South Africa boasts one of the world’s most advanced financial systems, and the country’s stock exchange market stands among the finest globally. According to the National Treasury, the South African financial sector is the engine of the national economy, contributing 0.2% to gross domestic product growth in the first quarter of 2023. For this reason, the sector’s health is crucial to the country’s overall stability. However, the sector harbours vulnerabilities, including inadequate risk management practices, weak regulatory frameworks, and exposure to heavily indebted entities. These factors, among others, have the potential to propagate financial distress throughout the system, thereby presenting significant systemic risk.
Before we dive into the nitty gritty of what may contribute to systemic risk in the South African financial system, let’s start by understanding the term systemic risk. The South African Financial Market Act 19 of 2012 defines systemic risk as a danger of a failure or disruption to the whole or a significant or substantial part of the South African financial system. Phrased differently, Systemic risk is the “Domino Effect” basically; it highlights how risk is transmitted from one point to another. A country that is resilient to Systemic risk is important to ensure financial stability. Therefore, it is crucial for South Africa to proactively identify, assess, and manage systemic risks to safeguard the stability of its financial sector and protect the overall economy. This article delves into the nature of systemic risk within the South African financial sector, examining potential causes and measures that can be taken to mitigate the risk.
The importance of understanding and measuring systemic risk.
It is critical to understand and measure systemic risk to identify factors, institutions, and sectors that pose significant threats to the stability of the South African financial system. By quantifying systemic risk, regulators and others alike can take proactive measures to mitigate potential crises and enhance the resilience of financial institutions. Market-based measures provide a unique perspective by capturing the interactions and interdependencies among financial institutions, allowing for a comprehensive assessment of systemic risk. In South Africa, the South African Reserve Bank is tasked to oversee financial stability and reduce systemic risk. Below we highlight key factors that may exacerbate systemic risk in the South African financial system.
Exposure of the South African financial sector to government debt.
The increased exposure of the South African financial sector to government debt can significantly increase systemic risk. For example, any decline in the government’s ability to repay its obligations can result in credit risk. This risk arises from the possibility of debt defaults, restructuring, or delays in interest repayments. With this in mind, if financial institutions hold a significant amount of government debt, their financial stability can weaken, leading to potential systemic risks. In addition, financial institutions interconnected with the government or having significant exposure to government debt can result in significant losses and face liquidity challenges. Figure 1 below reveals that non-systemically important financial institutions hold a significant share of South African government bonds when compared to systemically important financial institutions. In light of the failure of Silicon Valley Bank, this is an area of concern since non-systemic banks could present a systemic risk if several banks share a common exposure that could lead to a widespread loss of confidence.
Figure 1: SAGBs as a share of South African banks’ total assets
Sustained increase in private sector credit lending growth vs GDP growth.
In their financial stability review 2023, the South African Reserve Bank highlighted their concern over the gap between growth in private sector credit and GDP growth. A significant disparity between private sector credit extension and nominal GDP growth can create systemic risks in the South African financial system. For instance, if credit growth outpaces economic expansion, it may lead to a build-up of unsustainable debt levels and speculative lending practices. Consequently, leading to asset bubbles, increased risk of loan defaults, and potential threats to the stability of the South African financial system. Figure 2 depicts the growth in private sector credit lending vs. nominal GDP growth. The figure shows that South African private sector credit risk remains elevated as financial institutions continue to issue credit at a faster rate than economic growth.
Figure 2: Growth in private sector credit extension versus nominal GDP growth.
Capital outflow and less diversified capital market.
Simply put, capital outflows significantly increase the threat of systemic risk in the financial market. For instance, when capital leaves South Africa, it can result in funding shortfalls for domestic banks, businesses, and the government. A substantial outflow can cause a liquidity crunch, making it difficult for South African institutions and other key players to meet their financial obligations. This has the potential to disrupt the functioning of the financial sector and lead to systemic risk.
Similarly, a less diversified capital market reduces South Africa’s financial sector’s ability to absorb systemic shocks. Let me explain. The lack of diversification in the capital market can result in significant interconnections among market participants, assets, and institutions. When exposures and investments are excessively concentrated, any adverse event affecting one entity or asset class can quickly spread throughout the South African financial system. Since financial distress can easily spread across boundaries, this interconnectedness amplifies the risk of contagion and increases systemic risk.
SARB Enhanced contractionary monetary policy.
The recent increase in interest rates by central banks globally was a direct response to the aftermath of the COVID-19 pandemic, which saw a significant rise in the production and consumption of goods and services. South Africa was not an exception, the SARB implemented a more restrictive monetary policy to combat inflation. However, these actions, such as increasing interest rates and tightening monetary policy, can lead to unintended consequences and exacerbate systemic risk. When interest rates are raised by central banks, the cost of borrowing for businesses and individuals also increases. This, in turn, can result in reduced borrowing and spending, ultimately slowing down economic growth. If financial conditions are significantly tightened, it can strain heavily indebted entities such as households, businesses, and governments. Consequently, the risk of defaults, financial distress, and disruptions within the financial system also increases.
Idiosyncratic factors such as load-shedding, potential US sanctions, and FATF grey-listing.
The South African financial market may suffer contagion effects due to idiosyncratic events such as ongoing electricity generation challenges, potential US sanctions, and the FATF grey list. The interconnectedness within the financial system means that distress in one area can quickly transmit to others, amplifying systemic risks. For instance, the failure of a major financial institution due to US sanctions or load shedding can lead to a loss of confidence in the broader financial sector, triggering a wave of withdrawals, liquidity shortages, and potential systemic disruptions. Figure 3 shows how interconnected the South African financial system. For instance, major banks are affiliated with insurance companies and fund managers.
Figure 3: The South African financial system interconnectedness.
South Africa’s sub-investment credit rating.
A sub-investment credit rating can restrict South Africa’s access to international capital markets and make it more challenging to secure external financing. This limitation can hinder the government’s ability to fund its fiscal obligations, infrastructure projects, and social programs. Furthermore, it can impede businesses’ access to capital for expansion, job creation, and innovation. Insufficient access to financing can limit economic growth, lead to financial distress for borrowers, and potentially contribute to systemic risks.
In conclusion, South Africa can take several measures to reduce systemic risk in its financial sector. For instance, strengthening regulatory frameworks and supervision, especially in areas such as risk management, capital adequacy, and corporate governance, is essential. Enhancing the resilience of financial institutions through rigorous stress testing and capital requirements can help mitigate systemic risk. Furthermore, enhancing market transparency and disclosure practices will improve investor confidence and facilitate informed decision-making. Addressing issues such as electricity supply, sub-investment credit rating, FATF grey list, and other issues mentioned above will contribute to a more resilient and stable financial system. By implementing these measures, South Africa can reduce systemic risk in the financial sector and improve the resilience of its economy.
