South African banks are not the culprits as portrayed

South African banks are being targeted again. They stand accused of widening the gap between the bank lending rate and the South African Reserve Bank’s repurchase rate to grow their revenues and accumulate substantial profits to the benefit of executives, including exorbitant bonuses for chief executives.

I disagree.

The Sarb is not a primary source of funding for banks

According to a paper “Quantifying the tightness or looseness of monetary policy in South Africa”, authored by the Sarb’s Johan van den Heever and Danie Meyer, the key instrument of monetary policy in South Africa is the Sarb’s repurchase rate through a system in which the central bank routinely provides short-term financing to banks with a temporary shortfall.

It is through this mechanism that the private sector banks set their lending and deposit rates in alignment with the Sarb’s repurchase rate.

The business of banks is lending to businesses, individuals, and others, and the primary sources of the funds are deposits, such as savings and term deposits, and the banks’ own capital. The deposits carry interest rates that vary from floating to fixed coupons. Banks generally do not loan the total amount of deposits because they are subject to bank reserve requirements.

The spread between the Sarb’s repo rate and the bank prime lending rate is static

The gap between the Sarb’s repurchase rate and the private sector bank prime lending rate has been steady at 3.5 percentage points for many years.

According to Van den Heever and Meyer, banks are not forced to maintain a constant margin between the Sarb’s repurchase rate and their prime lending rates but do so by convention. The gap compares to 3 percentage points in the United States.

Banks’ net interest margin is on a downward trend

In PwC’s analysis of major banks’ results for the reporting period ended 31 December 2022, the local currency results of Absa, FirstRand, Nedbank, and Standard Bank are combined. The combined results provide an indication of how banks in general perform.

Indications are that the net interest margin of the four banks combined declined steadily to about 4.3% in the second half of 2019 (pre-pandemic) from about 4.7% in 2017. Bank margins were under severe pressure during the height of the pandemic in 2020. The combined net interest margin fell to about 3.7% in the latter half of 2020, a contraction of about 15%. Bank margins started to recover in 2021 and only returned to pre-pandemic levels in 2022.

The net interest income of the four banks in 2022 amounted to 4.4% of the average of gross loans and total deposits. In other words, the interest margin.

Lending and deposit-taking are not the only activities in which banks are involved. For the period under review, the aggregate non-interest revenue of the four banks was more than 41% of the total operating income of the banks, while net interest income was about 59%. Non-interest income, inter alia, consists of transaction fees, income from insurance activities, income from asset management activities, and investment income.

Banks need to incur operating costs. Costs, inter alia, range from human capital, investment in and maintenance of state-of-the-art technology to maintain and grow deposit and lending books to ultimately grow profits and market share in a very competitive market. Furthermore, the recent US regional bank failures are testimony to the fact that asset/liability management is crucial in managing risk and interest margins.

Assuming that operating expenses are proportionately split between net interest and non-interest income, the operating expense of the banking divisions was about 2.3% of the average of the average of gross loans and total deposits. In addition, bad debts will always be part of running a banking operation. When interest rates rise and, more specifically, economic activity tanks, bad debts increase because more people lose their jobs while businesses suffer and go belly-up. If the bad debt charge in 2022 related only to the banking divisions, the charge was about 0.7% of the average of gross loans and total deposits of the 4 banks combined.

It leaves us with a pre-tax interest margin of 1.2% and an after-tax margin of 0.9% if the 24.4% direct tax rate of the banks is used. Yes, about 0.3% lands in the pockets of the state. Applying the same methodology to bank results in 2020, my calculations show a pre-tax interest margin of almost zero on banking business for the four banks combined as provisions for bad debts surged.

CEOs’ bonuses are not astronomical

Executive bonuses, specifically those the banks’ chief executives, have little to do with the spread between the Sarb’s repo rate and the private sector banks’ prime lending rates, as the spread remained constant.

Regarding interest rates, remuneration has more to do with asset/liability management and therefore pre-tax interest margins, the growth of assets and market share, and the cost to maintain and increase pre-tax interest margins.

Furthermore, with the non-interest revenue of the four banks amounting to more than 41% of total revenue, the banks’ other businesses and own capital require exceptional leadership to steer the company to the benefit of all its stakeholders, including personnel, communities, shareholders, the government, and the environment. Executive compensation is well defined, subject to certain covenants, and open to scrutiny.

Critics of bank chief executives’ so-called astronomical bonuses in 2022/23 have a very short memory. In 2020/21, the coronavirus pandemic hit bank earnings, sank share-based rewards, senior managers and executives were not granted salary increases, and performance bonuses were slashed by more than half – all in line with guidance from the Sarb for banks to conserve cash by not paying dividends and executive bonuses.

Whether you like it or not, the much-envied sound banking and financial system in South Africa and the steadfast Sarb staved off financial and socio-economic mayhem during the pandemic. The business environment has returned to normal in 2022/23 and justifies the catch-up in executive remuneration.

The banking sector is one of the few pillars standing in a country that is effectively under business rescue after imploding from state capture, and to quote Ciaran Ryan from Moneyweb, will be key “to reverse South Africa’s nosedive into economic atrophy”.

Yes, South African banks are not the culprits as portrayed.

Ryk de Klerk is an independent investment analyst.

Disclaimer: The views expressed in this article are those of the writer and are not necessarily shared by Moonstone Information Refinery or its sister companies. The information in this article does not constitute investment or financial planning advice that is appropriate for every individual’s needs and circumstances.