Covid-19 stress testing indicates resilience of largest SA banks

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The high-level stress testing was done as part of postgraduate research by Corné Conradie, actuary and partner within the PwC actuarial, risk and quantitative team. The research is done in collaboration with Professor Conrad Beyers, Absa chair in actuarial science at the University of Pretoria.

The largest full-service banks, that include Absa, FirstRand, Standard Bank, Nedbank and Investec, were assessed. These banks account for 91% of all bank deposits and 94% of all loans granted by South African banks. According to Conradie, the resilience of these banks is key to ensure the resilience of the South African banking system as a whole.

Beyers said that it currently appears unrealistic to make reliable forecasts around the exact spread of the virus based on biological and epidemiological models. It is however possible, to use financial modelling to form a view on the impact on the banking sector, which forms the backbone of the current financial system. “It is clear that banks will experience significant strain, although the financial system appears to be stable for the foreseeable future”. Beyers said that deep changes in the financial system could be necessary to be more robust to future possible shocks.

Credit losses

The research shows that banks are expected to experience significant credit losses. These losses will be driven by defaults on residential home loans, company loans and retail unsecured loans. The likely causes of such losses is a loss of income of borrowers instead of affordability driven by increased prices and loan installments. Based on the nature of the stress, it is expected that unsecured loans will be the harder hit by the economic fallout of the Covid-19 pandemic. Residential mortgages are expected to be affected less compared to the 2008 crisis while companies may experience similar strain compared to the 2008 crisis.

It is expected that bank deposits will drop. Deposits by financial institutions are expected to be affected most, followed by public sector, company and retail deposits. This would be driven by lower interest rates, lower economic growth, lower stock market returns and lower household disposable income.

Despite these stresses, banks are currently sufficiently capitalised to withstand the shocks.

Compared to 2008 financial crisis

Conradie noted that the current financial situation is often compared to previous stress events such as the 2008 global financial crisis. The two scenarios are however different in various respects. The 2008 crisis was concentrated in the financial sector and was characterised by high interest rates and inflation with prime lending rates that peaked at 15.5% from June to November 2008 and inflation that peaked at 8.7% in May 2009.

The South African equity market dropped by 34% between June and October 2008. Over 2009, the South African economy shrunk by 1.5%. In contrast, the Covid-19 financial stress is much more widespread with nearly all sectors experiencing strain. Energy, construction, hospitality, transport and financial sectors are expected to be severely impacted. The underlying macroeconomic conditions are also very different. The prime lending rate is very low - at a level last seen in 1973 and inflation is within the South African Reserve Bank target range. The equity market showed a similar drop of 33% between the end of December 2019 and 23 March 2020. The impact on GDP and subsequent job losses are however, expected to far exceed the levels seen during the 2008 crisis. Initial estimates indicate a record GDP drop of more than 10% and a large increase in unemployment.

A number of positive developments and downside risks, together with other critical risk factors were identified.

Positive developments:

• Reduced interest rates, stable inflation and increased risk aversion will mitigate the negative effects of reduced disposable income. Loan repayments should generally become more affordable;
• The largest South African banks increased credit loss provisions by about 38% due to the move to the new IFRS9 accounting standard, making them more resilient to credit losses;
• Through payment deferrals, new loans backed by the R200 billion loan guarantee scheme and access to fixed deposits, banks provide additional liquidity to the market.

Downside risks:

• Over the last 12 years, unsecured lending increased on average by 9.6% per year. This loan category is likely to be severely impacted by the current crisis;
• Company loans grew by 7.6% per year to a total of 49% of all loans. These loans are highly sensitive to company profitability and business interruption. In comparison, home loans (which are affected less) grew by only 3.9% per year;
,li>Banks face significant liquidity risk if there is a large scale withdrawal of deposits. If this happens in conjunction with increases in loan defaults, further strain could be put on banks. Confidence in the financial system and economy guards against vast depositor withdrawals while stringent regulation and capital requirements mitigate the risk of credit losses and day to day movements in liquidity.

Critical risk factors:

• The actions of the government, financial institutions, other companies and society will play a major role in the severity of the stress;
• The government needs to balance management of health outcomes with growth in the economy.
• Poverty and lack of economic growth is highly correlated with life expectancy. The negative effects of unemployment and low economic growth will just take longer to emerge and is not as visible as a daily infection and death report;
• The effectiveness of government interventions, availability of affordable financing and the speed of economic recovery should be monitored and reported;
• Increased company failures can in turn cause a feedback loop that leads to further losses on retail loans.

“The exact effects of the Covid-19 pandemic will, however, become more apparent over the next year and is very dependent on the degree to which the pandemic is contained without causing large scale economic damage. A quick progression through the lockdown stages will reduce the negative effects while a resurgence of infections and further or prolonged lockdown will exacerbate the large negative impact that is expected. Therefore, only time will reveal the exact impact of this pandemic on the South African banking system," Conradie added.