Bank committee fears ‘doom loop’
• Committee ill at ease about banking-sovereign nexus, Covid-19 and a worsening economy
The “worry committee” is how the Reserve Bank’s financial stability committee is sometimes described. It is their job to ask: “What have we missed?”, as deputy governor Rashad Cassim put it at the release of the Bank’s Financial Stability Review. The “worry committee” is ill at ease about the banking-sovereign nexus. In fact it views this, alongside issues including the Covid-19 crisis and the worsening of economic conditions, as risks to the local financial system that have a high likelihood of materialising.
The “worry committee ” is how the Reserve Bank ’ s financial stability committee is sometimes described. Its job, as deputy governor Rashad Cassim put it at the release of the Bank’s Financial Stability Review, is to ask: “What have we missed?”
The committee is ill at ease about the banking-sovereign nexus. It views this and issues such as the Covid-19 crisis and worsening economic conditions as risks to the local financial system that have a high likelihood of materialising.
The nexus encapsulates the myriad ways in which the health of banks and governments are intertwined and, as a 2018 paper by the European Central Bank explains, how this “may multiply and accelerate vulnerabilities in each sector, and lead to adverse feedback loops”, or “doom loops”.
This feedback works through various channels, it says. Banks hold large amounts of sovereign debt; governments are typically the backstop for banks if they get into trouble. The health of both is inextricably linked to the performance of their underlying economies.
The problem came to the fore after the global financial crisis as embattled banks in some countries needed bailouts from governments, raising public-debt levels and weakening governments’ financial positions. In other countries, banks — given their large sovereign debt holdings — took hits to their balance sheets as fiscal distress increased.
The ensuing European sovereign-debt crisis — threatening countries such as Portugal, Italy, Ireland, Greece and Spain — is best associated with the problems posed by the nexus.
But now it has become a red flag for SA’s historically conservative and wellcapitalised banking system as the already moribund economy and creaking government finances have been thrown a coronavirus curve ball. In its Financial Stability Review, the
Bank says that the nexus is a threat to financial stability due to the government’s large and increasing financing requirements.
The local banking sector has ramped up its holdings of government debt, now reaching more than 15% of total bankingsector assets, having about doubled in the past 12 years, the Bank says.
The government’s finances have been marked by rising exposure to shaky parastatals, widening deficits and rising debt levels, culminating in the Moody’s Investors Service downgrade to junk status in March, leaving SA with a full house of subinvestment grade ratings from the big three agencies.
Due to the pandemic’s onslaught, the state’s fiscal metrics will worsen, with the International Monetary Fund (IMF) predicting that the deficit will hit 13.3% of GDP and debt levels will reach 85.6% of GDP by 2021.
Due to the lockdown, SA’s banks are expected to take strain as households and business lose income. Banks are already affected, with Capitec and Absa sounding profit warnings due to the lockdown, while the JSE’s financials index has slid 36% this year.
In normal circumstances, it was fine for SA banks, asset managers and other financial institutions to hold large sums of government debt, said CoPierre Georg, associate professor at the UCT School of Economics.
“If our banks were to get into trouble, for example because bad household and corporate debt rises as a consequence of Covid-19, they might face capital outflows by both retail and wholesale investors,” he said.
In a situation like this, when the solvency of SA’s banks came into question, it was the sovereign that provided funds for a bailout, Georg said. “But if a large chunk of sovereign debt is bought by our own banks, the sovereign cannot raise the funds to bail out the banks,” he said.
The Basel III regulations — introduced internationally after the global financial crisis to ensure banks are better able to withstand systemic shocks — have contributed to the banks increasing their government bond holdings.
Under Basel III, sovereign debt carried “exceptionally low risk weights” because sovereigns were deemed unlikely to fail, said Georg. This made them more attractive to banks because they had to hold less capital against these assets as part of their capital adequacy requirements.
Kuben Naidoo, CEO of the Prudential Authority, the financial-sector regulator, has said most big SA banks used their own internal risk modelling, an approach that did not view sovereign bonds as holding no risk.
Banks’ risk weightings for sovereign exposures have thus been increasing in line with the rising public debt burden and deteriorating sovereign credit ratings and banks having to hold more capital against their sovereign exposures.
But government failures were “not unheard of”, said
Georg, “and SA’s fiscal position even before Covid-19 means there is a strictly positive probability of sovereign default”.
The issue was more acute since SA’s relegation to junk status, he said. In the wake of Covid-19, there is little risk appetite, making attracting foreign investment difficult.
“This means SA financial institutions buy even more government debt than before just to keep constant debt levels,” said Georg.
But the real problem is economic fallout from the lockdown, he argued.
Though Naidoo said that SA would have to experience a scenario in which about 10% of customers defaulted, Georg is concerned that Covid-19 is just this sort of crisis. “I would not rule [out] ... historically unprecedented levels of bad debt,” he said.
But some factors lower the risk to SA’s financial system. Whereas the SA government has entered the crisis in a weak position, the banks are comparatively stronger because they are well capitalised and are under tighter macroprudential regulations than during the 2008-2009 financial crisis.
The Reserve Bank said that banks also did not enter 2020 in a credit cycle upswing, characterised by risky lending.
Stanlib chief economist Kevin Lings said that interest rates had been slashed to historic lows, providing a cushion for the system. And many large corporates and the bank’s biggest customers came into the crisis with much cash on their balance sheets and little foreign debt.
The system was, however, under a lot more pressure, said Lings. Much would depend on how the economy recovered from the lockdown. If SA was forced to return to level 5 and the economy faced another “sudden stop”, then these vulnerabilities “go up exponentially”, he said.