Banking and toxic debt

24 Jun.

Banking and toxic debt.

The big banks have made progress in reducing bad debts but a huge amount of toxic debt still clutters balance sheets.

Absa has initiated a new campaign aiming to educate its customers on how to reduce debt by learning how credit works and living within their means.

But the amount of bad debt on the books of banks does raise questions about the efficacy of their own credit risk management systems, supposedly the most sophisticated in the world. When the blame is put on indebted customers it is often forgotten that banks also have defects in their systems.

Part of the problem relates to the volume approach taken by banks, where lending is based on an aggregate view of a market and not always the individual financial circumstances of a customer.

This is changing , says Absa Retail Bank CEO Gavin Opperman. “We are much more in tune with the individual preferences of customers.”

He says the credit risk systems of banks have improved through the introduction of more careful lending practices and by keeping customers longer on the books of the bank. “As an example, we now have only 800 properties in possession compared to 4500 in the previous cycle.”

In the process, however, some lending to customers has fallen through the cracks. Absa recently lost its mortgage market share dominance to Standard Bank. Opperman admits the focus on new business has suffered but says it will be advantageous for the bank over the longer term. “You have to ask yourself where the client goes after being declined at Absa.”

That implies the client is accepted by another bank, possibly leading to a growing bad debt risk there . Opperman says Absa has become even more reluctant to take a mass approach in mortgage lending because the bank expects interest rates to rise at the end of the year or the beginning of 2012.

Absa is the only bank among the big four where nonperforming loans are still climbing. They rose by 10% in 2010. This partly reflects the reality of keeping defaulting clients longer on the books at the expense of resuming large-scale lending to increase normal interest income. But it is also the result of overlending in the past.

Nonperforming loans at Absa have climbed above R39,6bn and the figure is now more in line with that of Standard Bank, which aggressively reduced its exposure to R42,7bn after it was ballooning towards R50bn at one time.

What worries analysts is that some of the bigger banks, particularly FirstRand and Standard Bank, have reduced their impairment provisions, which may indicate an inappropriate optimism that a large number of nonperforming loans could eventually be recovered.

Impairments are specific write-downs of assets on a bank’s balance sheet while nonperforming loans are only arrear loans, usually more than three months.

Standard Bank reduced its impairment provisions by 8,4% to R17,1bn in 2010 while provisions at FirstRand were 10,4% lower and amounted to R9,8bn in the first half of its financial year. With nonperforming loans climbing at Absa, the bank did increase its provision level by 5,7% to R13,9bn.

The focus has been on Nedbank, which has nonperforming loans of R27bn on its books, giving it the dubious honour of having the highest ratio relative to its size. Its provisions were hiked by 14,6% to R11,2bn in 2010.

On the positive side, Moody’s SA banking analyst Constantinos Kypreos believes nonperforming loans have peaked. He does not expect declining levels to reach the lows of the past, though, and foresees some further risks.

“Consumers are highly indebted and mortgage lending is still frequently based on high loan-to-values.”

He also notes the relatively low provision levels at banks, saying the present average of 33% may be inadequate. “If a correction were to occur, banks would have to increase their reserve coverage.”

He says the fault does not lie with the credit risk models. “Some are quite sophisticated and adhere to the most advanced Basel 3 capital requirements.”

However, with hindsight, it was a mistake to approach lending as if customers were all the same, he says.

According to Kypreos, excessive lending can usually be prevented by focusing on the individual needs of customers and building relationships. But that is more costly. “This is one of the reasons why banks are moving away from lending to the middle market to focus on increased unsecured lending.”

By adopting this approach, credit risk models can more easily identify problem areas based on past experiences.

All the banks, however, expect further improvements in their credit impairment ratios. The figures show FirstRand at present has the lowest ratio to advances, 0,96%, which could further fall to 0,84% in the full year. Nedbank has the highest ratio, 1,31%, but this is expected to fall to 1% by the end of the year.

Falling impairments and a peak in nonperforming loans have not resulted in higher income for banks because lending has largely remained flat. The investment case for banks has remained negative for most of the year and only a gradual improvement is expected for the rest of the year.

The greatest market disappointment has been Standard Bank, showing an overall loss in its share price of 8,5% for the past 12 months. It remained above R100/share for most of the year in expectation of an income uplift, but has since fallen to R95. Analysts expect only a slow recovery at best.

Absa and Nedbank have shown pedestrian share price growth of between 5% and 10% for the 12 months. FirstRand has been the performer, with growth of 17,6% over a year.

FirstRand did experience positive investor sentiment after the unbundling of its related insurance holdings at the end of 2010, but has since then levelled off. Investors seem to prefer to wait for more favourable economic conditions before they commit themselves.

However, it is believed that FirstRand has the most upward potential should economic conditions improve, thanks to the exposure of First National Bank and WesBank to the retail market. Impairments look the most positive, though this is slightly misleading because a large part of the lending book is nonretail, where bad debts could be recovered faster.

FirstRand’s present focus on unsecured lending and cost expansions, especially at FNB , could imply riskier circumstances. But that could only become more pronounced in the next financial year.

FirstRand management have reassured investors that lessons have been learnt from the credit splurge before 2008, which pushed bad debts beyond the levels envisaged by the banks’ risk models.

At times those banks that increase lending could be favourite investments because income is increased. That time seems long passed under the present unfavourable circumstances where the focus is on reducing bad debt.

Source: Financial Mail