In his Chairman’s statement last year, my erstwhile colleague and co-founder of FirstRand, GT Ferreira, remarked that he was glad he was handing me the Chairmanship of the Group, “after, and not before the most difficult year of our short history”. Whilst I appreciate his sentiments he proved to be wrong about the year to June 2008 being the most difficult in the Group’s short history. The year under review, to June 2009, proved to be much worse, with FirstRand’s diverse portfolio of banking and insurance businesses producing a disappointing performance. Normalised earnings decreased 32% to R7.1 billion with a normalised return on equity (“ROE”) of 14% compared to 22% in the previous comparative period.

There are two fundamental reasons for this performance. The first relates to the extremely difficult macro environment, and banks in general are true bell weathers of economic health.

Whilst the global economy has continued to stabilise the outlook remains challenging. The Anglo Saxon banks and respective economies have been saved from calamitous collapse by unprecedented government interventions, the US consumer is not spending but saving and governments all over the world have mortgaged the future at the expense of the tax payer. The unwinding of the massive fiscal and monetary stimulus packages, coupled with rebuilding of balance sheets, particularly in the Anglo Saxon economies, will weigh on global demand for a protracted period. It is expected that the East will emerge stronger than the West.

The South African economy is still facing significant difficulties. Job losses are increasing and the manufacturing sector is still contracting. All of these pressures have a negative impact on banks’ earnings.

The South African Reserve Bank has continued to reduce interest rates and this is positive in the medium to long term as it eventually results in the reduction of bad debts and non performing loans and improved customer affordability levels. However the short term impact is negative on the margins of the banks’ deposits as well as the banks’ income on the capital endowment, in other words the benefit to earnings from improving bad debts “lags” the decline in gross interest turn on liabilities. The “endowment impact” has been enormous on the income statements of the local banks.

In the near term house prices are expected to remain under pressure, resulting in depressed recovery rates on mortgage security. Wholesale lending portfolios, which have been resilient for a large part of the economic downturn, are still showing signs of stress and it is not clear that the worst is over.

However, all our peers are operating in this same environment and whilst most of them have also reported significant declines in earnings for the period to June 2009, FirstRand fared worse. This relative underperformance is due to our “own goals” which were a direct result of some flawed strategies within the operating franchises of the Banking Group. In retrospect these strategies can now be seen as “bull market” strategies, and they quickly unravelled with the global crisis.

In some cases these were successful strategies for a number of years. RMB’s equities trading business based in the UK, which hit our earnings last year, delivered significant positive returns for two years and on the face of it seemed to be a successful foray into the international equity markets. The skills we deployed had certainly proved themselves in the local markets and appeared to have a competitive advantage initially, however, the positions were ultimately too large and we underestimated just how quickly liquidity could dry up in an extremely severe financial crisis.

The same could be said for the Special Projects International (“SPJi”) division within RMB, which also appeared, two years ago, to have a compelling three pronged strategy in the international markets:

• focusing on offshore credit assets leveraging off RMB’s fundamental credit skills;
• investing in various asset classes in countries that appeared to have above average growth opportunities; and
• investing in an Indian equity fund to capture the expected growth in the economy.

However, when the global credit and equity markets collapsed, these investments moved to a position of disadvantage. With no franchise value underpin, everything came down to the vagaries of the market, resulting in large losses mainly driven by markto-market impairments and lack of liquidity.

What is clear from all of this is that our investment and trading businesses did not travel well. Whilst the global crisis was unexpected and unprecedented in scale and depth, a combination of a lack of a real competitive advantage, no underpin of client flows and no franchise value meant that the earnings streams from these strategies were not only unsustainable, but significant losses were inevitable as liquidity disappeared. These businesses have been closed. The offshore equities portfolio is written down to approximately $18 million, however the legacy portfolios of SPJi will be with us for a while. They are illiquid and valuations are very difficult and as markets remain volatile further mark-to market losses may be incurred.

Other strategies in offshore markets also proved over time to be unsustainable. WesBank’s Australian lending business could not fund itself once the securitisation market disappeared, an example of how important it is to have a deposit franchise in a foreign country, particularly if you want to lend.

A result of these painful experiences is a fundamental shift in the Group’s overall strategy in its banking franchises. Going forward there will be an increased focus on client driven activities, and a healthier balance between these activities and proprietary trading or investment activities, both in the South African and international operations. In addition, secondary market activities will link to client activities or leverage the existing primary market position. Whilst it is likely that this shift may result in lower ROEs, it will improve quality of earnings and reduce volatility, and still produce acceptable returns to shareholders.

With specific reference to our international expansion, the Group will only enter into selected high growth emerging markets where we believe we have a competitive advantage and a “reasonable expectation to win”. The one geography outside South Africa where the Group has successfully grown a sustainable business is the African continent and this is where we will focus our efforts, with the objective of becoming one of the pre-eminent African financial services groups. CEO designate Sizwe Nxasana provides more detail on how the Group plans to execute on this strategy.