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.
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:
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.
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.
Leading up to the failure of SVB on 10 March, US banks took to the typical seasonal conference circuit with commentary that was pretty consistent with their outlooks during Q1 earnings. While a few banks cited deposit cost pressures, this was not universal. Looking ahead, while large banks came into the SVB collapse well-positioned, the operating environment has shifted, which could weigh a bit on near-term earnings.
There is likely to be fallout from the SVB saga. Regulation should get tougher, and earnings could get weaker due to slower asset growth, margin compression from higher funding costs and an inevitable uptick in credit costs, which has long been expected. Note that the impact from lending standards will surely tighten financial conditions, which could have economic implications, and commercial lending could come into focus. Finally, we expect deposit trends to be watched carefully across the industry, with the largest banks benefiting most, and for consolidation to potentially pick up.
Q1 2023 saw the return of financial stability concerns over inflation, the Ukraine–Russia war, and energy costs. Global risk aversion returned from problems at US regional banks.
Apart from CS, 2022 European bank earnings were some of the best since the GFC. The biggest criticism of European banks has been their lack of profitability in the negative rate environment. That has ended, with a surge in revenues and returns from passing on higher rates. Q4 2022 results show some tentative signs of what one would expect in an inflationary environment, such as slowing loan growth, rising expenses, and slowing deposits (households using excess funds for higher cost of living).
Bank managements are all still “very bullish” on 2023, giving guidance for further revenue growth and very limited credit losses in 2023. They do acknowledge that there will be a slowdown in the pace of improvement versus what we saw in 2022, with the pass-through of rates to deposits picking up and resulting in the net interest margin plateauing at Q4 2022 levels for many banks. Market instability and risk aversion are also likely to reduce investment banking YoY.
The lagged impact of persistent inflation and higher borrowing costs should eventually weigh on consumers. We are watching for downside risks in the areas of credit costs and inflation pressuring expenses. However, the sector is still materially better positioned than when it was barely profitable under negative rates. The global rate hikes are boosting banks’ earnings, but not without unintended market volatility (UK LDI episode, US regional bank stress, CS failure, etc.). Rising retained earnings, strong capital ratios, and consistent stress testing support our view that our high-quality European bank exposures can continue to navigate this environment.
Bank earnings in Q1 2023 (March 2023) were a mixed bag, though pre-tax pre-provision income was better YoY due to higher rates and better trading income. The robust loan growth of recent periods has cooled but is still pretty solid in commercial segments.
On credit, normalization remains gradual, with impaired loans only modestly higher, yet provisions and net charge-offs are generally below pre-COVID-19 levels, and consumer delinquencies are rising from very low levels. On capitalization, the industry trend is biased higher (excluding M&A), with CET1 generally anticipated to rise toward or above 12% by year-end 2023, influenced heavily by recent changes to the Domestic Stability Buffer (which could continue to rise). While a recent stress test by the Bank of Canada (BoC) highlighted the banking sector’s capital resiliency to a substantial recession, the housing market and household debt are financial stability concerns. More positively, while home prices are falling following a run-up during COVID-19, inflation is cooling a bit and the BoC’s recently paused rate hiking cycle could help mitigate worst-case outcomes.
Overall, major Canadian banks continue to boast above-average profitability vs. global peers with diverse revenue streams a point of differentiation, modestly offset by high/growing wholesale funding needs and concerns around high private sector household leverage. Looking ahead, banks acknowledge recession risks but most banks are explicitly guiding for positive operating leverage.
A major bank reported half-year results in March while others provided trading updates. In general, themes remain positive for credit investors. A key takeaway, similar to other jurisdictions, is that rising rates and decent loan growth are serving to boost pre-tax pre-provision profit, the first line of defense against credit losses. While this benefit is especially strong for Australian banks, 80%+ of whose revenues come from net interest income, it is notable that net interest margin (NIM) benefits may be close to peaking and that there are competing forces at play as the speed of the tightening cycle creates the prospect of weaker volume growth, higher funding costs and higher credit costs, especially in H2 2023.
Nevertheless, credit quality improved across the sector, in part reflecting a strong labor market. Capital levels trended higher and remain top-tier globally with new regulatory standards now active as of the start of the year.
Looking ahead, the focus is on the macro environment, the pace of central bank rate hikes, and the degree of tightening that it can practically achieve, given inflation dynamics and high sensitivity to rate hikes. Home prices are declining following strong post-pandemic gains, but overall pain from higher rates appears more at the tails than the average, with recent buyers that have higher debt and/or lower cash buffers most at risk. For the housing market, a recent resurgence in immigration is also positive. On the other hand, the flow-through of rate hikes to consumer budgets could hamper consumption and is a key economic risk factor, despite various structural elements of the housing market that remain supportive. This is offset partially by strong non-mining business investment intentions.
The Big-3 banks reported their Q3 results in early February, and each bank saw its year-to-date (YTD) profits exceed full-year guidance. However, none of the banks changed its full-year guidance due to uncertainties in the global economy and markets.
Decent profitability performance principally reflects solid top-line trends, including better net interest income, driven by overseas lending. On the other hand, fee income was a bit more mixed depending on the bank and efficiency remains similar at around 60%–61%, which is elevated. Importantly, asset quality remains good with non-performing loans either lower or flat QoQ and cumulative credit costs are still between half and two-thirds of full-year target levels. While an area worth monitoring is unrealized losses within the securities book, driven by rising rates and stock market declines, there was some relief during the quarter. Moreover, it is notable that unrealized losses on overseas debt securities are more than offset by unrealized gains in domestic equity holdings, all of which are incorporated in pro-forma capital ratios.
Overall, the major banks have decent capitalization and benefit from a strong assumption of sovereign support, but the operating environment is hampered by structural challenges (rates, population, overbanking, inefficiency, etc.) and the banks continue to pursue international loan growth, which should be watched.
Some cracks are beginning to emerge in credit fundamentals for non-financial corporate credit issuers. Focusing on the investment grade space in the US non-financial sectors, we observe that profit margins are declining across most sectors and interest expense has begun to rise, reflecting the backdrop of higher interest rates. However, leverage has been flat (aggregately) as debt growth has been minimal.
In non-financial sectors, top line revenue growth continued to be strong across most sectors, especially on a YoY basis. However, on a sequential basis, a third of the sectors posted revenue contraction, with tech and pharma specifically having the largest reductions. For the remaining, revenue growth has been slowing but is still modestly positive. Profit margin deterioration was far more pronounced, as 12 of the 18 sectors in the investment grade index posted YoY declines.
The broad-based weakening in margins reflects ongoing headwinds from higher labor costs, energy costs and FX headwinds for some sectors as well. Margins peaked on a YoY basis in Q2 2021 and they have been declining since. Margins still remain relatively strong on a historical basis, but we suspect that this narrative will come under pressure over the next 6 months. Lastly, we would note that though aggregate leverage levels across sectors were up slightly, on a sequential basis, they still remain comparable to pre-COVID-19 levels. Leverage trends remain largely stable ex-commodities as declining debt levels have matched slower operating profit growth.11
1 Technology deposits include SVB’s year-end 2022 deposits characterized as technology, early-stage technology, life science/healthcare and early-stage life science/healthcare.
2 Peer group includes (by tickers): Citi Bank (C), First Republic Bank (FRC), Comerica Incorporated (CMA), Huntington Bancshares Incorporated (HBAN), Fifth Third Bancorp (FITB), Capital One Financial Corporation (COF), Zions Bancorporation NA (ZION), Wells Fargo & Co (WFC), J.P. Morgan (JPM), First Horizon Corporation (FHN), KeyCorp (KEY), Synovus Financial Corp. (SNV), Bank of America (BAC), M&T Bank Corporation (MTB), US Bancorp (USB), PNC Financial Services Group, Inc. (PNC), Truist Financial Corporation (TFC), New York Community Bancorp, Inc. (NYCB), Citizens Financial Group, Inc. (CFG), First Citizens BancShares, Inc. (FCNCA) and Regions Financial Corporation (RF). Data as of Q3 2022.
3 Reflects growth in total assets of USD 71 billion from Q4 2019 to a peak of USD 220 billion at Q1 2022. SVB ended FY 2022 with total assets of USD 212 billion.
4 Over the three-year timespan ending 31 December 2022. Peers reflect banks devoid of material acquisitions during this time frame: Bank of America (BAC), Citi Bank (C), J.P. Morgan (JPM), Wells Fargo & Co (WFC), Bank of New York Mellon Corp (BK), KeyCorp (KEY), Zions Bancorporation NA (ZION), Fifth Third Bancorp (FITB), US Bancorp (USB), Comerica Incorporated (CMA), SBNY, First Republic Bank (FRC), Truist Financial Corporation (TFC), Regions Financial Corporation (RF).
5 Publicly traded banks with > USD 10 billion in total assets as of Q3 2022. Source: S&P CapitalIQ Pro, regulatory filings.
6 Publicly traded banks with > USD 10 billion in total assets as of Q3 2022. Source: S&P CapitalIQ Pro, regulatory filings.
7 "Press Release", Board of Governors of the Federal Reserve System, US Federal Reserve, 31 October 2018, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20181031a.html.
8 Asset sizes as of 31 December 2022.
9 State Street Global Advisors holdings as of year-end 2022, company financial statements.
10 S&P Global Ratings, Credit FAQ: “Will Unrealized Losses on Financial Assets Affect Ratings on European Banks?”, 23 February 2023
11 J.P. Morgan North American Corporate Research, “HG Credit Fundamentals: 4Q22 Review”, 17 March 2023.
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