The Role of Banks in the

South African Financial

System
Introduction
• Banks make a critical contribution to economic performance
• They take deposits and extend loans
• They facilitate transactions and provide payment, clearing and
settlement services
• They provide a variety of financial products that enable the corporate
sector and households to cope with economic uncertainty by hedging,
pooling, sharing and pricing risks
• They reduce the cost and risk of investment and of producing and
trading goods and services
Key role of banks
• Compared to other financial firms, banks are able to influence the
rate of investment through financial provision
• This justifies their key role in the economy
• Two aspects in influencing rate of investment:
• Their ability to create money
• Their ability to raise funds for investment projects
How banks create money
• Who supplies currency and what determines amount supplied?
• What is Money?
• Monetary aggregates are used
• M1 definition of money: Currency (C) and current account deposits (D):

M1=C+D
• Supply of currency (C) in the hands of Central Bank but determined by the
needs of trade
• Supply of coins and notes is endogenous
• When banks create money, they create demand deposits
• In SA, more than 90% of M1 are demand deposits
• Money creation relates to the non-currency part of money supply
How banks create money(cont’d)
• Who supplies deposits (D) and what determines the amount
supplied?
• Banks provide private customers, businesses and government with
demand deposits
• “Banks debts are commonly accepted in final settlement of other
people’s debts”-Sayers, 1967.
• Other definitons of money in SA (Monetary aggregates)
How banks create money(cont’d)
• M1(A) = currency -circulation outside-MS, + cheque & transmission
accounts held with-MS
• M1 = M1(A) + other demand deposits held with MS.
• M2 = M1 + other ST and MT deposits.
• M3 = M2 + LT deposits
• non-residents + government + interbank deposits- excluded
• If banks supply cheque accounts and these represent money then
Banks can create money
How banks create money(cont’d)
• How do banks create money? Is the creation of bank deposits under the
control of the banks alone?
• Supply of bank deposits determined by banks that can create current
accounts
• Two constraints in creation of current accounts:
• CB regulations in terms of reserve requirements and capital adequacy
requirements
• Reserves (at CB) and vault cash not part of Money supply
• For a initial deposit of R100,000 with a reserve ratio of 20%,
100,000/0.2=R20,000 additional can be created (Money multiplier)
Money Multiplier
How banks create money(cont’d)
• Factors determining the size of demand deposits:
• The reserve ratio (kept at the SARB in SA)
• Fraction of demand deposits in coins and banknotes
• Risk and excess reserves
• Risk (customers side)
• Open market operations
How banks raise funds for Investment
projects
• Commercial banking: deposit taking with a view of lending funds
• Investment banking (Merchant banking): raise funds for other parties
to undertake projects
• Funds for Investment can be accessed in the capital market or via
private equity
• Capital market funds raised through sale to the public of the in the
investing firm’s shares or other securities
• Private equity (venture capital) is raised directly from funds and
individuals by offering them a stake in the investment
• To fulfill this function, banks act as underwriter and agent
How banks raise funds for Investment
projects
• As underwriter: evaluating investment or firm and bearing risk of
selling securities and the cost of holding them until sold
• As agent: promoting the securities
• Buyers of these investments: Mutual funds, pension funds, hedge
funds and the public
• By providing these services, banks act as consultants to non-banks
firms and funds
• They offer research and advice services
Role of banks and their income
• There are individuals and firms with surplus of funds and individuals
and firms requiring loans
• Need to take into account interbank transfers and intrabank payments
• With intrabank payments, reserves remain unchanged
• With interbank transfers, the bank paying the amount loses reserves
• Interbank transfers usually settled via accounts held at Central Bank
• During trading day, interbank transfers are conducted increasing
assets in a bank (clearing account balances) and liabilities (increased
deposits)
Role of banks and their income
• At the end of trading day, banks net out amounts they owe each other
through the CB
• Net method (Only net is paid by a bank)
• Gross settlement method (used in SA-SAMOS)
• If Bank A owes Bank B R7million and Bank B owes Bank A R5million
• Net method: Bank A pays Bank B R2million
• Gross method: Bank A pays B R7million and Bank B pays A R5million
Income of Banks
• Banks pay interest on positive balances (interest expense) and charge
a higher interest for funds they lend (interest income)
• Banks earned an interest margin (interest income less interest
expenses)
• Banks also provide service for which they charge fees:
• Transactions for payment services, investment and trading-related
activities, financial advice, management of investment funds
• These activities provide banks with non-interest income
• Non-interest income less operating expenses=net non-interest income
Income of Banks
• Net interest plus net non-interest income = Total Revenue for Banks
• Non-interest income is now an increasingly important part of income
• In 2012, total non-interest income made up 56.7% of SA Banks’
income
• Interest income of SA Banks has been growing slower than its
counterpart
• Non-interest income tends to be less cyclical
Mismatch between Assets and Liabilities of Banks
• Banks are intermediaries between surplus units and deficit units
• Thus they borrow short and lend long
• Banks loans are assets and deposits represent liabilities
• Total Assets = Total Liabilities plus Capital
• Banks are risk takers as they borrow short and lend long
• However, make profit as interest paid on short term lenders are lower
than those earned from long term borrowers
• Several types of risks involved: risk of default, funding liquidity risk
(liquidation), market liquidity risk (turn assets to cash without loss of
value)
• Due to risks, banks impose prudential behaviour
Legal and Regulatory framework for Banks
• Financial system and banks have characteristics justifying regulations:
• The roles that money plays and the essential requirement for
confidence therein; the distinct nature of financial contracts and the
potential for pervasive private and social costs where markets failure
occurs
Key legislation governing Banking industry
• The Banks Act 94 of 1990: Most important act for SA Banks. The focus is
prudential regulation. The key objective is to regulate and supervise the
taking of deposits
• The Banks Act sets out the minimum capital requirement
• Basel I, II and III set out by the Bank for International Settlement (BIS)
• Basel II: effective in SA in 2008.
• Under BIS Banks required to maintain a certain level capital against risk-
weighted assets: Capital adequacy ratio (in SA 9.5%)
• Basel II: Comprehensive internal capital adequacy to assess how capital
cover overall risks
• Basel III: strengthen regulation, supervision and risk management of banks
• Basel III phased in from January 2013 to 2018
SA Banking landscape
• Financial sector contributed around 21% of GDP in 2010
• Bank assets were 112% of GDP in 2010 (116% in 2012)
• Loans and advances were at 96% of GDP in 2010 (85.8% in 2012)
• End of 2012, 16 registered banks including the big four (ABSA,
Standard Bank, FirstRand and Nedbank)
• The big four account for more than 80% of market share of industry’s
assets