Investment Institute
Viewpoint CIO

How it ends

  • 24 March 2023 (5 min read)

This is not 2008. However, markets have had their confidence in banks rocked, and investors have had to digest significant losses in both equity and credit markets. There may be more problems ahead as investors withdraw from certain bank-related assets and concerns remain about deposits. There is also the risk of credit impairments, losses in other sectors such as real estate, and a wave of banks reporting loan-loss provisions. The interest rate market seems to know how this story ends – rate cuts. If they materialise, fixed income returns will outrun those on cash.

Failures

Banks fail because they do not hold enough capital to absorb losses, because they are not able to meet deposit outflows, or they face a general lack of customers, and investor and counter-party confidence prevents them continuing with business as usual. Valuing a bank from an equity or creditworthiness point of view relies on having transparency on all these things. However, as current events have highlighted, things move quickly. In a world of digital banking, deposit flight can be rapid – and this speed can outpace a bank’s ability to liquidate assets to meet the outflows. The question for investors now is whether a systemic interest rate shock becomes a credit shock? If this does happen, then bank valuations must consider potential additional realised or marked-to-market losses on credit and securities portfolios, increased costs of funding to try and retain deposits and provisioning against loan losses as the economy deteriorates in tandem with tighter credit conditions. Further underperformance of bank equity and credit assets could be the result.

Confidence

Policy plays a role in facing up to a banking crisis. Regulators and governments can provide insurance against deposit losses and/or a backstop to the valuation of assets and facilities which allow banks to use collateral on their balance sheets to meet liquidity needs. The problem is that insuring all deposits in a system would be more than the funded insurance facilities that exist today, e.g. the Federal Deposit Insurance Corporation (FDIC) in the US. Total deposits at US commercial banks were $17.5trn at the end of February according to the US Federal Reserve (Fed). Providing a backstop to asset valuations is also problematic when credit assets become impaired – which was the case in 2008. If bank assets are US Treasuries, or similar high-quality securities, and have a redeemable par value, then central banks can provide facilities to swap them for liquidity either on a temporary or permanent basis, i.e. take the assets onto their balance sheet. If there are system-wide credit impairments that threaten solvency, this tends to become a fiscal issue. The Troubled Asset Relief Program (TARP, 2008) was a mechanism that allowed the US Treasury to purchase illiquid assets from banks to prevent them from incurring further losses and to help stabilise markets and the banking system in 2008. But this was taxpayers’ money, and it did not make good on the losses banks had already incurred.

Liquidity not fiscal support this time

This is not a 2008 situation. But no crisis is ever the same. Large US banks have been highly regulated since the global financial crisis and have doubled their core equity capital since then. They are subject to annual stress tests which assess bank capital requirements against adverse economic scenarios like a recession, rising unemployment and a decline in residential property prices. The issue now is that smaller banks are not subject to the same tests and were not subject to scenarios of rising interest rates. Interestingly, the last FDIC Quarterly Banking Review did identify the problem of unrealised losses in both available-for-sale and held-to-maturity portfolios ($620bn in the final quarter of 2022). There is of course the potential for these losses to further impact on the capital base of regional banks, a problem that a deposit flight could worsen.

The Fed can act

I doubt there is any political will in the US to call on the fiscal authorities to step in to support banks. So, the focus will be on the Fed and the FDIC, as well as other institutions which are providing liquidity at the moment. Before it becomes a fiscal issue, the Fed is likely to do all it can, including cutting interest rates and stopping its quantitative tightening programme. This has already partially reversed, given the recourse to the Fed’s balance sheet already used by banks facing liquidity problems in March 2023.

Deteriorating bank fundamentals

Things might not get that bad and the recent decline in bond market yields will have helped reduce marked-to-market losses in bank bond portfolios. But deposit growth is negative, and this will continue as credit tightens, creating the risk that more regional banks run into problems. In turn, this will impact on local economies and small- and medium-sized businesses, thus US recession risks are higher. There is negative feedback as recessions always see an increase in credit impairments which are themselves negative for the banks. Interest rates in money market funds and on Treasury bills remain high, reflecting the Fed’s policy stance on rates, and this is another source of tension in terms of deposits. One issue is the dependency of commercial real estate funding on regional banks in the US. Note that the real estate sector has also underperformed in both equity and credit, in both the US and Europe, in recent weeks.

Swiss shock

The shock to confidence in the European banking system came from Swiss regulators rather than for any fundamental reason. It was not a surprise that Credit Suisse would eventually merge with, or be sold to, another bank – or even be wound-up. However, the treatment of certain bondholders sent shockwaves through the European credit markets. In the agreement to sell the bank to UBS, the regulators decided that Additional Tier 1 (AT1) bonds in the Credit Suisse capital structure would absorb losses ahead of equities. This potentially turned the credit hierarchy on its head and regulators in the European Union moved quickly to reassure investors in these assets in other banks that they remain senior to equity in any resolution framework. However, the asset class has re-priced and investors’ losses from the Credit Suisse write-down will be substantial. In the short-term there is unlikely to be much demand for any new AT1 securities issued while the re-pricing has made it an awfully expensive capital instrument for potential issuers. The good news is, if one believes the regulator and if one is comfortable with European bank capital ratios, investors can earn high yields for perpetuity on the bonds of selected high-quality European banks.

Europe

There might be little contagion directly from Credit Suisse, and UBS will be a much stronger and larger institution, which strengthens as a domestic deposit taking institution in Switzerland and in global wealth management - it should be a less risky business than investment banking. In the European banking system, there is exposure to rising interest rates which could have generated unrealised losses on debt portfolios. The interest rate exposure of banks might be hedged but the entire system cannot be immune to rising rates (someone is always on the other side of the fixed rate swap). Capital ratios are high but impingement on capital could emerge in the coming quarters. On balance, however, European banks look in better shape than US regional banks. Notably the performance of the Euro Stoxx 600 bank sector is positive so far this year.

Last rate hikes?

The fact the European Central Bank (ECB), the US Fed and the Bank of England (BoE) all went ahead with another round of rate hikes this month could be taken as a sign that central bankers are relaxed about there being a systemic weakness in banking markets. However, the market does not believe this can continue; current pricing for policy rates has the Fed reversing this week’s 25 basis points (bp) hike by the middle of the year. There is a less than 100% chance of another 25bp hike from the ECB and BoE priced in. An interesting observation from current market pricing is the yield on a two-year Treasury note is now 137bp below the Fed Funds policy rate. Since 1990 this spread has been greater than 100bp on four occasions, each of which has marked the beginning of a Fed easing cycle.

Bonds look good, you can get quality exposure

Fixed income markets love a rate peak. Returns from bonds tend to be positive at the peak of rate cycles and beyond. Readers might be concerned about credit in the wake of the bad bank news. Yet, history suggests well-diversified portfolios will deliver positive returns based on current entry levels (from either a yield or spread basis). Investors can get exposure to high-quality credit in the bond market, from companies with strong balance sheets, limited need for bank funding and comfortable interest coverage.

Anecdotal evidence suggests investors are doing the opposite now, taking money out of bond funds and putting cash into the money markets or Treasury bills. I would suggest this is panic behaviour. Investors might miss a strong rally in credit if there is either news or policy action that turns sentiment around. And this can happen quickly.

But there are risks

However, being defensive is understandable given the concerns about other financial institutions. Things might get worse in the short-term. It is difficult to see equity markets performing well in such an environment. We have long had concerns that earnings still have downside in the US market given issues in technology, energy and now in the banking sector. Yet as bond yields go down, equity valuations start to improve. The current gap between the earnings yield and the US 10-year Treasury yield is 2.2%. On 2024's earnings-per-share consensus estimates, and on the 10-year yield, one-year forward, the gap increases to 2.82% and for 2025 earnings against the 10-year, two-year forward it rises to 3.37%. Lower bond yields and lower equity prices during this period of market concerns about financial stability improve the prospect for stock returns going forward. Beyond the current crisis of confidence, markets should perform better, and risk will be rewarded, especially because this is not a systemic shock like 2008 was, and like COVID-19 threatened to become.

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