The financial sector has been one of the best-performing equity asset classes in the past 12 months, buoyed by a stronger-than-expected economic recovery. The huge provisions that were reported, which were very conservative given all the uncertainties the coronavirus brought about in its infancy, have reversed into profits. This all while central banks have kept interest rates at historic lows. Banks earnings are driven predominantly by two factors: fees it charges for its services and the interest it earns on its assets. All of this is tied to the repo rate, the rate at which the central banks lends to commercial banks such as FirstRand, Absa and Nedbank.
The repo rate has been increased by 50bps in the last quarter, owing to two 25bps hikes at the previous two Monetary Policy Committee meetings. This has increased the repo rate to 4%, which has a direct knock-on effect on the prime lending rate, the interest rate at which banks lend to customers with good credit scores. The prime lending rate in South Africa currently stands at 7.5%. These interest rates are core to banks profitability. On the 18 November 2021, the day South African Reserve Bank chairman Lesetja Kganyago, I spoke to banking analyst Kokkie Kooyman and the lending rates effects on the business, and he had this to say:
Just a quick calculation. I took Absa as an example. If we take just a 25-basis point hike in interest rates, it means excessive earnings growth – without anything else after tax – will be 12% higher. It is simple: the Reserve Bank hikes interest rates by 25 basis points, Absa’s earnings will be 12% higher. [However], it doesn’t quite happen that way because the cost of funding also increases, so you can see how high-interest rates improve the top line. Usually, why banks do better is because the funding costs lag. You first get the revenue impact and then the cost impact coming through. And then, a large part of the balance sheet of banks’ funding that doesn’t re-price. Just think of your money lying in your overdraft account or in your account that doesn’t re-price. So, banks usually benefit from rising interest rates, and the benefit could be quite strong for two or three years.Â
This is the start of the interest rate hike cycle. Central banks globally are struggling to cope with inflation, which has been driven by excessive money printing and loose monetary policy, combined with supply chain disruptions owing to the pandemic. The banks share prices reflect this positive outlook (higher interest rate environment). Nedbank’s earnings guidance of R24 (using the mid-point of earnings guidance) are only 12.7% below pre-Covid-19 earnings (R27.50). With dividends reinstated following the interim results, Nedbank shareholders should be looking forward to receiving around an R8 final dividend if the dividend payout ratio remains consistent with pre-pandemic levels.
The big question is whether one can extrapolate Nedbank’s earnings beat to other banks. All have similar operations, at least the core retail units. It’ll be interesting to note the performance of the banks’ asset management and investment banking arms, as we’ve seen bumper profits from these divisions by international peers. Although the business and corporate action landscape is far smaller in South Africa.Â
The banks have major tailwinds at their backs. However, the banks will always have a ceiling in terms of the health of the South African economy. In many ways, banks are a proxy of a country’s economy. The South African economy is sluggish. This is priced into the banks. However, if the correct structural reforms are made, it could pave the way for booming growth and prosperity, which would turbocharge the banks. These signs, however unfortunate, are yet to appear.Â
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