The process of stricter regulation of financial institutions and markets following the global financial crisis is still in full swing, with the banks in the spotlight. The ongoing European crisis reminds regulators of the importance of the relationship between the health of the banking system and the real economy. The new committed credit facility for banks announced by the Reserve Bank on May 10 is a further step in the process on South Africa’s part.
The impact of the new regulations on the availability and cost of credit and consequently real economic activity should not be underestimated. The severity of the crisis has ensured the regulatory response has been just as severe and, as one would expect under the circumstances, the pendulum is probably swinging too far.
As the crisis was of a global nature, regulators are laying great emphasis on the international co-ordination of reform initiatives and that regulations should apply globally. Unfortunately this has resulted in countries that have not contributed to the financial crisis and that hold no systemic risk for the global economy, being subjected to the same requirements as the developed countries in which the crisis originated. Too little allowance is made for international differences in financial systems and the level of financial development, and the emerging markets are the ones bearing the brunt.
The capital requirements to which banks are subject are the crux of bank regulation and many of the complex rules and regulations to address specific risks can be eliminated by raising capital requirements sufficiently.
Solvability and liquidity are also interdependent; for example, the higher capital requirements are, the more faith there will be in the solvability of the banks, which will reduce the chances of depositors withdrawing funds from a bank and the bank consequently experiencing a liquidity deficit. The regulation of liquidity is, therefore, secondary to the regulation of solvability. As such, one cannot really object to banks being subject to uniformly higher capital requirements, as determined by the Basel III regulations.
However, making the stricter liquidity requirements applicable to banks in completely different institutional environments, with material differences in the way they are funded, is a different matter. What is a risky funding model in one country is not necessarily so in another. South Africa is one of the countries that, in spite of its financial system being highly regarded internationally, now has to try to meet the liquidity requirements of Basel III.
It is obvious that deposits from non-residents, which are the most risky as they are not subject to exchange control, make up only 3.5 percent of the total. We therefore do not have to be concerned about these. However, the outstanding feature is that deposits by companies and financial institutions account for 63.3 percent of the total compared with only 23.3 percent for households. It is this aspect that is unacceptable in terms of the Basel III liquidity requirements.
In terms of these requirements South African banks must change their funding base from wholesale deposits (from companies and other financial institutions) to retail deposits (from households) as a bank could experience serious liquidity problems should a few big clients withdraw their deposits simultaneously. It could mean the relevant bank would have to curtail its lending activities to the detriment of the business sector and the economy.
But how can this be done? South Africans’ low propensity to save is inevitably part of the problem and it would be of great help if this could be improved. A good start would be for banks to increase the interest rate on households’ deposits and make it more attractive for them to invest directly at a bank instead of in a money-market fund (which is deemed a wholesale deposit). The government has also indicated that it intends encouraging short-term savings by bigger tax concessions, similar to those that currently apply to long-term savings.
The banks obviously also undermined short-term savings by providing products such as access bonds that give people ready access to the equity in their home loans, mortgage bonds and vehicle financing without deposits, and very low or even no interest on savings accounts.
The government, on the other hand, is also undermining the precautionary motive by socialising personal risk (by expanding the social security network). Ironically, this is in contrast with a country such as China, which has a very high personal savings rate as the communist government has privatised personal risk.
A second problem lies in the term structure of bank deposits.
The dilemma is that long-term deposits account for only 20.8 percent of bank deposits, which means banks finance long-term loans such as mortgages by means of short-term deposits and that they could find themselves in a position where they do not have the necessary funds to accommodate depositors who want to withdraw their deposits. In order to limit this risk, Basel III requires banks to hold sufficient high-quality liquid assets to survive a crisis scenario (continuous withdrawals for a period of 30 days).
As it is impossible for local banks to suddenly change the composition of their funding in order to comply with this requirement, the Reserve Bank recently announced that it would make available a new liquidity facility, the so-called committed credit facility, as intended in Basel III and similar to steps announced by, for instance, the Australian Reserve Bank.
By means of this facility, participating banks will be able to gain guaranteed access to Reserve Bank financing to offset any deficit in their required liquid assets to a maximum of 40 percent of the cash outflow the bank is experiencing. Banks will pay a fee of up to 40 basis points (0.4 percent) of the agreed facility, whether it is used or not, to encourage them to structure their balance sheets in such a way as to limit their dependence on the new credit facility to a minimum. The assets banks offer as collateral when they want to use the facility must also meet strict criteria.
In essence, the new facility is nothing more than a variation of the central bank’s acknowledged function as “lender of last resort”. The use of this facility would be the first step in addressing a liquidity crisis, but should it prove to be inadequate, I believe the normal central bank’s function of “lender of last resort” would come into effect anyhow.
It is therefore an open question whether this facility is really necessary or whether it will not unnecessarily complicate the banks’ existing access to the Reserve Bank. The increase in banks’ funding costs will have a negative impact on the cost of credit, and the imbalance between short-term funding and long-term loans could result in the tightening of long-term credit.
The “belt and braces” approach currently favoured by regulators will undoubtedly have implications for the cost of doing business, economic growth and employment. The day will come when the pendulum swings back.
Jac Laubscher is the group economist for Sanlam.