Fiscal risks and their impact on banks’ capital buffers in South Africa

South Africa’s fiscal balances have deteriorated significantly over the last decade, while the economy has been recording disappointing economic growth rates even prior to the COVID-19 crisis. In this paper, we estimate a series of equations using the Arellano and Bond (1991) estimator to test how sovereign risk premia affect capital buffers, while controlling for variables identified in the literature, such as size of banks, the economic cycle, competition and equity prices. Unlike other studies, we use actual capital buffers provided by the South African Prudential Authority. We show that these are substantively different to the proxy buffers calculated using the common approach in the literature, indicating that results based on proxy measures should be interpreted with caution. Our overall results show a positive relationship between the sovereign risk premium and capital buffers, and the results are robust across different specifications. This suggests that banks are accumulating capital to mitigate against fiscal and other domestic policy risks, and the related financial stability issues. It is likely that this is contributing to higher lending rates.