The saga of Silicon Valley Bank and Credit Suisse (US:CS), now rescued by a UBS buyout backed by the Swiss government, reignites all of the old debates over whether the banking sector is a truly viable proposition for investors given how volatility can hit a bank’s balance sheet. Liquidity issues overwhelmed SVB as depositors withdrew their money, while the scale of the reported outflows at Credit Suisse last week suggest it too was in a perilous state..
The last stage of contagion is when this panic focuses more closely on the contents of major banks' loan books - it remains to be seen whether this develops given that regulatory controls have given banks far greater levels of capital to absorb losses, unlike in 2008. It pays to understand what type of bank you are buying, but investors always must remember that the act of banking is to assume short-term risk in return for long-term profit.
Are banks really bonds?
One of the more interesting commentaries on the market was by Liberum analysts, via their view on how banks are affected by interest rates: “Banks are simple, nothing more than listed bonds with a variable coupon. As such, they favour positively sloped yield curves...at all maturities, the opposite of the recent environment,” the broker said.
A sloped yield curve across the maturity of all debt means banks can borrow at one interest rate and then lend more lucratively further down the line, based on the fact that steady economic growth gives people confidence to borrow and banks can make a profit on loan volume as well as margin. Of course, the situation over the past few years where rates were managed down has meant that banks have struggled to lend profitably at all.
It was widely assumed that rising net interest margins would prove a boon for large systemic banks, as their slowness to pass on rising rates to depositors would provide a boost to margins. The last reporting season showed that this was indeed the case for those systemic banks with a lock on the UK banking market such as Lloyds (LLOY), Natwest (NWG) and HSBC (HSBA). However, most UK institutions had started to warn about lower expectations for net interest margins this year. Of this group, Barclays' (BARC) hybrid investment and retail banking model means the net interest margin assumes a less central place in its profitability.
This is why the commentary on the non-US banks has turned more bearish in recent weeks, not because the crisis in US banking could and claim more than just Credit Suisse, but because the competition for deposits may soon cancel out the benefit of higher rates until the yield curve normalises again.
That also means many fund investors may rethink their positions.
JP Morgan analysts point to the high weighting of financial shares within many portfolios, “We are currently seeing an unwinding of crowded long positions which have built up since the pandemic," the bank's European credit strategy team said. "For most of the past two years it has been almost universal consensus to be overweight on financials, with the average fund increasing their allocation from 34 per cent at the start of 2021 to 40 per cent by our latest data point in the third quarter of 2022.”
In other words, everyone who piled in is now selling out in order to rebalance their fund weighting. A share price rebound this week pointed to buyers returning, however.
The difference between US and UK/EU banks
Fundamentally, the largest UK & European banks have prepared themselves to face both a solvency and liquidity crisis through holding higher levels of capital and imposing limits on their rate of balance sheet expansion.
In general, we have always made a distinction with bank shares: some assume riskier trading and corporate banking positions, others provide mortgages, all are taking different types of risk. Still, there are key differences to note between institutions in the US and Europe, as Liberum analysts point out:
- All institutions in Europe and UK are subject to Basel III banking rules, in the US this applies to far fewer institutions.
- The role of banks is different. In the US, banks only provide 30 per cent of total capital in lending to the economy, with capital markets providing the rest. In Europe the proportion is reversed.
- European banks tend to keep loans on the books, rather than securitise them.
- The European market is more consolidated with the largest institutions controlling 68 per cent of total assets. This means that European banks are less regionally based, or dependent on one industry.
In short, banking investors must worry less about the solvency of European and UK banks, and more about how profitable they really will be once depositors work out that higher savings deals are increasingly available, plus the fact that higher interest rates will start to discount the net present value of future cash flows. In the end, it always pays to know what you are buying.
