The rationale for introducing new players in the South African banking industry appear to be based, for the most part, on the wrong notions. Firstly, some financial sector entrepreneurs and analysts believe that the new entrants, who dub themselves as digital banks, will have less operational expenditure because they will not have branches and ATMs. This, in theory, will yield high performance and profits. Secondly, some politicians think an envisaged state-owned bank will relax stringent credit requirements and offer cheap loans to needy people and aspirant entrepreneurs. These two notions are profoundly wrong.
One of the fundamental principles that each bank should adhere to steadfastly is the cost-to-income ratio. This ratio is one of the most significant in any bank’s annual report. It indicates how much of each rand earned is used towards the payment of the running of the bank – in other words, how proficient the bank is in the process of creating value for shareholders. Other than the cost-to-income ratio, banks should focus on their return on equity and their net-interest margin. The return on equity reflects how profitable a banking institution has been with its shareholder capital, while net-interest margin indicates the difference between what the bank is paying for its funding and what it makes from the loans that are granted to some of its customers.
There are five dominant retail banks in South Africa, namely Absa, Capitec, FirstRand (FNB/RMB), Nedbank and Standard Bank. One aspect that these banks are focusing on in their pursuit to improve the cost-to-income ratio is to moderate customer dependence on branches and to urge customers to start using cheaper self-service delivery channels such as the Web, cellphones and smartphone apps. Nowadays, an average of 99% of transactions in any of the dominant retail banks in South Africa is processed through their digital channels. And, other than Capitec, the dominant retail banks have been reducing the number and footprint of their branches in an effort to improve their cost-to-income ratios.
When three banks (TymeBank, Discovery Bank and Bank Zero), all of which have styled themselves as digital banks, entered the sector, they found two major players who were already operating without branches and in a mainly digital way: Investec and Sasfin. Despite not having ATMs and branches, and being mainly digital, both Investec and Sasfin have been reporting higher cost-to-income ratios than more traditional bricks-and-mortar banks. This means their operating expenses remain stubbornly high despite their embrace of digital technologies.
In recent years, Investec has reported a cost-to-income ratio of above 72% (and sometimes as high as 77% or more). This is exceptionally high by the South African banking standards. The bank attributed this to massive technology investment. I beg to differ. Standard Bank invested billions of rands in a technology revamp – much more than Investec did — but still managed to maintain a reasonable cost-to-income ratio (below 57%) during the years of large IT spend. (FirstRand’s cost-to-income ratio has been at around 52%.)
Sasfin has also had higher cost-to-income ratios than its traditional counterparts and, in recent years, it has often seen the ratio at 70% or higher. The more a bank is efficiently managed, the lower its cost-to-income ratio, and the more profitable it becomes. Just like Investec, Sasfin ascribed its high operational costs to investments in new digital platforms. Again, I am not in agreement: The other major banks have also invested massively in digitisation.
The cost-to-income ratio, return on equity and the net-interest margin are formulae that must be applied by the planned state-owned bank, traditional bricks-and-mortar banks and digital banks alike. New entrants to the cut-throat banking sector would be naïve if they thought they would automatically have lower operational costs and be successful merely because they are digital.
Advances in technology have made it simpler to start a fintech, but fundamental banking principles are still the same as they have always been. If they do not stick to fundamental banking principles, the new banks will fail. The notion that a digital bank will automatically have a lower cost-to-income ratio is wrong.
- Rabelani Dagada is professor of practice in 4IR at the University of Johannesburg. This piece is an edited and shortened extract from his book recently published by Unisa Press titled, Digital Commerce Governance in the Era of 4IR in South Africa. He is on Twitter @Rabelani_Dagada