Banks are businesses that are strongly keyed to interest rates. When rates are high, banks tend to see their earnings increase, albeit with a simultaneous growth in bad debts. When rates are low, bank margins get tighter even as lending books grow. It’s no surprise, then, that Standard Bank has seen its return on equity shrink since 2006, when rates were high, to today, when rates are close to historical lows. According to Standard Bank CEO Ben Kruger, this is likely to remain true for the foreseeable future.
Rates are set to rise, which will be positive for bank earnings in the medium term. However, in the immediate term, rising rates will tend to increase bad debts as the banks weakest customers come a cropper. Thus, banks will likely see some earnings weakness, followed by an uptick in the medium term as the benefits of higher rates are felt. – FD
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ALEC HOGG: Standard Bank’s full year earnings rose due to a strong rise in its lending income. The company’s joint CEO Ben Kruger joins us now to have a look at the numbers. Ben, maybe we can start off with the lovely improvement in the dividend – and that’s as far as the shareholders are concerned, a 17 percent rise there – but it has been a progressive decline in your dividend cover. Have you now gotten to the stage where, if you like, the bonuses are all over or the bonus increase in the dividends is – kind of – over?
BEN KRUGER:  You always begin with the difficult question at the start, Alec. You’re quite right. For us, the dividend cover is quite an important calculation. You would have noticed that during the course of the year, we have managed to absorb the full capital requirement for Basel 3 and notwithstanding that, our Tier 1 ratio increased from 11.2 percent to about 13.2, and our total capital is in excess of 16 percent. When we look out over the next few years, we think we are in a very strong position. We obviously still have – if I can call it that – our sterile capital in our PLC business that, once we complete that transaction, can be redeployed. Our capital position is very strong. Our earnings momentum we feel, is now very good, so when we look at the growth ahead we think our capital generation capacity is pretty good and this seems like a good time to reduce our dividend cover. Our target range has always been two to two-and-a-half and you’re quite right, so we’re at the bottom end of that target range. Having had to build up in anticipation of Basel 3, it’s quite a solid capital base.
ALEC HOGG: I pulled out numbers going back to 2006, Ben. It’s interesting to look at your return on equity. In 2006/2007, it was at 25 percent. You’ve dropped ten percentage points from that level for the last five years. Is this the new normal or was that the proper normal?
BEN KRUGER:  That’s actually a very good question. I’m amazed. If you go back to 2006, we’ve done an analysis in analysing our ROE over the last ten years and that’s pretty much the same time. When we go back to 2006, you’ll remember where interest rates used to be so when you look at the endowment impact, the endowment impact from then to the interest rate regimes where we are now: it’s almost six percent on our ROE.  In addition to that, the introduction of Basel two-and-a-half, which had quite a strong impact on our trading books, and Basel 3 at another three percent reduction. That is about nine percent of that total reduction and a few other things have happened but obviously, we’ve managed to pull some of that back. It’s a very interesting analysis and that’s the bottom line of that, so in banks I think it is quite interesting to note the impact higher interest rates have on the endowment balances that banks have, if you don’t have much increase – the credit costs associated with that.
ALEC HOGG: So if interest rates stay around the current level, then 14 to 15 percent ROE’s are where you probably will remain?
BEN KRUGER:  Yes, our target rate for ROE is 15 to 18 and we’ve come through what we would think is a very difficult phase, readjusting from emerging markets back to Africa. We’re coming to the end of that phase, so we would hope to have less capital not really properly deployed in generating revenue, as we were winding down those businesses. We would like to get to our target range as quickly as possible and for us, by 2015/2016, that clearly…our target range…if I say 15 to 18 percent, it’s more than 50 percent into that range would be appropriate for us.
@alechogg why is FNB earning above 20% then?
— Gerhard Visagie (@GerhardVisagie1) March 7, 2014
GUGULETHU MFUPHI:  Ben, it’s Gugu here with Alec. Keeping with interest rates and the potential hike and further increase in these rates, have you managed to mitigate any risks that could pose a threat to your business?
BEN KRUGER:  We look at it on two fronts. Firstly, when we do affordability testing with our customers and our lending profiles, we clearly try to be conservative and try to calculate what would happen if interest rates were to go up 250 percent, given the high debt levels of consumers, and particularly in South Africa. By the same token, I think it would be quite negative for growth and given what’s happened in the final quarter of last year, the initial projection of 250 basis points is most probably an overreaction at the time. Even if you look at the forward curves now, you’ll find that everyone is expecting much less, so we think it would have an impact, but more muted than expected two or three months ago.
ALEC HOGG: Another issue that I had a look at Ben, is a figure that we used to concentrate on with the banks: the cost-to-income level. You were doing great going back a few years. Between 2006 and 2009, you were around the 50 percent level. You’re now around the 60 percent level. Is that one of your targets, as someone and yourself, now driving the bank into the future to bring it back from the current level?
BEN KRUGER:  Yes, absolutely. Quite a few things have happened since 2006/2007. We’ve had a simultaneous wind-down of our international businesses, which always implies that your revenue base disappears faster when you wind down, and your cost base for compliance and running the risk down, stays for a little bit longer. Clearly, the regulator environment meant that you had to increase your cost base in international businesses quite significantly. In parallel with that, we’ve been building much bigger businesses on the African continent. We’ve rolled out many branches. We’ve opened up in different countries – and that clearly has a cost associated with that – as well as changing all of our core banking platforms, both in South Africa as well as in Africa, so those are quite significant cost increases for us to deal with. You’ll see in our results, we’ve shown the market, if we finally complete the transaction on Plc, our cost-to-income ratio as a result of that reduces by about two percent. Our target is definitely to get it to below 55 percent in this phase of building new businesses as well as redeploying new IT infrastructure.
ALEC HOGG: Just take us through the process you’re in now with the sale, as you say, of Plc – that last major offshore asset that you have – where you are at this point.
BEN KRUGER:  We have signed an agreement with ICBC, and I think that for both of us, it’s quite a formative transaction. If we only had businesses in Africa, the core functionality and the scale that you need in the UK to have an appropriately regulated banking license, means that it will just be too big a cost for us. If we look at China, for them becoming more tradable – and hopefully, the financial market starting to open up – this is the first major foray of a bank with an actual banking license in the UK.  This is really quite a unique event for them. For us, it changes us from the shareholder of reference to a minority shareholder in a business of ICBC that we think will be quite well positioned to leverage the growth of China, even if it’s at seven-and-a-half percent and their prominence in markets as they open up and start to develop. For us, the transaction has been signed, but we’re now into the phase of completing all the regulatory requirements. Clearly, they need to get approval from the UK regulators to assume ownership of this license, and that implies that they have to submit a business plan. They have to go through risk appetite, their governance structures, who the directors would be, and the people etcetera, which is quite a long process. We would expect that plan to be submitted round about June. We would expect a regulator to open on it over a period of three months, so we would hope to complete the transaction in the third quarter of this year, which for us, will be a very good result.
