The 2004 Annual Report of the Bank Supervision Department highlights four key messages, namely,1. South Africa’s banking system is currently stable and sound.2. Banking activities, however, go through various cycles, and it is important that a note of caution is sounded that bankers do not get caught up in the current euphoria of ‘good times’.3. Having regard to the challenges of banking cycles and in the wake of several high-profile corporate failures locally and abroad, increasing emphasis is being placed worldwide on the responsibilities and accountability of boards of directors. Some thoughts on the need for bank directors, particularly non-executive directors to receive training are therefore highlighted at the outset of the report.4. Risks relating to activities outsourced by banks require more careful attention from boards of directors. In Chapter 1 of the report, the issues discussed include the following: - Overview of trends in the South African banking sector During 2004, the South African banking system remained stable and, in general, banks were sound. Banks benefited from South Africa’s economic health, and their financial performance was strong during the year under review. Banks remained well capitalised, and the average capital-adequacy ratio increased from 12,2 per cent in 2003 to 13,5 per cent in 2004. Growth in the total balance sheet increased during 2004. By the end of December 2004, the total funds of banks – comprising capital, reserves, deposits and loans – had increased by 8,6 per cent (measured over a period of twelve months) to a level of R1 498,1 billion. Both the return on equity and the return on assets of the total banking sector increased during the year under review. By the end of December 2004, the average return on equity (smoothed) was 14,7 per cent, up from 11,2 per cent in December 2003, whereas the return on assets (smoothed) increased from 0,8 per cent in December 2003 to 1,2 per cent in December 2004. The efficiency (cost-to-income) ratio of the banking sector improved slightly from 64,6 per cent in 2003 to 63,9 per cent in 2004. The total gross overdues of the banking sector decreased by R3,4 billion, to a level of R20,4 billion at the end of December 2004. Provisioning by banks against these non-performing loans was adequate. - Stages of banking cycle A note of caution is given by briefly outlining the eight broad stages of a cycle through which banking and banks progress. South Africa experienced stage 1, a banking crisis, during the period from late 1999 to 2002. Many regulatory actions were taken and implemented during stage 2, and normality returned to the banking sector. During stage 3, many bankers became more prudent and instituted actions such as down or rightsizing of businesses, curtailment and critical evaluation of cost structures, disposal of non-core and non-performing assets and investments, and an overhaul of risk-management practices and structures, among other things. Recently, there has been evidence of the fourth stage, that of the economy and stockmarkets taking off. 2004 saw increased loan growth which is characteristic of stage 5. There were also signs of stages 6 and 7 - new competitors and excess liquidity and investment optimism - as evidenced by some international players expressing an interest in acquiring a stake in South African banks and reports of a build-up of excess cash in some banks. The vexing question is whether the cycle will be completed to reach stage 8, when overheating of the economy becomes of concern to regulators. Prudent bankers carefully plot the cycle and put in place suitable measures to ensure that their banks can survive the effects of any downturn . All chief executives of South African banks should advise their boards of directors appropriately, and the boards should play an active role in ensuring that depositors are protected. Overview of supervisory activities Modifications to the Bank Supervision Department’s supervisory approach were implemented. The