Capitec set to win big while Nedbank is at risk

Capitec is set to be the bank least impacted by interest rate cuts as the bank’s strategy of being less reliant on net interest income pays off. 

On the other hand, Nedbank is highly sensitive to interest rate cuts, with its headline earnings potentially falling by as much as 6% from a 100 basis point cut. 

This is feedback from Gary Davids, an investment analyst at Sanlam Private Wealth, who outlined the potential impact of interest rate cuts on South Africa’s largest banks. 

A reduction in interest rates is expected to provide significant relief to consumers, result in increased spending, and stimulate economic growth. 

However, banks face a different set of challenges as they have benefited from higher interest rates in recent years. 

South Africa’s banking industry is led by major players such as Standard Bank, FNB, Nedbank, Absa, Capitec, and Investec. The first four account for 90% of South African loans and deposits.

Davids explained that these banks have enjoyed a strong recovery since 2020, with their earnings exceeding their pre-pandemic levels.

A major driver of this was the positive impact of elevated interest rates on their existing loan books, effectively increasing the margin on these loans and enabling these banks to generate substantial profits. 

This tailwind has the negative impact of increased borrowers’ defaults, subsequently higher credit loss ratios for these banks, and a rise in bad debt. 

This cycle has come to an end. The Reserve Bank kicked off its cutting cycle in September with a 25 basis point cut, with a similar rate cut in November. Economists project a total decline of 100 basis points by the middle of 2025. 

The pivot towards lower rates encourages borrowing and increased spending, giving businesses room to invest and expand.

However, this pivot is also expected to squeeze banks’ margins, negatively impact their profitability and change how they grow their loan books. 

Lower interest rates immediately impact banks by reducing their net interest margins (NIMs)—the difference between what they earn on loans and what they pay on deposits. 

In a falling rate environment, the rates banks charge on loans drop since many are variable-rate, prime-linked loans rather than fixed-rate loans. 

While deposit rates are also expected to drop, the current environment is highly competitive as banks compete for customer deposits and loans, which will narrow NIMs and impact profitability.

The graph below shows the potential impact of a 100 basis point reduction in interest rates on the earnings of South Africa’s largest banks. 

Davids explained that the impact on each bank is vastly different as they have different ways of managing interest rate risk. 

Sanlam Private Wealth’s calculations show that Nedbank is the most sensitive to a 100 basis points interest rate reduction, resulting in a 6% decline in earnings. 

This sensitivity is partly attributed to its business composition and the current lack of an interest rate hedging strategy. 

Conversely, Absa and FirstRand have implemented interest rate hedging strategies to mitigate the impact of interest rate changes on their earnings. 

Consequently, during rising interest rates, Nedbank’s margins expanded, offsetting the impact of credit losses and supporting robust earnings growth.

In contrast, Absa and FirstRand saw their margins expand less significantly than Nedbank’s as interest rates rose and, as a result, limited their earnings growth during this period.

On the flip side, when interest rates come down, Nedbank’s margins are expected to contract much more sharply than Absa’s and FirstRand’s. 

Thus, their earnings are expected to be more stable and less likely to experience a less significant decline as rates fall. 

Capitec is set to be the big winner as it generates half of its revenue from non-interest income, which makes it far less sensitive to interest rate changes.

This is the core reason the bank has a premium valuation, as this revenue is not only more resilient but should also translate into more stable and higher profit margins.

While Standard Bank has recently implemented a hedging strategy for its South African loan book, which has reduced its sensitivity over the past 12 months, a large portion of the bank’s business is from the rest of Africa, which is not hedged.

Investec has no hedging strategy in place for either its local or UK business. While we’re illustrating the headwind on earnings for a 1% rate reduction, it must be noted that 50% of Investec’s earnings and loan book are from the UK. 

If the UK starts to normalise interest rates, it could reduce rates by much more than 1%, posing an even greater risk.

On the upside, lower rates often stimulate demand for loans, especially in the home loans and consumer lending segments. Lower borrowing costs make debt more attractive for individuals and businesses. 

They also enhance credit affordability, thus supporting banks in expanding their loan portfolios. This increased lending activity can offset some of the NIM compression, particularly for banks with strong retail portfolios, which can benefit from a lending and transactional banking perspective.

In addition, debt servicing becomes easier as interest rates fall, and the risk of default generally decreases. This means banks may not need to set aside as much in provisions for bad loans, which can improve profitability.