Spread bank risk with this eurozone fund

While the source of black swan events can never be predicted, it’s always worth remembering that the US financial system’s importance makes it a likely vector. Depositors and investors have also had to relearn an important and brutal lesson: historically, bank failures are commonplace. The US alone accounted for an average of two collapses a month between 2011 and 2020. In a digital age, they might even be more likely to occur. While queues snaking around branches remain the go-to visual symbol of the bank run, nowadays the ubiquity of online banking means the withdrawal of funds at the click of button can precipitate a much faster collapse than was previously physically possible.

As depressing as that may seem, investing in the sector still relies on understanding the market. The US is a vast banking market with a huge variation in regional and national names, functions and levels of regulation across a country the size of a continent. The EU and UK equivalents, by contrast, are more concentrated and typified by large, tightly regulated deposit-taking institutions with prudential regulations that emphasise risk and balance sheet management. Holding 14 per cent of the balance sheet in cash, on average, is a huge safety cushion for the UK’s high-street banks.

You’d struggle to see this from recent sentiment and price action. Since the SVB crisis sent contagion fears rippling through the stocks of global financial firms, the Euro Stoxx Banks Index has been hit hard, falling 15 per cent below the five-year high reached on 6 March.

For investors who smell an opportunity in the recent sell-off – but who don’t want to commit their eggs to one basket – a eurozone bank sector exchange traded fund (ETF) might be worth considering. As well as offering the comfort of diversification, UK investors can get exposure to the breadth, strengths and sound prudential regulation of Europe’s largest lenders without the hassle of directly holding foreign shares (the paperwork around withholding taxes can be complex). To this end, the Lyxor Eurostoxx Banks Ucits ETF (BNKE) may offer a more reasonable entry point for investors who want to go long on the positive interest rate outlook for the largest economic bloc in the world.

With a highly liquid sterling listing on the London Stock Exchange (LSE), BNKE is an attractive option for UK-based investors. Income paid out by its constituents is capitalised in the fund, meaning investors do not need to worry about managing dividends, while its low management fee of 0.3 per cent offers diversification and thematic exposure for a fraction of the cost of a fund manager. A eurozone-only focus also means avoiding exposure to Switzerland’s problematic banks, although in mirroring the weightings of the Euro Stoxx banks index, the fund is skewed to Spain’s financial sector (with 25 per cent of assets), and far less exposed to the eurozone’s largest economy, Germany (which accounts for just under 7 per cent of assets).

The interest rate outlook

One effect of the recent rout in global bank shares is that the market has rowed back on the rising rates premium that had been baked into the sector in recent months. This week, as the impact of the SVB collapse made itself felt, BNKE lurched towards a three-month low.

Has the outlook for interest rates fundamentally changed? ING analysts expect eurozone interest rates to hit 4 per cent at the end of 2023 and then stay there. Paradoxically, the rising cost of capital is a positive for banks in the short term as this can be handed on in higher loan margins. A few weeks before the recent drama, analysts at Berenberg pointed to an implied cost of equity of more than 15 per cent for European banks, a level that has prefaced a 40 per cent one-year sector rally on four occasions since 1990.

The key variable in the coming months is whether Europe’s economic performance will lead to credit impairments on loan books. Germany narrowly avoiding recession is one likely positive for the year ahead, as is the effect of a dramatic fall in gas prices for both households and businesses. Although bad debts edged up slightly in the recent reporting season, they have stayed at reasonable levels and meant that many of the pandemic period’s capital gains have held.

The bond issue

A big fear with the ECB’s experiments with quantitative easing and zero (or even negative) interest rates was that it would drive yield-hungry investors toward riskier assets. While bank capital rules prevent European banks from using risky assets in their collateral, changes in the risk profile and yields of government bonds – which are admitted as valid forms of capital – could be of concern.

This is because, as happened in the case of SVB, rising interest rates have served to reduce the mark-to-market value of government bonds. Given the choice between holding low-yielding long-term bonds to maturity and cash or short-dated debt, capital allocators the world over have dived into the latter. As The Organisation for Economic Co-operation and Development (OECD) has previously noted, the full impact of rising government bond yields is also “a priori ambiguous, depending on the size, structure and maturity of total bank balance sheets and the extent of hedging in a specific macroeconomic scenario”.

The other negative for banks is the higher costs this means for issuing debt or attracting new deposits. The risk of this should be offset by higher interest rate income, but treasury management will become more complex as banks look for diverse forms of funding, such as preference shares.

Boring is better

US tech’s three-year boom to bust odyssey has been largely portrayed as an equity market story. However, this obscured how much money had been shovelled into the sector to stoke the boom in the first place. It is therefore unsurprising that the retreat of capital market funding for the sector has been a proxy cause of the downfall of three of the banks most closely tied to this cycle: SVB, Signature Bank and Silvergate. But it is important to remember that poor asset and financial management played a big role in destabilising these US institutions.

However, this should not obscure the fact that for the first time in 15 years, eurozone banks are net beneficiaries of monetary policy. The sector, with its focus on retail customer deposits and lending in the mortgage market, has started to outperform US rivals both in terms of share price gains and interest rate margins, as lenders across the Atlantic have seen an implosion in the deal-making and investment banking fees on which they are much more reliant.

Before the start of this year, investors could see that the big retail banks’ earnings and margins were set to climb. While the SVB saga has obscured the immediate outlook, the fundamental facts have not changed for Europe’s financial institutions, which is why the logic of buying a diversified product that follows the trend could be a decent long-term buy.

With few of its constituents trading on more than eight times forward earnings, BNKE represents a basket of reasonably priced and income-rich shares that could show resilience as the year progresses. After the flash crash, investors should expect to see a relief rally.