Credit Research Outlook Q1 2023 A Different Kind of Banking Crisis
Health of financials, overall, seems to be in the range of adequate to robust in major regions, despite the impact from US bank failures and the crisis at Credit Suisse in March. Our investments from bank issuers are focused on debt issued by the largest and most diverse banks, most of which have systemic importance domestically or globally.
SVB and SBNY: Outlier Banks
The failures of Silicon Valley Bank (SVB), Signature Bank (SBNY) and Silvergate Bank, with assets amounting to USD 325 billion, in March, roiled global financial markets. The failures were surprising as they followed a lengthy period of calm in the US banking system, where the industry had been demonstrating solid loan growth, extraordinarily few credit problems, and healthy profitability. While these bank failures represented unique circumstances, the events spurred broader concern about the health of regional US banks—and, in particular, banks sharing similar attributes to those of the three failed banks.
We believe four key elements led to the eventual bank run on SVB, some of which were also present at SBNY:
- Concentrated Funding Base and Business Mix: SVB’s banking of the “innovation economy” was based on a concentrated funding base, with 39% of year-end 2022 deposits coming from early-stage tech and life sciences clients, and 63% from technology clients.1 Regulatory data indicates that 98% of SVB’s deposits were above the USD 250,000 deposit insurance threshold, compared to a median of 63% among SVB’s peers. 2 Similarly, the average deposit balance per account was USD 1.17 million, or nearly 36 times the peer median of USD 33,000:
- Excessive Growth: SVB’s balance sheet grew well above that of the nominal gross domestic product (GDP) over an extended (but short) period—a major red flag. Over the span of six quarters, the bank went from USD 71 billion in assets to a peak of USD 220 billion. Its ranking (from before COVID-19) by total assets among the largest US banks jumped from 42nd to the 18th by year-end 2022.3 Post COVID-19, its assets grew at 10 times the nominal GDP growth versus a peer median of 1.2 times.4 Soaring balance sheet growth has been a common feature of bank failures. For example, SBNY grew 6 times the nominal GDP growth, while Silvergate Capital, a small crypto lender, grew 21 times.
- Mismanaged Interest Rate Risk: As deposits rose feverishly, SVB plowed funds into investment securities, but did so imprudently. By Q3 2022, the peak reporting period for unrealized losses for US banks, SVB’s losses consumed 108% of its Tier 1 capital—the highest of 106 banks surveyed, and well beyond the average of 32% for survey participants.5 SVB also held the highest percentage of investment securities repricing beyond 5 years (48% of total assets versus a peer average of 15%).6
- Poor Governance: SVB did not have a Chief Risk Officer for much of the calendar year 2022, per media reports, evidencing very weak internal controls.
In our view, an important distinction should be made between the failure of SVB, and what occurred during the global financial crisis (GFC). For instance, whereas a typical bank liquidity crisis is often kicked off by solvency concerns and uncertainty around opaque, mispriced and/or hard-to-value assets, this was not the case at SVB. Rather, SVB’s “toxic assets” were government and agency securities that feature near-perfect price discovery and virtually no credit risk.
Our Approach: Only the Most Transparent and Regulated
In recent years, our approach to analyzing the US banking system has been influenced by the US Federal Reserve’s (Fed) 2018 “tailoring” proposal, which in our opinion led to softer regulatory oversight for US regional banks with asset size less than USD 250 billion—a blunt measure against which to set policy.7
This included banks such as SVB (USD 212 billion) and SBNY (USD 110 billion).8 Most notably, this included a weaker annual stress testing regime and the exclusion of various leverage, liquidity and funding ratios, such as the supplementary leverage ratio (SLR), the liquidity coverage ratio (LCR), and the net stable funding ratio (NSFR). Our credit research team maintains a dynamic, “through-the-cycle” approach to our approval list, which has helped us stay clear of outliers such as SVB and SBNY, whose characteristics—including these regulatory exemptions—made these banks unfit for our program.
The credit profiles of a bank such as SVB and SBNY—unacceptable concentration in the business model and/or funding base, excessive balance sheet growth or less stringent regulatory oversight than we believe is warranted—are inconsistent with our long-held standards for the SSGA Cash Desk. As a result, our investments from bank issuers are focused on debt issued by the largest and most diverse banks, most of which, in our opinion, have systemic importance domestically or globally.9 SVB and SBNY would have never qualified for our approval list.
The European Banking Sector
In evaluating the idiosyncratic vulnerabilities of the US regional banking sector with regard to the European banking investment universe, we highlight the following differentiating factors.
The regulatory environment for European banks has been proactive in mitigating the types of interest rate risk that can be taken. More than a decade ago, the European bank regulatory standards were adjusted after Dexia (a large Belgian bank) had to be taken over by the state due to unrealized losses on its government securities.
Available-for-sale (AFS) security portfolio unrealized losses are now incorporated into the capital ratios of European banks, which greatly mitigates the risk of the type of capital ratio destruction that SVB experienced. S&P reports that AFS unrealized losses lowered the European sector’s Common Equity Tier 1 (CET1) capital ratio by just 40 bp in 2022, which was more than offset by retained earnings of 120 bp.10 Further, European banks do not have single-sector-concentrated deposit bases, nor have they experienced explosive balance sheet growth, as the failed US banks did. All European banks are subject to LCR and NSFR requirements.
Credit Suisse (CS), broken by the recent market stress, was Europe’s most vulnerable link. For the better part of the last two years, CS has been in a compromised position due to its multiple risk management failures (supply-chain fund failure, prime broker loss, etc.). Its turnaround plan was one of the most ambitious since the Global Financial Crisis. Other major European banks completed their restructuring plans during easy, accommodative environments, while CS had to attempt its massive restructuring under a monetary tightening regime, with lowered asset values. Ultimately, CS ran head on into external market turbulence, resulting in a loss of any remaining confidence. No other major bank has such a toxic mix of a major net loss for 2022, management guidance of another major net loss for 2023, breaches of subsidiary liquidity requirements in 2022, an unrealistic strategic plan, and six months of uninterrupted franchise erosion (assets under management outflows had been continuous since October).
The state-sponsored rescue by UBS included new capital injection in the form of write-offs of CS AT1 bonds and a partial risk shield on CS’ illiquid assets (provided by the government). The continued government support of UBS and this new capital are, in our view, “game-changers” that can finally bring some stability to the CS saga. We view CS as an idiosyncratic credit event. The sector is now stronger given this untenable situation has finally been addressed.
While the acute elements that caused the US regional bank failures in March are not prevalent in the banks that are on our credit approval list, we believe that the resulting stress on US regional banks could have a material impact on the US economy, via the credit creation mechanism. US regional bank balance sheets will remain pressured from a variety of directions: lower market capitalizations, lower deposits, elevated funding costs, and downside risk for earnings. These headwinds will likely further tighten lending standards and thus constrain credit availability. Figure 2 demonstrates the type of macroeconomic impact constrained credit would have on sectors. Indeed, the possibility of further constraints on credit availability has already prompted many economists to downgrade their economic forecasts (Capital Economics, for example).
For us, that means continuing to select cash investment counterparties that are best equipped to maintain their fundamental credit profiles through a variety of macroeconomic scenarios, including a “harder” economic landing.