There cannot have been a more nerve-wracking time since 2008 to have been a bank investor than during the ongoing fallout from the collapse of Silicon Valley Bank (SVB) and questions over other second-tier institutions in the US.
The crux of the problem is that rising interest rates have introduced a whole new set of risks to bank balance sheets. Banks must hold a large pool of liquid assets to meet redemptions and when interest rates were practically zero, banks picked up long-dated government bonds, often trading at historically elevated levels, to bulk up their capital positions. The rise in rates has started the process of discounting even highly liquid government bonds such as US Treasuries, which means that redemptions must be met with a larger pool of depreciated assets. Effectively managing this effect is where SVB went wrong.
It is clearly a significant banking skill to efficiently match assets with liabilities over the long term. Nonetheless, it still feels as though the banking sector, along with the notion of how to approach investing in banks, is at an inflection point as we move from a low interest rate environment to one that is higher, but which feels more normal. Effectively, we are experiencing a real-world stress test of banking business models and the fundamentals of good banking practice.
One problem with the SVB collapse is that the bank, at least on paper, had similar capital and leverage ratios (15 per cent of risk-weighted assets ratio plus 12 per cent leverage) to much larger institutions that many investors would assume are safe. So there can never be a more important time to understand how banks actually work and how they expect to generate their future promise. The past few months had seen a mini bull market in bank shares (now brought to an abrupt halt) as investors assumed that higher interest rate margins would naturally benefit the big systemic players who would hold off from boosting the returns to depositors. However, it is still worth looking at the chicken guts of the system to see what augurs well for investors.
The banking confidence trick and a flighty reality
The first point to make is that banks fail; it is an almost inevitable consequence of a basic confidence trick that banks take in short-term deposits from savers and lend these at long redemption dates to willing borrowers, on the basic premise that depositors will not all demand their money back at the same time in a way that stresses a bank’s asset base. In 2008, the most obvious bank run was at Northern Rock, which saw people express their sense of panic by patiently queueing outside branches in prominent town centre locations, within easy reach of television crews – it was orderly, it was an expression of decent British values, and it gave enough time for regulators and the government to vacillate for days and then still find a solution.
The modern equivalent, which is more dangerous for smaller institutions, is the mass flight of deposits as savers log on to their banking apps and click “withdraw”. The fact that social media now plays a pivotal role in such mass events makes the situation even more unpredictable. In SVB’s case, the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) at least acted with commendable speed to head off a disorderly collapse, which was entirely absent from the 2008 crisis, which seemed to drag on for months before the final curtain came down. The reality is that all banks can fail; in fact, SVB is the latest of 500 US banks to fail since 2001, and banking itself is the assumption of short-term risks in return for predictable long-term profits.
Too big to fail?
But the question of moral hazard argument has not gone away. If capitalism cannot punish mistakes, the capital is stuck in underperforming assets. The making whole of depositors would seem to create a situation where regulators must stifle capitalism to save and violate Walther Bagehot’s well-known dictum: “Any to a present bad bank is the surest mode of preventing the establishment of a future good bank.” That begs the obvious question about what regulators would have done in 2008, let alone clearing up the aftermath of SVB.
The immediate impact is clear in that, according to FactSet, global price/earnings ratios for banks fell to just seven, even though banks enjoyed their most profitable year in 14 years in 2022 as interest rates started to rise towards historic norms.
All this, while troubling, does not really get to the heart of the matter when it comes to banks as a reliable source of investment returns. In reaching for the panic button, is the market actually asking the right questions about banks as investments? A crisis that started with liquidity has moved on to solvency – the capture of Credit Suisse through a state-backed takeover by UBS for a fraction of its $50bn of shareholder equity suggests that little value was left in the business after capital flight and the wipeout of its junior bondholders. At least shareholders, including Saudi National Bank, can console themselves with UBS shares.
So, is the crisis over? Some pundits aren’t convinced. Man Group’s chief executive, Luke Ellis, told a Bloomberg conference in London that more banks are likely to go bust over the next two years, with the US’s secondary banking system, and even possibly some challenger banks in the UK, at particular risk.
The market has yet to look at loan books to judge whether a combination of higher rates and economic problems could lead to higher levels of impairments. But the point to make here is that a solvency crisis is precisely what the banks have prepared for since 2008. Higher capital buffers and smaller balance sheets have created a firewall, at least for those banks that adhere to the stricter rules demanded by the Basel III banking regulations. Unfortunately, these regulations do not apply to most banks in the secondary market in the US.
The main lesson to draw from the most recent crisis is that if the institution is big enough, or systemically important to one industry, the regulators have got your back. That is why, paradoxically, there might not be a safer time to deposit or invest in the very largest institutions. Indeed, recent Federal Reserve data showed exactly this effect after the securing of deposits in SVB and Credit Suisse. In other words, depositors seem to have accepted large banks as a fact of life, a little like a public utility. That is especially true now that it seems deposits will be honoured in full, no matter what the circumstances of a bank’s demise. It should be noted that Federal Reserve chief Janet Yelland recently ruled out a universal deposit guarantee, but this is arguably what the Fed and the FDIC have effectively provided with their recent actions.
Are banks still investable?
The question is whether a cautious mindset is fair considering the strides that banks have made to clean up their balance sheets since 2008 – in an important lesson drawn from the Tokyo housing market crash. Banks either offloaded impaired assets into government-backed ‘bad banks’ or were heavily recapitalised to be able to withstand the losses caused by ill-advised lending.
Working out the investment case isn’t helped by the fact that prominent investors are generally split over the merits of owning bank shares (see box out). Yet Warren Buffett has had several large holdings over the years in Wells Fargo and Citigroup and even cleaned up with preferred Goldman Sachs shares in the immediate aftermath of the financial crisis.
It pays to work out what sort of banks fit the criteria for being systemically important, while retaining an appeal as a workable investment. This tends to be through having a market presence that can translate into higher profits. In the context of the UK market, there is a high concentration of clearing and lending shared between the big five High Street banks. It is a similar picture with Europe’s largest institutions: according to Citigroup data, approximately 68 per cent of assets are held by a handful of the largest institutions, which also supply the services that many companies need.
For example, roughly half of Banco UniCredit’s (IT:UCG) customers are corporates who also use its broking, syndication services, or just basic payroll to run their operations to finance the wheels of trade. It is a similar story for the likes of BNP Paribas (FR:BNP) in France, or Deutsche Bank (DE:DBK) in Germany. A Mittelstand firm in the middle of Bavaria, or a family-run business in Milan have limited options if they want to take their business elsewhere, and this promotes the stability of core deposits that recognises the other services that a major bank offers are key to doing business. And these aren’t the kind of unicorn businesses, or one-off rich individuals whose large withdrawals caused the runs on SVB and Credit Suisse, respectively. That is reflected in total deposits that have been flatlining in the US since April last year, but continued to rise in both the UK and eurozone. That could be a sign of the more advanced state of the business cycle in the US, or simply reflect the greater confidence that depositors have with leaving cash in the bank in Europe.
US banks, generally, tend to be focused heavily on investment banking fees, which have completely dried up since the tech boom imploded spectacularly over the past 12 months. Investors can see that if conditions stabilise the big retail banks will be earning money on the back of a sloping interest rate yield curve, once the anomaly of cheapening long-dated bonds has been worked out of the system, or is allowed to work out over time rather than being a cause for immediate panic. The unknown variable is how deposit churn, with customers shopping around for higher rates, will affect margins. Investors shouldn’t expect to have any insight before the third quarter of this year at the earliest. If the impact is limited and the stickiness that characterises so many people’s deposit accounts lingers for a while longer yet, then there is scope for banks to hit the more optimistic range of return on net tangible assets of 14-16 per cent for the year ahead.
Europe’s banks had started to outperform their US rivals in terms of share price performance and interest rate margins prior to the SVB blow-up, in a way that highlighted their underlying strengths. While investment banking arms are the engines of the big US banks, Europe’s banks have benefited from having a broader range of retail and commercial customers and also fulfil their primary function of supplying credit to the economy – something done mainly by the capital markets in the US.
Why consider bank shares?
The events in California underlined the deep well of suspicion that has lingered long after the events of 2008, which have been exacerbated by interest rate policies that meant banks had to make money on the back of unfeasibly small margins. To put that into an investment context, the price/earnings ratio for RBS (as it then was) reached a peak of 16 in October 2007 in the aftermath of its ultimately disastrous takeover of Dutch basket case ABN Amro. Slimmed-down successor NatWest’s (NWG) shares, despite a strong start to the year, can be had for a PE of under 7.5. For the first time in nearly 15 years, interest rate rises in both the UK and eurozone have started to highlight the sector’s strengths, as well as uncover some unexpected weaknesses in their funding models.
Funding is where the Europeans and the UK have the edge; whereas US banks have to buy government bonds in lieu of depositing assets with the Fed, in the eurozone and UK banks are able to access ultra-cheap facilities that meant greater access to cash. This means that the likes of NatWest and Lloyds Banking Group (LLOY), plus eurozone stalwarts such as UniCredit, have far greater resources to cover up to 30 days of depositor withdrawals – by some measures this coverage totals 160 per cent of withdrawable liabilities. Admittedly, these facilities must be paid back, but they have ensured a level of stability at a critical time.
UK titans
Both NatWest and Lloyds have their respective strengths – both are highly enmeshed in the UK housing market and commercial economy. Both have suffered and rebuilt themselves from the rubble of 2008 and the shares are some of the most liquid available on the London Stock Exchange. From a banking point of view, their insularity has prevented contagion from crossing the Atlantic, unlike the sprawling risk-stuffed balance sheet that the Royal Bank of Scotland had built up in the early 2000s – does anyone remember Greenwich Capital with any affection?
Of the two, NatWest is most geared towards interest rate rises, with its well-publicised refusal to raise rates as quickly as the Bank of England has been increasing the base rate. Whether it can maintain that position considering political pressure (plus the government’s still huge stake in the bank) remains to be seen, but it has made the greatest progress in terms of slashing its fixed cost base – all those branch closures in small towns – and digitising its operations. Lloyds is still very much a laggard in this respect, reflected in a lower forward PE ratio of 6.3, and it still sees value in being the last branch in the area. Its dominant position in the UK mortgage market via its £400bn loan book must be respected. However, shareholders have not totally given up on NatWest’s gearing to interest rates this year, which is why we slightly favour the remodelled lender.
Europe’s undervalued banks?
One benefit of the rout in European bank shares is that the crowded overweight positions for many managers, who were highly enthusiastic about financials over the past two years, have been cleared out in the aftermath of the Credit Suisse takeover. The next question then is whether there has been enough selling pressure on the sector given that older long positions have now been well and truly liquidated. The other point to note, as Liberum analysts have emphasised, is that the European banks have largely deleveraged to the point where it is now the shadow banking system where significant unknown risks currently lie. These include the usual suspects of hedge funds, private equity houses and mortgage intermediaries, which also weigh on valuations for the sector, which are currently 6.48, according to the MSCI Europe Banks index, with a current price-to-book value of just 0.6.
Banking ETFs
If the admin of holding foreign bank shares is too much of a burden, then using a London-based ETF to track the EuroStoxx banking index might be one way of playing a rebound in share values without taking on too much risk concentration, which is why we highlighted Lyxor Eurostoxx Banks Ucits ETF (BNKE) as a standalone idea for the brave in the teeth of the crisis last month. The index has pulled back some of its losses and the weighting towards larger financial institutions matches our thesis that bigger, in this context, is better. Europe’s banks have also been far more generous in terms of shareholder returns, for example Banco Santander ((ES: SAN), but also available on the London market as BNC) raised its payout ratio from 40 per cent to 50 cents at the last results, with a return on net tangible assets expected of15-17 per cent, which is important for this particular ETF. It is a technical quirk of the instrument that Spanish banks make up 30 per cent of the holdings, as the fund seeks to mirror their relative weight within their home index. Hence the comparatively small 4 per cent for Deutsche Bank: there are simply many other larger companies on the Dax. Spanish banks underwent a major overhaul in the aftermath of 2008, with the local Cajas responsible for the property market bubble.
Italian bank UniCredit is another standalone favourite because of its commercial profile and importance to the Italian economy. Despite falling foul of investors during the 2010s eurozone crisis in particular, it is another European bank where returns of shareholder capital have been exceptionally generous, with over €5.25bn of dividends and buybacks to be distributed this year. The rout in bank shares also means that shareholders will be getting their capital back at bargain rates, while potential share buyers are being quoted a forward PE ratio of just 5.8.
The other banking share where the price is starting to look slightly more attractive is HSBC (HSBA). The bank has suffered in step with the rest of the sector and the shares have given up almost all of their price gains this year. It is worth noting that HSBC managed to dodge the credit crunch in 2008 because of its strong depositor base in Europe and Hong Kong. So far, no one has raised any questions over its banking model, other than the usual grumbles over its internal power struggles and exposure to Chinese property development. With the forward price to PE ratio now back at 8, and the dividend yield of over 5 per cent, it wouldn’t come as a surprise if investors start to switch to long positions.
