Absa AT1 issuance shows well-capitalized South African banks can still optimize

South Africa's largest banks have steadily increased their hybrid capital since 2018, according to S&P Global Market Intelligence data, and Absa Group Ltd.'s recent additional Tier 1 issuance shows how lenders can still take steps to optimize their capital structures despite being adequately capitalized.

The country's largest lenders increased their capitalization after the global financial crisis, or GFC, but nevertheless face declining profits and higher provisions due to the pandemic. Under Basel III regulations, introduced after the GFC, banks must maintain enough capital to absorb unexpected losses, with capital typically consisting of nondeposit liabilities — short- and long-term debt — plus equity and deposits.

"Maintaining an optimal capital structure requires banks to actively manage and rebalance these three components," said Athenia Bongani Sibindi, associate professor at the University of South Africa's School of Economic and Financial Sciences.

Cushion against risk

Using deposits to make up part of a bank's capital is risky, especially as fintechs and challenger banks steadily take market share from more established lenders, with Capitec Bank Holdings Ltd., for instance, more than doubling its assets between 2016 and 2020.

"With the COVID-19 pandemic causing widespread job losses, banks will run into difficulties if they rely too heavily on deposit leverage," said Sibindi.

In May, Absa issued $500 million in Additional Tier 1, or AT1, hybrid capital bonds that were six times oversubscribed. The bank, South Africa's third largest by assets, has increased the proportion of AT1s within its capital structure since 2018, according to S&P Global Market Intelligence data.

AT1 bonds convert to equity if a bank's common equity Tier 1 ratio falls below a certain level — in Absa's case, 5.875%. As of Dec. 31, 2020, Absa's CET1 ratio stood at 11.2%, down 90 basis points year over year.

"All the big South African banks have historically issued additional Tier 1 capital, and it usually varies between issuing on local or international capital markets," said Constantinos Kypreos, senior vice president at Moody's Investors Service. "Such instruments are an important part of their capital management strategies, so we expect to see more of these issuances."

"The issuing banks can decide not to repay these notes, and/or skip coupon payments, with interest being noncumulative," said Kypreos. "These characteristics allow these notes to be classified as capital rather than debt."

The country's largest banks by assets — Standard Bank Group Ltd., FirstRand Ltd., Absa and Nedbank Group Ltd. — have steadily increased their Tier 1 eligible hybrid capital, according to S&P Global Market Intelligence data. From 2018 to 2020, Standard Bank raised this by 46% to $8.95 billion, while FirstRand, Absa and Nedbank boosted theirs by 20%, 58% and 62% respectively.

The quartet also bolstered their CET1 capital over the same period, albeit to a lesser extent.

"The banks are comfortable in terms of their capital," said Warwick Bam, an analyst at Johannesburg's Avior Capital Markets. "The pandemic's impact on banks is fairly well contained at this stage. We're not expecting a further deterioration in the economy, so there shouldn't be anything concerning for banks."

Impact on ratings

Sibindi agreed with this assessment, saying: "South Africa's banks are sufficiently capitalized." Capital increases have "the benefit of making them more attractive in the debt market as well as supporting their credit ratings," Sibindi added.

Moody's gave Absa's AT1 notes a B2 foreign currency rating, three notches below Absa's main rating, which reflects the higher risk involved with hybrid instruments. In terms of ratings, there is no difference in issuing such notes domestically or abroad.

"From a credit perspective, we assess core shareholders' equity as better 'quality,' because that's more stable long-term capital," said Kypreos.