FED RATE HIKES TAKE THEIR TOLL ON BANKS

After the most aggressive rate hiking cycle by the US Federal Reserve in 50 years, cracks are now beginning to appear in the global financial system. It is not surprising to us that highly leveraged sectors such as real estate and banks are now coming under severe pressure. Portfolio manager RASHAAD TAYOB takes a closer look at what this means for South Africa’s banking sector.

Since the Global Financial Crisis of 2008, developed market banks have funded their asset portfolios cheaply, with low or zero-cost deposits. During the COVID-19 pandemic, US banks were inundated with low-yielding deposits after massive government stimulus to corporates and consumers. Most banks made the unfortunate decision to invest those deposits in long-term Treasury and mortgage securities at all-time low yields.

Between March 2022 and March 2023, the US Fed hiked rates by almost 5.0%. The rapid increase in rates in the last year dramatically increased all costs of funding. As interest rates moved up sharply, fixed-rated bonds and loans have lost value, since bond prices move inversely to interest rates. As a result, US banks face unrealised losses on these assets estimated at $2 trillion. Many will face insolvency if they are forced to quickly sell those assets to settle deposit withdrawals.

The problem is that deposits are now leaving the banking system to capitalise on higher yields available elsewhere, typically in money market funds. Banks have been locked into long-term bonds and loans at much lower fixed yields and they therefore don’t have sufficient income to offer more competitive deposit rates.

Developed market banks therefore face existential conundrum: if they offer higher interest rates on deposits, they will sustain net interest-income losses, but if they don’t, deposit withdrawals will continue and force them to sustain realised losses as they liquidate long-dated bond assets. The upshot is that if interest rates stay high, we will eventually see more bank failures.

Unlike the US, South Africa runs a largely floating interest rate system. Home loans are issued at a floating rate linked to prime. Banks lend to corporates at floating rates and borrowers must hedge their interest rate risk. This system means that SA banks are naturally hedged, as their cost of funding is largely matched by their income.

US banks especially are in trouble because they ignored interest rate risk. Indeed, US regulators didn’t even include rising interest rates in their bank stress testing. To the South African banker this would seem bizarre — interest rate, currency and political volatility are a permanent part of the South African investment environment. The hiking cycle of 2002 saw rates go up to 14.3%, while in 2008 they reached 12.0% — yet no South African banks failed.

While SA banks have better managed their interest rate risks, they have also increased their exposure to longer dated government bonds in recent years to around 10% of their asset portfolios. These longer dated bonds have sustained unrealised losses as yields have risen — but these losses are manageable, given their size.

However, the biggest asset on the balance sheet of SA banks are their loan books — which average around 70% of total assets. Despite a very weak economy with growth of only 1% per annum over the last decade, impairment losses on loan books have been low. The big four SA banks have delivered good returns and are well capitalised, but face headwinds if economic weakness persists.

Unlike the US, which has 4,500 banks, the big four SA banks are dominant — they capture over 80% of all deposits. The concentrated banking sector allows investors and regulators to better scrutinise loan books and capital ratios. Banking failures are nevertheless still possible, as we experienced with African Bank. However, because the big four SA banks are systemically important institutions, the SA Reserve would step in to protect depositors in a crisis.

Nevertheless, the failure of Silicon Valley Bank in the US and Credit Suisse in Switzerland have highlighted risks to subordinated bond holders of all global banks. In these cases, regulators intervened to entirely write off subordinated bond capital (‘sub debt’) to prevent a disorderly collapse of the banks. Sub-debt investors and not depositors sustained the banks’ losses.

And herein lies the lesson (and the risk) for investors in the better managed SA banks: the R165 billion of sub-debt capital owned by the savings and investments sector (unit trusts and retirement funds) is at risk if SA banks run into trouble. Recent events have highlighted that only senior depositors at systemically important institutions are safe. Given the risks on the horizon, the Foord funds are structured with a high degree of credit quality and no exposure to bank subordinated debt. As always, it is safety-first at Foord.