Will digital banks disrupt South Africa’s big five?

digital banks

South Africa’s banking sector is undergoing a major shake-up, with the arrival of three low-cost digital banks that have the potential to reshape the domestic financial landscape in a way not seen since the arrival of Capitec Bank in 2001.

Capitec Bank’s emergence almost two decades ago – with the bank offering an aggressive pricing model for the retail sector – successfully challenged the hegemony of the four largest banks at the time: Absa Bank, FirstRand, Nedbank and Standard Bank. The arrival of three new banks in 2019 is also likely to have a strong impact, particularly on the digital strategies of the existing players, while increasing competition at a time when economic growth continues to be muted in South Africa.

“I think that new entrants and competition is really good for our industry. It’s good for our business and it’s good for customers in general,” says Mike Brown, CEO of Nedbank, one of South Africa’s largest banks, which saw its headline earnings rise 14.5% to R13.5bn ($967m) in 2018, with return on equity (excluding goodwill) up from 16.4% to 17.9% and total assets exceeding R1000bn for the first time in the bank’s history. “That said, I think that for a long time Nedbank has understood the importance of the digital journeys that banks all over the world are on,” adds Mr Brown.

A stable sector

As of December 2018, there were 34 banks operating in South Africa, including 15 local branches of foreign banks. However, the sector is dominated by five large players – Absa Bank, FirstRand, Nedbank, Standard Bank and Capitec Bank – which combined have a market share that exceeds 90%.

The sector had total assets of R5500bn in December 2018, up 7% year on year, according to the South African Reserve Bank (SARB), the country’s central bank. The sector’s return on assets figure was unchanged year on year at 1.3%, while banks’ return on equity rose slightly to 15.98%. Meanwhile, the cost-to-income ratio of the sector stood at 57.34%, with the Tier 1 capital adequacy ratio dropping slightly from 13.5% to 13.04% on an annualised basis.

“The South African banking sector is large, highly concentrated and well capitalised. Average capital adequacy and liquidity ratios are above regulatory requirements despite weak economic growth,” says Lungisa Fuzile, chief executive of Standard Bank South Africa, the largest bank in South Africa by total assets, which saw its group headline earnings rise 6% to R27.9bn in 2018, with total assets of R2100bn and a return on equity of 18%.

“In contrast, the operations of medium-sized and small banks, with lower asset quality, are more sensitive to economic activity, especially if growth remains low for protracted periods,” he says, adding that while these banks may be small, the broader banking system could be affected negatively if they begin to face challenges, triggering a macro-financial feedback loop.

With economic growth in the country likely to remain limited, South African banks are expected to see more limited opportunities to lend and expand in the short term. In its latest Banking System Outlook for the country, released in September 2018, rating agency Moody’s predicted that South Africa’s subdued gross domestic product growth would persist in 2019, with weak investment and consumer confidence limiting household spending and private investment. “The challenging operating environment will suppress business opportunities and loan demand and exert pressure on banks’ loan quality,” it added, with banks continuing to tighten their lending criteria in response to the weak economy, further dampening loan growth.

Despite this, the ratings agency changed its outlook for the South African banking system from ‘negative’ to ‘stable’, in the belief that the banks will proactively manage their loan quality and contain any risks stemming from the slower pace of growth, having built up strong liquidity buffers over the past few years.

Growth potential

While the overall economic landscape is less than ideal, there is still plenty of cautious optimism about the South African banking sector in general.

“Overall the banks are still robust,” says Cas Coovadia, managing director of the Banking Association South Africa. “Retail has had its problems, and significant parts of banking operations – such as mortgage financing – have been flat. Where banks have done well is more on the consultancy, advisory businesses and wealth management,” he adds.

digital banks

Those involved in the sector see opportunities for growth, particularly on the corporate side.

He also points to infrastructure financing as an important area of focus for banks operating in South Africa. “Government finances are stretched in South Africa, yet we have significant infrastructure shortages, particular in power. This creates an ideal opportunity for public-private partnerships,” he says. Nedbank closed 12 renewable energy project deals in 2018, valued at R13bn, as part of the fourth round of the government’s Renewable Energy Independent Power Producer Programme, a public procurement programme that offers strong lending and advisory opportunities for the banking sector.

Meanwhile, according to an April 2019 credit opinion report by Moody’s, the tightening of credit standards that commenced in 2015 has helped South African lenders reduce their exposure to the household sector, considered the most vulnerable to interest rate shocks, and redirect it towards corporates, which “have a better debt-servicing capacity”, according to the report.

New lenders

The arrival of three digital banks in 2019 could have a major influence on the domestic banking sector in South Africa. The emergence of Capitec Bank in 2001, with its aggressive price model. Siphoned off customers from the existing banks. And Capitec Bank has since become one of the largest bank in the country. With 266,000 clients added in January 2019 alone, its highest single-month growth to date. The bank achieved an average of 127,000 new clients a month in 2018, and for the financial year ending February 2019 saw headline earnings rise 19% to R5.29bn, with a return on equity of 28%. The bank currently has more than 11.4 million active customers.

The new lenders could make a similar impact. Some are predicting that the new banks could have cost-to-income ratios in the region of 30%, half that of the larger incumbent lenders, giving them a strong advantage as they look to grow their retail operations and overall reach. The banks’ digital foundations are also likely to appeal to South Africa’s younger, more urban demographic.

“As in any industry, new banks trigger all existing banks to become more competitive – with their innovation and their pricing,” says Lezanne Human, co-founder and executive director of Bank Zero. “The end customer is the real beneficiary in this process. We believe that our value proposition will resonate across all segments. Anyone from any segment, other than listed entities and government organisations, can join Bank Zero, as long as they have access to a smartphone,” she adds.

Bank Zero, which will focus initially on transactional accounts, as well as cash saving and investment accounts, will have a staggered launch throughout 2019, with various waves of beta testing.

Despite the ambitions of those involved in the new banks. It will likely be some time before high numbers of customers feel comfortable switching over. South Africans have shown themselves to be cautious about switching banks in the past. And one of the key challenges for the new lenders will be to build that level of trust. Despite this, Ms Human says that SARB’s Prudential Authority is strict when it comes to issuing new licences.

Greater offerings

One area that could see strong growth in the near future, driven partly by increased competition. Is the adoption of digital services and the roll out of fintech.

“South African banks are among the most innovative banks worldwide”. Says Co-Pierre Georg, an associate professor at the African Institute of Financial Markets and Risk Management at the University of Cape Town. He adds that the arrival of the new banks will change the competitive landscape in South Africa.

“Our banks enjoyed little competition for decades and made great profits during this time, at least for their shareholders.

Consumers can also expect to see a strong push towards new and innovative products and services. As banks operating in South Africa try to differentiate themselves and add perceived value. “Increased completion could see a focus on non-financial services, some disintermediation of the sector. But also a focus from traditional banks on offering an all-inclusive professional service”. Says Annabel Bishop, chief economist at South Africa’s Investec Bank.

“Offerings will clearly be important. Particularly distinguishing offerings, and client target markets. As well as who the new entrants will link to. The space they will play in, and the resultant disruption caused on the financial services industry,” she adds.

Changes to regulation

Some larger lenders engaged in important restructuring in 2018.

Nedbank also completed its own managed separation from Old Mutual in October 2018. One of the largest corporate actions in South Africa last year. With Old Mutual reducing its stake from 52% to 19.9% to become a strategic minority shareholder.

There have also been important regulatory developments related to the finance sector. In April 2018, South Africa implemented a new regulatory model for the financial sector known as ‘Twin Peaks’. Modelled on a similar regulatory approach taken by Australia.

digital banks

Meanwhile, International Financial Reporting Standard 9, or IFRS 9. Came into effect in South Africa at the beginning of January 2018. And has had a significant impact on the way provisions for credit losses are calculated. “South Africa has a relatively sound legal system, deep. Liquid and well-developed financial markets. A reflection in large part of its well-regulated and highly sophisticated banking system.” says Investec Bank’s Ms Bishop.

Foreign operations

Unlike in other parts of Africa, more than 80% of South Africa’s population have bank accounts. Which illustrates the maturity of the market but also the limited opportunities to expand customer bases.

Perhaps as a result. South African lenders have continued to increase their exposure to regional economies across the African continent. Tapping into underbanked markets as they look to increase growth as well as diversify their risk portfolios. Standard Bank now operates in 20 African countries. While Nedbank has operations in Lesotho, Malawi, Namibia, Swaziland and Zimbabwe. With representative offices in Kenya and Angola. Nedbank also bought a 20% stake in pan-African lender Ecobank Transnational in 2014. Which has the largest banking network on the continent, with roughly 2000 branches across 36 countries.

“The African operations will continue, and by and large they’ve been successful,” says Banking Association South Africa’s Mr Coovadia. “Places such as Ethiopia, as they open up, provide new opportunities for South Africa’s banking sector. Generally the continent is looking positive. There are still pockets of problems, such as the Democratic Republic of the Congo and Sudan. Which will remain for a while – but by and large places in east Africa. And west Africa are still good places for business,” he adds.

At the same time, South Africa’s lenders have shown a willingness to adapt to changes in the domestic market. In March, Capitec Bank lowered its banking fees, likely in reaction to the new competition. The bank is also in the process of buying commercial lender Mercantile Bank. As part of a move to formally enter the business banking space. Such incidences point to positive signs for the banking sector going forward.