Futuregrowth’s chief investment officer Andrew Canter is one of the deeper thinkers in SA’s financial sector. He needs to be. His company does a lot of big ticket lending to banks, a field where a single big mistake can wipe out years of profit. Not surprisingly, Canter has been analysing how global regulators are working on rules to ensure a repeat of the 2007/8 Crisis is avoided. That meltdown was caused by bankers over extending their balance sheets, safe in the knowledge that if the worst happened they were too big for Governments to allow them to fail. What we call systemic risk. Canter reckons the new rules will carry serious implications for banking profitability. Suggesting the once-standard 20% plus returns on equity may well be over. When Standard Bank’s Ben Kruger suggested as much in a recent interview with us, he was criticised as being too pessimistic. Maybe he was simply being realistic. – AH Â Â
ALEC HOGG: Andrew Canter is with us on the line from Cape Town. Andrew, thanks for agreeing to have a chat about a really thorny issue. Investors in banking shares are trying to work out what the regulators are going to do in reaction to the meltdown in 2007/2008. They have been sitting together. They have been making their plans. Is there much that’s coming out that could affect investors and indeed, banks themselves?
ANDREW CANTER: Alec, if you think about what happened in 2007/2008, there was an assumption that governments would bail out banks. That allowed banks to borrow quite a lot of money with impunity, without a lot of oversight from either regulators, or investors, or credit ratings agents.
That led to a situation where they just took far too much risk and ultimately, when they failed they failed hard and big.
Eventually, governments had to bail out the banks and the banking sector with enormous costs. In countries like Ireland and Spain, bailing out the banking sector literally bankrupted the countries and they had to go running to the IMF for their own bailouts. All global regulation of the banking sector as we look forward from that, is about how do we get that risk of bank failures off of the taxpayers’ shoulders and onto the shoulders of the investors and banks? Both the shareholders who buy the equity and the lenders who either make deposits in banks or buy bank bonds.
ALEC HOGG: Have the Irish and Spanish, have they been the leaders in this whole process – given that they were the countries were hardest hit by the old style banking regulations?
ANDREW CANTER: Oh no, this is global. We can say they were hit hardest because of the size of their banking sectors relative to their economies. However, let us make no mistake. The political climate globally, and particularly in Europe and the US has turned exceedingly toxic towards bailing out the banking sector, bailing out bank shareholders, and bailing out the managers of banks who drove these buses off the cliffs. It’s therefore not really the countries that took it the hardest – it’s a definite global theme. We’re talking about the G20 global regulatory framework – how banks are going to be supported or not supported.
ALEC HOGG: I suppose from a South African perspective, there were no bailouts here, and yet South Africa is going to align itself with what happens internationally?
ANDREW CANTER: Well, South Africa has always had very good banking regulations and a background interventionist Reserve Bank  – I’m going back 25/30 years now, to say that. While there were no bailouts in 2008 or 2009 in the crisis, we can’t forget that in the history of South African banking… We made an anecdotal a couple of years ago, and we were able to count up something like 20 bank failures in 20 years, leading up to 2010. You may remember the banks – the Prima Bank, the FBC-Fidelity, the Islamic Bank  – I could give you a whole list.
ALEC HOGG: Saambou….
ANDREW CANTER: They do fail and depositors never lost money to my recollection, but I think that in the future, that is not an open question. It’s ‘what will government do?’
ALEC HOGG: It is interesting because if you remember the A2 bank crisis here in South Africa, Saambou was one of those and that was just ten years ago. We also had BOE where the Reserve Bank decided not to come in and support it (so Nedbank acquired the company cheaply). Stepping back again, internationally there is a move towards making sure or at least, trying to not have the situation where banks are too big to fail.
ANDREW CANTER: That’s right. That’s cover what they’re going to do and then talk about too big to fail. Now, as we get to the idea where governments in the future don’t want to bail out individual banks or, if they can avoid it, the banking sector then what they want to do is transfer that risk onto the funders of banks. It would be the shareholders first, followed by the subordinating debt holders, followed by the institutional investors who hold on and finally, the depositors who hold bank accounts in those banks. In determining how each of those parties bears risks or takes losses in a crisis of a bank – that’s called a Resolution Regime – a horrible phrase, but a phrase that we’re all going to have to get used to because it goes to how you resolve the winding up of a bank or resolve a bank failure. Who’s going to take it on the chin? Who’s going to get their money back and paid out in full? There’s quite a lot of work going into that as to how that resolution regime for bank failures will work. What I could tell you is right now, it’s unclear who is paid first. It’s unclear, the differentiation – if there is any – between depositors and institutional funders of banks.
ALEC HOGG:Â I suppose there is a resolution regime in place already with companies that go bankrupt.
ANDREW CANTER: Well, that’s exactly right and that’s exactly what we’re talking about now. Business rescue is the Resolution Regime for companies that go bankrupt. If you can’t save them by business rescue practices that is keeping them alive to see if you can restructure the businesses, then eventually they go into liquidation and there’s an orderly process. There are clear legal definitions of who is paid first, in what order, and by how much. Whereas in the banking sector, because these resolution regimes are not yet written, it isn’t clear.
There are things out there talked about where you could force a bondholder of a bank – and I mean forced by government, the liquidator, in effect, the Reserve Bank (it would be the regulator at play here), could actually just say ‘okay, the bank’s equity capital has been wiped out. I’m sorry Mr Bondholder, you are now having your debt converted into equity’ or perhaps ‘ you were supposed to get paid in two weeks’ time, but I changed my mind and you’ll now be paid in three or four years’ time if the bank survives’. Perhaps you owed R1m, and so ‘by the way, I’m going to cut it back to R500 000. You should just take the lumps on that’. So that is what could actually happen. It has echoes of the business rescue practitioners’ role, but I think with a bigger force and with less clarity about where the lines are.
ALEC HOGG: It’s not entirely theoretical if you think about the travails of a company like Abil. So far, the equity shareholders have been happy to pump money in. The bondholders I suppose have had a bit of a haircut on the valuations. If Abil (and this is highly theoretical) were to go belly-up, would we know what to do?
ANDREW CANTER: Abil’s a current case and I don’t think it’s a good example to use because interestingly, Abil has never been a deposit-taking institution. They funded themselves in the institutional market. A more interesting question about a bank failure is how do you deal with the difference between depositors? That is the man on the street for example, you and I with our personal bank accounts or small business accounts from which we pay payrolls – versus institutional investors like pension funds and insurance funds, which is in the hundreds of millions of Rands of deposits of banks. That is probably the thornier issue because it brings in questions of whether you introduce a deposit insurance scheme.
ALEC HOGG: Very theoretically, if there were to be an Abil-type situation in Capitec, maybe that would give you a better example. If there is no deposit insurance as is the situation in South Africa at the moment, then depositors – what would happen to them?
ANDREW CANTER: Well again, we don’t know because the resolution regime isn’t written. Globally, it’s one of the pushes from the G20 – they already have this in many countries. This one’s called Deposit Insurance. An insurance scheme where banks pay a small fee on the deposits they take, which if a bank fails, the deposit insurance pays out those depositors up to a fixed amount. If I recall, in the U.S. it’s $40 000 per account as a cap on what you are paid out Dollar-for-Dollar. In South Africa, they’ll put a cap say of R100 000 per bank account. What that would allow is that if the bank fails and closes doors… Well firstly, it prevents that from happening because it keeps consumer from causing a run in the bank and literally queuing outside the bank to get their money out because they know that they’re insured up to a number.
In addition, if the bank were to close doors, people would still be able to access their money because the deposit insurance would kick in and they’d automatically still be able to make payroll and pay the utilities. Again, that’s only going to cover deposits up to a fixed amount. Above that, you start getting to these questions of  whether your debt covers to equity, and whether you take haircuts. In a Capitec or any one of the Big Five banks that take deposits, there would be questions on how to treat depositors versus institutional investors. Again, Abil didn’t have many depositors, so it doesn’t really apply to them.
ALEC HOGG: That’s amazing. These are really thorny questions, which… Have they never been addressed in the past?
ANDREW CANTER: It’s interesting because they should have been. The truth is the ongoing assumption that we’ve had for quite a long time that the government would ultimately, as a backstop to prevent the banking crisis or a bank failure, keep depositors from losing money has basically meant there are many unanswered questions, and that’s not really unusual.
Frankly, I’m pretty sure that nobody really understood – or perhaps, still doesn’t understand – what’s going on in the financial statements in the operations of banks.
There are so many risks and so many overlapping derivative structures and operations that I’m not even sure bank managers themselves know what’s going on with the balance sheet. They’re almost unanalysable. The fact that we just have faith that the Reserve Bank or the Central Bank is going to keep the banks alive, and people operate on faith.
I think as we go forward, it’s going to have a much more onerous obligation on investors to do analyses of these companies, more so with the ratings agencies – not to trust management so much, but that they should get in there and do better ratio analysis perhaps and get more disclosures. I think people have to be more attuned to potential risks of bank failures.
We’re really envisioning a case of government avoiding bailing out banks.
ALEC HOGG: And if the regulations are harsher, then presumably, bank profitability will also be affected.
ANDREW CANTER: Absolutely. If you think about what led to the financial crisis, we had banks that had implicit government support. They were able to borrow a lot of cheap capital and achieve quite a lot of gearing with that, maybe up to 45 times gearing on equity. You had managers who were incentivised to use all of that gearing, to take risks, and ultimately, a lack of oversight from the regulators and ratings agencies. It all led to chaos and disaster, so going forward we’re going to fix all of those things. We’re going to have less gearing because there are going to be higher capital requirements. There’s going to be more transparency about what the risks are and more oversight. Investors are going to price higher for the risks they take. All of that should reduce bank profitability.
ALEC HOGG: Less gearing does have a direct impact. Would you then look at banks differently, as an investment prospect into the future?
ANDREW CANTER: Remember, Futuregrowth is principally a lender to the banks, and not a shareholder. So from our point of view yes, we would look at banks differently. We’re going to look very closely at how the Resolution Regime comes to fruition, where our risks lie, and pay a lot more attention I guess, to the likelihood of any individual bank actually getting into trouble. We’ll probably judge management more harshly and assess the risk management tools with a keener eye because when banks fail, we will be forced to “bail in”. Our investors will be forced to convert to equity, take haircuts, or take extended terms of repayment in a bank failure.
ALEC HOGG: So presumably, you’re going to want to have that compensated for by a higher return – higher interest rate on the money you lend to banks.
ANDREW CANTER: Yes, that’s probably true. Ultimately, once you measure up all those risks, you’ll end up charging more for it. All of that being said, I don’t think that what’s going on is wrong. I think the fact is we saw what wrong is. We saw 2008/2009 where all of this led to a complete year collapse of the global, financial, and economic system, which had to be supported by governments. That was patently unfair – so more capital requirements, and better regulation and oversight. By the way, the key tenet is matching assets and liabilities. If a bank is making 15-year loans to people it owes money to, but it’s funding that with 91-day deposits, that’s a recipe for disaster because people can pull money out quickly and leave you with a very illiquid bank. That’s being fixed as well through a regulation that forces banks to match their term to maturity of the assets and liabilities.
That’s a good thing. That is good business. I don’t think there’s anything I’ve heard in the regulatory framework being discussed that’s patently wrong, stupid, or incorrect. It should affect how things operate. It should affect their gearing and returns on equity. It should affect their cost of funding from institutions and even from depositors – so be it. That doesn’t mean they’ll be unprofitable or a dire business. It just means you can have a reset.
ALEC HOGG: It probably also means that they’re not going to be making quite the profits that they might have made in their heydays. That’s Andrew Canter who’s with Futuregrowth and this undictated special podcast was brought to you by Futuregrowth Asset Management.
