Digest special edition: Banking Sector Update

• Silicon Valley Bank’s (SVB) demise, and the accelerated sale of Credit Suisse (CS), has led to volatility in banking stocks and markets as a whole. Although direct exposure to SVB and CS is small, there are concerns around how this volatility will impact economic growth.

• Bonds brought a degree of protection to investors over recent weeks, but UK and European equities have seen falls. Technology stocks have fared better. Portfolio diversification has again helped to avoid significant drawdowns over the period.

• Outlook for growth has weakened, but inflation may now be easier to contain. The European Central Bank persisted with a rate hike, but we may now see fewer from central banks, as they seek a balance between controlling inflation and maintaining financial stability.

Recap of what's happened with the Banking sector

Increased volatility and concern relating to the global banking industry was initiated when a handful of mid-sized US banks (including SVB) collapsed on the w/c 6 March. The causes of SVB’s bankruptcy were fairly idiosyncratic, and mostly resulted from the bank’s heavily concentrated client base and mismanagement of its bond portfolio (which led to heavy losses when assets needed to be liquidated to meet customer outflows). Further details are provided in the following article.

The following week, concerns spread to Europe, where the share price of CS, the large Swiss bank, came under intense selling pressure. CS had seen a sustained fall in its share price over the previous few years, because of several scandals and concerns relating to its governance and long-term profitability. On 15 March 2023, CS’s largest shareholder, the Saudi National Bank, stated that they would not provide additional equity to the bank, if requested. The timing of this quote was unfortunate given SVB’s collapse, putting investors on high alert for any further insolvencies in the banking industry. The Swiss central bank agreed to lend up to 50bn Swiss francs in additional liquidity to CS, but ultimately this could not stem the outflow of customer deposits. On 19 March, UBS, another large Swiss bank, agreed to buy CS for 3bn Swiss francs. The deal was brokered by the Swiss central bank and regulators, who have provided guarantees to UBS on certain losses. CS equity holders have sustained heavy losses and a junior bond tranche has been completely wiped out. Senior bond tranches appear to have been transferred to UBS’ balance sheet and should therefore witness a meaningful recovery in value. While SVB and CS have been the high-profile stocks, fears of contagion into a 2008 style financial crisis led to considerable market
volatility, most notably within the Financial services sector.

Asset class exposures and performance

Although larger than SVB, CS’ direct exposure in markets was still rather limited – at December 2022, CS represented 0.02% in the MSCI global equity index and 0.52% in the ICE global corporate bond index. Market exposure to the wider Financial sector varies by region and asset class. In terms of equities, the UK and Europe markets have a higher exposure to Financials, with 23% and 18% respectively, whereas the US is less exposed, with only 11%. Corporate bond markets tend to have a higher allocation to Financials because of the amount of debt that banks issue, and can be more prevalent in certain
shorted dated indices.

Performance in March is shown in the chart below. As shown, equities in general have been hit by the “risk-off” sentiment. The equity regions have performed in line with how we would expect, based on banking exposure, i.e. (on a relative basis) the UK has underperformed, while the US held up better. The US has also benefitted from strong performance in Technology companies, after these events lowered investors’ expectations on the path of interest rates in the US – lower interest rates tend to boost technology stocks.

Compared to equities, bonds have performed well. This is probably a combination of a flight to safety from investors into government bonds, but also reflects the shift lower in interest rate expectations, lowering yields and therefore boosting bond prices. Although corporate
bond markets have a large exposure to banks, the fall in yields has outweighed any increase in spreads (spreads being the additional return an investor receives from buying corporate rather than government debt) meaning performance is still positive.
 

Impact on growth, inflation and interest rates

Despite the concerns with CS, the European Central Bank (ECB) went ahead with a 0.5% rate hike on 16 March. Having previously given so much forward guidance that there would be a rate hike in March, the
feeling from the ECB was probably that, to not go ahead with the hike would have led to greater panic from investors.

The Federal Reserve and Bank of England both meet this week, but there is greater uncertainty as to how much further they will need to hike now. If the problems in the banking industry persist, and it leads to less bank lending and a tightening of financial conditions more broadly, this will have a similar effect as central bank rate hikes, reducing the need for them. If the issues escalate further and lead to a full banking crisis, then severe cuts to rates will be necessary. Although the inflation problem hasn’t gone away, a lower growth outlook may make inflation recede faster than initially expected.

Where do we go from here?

Markets have settled following the CS buyout. European banks rose 1.2% on the following Monday, 20 March. The exception is First Republic Bank, another mid-sized US bank, which fell another 47% on the Monday. In the previous week, a group of large US banks all clubbed together to provide $30bn of support to try and shore up its balance sheet. The regulatory regime in the US is weaker than in Europe, especially with mid-sized US banks, meaning there could still be failures to come in the US.

This episode is a good reminder that, ultimately, banking is a confidence game. CS had a liquidity issue driven by a crisis in
confidence, but had an otherwise sound balance sheet within the confines of a strong regulatory environment. The worst-case scenario of a globally systemically important bank falling over “á la Lehman”, has been averted. Regulators have shown that they are unwilling to let this happen, but there is still a cost to equity and bond holders. Concentrated exposure to one sector can be bad for investors, which is why it is important to look at diversification at a sector level and not just at regions. The resilience of bonds more generally has also shown the diversification value that they continue to provide when crises
occur.