
dynamic
risks in maximising profits, while
ted events. 3
anticipa
future
to
g
accordin
s
liabilitie
and
assets
of
mix
the
g
managin
can assist
Each bank must ensure that it has an effective ALM departm ent which
ways:
g
followin
the
in
the manage ment of the bank
rate
assist the bank's treasury departm ent with the liquidity and interest
■
INTRODUCTION
business cycle
Assetexplain and understand the importance, role and functions of the
Liability Committee
the interestdiscuss the management of net interest rate sensitivity through
sensitive gap management technique
sensitivity
discuss the management of asset price sensitivity and liability price
technique
ment
manage
gap
duration
the
through
nts
moveme
rate
with interest
rate
interest
with
understand the management of shareholder equity
technique.
movements through the economic value of equity management
• reading this chapter, you should be able to:
explain the importance of an effective asset-liability management
_framework
explain asset-liability management from the balance sheet
perspective
interest rates
• understand interest rate risk and the decomposition of market
Reserve
and
tions
expecta
market
curve,
yield
the
discuss the relevance of
ements
announc
Bank
and the
understand the relationship between market interest rates, inflation
"Cl
;~~gement of Interest
. . Asset-Liability
?fnent
enable the bank to manage its economic value of equity (EVE) over the I
term, where it focuses on the long-term impact of interest rate changes
bank's total capital
enable the bank to be proactive in its decision-making processes
ensure that the bank is better equipped for increased competition and for
sophisticated markets
improve the bank's budgeting process
assist the decision-making processes of the Asset-Liability Committee (ALCO)
provide the bank with better integration of all business functions a
objectives, especially during reporting to general management.
•
•
•
•
•
Although a bank must manage all balance sheet activities, the activities can
be divided into two books, namely the banking book and the trading book. The
banking book includes all activities that a bank performs as an intermediation
entity, whereas the trading book includes the transactions of both shares and
derivatives. The challenge with managing these two books is that they incorporate
a number of different risk exposures, ranging from credit and liquidity risk in the
banking book. to market risk, in particular, in the trading book. Each of these risk
types must be accounted for and managed, otherwise the bank could face severe
Given that income and costs are generated from respective sides of a bank
sheet, management must exercise effective control over the mix, volume,
and costs of both its assets and liabilities. As a result. the bank will be able
ctO
maximise its spread between revenues and costs and subsequently assist
controlling, to some extent at least, any risk exposure. It is, therefore,
that management policies and strategies are in place to ensure the minimising of
costs, the maximising of income and more importantly, the decrease in any possible
adverse risk exposure, bearing in mind that banks want to be exposed to a
reasonable amount of risk because it can be profitable.
11.2 ASSET-LIABILITY MANAGEMENT: THE BALANCE SHEET
PERSPECTIVE
In order to understand the functionality of the ALM framework, it is necessary to beg
with an evaluation of the balance sheet components that are sensitive to interest ra
and liquidity risk. This is followed by a discussion on the estimation and decompositi
of interest rates, and the effect of market expectations, announcements. changin
interest rates and business cycles. Section 11.4 will discuss the concept, role an
importance of the ALCO, followed by a section on management strategies an
techniques available to limit interest rate exposure through the management of a
bank's interest-sensitive gap, its duration gap and its EVE.
•
•
•
make recommendations regarding the balance sheet actions, which can
setting limits on the maximum size of major asset/liability categories, prici
loans and deposits and correlating maturities and terms
provide the bank with better cash flow and liquidity management
provide better control over the net interest margin (NIM) and other
margins
•
278 Bank Management in South Africa - A risk-based perspective
Buildings, equipment and longlerm securilies carrying fixed
rates.
Long-term loans made at a fixed
interest rate.
Money-market deposits, where
\he interest rates are adjustable
every few days.
Borrowings from lhe money
mark.et.
Demand deposits that have a
fixed interest rate or that pay no
interest rates.
Equity capital provided by the
bank's investors.
Retirement accounts and longterm savings.
Non-reprlceable
liabilities·
The longer the maturity of an asset or liability linked with a variable interest rate and
about to mature, the greater is the exposure to interest rate risk (adverse interest rate
movements). The effective management. of the maturity gap between assets and liabilities
Source: Rose & Hudgins (2010) 4
Short-1erm loans made to
borrowing customers, which are
aboot to mature.
Short-term securities issued
by governments and private
borrowers, which are about to
mature
II
Deposits at the Reserve Bank and i Short-term sa~ngs accounts
cash in lhe vault.
[ No,.;l~ri~~bl~f~~~bi
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!ems in the future. This chapter focuses spe.cifically on the components of the
king book.
The biggest problem with managing the asset and liability sides of the balance
t is the presence of a maturity gap, which exacerbates bank risk exposure,
cially in terms of interest rate and liquidity risk. A maturity gap entails the
atch between assets and liabilities. For example, customer deposits are short
, whereas the loans delegated to customers are long term. This results in a gap
tis exposed to risk and reflects the most inherent problem banks face - the longer'use' of funds (assets) are financed by shorter-term 'source' of funds (liabilities). 4
is exposes a bank to liquidity risk as the mismatch can cause a 'run on the bank'.
is was one of the turning points in the Global Financial Crisis, because when
arket participants realised the imminent magnitude of the crisis in 2007, there was
run on the banks. The maturity mismatch between the longer-term assets and
orter-term liabilities is, therefore, the most obvious and potentially catastrophic
ructural problem facing the way in which banks conduct their business.
With regards to interest rate risk, the revenues, costs and market value of assets,
abilities and net worth are all influenced by changing interest rates. The effective
anagement of interest rate risk, therefore, forms a critical component of the ALM
ramework. The focus on this will be the core of this chapter.
In order to understand fully the effect of adverse interest rate movements, the
first step is to recognise the components of the balance sheet that are influenced by
changing interest rates. These include interest-sensitive assets and liabilities, which
have the characteristic of being repriceable (see Table 11.1 for examples).
~'
~
279
Chapter 11: The Management of Interest Rate Risk: Asset-Liability Management
1'
The loanable funds theory and
components of
interest rates
The loanable funds theo ry divid
es mar ket part icip ants into four
mai n categorie'
businesses; governments; consume
rs; and foreign participants. Rem
ember that eac
• category entails both lenders
(surplus units) and borrowers
(deficit units). Th
dem and for loanable funds is dete
rmin ed by the beha viou r of borr
owers and thei
supply of all debt inst rum ents . The
supply of loanable funds, on the
othe r hand , i
determined by the beha viou r
of lenders and thei r dem and
to own these debt
inst rum ents . This dem and and supp
ly of loanable funds is illustrated
in Figure 1 l. h
where the equilibrium repr esen ts
the risk-free inte rest rate (i ), whi
ch is the rate a
whi ch both lenders and borr owe
0
rs respectively are willing to lend
or borr ow funds.
This also implies that each ban k
is a price-taker due to the fact that
ther e are a larg,
num ber of part icip ants in the fina
ncial market, thus mak ing it diffi
cult for one ban
to influence the equi libri um riskfree inte rest rate. 5
11.3.1
is imperative if the bank wants to
limit its interest rate risk exposure
. For this r,
it is important to be aware of the
procedures and committees that mus
t be in pla,
ensure that the bank's ALM framewo
rk can take effect (Section 11.4). It
is also imp6
to understand how interest rates
are compiled and wha t the full effec
t of interes
risk implies (Section 11.3), befo
re the techniques available to man
age the ne
effect of changing interest rates can
be understood. This leads to the next
sectio
will illustrate how interest rates are
determined and how business cycle
s, the R,
Bank announcements and market
expectations influence interest rates
. Section
also illustrates how the different
interest rates of securities are linke
d to the diff,
maturities of long-term and shor t-ter
m securities; this is known as the yield
curve.
11.3 THE CONCEPT OF INT
EREST RATES, THE YIELD CUR
VE,
INTEREST RATE RISK AND EXP
ECTATIONS
Alth oug h inte rest rate levels are
critical to financial inst ituti ons in
terms of
and borrowing, it is more imp orta
nt to und erst and wha t inte rest rate
s are, how t
are determined, and how they are
measured.
Interest rates are kno wn as the
price of money. They are the opp
ortu nity
that determines whe ther or not an
investor will invest in the lower risk
/lower ret
money mar ket or in a more risky
fund with high er retu rns. Two econ
omic theo
can be used to illustrate how inte
rest rates are determined. These
are the liqui
preference theo ry and the loan
able funds theory. The liquidity
preference the
focuses on the dem and for and
the supply of liquid assets and
explains t
movement of single inte rest rate
s on shor t-ter m securities on an
aggregate lev',
The loanable funds theory, on the
othe r han d, focuses on the dem and
for and sup
of aggregate loanable funds in
the economy. This theo ry analyses
the factors t
affect both lenders and borrowe
rs. It also examines the flow of
funds betwe
lenders and borr owe rs and expl
ains the interest rate movement
of both long-te
and shor t-ter m securities. 5 Alth
oug h both the liquidity preferen
ce and the Joana'
funds theories explain the mov
eme nt of inte rest rates, the loan
able funds theo
places more emphasis on the role
of an inte rme diar y such as a bank
; this is why t
focus of the rem aind er of this sect
ion is only on the loanable funds
theory.
280 Bank Management in Sout
h Africa -A risk-based perspective
,,, ,,,
I- - • - • - •
,,,
,,, ,,,
,,,
Oo
,,, ,,,
Loanable funds
Supply of loanable funds
,,, ,,,
ctors that influence the supply of
and dem and for loanable funds enta
il aspects of
four categories mentioned earlier.
Factors that influence the supply
of funds include
expected rate of retu rn on the loan
able funds relative to the expected
retu rns of
.ernative investments. Consumers
will always look for an investme
nt that has the
hest expected retu rn with the lowe
st risk atta ched to it. Other factors
to be considered
e the curr ent wealth position and
the future financial plans of cons
umers, who are
a cons tant decision-making proc
ess to enh ance thei r education,
heal th position
retirement plans. Remember that
retir eme nt funds are one of the larg
est suppliers
money in a financial market. In
terms of businesses. they often have
excess cash
ailable that can be invested temp
orarily before it is used for capi
tal or operating
penses. This excess cash is due to
the mism atch in the timing of cash
flows and the
\lanned real and operating expe
nditures. The government, on the
othe r hand , can
ffect the supply of loanable fund
s in two ways. Firstly, excess cash
can be invested
in securities to provide additional
revenues unti l the funds are requ
ired somewhere
else. Secondly, the Sou th African Rese
rve Bank (SARB) can influence the
availability of
redit and the growth in money supp
ly thro ugh buying and selling secu
rities in open
mar ket transactions. In terms of
foreign participants, securities with
the best expected
adjusted yields will always be purc
hased. This implies that if foreign
investors choose
alternative investments to South Afri
can securities, the supply of loanable
funds to the
Sou th African financial mar ket will
5
decr
In addition to the factors that ease.
influence the supply of funds,
ther e are four
factors that influence the dem and
of loanable funds. First, cons ume
rs borr ow large
, amo unts , especially for hou sing
, but also to finance the purc hase
of dura ble goods,
such as appliances, furn iture and
automobiles. Con sum ers also borr
ow mor e if the
cost of borr owi ng is lower relative
to alte rnat ive sources. Second, busi
nesses borr ow
to finance thei r working capital
and capital expenditure needs, whe
re the amo unt
that is borrowed depends on the
curr ent cash flow in thei r business
. This implies
.that if the business has a high leve
l of cash flow, less money will be
requ ired thro ugh
• rec: Koch & MacDonald (200 3) 5
The loanable funds theory framewo
rk
jQ
,,, ,,,
,,,
,,, ,,,
,,,
Rate Risk: Asset-Liability Managem
ent 281
Demand for
loanable funds
_Chapter 11: The Management of Inter
est
·····•···>•'ISll\'l'lll'.• 0. __,_,~~ .½-.·/SY? ~ ;'..!1/.Mi~-~-~-.'.·•~cc ~ ...\ .. ) ..
••.t..c.
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~[h~J,iefd Ctirveisillostrated oha···dia§Fkm.that'F~~~~r&~di~~f~ri!':~~f~~f..9i~i
,o~.sesoritieslhiitdiffer only in terms•of1T1atority,;pve~aspec1fistirhe):io~li:drj,:T1
'-impHe!Mhat all securitles must have the same feinor~s,.suchas.~~fa~lf.ri~~::.r~~
-;Jreatments, marketability and liquidity risk,in order frrisolatethe effects o1 maturity.
The loanable funds theory focuses only on a single risk-free interest rate. However,
in practice there is a variety of securities, with different degrees of risk and maturity
intervals that result in differing yields (interest rates) on these securities. This
difference between the yields is called the term structure of interest rates, which
explains why different securities have different interest rates. In order to understand
the term structure of interest rates it is important to understand the yield curve, as
illustrated by Figure 11.2.
11.3.2 The yield curve
borrowing. Third, government regularly issues debt in order
temporary imbalance between its operating income and expenditure sp
Loanable funds will be required to finance future government expenditure,
includes the construction of new schools, water treatment facilities, roads, ga
removal and sewerage facilities. Finally, foreign participants will always searc
the cheapest source of funds, thus influencing the demand for loanable funds
example, foreign corporations sometimes issue securities in South Africa tha
denominated in South African rand, because the interest rate obligations on t
securities will be lower than the interest rates on securities issued in altern
countries. 5
Prom the discussion above it is clear how the risk-free rate (equilibrium inte
rate) can be influenced and determined. An interest rate, however, is not sol
based on the risk-free interest rate as determined by the supply and demand for,
for loanable funds. An interest rate also incorporates a risk premium, which c
include a default risk premium, an inflation risk premium, a liquidity risk premiu
or a call risk premium and it depends on the maturity of the loan or security. T
default risk premium provides compensation for the lenders who provide t
loanable funds with the probability that the borrower will default on the loan; t
inflation risk premium is to compensate for the decrease in purchasing power due
higher inflation rates (see Section 11.3.3); a liquidity risk premium can also
incorporated in an interest rate if the security involved in the lending agreement i
less liquid and therefore difficult to sell; the call risk premium, on the other han
can be incorporated to compensate the lender for a decrease in expected returns, i
the borrower has the right to pay off the loan early; the longer the maturities are o
loans and securities the higher the interest rate will have to be in order t,
compensate for the exposure to longer periods of interest rate movements. 4 This,c
relationship between interest rates and maturities, specifically the yield curve, is
discussed in more detail in the next section.
282 Bank Management in South Africa - A risk-based perspective
Flat {No slope)
11.3.2.1
The unbiased expectations tlieory
•The unbiased expectations theory (or pure expectations theory) examines investor
behaviour by focusing entirely on the differences in their expectations regarding
future interest rates. This theory makes the assumption that investors are indifferent
From Figure 11.2 it is clear that the yield curve can constantly change form. It can be
horizontal (flat). which means that the market expects the long-term and short-term
interest rates to remain the same in the future. This implies that the yield to maturity
of all the securities is expected to remain constant irrespective of the maturity of the
· ·• individual securities. The yield curve can also have an upwards (positive) slope, where
the long-term interest rates exceed the short-term interest rates in the future. An
upwards yield curve is seen particularly during expansionary periods in an economy
when interest rates are expected to increase in the future (see Section 11.3.4).
Financial institutions that focus on long-term lending will benefit from an upwards
sloping yield curve, because their loans have longer maturities than their liabilities
(sources of funds), thus causing profits to increase. In other words, a bank with a
positive maturity gap, where asset maturities exceed liability maturities, will generate
a positive NIM if the yield is positively sloped. This is because interest revenues will
increase more than interest expenses (see Section 11.5). The yield curve can also
have an inverted (negative) slope, which implies that short-term interest rates exceed
long-term interest rates. A negative sloped yield curve is an indication that the
economy is possibly heading towards a recession of some sort, where interest rates
are expected to decrease in the future. 4
Why does the yield curve have different forms? This can be answered by
examining the four theories discussed in the following sections, which elaborate on
the term structure of interest rates. These are: the unbiased expectations theory, or
pure expectations theory; the liquidity premium theory; the preferred habitat
theory; and the market segmentation theory.
Maturity
- - - - - - - - - - Negative
(inverted) slope
Positive slope
Chapter 11: The Management of Interest Rate Risk: Asset-Liability Management 283
I
I
.
e
il:ii
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I
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id
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r . ~-.
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~
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id
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~
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.
·~
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,,
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,~'
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t
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~
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011
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Bank Management in South Africa A risk-based perspective
A640,00
.Option.1
R?00,00
R1 400,00
1
In Equation 11.1 , in denotes the mark
et rate on an n-period secu rity at time
t; ti
denotes the mark et rate on a one-period
security at time t; t + if is the one-period1
(1 + i,,)" = (1 + ,ii)(l + 1+ ifi)(l + 1+:J1) ...(l
+ l+n-ifi)
In order to estimate the forward inter est
rate the following equa tion is used: 5
From the discussion above it is clear that
the unbi ased expectations theo ry attac
h
a considerable amo unt of impo rtanc e
to forward interest rates, where investors
a
indifferent to the securities that differ in
maturity.
C
-
Table 11.2 Expe cted intere st incom
e
to the matu rity of securities. seeking
only the investment that will gener
highest retur n. This explains the relat
ionship between yield and different m
securilies based on the differences in
expectation of future inter est rate
following example clarifies this. 5
Suppose a risk-averse investor has RIO
000 to invest for a period of two
and considers Trea sury bills, given that
they are thou ght to be risk-free. Fo
two-year period the investor can cons
ider two investment strategies. The
includes investing in a one- year Trea sury
bill for the first year at a yield of 6.4~
then in anot her one-year Trea sury bill
for the second year. where the future in
rate is unkn own. The second strat egy entai
ls investing in a two-year Trea sury
a yield of 7%. If the sole objective of the
investor is to maximise expected retur
investor will be ambi valen t abou t the two
investment alternatives, if the total re
at the end of two years is the same from
each option. This implies that shoul
one-year Trea sury bill gene rate a 7.6%
yield for the second year, both options
gene rate Rl 400 in total for the two-year
period and the investment decision w·
strai ghtfo rwar d as the investor will be
ambivalent abou t the two options. Ho
if the one-year Trea sury bill generates
a yield high er than 7.6% in the second
the investor will consider the first optio
n. Also, if the yield is lower than 7.6%
fof
one-year Trea sury bill in the second year
the investor will consider option two.
mean s that the yield for both the long
-term and shor t-ter m securities is deter
mi
by the mark et cons ensu s forecast for the
future interest rate (forward interest ra
Expectations, therefore, dom inate the fund
amen tal shap e of the yield curve. 5
284
_hapter 11: The Management
of Interest Rate Risk: Asset-Liability Manageme
nt 285
11.3 .2.2 The liqui dity prem ium theo
ry
Whereas the unbiased expectatio
ns theo ry assumes that securities are
perfect
substitutes for each other, differing only
in terms of maturity, the liquidity prem
ium
theory incorporates the fact that in
reality investors prefer shor t-term secur
ities
because the risk (especially price risk)
and future unce rtain ty is less. For exam
ple.
supposing the expected retur n on a short
-term security is equal to the expected retur
n
on a long-term security. investors will
prefer the short -term security whic h has
less
risk and less unce rtain ty abou t futur
e changes of condition. Thus the liquid
ity
'rd rate on a security to be delivered one
year from the prese nt (t + 1): t + / 1 is
e-period forward rate on a security to be
delivered two years from the prese nt
); and t + n _ f is the one-period forward
rate on a security to be delivered one
1 1
·d before matu rity (t + n - 1) •
rom this equa tion the notio n can be deriv
ed that the long -term inter est rate
be considered as the average rate of
both the curr ent inter est rate, whic h
is
5
:ed for a loan, and the curr ent forward
inter est rate.
..:-- -
.
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.
i,
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ii
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Bank Management in South Africa - A risk-based perspective
Maturity
Shape of the yield
based on the unbias,
expectations theory
(with the constant-rate
expectations)
Equation
287
.-.~c
•--
;3.2.4 The market segnrentadon theory
ing the market segmentation theory borrowers and investors do not view
urities with different maturities as perfect substitutes. They concentrate their
nsactions within specific maturity buckets regardless of the expected returns of
urities outside these maturity buckets. This means that the interest rates are
termined only by demand and supply forces within each maturity bucket and
ere will be no substitution with securities outside. which may affect the interest
te. It will only be with extensive interest rate changes that market participants will
nsider changing to a different maturity bucket. 5
This raises the question as to why investors and borrowers limit themselves to
ly one specific maturity bucket? First, this segmentation phenomenon may be a
nsequence of government regulations that force market participants to use only
ertain maturity instruments. For example, short-term debt will be issued to finance
temporary imbalances in the operating spread. while long-term debt will be issued
to finance capital expenditure. The government is thus not allowed to use shortterm debt to finance capital expenditure. Second, market participants may limit
themselves to a particular maturity bucket as part of a risk-reducing policy. Third.
market participants may lack the necessary expertise to be able to switch between
maturity buckets. Finally, the goal of market participants may extend beyond the
maximising of profits, implying that they will be unwilling to take advantage of
profit opportunities. 5
In addition. it is assumed that the maturity spectrum can be divided into two
markets, where one illustrates the supply and demand for short-term loanable funds
and the other the supply and demand for long-term loanable funds. As depicted in
Figure 11.4, the aggregate lending and borrowing activities within each maturity
bucket are drawn to the same scale, and illustrate the fact that this theory will also
result in an upward sloping yield curve. This is due to the fact that for each interest
The preferred habitat tlreory
preferred habitat theory is considered to be a combination of the unbiased
,ctations and market segmentation theories. This theory makes the assumption
ari investor will have a preferential bond maturity range (maturity bucket) in
preferred habitat for investment. The investor will only be willing to buy a bond
t falls outside the preferred maturity bucket if a higher expected return (enough
premium) is offered. The investor is likely to prefer a habitat of short-term
ds over longer-term bonds (due to higher price risk), but will buy and hold
ger-term bonds only if they receive the required compensation. This implies that
stars can be attracted to less-preferred maturities by the higher expected interest
s, leading to an upwards sloping yield curve.
ences between long-term securities should disappear, which explains why the
;curve tends to flatten out over longer maturities as price risk decreases. Finally,
,e yield curve is inverted, short-term interest rates are expected to decline
ply, because as the maturity increases the liquidity premium must also increase,
this is offset by the decrease in the interest rate. 5
Chapter 11: The Management of Interest Rate Risk: Asset-Liability Management
"'·"'~------··--~--,-----
where,+ 1e1 denotes the expected interest rate on a one-period security, one perib
from the present; and 1 + 1 r 1 denotes the liquidity premium component of a one-perio
forward rate, one period from the present.
The problem with the liquidity premium theory however, is that neither th
liquidity premium nor the expected short-term interest rate is directly apparent in
the market. Market participants are only able to estimate the forward interest rate
and draw inferences from observing the yield curve. Nonetheless, if interest rates
follow the assumptions of the liquidity premium theory, there are four implications
to consider. First, even if the consensus is that the expected short-term interest rate
will remain constant, the yield curve will always illustrate a positive slope due to the
inclusion of a liquidity premium. This also implies that the liquidity premium will
increase along with the increase in the maturity of securities. 5 Second, the liquidity
premium will cause an upward bias to long-term interest rates compared to shortterm interest rates, which means that the normal shape of the yield curve will
always be positive under the liquidity premium theory. Third, the liquidity
t+l1 =t+1e1 +1+1rJ
This means that expectations still determine the basic shape of the yield curve,
the difference is that a liquidity premium must also be incorporated in the estimati
of the forward and long-term interest rate. The long-term interest rate will now
the average of the current and expected short-term interest rate and the liquid
premium. The forward interest rate, on the other hand, can be estimated using t
following equation: 5
Source: Koch & MacDonald (2003) 5
Figure 11.3 Incorporating the liquidity premium
Nominal
interest rates
premium theory extends the unbiased expectations theory by incorpora'
liquidity premium, which provides compensation for investors who invest in
term securities (see Figure 11.3 below). 5
286
-----•=--=--··· "'
·-c--~~~~
..--
Bank Management in South Africa - A risk-based perspective
Demand
for funds
The short-term market
Loanable funds
________
,._
Supply
of funds
Long-term
interest
rates
The long-term market
Loanable funds
-~---~~=---==----
Economists commonly attribute changes in interest rate to changes in the expect
or actual inflation rate. Interest rates increase as the inflation rate increases,
order to compensate for the decrease in purchasing power. To illustrate this conce
from the loanable funds theory perspective, consider the following example.
expected inflation increases, lenders will tend to lend fewer rand, becall
purchasing power will decrease. which in turn will decrease the value of the loan
11.3.3 The relationship between interest rates and inflation
To summarise: these four economic theories of the term structure of interest ra·
suggest that it is difficult to forecast future interest rate movements to use as an
to minimising interest rate risk. Although interest rates are determined largely
supply and demand forces, as shown in the loanable funds theory, risk premiu
the term structure of interest rates and expectations also have a significant influen
on the decomposition of market interest rate. Increased volatility, particularly int
current financial markets, can attach greater importance to market expectatici''
• This is why it is also important to understand and consider the interrelations
between interest rates and other macroeconomic variables including inflatio
business cycle and announcements by the SARB when formulating interest ra
expectations. The following sections deal with this.
Source: Koch & MacDonald (2003) 5
Figure 11.4 The slope of the yield curve under the market segmentation theory
Short-term
interest
rates
rate the amount of funds that lenders are willing to lend (supply) relative t,
amount borrowers want to borrow (demand) is greater for short-term secu
than for long-term securities. This means that short-term equilibrium wi
reached before long-term equilibrium, with the smaller relative demand press
short-term loanable funds pushing the short-term rates below the long-term
and causing the yield curve to be upward sloping. This scenario can also be reve·
where the amount borrowers want to borrow relative to the amount lender
willing to lend is greater for short-term securities than for long-term securities,
••
resulting in the yield curve becoming inverted (downward sloping). 5
288
iQ
I
;,,r
a
D1
S2
D2
Loanable funds
s,
----
-----------
1].3.J.1 The Fisher effect
The American economist Irving Fisher is well known for his contribution to interest
rate theory. Fisher was the first to investigate the foundation of the underlying
relationship between the inflation rate and the nominal interest rate, and describe the
esponse of the nominal interest rate to the inflation rate that became known as the
ishet effect. It stipulates that at any given period the nominal interest rate will be
ual to the sum of the expected inflation rate and the real interest rate. The Fisher
effect also states that changes in the expected inflation rate will have no effect on the
real interest rate, because this may lead to an equivalent nominal interest rate change.
According to Fisher, however, there is a one-to-one relationship between the expected
inflation rate and the nominal interest rate. Thus by correcting the nominal interest
owever, the supply of loanable funds will also decrease (S 1 to S2 ) at the same time,
cause higher inflation makes it more expensive to provide loanable funds. This
ultaneous increase in demand and decrease in supply shifts the risk-free nominal
terest rate to a higher equilibrium (i 0 to i 1 ). 5 The question now is: how much
oes the nominal risk-free interest rate increase? This question can be answered by
onsidering several further theories including the Fisher effect, the Mundell-Tobin
eory, and the Darby-Feldstein theory.
urce: Koch & MacDonald (2003) 5
igure 11;5 The impact of expected inflation on nominal interest rates
·o,.-,::ii~t rato
01111110
• implies that inflation will indirectly help the borrower to pay his loan. This
ept emphasises the borrower's behaviour, where he will tend to borrow more to
hase goods today, because it will become cheaper to pay back the principal
ents in the future. This scenario can be illustrated by Pigure 11.5, where the
land for loanable funds will increase (D 1 to D2 ) due to the greater demand from
borrower. 5
\ Chapter 11: The Management of Interest Rate Risk: Asset-Liability Managernent
...
)_
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291
The relationship between interest rates and the business cycle
,,-.-•-c•
••------
1/~
,.,_-c,,-<.Y
business cycle illustrates the distinctive expansion (upswing) and contraction
nswing) of economic activities over a number of years. History has shown that
st rates tend to follow these upswings and downswings of a country's real
s domestic product (GDP). For example, moving from the peak to the early stage
a contraction phase the economy is typically subjected to a depreciation of the
l'.ld; an unplanned increase in inventories; the deterioration of manufacturing
eduction: and the increase in interest rates because borrowers compete for the
r loans that are available. The reason for there being fewer loans is usually due
'the SARB's efforts to lower inllation by restricting credit availability, thus causing
e demand for loanable funds to exceed the supply of loanable funds. This is
owed by the latter stage of the contraction phase, which includes the decrease in
iness sentiment; a lower demand for credit: a depressed property market:
rease in share prices; and eventually a trough is reached. It is usually during this
iod that the SARB would try to stimulate growth in monetary reserves in an
ort to stimulate spending and to reduce unemployment, which causes interest
tes to decrease. 5 , 6
After a downswing in an economy, however, an expansion period always
llows, which includes a number of developments in the economy. for example,
anufacturing production starts to increase as a result of greater consumer
pending, which will cause inventories to decrease. In addition, the interest rate
nd inflation rate will decrease further, whereas the rand will appreciate. In the
ter stage of the expansion period a higher demand develops, with increased
ices for capital goods, which will stimulate a higher utilisation of production
pacity, but will also cause inflation to increase. As the peak is reached share
rices will start to lose momentum and property prices will start to escalate.
urthermore, the demand for credit will still increase, leading in turn to higher
nterest rates. This increase in interest rates is due to the higher demand for goods
nd loanable funds, which will be greater than their supply, thus placing more
ressure on prices and production. 5 •0
.4
mmarise: these three theories elaborate on the relationship between expected
ion and interest rates, but they ignore the influence of the actual inflation rate.
theless. in reality actual inflation and the ex ante real interest rate is not always
n and the actual inflation rate can also deviate from the expected inflation rate
, making it even more difficult to incorporate the above discussed theories. For
ple, in South Africa the actual consumer price index (CPI) inflation rate and
producer price index (PPI) inflation rate have a month lag period before they are
rted, thus making the use of expected inflation rates in present estimations
·e attractive than the use of actual inflation rates. Besides the use of inflation
s to determine interest rate movements, many economists use lhe trends in the
ness cycle/economic growth to determine interest rate movements.
Chapter 11: The Management of Interest Rate Risk: Asset-Liability Management
.-,n~>',..'l""'"""'~""'~"'"-·•••••·--•---"'•~-------_.,....
In Equation 11.4, r., is the ex ante after-tax real interest rate: i is the nominal mar
interest rate; and tis the marginal tax rate.
This equation implies that for lenders to have the same purchasing DO
•interest rates must increase more than inllation in order to pay the increment
income tax and to keep the ex ante real interest rate constant. This theory al
•argues that the market nominal interest rate will move in the same direction
expected inflation rate changes, but the relationship will be greater than one-to-o
due to the additional tax factor. 5
ra( =i-it-ne
11 .3 .3 .J The Darby-Feldstein theory
The Darby-Feldstein theory suggests that market participants are concerned
the expected after-tax real interest rates and not the before-tax nominal inte
rates or the real interest rates. The ex ante after-tax real interest rate can be defi
as the nominal market interest rate minus tax on the nominal interest rate min
the expected inflation rate. This is calculated as follows: 5
11.3.3.2 The Mundell-Tobin theory
This theory argues that there is an inverse relationship between expected
and the ex ante real interest rate, called the real wealth or real balance effect."
increase in inflation will lower the money balances of individuals (because
money will buy fewer goods and services) which will lead in turn to a decline in
wealth. To increase wealth to its original level. individuals will have to save m
This implies that an increase in savings will cause the supply of loanable fund
increase, which will cause the ex ante real interest rate to decline. Lower infla
expectations will produce the opposite effect. Therefore, the ex ante real interest
will move in the opposite direction if the expected inllation rate were to change.
theory also argues that the ex ante real interest rate is not constant and that nomi
market interest rates will move in the same direction as a change in ex
inflation rate, albeit that the change will be less than one-to-one. 5
In Equation 11.3, r is the real interest rate: i is the nominal interest rate: and
expected inflation rate.
From this theory it is clear that the new nominal risk-free interest r,
Figure 11.5 will increase by the same amount as inflation is expected to inc
However, the theories proposed by Mundell-Tobin and Darby-Feldstein disagree.
specifically, the Mundell-Tobin theory suggests that the nominal risk-free intere
will increase by less than the expected inflation, whereas the Darby-Feldstein t
suggests that the nominal risk-free interest rate will increase by more than
expected increase in inflation rate. 5 This is discussed further in the following secti
r= i-nc
rate for inflation the following equation can be used to demonstrate the calcula
the real interest rate:
290 Bank Management in South Africa -A risk-based perspective
-~----~ ~ - -.. ·,,,
Interest rates
Expansion
Peak
Trough
Expansion
Long-term rates
Short-term rates
Bank Management in South Africa - A risk-based perspec
tive
X
4)
X
100 = 10.71%
~-➔ ½ 7\'"f.-~".'"'.'.,'-""llll'-'7~,....> : : : ~ . ? > , -'""-*
.\ ··--;
"•.--·'""' =•·•
This yield is significantly higher than the yield that will be obtaine
d from buying
holding a 13-week Treasur y bill until the end of its maturity.
Still, for this strate
to be successful the upward sloping yield curve must be very
steep (especially to
able to finance the transac tion costs) and the interest rate must
be constan t for th
specific time horizon. This is, however, highly unlikely in practice 5
.
Conversely, during contrac tionary periods the relationship
switches and a
inverted yield curve will be present. During this period long-ter
m interest rates wi
exceed short-te rm interest rates (see Figure 11.2). This implies
that short-ter
• securities will be sold by investors in order to buy longer-term
securities to limit t
losses from decreasing interest rates. Financial institutions can
also follow alternati
[(300 ~ 11200)
for an annuali sed yield of:
(Rll 500 - Rl 1 200) = R300
The continuous upswings and downswings give market particip
ants an indicati6
when they can expect interest rates to increase or decrease (see Figure
11.6). Also,
able to determine when the economy is approaching a period of expansi
on or contra
enables market participants to determine in which maturity bucket
to invest. Du
expansion periods, short-term interest rates tend to be higher
than long-term int,
rates, suggesting that short-term investments will be more benefici
al. In an upw:
sloping yield curve environment traders are attracted to more active
trading strat,
commonly referred to as 'riding the yield curve'. 4 This strategy
allows investors toe
extra returns by buying longer-term securities, selling them at their
peak prices (befi
maturity) and then reinvesting in other shorter-term securities. For
example, suppose
investor buys a 2 6-week Treasury bill for R 1 2 000 that yields l 0%
annually and will
for Rl 1 200. Simultaneously, a 13-week Treasury bill is available
that yields 8% and
sell for Rl l 500. By purchasing the longer-term security, holding
it for 13 weeks, a
selling it at the existing 13-week Treasury bill price will generate
a profit of:
Time
Figure 11.6 The relationship between interest rates and
the business cycle
292
_
293
_,. ~--
:,.,<.¾-""'"'·-~---•-~~
-_~,.,.......,,.· ;.,, _·_,_.,_,
.~.- ~ -
+.W~wu_:J, •• ,~> ""'-··'"'··•--·--"' °""'~'~s:c.1"\
tegies to benefit from an inverted yield curve, such as: buying
more long-term
-callable securities; switching price deposits to a floating interest
rate basis;
king more fixed-rate non-callable loans; or applying strategi
es to become more
ility sensitive and/or lengthen the duratio n of assets (see Section
s 11.5 and 11.6). 4
th a positive yield curve the opposite is also true, where financia
l institutions will
nt to increase their asset sensitivity and/ or lengthe n the duratio
n of liabilities.
Chapter 11: The Management of Interest Rate Risk: Asset-Li
ability Management
Bank Management in South Afric
... ,... ~.~"'-'~'-':'."',1)\ffl'.<:"c":•''-"'\,:t,_l>""':'•"""~'"~-''"""'-,----,"
~--········-.. •.. --.
Monetary policy announc ements are capable of influencing bond
prices,
volumes in financial markets, yields in both the capital and money
markets and t
interaction in the interban k markets and lending activities. These
announcemeri
can have significant spillover effects and have a pervasive economi
c impact on t
decision-making process of households, investors, producers and other
policyma
in an economy. For example, when the SARB makes an announc ement
regarding
change in the repo rate, it can have significant financial advantages and
disadvantage
for an economy,· albeit only current short-term interest rates are
immediate!
influenced. Longer-term interest rates, on the other hand, are determin
ed based o
market particip ant expectations about possible future changes, as well
as the level of
consistency portrayed by the SARB regarding policy making. 8 For this
reason, policy
transpar ency is of the utmost importance to reducing uncertai
nty in financial
9
markets. The SARB must manage expectations through an effective
range o
communication channel s such as media briefs and MPC seminars in order
to reach all
the various stakeholcjers in the market. In doing so, the SARB not
only promotes
transpar ency but also manages market expectations, which in turn
enhance s the
credibility of the SARB in its endeavour to achieve its mandate relating
specifically,
11.3.5 The impact of SARB announcements
Besides using macroec onomic variables to generate interest rate expectat
io
also importa nt to monitor governm ent intentio ns regarding future
policy ch
and the level of transpar ency between the SARB and market particip
ants.
therefore, importa nt to monitor the impact of announc ements
from the S
because any changes in the repo rate will influence long-ter
m interest
expectations and eventually every particip ant's strategic decision-making
proc
the economy. This leads to the next section focusing on SARB announc
ements.
294
Current market price= [(CF ) ~ (1 + YTM) 1 ] + [(CF,2 ) ~
11
(1 +YTM) 2] + ... + [(CF,") ~(l +YTM)"] + [SR+ (1 +YTM)"]
Equation 11.5
Since interest rates are the 'price' for obtainin g credit, it is importa
nt to know how
this 'price' is calculated. The two most popular approac hes used are
the yield-tomaturity (YTM) and the bank discoun t rate. The YTM is the expected
rate of return
on a security held until its maturity date is reached based on the security
's promised
interest payments. the purchas e price, and the redemption value at
maturity. This
can be calculated as follows: 4
11.3.6 The measuring of interest rates and the management
of interest
rate risk
asting interest rate movements is extremely complex and accurate forecast
ing
ost impossible. That is why banks will attempt to manage their overall
interest
risk exposure as effectively as possible and base their decisions
on all the
!able current information. This raises an importa nt point with regards
to the
asting of interest rate movements; banks make informed decisions based
on all
ormation available to them in the market, but at the heart of these forecasts
is the
derlying monetar y policy stance of the SARB. This is because the
SARB makes
isions on repo rate movements based on its assessm ent of market developm
ents,
·ch include both domestic and internat ional developments. Keep in mind
that the
B currentl y has a mandate to ensure price stability. Any economi
c developnts, whether domestic or internat ional. which the SARB considers as
having the
tential to adversely affect inflation, are importa nt considerations for
banks. These
evelopments are, therefore, not limited to the monetar y sector and
exclusively in
nancial markets, but also include real sector developments. This implies
that by
anaging the interest rate expectations of banks, the SARB is able
to intluence
ank asset-liability manage ment decisions and eventually also
the financial
ellbeing of the entire economy. The remaind er of this chapter is
dedicated to
iscussing the different balance sheet techniqu es that banks can use
to manage
interest rate risk (note that the strategie s banks use to hedge interest
rate risk using
derivatives is discussed further in Chapter 12).
"aii~:,f:;:;~~~~~:;~~r,t~ies{ahd _action p\li~~
-~- ~yElr ~j~pecificti~~horito~.
·'I~J~t~d~1;t:#iter~sfrilt~iwith}o6%J(:(:i)racy,exp~bt~d
fr6rfr~ivet~l!;i,1estlfi:fr~t::~s~;c~2~r,i~?i~~ere.~ •
limited to, price stability, exchange rate stability. liquidity, foreign capital
flows
rail balanced economic growth.
rther to this, managin g the expectations of banks also incorpor
ates the
sting element that banks make use of to generate 'bounda ry rates' that
enable
to limit interest rate exposures (see Section 11..4).
'hapter 11: The Management of Interest Rate Risk: Asset-Liability
Management 295
Bank Management in South Africa -A risk-based perspective
From these sub-risk components of interest rate risk, it is evident that both cash
flows and the market value of the entire statement of the financial position can be
influenced by moving interest rates. In order to ensure effective management of
interest rate risk, banks have three different balance sheet management techniques
at their disposal. The first technique, called the interest-sensitive gap management
However. it is not the type of method used to estimate the interest rate
important, but rather how the balance sheet management techniques are ap
and managed to minimise interest rate risk exposure. Hence the manageme
the interest rate as such is of utmost importance to banks. Interest rate risk
be divided into two sub-risk components, namely price risk and reinvestment
Price risk arises whenever the market interest rate increases, thereby causing
market value of assets, liabilities and equity capital to decrease. Reinvestment r
on the other hand, refers to the risk that is caused by the decreasing interest r
that will force the bank to reinvest its future funds in a lower yielding asset, t
lowering the expected future income. 4 An additional risk component which can a
be included is called refinancing risk. This risk arises due to the uncertainty of
cost of a new source of funding (with a shorter maturity) that is used to financ
long-term fixed-rate asset. For example, if a one-year time deposit is used to financ
three-year fixed-rate loan, the bank faces the risk of refinancing at a higher inte
rate after one year if interest rates were to increase. Ceteris paribus, this will decrea
the NIM. The opposite is also true for decreasing interest rates, where refinancin:
will be cheaper after one year and lead to a lower interest rate expense that ultimately
improves the NIM, ceteris paribus.
YTM equivalent yield= [(FV - PP)~ PP] x (365 ~ N)
In Equation 11.6, FV is the face value of the security; PP is the purchasing p
the security; and N is the number of days to maturity. The bank discount rate h
tendency to understate the true yield percentage because returns are divided
face value and not the current purchasing price. In order to overcome this pt,
the bank discount rate can be converted to an equivalent value (known as the
equivalent yield), which is formulated as follows: 4
Bank discount rate= [(FV - PP)~ FV] x (360 ~ N)
The bank discount rate, on the other hand, estimates the interest
Treasury bills and other money market securities by using par value and a
year to determine the appropriate discount rate. The bank discount rate met
ignores the effect of compounding of interest rates. The following equatibn
used to estimate the bank discount rate: 4
In Equation 11.5, CF11 is the expected cash flow in period l; Cl\ is the
2
cash flow in period 2; CF 1n is the expected cash flow in period n; and SR i:
or redemption price of security or loan in period n. The YTM method assu
interest rates are compounded at the calculated YTM and also assumes th'
day year horizon is used.
296
297
so, the ALCO must recognise the importance of the vision, miss10n,
:oals and objectives of the bank in order to develop the appropriate strategy to
ercome the gap between where the bank currently finds itself and where it wants
o be in the future. However, the ALCO and the ALM can fail if the bank suffers
om poor communication channels, especially where decisions are not properly
Cbmmunicated to the various business lines. Also, the incompetence of members as
a result of unclear role definitions (job descriptions) and the failure to execute the
ALM plans and objectives effectively, can cause the ALCO and the ALM framework
to fail. In addition to these potential problems, is the danger of an agency problem.
This phenomenon is caused by the tension between shareholders and management
related to their different interests in the bank and their conflict regarding what the
future mission, vision, goals and objectives should be for the bank to be successful in
a highly competitive and complex market.
By taking minutes in each ALCO meeting and applying the required procedures
limit deviations from the purpose of the ALCO meeting, these problems can be
THE ASSET-LIABILITY COMMITTEE (ALCO)
LCO is a committee within a bank that comprises executive and senior
gement who meet to alter, strategically and intentionally, the mix of liabilities
ssets in anticipation of likely future events and consequences emanating from,
ot limited to, interest rate movements, foreign exchange exposure, liquidity
traints and problems with capital adequacy. In order for the ALCO to be
tive it requires the full support of the CEO and typically constitutes between
and eight executive and senior management members from all the major
ions within the bank, including treasury, linance, operations, corporate, retail
various risk departments.
The ALCO is used to manage interest rate risk. operational risk and the capital
ition. It also provides the bank with a clear view of what the required liquidity
1 must be to be able to meet all linancial obligations. Furthermore, the ALCO
t not only follow a defensive approach, but also use the ALM framework as a
ategic planning tool that is proactive to:
test various asset mixes and funding combinations
various pricing and volume relationships
identify new products and markets.
ue, enables a bank to determine the level of NIM sensitivity by evaluating
flow from assets and liabilities. The second technique, called the duration
nagement technique, compares the price sensitivity of a bank's total assets
e price sensitivity of its total liabilities to assess the impact of potential
s in interest rate on shareholder equity. The third technique, called the EVE
ement technique, enables a bank to evaluate the potential long-term impact
erest rate changes on shareholder equity. Banks usually conduct these
gement techniques under the guidance of the ALCO.
11: The Management of Interest Rate Risk: Asset-Liability Management
-----.----.,~_.,• ... •."""
• .. S
~
Step6
--
Step 1
/
~
Step2
The first step includes reviewing the previous month's results. where all t
targets set in the previous ALCO meeting are evaluated and all the success
and failures are identified. For example, if the required growth target for horn
loans were not achieved. the ALCO process would start by identifying th
source(s) of this failure.
Step 2
•
¢ •... ; _::•'"::r,y__ ~J ➔- ..-,.tA /Y..?..,\\l~,X,.:,
-<:---~"-·•
The second step of the ALCO process entails assessing the current balanc
sheet. The bank evaluates its current balance sheet structure in terms of
Step J
•
In order for the ALCO to be successful it must follow ten steps (see Figure 11.9) that
allow a financial institution to generate an appropriate strategy that incorporates all t
risks, requirements, regulations and expectations of management, employees, die
and of the bank supervision department. The steps in the ALCO process are as folio
Figure 11.9 The ALCO process
\
I
Step 10
Bank Management in South Africa - A risk-based perspective
Step9
298
299
'ent asset and liability mixes, changing market conditions, its current cost
,file and its maturity and interest sensitivity profile. By reviewing past
formances and the existing balance sheet structure it provides the bank with
proper platform to generate future strategies.
ep 3
iring the third step exogenous factors are projected in order to establish the
mronment in which the bank finds itself. Exogenous factors are those that
anate ft-om outside the bank and over which the bank has very little or no
ntrol. These factors include fluctuating exchange rates, inflation rate and interest
tes. Due to the fact that accurate forecasting is impossible (see earlier sections),
anks establish boundary rates within which management will position the
stitution. IT these boundary rates are properly determined and planned, the bank
·11 be able to generate effective strategies to stabilise and improve earnings and real
et worth, regardless of how future rate movements develop. In addition, the bank
ust also project endogenous factors that can influence ALCO decisions. These
endogenous factors are those over which the financial institution has control, such
as the training and skills of employees and their working environment.
Step 4
The fourth step includes developing suitable asset and liability strategies in response
ito the projected exogenous and endogenous factors. Different strategies are developed
to incorporate the boundary rates that were established in the previous step. During
this stage in the ALCO process various 'what ff' scenarios are defined and carefully
evaluated to determine the best strategy going forward, bearing in mind that a
particular strategy should not be limited to only one specific goal, objective or market.
Step 5
In the fifth step the asset and liability strategies are simulated to incorporate the
changing external environment. Different time frames are simulated for
different strategies. For example, a five-year time frame simulation can be used
to generate more capital or alternatively a twelve-month time frame simulation
can be used to measure the impact of interest rate changes.
Step 6
The sixth step entails determining the most appropriate strategy, given the
bank's perception of the future, its risk appetite and its goals and objectives.
Also, by reviewing the different simulations and risk reports, the ALCO can
make more informed decisions in choosing the best strategy to bridge the gap
between past and future performance expectations.
Step 7
In the seventh step the ALCO decisions are translated into quantifiable actions
or targets. These targets must be both realistic and achievable within the
desired time horizon.
Step 8
During the eighth step the quantifiable targets are communicated to all
managers and to all channels within the bank, especially the operations and
treasury departments. Proper communication enables each department to
recognise its role in the current strategy and see how the goals and objectives
can be reached if each department fulfils its tasks.
apter 11: The Management of Interest Rate Risk: Asset-Liability Management
Step 9
In the ninth step the strategies are monitored to ensure that there is
with the strategies and targets decided upon. The over-achievement
achievement of targets can influence all future decisions and strategies oft
Step 10
The final step entails the process of determining whether or not
strategy is still appropriate for the goals and objectives that were set. Du
dynamic and ever-changing nature of the financial environment, the p
exogenous factors, conditions, simulation assumptions and decisio
change continuously. This requires an ongoing review process to ensu
the current strategies are still appropriate.
Bank Management in South Africa - A risk-based perspective
INTEREST-SENSITIVE GAP MANAGEMENT
In Equation 11. 8, NPA is the difference between interest income and interest expe
Remember that the yield curve (see Section 11.3.2) does not move parallel over ti
which means that the spread between borrowing costs and interest income
never be constant. Management will, therefore, continually struggle to ensure
borrowing costs do not outgrow interest income.
The interest-sensitive gap management technique requires management
monitor and manage the different maturities and repricing opportunities
interest-bearing assets and interest-bearing liabilities. In the real world compu
based techniques are used, which help management to divide the interest-bear"
assets and liabilities into different buckets based on their respective maturities.
doing so, management is able to determine the level of interest rate exposure if t
asset or liability matures or if the interest rate changes in the near future. It al
allows management to evaluate the multiple factors that can influence the NIM O
the bank. These include the following: 4
•
changes in the spread between the asset yields and liability costs, which
reflected by the shape of the yield curve between the short-term and long-ter
interest rates
NIM= NPA c-Total assets (or earning assets)
This technique focuses on stabilising the cash flow from both the asset and
sides of the balance sheet. More importantly, it focuses on the important go
insulating the bank profits, particularly the NIM, from the damaging effec
interest rate movements. The NIM is therefore calculated as follows: 4 •5
11.5
In addition to the various steps in the ALCO process, it is also important that
department is fully committed to generating the required estimations and sc
(during step two to four of the ALCO process) to ensure that the appropriate as
liability strategies are selected and developed. In order to comprehend how th
department can be an effective 'number cruncher' for the ALCO process, it is nee
to understand the management techniques used to help generate some of
numbers for hedging interest rate risk. These are discussed in the next three secti
•
•
300
301
Equation 11.9
will increase.
In summary, a bank that is asset sensitive (with a positive IS-gap) benefits from
ncreasing interest rates, whereas a bank that is liability sensitive (with a negative
IS-gap) benefits from decreasing interest rates (see Table 11.4).
he NIM.
If the interest-sensitive liabilities exceed the interest-sensitive assets a negative
IS-gap develops and the bank is said to be liability sensitive. If interest rates were to
increase, the interest expense paid from the interest-sensitive liabilities would
increase by a larger amount than the interest income generated by the interestsensitive assets, resulting in a decrease in the NIM. Alternatively, should interest
rates decrease, the interest expense will decrease by a larger amount than the interest
Due to the interest expense declining more than the interest income, the
though in reality there will always be a gap, the challenge is to manage this gap
hich can be either positive or negative) as effectively as possible. Note that the bank
ust manage both a periodic gap and a cumulative gap: the periodic gap entails the
anagement of interest-sensitive assets and interest-sensitive liabilities across a
ngle time period or bucket; the cumulative gap entails the management of interest5
nsitive assets and interest-sensitive liabilities over all time periods or buckets.
If interest-sensitive assets exceed the interest-sensitive liabilities a positive IS-gap
evelops. This bank is then said to be asset sensitive. Should interest rates increase, the
terest income generated from the interest-sensitive assets will increase by a larger
mount than the interest expense paid from the interest-sensitive liabilities, resulting
an increase in the NIM. Alternatively, if interest rates were to decrease, the interest
"ncome will decrease by a larger amount than the interest expense, thereby decreasing
IS-gap= Interest-sensitive assets - Interest-sensitive liabilities
inimise interest rate exposure effectively, banks will attempt to minimise the
rence (or gap) between repriceable interest-sensitive assets and liabilities (see
ation 11.9) in each maturity bucket. 4 •5 This difference is called the interestsitive gap (IS-gap). By implication, the interest income and interest expense can
.managed indirectly in a changing interest rate environment over different time
e impact of increasing or decreasing interest rates
e impact of changes in the volume of interest-bearing liabilities that are
tilised to fund earning assets
he impact of changes in the volume of interest-bearing assets
changes in the asset and liability mix as management can shift between floating
and fixed-rate liabilities and assets. Management can also change the mix of
assets and liabilities in terms of maturities by moving from short-term to longterm assets and liabilities or, alternatively, move from assets that possess a low
expected yield to assets with a higher expected yield.
Chapter 11: The Management of Interest Rate Risk: Asset-Liability Management
Decrease
Zero
Decrease
Increase
Decrease
Increase
Decrease
Increase
Decrease
~
Size of financial instituti on
Equati on1
Increase asset sensitivity
Reduce asset sensitivity
cGoal
(3) By making more loans on a floating-rate basis.
(2) By shortening the maturities ot loans.
{l) By buying short-term securities.
{3) By substituting lloaling-rale loans wilh term loans.
(2) By lengthening lhe maturities of loaos.
(1) By buying long-term securities.
I Approaches aval!Able td}lfinantial 11'\iitittitl
Table 11.5 Summary of different approaches to change
the interest rate sensitivity
Banks are able to elimin ate a positive or negative
IS-gap using a numbe
approaches, as shown in Table 11. 5. If a bank wants to
reduce its asset sensitiv
it must change its focus from holding short-t erm to long-te
rm assets and liabiliti
This implies either buying additional long-te rm securit
ies or substit uting floati
rate loans with term loans. Both of these actions lengthe
n the maturi ty of the lo
(and thus assets), thereby reducin g the asset sensitivity.
Conversely, the bank
reduce its liability sensitivity by paying premiu ms to
attract longer-term dep
instrum ents, or it can issue additional long-te rm subord
inated debt. These actio
will in turn reduce the liability sensitivity by length ening
the maturi ty profile of t
liabilities. By implication, therefore, if a bank wants to
increase its asset or liabili
sensitivity, it will adopt the opposite approa ches to these
just discussed in order
have a short-t erm asset and liability profile on its balanc
e sheet. 5
!SR= Interest-sensitive assets -;. Interest-sensitive liabilitie
s
If the ISR (see Equati on 11. 11) is less than one it implies that
the financial institti
is liability sensitive (negative JS-gap), wherea s an ISR greater
than one implies
the financial institu tion is asset sensitive (positive IS-gap) 4
.
Relative IS-gap = IS-gap
There are several additio nal ways to measu re the IS-gap,
including the relatr
gap ratio and the interes t sensitivity ratio (ISR). If the relative
IS-gap is greater '
zero the bank is asset sensitive, whilst a negative relative
IS-gap indicates a lia'
sensitive barik. Note that a good proxy for the size of the
bank is total assets: 4
*fl,
denotes change
Source: Koch & MacDonald (2003) 5
Increase
Zero
Decrease
Increase
Increase
Decrease
Negative
Negative
Decrease
Decrease
Positive
Increase
Increase
6 Interest
income
Positive
: 6 • Interest rates
>
Bank Management in South Africa - A risk-based perspec
tive
Table 11.4 Summary of IS-gap position s
302
(2) By borrowing more through non-core purchased liab11ilies.
(1) By paying premiums to anract more short-term deposits instruments
.
{2) By paying premiums tu anract more lung-term depo~t instruments
{1) By issuing more long-term subordinated debt.
Equation 11.12
where NPA is the difference between interes t income and
interes t expense. Althou gh
some banks follow a more defensive IS-gap manag ement
approa ch (which implies
an IS-gap equal to 0), there are others that strive to
follow a more aggressive
t,NPA = Overall change in interest rates x Size of the cumulat
ive gap
addition to using the periodic IS-gap, a bank can also make
use of a cumulative gap.
he cumulative gap is a useful overall interest rate risk measu
re to determine the effect
,f sudden and unexpected interes t rate change
s on the NIM over a longer designated
·me period (see Equation 11.12) . The cumulative gap assists
the bank to be better at
anticipating future interest rate movement in order to make
final adjustments to IS-gap
manag ement strategy before its implementation. A bank
with a positive cumulative
gap will benefit (NIM will increase) from increasing interes
t rates, whereas a bank with
4
a negative cumulative gap will benefit from decreasing interes
t rates.
the impact of interes t rate change s on the NIM, based on
these asset or liability
tive positions, the safest position for a bank is to have a
zero IS-gap; that is, the
rest income from the interest-sensitive assets will change
at the same rate as the
test expense from the interest-sensitive liabilities. A bank
with a zero IS-gap can,
efore. be regarded as being protected (or immunised) from
the negative effects
nterest rate risk. However. in reality this is not true becaus
e the interes t rates
ched to liabilities and assets are not perfectly correlated.
For example, interes t
s on loans tend to lag behind interes t rates on money marke
t borrowings. This
lies that interes t income will tend to grow at a slower pace
than interes t expense.
rket evidence indicates that this is true, especially in econom
ic upswings, while
rest expenses tend to fall more rapidly than interes t income
during an economic
nswing (see Section 11.3.4 ).
In order to limit the interes t rate exposure, a bank
must ensure that the
;1\owing aspects are taken into consideration: 4
The bank must choose the time period during which the
NIM will be manag ed.
This period will then be divided into different maturi ty
buckets (or periods) in
order to determ ine the extent of the interes t rate risk exposu
re.
The bank must choose a target level for the NIM over this
estimated period.
The bank must ensure that accura te interes t rate forecas
ts are provided and
that the spread between interes t income and interes
t expense is manag ed
effectively.
The most efficient volume of the interest-sensitive assets
and liabilities must be
determined.
e: Koch & MacDonald (2003) 5
liability sensitivity
liability sens1t1vity
Chapter 11: The Management of Interest Rate Risk:
Asset-Liability Management
Bank Management in South Africa - A risk-ba
sed perspective
Negalive IS-gap
Markel interest rates decrease
•
Increase interest-sensitive assets
•
Increase interest-sensitive liabililies
and/or
Decrease interest-sensllive !1abililies
Decrease interest-sens/live asse1s
■
■
and/or
Altho ugh the overall TS-gap mana geme nt appro
ach is essential to mana ge a bari
NIM, it does have a numb er of drawbacks. Firstly
, after implementing this approa
the bank will still have a degree of intere st rate risk
exposure, commonly referred to
basis risk. Basis risk developed because the intere
st rate expenses paid from intere
sensitive liabilities are not perfectly correlated with
the intere st income gener ated
the interest-sensitive assets. This implies that both
the magn itude and rate of chan
of the intere st rates on the respective interest-sen
sitive assets and liabilities diff,
thereby exposing the bank to possible losses if
interest rates change. For exampl
borro wing cost will always move faster than the
intere st rates earne d on assets. In a
attem pt to overcome this problem banks _have develo
ped a weighted IS-gap approac
that incorporates the tende ncy of intere st rates
to vary in their rate of chang e an
magnitude, depending on the curre nt phase of
the business cycle. The weighted I
gap appro ach assigns different intere st rate sensit
ivity weights to the different asse
and liabilities on the balan ce sheet, depending
on the interest rate volatility level o
each asset and liability comp onent .
Secondly, the point at which some assets and
liabilities may be repriced is no
always identifiable. For example. dema nd depos
its do not have a predefined matur ity
period durin g which the bank will have access
to them. Finally, and probably the
most impor tant problem of IS-gap mana geme
nt. is that it does not consider the
impac t of intere st rate movements on the total
equity (or net worth ) side of the
balan ce sheet. 4 For this reason, it is good
practice to combine the
mana geme nt techn ique with both the durati on
gap and the EVE techniques. These
will be discussed in Sections 6 and 7, respectively.
Source: Rose & Hudgins (2010) 4
Posilive IS-gap
Market lnterest rates increase
Table 11.6 The aggressive IS-gap manag
ement approa ch
.forecast interesu ate
Best IS-gap position to be in
appro ach which is more depen dent on the accur
acy of their intere st rate fo·
For example, if the bank interest rate forecast shows
that intere st rates are g
decrease over the mana ged time horizon, the
bank will allow the interestliabilities to exceed the interest-sensitive assets
(negative IS-gap) which will
cause the NIM to increase (see Tables 11.4 and
11.6). Alternatively, if their
rate forecast shows that intere st rates will increa
se, the bank will allow the in
sensitive assets to exceed the interest-sensitive
liabilities (positive IS-gap) in o
increase the NIM. Obviously, this appro ach has
a greate r degree of risk for
because accurately forecasting interest rate move
ments is virtually impossibl
aggressive appro ach normally relies on hedgi
ng throu gh the use of interes
derivatives in an attem pt to minimise risk expos
ure (see Chapt er 12). 4
304
305
f {[(expected
t:= 1
t .;-
(1 + YTM)'])
CF in period t x period t) .;- (1 + YTM)']
.;- [expec ted CP in period
D=
Equat ion 11.13
The duration gap (D-gap) mana geme nt technique
enables a bank to mana ge the price
sensitivity of assets, liabilities and especially equity agains
t interest rate movements. Duration
can be defined as the present value-weighted measu
re of the maturity of a portfolio or
.an individual security in which the timing and amou
nt of all cash flows expected from
the portfolio or security are considered. 4 In other
words, duration measures the weighted
average maturity of a security or portfolio over
which its expected cash flow will be
received. There are several duration measures
that can be used. The most popular
measures include the Macaulay duration (see Equat
ion 11.13), the modified duration
4 5
(see Equation 11.14 ) and the effective duration (see
Equation 11.15). •
11.6 DURATION GAP MANAGEMENT
Interest Rate Risk: Asset-Liability Management
Bank Management in South Africa -A risk-based perspective
3.
where NW is the net worth; A is the market value of total assets; and L is t
market value of total liabilities. Note that if the market value of either the asse
or liabilities changes, the market value of the net worth automatically chang
as well. This implies that it is essential to ensure the effective management oft
weighted average duration of the assets and the weighted average duration 6
the liabilities in order to minimise adverse change to net worth.
Estimate the weighted average duration (DA) of the assets and the weighted
average duration of the liabilities (DL). This is then used to determine the D-gap a
follows: 4 •5
NW=A-L
In Equation 11.15, Pi_ is the price of the security if interest rates fall; Pi+ is the
of the security if interest rates increase; PO is the current (initial) price; i+ is the in
market interest rate plus the increase in interest rate; and i_ is the initial ma
interest rate minus the decrease in interest rate. In order to simplify estimations,
the Macaulay duration will be used for the rest of this chapter. 5
By applying the Macaulay duration in the D-gap technique, the bank wi!I
able to compare the duration of assets with the duration of liabilities. This
enable management to examine how the market value of shareholder equity (or
worth) will change in a moving interest rate environment. To apply the D
technique successfully, the following four steps must be followed by the ass
liability managers in the bank (note that the D-gap is also used in the E
management technique which is discussed in the next section): 4 · 5
1. Forecast the boundary interest rates (see Section 11.3.5).
2. Estimate the current market value of the bank's assets, liabilities and net wor
The market value of the net worth is determined by the traditional balan;
sheet equation as follows:
Effective duration= (P;_ - P;+l ~[PO x (i+ - i_)J
The modified duration provides additional information regarding the extent to
the price of a security will change (in percentage terms) for a given change in i
rate i. Both the Macaulay duration and modified duration estimations assum
all promised cash flows will be realised. However, in reality this is only appli
to option-free securities. As such, for securities that contain embedded optiori
effective duration will be a more applicable method to use (see Equation 11.15)
effective duration estimates the extent of price sensitivity of a security wh
security contains embedded options. 5
Modified duration = D + (l + i)
In Equation 11.3, D is the Macaulay duration: CF is the cash flow; t is the
period that is included; and YTM is the yield to maturity.
The second bracket [expected CP in period t + (1 + YTMl] can
substituted with the current market value or price of the security or loan:
306
f zi
i= I
x DI;
Equation 11.19
Equation 11.18
Decrease
Nooe
None
Increase
Decrease
Increase
<
=
=
Increase
Decrease
Increase
Decrease
lncrnase
Decrease
Negative
Zero
Zero
•
·-
·-
risk will
the liabilities is greater than the weighted average duration of the assets.
If a bank has a negative D-gap it means that the weighted average duration of
:Ii:~~--'"-- :C,::·{::tf'.
9~tlfi~~;te~ff0i;iwl:i1~a.~~!~~~~~~:j~r~§g')J
lJ1{
?~farfA~~~;~~:.iit~etts
be.
doratio#the greater;tf\e associatiid
longehti'e
the
ofmafuiify;
f?r
ITI!r~et·value)·?f~"Security~ry~)ht~r~s!C!~fe:%f1n'ad~ition/,the',lo~ger)t~ernaturity?f
~~Icular secu1fy;"thegfeaterttie 'rniig~ito~l'i'of·c:ha~·gein i(s)ll~r~E!ti\(alue•given·a
h.~99! in i9tE!r:e;s11tafe:. ~~~iJipllf~~fthangeJr1ihE!~arkef,t1~l~~•tor-a'gi~E!~
n1ent}he?r-yi))ostutat=·s1haffhe~:~~/fsinv~r'se~ra!idnship~=~ee~the•pri
~~tice fheldvefse r~rifiorls~ip bef~~Eihffie mbVehl~r\t ofi~t~f~!!tlte; ahdthe .· '
marketyalue.~!~fu'e as·set!{?rl}iibili!~~Jf1Jfie.aoov!\!xample\:~e~ernl){l~:thatbasic'\
From Table 11.8 it is evident that a bank will benefit from a positive D-gap if
the interest rate decreases and from an increasing interest rate if the D-gap is
negative. A positive D-gap implies that the weighted average duration of the
assets is greater than the weighted average duration of the liabilities. This
means that if interest rates do in fact decrease, the market value of the assets
will increase at a faster pace llian tile market value of tile liabilities, leading to an
increase in the bank's net worth.
ource: Koch & MacDonald (2003) 5
Increase
Decrease
<
Decrease
Increase
Negative
Decrease
Increase
Decrease
Increase
>
>
Increase
Decrease
Decrease
t. Market
,:/;Market
value·'bf total value of total
lialiilities,, •
NW..,
Positive
:fo the equations above,
w; is the rand amount of the jlh asset that is divided by
'the market value of total assets; Da; is the Macaulay duration of the i1h asset in
.the bank's portfolio; z; is the rand amount of the jlh liability that is divided by
,the market value of total liabilities; and DI; is the Macaulay duration of the /h
'.liability in the bank's portfolio. The estimates from the D-gap can be interpreted
• as illustrated in Table 11.8 .
. DL =
307
Equation 11. 17
Chapter 11: The Management of Interest Rate Risk: Asset-Liability Management
decrease at a faster pace than the market value of the assets, thereby leadin
Therefore, if interest rates increase, the market value of the liabiliti
Bank Management in South Africa - A risk-based perspective
(L'IL-'- L) is approximately equal to {-DI. x [L'li-'- (1 + i)) x L}
ouauo
- DL
x (TL -;- TA)
In Equation 11.22, TL is the total liabilities and TA is the total assets. If a bank ha·
positive leverage-adjusted D-gap the market value of its assets will decrease more than
market value of its liabilities in the event of increasing interest rates, thereby decrea
the net worth. Conversely, if the bank has a negative leverage-adjusted D-gap the ma
value of the liabilities will decrease more than the market value of its assets, if interest ra
increase, thus increasing the net worth of the bank (see Table 11.9). 4 · 5
Leverage-adjusted 0-gap = DA
In addition to these four steps, the leverage (or debt ratio within the balance
must also be incorporated. Since a bank's rand volume of assets will exceed
rand volume of liabilities (otherwise the bank is insolvent), it will seek to minim
its exposure to interest rate movements by making an adjustment for this levera
In order to incorporate this leverage, a bank can measure its interest rate expos
through estimating the leverage-adjusted D-gap (see Equation 11.22). 4
L'INW = {-DA x [lli-'- (l + i)] x A) - {-!\ x [L'li ..,_ (1 + i)] x L}
L'INW=L'IA-llL
Equation 11.20 can be substituted by Equation 11.21. Note that the
sign before the DA and DL represents the inverse relationship between the ma
value (price) and interest rates: 4 · 5
and:
(L'IA-;- A) is approximately eqm1l to {-DA x [L'li-'- (1 + i)] x A}
increase in the bank's net worth. Should a bank wish to change its Dany reason, such as the fact that interest rate forecasts are changing,
decrease (increase) its DA and increase (decrease) its DL to change a p
(negative) D-gap to a negative (positive) D-gap. Remember that an imm
bank portfolio is one with a D-gap = 0, where there is minimum (if not
exposure if interest rates change.
4. Forecast the changes in the market value of net worth based on the di
interest rate forecasts that were made in step 1. Remember that any chart
the weighted average duration of the assets or in the weighted average duof the liabilities will cause the net worth to change as well (see Equation 1
Additionally, due to the fact that:
308
(tk}
Decrease
Increase
Negaive
Zero
Decrease
Increase
Negative
Zero
Decrease
Positive
None
Nooe
Decrease
Increase
Increase
Decrease
tiMiirki>t'\iltoeof NW
309
~
-0 x [L'li-;- (1 + i)]
Equation 11.23
Equation 11.24
n Equation 11.24, D denotes the Macaulay duration and L',i the change in market
nterest rate. Convexity can also be applied as a risk-management tool by assisting
anks to control the level of market risk that is present in a portfolio. Convexity,
herefore, provides additional insight as to how investors will experience losses from
uctuations in security prices caused by yield curve shifts. Whereas basic D-gap
chniques make the assumption that only constant (parallel) interest rate changes
occur, convexity incorporates the concept of non-parallel shifts in the yield curve.
To understand how convexity measures the curvature of the relationship between
security price change and interest rate change, consider Figure 11.10 below.
Convexity = D - (60 -;- 6i)
Equation 11.2 3, (L',P .;- P) denotes the percentage change in the price of a financial
strument; D the Macaulay duration; and [L'..i -'- (1 + i)] the relative change in
terest rate associated with the different assets or liabilities. The negative sign before
e Macaulay duration represents the inverse relationship between the market price
a financial instrument and interest rate. This inverse relationship can be further
plained by the concept of convexity, which focuses on the non-linear relationship
tween the changes in a security's price and the changes in market interest rate:
(6P-;- P)
,bank wants to immunise its portfolio. it can eliminate a positive (negative) leverageusted D-gap by allowing its asset portfolio's duration to decrease (increase) or its
ility portfolio's duration to increase (decrease).
In addition to applying Macaulay duration to determine the D-gap position of a
itk, it can also be used to measure a financial instrument's price (or market value)
nsitivity to interest rate change: 4 •5
rce: Rose & Hudgins (2010)4
DA ::c DL x
D.= D
Increase
Positive
.:;: 't'it.'ln1efus1Jatl!sJ)t0{J
or me 1everaae-aa1ustea D-aac cosmo
everage-aaJUSl8Q,D•gao~oot1tiOff~~~cS&·':?
,., v
aDT,l:l
Chapter
11 : The Management of Interest Rate Risk: Asset-Liability Management
Bank Management in South Africa -A risk-based perspective
y2
Duration
1.1
0.1
(a) assetporttolio·
_(b)·Jfliability•portfolio.•
1. Caltl.llatefh~ weighfod duration of LostWorldBa:nk's:
Non°deposit borrowings \ ..
Deposits
Consumer loans
Commercial loans
lnvestmenFgraae
Ta'lile 11 .10 EJcercise 3
.LostWorld Bank holds assets and liabilitieswhoseavera:ged1.1fatio11 a~'d ri1h
afuounts artFstiown in Table 11.10.
From Figure I LIO it is evident that the lower the convexity (the lower the curva
in the price-interest rate relationship for a given asset/liability), the lower the
volatility of the asset tends to be. For example, asset A in Figure I I. IO has a hi
level of convexity than asset B, thus implying a greater systemic risk to which ass
is exposed. This is because asset A has a higher curvature, implying that the chan
in the price levels will be greater at a lower changing yield. Remember also that t
convexity will increase with the duration or maturity of an asset, because the long,
the duration the greater the exposure will be to interest rate movements. This impli
that an asset with both a low duration and a low convexity will display relative
small market risk exposure. 3.4
y1
r----------'-----::::::::= -,_____
Figure 11.10 Convexity and duration
P3
p2
pl
Price
310
:h 1
Although duration and D-gap techniques are straightforward to interpret, they still
have certain limitations. First, because it is extremely difficult to find assets and
liabilities that have the same duration, there is a higher probability that the duration
gap is not equal to zero, suggesting that it is almost impossible to immunise a bank's
portfolio fully. Second. there are always assets and liabilities consisting of cash flow
patterns that are not well defined, thereby making it difficult to estimate the
duration. Third, customer prepayments (whether irregular or early payment) distort
the expected cash flows in the duration estimation. Fourth, if a customer defaults
the expected cash flow is distorted in the duration estimation. Fifth, although the
D-gap technique is considered to be a 'maturity measure', in truth maturity is not
equal to the duration of a security or loan. For example, a financial instrument that
is paying out gradually over time always has a smaller duration than its maturity.
Finally, convexity can cause problems because the basic D-gap technique assumes
that the yield curve will change by relatively small amounts and in parallel shifts
(that is, a linear relationship where the long-term and short-term interest rates
change by the same proportion over time). In reality thi.s is not the case. For
instance, there can be major changes in interest rates, whilst different interest rates
move at different speeds (ie a non-linear relationship). This implies that the
accuracy of the basic D-gap technique will be reduced if the concept of convexity is
;chapter 11: The Management of Interest Rate Risk: Asset-Liability Management
Bank Management in South Africa -A risk-based perspective
a
The concept of economic value is important for measuring interest rate risk for
Iri Equation 11.25. PV denotes the present value: AssetPCF is the principal c
flows from assets; LiabilityPCF is the principal cash flows from liabilities; Asset
the interest cash flows from assets; and Liability cF is the interest cash flows 1fr
1
liabilities. Looking at this equation, it may appear that the EVE is similar to the f;
value of the banking book. where the fair value represents the actual value of t
assets and liabiliti.es at current market rates that are used to consolidate the balari
sheet. The difference, however. is that the EVE makes use of market interest rat
without differentiating the risk associated with individual borrowers. This impli
that the EVE will differ from the fair value of the assets by the value associated wit
the credit risk of the individual borrowers. Also, the EVE is not e1quivalent to the
value of total equity because it reflects the balance sheet as a portfolio of liabilities
and assets that are only subject to interest rate risk. On the other hand. the fair value
of share price depends on equity market parameter s and the various risks associated
with it. 3
1
EVE= Economic value of assets - Economic value of liabilities
= [PV (AssetrcF - LiabilityPCF)l + [PV (Assct,cF - Liability crl
11. 7 MANAGING THE ECONOMIC VALUE OF EQUITY (EVE)
This section extends ALM manageme nt by discussing the EVE manag,
technique. EVE measures the changes in the current shareholde r equity
potential changes in interest rates. 11 It can be defined as the difference between
expected cash flows on assets and the expected cash flows on liabilities. which
discounted to reflect current market interest rates (hence, the EVE is also knowi
the net present value approach). 3 •11 Remember that these cash flows include th
of the original principal amount and the applicable interest rate. Therefore, the
is calculated as follows:
not incorporated into the use of the various D-gap techniques. 4
In closing, both the IS-gap and the D-gap techniques do not assess
impact of interest rate risk exposure. Whereas the interest-sensitive gap te
focuses only on the sensitivity of NIM due to interest rate changes over the
term, the EVE technique provides more insight into the interest rate risk
for both the intermedia te (two to five years) and long-term (more than five
position of the bank. The EVE is. therefore, a useful compleme ntary technique'
in addition to the D-gap. As such, EVE. sometimes referred to as equity
determines the value of the bank in terms of today's market intere
environme nt and the sensitivity of that value to changes in market interest ra
does this by estimating the present value of cash flows from assets and lia'
across the entire life of a bank's balance sheet. 10 This leads to the followings
that will discuss the EVE managem ent technique as a tool to manage the imp
interest rate movements on the value of assets and liabilities.
312
of Interest Rate Risk: Asset-Liability Management· 313
In order to estimate the EVE sensitivity the following three steps mustbefol lowed: 12
1. Calculate the economic value using current interest rates. Remember that
the
economic value of the banking book (EVE) is the sum of the economic value of
all the banking book items.
Calculate the economic value under different interest rate scenarios. Each
scenario should reflect all interest rate dependent factors, including changes in
the amount and the timing of cash flows. In addition, each cash flow should be
value. 13
ue to the complexity of estimating future cash flows of all instrumen ts (because
of the many retail bank products that have indefinite maturities and uncertain cash
flows), banks usually measure the EVE sensitivity rather than the absolute change in
er of reasons. These are:
t provides a measurem ent for economic performan ce in terms of the spread
between the yield of assets and liabilities respectively, and market interest rates.
For example. if a lower interest rate is paid on deposits compared to the market
interest rate. the market value of the liabilities will be below face value. This
results in a positive economic value. As the economic value increases. the
spread between the bank interest rates and market interest rates also increases.
thereby leading to an improvem ent in economic performance. 3
It captures interest rate risk that is usually obscured by accrual accounting .
Whereas EVE sensitivity simulation s measure the interest rate risk created by
reinvestment by applying a discount rate adequate for the time period until a
cash flow occurs. accrual accountin g methods, on the other hand, treat cash
flows as if repricing were taking place monthly. This implies that accrual
accounting fails to provide any representa tion of potential reinvestm ent risk.
It enables a bank to capture interest rate risk from all time periods and does not
require any assumptio ns for new business or business scenarios. 12
It has the flexibility to reflect interest rate sensitivity over a wider range of
interest rate scenarios and can be integrated with other managem ent
information systems, such as required disclosures and hedge analysis.
It allows the bank to generate a specific and understand able monetary value of
interest rate risk exposure.
It enables a bank to capture yield curve risk. option risk and basis risk in the
capital calculation process.
It allows a bank to evaluate its current position in terms of interest rate risk.
This is achieved by assuming no future business, which in turn results in
generating a measure much like a mark-to-m arket of a bank's current balance
sheet that is able to provide a good basis for considerations of interest rate
exposure. 12
Chapter 11: The Management
~.
l
~
Bank Management in South Africa
- A risk-based perspective
EVE and the gap (repricing) anal
ysis
Gap (or repricing) analysis (sec Sect
ion 11.5 ) generates only roug h estim
ates for
inter est rate risk sensitivity of both
the econ omic value and earn ings . Gap
analysis
is stati c and compares rcpriceable
assets with repriceable liabilities with
in giver!.
matu rity buckets (or periods). 5 The
static gap in each matu rity bucket is
multiplie
by a sensitivity weighting factor that
is based on the weighted dura tion
of the
liabilities and assets of the matu rity
bucket unde r evaluation. The weighting
factor
applied in this estim ation acco unts roug
hly for the time value of the cash flows
. The
sum of all the resulting weighting posit
ions is then used to estimate the amo
unt of •
capital required for the estimated EVE
sensitivity level, for the given hypo
thetical
inter est rate changes. 15
11.7.1
Alth ough the EVE is considered to
be an effective com plem enta ry inter
est
measure, it has various weaknesses
that should be addressed whe n mak
ing the
estimations. First, the economic valu
e does not inco rpor ate non- inter est
inc
and overhead flows. Second, economic
value estimates can be distorted by
aver:
matu rity assu mpti ons and earn ings
volatility may increase whe n man agin
g
economic value sensitivity. Third, EVE
ignores the impact of new business
and t
futur e portfolio changes. Fourth. altho
ugh economic value sensitivity enab
les
bank to mea sure the volatility and
size of interest rate risk exposure
in all ti
periods, it is incapable of providing the
nece ssary insight into which periods
pose
risk. Fifth, due to the fact that the
EVE requires assu mpti ons rega rding
matu ri
for products that have no cont ractu
al maturity, increased controls and
testing
required, as assu mpti ons can be mod
ified and changed, leading to diffe
rent E
simulation results. Sixth, EVE estim
ates require accu rate assu mpti ons
of volu
chan ges that are caus ed by embedde
d options. Finally, the use of a disc ount
rate c
intro duce additional mea sure men t com
plications. These include: muc h unce
rtai
regarding which yield curv e to use: the
relat ions hip between yield curves; the
relat'
chan ge between shor t-ter m and long
-term inter est rates if mark et inter
est ra
change; and different results for the
econ omic value can be generated from
the u
of yield curve smo othin g methods.
It is, therefore, impo rtant to inco
rpor ate mod
risk in the estim ation of the bank 's econ
omic value. 12 •14
By acknowledging these weaknesses
in the estimation of the EVE, a bank
ca
provide more accu rate estimates for
its long -term ALM policy. Having said
this, i
order to cond uct the three steps
of EVE sensitivity, ALM man ager
s mu
acknowledge the different appr oach
es available to estimate the EVE sensi
tivity. Th'
is the focus of the following sections.
valued separately with an appr opria
te disco unt rate for its tenor.
3. Subt ract the results of Step 1 from
Step 2 to obta in the EVE sensitivity.
EVE sensitivity for a specified interest
rate shock exceeds approximately i
its own funds, regu lator s will requ ire
the bank to reduce its risk and/ or
more additional capital.
314
EVE and the duration gap analysis
1
l
6[l:(w ;xyie ldont hei1h assetl]
'
1 + [~(w;
x yield onthe i1h asset)] x MVA
Equation 11.26
= (DA -
D 1) x lli x proba bility
Equation 11.27
EVE and the discount cash flow
meth
od
This meth od start s by dete rmin ing the
average matu rity of ea:ch item in the
bank ing
book. This is followed by dete rmin ing
each item's inter est rate on the yield
curve,
with the use of bootstrapping tech
niques. By doing this. it enables
a bank to
11.7 .3
Equation 11. 2 7. DA is the weighted
dura tion of the asse t portfolio; Dr,
is the
weighted dura tion of the liability portf
olio; (DA - DL) is the dura tion gap (D-g
ap): and
is the chan ge in inter est rate scen ario
that is simulated. A value-at-risk (VaR
) model
can be used to estimate the probabili
ty of the NPV being influenced by
a different
inter est rate scenario at a specific conf
3
idence lcvcl. This implies that a NPV
-VaR
model can be used to estimate the chan
ge in EVE (or EVE sensitivity).
l'INPV
In Equation 11.2 6. w; is the rand amo
unt of the i1h asset that is divided by the
mark et
value of total assets; and MVA is the
mark et valu e of total assets. Rememb
er also
from the previous discussion that EVE
can be regarded as the net pres ent valu
e (NPV)
of the bala nce sheet's cash flows. whe
re the t.EVE == t.NPV. From this argu
men t the
D-gap analysis appr oach can also be
repre sente d by the following equation: 3
l'IEVE = -(D-g a ) x
p
'ation gap analysis (see Section 11.6 .)
focuses on the price sensitivity of liabi
lities
assets ·to chan ges in inter est ratcs 5. and
eventually the impa ct on EVE. Whe reas
gap analysis (Section 11. 7 .1) uses the
average dura tion weight of all positions
in
iven time bucket, the dura tion gap
appr oach estimates the precise dura
tion of
h asset and liability, respectively. Rem
ember that the EVE sensitivity will incre
ase
the dura tion increases. thus leading
to high er inter est rate risk exposure
whe n
terest rates change. In orde r to dete
rmin e the chan ge in the EVE with the
D-gap
alysis the following steps mus t be follo
3 15
wed: •
Forecast the boun dary inter est rates
(see Section 11.3 .5).
Estimate the economic valu e (mar ket
value) of each of the bank 's assets
and
liabilities.
Calculate the Macaulay dura tion of
each asset and liability separately.
Calculate the weighted dura tion of
the bank 's asset and liability portf
olio,
respectively.
Calculate the D-gap.
Calculate the sensitivity of the EVE (t.EV
E), as follows:
7.2
Chapter 11: The Management of Intere
st Rate Risk: Asset-Liability Mana
gemel'it 315
Bank Management in South Africa - A risk-based perspective
Under Basel II and Basel III banks are required to determine the potential a~
the bank's EVE if its banking book is subjected to a specific interest rate shock. If t
decline in EVE (which is related to capital) exceeds 20%, the bank is considered to b
an outlier and supervisors will require it to reduce its risk and/or increase its capital.
Furthermore, when measuring interest rate risk, banks must express the decline irf
economic value relative to the sum of Tier I and Tier II capital. This is done
11.7.5 EVE and Basel
Banks can make use of different simulation techniques in order to
possible effects of changing interest rates on earnings and the economic value
three most common simulation approaches available entail the static, the dyn
and the VaR approach that was mentioned in Section l 1. 7. 2. When calculation,
made using only the cash flows arising from the bank's current on- and off-bala
sheet items, it is referred to as a static stimulation. In this approach, the
sensitivity can be determined by simulating the resulting cash flows ove
estimated time horizon of the bank's holdings and discounting it back to t
15
present values. Dynamic simulations, on the other hand, incorporate assumpti
regarding the future direction of interest rates and the expected changes in ab
balance sheet over a specific estimated time period, These assumptions are
applied to forecast expected cash flows and to estimate dynamic economic value
1
earning outcomes. s Dynamic simulations make use of models, like the Monte C
simulation approach (Chapter 10), which possess the ability to generate seve
hundred interest rate movement possibilities. 16 It also shows the interacti
between interest rates and payment streams. 1S
Finally, VaR models estimate the potential loss from unfavourable ma
conditions over a given time horizon with a certain confidence level. 3 These mo
have the advantage of being able to assign specific probabilities to given E
outcomes. It can also be used to assess possible EVE volatility. In order to estimate t
change in EVE with the use of VaR simulations, the following steps must be followed:
1. Discount all future cash flows that are associated with a bank's assets a
liabilities.
2. Determine the NPV by summing all discounted cash flows.
3. Repeat Steps 1 and 2 for several hypothetical interest rate changes.
4. The differences in NPV (remember L'>EVE == L'>NPV) for the different interest
scenarios reflect the interest rate exposure,
11.7.4 EVE and the simulation approach
calculate the present value of the cash flows for each item in the banking bo
sum of the present value of all cash flows of both the asset and liability por
then determined to establish the present value of the entire banking bo
implication, the trading book is ignored. This is followed by simulating
different interest rate scenarios to determine the value of the banking book i
respective scenario. Once these three scenarios are estimated, the second seen
subtracted from both the first and third scenario in order to determine the cha
the EVE (EVE sensitivity).
316
317
REFERENCES
FNB (First National Bank). 2013. 'Lending rates.' https://www.fnb.co.za/rates/
lendingRates.html (Acessed 20 February 2013).
Oracle Financial services. 2013. J\sset liability management: An overview.' http://
www.oracle.com/us/industries/financial-services/045 .5 81.pdf (Accessed
20 October 2012).
Bessis, J. 2002. Risk Management in Banking. 2nd ed. New York: Wiley.
Rose, PS & Hudgins, SC. 2010. Bank Management and Financial Services. 8th ed.
Boston: McGraw-Hill.
Koch, T W & Macdonald, S S. 2003. Bank Management. 5th ed. London: Dryden Press.
Mohr, P & Fourie, L. 2008. Economics for South African Students. 4th ed. Pretoria:
Van Schaik.
7. South African Reserve Bank. 2011. 'Quarterly bulletin: June 2011.' http://www.
resbank.co.za/Lists/News%20and%20Publications/ Attachments/ 46 77 /Full%20
Ouarterly%20Bulletin%20-%20Tune%20201 l.pdf (Accessed 20 October 2012).
8. Issing, 0. 200.5. 'Communication, transparency, accountability: Monetary policy in
the twenty-first century.' Federal Reserve Bank of St. Louis review O5 8 7(March/
April): 65-83.
9. Siklos, P. L. 2000. 'Monetary policy transparency, public commentary, and market
perceptions about monetary policy in Canada.' http:/ /www.bundesbank.de/
Redaktion/EN/Downloads/Publications/Discussion Paper 1/2000/2000 12 23
dim '08.pdf? blob=publicationFile (Accessed 20 September 2012).
10. Blaxall, H, Glueck, JL & Velligan, BA. 2008. 'Economic value of equity for
community banks.' http://www.velliganblaxall.com/docs/eveOS.pdf (Accessed 20
November 2012).
erest rate risk exposure can have significant consequences for a bank if it is not
perly managed with an effective ALM framework. In order to comprehend the
sible influences of interest rate exposure it is important to acknowledge the fact
t interest rate risk can be divided into price risk, reinvestment risk and refinancing
. In order to limit the possible exposure to these risks, bank management can adopt
combination of three types of interest rate management techniques. The first
chnique, called the interest-sensitive gap management technique, enables a bank to
etermine the level of NIM sensitivity by evaluating the cash flows from assets and
abilities. The second technique called the duration gap management technique
'Ompares the price sensitivity of a bank's total assets with the price sensitivity of its
ta! liabilities to assess the impact of potential changes in interest rate on shareholder
uity. The third technique, called the EVE, enables a bank to evaluate the long-term
mpact of interest rate changes on shareholder equity. These techniques must be used
within the parameters set in the ALCO process in order to ensure that the desired goals
and objectives can be achieved that will enable the bank to overcome the gap between
its actual performance and its desired performance.
CONCLUSION
lying standardised interest rate shocks. Banks must also ensure that they comply
both the Pillar 2 and Pillar 3 requirements which address the measurement
the reporting of interest rate risk.
Chapter 11 : The Management of Interest Rate Risk: Asset-Liability Management
--,·····~""""~~-"'~"'~·-==~-~,""3",•'<-"'."''" "·"'--''.""",""'~'~' .• , - - ~ ~ ~ ~ -
1 l. Payant, R. 2007. Economic value of equity-the essentials. FMS white paper. h
www.almnetwork.com/stuff/economic value essentials.pdf (Accessed 20
November 2012.
12. De Waal, MM. 2007. Basel Tl economic value sensitivity: Worked exemplars
a
blueprint for ABSA implementation and validation. Masters study, North-We
University, Potchefstroom.
13. Van Vuuren, G & Styger, P. 2006. 'Duration analysis in South Africa: The sear
superior measures.' South African Journal of Economics 74(2): 266-293.
14. Bowers, TE. 2003. 'Extreme makeover: Reinvesting EVE.' IPS Sendero Newslett
1-4.
15. B[S (Bank for International Settlements). 2004. 'Principles for the managem
and supervision of interest rate risk.' http:/ /www.bis.org/publ/bcbsl08.pdf
(Accessed 28 January 2013 ).
16. APRA (Australian Prudential Regulatory Authority). 2006. 'Interest rate ris
the banking book'. http:/ /www.apra.gov.au/adi/Documents/Draft-APG-l l 7rulf (Accessed 28 January 2013).
318 Bank Management in South Africa -A risk-based perspective
ancient times, merchants distributed their cargo among various boats in order to
dge themselves against the possibility of losing all their goods. This primitive form
f risk management has come a long way and has grown in sophistication as the
nancial world started to come of age during the 16th century. Although risk
anagement is clearly not a new concept, the field has changed a great deal since
athematical advances in the 18th century first led to major changes in the way
isk was managed. During the 19th century, the field of risk management benefited
urther from advances in actuarial science. This progression also continued into the
0 th century, as stock markets developed and the public company grew into the
ominant business form it is today. However, as markets grew in size, they also grew
n complexity. In order to manage the risks that are associated with these
ophisticated markets, risk management has had to evolve at the same rate.
Today, the field of risk management is as complex as ever and has been driven
predominantly by the growth of the derivatives market. As the derivatives market
exploded after the year 2000, the risk management profession had trouble keeping
up with the innovation in financial instruments. By 2011 the derivatives market far
outstripped its physical counterparts, and at an estimated notional value of
$1 200 trillion it was roughly 20 times the size of the world economy. As the world
of derivatives grows bigger every year, and the universe of financial instruments
expands, it has become increasingly important to manage financial risk, and even
more so in the world of banking.
INTRODUCTION
reading this chapter, you should be able to:
explain how banks use derivative instruments such as futures, options and
interest rate swaps to manage risk
explain the difference between a micro- and macro-hedge using derivative
instruments
calculate forward values
explain how price risk can be hedged by using futures contracts
explain how price risk can be hedged by using options contracts
explain how interest rate risk can be hedged by using interest rate swaps
describe the hedging process used by banks
discuss alternative risk management tools used by banks such as letters of
credit, securitisation and loan sales
explain how banks use credit default swaps to hedge credit risk.
'irig)Risk in Banking
Bank Management in South Africa -A risk-based perspective
DERIVATIVE INSTRUMENTS
Derivative instruments are instruments derived from underlying assets and
value is also acquired from these assets. Because these instruments allow ma
participants to hedge themselves against market risk. they play a vital. role in
risk management process. However, in order to understand why deriva
instruments are so important, it is necessary to distinguish between the ca
physical and derivatives markets. The former can be described as the 'real' ma
where buyers and sellers of financial instruments deal in the actual underly·
assets. Examples of these instruments include company shares. government bon
and commodities such as oil, gold and coffee. The latter consists of the market wh
the future prices or values of these underlying instruments are traded.
derivatives market closely follows the cash market because their value is deri
from the underlying assets upon which they are traded. The instruments in t
market consist of forward contracts, futures contracts, options, swaps and the Ii
The derivatives market is further categorised into a regulated or exchange-trad
market and an 'over-the-counter' (OTC) market. The derivatives traded on t
regulated market are subject to standardisation, whereas the derivatives on the OT1
market are not. This means that the users of these instruments will be exposed t,
other risks - the most important of which, counterparty risk, has become mor,
prevalent since the Global Financial Crisis of 2007 /8.
ln South Africa, SAFCOM (SAFEX Clearing Company) regulates the local
exchange-traded instruments. This body consists of the major banks and acts as th
clearing house for the South African Futures Exchange (SAFEX), with clearin
members as the shareholders. SAFCOM is also responsible for compliance,
surveillance and other exchange services. When positions are taken by market
participants on SAFEX, SAFCOM requires both buyers and sellers to deposit an
12.2
In its most basic form, risk management can be described as the process of a
such a way as to minimise risk. Although this is a very crude and simple defi
it does capture the spirit of the very complex practice of risk managemen
formally. risk management can be described as a process of identifyin
analysing it, and then taking the appropriate action to mitigate the ris
important to note that the more formal definition of risk management d
include the avoidance of risk. Since wealth is stored in different forms. it is e
•to different types of risk. Risk management is therefore always concerned wi
weighing up of different risks and their effect on one's financial position. Alt
it is important for a company to implement enterprise-wide based risk manage
structures, it remains vitally important for banks to actively manage the
pertaining to its financial assets. ln order to investigate the world of
management more closely, it is important to look at the role of deriv
instruments in the risk management process as these instruments are
extensively by banks to manage risk. As such, the main focus of this chapter
management of risk through the use of derivative instruments. It concludes
brief look at other risk management instruments including letters of credit,
sales and the process of securitisation.
320
321
'C instruments on the other hand carry counterparty risk. There is no clearing
use to act as mediator betweericounterparties, leaving both counterparties exposed
default risk. Although this is the case, OTC instruments are widely used in the
arket to hedge a range of other financial risks. A good example of a widely used OTC
strument is interest rate swaps which are typically used to hedge interest rate risk.
Given the distinction between the cash market and the derivatives market, it
ould be clear that cash market transactions are performed in real time and are for
mediate delivery. Derivative market instruments on the other hand are performed
n real time for delivery at some future date. The risk manager can therefore mitigate
isk by acting either in the physical (cash market) or the derivatives market. In the
hysical market, positions can be hedged by simply exiting the current position by
elling the company shares, bonds or commodities for immediate delivery. When
cting in the cash market, only current positions can be closed by selling the
financial instrument. The risk manager is therefore only hedged against a loss that
coincides with a depreciation in the value of the financial asset held in the portfolio.
In the derivatives market. however, positions can be hedged in both directions. Here,
the risk manager can hedge their portfolio by selling or buying a derivative
instrument. This makes it possible for the risk manager to hedge against a loss that
coincides with both an appreciation and depreciation of the underlying asset value
of the portfolio.
When derivatives are used to hedge the value of a portfolio of risky assets typically consisting of government bonds and other interest rate instruments such
as loans - the risk manager can take either a long or short position on the derivatives
market. When the portfolio's value declines because of a drop in interest rates (in
the case of a home loan book for example), the risk manager will typically take a
short position in the derivatives market. Where the portfolio's value declines because
of an increase in interest rates (in the case of a bond portfolio for example), the risk
manager will typically take a long position in the bond derivatives market. As such,
there are various derivative instruments used by risk managers to hedge the
financial risks that banks are exposed to on a daily basis. The following sections will
the instruments used by risk managers to hedge these risks in the banking
·al margin to ensure that counterparty risk is eliminated. This deposit will then
sed to compensate either party in the case where one of the parties defaults on
position. In doing so, counterparty risk is eliminated from exchange-traded
ative instruments.
Chapter 12: Managing Risk in Banking
Bank Management in South Africa - A risk-based perspective
Exchange-traded derivatives
Fut11res
The futures market on the other hand works in the same way as the spot mark,
with the exception that delivery of the product and payment for the product occu
in the future. As mentioned earlier, futures contracts enable market participants to
negotiate a price now for a future delivery date. Since the futures market and the
spot market only differ in terms of the timing of the conclusion of the transaction, it
is logical that the price of the futures contract be derived from the current price of
12.2.1.1.1 Futures-basicconcepts
Before delving into the inner workings of the futures market, it is important
able to distinguish between the spot and futures markets. The spot market (a
called the cash market) is a market where transactions are settled immediately or
not then at the earliest possible opportunity. A good example of this would be a caSI
transaction for food and clothing. ln the South African bond market, a cash deal i
one made now (day T + 0) for settlement in 3 days' time (T + 3), whilst equities ha.,.
a settlement period of T + 5 days. A spot deal can thus be defined as a contrac
between a buyer and seller that is agreed upon now for payment by the buyer and
delivery by the seller in order to complete settlement of the deal at time T + 0. or as
soon as possible.
In many countries, South Africa included, futures contracts are divided
financial futures and commodity futures. Financial futures typically in
underlying assets such as interest rates (on bonds and bond indices), shares/cg
(individual shares and equity indices) and currencies (for example on the USO
exchange rate and currency indices). Commodity futures include contrac
agricultural commodities, also known as soft commodities (for example, lives
maize, coffee, etc) and future contracts on metals and energy (for example,
platinum, crude oil, etc). Despite the fact that futures arc available on all
different underlying assets, the principle mechanics remain the same - a Ji
contract allows the holder to buy a specific quantity of the underlying asset
predetermined quality in the future at a price determined in the present. This mli
futures contracts ideal hedging instruments where the quality and quantity of!
underlying asset can be predetermined. In order to fully understand how th
instruments can be used to hedge, it is necessary to highlight some basic fi
regarding futures contracts.
12.2.1.1
Options and futures are the two main types of instrument available to
manager in SAFEX. As mentioned above, these instruments are regulated
not incur any form of counterparty risk. This makes exchange-traded de
ideal for hedging various risks, including their exposure to changes in sh
commodity prices. This in turn makes futures and options a handy tool for h:
the bulk of the risk a bank faces because of changes in asset prices.
12.2.1
world. These instruments are further categorised into exchange-traded deri
and OTC derivatives.
322
323
12.2.1.1.3 Hedging with futures
Having covered the basic concepts, we can look at the process of hedging by using
futures contracts. When hedging with futures contracts it is possible to hedge price
risk regardless of the direction in which prices move. Say, for example, a risk
manager would like to acquire bonds in 60 days· time. Should interest rates drop
over the following 60 days, the risk manager will acquire the bonds at a higher price
in the future. In order to avoid the effect of the price increase, a Iona futures position
can be taken. This means that the risk manager should buy (fJO long) ajiitures contract
in order to hedye against an increase in bond prices due to falliny interest rates. As the
price of bonds goes up. a positive variation margin will accumulate on the risk
:manager's margin account. If the bond price increased after the 60 days, the risk
manager would have accumulated the difference in price on their margin account.
Once the bonds are bought, the futures contracts are sold with the positive margin
making up for the increased price paid on the underlying bonds.
1.2 Margining and mark-to-market
rder for both the buyer and the seller to transact on the futures exchange,
3X requires that both parties pay a good faith deposit, referred to as the margin
sit or initial margin. As a rule of thumb, this margin is usually set between 5°/4,
8% of the contract value. The value of the initial margin is however more
urately calculated to cover a possible 'one day loss' for the buyer or the seller. The
of this possible loss is determined by considering the biggest one-day change in
e price of the underlying asset over the past few years. It is clear that this deposit
JI be retained in the case where either party is unable to fulfil their commitments
ould the market move against them.
A second type of margin, often referred to as variation margin, is required
ere the market has moved against a position during the day. In order to determine
e flows between the buyer and the seller. each contract is marked-to-market
'M) every day. This means that at a specific point in time (usually at the end of
e trading day) each contract is valued. This process ensures that neither the buyer
or the seller accumulates losses too big to pay back. Profits and losses are thus
oved every day in order to ensure that the exchange remains able to guarantee the
itigation of counterparty risk. For example, if the holder makes a profit, a credit
try is made to the margin account and if a loss is incurred, the amount is debited
n the holder's account. If the holder makes a loss that they will be unable to pay,
AFEX will 'close out' the member's position. This entails SAFEX taking on an
ffsetting contract on behalf of the member. lf the loss incurred is greater than the
variation margin, the member's loss will be deducted from the initial margin
account and the balance paid out to the member.
nderlying asset. The difference between the spot price and the futures price is
fore the cost of carrying the asset for the holding period up until the time of
ry. Since these transactions are only concluded in the future, both parties need
mmit to the transaction at the present time. The following section will discuss
rocedure for taking in such a futures position.
Chapter 12: Managing Risk in Banking
Bank Management in South Africa - A risk-based perspective
e
~
...J
0
en
en
g
-30
-20
-10
10
20
nJO
30 -
o~
08
en
en
g
-30
-20
-10
0
1po
104
108
0
0
C
112
~
F't.it1..1res price fi:kedat
RHB
Price of the underlying asset
Figure 12.2 Short futures position pay-off diagram
Q.
e""
...J
10
20
30
D
o-,--.8
Price of the underlying asset
o~
Figure 12.1 Long futures position pay-off diagram
Q.
0
----
Alternatively, if the risk manager decided lo keep the bonds for, say, 25 da
selling them, they can short-sell futures contracts in order to hedge the bond
against a drop in bond prices. If the bond price does drop, the short futures
will accumulate positive margin flows to offset the loss in value on the bond
Once the bond position is liquidated, the risk manager will buy back the
contracts, keeping the positive margin in the margin account which will co
for the loss on the bond portfolio. The following example of the payoff diag
long and short futures positions will clarify how futures can be used for
purposes. Figure 12.1 below illustrates the pay-off diagram of a long futures
and Figure 12.2 illustrates the pay-off diagram of a short futures position.
324
325
markets.
king use of futures contracts' in this manner is known as rnicrohedging. When
erforming a microhedge, the risk manager attempts to hedge a portfolio of generic
ssets against some market movement. Macrohedging on the other hand,
onstitutes a hedging position that takes a portfolio view and allows for individual
sset and liability interest sensitivities or durations to cancel each other out. When
edging a portfolio on the macro-level there is also another issue to be considered,
amely basis risk. Spot bonds and futures on these bonds are traded in different
arkets. The change in yields may therefore affect the values of the on-balanceheet cash portfolio differently from the shift in yields affecting the value of the
underlying bond in the futures contract. This causes the movement in the spot and
the futures markets to be misaligned, causing basis risk. For now, we will investigate
macrohedging by means of an example where basis risk is assumed to be zero so
there is perfect alignment between changes in the prices of the spot and futures
res above illustrate two sides of the same position. A market participant
lieves that prices will go up will enter into a long futures position at RJ 18.
ely, a market participant with the opposite view will enter into a short futures
at R118. Should the price of the underlying asset rise, the long holder of the
contract will earn a profit (gain) on their futures position while the short
'will incur a loss (lose) equal to the profit of the long holder. This is why market
ipants refer to these contracts as a zero-sum game (one party wins what the
ite party loses). However, if the underlying asset price decreases below R118 the
ite will happen - the short holder will make a pro lit while the long holder of the
s contract will make a loss. In South Africa, SAFCOM acts as the counterparty
oth the long holder and the short holder of the futures contract. This means that
OM will debit the loser's account and credit the winner's account. Let us look
Chapter 12: Managing Risk in Banking
- - - - - - - - ~ - ~ ~ ii>.
ft
Bank Management in South Africa -A risk-based perspective
ff
1
1
•.• -
+I
P
51 +R
=_
1-o/x\E:X 1 :
ai~t,1
f
>--•-- •
X
AX T+7 = -OF
C/•·-• •A;
X
: Ai
>X>
PF) X 1+i
(NF
5-"'3'"~.'- -~-"'-~1
1- ,.
.0,J!O-."'J~-
- _-,,,,,,;,_ _ ~ - - .
~.Y>
=..
_->..¼ ~ -
• :
i6;.:-kDL] xA = Dj, x(NFXPF)
~---\/?>- -_- ...-< .
•
••
•= -- , ~ , - = ~ > ~ " " - • · •
V . Y . Y>ll"Yl\''lffll' . .......-,~.
By:~~ritelflngi';"'i. on both sides of the ~uation:
:-[DA- kDd
:
0
_- 5---·-••=<f.j - " " " " " " • ·
A
<fa. •·••oo·•··•·• _y -•~~~,m, _,,nnz. .c
J~a"\abiJ.to c:alculatethe gJir(onthefutG~fs BbrttdliC>
Now
on thebond p~rtfolio;it is possible to calculatethe.numberof_f~turescortlfa'eis
needed to fully hedge the bond portfolio against a change in interest rates. It is
important that the /osson the bond portfolio musfbe offset bY!~e ga1n·on the
future5portfol/o::This is the essence of a hedge ~-}~at; is, a fiedg~ is not'.d~he
make~ profit per se;'.a hedge is done to preventa loss;Jherefore;.it is logican
we set by calculating the following:
m~tYJe
t.Fse:...oFx(NF x PF) x 1"'.:;
we' c~r'! therEifdte rewrite the formula as:
and PF is the price ofeach contrar.tl
In Equation 12;3,'i= =NF>< PF
LiF
ln'brderfo ditulate tliefand value
abovecanbe+nanipolated asfollows:
1
; i ,
i
lh EquationJ2:2:
6F = change in the rand value of the futures contracts
F = rand value of the initial futures contracts
t?,;=durati~?~f!~~ bond to be deliV!!red agaihsftHtifotoftis
>.... .hi+1. shock_'to int_erest rates
Fi.
·••yt,r=,t:...6/Q''itlR
O~ciit1s cti~r.~haf!#~to;sible loss· £iir;~~~i-a change·[?~~?li~tete.
import~ltttoc~lcuiafoJhe,c~mber of fofurescorytracts· heededtohedge·
In ordert_o a6~ieve J~_is,Jhe risk rnanag~r must ~~tp~lc:ul~te
futures ccontr~·8t:tot~~ duration of the bond ·portfolio>This cal\be
means of therfoli6Wing formula:
••
iiNW= c:ffange in6ortfoHOTlet worth!
:o,{=duration of the asset portfolio
(D1..tdurationof the liability .Portfolio
\k :aratio ?!}he li~bilities to.assets (liA)
=_size of~~ifas~et portfolio
t,; : = shocltto irtterest rates
rri1::~Uii.hOri1~.'.f: •
:tiN\V= ...r~l\ti63x Pi11i
,y
;fli16rcier_t8·calcuf~te .the sit~ of the ~l<~6su~it~· be _ hed§e~i;ri~
riiimberot.r~tiires heeded to hedge ~+t isprs!;r~essary t9fa1egr~t~
adjusted duration gap as well as the Size.of lhifassets hedged by iim
fono~rngJor,~u.ia.:
326
~~
·-·=- -~
.?< -•--•-·
.. .-
_,..,.,-=~~=-=·•··/''"
is possible for banks to lose money regardless of whether or not interest rates
p or down, the risk manager will have to take the appropriate position. If they
to buy bonds in the future, the risk is that interest rates might fall and that bond
es will increase and expose the risk manager to future price risk. If the bank
ady owns bonds, the risk is that interest rates might rise, causing bond prices to
. In the former instance, the risk manager will take a long futures position, and in
latter case, a short futures position. Let us look at an example of a short hedge.
When comparin g this calculatio n (considering basis risk) with the prev
calculatio n where basis risk was assumed to be O (Equation 12. 7). it is clear that
t
ought to be a sizeable discrepancy in the amount of futures needed for the hedge
illustrate this, let us look at an example where basis risk is taken into considera
ti
NF
(D, - kD,)A
0 1, x P, x br
In the equation above, ip is the interest rate on the futures position. When incorpora
.
basis risk into Equation 12. 7, the risk-minimising number of futures contracts
be calculated as follows:
/Jr =
lli -e- (1 + i)
lli, -e- (1 + i,)
Now that we have a better understa nding of the hedging process, it is pos
drop the assumpti on of zero basis risk. In reality. because spot and futures
are not fully aligned, a risk manager would specifically have to consider thi
performing a hedge. The cause of basis risk is also intuitively logical. Sit
underlyin g portfolio being hedged comprises different. assets with different te·
maturity and different durations , it is impossible to fully hedge this position
futures contract on only one of the underlying assets.
In order to discover the risk-minimising number of futures contracts to
against a change in interest rates - while accountin g for basis risk - we ca
assume that Equations 12.l and 12.4 should be equal, thus setting Howe
order to compens ate for the 'sensitivity' of the change in the futures price b
of a movement in the spot price - basis risk (br) - it is necessary to factor br in
equation. Basis risk can be explained as follows:
329
Equation 12.11
61,)
Equation 12.12
;his means it is also possible to use~ as a hedge ratio that minimises discrepancies between
:he changes in the spot price and the changes in the futures price. A greater covarianc
e
,etween spot and futures prices and a smaller variance of futures prices will lead
to a ~
reater than 1. A 13 less than l would be caused by a smaller covariance between
spot
nd futures prices and a greater variance of futures prices, and also indicates that: futures
prices will be more sensitive than changes in the spot price. Conversely. a ~ greater
than
1 indicates that futures prices will be less sensitive than changes in the spot price.
Let us
look at an example of hedging a currency portfolio by means of the hedge ratio.
var(6f, 1
cov(L'.SI.
Equation 12 .11. µ.tis the residual at time (t - the difference between the estimated
lue and the real value) and~ is the slope of the line of best fit through the historical
anges in the spot price and the futures price. However, ~ can also be expressed
as:
llS, = o. + (:lt;J, + µ,,
ould be clear that using Equation 12.10 would be impossible at time t, because
futures price must still be realised in the future. It is therefore necessary
to
ate the change in both the spot price and the futures price in order to arrive
at
correct hedging ratio. This is achieved by plotting historical changes in the spot
e and the futures price, and then plotting a straight line through the observati
ons
t would minimise the sum of squared deviations between the estimated values
at
e t and the real values at time t. This line of best fit can be expressed as:
Equation 12.10
ismatch between the spot market and the futures market also occurs in other
.classes. Since banks also have some exposure to assets such as shares,
ncies and commodities. it is importan t to calculate the sensitivity of these
es markets based on their underlyin g spot market movements. So instead
of
]ating basis risk as a function of interest rates, the sensitivity of futures
.tacts on these spot price movements are calculate d by means of the hedge ratio
\culation of basis risk where the underlyin g asset is not an interest rate
ument. This ratio can be calculate d as follows:
Chapter 12: Managing Risk in Banking
:v.
Ra11tfamouhfct1ange in the tiliures'.pflce
> Corittacts neede~'(!$!~~om6~t=2120 contracts
at·
divide it by lhe size ofthefutures contract (tfie contract si:ieOfr SAFEX
1h6~~,r~o··hedgeiiisi<cha11gefate·risk,Yi~t1Rif~i'~&iil~~larri6llht
;;,$212 milfjciri x ($0, 1080 ~ $0, 1100)
i:<L$424. 000
Loss= Nominat'!ifiourifx(S1,. 1bS,)
fhtiJssible loss f6':~tanciBkr11<heck1Jiibfthe depreciatic5116t't11~
calculated as follows:
1~.3 Equal ~6rithlfch~rige$ihthe change-of spot priJ;~tJ,
future'?prices 6f an asset
-~-~-
Profifo11 futures
{Iffi~ihkans:fhat the..i~~Ji$424···0()6(~je54,. 545;45
- zshcift§ellinef 2 120 ~IJ~:"?t;tt1tures.co~tracts: The loss
ctnefefore be complet~lyfedged bythefl.11:Ui'es position.
• fulufMpcrsition can-He calculated as
j
;:.:a
<••.~51xfO
R2 = 1JJO
·,., h.>.-.W~.•······"""'-· ,1/,.\\~ ...
o:off.,c.,_·---~'-r~----'----.--~----.-------.---
a::ii b.16
~
'O 0:20
·c t<<
6 0;30
u '0:'40;
J:::. :·_:_::<·;:-/:.:.:·"
• (U
'a, :, ,.
.£ ;Jtflfo
•·.g, ;6:50
<,, .
1?
"' --<?:•:-:'··::··~,
07.0·
g_ ffao,
.~ {?61>
·g_ 0:90 1
f~tre~cy futures c.o~tr~crwm change to R.9.
(ot,~OtJ ?:i5/~Joye
f~~\i,~veitment.~itwou.ld .make it possi?l~}O p~~~ft'Yibedge .theJ
currency position;!linceJl = 1. See Figurel2.3 below;
~s.1~
~~~~ge in . the corr,~~cy futures niar~etover.the last }2 m~ciths,
311,i»"e ass~me ttiaflh!n:harige inthe~potcurrency mark:!.~a:~f€
330 Bank Management in South Africa - A risk-based perspective
y_,_,._~
'··<-·---··: •••• _e.:c. •• + __
,~~-•--~-••"'
1
_....,__,_
.s~=~--="''~"''
•-~~,,.;:.-_,.
_,, ·"' : > ·""'"""""""->-=-~~ --~-.:n~,s:.
..:··•... ~:=•.::=
'~ hedge,il:{ff6?J!!~~~~'§§i6i~/n theo . .
98 tMitJn,i~l~~~t;~s~,~~~s: the·"
mount:"~?~~~~ftip!e;i~!~t~~§~me .ti
theline~fci'tahgeof$0;1035as beta
,._-_,,., ___ ,. ..."~·------' ___ ..
· ~ .... --,.,,~,. ~. ,__,~y>.v .>V ~•""'··
Bank Management in South Africa - A risk-ba
sed perspective
Options
I Sharl
I=
I Long
Sell a call
Buy a put
Sell a put
~w,,_;,_r==•==-=~~~-
I Long
Buy a call
Oouon oosmo
I Fall
Rise
I Fall
Rise
IFall
Rise
Fall
.......
Unlimited loss
Gain of the option premium
Unlimited profit
Loss of Option premium
Unlimited loss
Loss ot option premium
Before exploring the use of options as hedgi
ng instru ments . it is esse"
under stand what options contra cts are and how
they work. An option is
contr act that gives the holder the right to
perform some kind of fl
transa ction. As with any other transa ction, there
are buyers and sellers of
The buyers will buy the right, while the seller
or writer of the option will
right to perform a financial transa ction in the
future. The chara cteris tics
partic ular option will determ ine when the holde
r may perform the transa c
the option is classified as European style, then the
option can only be exercised
end of its lifetime; if the option is classified as Ameri
can style, then the option
exercised at any time in the future up until the end
of the option's lifetime.
Options are furthe r divided into two types, namel
y call options and put o
A call option gives the holder or buyer the right,
witho ut any obligation, to
specified quant ity and quality of a specific under
lying asset in the future for
agreed on in the present. A put option on the other
hand gives the holder or
the right, witho ut any obligation, to sell a specif
ied quant ity and qualit y of as'
underlying asset in the future for a price agreed
on in the present. 3 This future
agreed upon is called the strike price.
In order to achieve a long position by using
option contracts, one o
positions can be taken: buyin g a call option (takin
g a long position) or selling
option (taking a short position). Similarly. a short
position can be achieved by
a call option (takin g a short position) or buyin g
a put option (taking a long posi
Option contra cts can thus be used to hedge either
an increase or a decrease i
underlying asset's value. This can be accomplishe
d by going long or going sho
the option position.
12.2.1 .2
As menti oned earlier. using futures contra cts
is one of the exchang,
instru ments a risk mana ger can use to hedge
their position. The othel
excha nge traded instru ment is the option contra
ct. The next section will c
workings of option contra cts and how they can
be used to hedge price risk.
332
333
ATM
ITM
is equal 10 the strike price
is less than the strike price
Long position: buying a call option
OTM
OTM
is less than the strike price
is greater than the strike price
ITM
ATM
is equal to the strike price
''':;Result: !TM.AT M or:,c>TM
is greater than the slrike price
,!'iice;o(thliJi~lfertyingasset
104
108
116
124
Price of the underlying asset at maturity
112
~llm
~~~~Ji;fj
' :\ 'h\11..'<i ~ -~
0
~~J1~~i~~0J~;;~,,
.,. ~
~," II~ i 't •: .\lt
i~"',.~\" '\[\ft•' '(',rt~~~;
\)) 4
Figure 12.5 Long call option pay-o ff diagra
m
-15
-10
-5
0
1to
5
10
15
128
132
gure 12.5 shows how a long call position can be
used to hedge the risk mana ger's
rchase of gover nmen t bonds in the future again
st a loss because of rising bond
ices. In Figure 12.5, the pay-off diagra m for a long
call position on bond futures y the R157 - shows that the risk mana ger's positi
on will be hedged from a bond
ice of above Rl 10. However, between Rl 10 and
Rl20 they will only minimise the
tion cost. Once the bond price increases beyond
Rl20 , the option position will be
'M. If the option expires below Rl20 , the option
will expire OTM and the risk
an ager will lose the whole option premi um or a
part of it.
20
.2.1.2. 1
1l1Mo rO
ions are also either 'in the money' (ITM), 'at
the money' (ATM) or 'out of the
ney' (OTM) depending on the spot price of the
under lying asset and the future
e agreed upon in the contra ct. Table 12.2 illustr
ates under which circum stance s
sand puts would be ITM. ATM or OTM.
Chapt er 12: Managing Risk in Banking
Long position: selling a put option
.:. +.1/Y\0,Y.-*.S«½f;ms.;p__ ., ___ />.=
Risk managers will not enter into short put positions without also holding othe
options otherwise they would be exposed to greater risk with a limited profi
opportunity. Figure 12.6 below shows how a short put position will leave the marke
12.2.1.2.2
Once the contract expires ITM, the seller of the call option will make delivery oft
underlying bond, and the buyer of the call option will make payment for the ban
RllO 000 in thi~ case. If the bond price has been increased to Rl20 by this ti
the risk manager would be hedged at R.l l 0, since they are only liable for
contract price. ff the R 15 7 trades at RlO0 by the end of the contract, the opti
would have expired worthless, but they are still able to purchase the bond on t
cash market at RlOO 000 (that is Rl00 x RlO0 000 nominal contract amount).
Although a call option can be used against the reduction in the value of
portfolio, it is also possible to hedge against rising prices by selling a put optio
There is, however, a cap on the amount of money that can be made on the selling'
a put option, and the only way to overcome this cap would be to increase t
exposure being hedged by selling more put contracts. This is not advisable as
hedging strategy on its own, but it is normally combined with other option positio
as part of a hedging strategy. We will now look at the implications of a short p
position.
; OTM. This Will be a loss dhthevanati0n margin acedunt; and
\f_paicHo the Sell!'lfoHMfalfoptiOn;
• >manager would have lost the full bption premium arid ·tfi!'l opti
,sR6rltiitfie pric~'~fR1~7bonds dosebn ~109,528$ aia6ti6ht!*pi
~?t?f
J;The·risk maii~ger purchased .th~talFppfion o~. onaR1str~~l'e§?~il!i~ft-f~.
(Rlo .;. 100) X R100O00 {nomimilco~tract amount) : H1 ff000!t~~t11R:.P[ibe
{Rl 10. If the R157traded atR1 lQ,2250 by.optiorHixpify, thep~llpption\1/duid
·
<been valued at (Fl110,2250 + 100))(~1o0ooo =R11022$'•"-••- .."- •
\tutu res contract)/This would leave the risk mariag!t Y;'itlf
' \'- Rl 10,000 :,i R2~5.111is MTM profit is~lso knovm as ti
·.Remember, alth6?gh the position was cl?.sed at.a~.·.~r~ptbfit,lhe
not make a profit[?" the· hedged position;.~ftet ~.~.~~;Ii,.~9 t~e.?~~i?~~t'
P~;.~!~:~i.s r1!~2sm~I
R10 000./the ris~1r,anager is .still H9 77s
ma~agi!'t:;was.;p~lt~ble···to recover • R22s P!.PPtio~§'?~t~;.>A.s·•a result;.the
WOUid only shdw;a net.profit beyond a bond price ofR120,
bonds to the risk manager (buyer of the bonds and holder of the call) at the strik,
of R110 once they have exercised the call option at expiry. For every day betwe
present day and the end of the contract, there will only be a cash settlement b
the parties in the contract as the value of the bond changes on a daily basi
following scenario gives an example of how the risk manager's position would
for different values of the government R 15 7 bond at expiry.
It should be clear that the writer of this call option is legally obliged to deliv,
334 Bank Management in South Africa -A risk-based perspective
Chapter 12: Managing Risk in Banking 335
◄ fU...
10
.
V
•~-
~
..
Strike pric~;;,;pnderlying
asset price}:ltR124
~
•~-
Price of the underlying asset at maturity
◄M 7
0
~ y.,._,
· - • ~ " ~ - ~ ~-~'"·"""'""""
__ .-·,_n_.,__,,>--<><•-.<--·-·'-·-<-=-
-~"""""'--~"
~}riii'~~~~ger so1a 11W'W!ii!1!~~faJ?t86 futures contrietfol'(R10+jo0}f •
00-0cf(rtriTinal eontrat:!;~lll~t1~t) e:f!tppooat a strike price?fi~124.Jnlhe ....,
te!~~/J186ht>ndS!ta~~d1!!f!1,g~.2~31f'.i~n the day otop!l~1expiry,theptrt
~llt~a~.e\~i<pired at,~ y.'0~'1!~~~£l~;it!1f~r,t~~J1olde.r . of;thEi•f!u;;:and the risk
- e~v;,111 ;~~ap t:h~i!'ntifo~ptiomet:~i~'!!-p','.1\o'.boo,,shdold !h~price ,of.,R186
.n~~.?e~.1.J~iltoptionaxpiry>ittt~tiS~tm~~ager;~duld give UP .•.~~poo .of the
,ti?~premiurrithr6ugh a·negat1v~l'fl~rgi~.~ow,'th1s··1oss·on they~ri~tion margin
count will blpaid overtothesellerottheput option 0Verthe lifeifime•of the
should be clear from Figure 12.6 that the risk manager, as the writer of this
articular put option, is legally obliged to take delivery of the bonds from the
ounterparty or seller of the bonds at the strike price of R124 once the counterparty
the holder of the put) exercises their put option at expiry. The following scenario
ives an example of these nows.
igure 12.6 Short put option pay-off diagram
-20
'J
~s
1 0
at
5
icipant in a long position. Remember, a long position will make money in rising
kets and lose money in falling markets. In Figure 12.6, the pay-off diagram for a
t put position on, for example, Rl86 bond futures at expiry indicates that the
r of the put option will keep the option premium for bond prices equal to or
ter than Rl24. However, between Rl24 and Rl 14 they will only keep a fraction
e option premium. Once the bond price decreases to levels below Rl 14, the
ion position will register a loss.
-
.. n ...,mtm\1··;; .,,,,..,.,%A,,··,.
Bank Management in South Africa - A risk-based perspective
Short position: buying a put option
-15
-10
-5
1~0
0
5
104
108
Breakeven = Underlying
strikeprice ..;Option
premi0m (Rl'14)
120
1N
Price of the underlying asset at maturity
Figure 12.7 Long put option pay-off diagram
a..
e
:;:,
..J
0
U)
U)
g
10
15
20
128
Buying a put option gives the risk manager the right to sell bonds at a specific
in the future. This makes put options on bond futures a very effective hedging
against increasing interest rates (falling bond prices). Figure l 2. 7 illustrates h
long put position can be used to hedge the risk manager's actions against a dr,
government bond prices. From Figure J 2. 7 it is clear that the risk mana
position will be hedged from a bond price of below Rl24. The position will
however show a profit on the margin account between Rl24 and Rll4, since
option cost of RIO must first be reduced. Once the bond price decreases past RL
the option position will be in profit. If however, the option expires above Rl24,
option will expire OTM and the risk manager will lose the whole option premium ..
12.2.1.2. 3
Once the contract expires, the risk manager or seller of the put option wi
forced to take delivery of the underlying bond if the option expired below R
Since the buyer of the put option has the option to sell the underlying bonds,
will do so if the option is ITM. If the option expired OTM, the option buyer wil
exercise their option but rather sell the bond in the cash market for more tha
strike price.
The risk manager might also be in the position where they are required to
short position in order to hedge against falling prices. When hedging agai
increase in the interest rate for example, bond prices will drop, causing the va
a bond portfolio to drop. In order to hedge against this drop in prices, the
manager can take one of two positions: buying a put (long put) or selling a
(short call). We will first look at the long put position.
336
12.2.1.2.4 Short position: selling a call option
As was the case with the short put, the short call will once again put an obligation
On the risk manager. These short positions will always be accompanied by other
option positions in order to prevent unlimited losses. Figure 12.8 illustrates how a
,short call position can be used to hedge the risk manager against a drop in
government bond prices. From Figure 12.8 it is evident that the risk manager's
position will be hedged from a bond price of below RJ 10. Although a bond price of
'less than RllO will benefit the risk manager (option seller), it will not constitute a
perfect hedge on its own. For bond prices greater than RllO, the risk manager will
bank the full option premium as a profit. As the price increases past RllO however,
the risk manager will keep less of that profit until the underlying bond price exceeds
Rl20. Once the bond price increases above Rl 20, the risk manager will have to pay
a variation margin on the short call position.
brice the contract expires ITM, the seller of the put option will take delivery of the
nderlying bond, and the risk manager will sell the bond for the contract price of
124 000 (Rl24 x RlOO 000 nominal contract amount). The other way options
an be applied to hedge against a drop in bond prices is by selling a call option.
As is the case with selling put options, this will not give the risk manager a
"omplete hedge if the hedging portfolio consists of only short calls. The short calls
ill be combined with other options to form part of a greater hedging strategy. In
order to understand the implications of a short call, we will examine the payoff
iambut Willbe al51e:tcfSell'theirR186 bondS'fn;the cashmarkerto rthls
tHian°Rl24al o'ptl6rf~Xplry;'therisk r'h·anag~t''VJOUid·•halJe'•iost!heJull
R}go J
;;f1iik'rria~~~kiriuf~h~;~ait11Jit;t1tf6pti6f16~'&n~Af~~'iatures·contf~atte>i
•••• ·- 1).~/~}00 ,o~gJryolj1fltaJcontra6t~rn~u~t),:C'.~1~~llO,at astrike~ti~e.:.of
/?t86.trl!idfl~ ;'afl'{t20'/'125.4 by6pUon .exp fry/ thia put option ),\>()?Id ,have
y~f~~d ~!{R129JJ8~4 tlfQO}ii}-~'foo 000{"' Rj2OJ 25J~o: Thiswool~;leave the
2~,~~ ~f~.~\8t~;~O>Sinciay~e
··aryatier,'lllt~la P,ftl~!o~tR12,4{~~0f
.R1O;,000;~1~ejposl!iori1stun '1osiri9J'l'6';125;45J~[pe posltibn Vlt>~ld'tinly
pf6!itjor,~o~d :pr]~~s,towert~an'flj 14:t:St,ffui1:il~e price of Rt8o,bonds'
• the holder of the put, the risk manager will have the choice to exercise the option
e it is ITM. The seller or writer of the put will however be legally obliged to take
ivery of the bonds from the risk manager (seller of the bonds) at the strike price
·Rl 24 once the risk manager exercises their put option at expiry. The following
nario gives an example of how the risk manager's position would differ for
rent values of the R 186 at expiry.
Chapter 12: Managing Risk in Banking 337
l
I'
i'
~
I·
i,
i
!
¾
!
,1!
i
~
2
- o
-15
-10
-5
0
1~0
5
104
112
'
~
1?0
··5
"-.
l'l~
Price of the underlying asset at maturity
Strike pl"ii:e f: Undertying
.;assetpric eat R110
108
10-r-------~
15
Bank Management in South Africa - A risk-based perspective
128
~~~~
.
From these examples on the possible option positions. it should be evident
options can be used to great effoct for both an increase and a decrease in as
prices. When hedging, however, risk managers will always combine short opti
positions with other option positions in order to prevent the occurrenc e
unlimited losses.
o,f
07n
?!
~Ippoq.
ari~.¥i•
The risk manager sold a call option ona R157.f~hJt~sConfrac!.1&(~10/f1o
R100 000 (nomi~al contract amount) >= ~}{){)00 at ~ strike price ~11'9·tlft
.R157 traded at 'f'.t108;50 by option expiry; t~e canoptio,nwould ~~Ve b:en<:.f
) the risk rnanager1N0Uld be able to·keep thetun.o,pt'.O~J)~err,furr, i?f
>However, .if the R.157 ~raded at R123,5568 .the caUppti?n would.~: 1~.
R123 556;80.Jh :risk manager .would b:.calledia t}~~ e7? of.f~:,t:~ fo sellf
bonds .t()the hol~.er ofJhe call option for R110 a9q/th.~s kising ~~t
opportunity of.~aking R13 556,80;Jf the{iskrna n~g:rpid not ~13yea~fJ
they would have to buy those bonds for the spotp;~cee f l=ll23 5-5-6,~9•}~efef:J
realisinif.a loss R13 556,80. Since the fisk man~~erteceived an option
R10000,cthe loss on the transaction is only R3 556,80,
As the seller or writer of the call, the risk manager will be legally obliged to
delivery of the bonds to the counterpa rty or buyer of the bonds at the strike pric
Rl 10 once the buyer of the call exercises the option at expiry. The following seen
gives an example of how the risk manager's position would differ for different val
of the R.15 7 at expiry.
Figure 12.8 Short call option pay-off diagram
Cl.
e
ta=
s
0
,,,,,,
g
338
.i~the rate
IL) l ·••.l·F•·.·jf;,,[ 1 :,~(ire
+(ir5 "x Isl
1
• • 'tlielf'R
ootratero
according to their needs.
From this description it is possible to define a forward contract as a contract that
obliges the seller of an underlying asset to make delivery in the future, and the buyer
of the underlying asset to take delivery in the future, of an agreed quality and
quantity of that asset at a price agreed upon now. This goes some way to explaining
why forwards are such popular hedging tools. In order to understan d how forwards
are applied in hedging uncertain future outcomes, we will look at an example of
such a hedge on an interest rate contract. Before giving an example of a forward
transaction , it is necessary to understan d the implied forward rate (TFR).
!though the majority of forward contracts are based on foreign exchange
currency-related) transactio ns, forwards are also available on interest rate
Instrumen ts and commodities - that is, all assets to which banks have exposure. Just
like spot and futures transaction s, forward transactio ns arc also made at a price
agreed upon now (T + 0). However, for forward transaction s, the settlement date
can be anything from a week to months in the future because these transactio ns are
not regulated by an exchange, and the settlement date is fixed by the counterpa rties
Forward contracts
e major difference between OTC derivatives and exchange- traded derivatives is
fact that the former carry counterpa rty risk. There is thus no formal exchange
nsure that both parties honour their part of the transactio n. OTC derivatives
differ from exchange- traded derivatives in that they are not standardis ed. The
nterparties to the transactio n are free to change the quality, quantity, price,
terest rate, spread and a range of other variables to suit their specific needs. This
ait makes OTC derivatives attractive to banks and large enterprises that borrow
m banks, explaining why OTC remains the biggest derivatives market.
The main OTC derivatives utilised by banks are forward transactio ns and swaps.
'orward transactio ns (or forwards as they are known in the marketplace) work on
e same principles as futures contracts, while swap contracts allow two or more
unterparti es to exchange specific cash flows periodically in the future based on
ecified spot prices or interest rates. But let us first have a closer look at forward
hough exchange-traded derivatives offer banks and other market participan ts the
rtunity to hedge their market risk exposures free of counterpa rty risk, the
rity of hedging instrumen ts are not made up of exchange-traded products. Most
ing instrumen ts used by banks operate on the OTC market. The next section will
er the OTC derivatives most commonly employed by banks to hedge their risks.
"""aina Risk in BanKtna
?
··).J
..
·i·ty·.·
1
x
_:,"?7",>v_y_,,.,,..,,...c. __,_-7_,,_,._q ½? .. : . __.,;,,,,,._~: •·· ..
V. - " ~ ½ 0 ¼ -
1
(
IL
-
1
'''""
[!3.578431]
'""== =
X
...· ..6..·.........5·•.·•.·5 ...•.·.•
. .3.·•·
.... ·•·•·.·
... •·.r
•.··•··•.1·.··•.·...·..·.·•·.·..••...·.•··.••.•.•··...••.·•
++ (ir
5 Xt~
fJ•·.·1·.·.•.· ·. •.· ·.• .•.•.
(irl
= 7,9'Cl96o/ci3q;
1
=-!
>
J.
i:3as . l
·r, + (o:oaf~ . ~-;~:11 i•···•·.·<r
1
; +(0.04~:~~) -- x 157-Sr
§rridi,in;fhis··6£~;ifn~f!akinofutliresB~~frdcitJ~~¥1(~hlefo~~e~gi11g,(the
managef;dedd~S}O en.ter into a forWard ~~ntrac~;~r!.h..8J8D~riyf1tiy~~~
orderfor.'.fhe ban~t? quote·the constructioncompa~y,jt\\lillih.ay~t?Pfll;
.IF~.~owever, cal~olatingthe IFR Tequiresthe bank tO•??fair t~~j~~~li;fl~l~to'n
rates of both a'5~iday lnstrurnentand,a 157-day instrument.(the~.?Q!~~;tyJiil erid
>\f57 days from noW);Th.~ risk manager finds that the corrent:,narket ra~~!?". a' 55•d
';~co is 4:5% andj~e cu~ent market rate for a 157:cfay NCOis 6:'75%.\Giventhese
crates, the.lFR is c~i~:l:ted . as foHows:
m
Let us assume that a large construction company will receive, 55 dayslr&m no
a progress payment for work already completed of R150 rnillionC)n aJarge
construction contract.The construction company only needs R30 rnillf6n of the
_.paymentamounfJ~rwages until the end of the contract andth~yatelci()kirig to...
20 million ina negotiable Certificate<1f ~~p~si~{~SD) for
_•• invest the remainirig
•period of 102 days, The risk manager at the construction company is; however,
-- "worried fhat the irit~resnate on the NCO will decrease Withillthe nexf55days,
-· meaning that the·:yJeld on the investment Will not bEi as high as itwoulcl have\bee
had the funds oeen invested in the NCO now,
Once the IFR is calculated, it is possible for the counterparties of a forward transaction
put the transaction together. The IFR will never be used expressly, but rather as a fair v,
benchmark of what the rate ought to be. The counterparties will negotiate around this
in order to add a profit margin to the deal. Let us look at an example of such a forward d
}Here MV is the matunfyvalue bf the80ntract
.. ·..•..· ..
......•...·Y.·
IFR.·••.·.·.·.·.···.·.•d
i\ MV
365
... ..'
.. m•..·.t··"
·t·.o
[, +·.( 100 X
Price = ·
;.<·.·•
. •.•:.•~.•.•i· .·.· ·
/
bride the IFR M'c:alcufated,it is possible;focald6lafothe
contract by means of the following
=
:In Equation 12:'13:
<>. irL = spot interestrate for the longer period
<;:;rs= spot interest.rate for shorter period
/ tr =·longer p~riod, expressed in days~365
• ts Shorter period, expressed in days/365
Forward contracts can also be applied with great success on bond portfolios. In
order to do this. the risk manager will first have to calculate the duration of the
portfolio. Once the duration is known, the possible loss on a bond portfolio can
easily be calculated given a change in interest rates. Once the possible loss is known,
the risk manager will simply sell bonds at the current trading price for future
delivery. The loss incurred on the current bond portfolio will be offset by the profit
on the forward transaction - thus mitigating the risk of a change in interest rates.
Let us look at an example.
Bank Management in South Africa - A risk-based perspective
~-
•
.
~
= ~R10 404 929,58
~:g!;
=---0~ X p x:1~ i
··•·.·.
= "-'7:5 x R98.5 milliohx
•
12.2.2.2 foterest rate swaps
Financial institution s make use of a multitude of different swap contracts in ord,
to hedge a variety of risks. Swap contracts are found on equities, commoditie
interest rate instrumen ts, currencies and as well as on other derivative contrac
These contracts all work in a similar manner. For the purpose of explaining h6
swaps can be used as hedging instrumen t, this section will cover the hedging
interest rate risk with interest rate swaps.
Interest rate swaps allow a financial institution to hedge against losses that occ
because of a change in interest rates, or, alternatively, which are caused by a mismat,
of interest flows. An interest rate swap is a contract that allows two or mo
counterparties to swap differing interest obligations via a third party (usually a marke
maker for swaps). These interest obligations usually differ in terms of the frequency o
change in the interest rates. Counterparties would thus normally swap a fixed rate ca
flow for a series of floating rate cash flows on the same notional amount denominat ed'
the same currency. The counterparties to the swap need not actually swap the notion
amount. but only the proceeds on the notional amount as calculated on the fixed ra
and the floating rate respectively. With fixed-for-floating swaps the counterpar ty tha
When studying tll'.e above example, it seems easy to perfectly hedge against a chartgf
the interest rate. However. since the market is comprised of competent and skilled r
managers, most banks and other financial services companies would have anticipa
the same drop in interest rates. The risk manager at any particular bank might theref,
struggle to sell their bonds forward at such a good rate. In reality, they will have to ofl
the bonds for forward delivery at a discount in order to sell them. This means that th
will still be a margin of error, similar to basis risk when operating in the futures mar
In order mitigate the uncertaint y of the size of this discrepancy between the actual l
and the projected loss, many financial institutions make use of interest rate swaps. T
next section will cover the manageme nt of risk by means of swaps.
·•-,nbrcfer-td hedgelhis~ 6tlclntiai capit;I los;,Jhe riSkl'rlanager can t.ake a.H
ba'lance-sheet position by selling ten R1 O million face value bonds for fo
.delivery in three niohths' ti meat. R9.85 miUion eaCh-)lf fh~ risk manager
about the t:hange irijnterest rates;it v.iould be po~si?le Je>buyiten ~1? r\'liUi
value bonds at R8;~09 5.07,04 each after receiving ~?-8SrniUionJe>rthe.bory
_..: were sold ioiwardh"l"hismeans·an off-balance•sheE!f·Pre>~t e>f .R1.?~0~92;96
bond (R1 o 404 929;60);cthereby offsetting the Joss orrthe bond portfolio.
•
zll:
>A riskrrtanag erof Fifth Second Bank buys ten goverrtrflent bond.swith af.
orn10 million each at~ current value of 98 . 5% (R98.5irnillion); Soon~~~r
_purchase, the risk manager realises that interest ratesar:.ab outto increase&
-·basis points (1.5%)over the next three rnonths from the c.orrentfo~el ~f:~-5,'}n
calculatecUhe ·duration on the bond portfolio to be 7.5 years the risk manager'
icalculates·the expbsure as follows:
342
•
,0~·
.>~~~~ ,_
--"'-~ ,..._
·'''1?ti\:::.::..:·.:.:,~c:,.:.:;:ci;;
.,,_;•
~~-~~~---==<'>-n,,,,,,-~~-m--~-"*-~
9
•··" ~~s~i!lhaf tibttt~onf~ ~ny!ff.ai) ¢oiflpant,~hayfb.o~\V'ed R}2sl-nit1ion!
y~bdrrowe .dJhis lTll:irl8Y.'ftorTl~l.i~tair_.B~l11<~!~1B1~ .VJ~.ili,q()Tpa
·'""oriiteiffonas,aHf1ix~"lnteit~si:,riil:e"t>f6:So/owSTnce$6th\ttiese··ca
--~-
ps the fixed interest payments for floating rate payments is the buyer of the swap.
seller of the swap would therefore receive the fixed rate and pay the floating rate.
Although the fixed-for-floating swap is the most commonly used swap, the
nterparties may also swap two floating rates. These swaps are referred to as basis swaps
ause they have different base rates. In South Africa. the lloating rates will normally be
Johannesburg Interbank Agreed Rate UIBAR), the South African Benchmark
rnight Rate on deposits (SABOR) and the prime lending rate. In principle, fixed-farting and basis swaps work in the same way. The main difference is that the fixed leg in
fixed-for-floating swap can be replaced by another floating rate. The following example
,ws bow interest rate risk can be hedged by making use of interest rate swaps.
Chapter 12: Managing Risk in Banking 343
(111;'_<,.m="'"'T:'T'" -'ll'I-·•·
Bank Management in South Africa - A risk-ba
sed perspective
p~
Other swap instru ment s
Currency swaps
12.2.2.3.1.
. > ....... ·•- ..
As is the case with interest rate swaps, curre
ncy swaps necessitate two opposing
views about the direction of a specific pair
of currencies. In its most basic form, a
curre ncy swap involves the exchange of the
principal as well as interest payments irL
one curre ncy for the principal and interest
payments in anoth er currency. At the
start of the swap, the amou nts are usually of
equal magnitude (given the exchange
rate at that time). These principals are then
swapped both at the beginning and end
of the contract. The following example expla
ins how curre ncy swaps can be used
hedge curre ncy risk.
There is a variety of other swaps available in
the interest rate market. Although
of these are based on interest-generatin
g assets, they serve the purpose
exchanging any type of cash flow that origin
ates from an interest-bearing as
Examples of these swaps include: amortising
, step-ups, roller coaster, deferre
extendable, puttable, const ant maturity, index
amortising and timing mismatched
Swaps are also available on other underlying
assets. such as on equities (f1
example floating-for-equity swaps), commoditie
s and currencies. Of these varieti
curre ncy swaps are the most impo rtant for the
daily dealings of the bank. Curre n
swaps allow the user to transfer cash from
one curre ncy to anoth er in order t,
mana ge curre ncy risk.
12.2. 2.3
If this were a basis swap. the fixed leg (6.5%
) would have been replaced by a floa
rate like SABOR. The rest of the trans actio n
would rema in the same. Basis swaps
used in situations where a financial institution
is both lending and borrowin
different floating rates. The financial institution
will then mimic its cash flows
one or more swap vendors.
.· · •· lrihrd e(for the~~ apvei idor..to··rnake a pre!itf
thE!y~inf~kia.~pr~~~\e~b
·.\/sides· of the tran?action.lnthls instance; .we
assurne.th~t!~e ~\\l~f>y. ~~
·}0:25 % spread o.nl6oth ~ides of the deal. Fig~re
7
.1.2.~ abeye sh~':"'stha~
• pay afil<ed . rate(riem1ally higherlhanthe·•~~r
rent·.ffoatingrate) to}hEi:s~~p(Je?i"
-receiveJIBAR. lei~0.• 2~'Jlo .i~.retur~.-•.l~this.•1t:~Y·•
PO'Jl~.a~y~w.in•.~ehe~d7c
/Jncrea~~fn'ttiejnt.eresfrate,••·since·theinterest
lhey l't3Cei~e•.frorn the swap •
•·•·. lncreas:e_linearlycwith•th ii.ncrease•••i~.••inter
est·.!hey·pay.on;Ali!ltair
\swapvend6r-.vi11 . !hen.p7
~y comp a~ys•.~ .•~q'Jlo.(6 •.5
h{JIBAR:ottthis't!~yCompMy ~teceiyes a
TI.~ed.r~!-:\
-/xrateoblig~ticm!o.thek•.i~yesto~;\~heui.~th7!~t
ElrEl~tlat~i./i. ··••·•·••··•···••··•··,
.·•xbElnafif~i2ce it~o-.vpays··~fi~ed. r~te.~eVJe~E
lr,··.bEl?~~~ElP.?n:1P.~~~
Yl:tot he swap vendor, itWfll pay rnorewhen
the interest rate 'goes up!
344
'"" ...... ~-~ ~ . - .
. . •=~-\~/
Bank Management in South Africa - A risk-based perspective
Credit swaps
Credit swaps can be divided into two types of instrument, the credit default
(CDS) and the total return swap (TRS). CDSs saw exponential growth in the years
prior to the financial crisis of 2008. This growth came from the need for banks and
other linancial institutions to hedge one of the most menacing risks - that is, credit
default risk (or counterparty risk). Since a bank's main business is that of lending
out money, they are more vulnerable to non-payment of debt than to market
movements or even changes in the interest rate.
CDSs are more of an insurance product than a true derivative instrument.
with options, they require a premium to be paid. However, where the premium on
an option is paid off over the lifetime of the option, the premiums on CDSs occur
monthly and do so for the duration of the cover it offers. So, if a bank (or any
financial institution for that matter) requires insurance on some outstanding debt
owed to them, they would purchase a CDS from a CDS writer for the notional
amount outstanding. In the case of a bank, this nominal amount will usually be
made up of several hundreds or even thousands of smaller loans - such as home
loans, credit card payments, etc. The CDS writer will require monthly payments for
ensuring this outstanding credit. In the event of one or more of the bank's clients
failing to repay their loans, the CDS writer will pay the amount owed - thus
mitigating the default risk. If, on the other hand, none of the bank's clients fail to
pay their debt, no payment is made by the CDS writer.
TRSs behave somewhat differently to CDSs. The TRS can be used to hedge
against an increase in the credit risk of a counterparty. In the case where the credit
12.2.2.3.2
As with forward contracts, swap contracts are exposed to counterparty risk.
managers should therefore be prudent and ensure that they do not take excessi
exposure in these instruments. However, since the bulk of derivative instruments
the financial markets are traded OTC, most banks and other financial institutio
are exposed to counterparty risk. This risk, also known as credit default risk, is the
usually hedged by means of credit default swaps. The next section will short!
discuss the use of credit default swaps in hedging credit default risk.
If at T + 2 the exchange rate was R14,50 per pound (in other words, the rand
depreciated against the pound), then the South African bank would be better o
it would have been in the absence of the swap. This means that the UK compa
would have been better off not entering the swap agreement. If however the
appreciated to R13,50 per pound, the UK company would be better off with t
in place, and the South African bank would be worse off. Clearly, like futures,
and interest rate swaps, currency swaps are also a zero-sum game.
The swap described in Figure 12.1 O is done for both principal and int,
relevant amounts. At T + 2 (expiry of the swap) the amounts plus in
exchanged again in order for the South African bank and the UK company
, their investors and creditors respectively. However, the swap would always
beneficial to one of the two participants.
346
347
12.2.3.1 Letrers of credit
A letter of credit (LC) is a type of promissory note. Banks issue LCs as an off-balancesheet product to third parties such as import-export companies, local municipalities,
parastatals and any other entity that is in need of a guarantee to raise funds for a
specific transaction. The LC acts as a guarantee that the bank will make interest or
principal payments (or both) should the buyer of the LC default on its payments to a
third party. By acting as a guarantor for third parties, banks charge a fee or premium
that contributes substantially to non-interest revenue in the further hope that the
buyer of the LC does not default on its commitment to the third party. Since the bank
stands to lose a great deal in the case of a default by the guarantor, it always performs
thorough credit checks before selling an LC to the counterparty. As such, the risk
associated with the guarantor is priced into the premium that is charged for the LC.
The LC therefore acts as a hedging tool for external parties to the bank.
12.2.3 Alternative risk management instruments
There are a number of other risk management instruments that banks use to hedge
their own risk, or alternatively, offer to counterparties for risk management purposes.
The most widely used instruments in this category include letters of credit,
securitisation and loan sales. This section briefly discusses these three alternative risk
management instruments.
ation of a counterparty changes, the bank will receive the total return based on
annual fixed rate (j) plus changes in the market value of lhe debt. For this
tection, the bank annually pays a fixed rate of interest and the capital gain or
ss on the market value of the outstanding debt over the period of the hedge.
Both TRSs and CDSs allow banks to hedge their credit risk for a fraction of the
portunity cost of holding capital for the outstanding amount of credit they
pply. This allows them to use their capital more efficiently, without running the
sk of bank failure in the process. There is however something else to consider. CDSs
d TRSs remain OTC products, which are themselves exposed to counterparty risk.
,ike insurance products, these products are safe to use in normal economic
ircumstances, but will fail to provide a full hedge in crisis periods where the entire
nancial system is under pressure. This was evident from the losses incurred by
anks during the 2008 financial crisis despite the large amount of CDSs and TRSs
eld by these banks.
Although there is a variety of instruments that banks and other financial
institutions can use to hedge market, interest rate and credit risk, it should be clear
that a perfect hedge is never possible. Even if the risk manager is able to match the
value exposed to risk with the profit on the derivative instruments, costs will still be
incurred whilst hedging these risks. There are also hidden opportunity costs to be
considered when deciding to hedge a particular position. It is therefore necessary for
the risk manager to carefully consider whether the risk is worth hedging, whether
the type of instrument to be used is the correct one given the circumstances, and
what other risks are taken when using a specific derivative instrument.
Chapter 12: Managing Risk in Banking
Secur itisati ori
12.2.J .3 Loari sales
Apart from the securi tisatio n process, banks
can also sell loans separately.
process, know n as loan sales, can take different
forms. The two most popul ar are
participation loans and assignments. In a partic
ipation loan, a bank share s part of
the loan with anoth er bank. By taking over only
a portio n of the loan, the purch ase
of this partic ipatio n loan (such as anoth er bank)
is usually a party that was not part
of the original loan agree ment. The reason
banks are willing to enter into a
participation loan could be becau se the retail custo
mer has credit needs that exceed
the lending mand ate of the bank. Furth ermor
e, it may be that the size of a
partic ular loan pushes a bank beyond the allowe
d exposure for a single client or
Securitisation only starte d to come into its own
in the late 19 70s and early 19
a liquidity and credit risk mana geme nt tool. The
process of securitisation irt
the pooling of relatively illiquid assets such as
mortgages, credit card loans 6
stude nt loans. Once pooled, these assets are held
in special purpose vehicles (
where they are divided into different risk tranch
es which are rated by
agencies and sold off to investors. The financ
ial institu tion effectively co:
illiquid assets into publicly traded securities whilst
getting rid of both credit ris
liquidity risk in the process. This is an impor tant
feature of securitisation: it re
risk from its balan ce sheet and transfers it to other
marke t partic ipants .
Securitisation is not only a way for banks (and financ
ial institutions in gene
generate extra fees on assets it sells, but is also very
useful as a risk mana geme n
As such, it has become a popul ar way for banks
to earn off-balance-sheet non-in
income. Since the bank still earns a fee for handl
ing the interest payments on b
of the investors, it is able to earn this witho ut taking
on the credit risk associated
the income stream. This also frees up capital
that the bank can lend out aga
thereby earnin g extra fees (such as bond origin
ation fees). The bank also has
opportunity to cross-sell its products and earn furthe
r income from these new die
The securitisation process suffered some bad public
ity with the Global Finan
Crisis of 2007 /08. Many of the financial institu
tions that pooled mortgages for
securitisation process starte d to extend credit
to non-c reditw orthy clients with
intent ion to sell these 'bad' or 'subpr ime' loans
to third party investors. Si
securitisation ensur es that the banks are not
exposed to the credit risk of th
loans, the banks reduced the qualit y of the credit
risk assessment process, b
throu gh not performing the neces sary backg
round credit checks, requir ing
collateral or merely being less prude nt in the granti
ng of loans in general. Inste
they were heavily incentivised to extend as much
credit as possible in order top
enoug h loans togeth er that could then be sold
off as collateralised debt obligatio
(CDOs). The incentives for trader s and financ
ial engin eers to trade CDOs w
immense and by the time that investors starte d
to realise that these CDOs were n
going to rende r the return they hoped for, it was
already too late. As more peo
starte d defaulting on their mortgages, banks
tried to remove the CDOs from th
balan ce sheets. This in turn created panic in the
marke t and eventually led to t
financial crisis and the collapse of global financ
ial markets.
12.2.3 .2
348 Bank Management in South Africa - A risk-ba
sed perspective
REFERENCES
Douglas H. 2009. The Failure of Risk Management:
Why It's Broken and How to Fix lt.
Hoboken, New Jersey: John Wiley & Sons.
_12.3 CONCLUSION
·This chapt er has analysed the risk mana geme nt
process primarly throu gh the use of
derivatives such as futures, options, forwards and
swaps. It is impor tant to discern
between these instru ments based on where
they are issued. Since futures and
options are exchange-traded, they are free of
count erpar ty risk. Forwards and
swaps, on the other hand, are traded OTC, which
exposes the bank to count erpar ty
risk. This makes for a variety of options for the
risk mana ger in the decision to best
match the derivative instru ment to the partic ular
risk being hedged.
Despite the variety of instru ments banks can
use to hedge the various risks to
which it is exposed, a perfect hedge is obvio
usly not possible. Even if the risk
mana ger is able to match the value exposed to
risk with the profit on the derivative
instru ments , there will still be costs incurr ed
to hedge these risks. There are also
hidde n oppor tunity costs to be considered when
deciding to hedge a partic ular
position. Hedging with partic ular instru ments
also exposes the risk mana ger to
other risks. Care should thus be taken in apply
ing the correc t instru ment in the
correc t circumstances. Finally, altern ative risk
mang emen t tools such as letters of
credit, securitisation and loan sales provide the
risk mana ger with more options
when mana ging, in particular, credit and liquid
ity risk.
nd the exposure to a specific sector or geographic
area. These possibilities make
sales an attractive proposition for banks.
Where participation loans leave the ownership
with the originator, assignments
essitate the transfer of ownership to the buyer of
the loan. When this occurs. the
rower of the original loan often needs to agree
for the sale to take place. This
al agree ment is necessary because the legal claim
on the borrowed funds now
ts with the buyer of the loan. Although loan
sales are often used as a risk
nagement tool, banks also use these as opportunitie
s to dispose of low-yielding
ets. By doing this, the proceeds are used to acquir
e more lucrative assets, thereby
creasing the overall yield on their asset book. Loan
sales can also be an oppor tunity
dispose of some illiquid assets and replace them
with more liquid assets. This
sures that the bank mana ges its liquidity risk, as
well as its conce ntrati on risk and
some instances credit risk.
If mana ged properly, loan sales can be a good risk
mana geme nt tool albeit that
Uing loans is not a risk-free exercise. If a bank
does not mana ge the selling of
ans, it might end up selling most of its low risk
loans, thereby leaving it with an
,verall highe r risk profile on its loan book. This can
easily happe n since high qualit y
ans sell easier than poor qualit y loans. It is also
possible for the borro wer to default
fter the sale of the loan. Because there is a chanc
e of this happe ning, the seller
ften gives the buyer of the loan recou rse in the
event of a default. This leaves the
original seller of the loan with a degree of credit
risk, thereby defeating the purpo se
of the sale in the first place.
Chapt er 12: Managing Risk in Banking 349
John Wiley & Sons.
Saunders A & Cornett MM. 2008. Financial Institutions Management: A Risk
Management Approach. New York: McGraw-Hill Irwin.
Fabozzi FJ, Neave EH & Zhou G. 2012. Financial Economics. Hoboken. New Jer
",....,,,_..,,-~"'=---.,,.,,,.,
3.
2.
350 Bank Management in South Africa - A risk-based perspective
· - - • y.:.r+_
3
>
J
> ?Q•
--,
iCES AND
F- FUNDS IN
~NKING
'T
>:... --~---
ctziGING THE
FIVE
.... _.- --------- >
~
67%
9%
100%
1500
200
2250
Total Assets
Loans
Other Assets
2%
22%
.,. Percentage of assijts
50
•.,. ---:-;",if'
500
I"'' i\'.9~'311~~21201 s (Rmillion)
Gash
><c"L'.
Securities
Assets
Breakdown of the assets of a typical bank
BREAKDOWN OF THE ASSET BOOK: A RECAP
In order to better understand the basic workings of the assets, let us reconsider the
typical items found on a balance sheet of a hypothetical bank. This is provided in
Table 13.1 below.
INTRODUCTION
As discussed in Chapter 7. the balance sheet of a bank is different to that of a
company not involved in financial services. Items such as inventory, accounts
receivable and other working capital items are excluded from a bank's balance
sheet. Furthermore, the assets of a bank would not be in the form of land and
buildings, but rather in monetary items such as loans and advances. For these
reasons, an analysis of the assets of a bank is vitally important to ensure that
analysts not only understand the difference in composition thereof, but also what
strategies bankers use to manage the assets. This chapter deals with this.
er reading this chapter, you should be able to:
interpret the main assets on the balance sheet of a bank
discuss the way a bank manages its cash and why the amount of cash is kept
to a minimum
distinguish between the different types of loan held by a bank
distinguish between the different risk grades of a loan
explain how the secondary market works
explain the various de-risk strategies a bank can employ
explain the loan syndication process
explain how a high-yield bond can be used to manage the assets of a bank
explain how the debt capital market functions
evaluate the different investment maturity strategies a bank can use to manage
its investment book.
RNING OBJECTIVES
ging the Assets of a Bank
-.. •.
·••1'1\\1'.,50.
•
>
•---i---=•·
Other assets include property and equipme nt owned by the bank and represen
a small fraction of assets. Given the nature of intermediation, a bank is able
td
generate large revenues without committi ng itself to excessive fixed property
assets, in comparison with, say, a manufac turing company where plant,
property and equipme nt (PPE) are major assets. This accounts for one of
the
major differences between the balance sheet of a bank and that of a non-bank
;
To put this into context, Table 13.2 compares the PPE of South African banks
with non-bank s operating in South Africa.
Other assets
,ASii bank'Sassetstisualfy generate the most income(a :shppose dfbridhli
income items related to fees and commissions), investors scrutinise thertnh
In addition to assessing the inherent risk associated with the respective
also want to ensure that the assets generate sufficient returh'on theirl.nves
t
'check to see ?bank has _a good mix of liquid ?nd illiqul~a~s~ts soihatj~t
h~~
of a liquidity squeeze;' for example, it is able to meet its shorMerm obligation
s.
The largest percentag e of any bank's assets is made up of loans and advances
its clients. 1 Loans are usually the highest revenue- generatin g asset for a ba
and are central to its intermed iation function. Unless properly mitigated, loa
can increase the bank's exposure to credit risk in particula r and cause it to fa
substanti al losses in the event of impaired or non-performing loans.
Loans
Fixed-income securities are generally not considered to be attractive assets f1
bank as the yields they generate are not high. Securities that have better er,
ratings (typically investment-grade) tend to be more liquid, which incentiv
the bank to hold more of these in an attempt to achieve desired liquidity rati
Bonds, debentures, notes, options and shares are good examples of s
investment-grade securities. In South Africa, banks hold between 15% a
20% of their earning assets in securities, with the primary purpose of havi
safe and liquid assets available. Lower risk securities include Treasury bills a
other government-related debt and yield around the same as the rate for
t
current long-term South African governm ent bonds.
Securitie s
Cash makes up a very small portion of the bank's assets and in most cases
likely not to be more than 2% of the total asset pool, The main driver fort
that cash generates the lowest income for a bank. implying that there i
opportunity cost for holding too much. This is because a bank would rather
its money in an asset that earns interest than in one that sits idly and e
nothing - such as cash. Although banks must hold sufficient cash to mee
particular, the withdrawal demands made by its clients, cash managem ent
function within a bank ensures that the opportunity cost is not too excessive.
is especially vital considering that the opportunity cost is linked to ensuring
services (such as cash withdrawals) are performed by the bank.
Cash
Bank Management in South Africa - A risk-based perspective
:ti'"-?-~-"~-~ ---·- .. ,.--...
-
•
•
•
354
29%
14%
50%
1%
PPE/Assets
Managing cash
=--
Banks are required by law to have a certain amount of cash and to use sophistic
ated
statistical models to predict the amount that might be be required at any
time
during the day. This method assists the liquidity manager s within a bank to
hold an
•· amount not only suitable enough to comply with regulator y requirem ents
but also
to have enough for client requests. Bear in mind that holding too much vault
cash
poses increased risk for a branch. especially in the event of robberies or lire.
The
. former in particula r could lead to high costs for a South African bank due
to the
•·• frequency of cash-in-t ransit heists. Most banks would also apply to the
South
African Reserve Bank (SARB) for the vault case to be included in the minimum
' reserve requirem ent stipulated in the Banks Act (94 of 2000).
The daily demand for cash at a bank is usually a function of the type of client
it
has. For example, a bank that has large corporate clients will in most cases have
more
cash. as these corporates tend not to want to hold cash on their premises and
would
thus prefer their cash to be earning interest at the bank. Therefore, if a bank
has a
large inflow of cash from its corporate clients, it runs the risk of reaching the
ceiling
limit for vault cash holdings much more quickly, which will require it to send
the
excess cash to the SARB. or in other instances, move it to other banks in
need.
0
{,i=fbfl'1200s'tdicl12·there.'w~f~··aWdut~36ClATM •itticl<S·•in
tesulted in a 1os§6fa\mosfR2;9:biHi6nkThiSfa one of the reasonswhv'most
African banRS"e~coufage th~irc:Herlls.tci~seff€sscashin favour-of
and electronic tiahkihg facili\iest .tflf1F'?L ilf •,~;.
•
ash is regarded as a non-earn ing asset because a bank does not earn any income
om holding it. For this reason, a bank will aim to hold as little as possible,
whilst
nsuring that it.has enough meet the daily demands of its clients. In most cases
this
sset is called 'vault cash' as it is normally kept in vaults (or safes) at branches
in
rder to fulfil over-the- counter transactio ns. A large proportio n of this vault cash
is
lso kept in automate d teller machines (ATMs).
3.3.1
MANAGING THE ASSETS OF A BANK
bank can therefore have a variety of assets, but they are generally classified into
the
Oad categories mentione d above. The following section discusses the managem
ent
these asset categories in more detail.
ctual names have been omitted but represent actual South African companies
n of PPE for banks and non-banks
Chapter 13: Managing the Assets of a Bank 355
These facilities assist a client's liquidity needs and are usually provided on an
unsecured basis. They therefore do not have a specific tenor and are 'ondemand'. The revolving and unsecured features of overdraft facilities suggest
that a bank can demand its facility back the moment it realises it may be at risk.
Banks also expect clients to pay this facility down to a certain maximum
amount frequently and not be fully drawn all of the time.
Assd finance
These loans are usually provided to a client to fund the purchase of an asset
(such as vehicles) over a short period of time usually not exceeding a tenor of
five years.
Trading loan
•
•
■
Risk rating a loan
All loans, or more specifically all counterparties. are rated by banks in order to
determine the probability of their defaulting (PD) on their respective loans. When
calculating the PD of a counterparty the PD is assigned to the loan itself - that is,
13 .3 .2.1
The following section discusses two of the most common methods for a bank to
adequately manage its loan portfolio.
These facilities assist clients with their trading exposure and include derivatives
to enable interest rate hedging and currency hedging. Banks usually have very
specific ways of calculating the potential future exposure in order to determine
the size of the limit or the future mark-to-market exposure (on these loans, cash
flow only occurs at the end of the trade).
Term loans include all funding with a tenor exceeding one year (up to 30 years
in some cases) and make up close to 80% of a bank's loan portfolio. Examples of
these loans include project finance loans. mortgages loans. acquisition loans
and leverage finance loans.
o,,e,·draft
Loans make up the majority of a bank's assets mainly because they generate the
most income (through fee income and interest income). The main categories of
loans are typically:
•
Term loans
13.3.2 Managing loans
Conversely, banks that have mostly retail clients have to ensure that they meet hig
cash demands on a daily basis due to the volume of cash withdrawals. Therefore, if
the bank has a large number of retail clients it runs the risk of reaching its floor limit
of vault cash. If this were the case, the bank would be forced to borrow from the SARB
or alternatively from other banks with surplus vault cash. For banks to adequately
manage their vault cash. they must consider the trade-off between holding cash on
the one hand and buying cash in the overnight market on the other. The opportunity
cost of holding too much liquidity is central to this decision and requires that banks
have an upper and lower limit wherein they manage the amount of vault cash. When
vault cash lies between these two levels, no action is needed.
356 Bank Management in South Africa - A risk-based perspective
357
13.3.2.2 The secondary market
Basel II and Basel III require banks to calculate the PD on all their loans/
counterparties in order to determine the amount of capital they need to hold. Given
that the PD indicates the risk of a respective loan (or counterparty). it follows that
lower PDs indicate a better quality asset (and vice versa) on the books of the bank.
Table 13.3 ind_icates how the credit rating agency (CRA) Moody's Investors Service.
for example, links specific PDs to specific ratings.
Therefore, when a bank rates its loans (or counterparties) it has to ensure that it
measures the risk as accurately as possible in order to avoid unexpected losses.
There are generally three variables that determine the PD of a firm (counterparty):
1. the market value or net asset value (NAV) of the firm
2. the level of the firm's debt obligations (commitments)
3. the sensitivity of the market value of the firm to changes in asset values.
the PD of the counterparty equals the PD of the loan. The PD is therefore the
likelihood that a loan will not be repaid and thus become a default loan. The credit
history (history of any defaults or delinquent repayments) of the counterparty and
type of loan are specifically taken into account when calculating the PD. Most banks
use historical cash flows to assess the ability to service the loan. The stability of a
client's cash flow is usually the strongest contributor to a lower PD, albeit that
certain industry data may also influence the calculation of the PD.
Chapter 13: Managing the Assets of a Bank
Aaa
I
Aa
I
A1
I
A2/A3
I
Baa1
I
Baa2
I
I
Baa3
0.20-0.25
I
Ba1
I o.2!>--0.30
When a bank originates a loan they will decide to either keep it or sell it on
secondary market. This decision will usually be based on the following factors:
•
Participan ts in the secondary markets
These participants can be other commercial banks. development banks who want
to grow their balance sheets or asset and fund managers. The asset and fund
In actual monetary terms, interest normally accounts for roughly
income a bank will earn from a loan, and fees the remaining 35%.
A further reason for banks to calculate the PD on an asset is because they use the
ratings extensively when they want to sell an asset on the secondary market. T
better the risk rating the easier it is to sell; the poorer the risk rating the more diffic
it is to sell the asset. It should be noted that not all assets are formally rated by a CR
hence Table 13.3 is only a guideline as to where such an asset would rank if it wa
formally rated. Therefore, in the case where an asset is not formally rated, a bank ca
use an 'informal rating' to indicate the quality of the asset by calculating its PD an
assigning it a rating. If this were the case, the bank would apply its own in-hous
methodology.
The secondary market is made up of organisations that buy loans from banks and
other lending institutions. This market creates a situation where loans are sold to othe
investors who have not previously been part of the loan when it was originated. Th
more market players there are in the secondary market. therefore, the better the
liquidity is. Loans with better risk ratings (and thus lower PDs) are easier to sell as the
buyer perceives them to be of a lower risk. However, low PD clients generally do not
generate as high returns as the high PD clients would. Most banks are extremely focused
on selling portions of their assets in the secondary market as it 'frees up' liquidity when
there is a demand from depositors. By generating liquidity in this manner a bank is able
to participate in more transactions, which in itself is potentially profitable.
With this in mind, how does the secondary market work?
Banks are always looking to lend money to clients in order to earn both a fee
and interest. In many cases, however, banks earn more revenue from the fees they
will charge for the provision and structuring of the loan, especially for corporate
clients. Once the client has accepted the loan, the bank will charge the client various
fees, including fees for arranging the loan, for committing the loan (unconditionally
agreeing lo provide the loan to the client), if the loan is provided in a foreign
currency and interest on the outstanding amount for the duration of the loan.
Source: Moody's KMV (2008) 2
Moody's
equivalent .I
external
rating
0.15-0.20
Bank Management in South Africa - A risk-based perspective
Table 13.3 Moody's EDF vs Moody's external ratings
EDF(%)
I 000-002 I 0.02-0.03 I 0.03-0.05 I o.o!>--0.10 I 0.10-0.15 I
358
359
In most cases when banks originate a loan, they will be required to underwrite or
sponsor it. If they decide to sell a portion on the secondary market and also keep a
All banks have a portfolio committee that manages the concentration risk of a
particular sector in order to avoid overexposure. For this reason, if a bank has
heavy exposure in, say, the property market, it can decide to sell a large portion of
its mortgage book; alternatively, if a bank has very little exposure in the agriculture
sector, it can decide to keep these loans on its book, or, purchase additional
agricultural loans on the secondary market. Whatever the decision, concentration
risk, and thus the diversification of this risk, is an important consideration.
Li<1uidity requireme nts
As mentioned before, liquidity is a scarce and expensive resource for banks. If a
bank has a liquidity shortage, it may decide to sell assets in order to generate
liquidity (see the example below). As such, a bank is faced with a trade-off
between liquidity and return - if it needs liquidity, it may be required to sell an
asset that generates significant return, suggesting that it will lose that return.
The opportunity cost of holding too much liquidity is therefore an important
consideration when dealing in secondary markets.
Sector concentrat ion
managers usually have a large pool of funds available to invest. This creates a
ready market for the banks should they sell the loans on the secondary market.
Risk capital
Sometimes a bank may decide to lend to a risky client and earn a higher return.
The problem with this is that the higher the associated risk of the loan, the
more regulatory capital the bank is required to hold against that loan. This is
expensive for the bank and incentivises it to sell the loan on the secondary
market. (Regulatory capital requirement s are risk-weighted and serve as a
buffer to absorb losses-mor e on this in Chapter 15.)
Chapter 13: Managing the Assets of a Bank
Bank Management in South Africa - A risk-based perspective
ry,ost?~Hk§VJ6ci1~-~~~~r~~r iHY~
In the event of a bank not being able to sell an underwritte n loan, it is guided by the
fees it could earn when keeping it on the books. The bank also needs to consider
whether it has sufficient liquidity to do so and this needs to be commensur ate with
/u~~erwti~err·,?~~jis_it! liquidity. For example; if th~-~an~ii! u
sVery weU0 kn6Wn~nd relatively .,ow.risk client (and this enen\.i
-Jb~~ks), i!fan ~ef~sun1;d (hat many oth;~ .~anks ~n~ n,~~.ke
;ver,;Jnterestedjn;tfanking··this.client,1hi!•rtiean!.lhas.the'on
•61.!l'o ~~1:9e·r.;!.~ti~~lt,higher.fees_gi~_;".!hi~--•~rn1.~n-~
ISo~pplies wh.e1;tHerrjs·• no_yeal~eman.d.fOri~nun~~igHirisk;lfryd ·n<l_l;1e11,~r'lown i.n the market), .where the bankwi11 6e"f.
\its-fees-irrordertb•sell the loan,
{"~!ri\~§firrip~~cihtfabt8rJfiat
portion on their books. the latter would be called the hold portion. In banking,
underwriting is usually the amount of money a bank is prepared to lend to a cl
based on its assessment of the client's creditworthiness - the bank would usually
legally commit to lending this amount. While the South African market is shallo
than those in the US and Europe, it is significantly less volatile. The market
associated with underwriting risk is therefore less pronounced in South Africa.
Underwriting typically runs for a period of six months but may be Ion
depending on the timeline of the transaction. Underwrites go through several le
of committee approval- that are based on the amount to be underwritte n and
risk rating of the counterparty . The underwrite paper that is tabled at vari
internal bank committees provides the detailed analysis of a number of fact
which are crucial to a successful underwrite. These include:
An extensive liquidity analysis
■
Most banks will usually only underwrite a loan if they are able to sell some of
other market participants (see Example 13.2) - but they may decide not to seli
portion if they believe it is an asset they would prefer to have on their books and th,
have the liquidity to support the full underwrite. Subsequently, the liquidity analy
will indicate which other market participants are interested in buying a portion oft
underwritten loan and will also indicate the amount they are interested in buying.
Recent market activity
■
This indicates which banks in the market have recently done an underwrite, its
total amount and which participants were involved in the sell-down of the
underwrite and the monetary value of the transaction.
Underwrite protection s
■
Sometimes the bank will request certain protection. For example, the client can
agree that if the bank cannot raise the full amount requested, the client will
settle for the amount raised (albeit sometimes being a lower amount).
Holdlevel
■
The hold level is the final amount that the underwritin g bank and all other
countcrpart ies who bought a portion of the debt will settle on - the amount
they arc prepared to be 'at risk'.
360
361
A syndicated loan occurs when a group of lenders fund one (usually large) loan to a
client. This group in effect shares the credit risk in accordance with the portion they
fund, with one of the lenders in the group typically managing the loan for an
additional fee. With only four large commercial banks in South Africa, large
transactions of this nature are usually done on a syndicated basis as none of these
banks would be able to provide such large loans on an individual basis due to the
underlying regulatory capital requirement s set out in the Banks Act.
An example of this is where a South African bank acts as the 'arranging bank'
for a RIO billion. five-year term loan for a client. This syndicated loan would
subsequently be divided amongst various participant banks based on their
respective appetite for the loan. In most cases, the arranging bank would propose to
also take a portion of the loan in order to encourage the participant banks to take
up more. If the participant banks are willing to take up more than the R l O billion,
the syndicated loan is oversubscribed. This is usually a positive indication as it
suggests a sound risk profile for the client and thus the willingness of banks to lend
to this client. Should the loan be oversubscribed, the arranging bank may be far
more comfortable to merely earn the fees for arranging the loan (as it docs not earn
any interest on the loan).
Generally speaking, there are three ways to underwrite loan syndications. First,
an underwritten deal or transaction is where the arranging bank guarantees the full
amount of the loan. The arranging bank will then approach various other banks
with the purpose of selling a portion of the loan to them and this effectively implies
the syndication of the loan. In favourable market conditions this may seem easy as
most other financial institutions have a strong appetite for loans; however, in
subdued market conditions not all banks will have such an appetite and the
arranging bank will be forced to take up the residual portion that could not be
Loan syndication
13.J.2.3 Risk-out strategies
Any loan that a bank provides to a client is a risk for the bank as there is a possibility
that the loan (and the interest the bank earns from the loan) may not be repaid. If
this risk increases because, for example, the risk profile of the client is increasing, or
the bank is facing liquidity constraints, the bank may decide to either reduce
exposure to the loan or to exit the loan completely. This can be done by using several
;types of de-risk strategics. These de-risk strategies generally have two objectives: (i)
3
reduce risk on the loan book and (ii) create liquidity. The most common de-risk
strategy in South Africa is loan syndication as it is a technique that is well
understood by the market, relatively easy to execute and has the lowest risk from a
legal documentat ion point of view.
e fees received. If the bank encounters liquidity constraints, or another bank or
arket participant shows interest in taking up a portion of the underwritte n loan,
c bank may decide to sell a portion - this is commonly referred to in banking as a
-risk, where the bank has reduced its risk to the client.
The next few sections of this chapter will explain the various risk-out strategies
bank can use to reduce its risk to a particular client or loan.
Chapter 13: Managing the Assets of a Bank
Bank Management in South Africa - A risk-based perspective
--~~•"!J"'\I~----~~·-----~~-~
syndicated to other banks. For this reason, the arranging bank will only under
the loan if it is confident there would be sufficient appetite from fina
institutions. As such, it is important that the arranging bank performs a s,
market review of potential participants in the loan before formally agreei
underwrite. Second, a best-efforts syndication usually involves more risky clients.
arranging bank will aim to raise the full amount that was requested by the cli
but due to the high risk profile of the client, the transaction runs the risk of b
undersubscribed because of insufficient appetite from other banks. In such a
the client has two options: take the amount on offer or decide not to progress
further with the transaction and not to close the transaction. Finally, a club deal
smaller loan, usually ranging between R250 million and Rl billion, where the cli
itself tries to arrange, with its group of relationship banks, that each bank lends
equal portion of the loan. As such, there is no arranging role for any of the ba
and each share the fees based on their respective participation in the loan.
Several players participate in the syndication process. The arranging bank i
most cases also the bookrunner, which is the custodian of the client relationship an
usually the bank that manages all aspects of the syndication prior to the fl
execution of the transaction. The bookrunner usually gets extra fees for co-ordinati
the transaction, gathering the documentation and managing all the negotiations. 4
the case where the client is South African, the bookrunner will most likely be one
the local banks. If however, the bookrunner is a large multinational bank (such/a
Goldman Sachs, Morgan Stanley or Barclays), a South African bank is more likely t
be the mandated lead arranger (MLA). The MLA is often the largest contributor to t
syndicated loan and is usually a top tier bank or investor in global terms. The ba
acting as the MLA has to sign a mandate with the client in order to secure a role int
transaction and will receive a significant portion of the upfront fees. The participa
are the parties that seek quality loan assets and also have a relationship with t
bookrunner. They generally take smaller portions of the syndicated loans compared
the MLA and do not receive the same amount of fees due to their lower level o
commitment. In South Africa the participants in a syndicated loan are usually ass;
managers such as Investec Asset Management, Old Mutual Asset Management an
Sanlam Investment Management. More often than not, participants are not able t,
arrange the loan as they do not have a banking licence.
In order for the syndication process to occur, the participating banks need t,
provide their syndication proposals to the client who will choose an MLA. The ML
will prepare the information memorandum (IM) which contains all the operational,
functional and strategic details of the company or client requesting the loan. The IM
must also contain a detailed breakdown of the proposed transaction, the
syndication process and the potential fees/income a participant could earn. Mos
new syndicated loans are initiated by a meeting where the transaction and IM ar
presented to banks willing to participate. The management team of the client is als
present to ensure that any uncertainties regarding the transaction are clarified. Exi
strategies are also discussed at this meeting.
The syndication process generally consists of three phases. In phase one (th
pre-mandate phase) banks provide the client with their proposals for the syndicatio
362
-·,.
.·•···.·.
•...
Initial Documentalioo meetings
Final commitments received from the other banks
All participants agree on dcx;umentatioo
Signing of all the documents
T + 27
T + 34
T + 45
T + 47
:d.Y.it ... ,c. .
Client and MLA and participant banks
Client and MLA and participant bankS
Client and MLA and participant bankS
Client and MLA and participant banks
Client and MLJ.
Client and MLA
Client and MLA
MLA and lawy01s
Client and MLA
Client and MLA
-
... ..
Once the syndicated loan has been approved, it needs to be decided what. type of
loan will be used. Generally speaking either a revolving credit facility (RCF) or a
term loan is used. An RCF allows the client to draw funds. repay the funds and then
draw the funds on a continuous and revolving basis. Functioning in a similar way
Formal presentation to the other participant ban~
T + 24
T + 26
T + 10
Formally invite all other participant ban~
Preparation at the final invitations and information commences
·;.
Drafting of all the legal doeuments commence
-,.
Commence on discussions with other participant banks
•····
T+8
Review the term sheets and pricing
.
T+9
T'
itlate'?t>
Table 13.4 A typical timetable for loan syndication
the client will choose the bank or MLA with the most experience in syndication
nd also the banks with the most competitive fees. During phase two, which is the
ctual syndication, the MLA will perform the syndication by organising meetings,
rranging legal documentation, negotiating the final terms of the loan and agreeing
n the final fees. During this phase the loan will also be executed: funds will flow
rom the participant banks to the client after signing all the legal documents. During
the third phase, the loan is managed thoughout its term - the arranging bank
through its role as bookrunner makes sure that the client makes all payments,
submits all the required information that the other banks may need and ensures
that the client complies to all the conditions set out at the pre-mandate phase.
In South Africa, the syndication process follows these three phases and reflects
the detailed and complex nature of selling the transaction to other banks and
financial institutions. The roles of the participants in each of the phases are based
on their relationships in the market and access to paper. Paper in this case refers to
the financial instrument that •the issuer provides to investors through this
transaction and is called paper as the investor only receives a piece of paper
indicating the terms of its investment. The arranging bank, on advice from the
client, will choose the other participants that is, the investors in the syndication.
lawyers advising on the transaction and accountants performing some financial
analysis, in the syndication based on their appetite for the loan and relationship
with both the client and arranging bank.
Table 13.4 provides a brief overview of a typical timetable associated with the
loan syndication process - it provides more detail on how many days it usually takes
to execute a successful syndication. It is important to note that not all syndications
will follow this exact timetable, but this nevertheless serves as a good indication.
Chapter 13: Managing the Assets of a Bank 363
, , __ _ , _
_ ; . _ , . , _ . . . . . . . . ~ w , ..•
Bank Management in South Africa - A risk-based perspective
C
:5
0
I
Time (years)
High-yield bonds
3 ; · ' ' " " " " " " ~ -~~-"-""~-~----•
,,,
~----
A second method for banks to de-risk portions of their assets is through the big]
yield bond (HYB) market. An HYB is very similar to any other bond a bank maissue on behalf of a client but with two main differenres: (i) the interest rate retur
on an HYB is much higher due to (ii) its being regarded as a riskier security than
normal bond. In most cases a bank would either refinance a client's existing deb
through an HYB issue or provide the client with new funding in the form of an HYB,
In the South African market, the most common way to issue an HYB is throug''
underwriting. Consider the following example: a bank currently has R400 millio
extended to a client, which means that the bank is at risk for the entire amount.
the bank decides to exit this loan, but the client still needs the R400 million of de
it can issue an HYB on behalf of the client and simultaneously underwrite it (whic
guarantees that it will buy the entire bond in the market if no other investor wan
to buy it). Various investors including other banks, asset managers, individuals and
hedge funds may then undertake to buy a certain amount of the bond as part of the
HYB. If, say, R300 million is bought by these investors, the arranging bank would be
13. 3.2. 3. 2
A bullet loan is a term loan that requires the client to pay back the full outstand
principal amount at the end of the tenor. For the entire duration of this loan th
is therefore no reduction of the principal amount. A balloon loan is where a p
specified portion, usually a percentage, of the loan is left payable at the end of t
tenor. Over the duration of the loan, capital and interest repayments are made,
will not be sufficient to pay back the full principal amount at the end of the ten
Effectively, the final payment will be the balloon or residual payment. Finally,
amortised loan is considered to be more conventional and requires repayments o
the duration of the loan that reduce the outstanding principal to zero at the end
the tenor.
Figure 13.2 Payment schedule for three tenn loan profiles
·uC
ct
0.."'
ca .s
"' -g
E ·-
0
::, O>
C
-
to an overdraft facility, the bank may impose the conditions that the RCF
be fully drawn all the time and that it needs to be repaid frequently. A ter
on the other hand enables the client to make an initial drawdown on the loa
is equivalent to the limit of the loan. Repayments will then be made based
predetermined schedule of payments or a one-off lump sum payment upon ma
(or a combination of both). Figure 13.2 provides a schematic indicating the pay
schedule for three different term loan profiles.
364
365
Financing through the debt capital market (DCM) is the third strategy that banks
can use to de-risk. Bonds that are issued on the DCM are also used by banks to
replace existing debt from loans or are issued as an alternative to primary debt. The
issuers/clients in the DCM are mainly well rated as low risk clients by external CRAs.
In most cases it would be necessary for the issuing client to have an external rating
when issuing notes on the DCM (with an HYB, no external rating is required).
So, how does the DCM work? Figure 13. 3 provides a brief overview of a simple,
or vanilla DCM transaction.
Debt capital market
ed to take up the remaining Rl00 million. Conversely, if the full amount of
00 million is bought by investors, the arranging bank will not have to take up
exposure. The net effect is that the arranging bank is totally de-risked and the
nt will pay interest on the notes to the investors rather than to the arranging
nk. Albeit that HYBs require clients to pay high interest rates to investors, they
an attractive proposition as they typically do not have any covenants attached to
em (they are covenant-light), are unsecured and are issued with a bullet payment
ofile. All in all these factors suggest less restrictive terms for the client.
Furthermore, an arranging bank would in most cases not issue an HYB if it is
bt relatively certain that it would be able to sell at least 60% of it to investors. If the
YB is issued and there is no interest from any investors, it is considered to be a
ailed issuance. This is considered to be an extremely negative result from a
eputational point of view, as it suggests that the arranging bank probably did not
ave the expertise to adequately execute the transaction. In South Africa, it is very
nlikely that any of the banks would invest in an HYl3 offering, as it is mostly the
sset managers, hedge funds and private equity firms that would invest. This is
ecause they are regarded as having a higher risk appetite and are not restricted by
the regulations imposed on banks.
There are two main features of HYBs that need to be considered. First, HYBs
create liquidity for the client and this is a method for the bank to de-risk. If an HYB
s fully subscribed by investors (that is, the arranging bank is not required to take up
portion of the bond), it means that the arranging bank has provided the client
with the required funding without using any of its own funds. The HYB therefore
creates liquidity for the client through its being financed by external investors,
without the arranging bank taking any risks. A second feature of HYBs is that they
have an associated credit risk attached to them - that is, the likelihood (or
probability) that the issuer of the HYB (client) will not be able to meet any of its
obligations. An HYB is regarded as a high (credit) risk debt instrument and as such
investors earn a high yield (return) on it. Due to reasons mentioned previously,
HYBs are considered high risk and in most cases would rank junior to other debt in
the event that there is an unwinding of the company. Most companies would issue
an HYB when it does not have the cash flow to service the amount of debt at that
point in time. The underlying assumption in this case would then be that over time,
as cash flow improves, the debt will be serviced - hence the bullet repayment
structure.
Chapter 13: Managing the Assets of a Bank
Bank Management in South Africa - A risk-based perspective
•,-o-.-c-_---c._.,..,,~~~,•--
oo-.-c.•>"
There are two main markets in the DCM - primary markets
markets. New stock and bonds are sold on the primary market to investors. T
main institutions that raise funds in this market are typically governments (ors
government entities such as municipalities) and asset managers. The main bu
of stock in the primary market include banks, pension funds, hedge funds and oth
wealth-related funds. Existing (or previously issued) securities and stock are boug
and sold on the secondary market- these are usually traded on securities exchan
over-the-counter or on other trading platforms. If there is a strong secondary mar.
investment activity in the primary market is much more robust and frequent as
investors know they can liquidate their positions if the need arises.
From this discussion it should be clear that the DCM is very similar to the H
market. There are a few differences however. In addition to the reasons provide'
previously, these include:
■ In the HYB market, bonds are rated as sub-investment grade (a rating of BB ari
lower). hence their high yield and high risk; bonds issued in the DCM are rate,'
investment grade (rated higher than BB).
■ Given their risk profile, bonds issued in the DCM are more likely to be listed a
part of an index on the JSE.
As illustrated in Figure 13. 3:
■ There are various regulations governing the DCM - those imposed
Johannesb urg Stock Exchange (JSE), the Companies Act (71 of 2008), etc.
■ If the issuer does not already have an external rating, it would apply t
externally rated by any of the external CRAs.
■ Once rated, the issuer will issue a bond to the market, which is facilitated by
arranging bank. The arranging bank underwrites the issuance of the
(guarantee s to buy a large portion of the bond if investors do not) in a si
manner to an HYB.
■ Various investors such as hedge funds, asset managers.
institutions typically buy the notes.
interest on the bond is then paid to these investors.
The
■
Figure 13.3 Overview of a simple DCM funding
366
Je
CiiillnH''·theccimoarivcarHssU'ea•bo1
,re
:e-the8~Bton t
. . ··. . 1bftb 'buyfrii~r1Fot
fayJ~ against!~isissye~!)~~ir~~r
••• ~. •c~~a,p~~~Effa~~~x,
0
~:~"ct.::. "r~;i1Wr p;1~"k4r~i~l~t,r
South African banks prefer South African government bonds and local government
(municipal) bonds and notes. Although they do hold small amounts of equities
(shares) and other debt securities (mainly corporate notes and bonds), they select
these securities in order to best meet the objectives they set for the investment
portfolio. Very briefly and by no means exhaustively, the most common investments
that a South African bank would select include:
Governm ent bonds
These investments are lower in risk and lower in return due to the higher risk
rating of the government issuing the bond. South African government bonds
A bank also has an investment portfolio that acts primarily as a complement to the
loan book. The investment book:
has a lower degree of credit risk than the loan book
■
diversifies the composition of the asset book
provides an additional source of liquidity
generates additional interest income
fills up the balance sheet
enables geographical diversification
provides for certain tax benefits.
13.3.3 The investment book
•J"c?f/~
primary issues of bonds in the DCM effectively face the same risks as those in the HYB
ket. However, if the arranging bank is not able to sell all the notes on behalf of the client,
uld be more willing to hold notes issued in the DCM. Nevertheless, the most important
ture of a bank's de-risk strategy is that it provides an effective means for generating
idity. The reasons for a bank to sell the asset on the secondary market are mainly driven
the risk inherent in the asset and the liquidity position of the bank. Therefore, the method
de-risking is usually driven by the state of the economy - if the economy is healthy, it is
sy to de-risk assets; if the economy is not healthy, it is more difficult.
The DCM is regarded as being much more liquid than the HYB market mainly
because there are more investors that are willing to invest in these relatively
lower risk and secured bonds (as opposed to the typically higher risk and
unsecured HYB bonds).
Chapter 13: Managing the Assets of a Bank 367
,, ...• ,-, .;.
·•·"""'•"""
A bank may in some instances purchase a direct shareholding in a com:
and rely on the dividends as a source of revenue. In most cases this typ
investment offers the highest return, but also the highest risk as the eq
position of the bank ranks far junior to common creditors and other senior
providers .
Corporate bonds are an extremely popular investment for South African
mainly because they are the most common and frequently issued inve
available. South African banks usually take the credit risk on the und
issuer (borrower) and the majority of these bonds have a relatively long t
usually in excess of five years. The riskier the issuer and the longer the t
the higher the return for the bank.
Money market instruments
There are many types of money market instruments that a bank can inve
and these vary in complexity and risk. Tn general money market instrum·
are more liquid but offer lower returns. The money market does however
the highest rate of return for liquid funds.
Common equity
-.. ,_,,_.51 .. « ; : : ? f ½ ? . ? M . - = + 0 . ' Y , """~
By using the ladder (or spread-maturity) strategy a bank would spread its
investments over a certain period maturity proflle in order to ensure a stable source
of income. An example of this strategy is where the bank invests in bonds that have,
say, five, seven and ten year maturities respectively. When the five-year bond
matures the bank will refinance it, which will once again ensure that the maturity
profile is spread out over the predefined period. A feature of this strategy is that
there would be a wide interest rate spread across the different maturities for each
respective bond held in this portfolio.
The five investment maturity strategies are: 5
1. Ladder (or spread-maturity) strategy
13.3.3.1 Investment maturity strategies
The investment book of a bank plays a significant role in its liquidity manageme
as it enables the bank to sell its investments if it is in need of liquidity. It is therefo
vital that a bank manages the maturity profile of these investments so that a sou
mix of both short- and long-term investments are held on its balance sheet.
illustrate this more clearly, it would probably not make any sense if an individ
were to invest all their money in a five-year fixed investment as they would not
able to access any of these funds prior to the five year period lapsing. It would ma
more sense to have a combination of both short- and long-term investments as thi
would, on the one hand, ensure that short-term liquidity needs could be met, and o
the other, earn a higher interest rate on long-term investments. A bank will aim to
manage its investment portfolio in a similar manner by choosing between five
investment maturity strategies.
•
•
■
tend to have a medium- to long-term tenor, which in South Africa could
from five to fifteen years.
Corporate honds
368 Bank Management in South Africa - A risk-based perspective
369
A bank also has physical assets that make up a relatively small portion of its balance
sheet. These are typically in the form of both fixed and moveable property.
A bank aims to keep its fixed property as low as possible because it does not
want to incur the maintenance costs associated with it. ln many cases a bank leases
the office space where its head office is situated and may even do so for the branch
network. In such cases, the bank may finance the landlord for the development of
the property and once completed, lease the property from the landlord. Typically,
owned properties do not exceed more than about 15% of a bank's total property
requirement. Since property finance makes up a large portion of a bank's business.
there are instances where the bank has to repossess a property due to client default.
Even though the bank has a mortgage over the property. it never takes ownership of
it as the title deed never transfers onto the name of the bank. As a result, a bank will
not add repossessed properties to its balance sheet.
Movable property on the other hand typically includes the equipment (computers,
desks and chairs) banks use to perform their day-to-day operations. Similar to fixed
property, a bank will also try to lease as much of this equipment as possible as it allows
for a significant operational advantage - if a computer fails, or a desk or chair breaks,
the bank is able to return it to the lease provider in exchange for a new one. Most of the
equipment within a bank is leased and the maintenance of these is also outsourced. As
with fixed property, a bank does not want to spend its time maintaining the equipment it
uses. so it makes good business sense to use several service providers to lease from.
Front-end load maturity strategy
front-end load maturity strategy requires that a bank only invests in short-term
stments. This will aid its liquidity and minimise losses as the bank will be able to
idate its position much more quickly.
Back-end maturity strategy
e back-end maturity strategy is the opposite of the front-end strategy and requires
at a bank holds investments with a much longer maturity. In doing this, the bank
,timises its returns due to the higher risk associated with the longer maturity, but
tentially jeopardises its ability to generate liquidity in the short-term.
Bar/Jell strategy
e barbell strategy is one where a bank would apply different maturity profiles to
'ferent types of investment. Most banks would apply this strategy as it ensures that
portfolio has investments with both long-term maturities (more risky, but higher
turns) and short-term maturities (less risky, but lower returns). It can be expected
at the liquidity position of a bank at a certain point in time would strongly dictate
hether or not this strategy will be applied.
5. The rate expectations approach
inally, the rate expectations approach calls for shifting maturities towards the short
end if rates are expected to increase and towards the long end of the maturity scale
if interest rates are expected to decrease. This approach requires active management
,y the bank and requires an in-depth understanding of the condition and
tendencies of the financial markets from which these investments are sourced.
Chapter 13: Managing the Assets of a Bank
CONCLUSION
Bank Management in South Africa - A risk-based perspective
Edwards B. 2006. 'High Yield in France.' http/ /www.lw.com (Accessed April 2013).
Epstein G. 2005. Introduction: Financialization and the World Economy. Cheltenham
and Northampton: Edward Elgar.
Rose P & Hudgins S. 2013. Bank Management and Financial Services. 9th ed. New
York: McGraw-Hill/Irwin.
Reinhart C & Rogoff K. 2010. This Time is Different: Eight Centuries of Financial Folly
Princeton, NJ: Princeton University Press.
Moody's KMV. 2008. 'Overview.' http/ /www.moodyskmv.com (Accessed April
2013).
..,-.,-......._ , . ~ ~ - = ~ 7 ~ ~ = " " ' " = = ? > " " ~ - - .
5.
3.
4.
2.
1.
REFERENCES
The next chapter discusses the management of liabilities and highlights that.
with assets, liquidity and return are central driving forces.
This chapter discussed the main assets of a bank, which consist mainly of
loans. Cash is regarded as one of the best assets that any company, private indi
or bank can have as it ensures sufficient liquidity. However, if cash is merely s
it does not earn a return. A bank can therefore invest its cash and earn a rela
low return in various low risk investments, or, alternatively, it can lend
customers in order to make a higher return. The latter is what shareholders
bank would prefer and it also minimises the risk/return trade-off.
Loans can also be liquid and there are several techniques a bank can use to
or de-risk, its assets. These techniques vary from relatively low risk and ea
execute loan syndication to relatively high risk, but more difficult to execute H
Liquidity is however not the only factor influencing a bank's decision to sell an a
Other factors include the state of the economy, whether or not the bank's exis
portfolio is concentrated in a specific sector, or it could be a simple invest
decision. It is for these reasons that a bank will decide to buy assets on the secon
market in order to increase the size of its balance sheet and subsequently incr,
its returns. If a bank has sufficient liquidity, but docs not have strong relations
with its larger clients, it may decide to buy an asset from another bank in order
grow the balance sheet and gain access to the client. Liquidity and return a
therefore the two main driving forces influencing a bank's strategy to manage '
assets.
13.4
370
INTRODUCTION
A bank's income-earning assets are generally considered to be central to its
existence, especially in its intermediation function. Generally a bank would aim to
borrow funds from depositors and the South African Reserve Bank (SARB) at a low
interest rate and then lend this to clients through, for example. mortgages and
vehicle loans, at a higher interest rate: the difference is called the interest rate
spread, which is the net interest income generated by the bank. By implication, the
more financing a bank can generate at low interest rates, the more likely it is to earn
a larger spread and be more profitable.
Where assets are the 'use of funds', liabilities serve as the 'source of funds' for a
bank. Deposits from clients are regarded as the most important source of funding for
a bank for two reasons: first, they are cheap (think of the low interest rate you would
earn if you made a deposit at a bank); and second, they are relatively easily
obtainable (think of how many of us would want to make a deposit at a bank in
order to earn interest). Other important sources of funds include the SARB. from
which South African banks borrow funds at the repo rate, and other banks, which
are usually each other's largest clients, as they will borrow from each other through
the interbank lending market. As a rule. banks try not to borrow from other banks
or the SARB as it is relatively more expensive for them: in many instances, however,
they are forced to do so, especially given that they are not always able to raise
sufficient funding from normal client depositors. Funding from depositors is mostly
'on demand', meaning that the depositors are able to withdraw their funds at any
time - for this reason, funding from other banks and the SARB may be preferred, as
funding can be arranged over a longer term.
Jter reading this chapter, you should be able to:
identify the main liabilities on the balance sheet of a bank
explain the difference between deposit and non-deposit liabilities of a bank
explain the closed and shortage system within the banking sector
identify the role of interbank lending in the financial system
explain how a bank creates money through the reserve requirement
discuss the source of funds approach to managing liquidity for banks
calculate and explain how banks can manage the liquidity gap
identify and explain the methods for estimating liquidity needs
have an in-depth understanding of the role that bank assets and liabilities play
in managing bank liquidity
know how to develop indicators to identify liquidity shortages.
£ARNING OBJECTIVES
Liabilities of a
THE LIABILITIES OF A BANK
Deposits
~----=-.'-""'ll "'l.~"'~-"'.•~. \l\\l_«'-""',;'1
'-ll'l.,.._~-,•- •--=~
•
·---- ~--- ·
Deposits usually make up the largest portion of a bank's liabilities, mainly
banks are able to raise deposits at lower interest rates compared to other liabilities.
from
Deposits are made up of those from retail customer s (individuals) and those
split
be
can
and
s)
companie
or
ns
(institutio
s
wholesale customer
14.2.1
Figure 14.1 Sources and uses of funds
As established in Chapter 1, banks are considered to be one of the most impor
vari
financial institutions in any economy as they organise funding through the
inje
be
to
money
for
method
main
the
is
this
clients
their
to
provide
they
loans
ba
into the economy and a central feature of monetary policy. For this reason,
vari
The
s.
customer
their
to
lend
to
order
in
must borrow from various sources
types of bank liabilities can be split into three categories, namely deposits, non-dep
sour,
borrowings and capital (see Figure 14. l ). Funds generated from these three
importan
is
It
clients.
to
lent
be
can
that
funds
is,
that
are called 'available funds'
realise that these liabilities are costly to the bank: deposits and non-deposit borrowi
p
require the bank to pay interest expenses, and capital, besides implying ownershi
bank
a
how
therefore,
n
implicatio
By
.
payments
dividend
requires
shareholders,
vital
able to use the source of funds on the asset side of the balance sheet is
survival.
ensure
to
also
but
ty,
profitabili
ensure
to
only
important, not
14.2
A further source of funds for banks is sharehold er equity - that is, the capita
sharehold ers provide to a bank as a source of funding. Most large banks acr,
world are listed; in South Africa all the main banks are listed on the Johann
Stock Exchange (JSE). The sharehold er equity for a bank is thus considered to
stock traded on the JSE, which in most cases is a relatively low cost fundings
fl
for a bank. In summary, therefore, if a bank is in need of funds, it raises
capit
raises
or
SARE.
the
or
banks
other
from
borrows
through its depositors.
the equity market by issuing more shares and thereby increasing traded equity.
following few sections will describe the above in more detail.
372 Bank Management in South Africa - A risk-based perspective
373
nsaction deposits or non-tran saction deposits. Transact ion or demand deposits
and
those which a client can withdraw without any limitations or restrictionsl
usually payable on demand - a client can withdraw the funds at any time (this
the
buld be, for example, via an ATM withdraw al or an instructio n to transfer
or
savings
include
deposits
on
transacti
of
Examples
oney to a third party).
as
eque/cur rent accounts. These deposits are usually unfavourable for a bank
will
bank
a
result,
a
As
funding.
of
ey are inherently an unstable source
a low
iscourage clients from making these types of deposits by offering them
of
nterest rate - if a client decides to deposit the funds for a longer or fixed period
the
effect,
in
So,
rate.
interest
higher
a
with
client
time, the bank will provide the
be the
longer a client is willing to commit their funds to the bank, the higher will
longer
ing
encourag
of
feature
return that the bank is willing to offer. This built-in
\;term funding sources is a vital aspect of liability managem ent.
Given the very nature of a bank in using liabilities to fund assets, an unstable
(or
source of funds raises an importan t risk associated with the intermed iation
rm
longer-te
fund
liabilities
m
short-ter
unstable
antly
predomin
funding) model
to
assets. Associated with this is liquidity risk and interest rate risk - a bank needs
the
and
risk)
(liquidity
funding
of
stability
and
•manage both the availability
volume
maturity mismatch between the assets and liabilities (interest rate risk). The
just as
and maturity profiles of liabilities on the books of a bank are therefore
ility
asset-liab
of
feature
central
a
is
This
importan t as the types of liabilities.
11.
Chapter
in
discussed
as
ent
managem
The second type of deposits are those of a non-tran saction (or time) nature.
if any,
These deposits are usually interest-b earing and have either very limited.
as
transactio n-related features. Examples include call accounts . time deposits (such
deposits
of
s
certificate
e
negotiabl
deposits).
fixed
32-day notice deposits or one-year
(NCDs) and money market deposit accounts (MMDAs). Call accounts and MMDAs
are deposits that offer higher interest rates depending on the size of the account
ed in
balance. Normally a minimum balance, of say R20 000, must be maintain
amount
fixed
a
to
either
limited,
are
als
withdraw
and
rate
higher
the
earn
order to
the
or the number of withdrawals. MMDAs are typically transacti on accounts with
to
attached
rates
interest
The
rate.
interest
higher
a
added benefit of earning
n,
MMDAs are also directly linked to rates in the money market. so by implicatio
that
these rates are higher when compared to other deposits. Time deposits are those
can
they
which
upon
time
ined
predeterm
a
for
funds
commit
to
allow the depositor
the
either reinvest or withdraw the deposit. Certain types of time deposit require
example.
For
available.
are
funds
the
before
depositor to ask for notice of withdraw al
n.
a 32-day notice requires a notice period of 32 days before funds may be withdraw
fixed
Without notice, the funds may not be withdraw n. Alternatively, a one-year
unless
deposit can only be withdraw n one year from inception and not before then,
savings
normal
a
to
similar
very
is
NCD
An
.
depositor
the
by
incurred
is
fee
a penalty
account with the only difference being that it is usually for a fixed term (anything
it.
from three months to about five years) and has a fixed interest rate attached to
A typical feature of non-tran saction deposits is that the bank offers higher
d for a
interest rates to clients. but requires in return that the funds are committe
Chapter 14: Managing the Liabilities of a Bank
Bank Management in South Africa - A risk-based perspec
tive
14.2.2 Non-deposit borrowings
,In some instances, a bank is unable to raise sufficient deposits
from its
base to facilitate its lending activities. Keep in mind that the attracti
on of deposi
as much an exercise in market ing and advertising as it is in
offering competi
returns . If clients are not attracte d to a bank's brand, for exampl
e, a competi
interest rate may mean nothing . The attracti on of deposits
is therefore in itsel
volatile and risky proposition if it is the only means of ensurin
g a stable source
funding. In this case banks will be forced to borrow funds from
two main source
the SARB and other South African banks.
If banks borrow from the SARB, they are charged the repo rate.
This type
borrow ing is generally more expensive than raising funds through
deposits as t
repo rate is higher than the rate a bank would charge its custom
ers for a norm
deposit. In addition, the SARB does not have unrestr icted lending
capabilities - th
is, depend ent on the prevailing moneta ry policy stance of the
day, the SARB is ab!
to influence the supply of money in the economy. Thus borrow
ing from the SARB i
neither a given nor a guaran tee that it will pay repo. The
underly ing marke
conditions and the SARB's interpr etation thereof with regards
to moneta ry polic
is central to the conditions under which the funds may be borrow
ed. Further mor
the SARB acts as the so-called lender of last resort - that is,
to be a lender when n
other lender is willing to be. In South Africa, the SARB acts
as the lender of las
resort to any of the large banks in order to ensure that
no bank is faced with
liquidity problems. Failure to do so can result in liquidity
problems in the entire
bankin g industry.
ln most financial markets, banks extensively lend money to
and borrow from.
each other - this is called interba nk lending. Because the South
African banking
industr y is relatively small in compar ison to its interna tional
counter parts, the local
banks are in a unique situatio n where they are each other's
largest clients. ln most
cases banks have facilities (accoun ts) with each other that are
set up in such a way
that funds can be transfer red easily from one bank to another
. Basel II and Basel III
require banks to have minimu m liquidity in the form of cash
or near cash in order
to mitigate the risk from a sudden increase in withdra wals
by clients. lf the bank
runs the risk of breachi ng this minimu m amount , it will borrow
from other banks
in order to fund the shortfall. In South Africa, banks use
the Johann esburg
Interba nk Agreed Rate QIBAR) to lend to each other.
longer period of time. By limiting the numbe r of transac tions
allowed, the sta
of these deposits as a source of funding is further enhanc ed. Ideally
a bank wa
have a stable source of funding that is not sensitive to withdra
wal, even in tim
economic stress. These so-called core deposits are vitally importa
nt to ensure as
source of funding, in particu lar for the grantin g of loans.
Therefore, in or
encoura ge a more stable source of such core deposits, a bank
can offer higher
more competitive interest rates, but not to the extent that
the interest expen
excessive or comparable to the cost associated with borrow ing
from other bank
the SARB. Limited withdra wals and transac tion-rel ated features
further enhan
stable funding source.
374
Equation 14.1
In order to maximise net interest income, a bank wants to
source funds cheaply
(from depositors. the SARB or other banks) in order to increas
e the spread it earns.
However, it is required practice to ensure that it keeps some of
its deposits as a reserve,
meanin g the bank cannot lend out all the money it receives from
depositors as it may
3
at any momen t be withdra wn by the depositors. Basel II and
Basel III also provide
detailed guidelines on how to adequately calcula te this minimu
m reserve amoun t
Interest rate spread= Interest income - Interest expense
14.3.1 Extending loans
The most common way for a bank to manage its liabilities, or deposits
. is to extend loans.
Extending loans is the core business activity of a bank and the
interest generated from
these loans can sometimes contribute almost: 60% of total income.
Banks need to price
these loans in such a way that they earn a favourable interest rate
spread:
14.3 USES OF BANK LIABILITIES
Banks must carefully plan the ways in which they use their funds
in order to ensure
that they make a return that exceeds the cost. This section
explains how banks
manage their liabilities in order to maximise profits, whilst at the
same time ensurin g
sufficient liquidity.
4.2.3 Capital
'he capital of a bank is theoretically the difference betwee n its
assets and liabilities
(it is also called net worth or equity). Technically speaking. althoug
h capital is not a
liability, it is still owed to its shareho lders - if the bank is liquidat
ed, for example, the
capital value would go to the investors. Therefore, just as deposit
and non-deposit
borrowings are costly to a bank (via interest expense), holding
capital is also costly
as shareho lders expect dividends on their equity holdings, which
is a function of the
net profits generated by the bank. Further to this, the more
capital a bank holds
· (wheth er legally required or not), the less it is able to lend
to potentially profitable
customers. Therefore, althoug h capital manage ment is strictly
governed by the
Basel require ments in South Africa. there is. as with holding
too much cash in
liquidity manage ment. an opportunity cost for holding too much
capital. Chapte r 15
provides an in-depth discussion on capital adequacy.
.... • ....
·~t-
Bank Management in South Africa - A risk-based perspective
The shortagegystem
. . . . . :•.~_.7,...
< ~ - - - ...~"'"""'
>
. .1fh~f£f~se-d money
f;.ltJs,-1mportant to consi.1'1~rt2efl0Wofrnoheywhen
)'the following fourscehariosdepict this in Figure 14.3:
tylt~fu
Ab~~k r~ceives a ·#~~~sitiBt R1.0() .6rWhich'.if.~ill.keep;~;~~S~s
• .• mea2~that the bar~t~~n'.:.rd R97,50,Which mayt~:2}P: i2iE!~f~dJnte
.·• through inoar'i';'Th.is:J~firtu.rr.•spent on pur~ha~ing· 9?~~~/?t:~e"-'i8El~a2
redeposited .at •anot~erban~.Ofhe.dE!posit •.of R~r,soc~rl~?9pe·.10.anE!.~jt~~
client; but thereserv!i'j~f 2,5.'Yo·alsoapplies.·wi.s· .meiihs;f2.a~)~~5,2~j~loane,
res~rveof 'R2;40 is ki"t'~J-Th_iscontinues as .me·number,of tr~~.sa?tionsa
relen'clihg cbritinue'.So;foran initial amount of R100, a rippl~E!ffEl?t
/smaller
is.called the shortage system in the supply
-~-<
-·
.a-·each time) wliich
•...
. Figiiii14.2
.'Thti~~~rtage s~~fe~>/• >\\ i?·/·.•••·•·.•••·····• •. •.• ·· •
Alt~8ugh banks play an integral rnre in the etdnomy Xherl1&rdr211,~~~
• le~tjfs dependent an/he ITlinimam reserve requirement. The CUrrElntrE!~
>tequlren'ient in Sootti}i\frica is2;5% of a bank's total deposits,4 whic~pii~"t:
:either in the form of·6ashor inthebank's reserve accountwiththeSARB.T,
+following example explains MW this reser'lie tequirernehflnfluehcesfhe}sti
,:mon:ey (see Figure t4.2), •
[[@'iJiscassion'f~/a(tlas •focused ·on •th~ifability ~~§~fs(>n t~&@~i~11de
:;nk>Bot;,What·•·h:;~!:si~the·.econom•yt~tthese·activities•·occur?
- in South Africa, these guidelines are incorporated in the Banks Act (94 of 1
Section 10A(2]).
376
Bank Management in South Africa - A risk-based perspective
.•
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•t.···.····.·.•.•.•.•o
c·.·•.· • ·e·•.· ·. •· •· •·a·.•·. g·.• · .· •.·•.•· •·. a. ·.·•. n•.· · ·.• ·.• .••.·•·n. ·•.o.':lfu.• . •.· •. •.n·. .·.•d·•·• .•· .•s•.· .•· .· . .·• '•. •e•·. . . •. a·. •.·•. ·•. ·v•.·e B·.· •a·•.·• ·.·.•·.•·.n·•.k·•. ·• ·• .·• ·•.A• ·• ·. •· .• .·•. •.
.,...,.,.,... ___==----~~-._,.,,.-,_=~ ~~
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When a customer makes a deposit into a bank it becomes, in a sense, the property
of the bank - the client receives an 'asset' in the form of, say, a savings account
(bearing in mind that the savings account is a liability to the bank). Because banks are
only keeping a fraction of the deposit as reserves (2.5% in the case of South Africa).
clearly the bank reserves on hand are insufficient to meet the demand of all its
depositors at once. For this reason, it is assumed that not all customers will demand all
their deposits hack at exactly the same time. If. however, there is a run on the bank,
•• the demand for deposits will far outweigh the reserves. suggesting that the bank will
.,.•,«
As indicated in Figure 14.2. banks are required to keep a portion of their customer
deposits as readily available reserves, which can be in the form of either cash or
deposits at the SARB. In effect, the SARB regulates the value of cash reserves banks
need to hold by imposing this minimum reserve requirement. In March 1993, it was
decided that the minimum reserve requirement would be included in Section lOA of
the South African Reserve Bank Act of 1989 2. Also. Basel II and Basel III impose
several reserve requirements to ensure that a bank is able to meet customer
demands and absorb credit losses.
14.3.2 Reserves
The above four scenarios are examples of what is called the closed system - when fr
deposit is transferred, it is usually from one bank account to another and no money
leaves the banking system. The only time money will leave the banking system
briefly is when a customer withdraws cash at an ATM. This is however only briefly
as the customer will spend the money, which will in turn re-enter the books of .t
particular bank. The flow of funds is therefore always within the banking system.
thedaposit;bbt as mentioned in scenario 13, Bank B Will
;withcBank Mita higheffate, tdearnmore interest.
suppiier'sa6&ounf~t]~ah~:~iAgairi,.Elank••.Efv.iillhaveJq
Sl3ankAtJhe·tondsWillbe transterredfrom Client A's accounfat Ban·
/;cJ~~~;.;_~;rh6~~ki;i11ie.suppHer in 'Scena.~ob ban~!~i!t Bark
•..
.•.t
·
. ••.•.• •. • .• .•·.e·. f e·.· c•· •· ·.·. • . •· .'·•·•s .· ·•.· .·.•t.••.•.·• ·h• · •· •.·•.a.·
• ;j;lunfJ~toj5ay, •. say, it.l~[?e· supplier r,'~d .ihcid:~t~lly als?·?~.".~?~it~
• rmoffeyV1iHpe transf:.t~?f~O~Clit9r!A'S ~ccountto the supplier's a,
.1.1clMario/6Iq~B'1A~f
J1~At!ife~oni~ jj9fi~~ri :~~<I!!~Jtter di
f Bank A'stlqbiclity positron,,
:witfiora~Jhe .initi~l~~P?sit. The neit effedJsstill thartherawill . be
tmoriey. In (lrder to ~~~o .it ~an deposit.the~o~:Y 'Ni[~tB!~~:'A
•/the•e~:!~8Y/a,:El;payirg ,pltert A. As ~res?lt, ~~rk B.~ill :~t~ a. . . . •// . •· ..· •·
)difference betweenf~ti.interestiear~ed fromi~.ank A an~.th.ti)ntares.!'P~I?ffh
=9ank;B11eeds to eh~?re that it~as ~uffi~ientftJ~ds whe,~f~![~nt A decides lo
§I inttir'Eiston;the R2 ?iHion deposit, but it WiUl!l~o want Ie:!r~ some interest
} Bank~ has Fl2 bilUon :xtra funds as a liability:Bank B<r.~~has to p~r~Hen
>Sc~1afi6B,:lf.Cliefi.!~~.~.~tsto hav:.!~e··mOney ihiit~.~a~~~#§fo&~tl <
/ .Bahl( A•t.~e latter v.,ilJt.~~nsfer the money out.of its· owr !c~.ount··to~!nk)f••
378
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~ - r y . ____ ,..,.,.,-,·•~-.,.--
~ ~ ~ ~ ~ - - - 5 = - - > _· -''!JI'~·,,,
In South Africa during 2011 and 2012 banks experienced a slowdown in their credit
.extension largely due to the slowdown in the economy on the back of the GFC. During
this time, however, many South African banks experienced an increase in their
deposits and especially in those from large companies. One major reason for this was
that many companies decided to remain liquid whilst waiting for the economy to
improve before committing to any investment or acquisition opportunities. As a
result, local banks experienced an increase in the number and value of deposits
during this period. 3 Surely, then, this situation is a favourable one for the banks? If so,
what could the banks do with all these deposits?
Typically, if a situation like this arises, a bank will try and lend the excess liquidity
via the interbank market to other banks that are in need of liquidity. This is usually
done for a very short period of time (mostly overnight. but could also be for up to a
week) and at the prevailing JIBAR. The interbank market performs a very important
function with regards to liquidity management by banks. Some of the main roles that
interbank lending plays in the modern financial system are highlighted below.
Support banks with their minimum reserves requirement
■
When a bank does not comply with the required minimum reserve, it will
borrow from another bank that has sufficient deposits to cover its minimum
reserve. In this instance, the bank lending to the bank in need alleviates
pressure from the SARB to make the loan.
Manage liquidity risk
■
A specific bank may have a large liability (deposit) due in the short-term and
not have sufficient liquidity to fund this payment. With the interbank market,
this bank can obtain a loan from another bank to service this liability.
Key role in the derivative market
■
When a bank offers an interest rate swap to a client by providing them with a
14.3.3 Interbank lending
eed to borrow, from the SARB or other banks, to fill this gap. The lender of last resort
unction of the SARB is therefore a vitally important role for banks in times of distress.
Given that banks grant many different types of loans, the reserves can add up to
e quite substantial. Because a bank is not allowed to lend these funds, it has two
23
ternatives. First, it can deposit it at the SARB and earn very little (if any) interest. •
all the commercial banks in South Africa were to do this, the SARB would have a
·ery large pool of funds invested with it and may decide in turn to invest at one of the
ommercial banks. If the SARB decides to invest a portion of this pool at any of the
ommercial banks in South Africa, the commercial bank would be allowed to treat
this deposit as part of its own reserve requirement, as it will not be allowed to lend
these funds; however, it would need approval from the SARB to do this .
The second alternative for a bank is to store the reserves physically as cash in the
. vault of the bank. In most cases this would be the least desired approach for both
the bank and the SARB as the funds will not assist in the creation of more money in
the system and neither the commercial bank nor the SARB will earn any interest.
The opportunity cost associated with holding the reserves in cash will therefore
.· become an important consideration for the bank,
Chapter 14: Managing the Liabilities of a Bank 379
fixed interest rate, the bank can buy the latter rate from another bank and se
the variable rate it would have charged the client of the other bank.
Banks have various financial market instruments at their disposal to loan
deposits to other banks (or to make investments in other banks). The followi
are amongst the most common:
- Negotiable certificates of deposits: Through an NCD, a liquidity-selling
will inform another, liquidity-buying bank that a certain amount of mane
was deposited with that bank and that the funds would be redeemed at th
maturity date with a certain amount of interest.
- Repurchase agreements (repos): Repos are agreements between banks
the lending bank agrees to sell a security to a borrowing bank and then als
agrees to buy back the security after a certain period of time at a given price,
Bank Management in South Africa - A risk-based perspective
The liquidity gap is simple to calculate as it is merely the difference between
demand for funds (an outflow from the bank) and the supply of funds (an inflow to
the bank). A positive gap suggests excess liquidity and a negative gap a shortage in
liquidity. For the former, the bank would need to invest the excess liquidity in order to
Liquidity gap = Inflow source or supply of funds - Outflow use or
14.4.1 The liquidity gap
A liquidity gap can be defined as the difference between a bank's total use of funds
(through the total liquid assets) and the bank's total source of funds (through the
total liquid liabilities). By establishing this gap, a bank is able to assess its overall
liquidity position and provide one measure of its financial risk regarding its liquidity.
The liquidity gap is thus:
14.4 LIQUIDITY MANAGEMENT
By managing its assets and liabilities a bank effectively manages its liquidity.
example, if a bank has a large customer base it will also usually have a larg
depositor base. This in turn suggests that it will most likely have a strong liquidit
base. In times of economic slowdown, depositors tend to use their deposits to fund
their lifestyles - this typically forces a bank to sell liquid assets or call in short-term
loans in order to fund the demand for liquidity. If a bank only extended long-term
loans it would be in serious trouble as it would not be able to fund depositors theit
money. If this is not managed properly, this situation can cause a run on the bank. It
is therefore important that banks manage the mix, volume and types of assets and
liabilities it holds in order to manage its liquidity position.
This section has established that banks use their liabilities in three main ways: to
to customers to earn a spread; to keep reserves to ensure they have sufficient fun
for on-demand withdrawals; and to lend to or invest with other banks. Underlyin
these three uses is the ability of the bank to properly manage its liquidity. This is th
focus of the next section.
380
381
Managing cash and liquidity in this context is like managing commodities; just as
supermarkets handle food and domestic essentials, banks develop highly efficient
models and actively get involved in managing liquidity rather than merely monitoring
events. The process is therefore dynamic and requires a proactive approach. Waiting
for events to occur can, in this case, be detrimental to the liquidity position of the
bank. Therefore, banks must measure their gross outflow and inflow of funds on a
daily basis and ensure that they have good relationships with other banks in the event
that they need to borrow from them.
Managing the liquidity gap is a crucially important function in banking. Sometimes,
however, banks struggle to manage their liquidity positions. Some of the most common
reasons for this include: 3
■
the lack of comprehensive and real-time information
■
poor systematic understanding of the behaviour of their customers
■
limited ability to store and analyse historical cash flows and customer behaviour
■
limited use of systematic processes to predict future customer behaviour
■
poor processes to capture cash movements from across the bank
■
inaccurate intraday (within the day) and end-of-day position forecasting.
avoid the opportunity cost of holding it in liquid form; for the latter, the bank would
need to acquire (or source) funds from somewhere in order to meet the liquidity
demands.
Chapter 14: Managing the Liabilities of a Bank
Methods for estimating liquidity needs
=~--="'"'"'";-:~..,_~- ~."-.~·-=
14.4.2.1 Estimati119 the source a11d the use of fu11ds
By estimating (or forecasting) loans and deposits for a specific period a bank is able
to determine the value of funds that will flow in and the value that will flow out. It is
important that a bank understands where it will source funds from (including
customer deposits, funds borrowed from the SARE, or funds borrowed from other
commercial banks), and also the accessibility of these sources (for example, how
willing would other commercial banks be to lend the funds, or does the bank have a
These are discussed briefly below.
There are a few methods that a bank can use to estimate its liquidity needs in order
to close the liquidity gap. The common methods include:
estimating the source and the use of funds
■
developing indicators for liquidity
■
market indicators.
■
14.4.2
Two common ways of managing the liquidity gap are through behavioural cash
analysis and cash matching:
1. Behavioural cash flow analysis
Behavioural cash flow analysis can be applied to both intraday and future cash
and is a key risk management tool to accurately predict cash movements frc
multiple sources. The accuracy of predicting intraday cash flows can be significan'
increased through, for example, an insurance company regularly receiving inco
from insurance premiums via direct debit order. On receipt of the income, t
insurance company has to utilise the cash - much of it will flow out across the sa;
day payment systems, perhaps into short-term deposits, securities purchases a
other investments. By understanding their customers' businesses, banks c
balance the flows across the retail payments network with the same-day flo
across the intraday payment network.
2. Cash matching
Cash matching is a simple method to manage the liquidity gap and involve
managing the periods of cash inflow and outflow respectively. For example, a die
has a deposit maturing in six months time and has indicated that the deposit is.
needed upon expiry. The bank will then aim to ensure that it also has a loan that
matures in six months that matches the size of the maturing deposit. The net effect
is that the cash flows cancel each other out (that is, are matched).
In theory, managing liquidity is not complex. However, in practice it is not
simple. This is because it demands a full and timely awareness of all the sourc
uses of liquidity across all instruments, account balances. and the entire spec
of business units within the bank. Depending on the source, customer or ty
transaction, the liquidity manager (in the Treasury department of the bank)
different levels of liquidity management; those who manage the day-to-day liqui;
gaps/surpluses and those who manage liquidity on a more strategic level.
382 Bank Management in South Africa - A risk-based perspective
•• .. YP>~0
383
__ 0·.c~•~ ➔
__ .•,.,~,---.··,·
14.4.2.2 Developing indicators for liquidity
There are various factors that influence a bank's usage of liquidity (especially
intraday liquidity). For this reason, it is very difficult to identify a single indicator
that can provide sufficient information about their respective liquidity needs. Banks
therefore use a combination of liquidity indicators to monitor liquidity needs:
Daily maximum liquidity requirement
This indicator measures a bank's maximum liquidity required per trading day
and can be calculated by measuring the maximum outflow of funds a bank
encountered per day over the past few weeks and then make the assumption
that it would need a similar amount of liquidity in the next few days.
Available intraclay liquidity
■
Once a bank has determined its daily maximum requirement, it can calculate
its available intraday liquidity. This is done by measuring its current level of
deposits and then determining how much of this will most likely be an outflow
during that day - either through, for example, withdrawals or loan payouts. If
the bank does not have sufficient deposits to fulfil these needs, it will most likely
borrow from another bank overnight in the interbank market.
Time-specific and other critical obligations
■
Banks can also measure the volume and value of their time-specific and other
critical obligations. More specifically, this would entail formulating an agreement
with another bank to fund minimum reserve requirement over a certain period of
time, or obligations that cannot be neglected.
rge enough customer base lo provide it with sufficient deposits?) In doing so, a
nk is better able to establish the likely uses for these funds.
Chapter 14: Managing the Liabilities of a Bank
Intraday loans extended to financial customers
Banks will monitor and measure the amount loaned to other banks. This
extremely helpful as banks usually only lend to each other overnight, suggesti
their high degree of liquidity, as the bank would be able to call on this very quick
and easily. This type of indicator also measures the bank's relationship with oth
banks - the better the relationship, the easier the access to this liquidity.
Bank Management in South Africa - A risk-based perspective
~ - - ~ - , • • , ~ · , . , , , 7 " ' , x J / 3 2 V / . Y - . · ..<•·•••·•.- - - - - - ~ - - • - ~ ~ - ~ -
14.4.2.3 Market indicators
A bank can also look at the market conditions to determine whether or not it will
have liquidity constraints. The most common market indicators include:
Interest rates and market liquidity conditions
•
Interest rates are a good indicator of market liquidity. If interest rates are relatively
low for a prolonged period of time, it encourages risk-taking and excessive credi
growth because debt is regarded as cheap. At the same time clients would b·
discouraged from making deposits or investing their money in banks because the
will not earn a high enough rate of return. A situation where both of these a
occurring simultaneously (an increase in debt and decrease in deposits)
damaging for liquidity. The opposite is also true: when interest rates are high, debt is
expensive, but deposits will most likely increase as clients will want to earn the
higher rate of return.
Asset prices and bank lending crHcria
•
If banks lower their lending criteria or become less strict in terms of lending,
more clients will have access to loans. IT there is an increase in, say, mortgage
loans more houses would be sold for higher prices as the demand increases. This
will most likely push up the prices of certain assets (in this example houses) to a
level that is higher than their underlying (and realistic) value. This is commonly
called an asset price bubble and tends to create unrealistic liquidity conditions,
as most clients will think their assets are worth more than the actual price. In
other words, the more credit clients are able to get, the more expenditure
increases, resulting in increased market activity that pushes asset prices higher.
The moment credit extension falls, however, so too will market activity, and as a
result, asset prices will decrease from the inflated values to more realistic actual
values.
Uncertainty and risk appetite
•
A further market indicator is risk appetite, especially the appetite banks show
towards each other. If the risk appetite is high, banks will readily lend to each
other, especially if one of the banks is in need of liquidity. Conversely, the
opposite is true; low risk appetite, especially during a subdued market, results in
banks not readily lending to each other. In such a situation, banks will be forced
to borrow from the lender of last resort, the SARB. Should the news spread that
a particular bank had to borrow from the SARB, it is very likely to have a
knock-on effect that results in the risk appetite for each bank reducing even
further. This clearly has systemic risk implications.
•
384
385
F
.. •'='>-'•••,-,.,•-•
-•••••••••••••••
REFERENCES
Thomas, L. 2005. Money, Banking and Financial Markets. London: Cengage
Learning.
2. Van Der Merwe, E. 2015. 'Monetary policy operating procedures in South Africa.'
http//www.bis.org (Accessed 2 July 2015).
3. Esterhuysen, J, Van Vuuren, G & Styger P. 2012. 'Liquidity creation in South
African Banks under stressed economic conditions.' South African Journal of
Economics 80(1): 106-122.
4. South African Reserve Bank. Banks Act of South Africa (94 of 1990). http//wwW,
rcsbank.co.za (Accessed 4 July 2015).
CONCLUSION
As mentioned throughout this chapter, a bank acquires funds from various sources
and pays a certain price (interest) for these funds. The bank then loans the funds to
its clients at a price higher than it paid for them, thereby generating net interest
income. Embedded in its role as a financial intermediary, this source and use of
funds speaks to the very core role of a bank. The lower the cost at which the bank is
able to source funds on its liability book, the larger the margin it can charge its
clients. The ability of a bank to manage its liabilities in such a way that it can
ultimately generate net interest income, whilst at the same time maintaining
liquidity is a central feature of liability management. This is a particularly crucial
management function, given that the maturity prolile of liabilities (shorter term) do
not match those of the assets (longer term). This maturity mismatch is in essence
the structural challenge every bank has on its balance sheet, hence the importance
of liability (and asset) management.
Capital Hows and international reserves
The last set of indicators that can measure liquidity relates to capital flows and
cross-border credit. Recently emerging markets have become an important
investment opportunity for the world mainly due to the strong growth
experienced in their economies when compared to the developed world. Given
that strong economic growth usually goes hand-in-hand with high credit
growth, it suggests an environment in need of liquidity. If, in this case, the
emerging market cannot create this liquidity within its borders, it will borrow
from other countries through cross-border lending facilities. For this reason it is
important to monitor cross-border lending as an increase in this suggests higher
liquidity demand, especially if it is coupled with increasing credit extension and
strong economic growth.
Chapter 14: Managing the Liabilities of a Bank
-•·""""'""''''·'"·\"
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OBJECTIVES
········
------ ~---- -· ................•··-···..
1980s.
The evolution of capital standards, from I3asel I to Basel III. mirrors changes in
the environmen t in which banks operate and changes in the instruments and
processes used to measure and manage risk. For example. the original capital
standards under Basel I used a simple metric to determine regulatory capital
charges for credit risk only. As the trading book of banks became more prominent.
an explicit capital charge for market risk was introduced in 1996. As risk
.measureme nt and managemen t became more sophisticated, the simple Basel I rules
became outdated in the mid-2000s and after a lengthy consultation process, Basel II
was adopted. Basel II allowed banks to use their own risk measuremen t and rating
systems in the calculation of risk weights for regulatory capital. and an explicit
operational risk charge was also introduced. Following the Global Financial Crisis of
2007/2008 , Basel III was introduced, with the aim of increasing both the quantity
and quality of capital held by banks.
INTRODUCTION
The management of capital is fundamental to a bank's survival. Especially during
periods of extreme stress, the ability of a bank to use its capital reserves and absorb any
losses can be the difference between exacerbating systemic risk and limiting the risk to
one particular bank. In a day and age where systemic implications are increasingly
present. it has become important that national regulators not only provide suitable
guidelines for banks to manage capital. but also adapt them as markets evolve. This
chapter reviews the evolution of capital standards since their global inception in the late
reading this chapter, you should be able to:
explain the importance of capital for banks
explain why banks should be regulated
provide the three definitions of capital
explain the role of the Basel Committee on Banking Supervision (BCBS)
regarding the regulation of banks
identify the main features and differences between Basel I, Basel 1996
Amendment, Basel II, Basel 11½ and Basel Ill respectively
calculate and interpret the capital adequacy ratios according to Basel I, Basel
1996 Amendment, Basel II, Basel 11½ and Basel Ill respectively
apply the Basel requirements to South African banks.
.t:A.t1NINl:J
1~}1nc:fcapital Adequacy
>
Bank Management in South Africa -A risk-based perspective
15.2.2 How much capital does a bank need?
The amount of capital needed by a bank is primarily determined by the regulatory
requirements outlined by the national regulator. These regulatory requirements
outline predetermined capital requirements based on the amount of risk the bank
takes as well as the operating environmen t it functions within (especially more recent
capital standards). Failure to meet these requirements can force the regulator to take
legal action against the bank, especially if in its view, the failure could lead to systemic
risk. However, holding too much capital is expensive for a bank due to the opportunity
15.2 REGULATI ON FOR BANK CAPITAL
15.2.1 The purpose of bank capital
Tn the event of unexpected loss or even failure, bank capital acts as a buffe
absorb this loss, which directly affects the owner's equity or capital. This in t
creates a strong incentive to prudently manage capital in the interests of ensuri
the safety and soundness of both an individual bank and the banking system a
whole. Capital is intended to protect the stakeholders of a bank and the ent'
system of banks, including depositors, counterpart ies and clients in general. Giv,
the nature of banks to engage in risk-taking activities (especially with the incent'
of maximising returns), the purpose of regulating bank capital is to ensure t
banks hold sufficient reserves against these risk activities. In doing so, the regula
limits the risk of bank failure and preserves public confidence. Banks should h
sufficient capital to avoid systemic risk, hence, capital adequacy is at the forefront
regulation and financial stability in the banking industry.
A further reason to regulate bank capital is to limit the burden on governm
(and thus the taxpayer) to bail out banks should they fail. This 'safety net' m
however, create a situation where banks knowingly take on more risk expecting th
they will be bailed out. This moral hazard is one of the major reasons nation
regulators implement deposit insurance.
Three definitions of capital commonly exist. First, in its simplest form, capital
the difference between the total assets and total liabilities held on the balance sh
of a bank. This is known as accounting capital and typically includes ordinary shar
and retained income. Second, economic capital is a measure of risk given the goi
concern of, in this case, a bank. 1 As stated by Burns, '[e]conomic capital is based
• a probabilistic assessment of potential future losses and is therefore a potential
more forward-looking measure of capital adequacy than traditional accountin
measures' . 1 In effect, therefore, economic capital is that which is needed to absor
unexpected losses given a certain probability of occurrence and is a vital componen
of the proposed Basel Capital Accord vis-a-vis the incorporatio n of risk. Finally,
regulatory capital is the chief concern of this chapter. This type of capital i
specifically prescribed by the Basel Accord and has evolved over time as capit
standards have adapted to changing market conditions. In the case of South Afric
regulatory capital is the amount of capital required by the regulator, namely, th
Bank Supervision Department (BSD) at the South African Reserve Bank (SARB).'
Given these three definitions, the ultimate purpose of capital is to act as the last line
of defence in the event of bank stress.
388
389
Macro factors include those that are external to the bank and outside of the immediate
control of managemen t. These include both global and domestic macroecono mic
environmen ts, macroeconomic policies (monetary and fiscal) and business cycles.
These macro factors are transmitted through financial markets to which the bank
Figure 15.1 The factors influencing the amount of capital for a bank
cost involved. On the one hand, the amount of capital must be enough to act as a
buffer against losses as it is the last line of defence against failure; on the other,
holding too much is inefficient as capital in itself is idle and not revenue generating it is rather the use of the capital that could be profitable. One can therefore understand
the dilemma of bank managemen t in managing their capital reserves.
Figure 15. l provides a schematic for the factors influencing the amount of capital
for a bank. Capital requirements set by the regulator of the specific country form the
heart of the amount of capital to be held. These are minimum requirements that are
typically aligned to the standards set by the Basel Committee on Banking Supervision,
or BCBS (more on these standards in the next section). The capital requirements set by
the national regulator are based on the environmen t in which banks operate. These
are both macro and micro factors.
Chapter 15: Banks and Capital Adequacy
is exposed. The availability of liquidity and the cost of capital play
into the abil
and price at which banks can acquire capital to meet their regulato ry
requirem en
Market perceptions also play a role in determin ing capital levels.
During times
excessive systemic risk, such as the Global Financia l Crisis (GFC), the
market pla
a higher premium on the level of capital required by using it as a
proxy for ba
stability. During and after the initial stages of the GFC, banks have been
holding mo
capital in an attempt to both restore market confidence in the banking
sector and
cater for unforeseen events of a crisis that has by no means reached
its conclusi
by the end of 2015. A natural outflow of the current situation is that
credit rati
agencies (such as Standar d & Poor's, Moody's and Fitch) assign ratings
according
the bank's ability to absorb systemic risk through its capital buffers.
A result of th
is that a bank with higher capital levels may get better ratings than a
peer bank wi
lower levels, albeit that both would be considered to be 'healthy '. The
case in point
that the risk in the system is currentl y a dominan t part of the rational
e used to ass
bank and market stability.
Moreover, the amount of capital held is also a function of the
state of t
economy. During economic upswings, bank manage ment may feel that
the amount
capital does not have to be as much as when the economy is in a downsw
ing. This h
potentially devastating effects because if banks are short of capital
in downswin
the cost of capital increases, thereby not only squeezing profits, but
also puttin
pressure on the bank to maintain minimu m regulatory capital levels.
The state of th
economy is directly affected by the monetar y and fiscal policies deemed
appropriate b
the policy authorities at the time. This is in turn a function of not only
the domesti
macroeconomic environment, but also global macroeconomic developm
ents. What i
importa nt to take note of is the interconnected nature of the
external macr
environm ent - domestic systemic risk can be exacerbated by events on
the other side
of the globe. Clearly, therefore, a failure to incorporate macro factors
into the amoun
of capital that a bank holds is failure to manage the external environm
ent that the
bank functions within.
The micro environ ment includes all factors that are within the bank
and are irt
the immediate control of manage ment. Central to these factors
is how the
manage ment deals with operatio nal risk attached to the people,
processes and
internal policies of the bank. The manner in which the bank manage
s its operations
within the context of the overall risk philosophy that the Board has
set plays into
how the bank is able to run operations better. The competency of
manage ment is
therefore vitally importa nt and the quality of corporat e governa
nce is just as
importa nt. In dire times, the ability of the manage rs to manage the
bank out of risk
is an importa nt first step to avoid having to raise capital. Because capital
is the last
line of defence before failure, the first line of defence is the manage
ment and the
skills and competencies they bring to the processes and internal risk
manage ment
philosophy of the bank. If a bank is better able to manage the risk in-house
, it relies
less heavily on capital. This is ideal. as holding too much capital
is expensive.
Competitors also play a role in influencing the amount of capital
held by banks.
especially in the market environ ment.
'
What is importa nt to take note of is that the direction of causality
between
390 Bank Management in South Africa - A risk-based perspective
Before the first formal global capital accord was established in 19 8 8,
the regulati on
of capital was simple and not uniform. The capital-to-total assets ratio
was typically
used by banks across the world, and the discipline and extent to
which formal
standard s were applied varied from country to country. 2 Countries
that had poorly
regulate d capital standard s were considered to have a competitive
advanta ge over
those with more strictly enforced capital standard s. 3 As the world
became more
global and banks competed more with each other, the need arose for
uniformity in
capital standard s. Innovati on in product and instrum ent developm
ent, as well as
increasingly complex transact ions, further added to this need for uniformi
ty.
The BCBS drafted the first formal set of minimu m capital standard
s in 1988.
This became known as Basel I and was driven by the Group of Ten (G-10)
-Belgiu m,
Canada, France, Germany, [taly, Japan, the Netherla nds, Sweden,
Switzerland, the
UK and the US - and Luxembourg. The recomm endation s of the
BCBS are not
legally binding unless they are incorpor ated into the legal and regulato
ry framework
of a particul ar country. 3
Bearing in mind that regulatory capital requirements need to be appropri
ate for
the broader financial system of a specific country, Chapter VI of the Banks
Act (94 of
1990) stipulates the prudential requirements for banks in South Africa.
Section 70 in
particul ar sets the absolute and risk-based minimum capital requirem
ent for banks on
an individual and consolidated basis. Under Section 4 of the Act.
the Registrar of
Banks is granted the authorit y to adjust capital adequacy requirem
ents in excess of
the prescribed minimum requirements as deemed fit. Regulation 38,
as published in
15.2.3 Capital adequacy standards: global reform and South
Africa
macro factors, capital levels and micro factors is both top-down
and bottom-up.
That is, the state of the economy affects the amount of capital held
by banks and the
amount of capital held by banks can affect the state of the economy
. Due to the
guidelines set by the BCBS being based on events that occur in both
the macro and
micro environments, their interplay is crucially importa nt to take
note of when
managin g both current and future capital levels. Manage ment needs
to plan ahead,
but cannot do so if it does not consider the context within which it needs
to manage
capital adequacy.
So, how much capital is enough? This is not an easy question to
answer. It
depends primarily on the minimu m capital requirements of the regulato
rs. but it also
depends on the risk appetite of the bank; and so too the condition
of the economy,
both nationally and internationally; the manage ment philosophy is also
importa nt as
is the quality of the in-house governance structures; the cost of
capital and the
market liquidity in acquiring capital also plays a role. In some form or
another, all of
these factors play into the capital requirements. Capital manage ment
is therefore a
complex issue. For this reason, it has received a vast amount of attention
from a
regulatory and legislative point of view in the past three decades.
In fact, the
manage ment of capital (or capital adequacy) is regarded as the
most importa nt
regulatory focus for banks across the globe in recent times. So much so
that regulators
from different countries have come together to formulate internat
ional capital
standard s for banks. This is where the role of the BCBS becomes clearer.
Chapter 15: Banks and Capital Adequacy 391
Bank Management in South Africa - A risk-based perspective
l
Matters related to specified minority interests, that is, non-controlling interes1s, in shares and/or instruments qualifying as capital
Inherent in these guidelines is how they have changed over the years as the BCBS has
amended the proposals. For example. Basel I of 1988 stipulated basic risk-weighted
assets incorporating only credit risk. Over the years, Basel II included operational and
market risk, and more recently, Basel llI has included additional capital conservation
and countercyclical buffers. These changes (especially those of Basel III) reflect the
dynamic and interconnected nature of global financial markets and how the BCBS
has been forced to adapt the capital standards in accordance with changing financial
markets. In South Africa, the Banks Act as well as the Directives and Guidance Notes
applicable to capital adequacy reflect these changes. The management of capital
is therefore not static - as long as participants innovate and enter new markets,
a new set of conditions will apply with a new set of risks that set the context for
capital adequacy standards. Capital adequacy is therefore an ongoing feature of risk
management.
The following sections highlight the changing capital adequacy standards
through the years starting with Basel I in 1988.
Source: Government Gazette (2012)-l
16
r,onditions tor the issue of instruments or shares of wt1ich the proceeds rank as Tier 2 capital
Tier 3 unimpaired reserve funds
15
capital
Conditions for issue of instruments or shares of which the proceeds rank as common equity Tier 1 capita! and/or additional Tier 1
14
13
Percentage of capital obtained through the issue ol certain shares and debt lnstrumenls that may qualify as ner 2 capital
Conditions relating to instruments not qualifying as common equity Tier 1 capital and/or additional Tier 1 capital due to a prescribed
limit or zero
11
12
Conditions relating to reserve funds and retained earnings
Qualifying capital and reserve funds and related matters
The minimum required capita! and reserve funds
Conditions relating to the calculation of minimum required capital and reserve funds in respect of a securitisation scheme or
resecuritisalion exposure, and related matters
Conditions relating to external credil assessmenl tor securilisation scheme or resecurilisalion exposure
Guidelines for adjustments and deductions from capita! and reserve funds
The duties and powers of the Registrar upon non-adherence 10 capital adeQuacy guidelines
Catculation guidelines applicable to the various tiers o1 capital
The measurement of aggregate risk-weighted ex~ures as per section 70 of the Banks Act
A respective bank's disclosure in the 8A700 is not for public viewing
I Brief description/Heading
10
Section
Table 15.1 Section of Regulation 38 (Form BA700) applicable to capital adequacy for
South African banks
the Government Gazette, provides the specific Directives and interpretations for t
completion of capital adequacy and leverage as stipulated in the BA700 form. T
form requires banks to report their capital adequacy (and leverage) to the Registrar
a monthly and quarterly basis. The sections of Regulation 38 are provided
Table 15.1 below.
392
393
CRWAtoial
Equation 15.1
Source: BCBS (1988:17-20) 6
Issued and fully paid ordinary shares or
common stock
Perpetual non-cumulative prefereoce shares
Share premiums
Retained profit
General reserves
legal reserves
Minority equity inlerests
I
Table 15.2 The definition of capital under Basel I
Subordinated term debt
Hj\)rid (debVequity) capilal instrumenls
Undisclosed reserves
Hevaluation reserves
General provisions/general loan-loss reserves
In Equation 15.1, CRWA
is the sum of the credit risk-weighted on-balance-sh eet
10181
assets (CRWA n) and the credit risk-weighted off-balance-sheet assets (CRWA 0 rrl•
0
The BCBS defined capital as the sum of Tier 1 or Tier 2. Table 15. 2 provides the
components of these two capital tiers.
-
CAR _ Tier I capital+ Tier 2 capital
The formula for the CAR under Basel I was:
Calculating the capital adequacy ratio under Basel I
Basel I provided specific criteria that bankers could use to determine their minimum
risk-weighted capital adequacy ratio (CAR) that incorporated both on-balance-sheet
and off-balance-sheet credit risk exposures. These on-balance-sheet and off-balancesheet items were risk weighted according to their perceived credit risk in order to
calculate the total risk-weighted assets (RWAs) for the bank. The CAR (sometimes
called the Cooke ratio 3 ) was calculated by assigning risk weights to the respective onbalance-sheet and off-balance-sheet items. By the end of 199 2, banks had to have a
CAR of at least 8%. Today this ratio fs still being used as the basis to calculate RWAs.
with recent developments adding additional risks to the denominator. The principle of
RWAs is therefore an important one when dealing with capital adequacy.
BASEL I
The BCBS drafted the first formal set of guidelines aimed at capital standards in
1988 although adherence to these guidelines was not made compulsory. Basel I was
developed to 'establish minimum levels of capital for internationally active banks'
that had to be implemented by the end of 1992. 5 As long as regulators from
different countries applied the guidelines as being minimum these could be adapted
to suit a respective national context. At the heart of the first Basel Accord was the
focus to manage the quality of a bank's assets, hence the initial focus exclusively on
credit risk. Basel I was drafted with the intention of addressing two objectives that
were particularly pertinent at the time. The first was to strengthen the safety and
soundness of the international banking system; the second to promote fairness and
consistency by providing a framework applicable to banks functioning anywhere in
the world.S Bearing in mind that financial markets were becoming increasingly
global during the late l 980s, Basel I provided an important means to assess the
soundness of banks from any country given its universal applicability.
Chapter 15: Banks and Capital Adequacy
-'· ".' _.W"
·'"•'•? -""•>~_-?- .. !\\'II,\\~»:'•~•
Bank Management in South Africa - A risk-based perspective
Cash items in process of collection
d)
e)
Claims on banks incorporated outside lhe OECD
Claims on central governments outside the OECD
Claims on commercial companies owned by the public sector
Premises, plant, equipment and other fixed assets
b)
c)
d)
e)
Capilal instruments issued by olher banks
All other assels
g)
h)
Real estate and other investments
Claims 011 fhe private sector
a)
Loans fully secured by mortgages on residential property
Claims on non-domestic DECO public entities exclLJ9ing central government
c)
Claims on banks incorporated in lhe OECO and loans guaranteed by OECD incorporated banks
Claims on domes1ic public-sector enlilies. excluding central government, and loans guaranteed by such entities
Claims on multilateral development banks
Claims on banks incorporated in countries outside the OECD
b)
a)
e)
Olher claims Oil OECD cenlrar governmenis and central banks
Claims collateralised by cash of OECO cenlral government securities or guarantew by OECD central governments
c)
d)
Cash (and gold held al lhe bank)
Claims on central governments and central banks
b)
Asset classes
a)
~>.~. A
■
■
""·.-C.
m,, ,,P
These risk weight categories provide a few important insights into capital adequacy
vis-a-vis on-balance-sh eet items:
An on-balance-sh eet asset with higher credit risk has a higher risk weight (and
•
vice versa).
As the credit risk increases the bank has to hold more capital (and vice versa).
Idle assets (that is, assets that do not generate revenue in their current form
such as cash) are considered low risk and therefore carry low, if not zero, risk
weights.
Source: BCBS (1988:21-22) 6
100%
50%
20%
0%
. Risk weight
Table 15.3 Risk-weight categories for on-balance-sheet assets according to Basel I
The definition of capital as two tiers was the first attempt at classification accord
to their inherent risk. This definition of capital was one of the major contributi
made by the BCBS in Basel I and has been modified through the years to reflect
changing environment to which banks are exposed. Deductions were also propo
including goodwill from Tier I capital and certain types of investments in subsidiari
As the CAR formula indicates, the sum of Tier I and Tier 2 capital is divided by
CRWA10131 , which is an amount reflecting the risk-weighted credit risk for both
balance-sheet and off-balance-sheet items of the bank. The risk weights for on-baland
sheet asset classes are provided in Table 15.3 below. To calculate the CRWAon' eac
respective asset on the balance sheet is multiplied by its corresponding risk weight tog,
the item risk-weighted amount. The sum of all these item risk-weighted amounts equa
the total risk-weighted on-balance-sheet assets (CRWA0 n).
394
395
Endorsements of character
Standby letters of credit serving as guarantees
Standby letters ol credit related lo particular transactions
■
Credit lines
•
Commitments with an original ma1urity of up to one year, or which can be unconditionally cancelled at any time
Short -term self· liquidating trade-related contingencies
Formal standby facilities
■
Commitmenls with an original maturity of over one year
Revolving underwriting facilities
Nole issuance lacililies
Bid bonds
Warranties
•
Per1ormance bonds
■
•
Transaction-related contingent items
Partly-paid shares and securities
Fo!ward deposits
Forward asset purchases
Asset sales with recourse
Sale and repurchase agreements
•
•
Direct credit substitutes
Source: BCBS (1988:23-24) 6
0%
20%
50%
100%
I
Table 15.4 Credit conversion factors for off-balance-she et instruments and transactions
(CRWA0 m) according to Basel I
'Crndit.cbrwernion faiJ.toi'. Off,6aJan/:e,sr\iietJlisiri:r~ccf'.½"~' ''§ 'cf.;:;
Off-balance-sheet items are those that do not explicitly appear on the balance sheet
and typically include letters of credit, loan facilities, interest rate derivatives, foreign
exchange derivatives, equity derivatives and commodity derivatives to name only a
few. In order to calculate the CRWA 0 rr two steps are followed. First, a credit equivalent
amount (CEA) must be calculated. The purpose of doing this is to provide an amount
that is equivalent to a loan with equal credit risk. Second, the CEA must be assigned
an appropriate risk weight.
Given the numerous types of off-balance-sheet exposures, Basel I made a
distinction between off-balance-sheet items: those that are instruments or transaction
related (or CRWA01nl and those derivatives that are foreign exchange and interest rate
related contingencies (or CRWA 0 rrol- For the former, the process was quite simple:
apply the two steps as mentioned above (using Table 15.4).
National entities such as governments and central banks are considered lower
risk and thereby carry lower risk weights.
Foreign entities such as companies, governments aJld central banks in countries
that are not from the developed economies (that is, non-OECD countries) carry
higher risk weights.
Chapter 15: Banks and Capital Adequacy
Bank Management in South Africa - A risk-based perspective
one year
Off-balance-sheet derivatives
0.5%
0%
Interest rate contracts
1%
5%
f_P.isume:}'~;Jnfof~~tlorfpertairiingto --~ta~-~i Ba~l<ii:er~f
to'1a1culat.e~he.:cAB!Or_t_he•·banktodeterminew_het~~r-~rt/Ofitc
7(8%. minimurri require~ent set_ in Basel I. [able, 15.~pre~!de~}~e •ba
>jnfomiatio n afongwitht he applicable riskweightc aicufations : •
!d~d.iirid;yotiS;;;····
In summary, the major proposals made by Basel I regarding capital ratios were: 6
total regulatory capital was the sum of Tier 1 and Tier 2 capital
•
the CAR had to be at least 8%
•
■ the total of Tier 2 capital was limited to a maximum of l 00% of Tier 1 capital ·
■ subordinated debt could not exceed 50% of Tier 1 capital.
In years following Basel J, netting was introduced, which effectively reduced t
credit risk equivalent amounts for banks through derivative exposures signed for
the Internatio nal Swaps and Derivatives Association (TSDA) master agreements. 3
Source: BCBS (1988:25) 6
~
< ooe year
Residual maturity
(CRWA011 oJ according to Basel I
Table 15.5 Credit conversion factors (add-ons) for off-balance-sheet derivatives
The credit conversion factors (or add-ons) for the CRWA0 rr O are provided in Table I
Total notional principal amount of contracts x Credit conversion factor
The current market risk exposure is the total replaceme nt cost, and the pote·
future exposure is:
CRWAorID = Current market risk exposure+ Potential future exposure
For the latter, however, the calculation of the CEA was slightly more complex.'1
the current exposure method, banks had to (i) determine the total replacemert
of all contracts with positive values by marking-t o-market the current expo
the derivatives and (ii) apply an 'add-on' factor that reflected the potential
exposure over the remainder of the contract. 6 The CRWA0 rr O was therefore cak'
as follows: 6
396
"'h-""·'·•·:".!
.;.<,~2 .'''"'""~'11'\' .,.·,.e
y
~-v--_ ,..,
s.:.,.'!lffl•"-'·
=
-~"'"Y..: ...,,.,.
•
r...,.;,i">'T:".>.-«1<1
T " ' · ' = · - - \ - . . ...2...
,>
y·_. \!--~
...
Chapter 15: Banks and Capital Adequacy
397
d mo
As financial markets became more integrated and banks compete
particul
In
risks.
new
of
internationally, they were summarily exposed to a plethora
commodi
the exposure to changin g interest rates, inflation, exchange rates and
i
devastat
in
liabilities
and
assets
of
values
the
affect
to
l
potentia
the
prices had
rath
the
Given
levels.
capital
ways. This market risk would then subsequently erode
in 1996 t
crude and simplistic proposals of Basel I that focused only on credit risk,
risk in th
market
ate
incorpor
to
accord
initial
the
to
ent
amendm
an
proposed
BCBS
for 'risk:
catered
ent
amendm
This
calculation of total capital requirements.
[and
book
trading
the
in
equities
and
ents
instrum
related
pertaining to interest rate
Five broad risk
bank'.7
the
out
through
risk
ities
commod
and
risk
e
exchang
foreign
capital charge
categories were therefore identified to contribute to the market risk
price risk of
and
prices
ity
commod
prices,
equity
rate,
e
exchang
(MRCC): interest rate,
contribution
major
the
were
risks
market
these
measure
to
used
methods
The
options.
of the Amendment of 199 6.
'only if it
The Amendm ent proposed that an additional Tier 3 capital be used
Tier 1 capital. 7
could be used to support market risks' and may not exceed 2 50% of
that had to be
This additional capital tier consisted of short-te rm subordinated debt
be repayable
not
years,
two
least
at
of
maturity
a
have
up,
paid
unsecured, fully
regarding
clause
lock-in
a
before the agreed repayme nt date and be subject to
7
y in the
flexibilit
greater
banks
allowed
This
interest and principal payments.
Tier 2
and
1
Tier
on
solely
rely
to
have
not
did
they
as
capital
their
of
manage ment
be
could
2
Tier
of
ents
compon
h
capital as per the original Basel I proposals. Althoug
capital charge
15.3.2 The 1996 Amendment to Basel I: explicit market risk
South Ali
Although Regulation 38 currently provides guidance for banks in
Ali
South
for
e
Regulation 21 was used during the Basel I period. The differenc
ca
tertiary
and
ry
seconda
primary,
between
banks was that the SARB distinguished
50% . .
use
only
could
banks
African
South
ore,
Furtherm
capital.
when defining
applied usf
revaluation reserves as secondary (or Tier 2. as above) capital. If this was
be sligh
would
bank
African
South
a
for
CAR
the
the same information as above,
CA
identical
an
had
bank
foreign
a
if
that
suggests
this
on,
implicati
By
10.3%.
lower at
capit~
ry
regulato
more
hold
to
to a South African bank, the latter would be required
g market.
This is understandable given the risk profile of South Africa as an emergin
0
,;!Iiii~-~~~1ta~oist~~1~1 ~> '°' · ·. . ·•· · •· <> ,/·· . . <· >"
;:\istart~~r~!l:tB~for;!helMA.cdufdbe•used;'banRshad
~iter\a'!~t e~i1!h;!f~~'~i11tho
)pthl!Y~d~e!~~fo spe~~cally.t~f5~~!ift~1iye~
is,Jli~qU~~•it~trveguidelih~s'¾'ere D•
natrri~~e
h~iII"!~r
~eV;lo~!
") h~d TllO!~r~~i?ili'}"f?
ireihent iipplidal:iie.th,15i!ii-iks)t:.ihenusing th~'fMA. •···
cregardea ai{beingtheJniniriiurn'rl!qiJ
--:c~L/ -5~~ ,; -.::-::--A~
:.c;.~':"r'.S'· s- ·::_-/cf>
"' •,=:c~ ~;:_:·::/i::- -
original 1988
substituted for Tier 3 (also up to a limit of 2 50%), the condition of the
subordin ated
and
capital
1
Tier
exceed
not
Accord still applied -Tier 2 capital could
of market
nature
volatile
the
Given
capital.7
1
Tier
of
50%
exceed
debt could not
nt.
importa
was
y
risk and its adverse effect on the balance sheet, this flexibilit
distinction
In order to better understand the effect of market risk, there needs to be a
refers
former
The
sheet.
balance
the
on
/Jook
trading
and
book
banking
the
made between
that
is
here
intention
The
deposits.
to traditional banking activities such as loans and
early
be
there
Should
.
maturity
until
held
are
book
banking
the instruments in the
refers to those
redemption, penalty fees would apply. Conversely, the trading book
i.s to not
intention
The
basis.
daily
a
on
instruments that are traded in financial markets
,
example
for
manage,
to
used
arc
trades
these
as
maturity
until
nts
hold these instrume
nts
instrume
These
basis.
ay
liquidity or funding requirements for the bank on a day-to-d
are recorded at
need to be marked-to-market on a daily basis in order to ensure that they
on a daily
liabilities
and
assets
g
revaluin
of
practice
the
is
-market
fair value. (Mark-to
and
assets
of
value
the
in
basis in order to account for daily market fluctuations
exposure
market
actual
the
of
reflection
fair)
(and
liabilities.) This gives a more realistic
al capital
of the bank, which in turn, provides a more realistic reflection of the addition
requirements based on, in this case, market risk.
the MRCC.
The Amendm ent proposed two methodologies for the calculation of
h;
approac
models
internal
the
and
h
approac
ised
standard
the
were
These
I. The standardised approach
, where
The standardised approach (SA) adopted the so-called 'building-block' approach
exchange risk,
capital was assigned separately to debt and equity securities, foreign
37
each of these
commodities risk and price risk for options. • The risk charges associated with
). The
(MRCCsA
charge
capital
risk
market
overall
an
into
ed
positions were aggregat
charges
d
calculate
y
separatel
minimum capital requirement was expressed in terms of two
g to the general
- one applying to the specific risk of each security and the other accordin
instruments.
of
types
different
between
ons
correlati
of
taken
was
account
market risk. No
2. Internal models approach
use its own inThe internal models approac h (IMA). in contrast , allowed a bank to
VaR refers
book.
trading
its
in
(VaR)
-risk
value-at
the
estimate
to
models
risk
house
holding
given
a
over
ce
experien
to the maximu m loss that the portfolio is likely to
as it
banks
by
preferred
often
was
IMA
The
ity.
probabil
period and with a certain
less capital. 3
hold
thus
and
.
portfolio
d
diversifie
a
having
of
benefit
the
them
allowed
e the capital
The output generated from the VaR would then be used to calculat
A).
charge under the IMA (MRCC,M
Chapter 15: Banks and Capital Adequacy 399
.~,~c--:. ~ ~ ~ - - - ~ : . Y - l ! > l \ \ ~ , . . , . ____
Banks have the choice to
Scenario·s· reqtiiring ·a
simulation by lhe bank.
Supervisory Scenarios
requiring no simulations
by the bank.
. v_.0. <.~m--.,•····
Amultiplk:ation factor (m) of
at least three will apply to the
VaR output. This will etteclively
'calculate the general market
risk charge (MRCCr,)
capital requirements
Each bank must meet daily
use any VaR model such as
variance-covariance matrices,
historical simulations or Monte
Carlo-simulations
/n!ll\\\"4-'.~7D.'-_\...~_-'."!•<:< <<<-l'<r.~~ .Vi" W y e , -____ '"·
... ; Both the Board and _ -·~
; management must actively-•manage risk and regard it as'
an essenlial aspect of business-_._
·-'_operations
management pdlicies
unit to overs·mnn~house rtsk
Banks must have an
indepeodenfoskcontrof ··\
extemarvalidation in the IMA aceording'to the .1996
,.,dU81itadVS '--~ ~ . ~ ~ ~f >- f QUSiititative
5.
Tabte-15.S_Selected .sfaridards tor qualitative,•·quanmati~e, stress
400 Bank Management in South Africa - A risk-based perspective
= MRCCtMA
X
12.5
MRCCG = max (VaRi-1; m, x VaR.,,)
MRCC 1MA = MRCCc + MRCC5
where:
MRWAtotal
Equation 15.6
Equation 15.5
Equation 15.4
Based on the 1996 Amendment, when the IMA method was used, banks had to
calculate a VaR with a ten-day holding period (or time horizon) and 99% confidence
level and would be used to calculate the general market risk charge (MRCCG). Banks
were further required to conduct a back-testing programme. which was an ex-post
comparison between the VaR model and actual daily changes in the portfolio over the
previous 2 50 trading days. 3 •7 If the VaR output for a respective trading day was found
to be less than the actual loss incurred o