Banks under stress: the case for selective investing
Events in recent weeks have exposed weaknesses in some banks. Others, though, are well positioned to benefit from higher rates – and are attractively priced.
A banking shock that started in California has reminded the world that banks are businesses that critically depend on the confidence of depositors and investors. But it has also enabled investors to distinguish between the types of risk different banks are facing.
Banking shockwaves started in the US…
Silicon Valley Bank unravelled in a matter of days due to a combination of weak capital, weak liquidity and depositor concentration. Many of its clients operated in the same industries and region, and were prone to discuss their actions and make near-simultaneous withdrawals.
The ramifications of that collapse have yet to fully play out, but the financial world swiftly searched for other vulnerable institutions. Silvergate (a cryptocurrency-focussed bank) collapsed with little sympathy from US regulators, and Signature bank – another tech-focussed bank with similar issues to Silicon Valley Bank – has been taken over by receivers. Regional US bank failure risk remains, with all eyes on First Republic.
…and appeared to spread to Europe
Investor anxiety intensified around Swiss banking group Credit Suisse, and on 19 March UBS announced that it had agreed to acquire it. This brought to an end several difficult years for the Swiss business, which included risk management failures involving Archegos Capital Management and Greensill Capital. Those incidents led to outflows from its highly regarded wealth management business as high net worth individuals withdrew assets en masse.
In the days that followed the UBS/Credit Suisse announcement, investors became concerned about other European banks, and share prices fell across the sector.
But no two banks are the same
While the timing of the drama on both sides of the Atlantic will not be seen as coincidental, there is a difference between the fear of systemic failure around the US regional banking market and the isolated failings of Credit Suisse. The latter is not a canary in the coalmine for UK and European banks as whole.
Credit Suisse’s downfall was primarily its own doing, with failures in parts of its operations undermining the credibility of other divisions. When Credit Suisse published its 2022 annual results in early February it became clear that the contagion of the investment bank had spread.
Silicon Valley Bank would not have been allowed to operate in the tighter regulatory environment of the UK or Europe, given its large interest rate mis-matches and lack of liquidity cover. And US regional banks are very different to large US banks.
The wider bank universe: value and risk
We see opportunities among banks. As my Equity Value colleague Kevin Murphy says: “Banks rely on confidence, which is why they are heavily regulated. That regulatory oversight allows customers to trust the banks with their deposits. The reliance on confidence is also why the central bank operates as a lender of last resort – just in case customers’ support falters.
“As we know, confidence can be tested, and as a team we spend significant time pouring over banks’ balance sheets to understand the stress points of each.
“That work highlights increasing buffers against stresses, increasing liquidity and an attractive earnings dynamic. While we have less invested in the sector than 18 months ago, that is due to a broadening opportunity set within the market, not a diminution of opportunity within the banks themselves.
“We believe current valuations more than compensate for the risks inherent within the stocks.”
The banks we favour remain on low valuations yet generate significant profits. Across the team we have exposure to the likes of Standard Chartered, Natwest, ABN Amro, UniCredit, Citigroup, Intesa Sanpaolo and BNP Paribas.
The zero-rate environment forced many of these businesses to restructure. And after a decade of cost-cutting they are much leaner today than they were in the wake of the crisis. Now that interest rates have risen, they are beneficiaries of operational and financial gearing where increased revenues run through directly to profitability.
The market remains concerned that a deterioration in economic conditions will lead to loan losses eating away at these profits. While the concern is valid, the banks we own have high levels of Tier One capital. Their balance sheets should be able to absorb these losses. Many also have significant provisions previously set aside from the Covid-19 pandemic. These went unused and can be tapped into.
Some banks are also returning cash back to shareholders, either through share buyback programmes, dividends, or both. We are supportive of this, so long as balance sheets remain robust.
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