Amid three bank failures in the US and fear of one in Europe, havoc descended upon the banking industry last week, dragging the broader equity and bond markets along for the ride. The dust hasn’t quite settled, either. While most of the issues for Silicon Valley Bank (SVB) and Credit Suisse could prove to be idiosyncratic, investors have responded in a risk-off manner.
YTD Performance Comparison: MSCI World vs. Financials vs. Banks
Tighter monetary policy has made things difficult for many industries, but banks were considered well-monitored and regulated by the Federal Reserve. However, the smaller, regional banks did not face regulations as onerous as those faced by the larger players – which became brutally clear recently.
SVB had a concentrated customer base (consisting mostly of large deposits from tech companies) and unhedged, bond-heavy assets. This made SVB more vulnerable than other banks to deposit outflows, as they needed to be funded by bonds that had fallen in value. The crunch in liability matching followed the demise of fellow crypto-friendly bank Silvergate Capital days before and, shortly thereafter, the closure of Signature Bank by New York state financial regulators.
Three banks with similar problems, though hopefully not systemic problems. The Federal Reserve, US Treasury and Federal Deposit Insurance Corp acted quickly last week to assure that SVB depositors’ money was safe (despite most of it being uninsured). And they set up a new Bank Term Funding Program that offers one-year loans to banks under easier terms to help stem any contagion after SVB’s collapse. And on Thursday last week, 11 large US banks contributed a cool $30 billion of uninsured deposits to First Republic Bank, signalling the strong support available.
News concerning the issues laid out above will rumble on as investigations start into the supervision of SVB. And, in this nervous atmosphere, deposit runs are impossible to rule out for US regional banks. However, regional banks account for just 6% of the S&P US Financials Index. Large cap banks tend to have a lot more liquidity, are more diversified with broader business models, have a lot more capital than smaller banks, and are better managed with regard to risk.
Investors are undecided on what comes next. We saw extreme flows both ways in bank and financials sector ETFs last week. President Biden has said “the banking system is safe” and that new regulation would “strengthen the rules for banks to make it less likely this kind of bank failure would happen again.” However, such statements need to be counterbalanced by Moody’s downgrading of their outlook on the US banking sector to negative, noting that "operating conditions have sharply deteriorated" and “significant excess deposit creation… has given rise to asset-liability management challenges.”
Credit Suisse has faced problems for years and, in 2022, saw large withdrawals of funds and a significant loss for the year. The major Swiss bank had already started an overhaul of its business, cutting costs and creating a separate investment bank. Although, looking at the company’s share price, you could be forgiven for not realising improvements were afoot.
Then last week, not to be outdone by a group of new-aged US regional banks, the 167-year-old Swiss bank added to market woes in a big way. Concerns mounted after the SEC found material weakness in the bank’s financial reporting. Next, its biggest shareholder, the Saudi National Bank, announced it would not increase its stake (given regulatory constraints). These latest developments sent Credit Suisse shares and bonds tumbling.
The reasons behind these falls are not strictly linked to the problems at SVB, but the bad news came at a time of nervous sentiment toward banks. Again, the problems seem largely company-specific. Fast forward through a busy weekend of negotiations and the solution has become UBS buying Credit Suisse. This arrangement should provide relief to counterparties worldwide. Although, the sale has driven new concern, in this case regarding the (lack of) value of unsecured bonds (AT1s), which form part of banks’ capital.
Most analysts would agree that European (including UK-based) banks appear well-capitalised. The regulatory environment in Europe has been on a tougher trajectory since the Global Financial Crisis. Regulators including the ECB and BoE have scrutinised banks’ interest rate risk in their books through exhaustive stress tests and found the firms within their purview to be soundly positioned. However, from here we can probably expect more scrutiny and regulatory oversight, as in the US, and this will be costly.
There is a possibility that the recent financial stress could lead banks to curtail lending to the real economy. Such a shift would tighten broader financial conditions and start to do some of the work that the central banks have been targeting with the large rate rises so far this year. Whereas expectations for the Fed’s actions this week have become much less hawkish, the ECB stuck with its plan and raised deposit rates by 50 basis points last week. This move shows faith in the bank system and higher rates, together with the steepening of the yield curve we’ve seen, should support further earnings growth.
For investors in the financials sector, does the recent collapse in share prices represent a buying opportunity? Or do these falls signal genuine vulnerability at banks as they grapple with weakening economies and rising rates? The answer could be both. Banks’ earnings estimates may still move higher on rate moves, but a higher risk premium is necessary.
We expect some investors will want to take advantage of the share price falls. But even with the lessons learned last week, no one can rule out the possibility that other banks will find themselves poorly positioned, forcing regulators to take action. Minimising the impact of idiosyncratic risk is one of the benefits of buying a diversified set of companies via an ETF, as is the full transparency of holdings and liquidity inherent in the vehicle.
Furthermore, investing in the whole financials sector offers relatively safer, less volatile exposure than selecting single stocks, with the benefits of further diversification. Insurance businesses offer quality aspects, in terms of return stability and less cyclicality, and the prospects for reinsurance rates hardening this year. Diversified financials boast a structural growth element from asset managers, expansion of exchanges and index businesses. These industry groups provide a useful counterbalance to investing purely in banks.
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