There could be significant repercussions for the financial sector if South Africa does not exit the Financial Action Task Force (FATF) grey list by June next year, the South African Reserve Bank (SARB) says in its second Financial Stability Review (FSR) of 2024.
The SARB says the outlook for financial stability has improved since the release of the June FSR. This is largely attributable to the orderly general election and the formation of the Government of National Unity, which contributed notably to stabilising the political landscape. The improvement in the and supply of electricity, evidence of fiscal consolidation, and an improved sovereign credit rating outlook have also supported positive investor sentiment towards South Africa.
Despite the improved financial stability outlook, the SARB says a number of key risks to remain. These include the risk of escalating global conflicts; deteriorating public sector debt ratios; rapid capital outflows amid declining financial market depth; increased financial distress in households and small, medium and micro enterprises (SMMEs); critical infrastructure failure; and remaining on the grey list over the medium term.
A section of November’s FSR was devoted to an assessment of the vulnerabilities in the commercial real estate (CRE) sector. The assessment found that financial imbalances within the sector have significantly increased since the Covid-19 pandemic.
Households under pressure
The SARB says there is growing financial distress among households and SMMEs, compounded by rising interest rates and broader economic pressures. Despite some resilience immediately following the pandemic, vulnerabilities in the credit market are becoming increasingly pronounced.
During the lockdown, households experienced a surge in gross savings as a share of GDP, providing temporary financial relief. This, coupled with regulatory relief granted to banks by the Prudential Authority in 2020, allowed banks to restructure significant volumes of loans. As the economy reopened, households relied on these savings to cushion the effects of rising interest rates. However, as National Treasury phased out the regulatory relief in October 2021, borrowers began facing mounting financial stress.
This stress is evident in the increasing ratio of non-performing loans (NPLs), a key indicator of credit risk. Between March 2023 and July 2024, NPLs rose significantly, from R257 billion to R304bn, with the NPL ratio climbing from 4.7% to 5.7%. This marks a stark warning for the financial system, because NPLs have historically been a precursor to banking crises. According to the SARB, “the reliance on restructuring, while temporarily effective, could obscure deeper credit vulnerabilities, introducing systemic risks if left unchecked”.
The National Credit Regulator reported nearly 28 million credit-active consumers in early 2024, with more than 10 million (36%) having impaired credit records. Despite a declining trend in impaired records since 2019, this high percentage underscores ongoing financial challenges. Additionally, household debt-service costs, which peaked at 9.2% of disposable income in the first quarter of 2024, have placed further strain on borrowers.
Housing affordability also reflects these pressures. Despite a demand-supply imbalance keeping the residential market strength indicator above 50 index points, real house prices have declined since 2022, pointing to affordability constraints. Mortgage defaults have risen, with payments overdue by more than 90 days increasing – a trend that banks have countered by boosting their provisions for doubtful debts.
Financial distress in the SME sector
The SME sector, which comprises 5.7% of banks’ total loan portfolios, is also showing signs of heightened distress. Since mid-2022, NPLs in this segment have outpaced overall NPL growth, leading to a decline in banks’ SME corporate coverage ratios to below their long-term averages. SMMEs, often more vulnerable to economic shocks such as rising interest rates, face growing challenges.
Banks have increased provisions against SME corporate loans, indicating a proactive stance in managing these risks. However, the SARB warns that individual banks with greater exposure to SME loans may need to re-evaluate their risk management strategies. The SARB also highlighted that “small businesses generally have less room than large corporates to shield themselves from economic shocks”, necessitating careful monitoring of the sector’s vulnerabilities.
Banking sector’s resilience
Despite the pressures, South Africa’s banking sector has demonstrated resilience. Increased provisions for general and specific exposures since early 2023 have enhanced banks’ capacity to absorb potential losses. The overall coverage ratio, which measures the ability to cover outstanding exposures, has improved, reflecting robust risk management strategies.
However, the challenges posed by rising NPLs and declining credit quality across households and SMMEs require sustained vigilance. “Although aggregate banking resilience remains strong, financial stability risks could escalate if these underlying vulnerabilities are not managed effectively,” the SARB said.
Risks of remaining on the grey list
By January 2025, the country must satisfactorily resolve the six remaining action items on South Africa’s 22-item Action Plan, after which the FATF Africa Joint Group will conduct an on-site visit in mid-2025 to validate compliance. A favourable assessment during this visit would lead to a recommendation for removal at the FATF Plenary in June 2025.
However, failure to address the action items by February 2025 would prolong the process, requiring South Africa to continue reporting to the Africa Joint Group every four months. This means the next opportunity for delisting would be delayed until October 2025 at the earliest.
Remaining on the grey list poses escalating risks to South Africa’s financial system, the SARB says. According to National Treasury, “domestic financial institutions’ access to the global financial system could become increasingly restricted the longer [South Africa] remains on the grey list”.
The SARB says the key risks include:
- Strained correspondent banking relationships: Prolonged greylisting diminishes reliance on existing correspondent banking arrangements, increasing the likelihood of restrictions from foreign regulators. Without these relationships, the ability of South African banks to engage with international counterparts could be hindered.
- Enhanced due diligence: Heightened international scrutiny would lead to stricter risk assessments by developed market institutions, potentially increasing compliance costs and reducing the economic viability of existing facilities. As a result, facilities may not be renewed, and foreign financial institutions may curtail or even terminate services in South Africa.
- Impaired hedging capabilities: South African financial institutions rely on global banks to manage interest rate and foreign exchange risks because of their limited domestic capacity to absorb such risks. These contracts often require clearing through central clearing counterparties in financial hubs such as London. Prolonged greylisting could impose additional costs, making hedging through offshore markets more difficult and increasing banks’ capital requirements.
Vulnerabilities in commercial real estate
The CRE sector faces significant financial imbalances and vulnerabilities, but these pose a limited risk to the broader financial system remain because of the banks’ low direct exposure to sector, the SARB says.
The SARB’s assessment disclosed several vulnerabilities in the CRE sector.
Rising municipal taxes and investments in alternative electricity solutions have driven up operational costs, while water supply challenges and extreme weather events have added to the burden.
The shift to e-commerce and hybrid work models has led to declining demand for retail and office spaces, driving up vacancy rates. Notably, vacancy rates, which began rising as early as 2009, saw a sharp spike during the pandemic and remain above pre-pandemic levels.
Tenant payment behaviour has also deteriorated, with the percentage of tenants in good standing still below pre-pandemic levels. Defaults contribute to reduced rental income, creating a feedback loop of financial strain.
The decline in demand for office and retail spaces has had a cascading effect on property values and debt servicing. Lending to the CRE sector has slowed, with commercial mortgages comprising a smaller share of total lending. Higher interest rates have weakened CRE asset quality, leading to moderated credit impairments in recent months.
“Financial imbalances within the South African CRE sector have significantly increased since the Covid-19 pandemic,” the SARB stated, adding that these vulnerabilities are compounded by physical risks stemming from climate change.
The SARB noted that the banking sector’s reduced exposure to the CRE market has mitigated potential systemic threats, although it has intensified financing difficulties for the sector.
“Global and domestic conditions in the CRE markets are currently in a downward phase, which poses several financial stability concerns. The structural growth constraints interacting with higher interest rates have skewed the supply and demand dynamics in the CRE sector, negatively impacting cash flows and property values. In response to this and potential future stress, investment and lending activities are deteriorating,” the FSR says.
“Domestically, financial and non-financial institutions face potential credit losses from the exposure to the CRE sector. While investors could face large losses, systemic risks currently appear limited.”
