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Finance: US financial turmoil: Ripples in South Africa


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Over-extension of credit ,and trading in credit risk. These are probably the key factors behind the financial turmoil which has ravaged markets in the United States, an event of such magnitude that some market watchers are equating with the Wall Street crash of 1929. In turn, it is having ripple effects on markets around the world.

That’s according to Hannes Boshoff, Associate director Transaction Advisory Services, Ernst and Young.

He believes the cracks were laid when in 2004 the top five investment banks were permitted by the US Authorities to increase their gearing to 1:30 or even 1:40. “Three of these five bedrock institutions are now gone – Bear Stearns, Lehmann Brothers and Merrill Lynch have succumbed as the credit crunch has taken hold,” says Boshoff.

Only Morgan Stanley and Goldman Sachs are still standing but Fitch is reporting that both of these companies might experience some liquidity and capital pressures and they are now under direct supervision of the Federal Reserve.

The legislation change which permitted the change in gearing was flawed, says Boshoff. “At the root of the problem is an overextension of credit which was complicated by credit derivatives and not managed well. The result was that these organisations [and others] were writing bad business. By over extending loans to those with poor credit ratings – who came under significant financial pressure as the market conditions changed – massive write-offs and provisions resulted,” says Boshoff.

Banks borrow from one another to maintain liquidity. However, as these institutions write off their bad debts, and their capital ratios came under pressure, they began to distrust one another. This lack of trust within the banking system made banks more and more reluctant to lend money to one another, resulting a significant liquidity crunch.. Making good the loans was no longer assured given the amount of bad debt in the sub-prime space. Banks also borrow from depositors; if the depositors fear that the banks will be unable to repay them, then there is a run on the funds. The crisis deepens further when the banks are forced to sell assets to cover liabilities – and when asset sales are forced, their full value is rarely realised.

Simple economics; if debtors don’t pay you are in trouble.

What of the impact of this crisis on the South African banking and financial services environment Much has been made of the rush to extend credit prior to the introduction of the National Credit Act, with new organisations joining the old guard in an apparent stampede to indebt the consumer. Perhaps surprisingly, Boshoff says even this seemingly reckless lending is not nearly as extreme as the situation in the United States. “Credit exposure in our market is much smaller in extent and not as severe as in the US,” he confirms.

“There is increased pressure at present; however, that is more the factor of the economic cycle rather than the world situation,” Boshoff opines.

The Reserve Bank Governor indicated in his recent address to shareholders, that South African banks do not have the same exposure to the prevailing risks as the international banks. Boshoff notes “Our banks are, by and large, in better shape than the international banks and will probably still lend with confidence.”

While the impact of the collapse of the major US institutions is limited domestically, it is the bigger infrastructure projects which may face some difficulty in terms of finding funding at the right price, believes Boshoff. These include projects like the power, energy capacity upgrades.

“Such projects require funding on a massive scale. This crisis may necessitate finding that funding from outside the usual avenues, being the large international banks. It will take ingenuity and will require looking elsewhere in the world to make sure that these critical projects are not compromised,” says Boshoff.

While legislation aimed at preventing just the sort of collapses is playing out in the US has been introduced (such as Basel II and Sarbanes-Oxley) and continues to be introduced, it is unlikely that it alone will prevent such disasters in the future, Boshoff believes.

“Legislation can never take away greed and fear. On its own legislation cannot prevent situations like these especially if loose fiscal and monetary policies are followed. However, legislation can ease the impact but it must apply to all financial institutions. Its effectiveness is enhanced by the application of disciplined fiscal and monetary policies. Where the banking legislation excluded these US investment banks and loose fiscal and monetary policies followed, a situation arose where traders working in these banks earning big annual cash bonuses were consistently pulling in the direction of short term profit (based on internal valuations of assets determined by complex models, rather than by cash generated) at the expense of long term sustainability.

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