Impact of Basel Regulations on Monetary Policy:

SARB Roundtable
June 2019
 2

Agenda
1. Background
2. Relevant regulatory changes
• LCR, NSFR and Capital

3. What was the expected impact?

4. Impact of Basel regulations on banks’ balance sheets
• A shift in sources and costs of funding

• Reallocation of resources

• Some (un)intended consequences?

5. Conclusion
 3

Financial sector themes

Regulatory factors Market conditions

• Confluence of SAM & Basel III • Liquidity – funding, primary, secondary, financing,
• Broader savings reform etc.
• Retirement reform
• Market demand for safe-haven liquid assets –
• Retail distribution
• TER & cost of delivery
currently fulfilled by banks
• “Rise of the robo advisor” • Market pricing, failure to differentiate and price risk
• Interactions between regulations • International market backdrop
• The unregulated and unaccountable
• Shadow banking

Economic factors Market developments

• Constraints on SA Inc’s financial resources • Infrastructure, market infrastructure and, minimum
• Financing requirement of SA Inc. standard of operational capability of market
• Increase national savings – a national priority and participant is increasing
financial stability imperative • ETP, CCP and TR
• Intense competition for savings • Cross-border
• Search for efficiency • Fintech
• Unstable political economy
• Financial stability of SOEs
 4

Complex interactions between the financial system and economic policies

Understanding how economic and financial sector policies interact

Financial stability policies Monetary policies Fiscal and debt policies

• Capital adequacy • Policy rate • Fiscal policy

• Financial regulations • Liquidity facilities • Debt management
• Economic capital • Quantitative actions • Reserve management
Financial system credit Sovereign system Global market claims
Household risk indicator credit risk indicator on sovereign
balance sheets

Financial sector Sovereign balance

Monetary policies
policies sheet policies

Corporate
sector balance
Interest rate term structure
sheets

Guarantees

Sovereign equity claims (from capital injections

Source: Dale Gray and Samuel Malone, Macro Financial Risk Analysis in National Treasury Structural, “A Safer Financial Sector to Serve South Africa Better”
 5

Asset allocation of different institutions

Non-bank financial institutions AUM September 2018 Non-bank financial institutions AUM by asset allocation September 2018

ST 24
MMF 316 100%
Insurers, 246
237
538 58
187
80%
Unit
trusts 1,268
1,560 1,004
2270 60% 29
Banks, 1,536
5410
PIC, 40%
2101,
97
LT 20% 1,169 814 908
742
Insurers, Pension
2 897 Funds, 0%
Pension LT Insurers PIC Unit Trusts ST Insurers
3021 Funds
Cash and fixed income Equities Other

Non bank FI - AUM >R10tn FI asset allocation may not always be optimal after consideration
SA banking industry >R5tn of other constraints

Sources: SARB, FirstRand

 6

SA Inc. : Liquidity profile of assets and liabilities

Illiquid (banks) Mortgages & Long term

asset-based Pension
finance, 14% funds, 17%
Loans, 2%
Other, 4%
Credit card,
overdrafts &
PIC, 13%
unsecured, 12%
LT insurers,
19%
Equity, 31%
Unit trusts,
11%

Fixed income,
23%
Banks, 39%

Cash &
Liquid (savings) deposits, 13% Short term

Assets Liabilities

Sources: SARB, FirstRand

 7

Liquidity mismatches are concentrated

Illiquid (banks) Mortgages & Long term

asset-based
finance, 14%
Loans, 2%
Other, 4% Banks, 39%
Credit card,
overdrafts &
unsecured, 12%

Unit trusts,
Equity, 31% 11%

LT insurers,
19%

Fixed income,
23% PIC, 13%

Pension funds,
Cash & 17%
Liquid (savings) deposits, 13% Short term

Assets Liabilities

Liquidity mismatch is concentrated in the banking sector

Sources: SARB, FirstRand
 8

SA liquidity gap
Financial assets Supply side

96M+
96M+

60M-96M
60M-96M
SA Inc.’s balance sheet is not severely
36-60M liquidity gapped. 36-60M

12-36M However, the structure of the balance

12-36M
sheet creates concentrations of
6-12M liquidity risk by institution ALM is not
6-12M
optimal.
3-6M
3-6M

1-3M
1-3M

0M 0M

- 500 1,000 1,500 2,000 2,000 1,500 1,000 500 -

Interbank Bank: Tbills
Retail Depos Non FI Depo's UT - Money Market
Bank: Gov Securities Bank: Other
PF Official PF Private PIC
Equity Market Debt Market
Life Cos Other

Source: SARB, FirstRand

 9

South Africa’s funding sources

Net capital formation and financing thereof (Rbn)

Rbn
500

400

300

200

100

-100

-200
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Household savings Corporate savings Government savings Foreign savings Net capital formation

Sources: SARB, FirstRand

 10

Domestic savings remain constrained; foreign flows under pressure

Current account deficit to GDP (%) Foreign portfolio flows into SA (net)

%
GDP
US$m
90,000
2
80,000
1
70,000
0

60,000
-1

50,000
-2

-3
40,000

-4
30,000

-5 20,000

-6 10,000

-7 -
1994 1997 2000 2003 2006 2009 2012 2015 2018 Jan 00 Sep 02 May 05 Jan 08 Sep 10 May 13 Jan 16 Sep 18
(10,000)
Cumulative equity flows Cumulative bond flows
Source: SARB, FirstRand.
 11

Macro affordability and regulation weighs on credit extension

Private sector credit growth Real private sector credit growth

% y/y % y/y
40 35
35
30
30
25
25
20
20
15
15
10
10
5
5
0
0

-5 -5

-10 -10

-15 -15
Jan-95 Jul-98 Jan-02 Jul-05 Jan-09 Jul-12 Jan-16 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10 Jan-13 Jan-16

Credit extended to households (% y/y) Real credit extended to households (% y/y)

Credit extended to corporates (% y/y) Real credit extended to corporates (% y/y)

Sources: SARB, Stats Á, FirstRand

 12

Less funds available for investment spending

Investment spending growth
% y/y
20

15

10

-5

-10

-15
Mar-94 Jan-96 Nov-97 Sep-99 Jul-01 May-03 Mar-05 Jan-07 Nov-08 Sep-10 Jul-12 May-14 Mar-16 Jan-18

Sources: SARB, FirstRand

Relevant regulatory changes
 14

Basel III and IV: International banking regulations

Comprehensive set of regulatory reforms to make banks “safer”

• Intention:
• To promote stability in the banking sector which will lead stability in financial system
• Reduce damage to the economy by banks that take on excess risk

Source: BIS
 15

Basel IV in a nutshell
Common equity Tier I capital (1)

Additional Tier 1 capital

Tier 2 capital
> 8% +
Credit and counterparty capital buffers
Market risk (3) Operational risk (4) Other risk (5)
risk (2)

Capital floors 1 Credit risk 2

• RWA (using internal model approaches) floored by a percentage of • Revised standardized approach including broadly revised risk
RWA as determined through the standardized approaches. weights and additional due diligence requirements
• The capital floors will eventually be 72.5% based on the new • Constraints on the use of internal models (for some credit portfolios)
standardized approach and introduction of parameter input floors for the IRB approach
• Introduction in 2022 via a phase-in over five years: • Ban on use of internal models-based approach and introduction of a
• 2022: 50.0% 2025: 65.0% standardized approach for CVA
• 2023: 55.0% 2026: 70.0% • New rules for securitization RWA and simple, transparent and
• 2024: 60.0% 2027: 72.5% comparable (STC) securitizations (already finalized in 2016)
• New standardized approach for the calculation of EAD for derivative
exposure (already finalized in 2016)

Market risk (finalized in 2016) 3 Operational risk (OpRisk) 4

• Revised boundary of the trading book and stricter approval of internal
models
• Sensitivities-based approach as new standardized approach, which
also serves as a floor for the internal model approach
• Internal model approach with expected shortfall based on stressed
calibration as key metric, and considering product-specific liquidity
horizon
• Replacement of existing approaches by a new standardized
approach
• Fundamental assumption that operational risk is related to size
• Use of the ‘unadjusted business indicator’ as a measure of
operational risk exposure combined with collection and analysis of
historical loss data

Source: PwC: Basel IV: Big bang - or end game of Basel III? December 2017.
 16

Guidance note 6 of 2018

• Proposed implementation dates for Basel regulatory reforms
Regulatory reform Proposed implementation date

Capital requirements for equity investments in funds 1 October 2019

Capital requirements for bank exposures to central counterparties 1 October 2019
Standardized approach for measuring counterparty credit risk exposures 1 October 2019
Revisions to security framework 1 April 2020
Total loss-absorbing capacity holdings 1 April 2020
Large exposures framework 1 April 2020
Interest rate risk in the banking book 1 June 2021
Interest rate risk in the banking book: disclosure requirements 1 January 2022
Minimum capital requirements for market risk 1 January 2022
Revised standardized approach for credit risk framework 1 January 2022
Revised internal ratings-based approach framework 1 January 2022
Revised credit valuation adjustment framework 1 January 2022
Revised operational risk framework 1 January 2022
Leverage ratio – revised exposure definition 1 January 2022
Output floor 1 January 2022: 50.0%
1 January 2023: 55.0%
1 January 2024: 60.0%
1 January 2025: 65.0%
1 January 2026: 70.0%
1 January 2027: 72.5%
Source: Prudential Authority - Guidance note 6 of 2018.
Relevant regulatory changes
LCR
NSFR
Capital
 18

Two structural factors that constrain the efficient allocation of SA resources

1. The presence of supply/savings constraints, with 2. Presence of concentration risk making it difficult to
operational inefficiencies diversify specific risk combined with perceived
information asymmetries

𝐸 𝑅𝑖 = 𝑅𝑓 + 𝛽𝑖 𝐸 𝑅𝑚 − 𝐸 𝑅𝑓 + 𝐸 𝜖𝑖
Expected Risk free Amount of Price of risk Idiosyncratic risk
return risk factor

Correlation problem, so You cannot get a wel-

unexpected loss in highly diversified debt securities
negatively skewed portfolio in SA

This impacts efficient resource allocation ….

Source: Adapted from the “Credit Spread Puzzle”, BIS Quarterly Review, Q4, 2013.
 19

LCR acts as a monetary policy tool

16,000
+ As maturity transformation increases (liquidity
mismatch)
12,000 + Increase liquidity reserves

Credit growth constrained

— Constrains private credit extension
Theoretical maximum money supply

8,000 • Purchase of government securities leads to

public sector credit instead…

4,000
• Change to the transmission mechanism
• Multiplier can only grow in a specific way
• Term savings are required
0
0.0% 5.0% 10.0% 15.0% • Limits the potential intervention by central banks
Liquidity reserve ratio
when money multiplier collapses in stress
Theoretical Money Supply Limit Current Range

Source: Economic Growth And Transition - Econometric Analysis Of Lim's S-curve Hypothesis
 20

Liquidity reserves impact the credit creation process

% of funding in HQLA

0% 20% 40% 60% 80% 100%

Money multiplier

Insured 3%
13.3x
Retail
Retail

Uninsured 10% 10x

Operational 25% Increasing the reserve

Corp &&

4x
PSE's
public
Corp

requirement reduces
40%
Non-Operational 2.5x the multiplier effect
Operational 25% 4x
FI's
FIs

Non-Operational 100% 1x

< 30d 100% 1x

Other
Other

>30d 0%

Multiplier can only expand in a specific way - term savings is required or credit extension via capital markets/shadow banking

Sources: FirstRand
 21

Guidance notice 4/2018 regarding LCR

• The SARB will phase out the CLF over a period of three years. Over the phase-out period, the size of
the facility will be limited as follows:
Period Cap as % of HQLA requirement

1 Dec ‘18 – 30 Nov ’19 40%

1 Dec ‘19 – 30 Nov ’20 30%

1 Dec ‘20 – 30 Nov ‘21 20%

1 Dec ‘ 21 - onwards No longer provided

• In the event that market conditions change, the SARB may re-evaluate the phasing-out

Significant structural difference are observed in LCR per deposit institution

Sources: SARB, FirstRand

 22

Evolution of LCR in South Africa by various banks

Over the last three years, the industry as a whole has increased its LCR from the low 80% levels to a little under 120% in September
2018, in line with the prudential transition to the steady state requirement of 100%. Over that period, the CLF contributed between
10% and 20% of the industry’s quarterly average LCR

SA Inc. LCR

135%

115%

95%

75%

55%
Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Sep-18
FirstRand Group Nedbank Group Standard Group ABSA Group
Total TOTAL-excluding CLF Regulatory Requirement

Although this suggests that compliance is possible without the CLF, in our experience, the standard deviation of the daily
LCR is circa ±25% that of the quarterly average
Source: Quarterly Pillar 3 disclosures
 23

Analysing the drivers of LCR compliance of SA Inc.

Over the last four years, the increase in SA Inc.’s LCR has been primarily driven by an increase in HQLA as there is little opportunity
for the industry to optimise NCOF due to the limited availability of discretionary savings in the country. This increase in HQLA has been
achieved through increases in both the CLF and other assets in similar proportions

Indexed contribution of the growth in LCR for SA Inc.

1.70

1.60

1.50

1.40

1.30

1.20

1.10

1.00

0.90

0.80
Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Sep-18
HQLA Net Cash Outflows HQLA (excl. CLF)

Over this period, there has been little corporate and SOE issuances which suggests much of the (non-CLF) HQLA growth
can be attributed to government securities

Source: Quarterly Pillar 3 disclosures

 24

Local bank holdings of SAGBs and SATBs

SAGB and SATB issuances have increased by 42% (R1.45trn to R2.0trn) over the last four years. Local banks have
increased their holdings of SA government securities by 38% (from R237bn to R327bn) in the same period

Government bond and T-bill ownership in SA (Rbn)

2,300 R90bn growth in SAGB

and SATB by banks

1,800

1,300

800

300

Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18
-200
Non-residents Other FI's Banks

If the current CLF levels of R140bn are to be replaced in the next three years to maintain current LCR levels, issuance growth in SA
will need to be maintained (at least)
Source: FirstRand
 25

Local bank liquid assets as % of interest-bearing assets

SAGB and SATB issuances have increased by 42% (R1.45trn to R2.0trn) over the last four years. Local banks have
increased their holdings of SA government securities by 38% (from R237bn to R327bn) in the same period

Liquid assets

20%

18%

16%

14%

12%

10%

8%

6%

4%
Oct-09
Oct-08

Oct-10

Oct-11

Oct-12

Oct-13

Oct-14

Oct-15

Oct-16

Oct-17

Oct-18
Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Apr-13

Apr-14

Apr-15

Apr-16

Apr-17

Apr-18
Jul-09

Jul-18
Jul-08

Jul-10

Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16

Jul-17

Jan-18
Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17

Jan-19
If the current CLF levels of R140bn are to be replaced in the next three years to maintain current LCR levels, issuance growth in SA
will need to be maintained (at least)
 26

Domestic savings pool has impact on LCR compliance

Basel III liquidity regulations give preferential treatment to bank retail deposits. However, South Africa’s retail savings
have a structural weighting towards pension funds and insurers compared to bank deposits. In turn, the pension funds
and insurers invest these deposits with asset managers. Hence, banks access most savings of household sector via
volatile wholesale funding

Household discretionary savings vs. contractual savings (Rm)

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Household Bank Deposits (Discretionary) Pension Investments and Long-term Insurance Policies (Contractual)

Sources: FirstRand
 27

Shortage, liquidity reserves and money creation

SARB-administered shortage SA ratio of M3 and M2 to M1

60
2.7

50 2.5

40 2.3

30 2.1

20 1.9

10 1.7

0 1.5
Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jan-07 Nov-08 Sep-10 Jul-12 May-14 Mar-16 Jan-18
M3/M1 M2/M1

Regulation, savings, monetary policy and mechanical implementation of

monetary policy stance compounds to tighten liquidity conditions
Source: SARB, Bloomberg, FirstRand
 28

NSFR update
• In proposed directive published 18 November 2015 (Ref:15/8), the SARB announced amendments to
the NSFR

• Summary key SARB proposal

• Affirmed the 5% RSF for off-balance sheet contingent funding obligations
• Deviation from BIS Basel III
• As per Basel III funding from financial institutions
• Where remaining maturity < 6m, receives a 0% ASF
• SARB has proposed applying a 35% ASF

• SARB indicated that the BIS calibration does not reflect the actual stability of this funding source for
SA
• SARB considered actual local conditions, determining that regulatory and economic barriers that
prevent liquidity from flowing out of the domestic economy

Significant outcome in regulatory reform agenda

Source: FirstRand
 29

Recalibration of NSFR impacts R700bn+ in balances for the sector

1,200 Additional R255 billion ASF 30%

26%
1,000 114 24% 25%

94
800 19% 264 20%

15% 16%
123
600 83 15%
230 680
400 106 10%
316 48 326
137
200 5%
70 327 87 61
31 35
135 86 93 76
0 0%
Transactional Demand 1d-1m 1m-6m 6m+

Retail SME Corporate Govt & Para Institutional Foreign Other

Largely addresses NSFR shortfall of the SA banking sector – the bank estimates
that FRB exceeds the NSFR minimum requirements under this calibration
Source: SARB BA900 Total, December 2015.
 30

Comparing how banks mitigate their risk of outflows

Inflows and HQLA % of outflows

80%
70%
70%

60% 58% 56%

53%
49%
50% 46%
40%
40% 35%
30% 26%
20%
9%
10%

0%
Bank 1 Bank 2 Bank 3 Bank 4 Bank 5

Inflows HQLA

Significant structural difference are observed in NCOF

(inflows and outflows)
Source: Individual banks common disclosure templates as at 30 June 2015
 31

Basel IV – revision to capital approaches

• Revision of the standardised approach of credit risk

Credit risk
• Revision of the internal ratings-based approach
• Redesigned standardised approach
Operational risk
• Abolition of all alternative approaches
• Revision of standardised approach
CVA risk • Introduction of basic approach
• Abolition of the internal model approach
• Revision of the standardised approach
Market risk
• Revision of the internal model approach
• Phase-in over five years, starting 50% in 2022 to fully-loaded 72.5% in 2027
Output floor • Calculated on the basis of institute-related RWA in accordance with
standardised approaches
• Add-on for global systemically important institutions
Leverage ratio
• Revision of framework

Source: FirstRand
 32

High level summary of changes

Capital floor
• Set at 72.5%
• Banks using internal models must hold at least 72.5% of the capital calculated under the
standardised approach
• Capital floor set at an entity level, rather than a risk-type level
• Capital allocation within the entity needs to be revisited
• Standardised approaches
• More risk sensitive across all risk and asset classes
• No advanced approach for operational risk
• Credit risk standard approach risk weights are reduced for key sectors, e.g. real estate
• FRTB (market risk) – no changes announced
• All changes are scheduled for one ‘big bang’ implementation on 1 January 2022, with the capital floor
transitioned from this date

Source: PwC: Basel IV: Big bang - or end game of Basel III? December 2017
 33

Capital ratio for US bank industry over time

Source: Young Research

 34

Improved capital underpin for SA industry

SAGB and SATB issuances have increased by 42% (R1.45trn to R2.0trn) over the last four years. Local banks have increased their
holdings of SA government securities by 38% (from R237bn to R327bn) in the same period

Capital

10.0%

9.0%

8.0%

7.0%

6.0%

5.0%

4.0%

Oct-15
Oct-08

Oct-09

Oct-10

Oct-11

Apr-12

Oct-12

Oct-13

Oct-14

Oct-16

Oct-17

Oct-18
Apr-08

Apr-09

Apr-10

Apr-11

Apr-13

Apr-14

Apr-15

Apr-16

Apr-17

Apr-18
Jul-08

Jul-09

Jul-10

Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16

Jul-17

Jul-18
Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17

Jan-18

Jan-19
If the current CLF levels of R 140bn are to be replaced in the next three years to maintain current LCR levels,
issuance growth in SA will need to be maintained (at least)
Source: FirstRand
What was the expected impact
 36

Stylised model to express the expected impact on the economy

Pattern and
cost of bank
funding

Terms and
Regulatory Bank asset availability of Impact on the
reform allocation credit (bank and economy
non-bank sector)

Bank
business
model

Source: BER Basel III assessment, 2012

 37

Expected impact on the economy: BER assessment, April 2012

Real GDP growth under different credit cost and availability scenarios: Annualised GDP forecast: 2010 - 2018

4.5

Expected reduction of
4
0.65 ppt over 5 years
(17%)
3.5

2.5

1.5

0.5

0
Base GDP2 Real GDP with +75bps Real GDP with +115bps Real GDP after credit
credit cost credit cost restriction

Source: BER Economic Impact Assessment, April 2012

 38

Expectations of Basel III for banks at the onset of implementation

banking activities
Investment

Retail banking
B
a
Expected business adjustments
n
k
Tier 1 Short- Long-
R Capital term
term
O funding
liquidity
E

Sources: McKinsey Working Paper on Risk, Basel III and European banking: Its impact, how banks might respond, and the challenges of implementation
Impact of Basel regulations on banks’ balance sheets:
A shift in sources and costs of funding
 40

Pillars of market liquidity – suggest all markets are constrained

Greater liquidity transmission is required across markets

Cash market Repo market FX swap market

(funding liquidity) (financing liquidity) (cross currency liquidity)

In an efficient market banking system should transmit liquidity to all markets as required

Central bank market operations

Charles Goodhart of the BIS Advisory Committee, BOE and LSE explains:
“Ultimately, Central Banking is about providing liquidity and liquidity provision is an essential and central component of financial stability.”
 41

Components of fixed income risk premia

Risk premia
Liquidity premium • Liquidity risk premium
• Concentration risk premium
• Supply constraints
Credit risk premium • Other risk premia
• Incomplete closed market
• Uncertainty arising from
Credit: EL
resolution framework
Term premium Term premium
Risk premia
Inflation risk premium Inflation risk premium
Expectation
+ fixed income premium
E[Inflation] E[Inflation]
Expectation
E[Real yield] E[Real yield]

Government debt Corporate debt

Depending on the nature of the risk premium, the market

action to restore equilibrium would be very different

Source: FirstRand
 42

SA sovereign risk ads to required real yield; offset by falling global yields
South Africa 5-year CDS US 5-year real yield

bp
%

5.0
300

4.0

210bp
250 3.0

2.0 150bp
200
1.0

120bp 0.0

150 30bp
-1.0

-2.0
100 Jan-00 Jan-03 Jan-06 Jan-09 Jan-12 Jan-15 Jan-18
Jan-10 Jan-12 Jan-14 Jan-16 Jan-18

Sources: Bloomberg, FirstRand

 43

Persistent focus on inflation target contained lift in nominal risk-free yields

South Africa 5-year breakeven inflation rate

bp

800

750

700

600bp
650

600
500bp
550

500

450

400
May-12 Nov-12 May-13 Nov-13 May-14 Nov-14 May-15 Nov-15 May-16 Nov-16 May-17 Nov-17 May-18 Nov-18 May-19

Sources: Bloomberg, FirstRand

 44

Application of the Moody’s KMV G-Core model to determine credit

spread
bp
250

Total funding spread (bp)

195
200 186
176
167
158
145
150
128 120
118 111 Market price of risk
93 102
98 85
76
100 63
78 61
54 12 12 11 12 12
12 11
50 50 12
8 Implied risk neutral credit
58 61 62 63 63 63 spread
7 44 53
35
21
-
1 2 3 4 5 6 7 8 9 10
Tenor (m)
Risk Neutral Credit Spread BBB- Risk Neutral Credit Spread BB+ Risk Premium

Decomposing the credit spread term structure shows component attributable to “risk premium”
Sources: Moody's, FirstRand
 45

Liquidity & repo financing markets reflect some inefficiencies

TB swap spreads “TED” spread Average traded repo rate in government collateral (%)

7.35
100 TBS above swap curve
7.16
7.15 7.08
75
7.00
6.95
6.95 6.87
6.86 6.84
50 6.81
6.76 6.74 6.76
6.75 6.72
6.66 6.66
25

6.55 6.48
-

6.35
-25

6.15
-50

TBS below swap curve 5.95

-75
31-May-13

31-May-14

31-May-15
31-Jan-13

31-Jan-14

31-Jan-15

31-Jan-16
31-Jul-13

31-Jul-14

31-Jul-15
30-Nov-13

30-Nov-14

30-Nov-15
31-Mar-13

30-Sep-13

31-Mar-14

30-Sep-14

31-Mar-15

30-Sep-15

5.75

3M TBS 6M TBS 9M TBS 12M TBS Poly. (12M TBS)

Source: Bloomberg, FirstRand

 46

Many channels acting on the price of money

Official interest rates External shocks

Money market
Expectations
interest rates
Changes in risk premia
Money, Asset Bank Exchange
credit prices rates rate
Changes in bank capital

Wage and Supply and demand in

Changes in the global
price-setting goods and labour markets
economy

Domestic Import
prices prices Changes in fiscal policy

Changes in commodity
Price developments prices

Textbook monetary policy transmission map;

new regulatory regime impacts the credit channel

Source: https://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html.
 47

Many channels acting on the price of money

Official interest rates External shocks

Money market Regulatory effects Proposed

Expectations
interest rates
Changes in risk premia
Money, Asset Bank Exchange
credit prices rates rate
Changes in bank capital
Regulatory factors include:
Wage and Supply and demand in • LCR
price-setting goods and labour markets Changes in the global economy • NSFR
• Leverage ratio
• Capital coverage
Domestic Import • D SIB
prices prices Changes in fiscal policy
• Capital conservation
• Capital quality
• Resolution
Changes in commodity prices
Price developments • Write off
• Convertibility

Post-GFC regulatory effects have been powerful, impacting price, availability and risk appetite; significant observable effects on
credit transmission channel

Source: https://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html and FirstRand edit

 48

It all transmits to the price of credit

• Hypothetical example showing credit carrying cost has already increased 358bps since June 2013
before credit loss ratio

11.00%

9.95%
10.00%

8.65% Liquidity risk premiums

9.00% +102bp
1.80%

8.00% Liquidity risk premiums +76bp

1.54% Cost of capital
1.37% +66bp
7.00% 6.49% Cost of capital +40bp
Liquidity risk premiums 1.11%
6.00% 0.78%
Cost of capital Repo +175bp
5.00%
0.71% Repo 6.75%
+100bp
Repo 6.00%
4.00%
5.00%
Assumptions Jun-13 Avg Jul-15 May-19

Risk free rate Regulatory capital requirement

• 2013: 7.5% • 2013: 9.5% • Average bank RW: 60%
• 2015: 8.25% • 2015: 14% • Asset term 36-m

Sources: Bloomberg, FirstRand

 49

Money market trade statistics

NCD distribution by issued tenor (months) NCD distribution by size of issuance (months)
200 120
Industry benchmarks High-value trades enable
180 (e.g. STEFI) outperformance
100
160
55

140
80 28 32

120
42 22
100 60
21 17
16
80 16

44 18 40 13
60 22 15 21
28
18
17 6 10
11
40
20 7 14
18 18 10
5 5
20 10 43 8 25
4 3 21 19
7 8 21 21 4 13 13
7 3 5 8
2 0 9
- 0- 0 0
1 0
1 0 3 2
1 0
1 2 0 11 -
1 2 3 4 5 6 7 8 9 10 11 12 <24 <36 <60 <20m <50M <100M <200M <300m <500m >500m

Bank 1 Bank 2 Bank 3 Bank 4 Bank 1 Bank 2 Bank 3 Bank 4

Market statistics infer that money market investors appear to run a rolling 12-m strategy

Source: STRATE
 50

Noteworthy pricing pressure in funding markets

Mid bank funding spreads [mid bp]
bp
GFC Spreads imply liquidity constraint

200

180

160

140

120

100

80

60

40

20

0
Jun-07 Mar-08 Dec-08 Sep-09 Jun-10 Mar-11 Dec-11 Sep-12 Jun-13 Mar-14 Dec-14 Sep-15 Jun-16 Mar-17 Dec-17 Sep-18
12-month NCD/ spread 3-year NCD spread 5-year NCD spread

Liquidity pricing at level seen in the crisis as consequence of misaligned market forces, economic conditions, regulation and market
operations
Source:
Source: Bloomberg <RMBP> and
Bloomberg <OTC ZAR>
<RMBP3>
 51

Impact on the banking sector’s professional funding cost: paying

more for term funding
Bank sector funding: Spread between 12-month NCD and 3-month NCD
Term spread (bp)
(12-m/3-m NCD
250
Prof cost of funding

200

150

100

57bp
50

-50
Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 Mar-17 Sep-17 Mar-18 Sep-18 Mar-19

Source: FirstRand
Impact of Basel regulations on banks’ balance sheets
Reallocation of resources
 53

Implied value of liquidity mismatch drives balance sheet structure

Shareholders
underwrite the pricing
risk (albeit temporary)

Funders
Borrowers
• Savers (average
(Average duration Bank
Balance duration – 3 months
of four years
sheet • Professional funding
R5,6trn
– 12 months
Prime plus 144Bps
Repo plus 114bps

Liquidity
mismatch Value
R18bn industry

Source: BER Basel III assessment, 2012

 54

Expected impact on banks’ balance sheets

Pre-Basel Post-Basel Pre-Basel Post-Basel

Other Other
Other Other
Long-term Long-term
and short- and short-
Debt term debt term debt
securities Higher Debt
securities Equity Equity

Lower Debt
Professional securities
funding

Customer
lending Lower Customer
lending Retail &
Retail Higher Commercia
Deposits &
l Deposits
Commercia
l Deposits

Assets Liabilities
• Increased competition for retail and corporate deposits
• Reduction in professional funding
• Increase investment in government bond and other “high quality liquid assets”
• Reduced customer lending
Source: European Banking Authority, ING Investor Day, January 2012
 55

Change in advances composition: industry

ADVANCES Dec-13 Dec-18

Retail 46% 39%

- Residential mortgages 28% 24%
- Vehicle asset finance 8% 7%
- Unsecured 10% 8%

Corporate 40% 48%

- Mortgages, instalment finance and leasing 12% 13%
- Corporate loans 17% 20%

- Other 11% 15%

Non-core 14% 13%

Source: SARB BA information

 56

Change in funding composition: industry

Funding Jun-13 Dec-18

Retail 21% 23%

Corporate 17% 15%

Commercial 23% 24%

Professional funding 39% 38%

Source: SARB BA information

 57

Bank sector assets: reallocation of funding from private sector to the

government
Bank sector assets: Government bonds and Treasury bills vs. private sector credit (% of total assets)

% % • Contributed to shift of
8 85 funding resources
from the private sector
83 towards government
7
Government bonds (% of total assets)
81
6
79

5
77

4 75

73
3
Credit to private sector (% of total assets)
71
2
69

1
67

0 65
Jan-00 Jun-01 Nov-02 Apr-04 Sep-05 Feb-07 Jul-08 Dec-09 May-11 Oct-12 Mar-14 Aug-15 Jan-17 Jun-18

Source: SARB, FirstRand, December 2018

Impact of Basel regulations on banks’ balance sheets
Some (un)intended consequences?
 59
59

Less volatility in bank sector advances and the cost thereof

Credit extended to the private sector (% y/y)

%
25.0

20.0
Pre-credit boom period:
Basel III implementation
15.0 *real growth: 8.3%
period:
*standard deviation: 4.2%
Credit growth * real growth: 1.9%
10.0 * standard deviation: 2.0%

5.0

0.0

-5.0

-10.0
Jan-94 Nov-95 Sep-97 Jul-99 May-01 Mar-03 Jan-05 Nov-06 Sep-08 Jul-10 May-12 Mar-14 Jan-16 Nov-17

Source: SARB, FirstRand, December 2018

 60
60

An increase in the cost of credit & a decrease in credit supply (pvt sector)
Cost of debt (households): spread above the prime rate Bank sector assets: Pre-Basel Liquid Asset Ratio scenario vs actual
Basel III Rbn
%
implementation:
3.0 GFC aftermath: 4,500
2.50% spread
2.15% spread
2.5
4,000

2.0

SARB 3,500
Pre-GFC: HH
-0.2% debt service cost
1.5

1.0
3,000
0.5

0.0 2,500

-0.5
2,000
-1.0 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19
Advances: No Basel Incentivised Allocation to Bonds
Mar-00 May-02 Jul-04 Sep-06 Nov-08 Jan-11 Mar-13 May-15 Jul-17
Advances: Basel Incentivised Allocation to Bonds

Source: SARB, FirstRand, December 2018

 61
61

More funds available for government spending (liquid assets)

Bank sector government debt holdings (% of total assets) & government spending (% total SA spending)

23.0 8.0

Government bonds (% of total assets)

22.0 7.0

21.0 6.0

20.0 National acc - spending 5.0

19.0 4.0

18.0 3.0

17.0 Government consumption spending (% of total SA spending) 2.0

16.0 1.0
Mar-00 Sep-01 Mar-03 Sep-04 Mar-06 Sep-07 Mar-09 Sep-10 Mar-12 Sep-13 Mar-15 Sep-16 Mar-18

Government consumption Government bonds (% bank sector assets)

Source: SARB, FirstRand, December 2018

 62
62

More funds available for government spending (liquid assets)

Public sector investment spending growth (% total spending) & Bank sector investment in government bonds (% total assets)

4.0 8.0

3.8 Government bonds (% of total assets)

7.0
3.6

3.4 6.0

3.2
National Acc Spending 5.0

3.0

4.0
2.8

2.6 3.0

2.4
Government investment spending (% of total SA spending) 2.0
2.2

2.0 1.0
Mar-00 Sep-01 Mar-03 Sep-04 Mar-06 Sep-07 Mar-09 Sep-10 Mar-12 Sep-13 Mar-15 Sep-16 Mar-18

Government investment Government bonds (% bank sector assets)

Source: SARB, FirstRand, December 2018

 63

How much has reallocation of funding sources contributed to lower

private sector investment spending?
Private sector investment spending growth

17.0 85

Loans and advances (% of total assets) 83

16.0
81

15.0 79

77
14.0
75
13.0
73

12.0 71

69
11.0 Private sector investment spending (% of total SA spending)
67

10.0 65
Mar-00 May-01 Jul-02 Sep-03 Nov-04 Jan-06 Mar-07 May-08 Jul-09 Sep-10 Nov-11 Jan-13 Mar-14 May-15 Jul-16 Sep-17 Nov-18
Government bonds (% bank sector assets) Total loans and advances (% Total assets)

Source: SARB, FirstRand, December 2018

Conclusion
 65

In summary

• Banks have increased the loss absorbing capacity in terms of

• Capital, expected loss provision (IFRS 9), resolution plan (TLAC)
• Banks have increased their liquid assets
• Banks have realized the importance of deposit franchise
• Increase price of money to savers
• Increased discretionary savings
• Manage liquidity mismatches
 66

In summary

• At what economic costs?

• Reduction in money multiplier
• Increase in price of money to advances
• Increase the correlation between sovereign and banking industry
• Decrease in GDP
• Change composition in balance sheet, i.e. increase liquid assets, transmitted through to
other sectors of the economy.
• Cost of reduction in SA Sovereign Risk would have a severe earnings impact
End
 68

Integrated financial sector policy: Multiple investor needs, competing

platforms, providers and investments

Investors Decision Institutions Decision Investments (AUM)

levers l levers ll

Cash and near cash

Pension funds
Individuals
Economic incentives Economic incentives Money market funds
Long term insurance
Banks

Corporates Corporate bonds

Investment funds

Tax incentives Tax incentives Government bonds

Banks
Government Equity

Alternative investments
Corporate - JSE
Regulatory incentives Regulatory incentives Property
Foreign
Government
Foreign sector

Banks are only one of many platforms

Source: National Treasury Structural Liquidity & Funding Task Group

 69

Assets under management by FI licence

R16trn
100%
2% 5% 8% 10% 13% 14%
9%
25% 11%
80% 12% 13% 13%
30% 22% 19%
60% 20% 18% 18%

21% 20% 19%

40%
20% 19%

53%
20%
34% 35% 37% 34% 34%

0%
1990/03 2000/03 2005/03 2010/03 2015/03 2018/03

Banks Pension Funds LT Insurers PIC Unit Trusts Money Market Funds ST Insurers

Sources: SARB, FirstRand

 70

SA’s income growth is under significant pressure

Corporate income growth (gross operating surplus) Remuneration of employees

% y/y % y/y
15 22

20

18
12
16

14

9 12

GFC 10

EM crisis 8
6
6

EM crisis GFC
4

3 2
Dec-94 Dec-97 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 Dec-15 Dec-18 Dec-94 Dec-97 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 Dec-15 Dec-18

Source: StatsSA, FirstRand.

 71

The cost of doing business are increasing

South Africa: Ease of Doing Business Index

Ranking
90

80

70

60

50

40

30

20

10

0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Sources: World Bank (Doing Business), FirstRand

 72

Basel IV timeline
Overview
No standardized rules on capital adequacy Pillar I capital ratios
1988 – Basel
Capital Accord for banks. Rules depend on bank
regulators of individual countries. No rules Capital ratio
Pre-Basel in some countries
CET1
1988 Basel sets
RWA
rules for credit 1996 – Market
risk only risk amendment
LCR
Credit risk BCBS adds standardized approach and Liquidity buffer
internal model approach for market risk Net cash outflows
2004 –
Finalisation of the
revised Basel II NSFR
framework Credit +
Available stable funding
market risk
2009 – Basel 2.5 Required stable funding
Basel II rules for
credit, market and changes to
market risk and Leverage ratio
operational risk Credit + market securitisations
+ operational Tier I capital
risk Total exposure
2010 – Basel III adds revised definition of capital,
Introduction of the risk-based capital requirements, a leverage
new Basel III Capital + ratio requirement and new liquidity
standards Large exposures
framework liquidity +
leverage

Source: PwC: Basel IV: Big bang - or end game of Basel III? December 2017.
 73

Summary of comparisons between standardised approaches –

Basel II vs. Basel IV
Risk type Basel II Basel IV
Credit risk • Calculation of risk weights per exposure • Seeks to improve the granularity and risk sensitivity of the standardised
Standardised • Risk weights for a country (sovereign) exposure ranges approach
from 0% to 150% and for an exposure to another bank • New additions:
approach
or corporation ranges from 20% to 150% • New risk weights for rated and unrated exposure to covered bonds
• Credit ratings considered in determining the appropriate • Exposure to project finance, object and commodities finance - risk
risk weights weights for rated exposures follow the general corporates and three
subcategories of specialised lending is introduced to improve granularity

Operational • Very similar to BIA, except that different business lines • SMA - new standardised approach is an accounting measure based on the
risk have different multipliers bank’s income (business indicator component) and historical losses
• Total capital charge – three year average of the simple experience (internal loss multiplier)
Standardised
summation of the regulatory capital charges across • Assumes operational risk increases at an increasing rate with the bank’s
approach each business line in each year income and the likelihood of incurring operational risk losses increases in the
future if the bank has higher historical operational risk losses
• Combination of BIA, TSA and ASA

Market risk • Simple sum of the three components: the risk charges
Standardised under the sensitivities-based method, the default risk
charge and residual risk add-on
approach
• Sensitivities-based method: delta, vega and curvature
• Using elements from the former standardised measurement method, the
sensitivities-based method builds on the elements and expands the use of
delta, vega and curvature risk to factor sensitivities
• The standardised approach capital charge is the sum of the sensitivities-
based method capital charge, default risk charge and residual add-on

Source: FirstRand
 74

Expected impact on monetary transmission mechanism

• Interest rate channel: An increase in lending spreads

Relationship between the central bank’s policy rate and other interest rates. For example:
• Higher liquidity and capital requirements suggests wider spreads between risk-free rates and
rates faced by bank customers because of:
• Higher funding costs
• Lower return on investment (more investment in government bonds due to LCR and NSFR)

• Credit channel: A decrease in the availability of credit to the private sector

Basel III increases the amount of capital banks should hold against risk-weighted measures of assets
• Any effects on monetary transmission will be greater in those financial systems where firms and
households are more reliant on banks for their external finance

• May require a slightly different policy rate all else equal

Source: Committee on the global financial system markets committee, CGFS Papers no 54
 75

Bank sector assets: shift away from mortgage lending

Bank sector assets: Home loans, “other” corporate loans and institutional (% of total funding)

% total % total

22.0 40.0

20.0
Other corporate loans 35.0

18.0
30.0
Home loans
16.0

25.0
14.0
Non-core loans
20.0
12.0

10.0 15.0
Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Jan-19

Non-core Other corporate loans Home loans

Source: UBS, FRB SARB BA900, December 2018