Banks, blockchain and ‘swimming naked’

Introduction

0:00Welcome to the Denker Capital Podcast, where our highly experienced team of in-depth thinkers and other experts share their insights on a range of investment-related topics. In this podcast, we have conversations about developments in South African and global markets and what these may mean for investors. We analyze specific stocks and sectors and explore general themes relating to the fundamental principles that underpin sound investment decisions in an ever-changing world.

0:34Today is the 25th of January, and we welcome listeners to our first podcast of 2023.

Guest Introduction

0:40It's hosted by Nigel Barnes, Head of Business Development at Denker Capital. We've traveled to Stellenbosch today, to the boardroom of Michael Yordan, CEO and founder of investment company Montegre Capital, Chairman of Bank Zero, and former CEO of FNB. Koki Koeman is with us too. He's our global financial specialist and manager of the Denker Global Financial Fund. Today, they'll have a conversation about the opportunities in the financial sector and the broader investment markets, the challenges banks are facing,

1:11blockchain and decentralized finance. And Koki will also touch on how all these factors shape the portfolio of the Denker Global Financial Fund. Michael, Koki, thank you for joining me for the first Denker Capital podcast of 2023. Fantastic, Michael, to be here in your boardroom. Stellenbosch is putting his best foot forward this morning. So it's really great to be here. And thank you for taking, both of you, for taking some time.

Financial Sector Discussion

1:37Michael, I listened to your Think Big presentation or interview yesterday with our friends at PSG. And, you know, there was a lot of good themes and discussion there. I want to dive a little bit into one or two of those areas, but not cover off, you know, the same as some of our listeners would have heard yesterday. And to frame all of this, as normal, I like to sit in the position of the investor and try and ask relevant questions that the investor or the allocator of investments

2:09is really thinking. So, Koki, thanks for joining me. Obviously, clearly, the focus here is on the financial sector. And to open this up, let's start there. You know, based on the current macro environment, how do you two guys see the financial sector locally, globally? Interest rates is clearly the big theme, the inflationary environment. I don't know which one wants to kick off. Michael, do you want to start us off? And then, Koki, you can interject as we go along. Well, one of the advisors to Bill Clinton said that if he dies, he would like to come back

2:44reincarnated as the bond market. The reason he said that is the bond market terrifies everyone. But strangely enough, that has been debunked of late by the massive, massive action that central banks all over the world have taken and have even resorted to buying bonds. So, we've just come through an incredible period where the bond market has been rendered impotent. And interest rates have been near zero for the longest period that it's ever been in history. That is from 2008

3:16to 2022. So, for nearly 14 years, interest rates have been close to zero, at least in developed markets. And that has massive, massive implications for the pricing of all assets, because assets, after all, are a discount of future returns. And if you discount it at zero percent, it means that, in theory, the profit you're only going to make in 100 years is worth as much as the profit that you would make next year, which is why growth stocks and many other speculative assets actually shot up so

3:48much. But zero interest rates affect everything in the economy, economic growth. It affects households, you know, how much money they have left to spend after their mortgage payments or what type of mortgage they can afford. It affects the decisions of corporates, whether they're going to invest in CAPEX or buy back their own shares. So, this single interest rate, the one I would like to be when I'm reincarnated, you know, what are global interest rates, is the most powerful thing in the world. But it's been zero for too long. And because it's been zero for so long, our risk management has

4:21not been appropriate. It's been possible to invest in zombie companies. It's possible that companies have continued to exist because they didn't have to pay back their debt or service their debt because the debt servicing costs were so low. And it is completely unlikely that we will emerge out of this scale. Interest rates are going up quite fast. The impact of that hasn't yet flown through the entire economy. But I believe the repercussions on investment decisions, but on everything in the

Banking Challenges

4:50economy, are massive. And we've only just started this process. Sure. Does that mean that, I mean, Coggy, comment here in terms of the debt levels that we might see within the banks and other financial institutions rising? Is that cause for concern? Sorry, I'm trying to paraphrase what Michael said, because the huge impact of what he said is, for the banks, obviously, initially, higher interest rates are a huge positive. I mean, we've been saying the whole time, it's like manna from heaven for them.

5:24Simply also very low base in Europe and US that came from, I mean, negative interest rates to say two or three. So, the higher interest rates really have a positive impact on the net interest margins, on the return on capital. I actually happened to visit the bank in December in Europe. We were sitting there with a model in front of me. I suddenly realized the loan book over the last 10 years at more than double, I think three times. But the interest income was the same. And that was a

5:58squeeze on margin. So, the guys were working twice as hard and obviously trying to save money on expenses and other. And suddenly, in the last six months, which was the end of 2002, the net interest margin shot up. And that's really what's happening. So, secondly, on the banks, and I'd like to hear what Michael said, but post 2008, we've been saying this the whole time, that the impact of the regulatory changes will be seen now, that it's been much more difficult for banks to be the normal free lending selves.

6:28So, bank balance sheets and their loan books are very clean. And so, the big surprise so from the market we think is wrong there, is that your bandwidth is going to be a lot lower than expected. So, of course, that's normally what happens. High interest rates, and then corporates start battling, but the corporates at the banks of exposure to are a lot stronger as well than, I think, in the past cycles. I don't know Michael, do you agree with that? Yes, I've found in the past that some of the bank

7:01analysts, certainly not bookie, but some of the banking analysts globally are actually quite lazy in understanding the impact of interest rates on balance sheets and on income statements. In very, very basic terms, high interest rates are great if you have a deposit franchise, and negative if you have a lending franchise. Obviously, most banks in the world are both, but they are completely separate profit drivers, and they need to be understood not as a mix, but separately. In other words, when you raise your deposits, have you used treasury there to maturity transform those deposits?

7:36So, it could be that you don't share as much as you can when interest rates go up or down, or you could. So, that's the one thing analysts need to understand. And on the credit side, well, the cookie, of course, is broadly correct saying, you know, regulators have prevented banks from maybe taking the worst risks. It's by no means clear yet what people have done over the past 14 years where interest rates have been close to zero. As Buffett said, you only know who's been swimming naked once the tide goes out. Sure. The tide is going out now, and it's going to,

8:09this is a fascinating call that investors have to make, at least bank investors, is who were rigorous in their credit assessments, who didn't just grow market share for the sake of growing market share, who they have in that book some big negative surprises that are going to come. I dare say that I have confidence in the South African banking sector. I don't think we've gone overboard. But anywhere where you've seen growth that is too fast, whether it's, I don't know, the Chinese property sector, for example, we haven't at all started dealing with the bubbles that have formed

8:44during the smoothing year period. Sorry, Kofi, how easy is that for you and the team to really analyse? Look, a lot of what we do, we spend a lot of time modelling fast behaviour. So normally, often your best predictor is what happened in the past. You look at the banks who have always had the lowest cost of risk, the lowest bad debts, and generally, you know, that's in the DNA, that will stay. And secondly, as Michael said, you look at those who didn't grow their loan book excessively,

9:17and loan growth was until 2021 was actually really subdued compared to previous cycles. So you look for those banks that have been conservative. Interesting, a lot of the excesses that took place was in the low end of the market, the so-called buy-now-pay-later space, and a lot of the fintechs came. It wasn't the low cost of money. The funding was very easy and they just lent out to the lower end of the market. And we see a lot of stress there. And so we're really blessed that we've got very little, in fact, nothing in that space. So there's already a, the bubble there has been pricked. If

9:51you look at a lot of those guys, Stone, Klarna, et cetera, et cetera, their bad debts have just three, four, five, six times up higher because they were irresponsible in the lending. Okay. So the historic interaction you've had with these organizations over time, Cocky, understanding how they've managed their loan books in the past is really the benchmark for how you look at things, look at things right now. But I mean, overall, guys, increase in interest rates, positive for margins

10:23and profitability and earnings for these organizations. And because of the regulatory controls, we should see, you know, the bad debt component and the more control that we might have seen in the past. Is that, would you agree, some of that, some of that? Which is quite a positive answer. The answer is yes, but so, so if I could just mention one big figure, it's the total amount of debt in the world, which is $300 trillion. And to put that in perspective, that's 350 percent of

10:54global GDP. Three and a half times GDP is global debt. Now, at the turn of the century, it was 200 percent. So in the 22 years, it's gone up by one or five times whatever GDP has done. Now, the point Cocky's making validly is that not all that debt has come through the balance sheets of banks or sits on the balance sheets. Some of it may have been arranged by the investment banking components. But that debt, should something go wrong, and something will go wrong, you know, when interest

11:24rates go from zero to five percent, it will have a wider impact on the economic system, the financial system, and will find its way back to that. For example, that could have led to some money, small amount of money to a corporate who had a bond issue. But when they start struggling to pay the bonds that they have, that doesn't mean that the corporate loan isn't also affected. Or maybe more ominously, the risk weighting that banks typically have when they invest in government bonds can be zero. It is seen as risk-free in quotation marks. And it is by no means risk-free. You know, countries

11:58that have debt to income ratios in excess of 100 percent are not risk-free. And that includes the biggest of all, the United States. So while the regulators have been smart, here's one huge blind spot, for example, that when banks invest, it's a form of lending, it's a form of credit, in state bonds, it's seen as risk-free. I'm telling you, it's everything but risk-free. Now those things are going to be revealed as the tide goes up. Many have been swimming naked. When Michael is taking a ride, you'll recall the European

12:31debt crisis. What is that? 2012, 13 to 15, when the risk was that Italy and Greece might fall over, and the banks had a lot of European bond exposure. So, I mean, that I agree is the biggest risk out there that, you know, government debt that we see is safe, appears not to be safe. You have a repeat of that. Actually, it doesn't happen to see all the Turkish as well, but so the Greek banks. Now, Greece

13:02has improved dramatically, but all the debt to have is at a fixed rate. So they would be good, but someone is carrying a risk. So the European Central Bank is sitting with that Greek bank, having to pay more for funding, but the servicing is lowly. So I agree, I think you're going to have, but that would be a global, that would cause a global recession. That scenario where you have government, the risk of government defaults. Yeah. In terms of the portfolio copy, I mean,

13:33taking all this into consideration, I mean, how have you been shaping the portfolio on a global basis? No, thanks Nigel before me. No, I mean, obviously, I've been around a few years, so we know the banks that we invested in well, so we've always focused on the quality of management, the historic track record, and at the moment, there's about 20% in US banks, a lot in European banks, also about 20%. They are, you know,

14:06very mispriced by different deals, but I agree, the risk of bond defaults is high, but then there's a 20% exposure in the property casualty sector, which is doing very well at the moment, and then some emerging market banks in India, Indonesia, countries that are actually still growing at 7-8% real. So, you know, we diversified it a lot. Yeah, okay. And just moving on, but staying very much within the financial sector on the same theme. Michael, for many years, you ran a large listed

14:42financial services, diversified financial services business. What other challenges would you be seeing

Financial Services Challenges

14:49if you were sitting in that chair today, would be, you know, really the big challenges or what would be keeping you awake at night? I mean, the things like service levels and, you know, maybe we could unpack that a little bit. Of course, they're the business basics. You've got to have happy customers and happy staff members, but to make it a bit more technical, all banks are actually fintechs. You know, the label fintech isn't just for these new startups. You know, banks are running on technology and massive technology investments, but much of that may be legacy because the new technology that is

15:24being developed now is cheaper, is more ployable, can be implemented faster. And there's this saying in the world, which goes beyond banking, but, you know, how long is it going to take the incumbents to get innovation? Are they going to be able to do so before the startups get distribution? That's the big kind of challenge that's happening between incumbents and startups all over, as well as in banking. So, with the knowledge that I have now of being chairman and part of the founding team of Bank Zero, is that it is possible to start a new bank at a fraction of the cost of existing banking. When I say fraction, I'm not talking 1%,

15:59I'm talking a fraction of 1% of what it costs for an existing bank. So, were I to run a big old incumbent bank, I would be terrified. As it was said, only the paranoid survive, and I would be looking at ways of hedging the risk to make my cost of intermediation much, much less. So, I think that is possibly the most significant challenge for banks, insurers, and asset managers out there, is that there are new technological solutions, and maybe we can talk about crypto later, that can offer the same type of

16:33solutions to customers, but at a fraction of the cost which has been done today. Yeah, yeah. Koki, I want to get into decentralized finance and crypto and other areas in a second, but in terms of shaping the portfolio and the large listed financial groups that you look at, have you started to tilt more towards those that are investing in some of these new technologies and are really aware of? No. Well, yes and no. I mean, Michael will tell you that, generally,

17:04the innovators tend to be very expensively priced, and your problem is, initially, you don't know who's going to win. So, a lot of the innovators have actually fallen over and grew too fast, and they still tend to be monolined, which have one product, do very well in it, but then do really compete with the bank and offer mortgage, car, et cetera, et cetera. It takes time, but yes, obviously, every bank management we see, we ask those questions, and we check how innovative, whether they are aware of

17:40the challenges, as Michael, do they stay awake with Michael? Well, not with Michael, but do they stay awake and worry, and they're not only half the battle, but one of the banks we did actually invest in was a signature bank, and it's a fascinating story. We're not going to where we're going to go to. They were the bankers to seven of the crypto exchanges, and got in very early, and he had a huge run on stable coin deposits, and so much of it became 20% of the deposit base, and obviously, this was

18:17free money. It did very well, and then when we had the Terra Luna collapse, and you had, especially FTX collapse, suddenly, even investors in stable coins suddenly started panicking, and those deposits flew out again. So, it actually, I think in terms of innovation, when there's a bubble, sometimes they initially excesses, and so we've waited. We stayed with the signature bank, and by the way, it's come back from $300, or three times twice the book, one-time book, so it's about $300 to one. So, we're actually

18:51investing now again, but so the innovation, you're going to get a second and a third chance to invest, but we're certainly looking at all the players the whole time, interviewing them, trying to stay abreast of, but the first wave is mostly over. I'd love to hear what Michael thinks as to, you know, higher cost of capital, is innovation dead? We know not, but it's more expensive, I suppose. So, what exactly is your question? I've got lots of answers, but I want to make sure I answer the right one. So, we've seen also in your previous tech bubble in 2000, that innovation comes in

19:25in spurts, driven often by things, this one is driven by low cost, low cost of funding. So, do you get a real slowdown now, and blockchain just becomes unimportant for five years in the background there, guys in labs have been working, or do you think it's going to increase its main speed? Right, if we're talking about blockchain in particular, the same basic principles that apply, that apply to nearly all the other technologies we've seen out there, whether it's AI, or 3D printing,

19:56or genetics that are designed, and that is that if something gets discovered, it gets hyped, everyone gets very excited about it, and at some stage, that hype is overdone, it comes down, and then it may actually go undercover for a long period. You know, AI was discovered decades ago, and it never kind of came to fruition. Suddenly, we have chat GPT, and now we realize that there's a very good example of how it can be very, certainly, all of us in all of our endeavors. So, I believe it will be with blockchain. I happen to be a bull on crypto and a bull on blockchain. I

20:27think there are many, many practical ways in which it can improve life, but so far, not many of them have become evident. I know there will be people out there that, you know, disagree with me vehemently, but it's not come to the popular imagination, other than as a speculative currency. And that, for me, is quite separate from the use cases for which you can use blockchain. The one positive about the fact that the market has certainly also been in a bubble situation is that those developers have been able to attract a lot of capital, also free capital,

21:00which has allowed them to experiment magnificently. So, the amount of work that has been put in by developers in the blockchain or the decentralized world is actually quite immense. So, I remain a bull, but it's also not yet clear where the winners will be then. Just like at the beginning of the internet, we weren't able to say that, you know, somebody like Mark Zuckerberg would, you know, become one of the world's richest men through Facebook. It's not, you know, I'd say it seems quite easy or that, you know, Amazon would be like the e-commerce winner and so on. I think we're at those

21:32very, very early days where it's easy to be bullish on the entire macro promise that blockchain can deliver. But at this stage, quite difficult to say who the individual winners will be. But the development on blockchain is continuing because it has significant advantages over the current processing. I know cars like JP Morgan have built a blockchain, an in-house blockchain for their clients and, you know, just the lower cost and speed of transaction.

22:02And the auditability and the trust that you get with it. Although I suppose to give a balanced view, it is not in every single instance the best technology to be used to solve a problem. There are certainly cases where simply having a centralized database is better able to solve the problem. But if that centralized database or system comes with a monopoly that behaves like a monopoly, then decentralized finance is a far superior alternative.

22:32Yeah, I mean, it's fair to say that obviously there's one very, very prominent scandal happening at the moment globally, but in this area, but the FTX scandal, but the regulators are catching up, right? And I mean, that should give more comfort and, you know, start to develop this whole segment as we move forward.

Blockchain and Crypto

22:51So, yeah, Certificate is a significant fraud, one of the largest, I think, we've experienced. Sure. Interestingly, it is not a decentralized protocol that has failed. It's actually a centralized institution. It's obviously everything they did had to do with cryptocurrencies, but they themselves were a centralized institution. There was a lot of failure in there. And those failures are basic errors that, you know, are things that a properly regulated bank would never have been able to commit,

23:24loans to subsidiaries and large exposures and unedged exposures and currency risks, you know, to the extent that they have. So, it's good that regulators are catching up. As they always do, they are mostly behind the innovation and play catch up, particularly when these large things go wrong. Yeah. But that would be a regulation of a centralized institution. I think what probably also needs to happen and is increasingly happening in the world is the way that regulators perceive cryptocurrencies. What are they? Are they commodities or currencies? They're bringing them into the regulatory net.

23:58And when they do so to protect consumers, I think that is the right thing to do because a lot of naive consumers have fallen for crypto as a get-rich scheme, which certainly is not what it should be. And there should be, you know, for most people, certain, there are definitely portfolio limits as to how much they should invest in these type of currencies. And therefore, I think the real players are actually welcoming a regulatory intervention in the sector. Yeah. Kogi, I'll put you on the spot. I mean, in terms of this development of, I mean,

24:29you mentioned Signature Bank as one of the holdings in the fund. What, roughly what's the exposure within the portfolio at the moment to these new areas to, like you talked about crypto exchanges, et cetera? Yeah, let's call it 5%. I mean, we also invested in a small private equity manager who focuses on emerging market fintechs. Okay. And VEF and that share price also collapsed. Nothing, the businesses, individual businesses

24:59also doing, are still doing exceptionally well in Brazil, India, et cetera, et cetera. But, you know, investors are just fleeing those investments and we're picking up some up there as well. Yeah. So same as with Signature Bank. The client behavior and investor behavior goes in cycles, but the bank was not irresponsible in growing that area. And so, yeah, so that's really where we're slowly picking up. But nothing said that all the banks we've talked to are working on or

25:30investigating, you know, blockchain, DeFi ways of, you know, I think crypto is taking a bit of a, you know, the on-ramping and off-ramping because as the regulators get involved, they first want to see what regular changes they're going to be. But Michael actually recommended it, it was a year and a half ago, I think, that I read Steven and Simon Dingle's book, Beyond Bitcoin, by the unfortunate title with it, and the end of banking. I was going to ask him,

26:03are we now, you know, beyond banking and the end of Bitcoin? But that book, I would still recommend it because it really gave me a good foundational insight into what was happening and who were the players and what they were doing. But one way they were wrong is the whole liberalist theory of permissionlessness. To remember, you wanted everybody to be able to participate without and regular, well, society just can't allow bad actors to be permissionless,

26:35just call it in their phraseology. But interestingly, one is, you know, the trustlessness. I read recently, aid agencies are increasingly using blockchain ledgers for distribution of funds because it is transparent, it's visible, it is so you can give money to the Kenyan government and you can see exactly where that money goes and when it arrives. So, if used correctly, it cuts down on

27:06corruption in that type of, well, everywhere. But yeah. And those are the use cases that over time will develop. That seems to be a very interesting one. I mean, one in South Africa I find interesting is where people generate solar power with all the load shedding, but sometimes they aren't available to use it. It might be on holiday hours so they're not there to be. They want to share it with their neighbours. Now, this type of thing can very easily be built on a blockchain where there are micro payments and at the end of the month they net off or at the end of the day, you know,

27:38what has happened and do the settlement. That type of thing would be crazy to run on a spreadsheet or through a normal type of bank account. So, many of these micro solutions are out there and what's happening in the world is it's one massive laboratory and out of that are going to become very, very, very interesting things. And the cases I've mentioned that may not even compete with the banking system as we know because the type of transactions are currently not happening there, it's not a source of income, but it could grow massively. I mean, a solar rose in the African continent and you may have all this blockchain-based settlement of electricity usage without it ever

28:14touching the banking system. Sure, sure. Interesting. And it's quite interesting to know that there's a component of the portfolio from an investor's perspective that, you know, you're focused on this area and in touch with this area and learning all the time. So, the analysts, Craig and Barry and all three of them really are focusing on the so-called payment space and processing space. And yeah, as Michael alluded to, it's the service levels, it's reaching the digital space, reaching your clients in a more user-friendly way. And so, we're continuously ranking banks on

28:47we perceive the ability or to see the future and work towards the thing. So, even JP Morgan, one of the largest banks in the world, is way ahead of a lot of other US banks on that space. Yeah. Yeah. Okay. Guys, that's great. I mean, we've touched on the broader financial sector and some of the positives and challenges there. We touched on decentralized finance, if I can use that term, and focus there and some of the things that happen and the lack of cheap money and how

29:19that's impacting things. That's great. So, I think let's finish off with the third area. I mean,

Investment Opportunities

29:23Michael, I heard you use the comment about where the puck is going is the important focus. I mean, I know you also mentioned that you've got a lot more time to read and think about things than you did perhaps in the past and, you know, very focused on solving problems. You also made a very strong comment yesterday about, you know, people need to really pick things up and take their own responsibility and not apportion blame to, you know, to government, etc. So, I think that's all, you know, it's all very relevant. But in terms of where the puck is going, guys, you know,

29:55opportunities for investors, where do you see things? Michael, I mean, I know this is, you know, this is what you do day-to-day. It's such an exciting world because there are many, many more entrepreneurs all over the world that are trying to solve the problems in front of them and the world's become flatter. So, if somebody does something successful in, I don't know, Ohio or in Beijing, you know, you can read about it on the internet and you can try and do something like that in your own country. I mean, these things just, you know, obviously didn't exist 2,000 years ago, but even 20 years ago. Yeah. And because many of these things are digital, tech type of solutions,

30:29the cost of copying them are close to zero. So, there's a massive amount of entrepreneurship happening all over the world and in South Africa that, you know, really just didn't exist. So, and that means problems that aren't just problems, they are all business type of opportunities. Now, some of these things are difficult to invest in if you only want to invest in listed shares. Sure. You know, because it's private, that's either private equity or venture capital. That's what I do. It's what I love. It's risky, but it's very, very energizing because you surround yourself with

31:04people who are complex problem solvers and, you know, see better ways of doing things. And so, that's very, very gratifying. So, kind of my message would be to not only invest in listed shares, but certainly I think bonds are boring and also arguably quite dangerous given where interest rates are going. And to have some of your portfolio personally or, you know, outsource it to experts, to have it in venture capital and startup companies that are going to produce superior growth. And I,

31:34apart from the fact that it solves problems and it's really good for, you know, making the world better and creating jobs, I can tell you that if done properly, the IRRs, the rates of return that one is able to get out of these type of startups is significantly superior to anything in listed markets. Sure. Okay. Cocky, so the challenge for you there is to keep a focus and as these businesses develop in the finance sector, to bring those into the portfolio for the benefit of the fund and for investors. So, that's great. That's why we travel the world. And as Michael says, it is hugely exciting to talk to

32:08the new players, but even within existing banks who often have, in Brazil, the two largest banks, have a spin-off outside the bank. Very clever. Outside the whole corporate thing and let them run. To go talk to those guys, what are you doing? Yeah, no, it's really hugely exciting times. Great. You asked me, you know, what it would be like running a big bank. I think that is the correct approach, the one that Kuki has mentioned. You know, if you try to control it too much with your existing culture, your existing HR process, your branding strategy, etc., etc., you're not going to have the entrepreneurial freedom that those startups have and you're not going to think

32:42first principles and then feel the pressure there. But I think it's very clever for a big bank to say, I'm going to hedge my bets by having a separate institution that competes against me. It's a rave. I can see many corporate cultures won't allow that, but it's exactly the right thing to do. Thank you. Gentlemen, thank you very much for taking the time, Kuki. As always, thanks for being on. And Michael, it's been fantastic seeing you and wishing you all the success with all your ventures this year. Really appreciate your time and opening up the boardroom for us today. So nice. Thank you. And we'll see you again soon.

33:13Thanks, Nigel. Thank you.

33:17Thank you for listening to this episode. We hope you found it interesting. If you would like to join us again, please subscribe for more investment insights. To find out more about our team and the funds we offer, please visit our website at DenkerCapital.com.

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