(Ecofin Agency) - South Africa's six largest banks are preparing to raise R360 billion ($20.23 billion) by 2030 in response to new requirements set by the South African Reserve Bank. This complex but essential financial tool, known as the Financial Loss Absorbing Capacity (FLAC), aims to boost banking stability and prevent the need for government bailouts.

When major banks faced significant losses, governments often used taxpayer money to rescue them through "bailouts." This approach was common during financial crises like the 2008 global crisis. Today, regulators aim to protect taxpayers from this burden, particularly as South Africa's public debt approached 70% by the end of 2023.

FLAC acts as a financial cushion, absorbing losses from struggling banks without relying on public funds. Here’s how it works: when a bank faces significant losses, its creditors—those holding FLAC instruments—see their debt converted into equity. In simple terms, creditors become shareholders if the bank runs into trouble. This process, called a "bail-in," shifts the burden away from the state. The idea is straightforward: in a crisis, the bank’s creditors share the losses, not taxpayers.

This is not a new idea. FLAC is closely related to the Total Loss Absorbing Capacity (TLAC), already in place in Europe and the United States after the 2008 financial crisis. Banks there must raise the equivalent of 18% of their risk-weighted assets as TLAC to ensure that, in case of a financial storm, there’s enough reserve to cover losses without dipping into public funds. South Africa is adopting a similar approach to strengthen its banking system.

South Africa’s banking sector is dominated by six major players—Absa, Standard Bank, FirstRand, Nedbank, Capitec, and Investec—who control 90% of the country's financial assets. These are the banks considered "Too Big to Fail." If one of them struggles, the effects on the economy could be significant.

Although the South African banking system seems strong, it still faces some vulnerabilities. These include its reliance on sovereign debt and connections to companies that may be financially unstable.

The reform introduced by the South African Reserve Bank follows international guidelines, particularly those for Global Systemically Important Banks (G-SIBs). These banks must hold a minimum of 18% of their risk-weighted assets and 6.75% of their total exposure in loss-absorbing capital. South Africa is aligning with these standards by requiring local banks to issue debt instruments that can convert losses into capital when necessary.

South Africa’s banks, like Absa, Nedbank, and Standard Bank, are adjusting to this new environment. Their strategy is clear: they aim to transform their unsecured loans, which are typically regular debts, into FLAC instruments. These "senior" loans, as they mature, will be reissued as loss-absorbing instruments instead of being repaid or renewed in the usual way.

“The plan is to roll over maturing senior unsecured notes into new loss-absorbing flac instruments,” said Constantinos Kypreos, Senior Vice President at Moody’s, in an interview with Bloomberg.

Absa and Nedbank have already confirmed they will adopt this approach to meet the new regulatory requirements. Other banks, such as Capitec, which is mainly funded by individual deposits, are more cautious and prefer to issue separate FLAC instruments. Meanwhile, Investec and Standard Bank are still fine-tuning their strategies with the Prudential Authority.

This regulatory shift, praised by Moody’s, is seen as a key defense against systemic risk. If a large South African bank were to collapse, the Reserve Bank now has the power to trigger a bail-in and avoid a costly public bailout. Moody’s has called this a "positive step" for the country’s bank credit ratings.

However, the road ahead for the banks is challenging. They need to raise substantial funds by 2030, with 60% of FLAC requirements due by 2027. While some of their excess regulatory capital can be included in these calculations, these new obligations still pose a significant challenge.