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Ernst & Young Launches the Financial Services Banking Confidence Index Q2 2007

18 July 2007 Ernst & Young

The latest Ernst & Young Banking Confidence Index shows that both retail and investment banks faced continued slower growth in income flows in the 2nd quarter of 2007. Coupled with this, there was definite pressure on interest income. Nevertheless, all retail and investment banks remain satisfied with current business conditions, and continued to record a full 100 confidence level reading. [It should however be noted that the impact of the NCA and interest rate increase in June only came into play towards the end of our fieldwork period.]

These are the findings of the 22nd quarterly Ernst & Young Financial Services Index for banking released today. The research and analysis of the study was done in conjunction with the Bureau for Economic Research (BER) at Stellenbosch University. Confidence is measured by satisfaction with prevailing business conditions, and the survey monitors both retail and investment banks.

Says Emilio Pera, Lead Financial Services director at Ernst & Young: "What we notice, is that for the first time in quite a few years, the retail banks are faced with cost growth that is very much in line with revenue growth. Basically, banks have been spending to increase capacity through the last few years, as they faced greater demand. Now, revenue growth is slowing, whilst cost growth continues to rise. In addition, rising spending is also attributable to the cost of implementing systems/processes to cope with new regulation i.e. FICA, NCA and Basel II. Basically, these are expenses the banks cannot avoid, regardless of the business cycle."

Interest income growth was squeezed once again in the current quarter. Fee income growth remained strong and stable in the quarter under review, whilst net interest revenue growth continued to slow. Continues Pera: "This is quite an interesting development. At a time when fee pricing is coming under such scrutiny in the retail banking market, they are facing declining interest earnings growth. This could leave them in quite a tight spot going forward, particularly if the declining interest income trend continues, as it is expected to do."

Continues Pera, "We expect fee pricing to remain an issue, at least for the remainder of 2007. The Competition commission is currently formulating a response to the banking industrys position, and as we saw in the case of the life insurance industry, there could also be a compromise solution, whereby the retail banks may agree to forfeit some of their fee revenues. Even so, the retail banks anticipate only a marginal fall-off in fee revenue in the forthcoming quarter."

As a result of slower revenue growth and higher cost growth, retail banks reported falling net profits, in contrast to the previous quarter. Says Pera: "Banks benefited from very strong retail market conditions since mid-2004, but with higher interest rates, and slowing disposable income, banks are undoubtedly facing slower growth in demand."

Thus far, there has been no impact of slowing growth on confidence levels. All banks, both in the retail and investment banking markets, remain confident about business prospects. Comments Pera, "Whilst the buoyant growth in the retail market is slowing, this has yet to result in lower confidence for the retail banks. Investment banks, on the other hand, continue to benefit from growing infrastructure spend and capacity boosting activities in the corporate market, so we understand why their confidence remains sturdy."

Investment banks reported much stronger investment income growth in the 2nd quarter, off an already high base. 'Strong rising equity markets and corporate profits growth continues to feed investment income growth, their primary revenue source," Pera adds.

Similar to the retail banks, investment banks are facing very strong rising costs. "In fact,' says Pera, "the rate at which costs are rising is at a record high. Not since the inception of the index in 2002, have costs risen as rapidly in the investment banking market. The rising costs are not due to rising provisions, which have remained stable. Nor have employee numbers risen more rapidly either. Rather, the rising cost growth is due to the abovementioned compliance and regulatory costs."

Continues Pera, "Raising one's profile and growing capacity to exploit available opportunities does push costs up. Even though employee numbers continue to rise at a steady rate, the cumulative effects of growing employee numbers have had an impact on costs over time."

In line with the retail banking market, investment banks also faced profit squeeze in the 2nd quarter. Overall, income growth slowed slightly, hurt by slowing interest income and fee income. Coupled with the strong rising costs, the impact was a slowdown in net profits. "Unlike the retail banking market, we do not expect this trend to necessarily continue in the next few quarters. Indeed investment banks' expectations are that net profit growth should resume an upward trend in the quarter ahead," comments Pera. "The outlook for the investment banking market remains solid, led by governments capacity building drive."

Concludes Pera: "Thus far lower interest revenue faced by retail banks has not impacted their confidence. Even with continued rising costs growth, and profits squeeze, the banks are still reporting strong profits growth, albeit at a slower rate than in the last few years. Given the structure of South African banks, which generally have a retail and corporate component, any fall-off in one market can be offset by an uptake in the other market, and that is where we expect the banks to benefit in the quarters ahead. Slowing retail growth will be compensated for by accelerating investment banking demand. The banks with no exposure to investment banking are likely to feel the pinch of slower profit growth through the remainder of 2007."


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