Nicholas Nhundu
The South African retail banking sector remains highly concentrated with six large banks accounting for more than 90 percent of retail deposits; namely, Standard Bank, Absa, First National Bank, Nedbank, Capitec and Investec1. Some of the small players such as Grindrod and uBank have been operating since 1994 and 1975, respectively, yet their deposits have not grown significantly in this period.2 The sector has experienced few successful entrants since the establishment of Absa 25 years ago,3 and only Capitec has managed to penetrate the industry successfully.
Barriers to entry or expansion can arise as a consequence of the natural features of the market (structural barriers such as the presence of significant network effects) or can be created by the behaviour of incumbent firms (strategic barriers).4 Drawing on a recent study supported by the National Treasury as part of a broader study on barriers to entry, we consider the nature of barriers to entry into banking in South Africa and whether Capitec is the exception that proves the rule.5
International experiences of barriers to entry and expansion in retail banking
Notable investigations into barriers to entry and expansion in retail banking include the retail banking market investigation by the United Kingdom (UK) Competition and Markets Authority, and the retail banking inquiry by the Netherlands Authority for Consumers and Markets.7
The inquiry in the Netherlands focused on consumer switching behaviour, amongst other aspects, and found that although small banks offered higher savings interest rates consumers were not likely to switch to small banks. Only 13 percent of the consumers were prepared to switch banks while 50 per cent indicated that they have never switched banks. This highlights the challenges facing new banks in attracting consumers. Along with economies of scale it implies that entrants have substantial sunk costs in establishing the business before they reach a commercially viable operation.
The UK investigation specifically found that a wide branch network was one of the most important factors for SMEs and individual customers in choosing who to bank with. A high-street presence in terms of branch networks promotes brand recognition and loyalty for a bank. Establishing such a network implies various costs in terms of acquiring and maintaining branches which is a challenge for entrants in particular.8 The study also identified costs of acquiring and setting up information systems technology, switching behaviour, high capital requirements and access to payments systems as potential constraints.9
The costs of complying with complex financial laws and regulations that frequently change were also identified by the Netherlands inquiry as a significant barrier, along with limited differentiation in the supervision of prudential laws and regulations particularly with respect to small banks. The assessment found that smaller banks pose lower systemic risks to the industry than bigger banks and thus do not warrant equivalent treatment relative to larger banks with higher risk profiles.10
Lessons from South Africa
The study of entry and competition in South Africa found that the leading South African retail banks can be said to enjoy market power derived from various factors including barriers to the entry and growth of smaller banks.11 The main barriers to entry and expansion include regulations and scale economies (including the need to establish a branch network), and the required financial backing. The rivalry provided by Capitec, when it managed to overcome the obstacles to being an effective competitor, illustrates the benefits of competition as banks charges came down substantially.
The study demonstrates that Capitec’s entry into the industry resulted in significantly lower bank charges which conservatively amounted to annual clients’ savings of R19.9 billion in 2014. The savings were calculated from the impact both on those clients who switched to Capitec and the effect on clients who stayed with their existing bank but benefitted from reduced charges as the banks responded to Capitec’s lower charges. There is a further set of important benefits associated with those opening accounts with Capitec who would not otherwise have done so.
The major South African retail banks were also observed to have taken advantage of various mechanisms (such as complexity of fees and lack of price transparency) to deter customers from switching.12 The strong position enjoyed by incumbent banks is also reinforced by a regulatory environment which in its current structure makes it especially difficult for new banking entrants to participate in the market. Some aspects of regulation changed after the Competition Commission’s banking inquiry, including the possibility of cash being drawn at supermarket tills which reduced the need for a nationwide ATM network to be established by Capitec.
The duration required for Capitec to build its business to the point where it was able to challenge highlights the size of the entry barriers. From its establishment in 2002 it grew slowly mainly due to lack of funding. The organisation struggled to raise financing and for the greater part of its infancy it was self-funded with significant portions of profits being retained and reinvested.13 However, the partnership with PSG (an independent financial services group) played a pivotal role in ensuring the survival of the entity through providing equity financing.14 Only around 2006 was it able to attract a notable amount of deposits.
Capitec overcame customers’ reluctance to switch, a key barrier to entry in retail banking, by developing a simple product that is easily understood. It also worked deliberately to convert its lending clients into transactional service clients. For this reason Capitec employed dedicated staff to work on switching clients. Branch personnel were also trained to convert lenders and savers into banking clients. Initially Capitec’s clients were cash convertors who would take out cash soon after the salary was deposited, however the profile of these clients has changed over time to more mid-market customers who switched from other banks.15
The naturally capital-intensive nature of retail banking and the need to establish customer awareness and trust suggests that banking entrants may well be firms from other areas of business such as mobile telecommunications or supermarket chains, however, we understand that applications from such entities in South Africa for banking licences have been turned down by the Reserve Bank.
Funding remains a major problem in South Africa specifically for small enterprises and new entrants with no track record. Equity investors perceive these firms as unsafe investments whose returns cannot justify the inherent risk.16 The initial funding is required for sunk costs which will not be recovered in the event of a failure.
Access to debt financing is another challenge because new entrants cannot issue investment grade debt instruments given their size and the fact that they have no track record, in most cases. As a result they are limited to the junk market which is not developed and relatively expensive in South Africa.17
Capitec indicates the burden on a smaller entrant. Capitec had a lower debt relative to equity financing than the incumbents and the industry average (Figure 1). The lack of access to debt financing especially during infancy does not only impact the entity’s ability to expand its operations, but it also affects profitability given a low financial leverage.
Figure 1: Comparison of debt equity ratios in the retail banking industry18
Regulation
South Africa has a world-class banking system regulation that compares favourably with most developed countries. Although the strict regulations have safeguarded a healthy and stable retail banking industry, they have also restricted the proliferation of new entrants and the growth of small and medium-sized banks.19
The Banks Act requires that any organisation that wishes to operate as a bank in South Africa acquire a banking licence. However, the process of applying for a banking licence has been described as onerous, extremely complex and time consuming.20 In addition to the R250 million required as capital,21 the Reserve Bank also scrutinises aspects such as the directors, the business plan, products, risk management policies, corporate governance, internal auditing, external auditors, anti-money laundering measures and IT capabilities.22 While these are standard requirements in most countries, it is significant that only one banking licence (Finbond Mutual Bank) has been issued in South Africa in the last 15 years.23 Capitec was able to benefit from accessing the licence held by PSG.
There are also prudential laws that include capital adequacy ratios that have to be maintained on an ongoing basis. Capital adequacy is a proportion of a bank’s capital that has to be set aside (in very liquid assets) in case of an unforeseen event that may cause the bank to fail. They are meant to protect customer deposits and ensure that banks are able to absorb losses. For new entrants and other small- to medium-sized banks, capital adequacy ratios mean that they need to devote part of their limited capital to meeting capital requirements only.25 This is a substantial cost for new entrants given that capital set aside for adequacy requirements has to be in very liquid assets that bear little return.
The balance in regulation between the clear prudential rationale and the chilling effect on competition is contested. Easing regulation enhances competition and promotes efficiency, while strict regulation brings about stability by providing incentives and protections that restrict businesses strategies in the interests of preventing risky behaviour. Currently there is no consensus as to which competitive structure optimizes both competition (efficiency) and regulation (stability).26 However, it is apparent that neither extreme is ideal. The costs of limiting competition are generally less well understood and there is a danger that the balance is tilted in favour of protecting the established position of incumbents under the rationale of prudential requirements. Other means of guarding against risky behaviour such as through closer bank supervision should not be forgotten.
Conclusion
Retail banks play a pivotal role within the economy and the degree of competition in the retail sector matters for the efficiency of production and innovation not only in the retail banking industry but the economy as a whole. The study demonstrated high client savings on bank charges as a result of Capitec’s entry into the market. Furthermore the study also illustrates that Capitec’s entry provided the incentive for incumbents to cater for the low income segments of the market, thus promoting financial inclusion.27 The aforementioned findings are also supported by recent studies in the role of competition in banking which point to the fact that competition in banking promotes financial inclusion, efficient functioning of financial intermediaries and markets; and financial stability.28
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Notes
1. Barry, H. ‘SA’s banks have high fees, operating costs – index’ (15 April 2014). Moneyweb.
2. Grindrodbank Website and uBank Website
3. Van der Merwe, E. L. (2008). Origins of the ABSA bank UJdigispace
4. Banda, F., Robb, G., Roberts, S. and Vilakazi, T. (2015). ‘Key debates in competition, capabilities development and related policies: Drawing the link between barriers to entry and inclusive growth’, CCRED Review Paper 1; and Office of Fair Trading UK Website
5. Makhaya, T., Nhundu, N. and Guma, N. (2015). 'Competition, barriers to entry and inclusive growth: Capitec case study'.
6. Competition and Markets Authority UK Website
7. Netherlands Authority for Consumers and Markets Website
8. Competition and Markets Authority UK. Website
9. Competition and Markets Authority UK. Website
10. See note 8.
11. Okeahalama, C, C. (2007). Estimating Market Power in the South African Banking Sector. International Review of Applied Economics. Vol 21(5):669-685.
12. See note 23.
13. Capitec Bank Website.
14. See note 13.
15. See note 4.
16. Nhundu, N. (2014). ‘Risk-adjusted performance comparison of South African venture and non-venture companies’. M.Com Finance (Unpublished); and Note 4.
17. See note 13.
18. See note 5.
19. See note 5.
20. Donnelly, L. ‘The taxing issue of a state bank’ (17 October 2014). Mail & Guardian; and Cobbett, J. ‘SA’s newest bank pays 10% on deposits’ (21 January 2013). Moneyweb.
21. South African Reserve bank Website
22. Cobbett, J. 'SA’s newest bank pays 10% on deposits'. (21 January 2013). Moneyweb.
23. See note 19
24. KPMG Website
25. See note 21.
26. Vives, X. (2010). Competition and stability in banking. IESE business school, Working Paper 852; Carletti, E. (2007). Competition and regulation in banking. Center for Financial Studies at the University of Frankfurt: Working Paper; and OECD website.
27. See note 5.
28. Leon F. (2015). What do we know about the role of bank competition in Africa? CERDI Working Paper number 16; Aghion, P, Bloom, N, Blundell, R, Griffith, R, and Howitt, P. (2005). Competition and innovation: An inverted-U relationship, The Quarterly Journal of Economics, Vol. 120(2):701–728; and Allen, F. and Gale, D. (2004). Competition and financial stability, Journal of Money, Credit and Banking, Vol. 36(3):453–480.