In the wake of the failures at Silicon Valley Bank, Signature Bank and Credit Suisse, the situation in the global banking industry remains uncertain at best.
UBS Takes Its Medicine, Swallowing Credit Suisse in a Forced Merger
Over the weekend, the Swiss National Bank (SNB) and the nation’s banking regulators engineered a buyout of Credit Suisse (CS) by rival bank UBS just a few days after CS was provided a liquidity lifeline by the SNB. Credit Suisse’s position among Swiss and European banks weakened significantly over recent years, experiencing massive depositor outflows (160 billion Swiss Francs in 2022) for many quarters in reaction to strategic missteps and multiple management changes.
The weakness and forced takeover of Credit Suisse triggered reverberations throughout the European banking industry, as it did in the U.S. following the closure of Silicon Valley Bank (SVB) and Signature Bank. The Euro Stoxx 600 Banking Index lost close to 150 billion euro in market cap in recent weeks. While that selloff has been painful, it’s also important to note that the Euro Stoxx 600 Banking Index was up more than 60% from October-February, so last week’s slide may have been exacerbated by an element of profit-taking around the recent volatility.
Broadly, we believe that the systemically important European banks have strong liquidity metrics, robust duration management, and better depositor profiles than their U.S. counterparts (~63% of deposits across Europe are insured). Given this setup, we believe the risks of contagion, through European banks, related to the recent SVB or Credit Suisse events have been de-risked by the massive financial backstops provided by various regulatory agencies in the U.S., Switzerland, and the EU. As of the time of this writing, bank stock prices have largely behaved orderly with the SX7E (Euro Stoxx bank index) rallying after the losses of the last several trading sessions. Though full resolution of the U.S. banking situation has yet to occur, we see today’s trading as providing some comfort with respect to bank stock prices.
All Eyes on the Fed and This Week’s FOMC Meeting
The Fed is acutely aware, at least now, that the tightening cycle is beginning to create negative side effects: for SVB, specifically in the form of realized losses from their U.S. Treasury and Agency MBS book in order to meet depositor redemptions. The joint Fed/Treasury/FDIC announcement of the Bank Term Funding Program (BTFP), which allows banks to take advances from the Fed for up to one year by pledging government debt as collateral, was meant to address this very problem. This was a welcome development for markets, but it remains to be seen if this stems the risk of herd behavior in the form of businesses moving their deposits to larger institutions, thereby putting regional bank balance sheets at risk. Unfortunately, early data points to depositors moving savings to larger institutions, which may leave smaller regional banks exposed.
Meanwhile, the market has significantly repriced Fed and global central bank monetary policy expectations in the wake of the banking stresses. We expect the Fed to deliver a 25-basis point hike on Wednesday. This action will allow the Fed to demonstrate a continued vigilance in bringing down inflation from still unsustainably higher levels, while acknowledging new growth risks. Our view is the Fed sees the Fed Funds rate as just one tool in the broader toolbox; that is, they can manage the Fed Funds rate to tackle inflation while separately using their balance sheet to manage very specific risks (i.e., the BTFP program to shore up bank liquidity). Nonetheless, the Fed is still fighting itself to some extent. Introducing the BTFP is by definition an expansion of their balance sheet, even as they continue to quantitatively tighten through the reduction of Treasuries and Agency mortgages from their balance sheet.
More broadly, there will likely be a greater focus on the quality of balance sheet management, regardless of the entity and how often their balance sheet is “priced.” But market conditions are volatile, and we will continue to monitor and pivot in real-time as needed.
There are new questions the market must grapple with, and not enough answers yet. Specifically, how will the regulatory environment for regional banks evolve? Will banks be subject to increasing capital ratio requirements? Even outside of regulatory questions, uncertainty over profitability has risen as (1) depositors transition to larger institutions, (2) competition increases for the depositor dollar from CDs and short-term government bonds, and (3) potentially increased M&A activity as regional banks assess their position in the marketplace. Increased regional bank scrutiny from regulators may be positive for bondholders, but details, to the extent they are implemented, are yet to be determined.
Regardless, investors will reward entities with stronger asset-liability management, a more diverse depositor base, and less concentrated business model in terms of who they serve. This is the key difference between now and 2008. The global financial crisis threatened the solvency of banks as they had a very troubled asset (housing) on their (then) weak balance sheets. Today, large bank balance sheets are robust, risk has been transferred to non-bank entities with longer liabilities, and central banks are readily available to step up and provide liquidity. Today’s banking stress is a function of a duration mismatch – a balance sheet consisting of short-term depositors (liabilities) and longer-term investments (assets).
How Does This Impact Positioning?
Our focus has and continues to be in high quality financials. Large banks generally remain well capitalized and buffered from solvency issues and look to gain from a potential shift in business from regionals. Nearly all of our bank exposure is in large, multinational banks from developed countries. This is fundamentally favorable in a number of ways. First, the business and geographical diversity of these issuers are much more widespread than in regional banks. Additionally, the deposit franchises are larger and broader, and liquidity bases are more diversified. Further, the issuers’ capital bases are larger and better structured, from common equity to senior unsecured debt on a holding company level. Finally, these issuers tend to have more sophisticated asset-liability management capabilities to manage market volatility. Within corporate credit broadly, spread widening will create more opportunities within portfolios, though this is somewhat muted by the fall in rates, which have kept dollar prices more stabilized.
Across corporate issuers more broadly, we continue to focus on non-cyclicality, specifically within utilities, food and beverage, and healthcare, among others. Spreads have widened but the market has been generally orderly, and we have not seen forced selling. That said, wider spreads are more than offset by falling yields on the front end. Fundamentally, the events of this week are, on the margin, negative for corporate credit, as a more cautious tone of lending will flow through to growth. We will remain nimble in both the IG and HY primary markets when they re-open given what we expect to be choppy supply/demand fundamentals.