"A man I do not trust could not get money from me on all the bonds in Christendom”
– JP Morgan
The banking system is facing a crisis of confidence. The business models of banks depend on the faith of depositors and work on the premise that a large number of depositors won’t want to be repaid at the same time. Recent events in the US with the collapse of Silicon Valley Bank and more recently the takeover of Credit Suisse have been a stark reminder of the consequences when confidence is lost.
Over the weekend of March 18 – 19, UBS agreed to buy Credit Suisse for CHF 3 billion in a government-brokered deal. The Swiss National Bank is providing UBS with a CHF 100 billion liquidity line to support the takeover. Credit Suisse shareholders (who did not have the option to vote on the deal) will receive CHF 0.76 for each share, well below the previous week’s closing price of CHF 1.86. Controversially, investors in certain Credit Suisse debt securities will see their holdings written down to zero.
The speed and manner in which the deal was completed were intended to calm the nerves of investors and, more importantly, depositors following a week of disruption in both the US and Europe. The move seems to have initially been well-received by markets, with both equities and bonds recovering after an initial sell-off on Monday morning. However, uncertainty is likely to remain.
What are the risks?
We continue to believe that systemic risks to the banking system are relatively low. As a result of the 2008 Great Financial Crisis, major global banks operate within a tight regulatory framework that requires them to have high levels of capital and liquidity to deal with periods of stress. Furthermore, as we have seen over the past couple of weeks, central banks have the ability to implement emergency liquidity measures to help support the banking system.
The issues facing Credit Suisse were not representative of broader European financials. While Credit Suisse has been unprofitable for the past couple of years and faced significant asset outflows, the outlook for broader European financials is more positive. Analysts have recently upgraded the outlook for 2024 earnings of pan-European banks by more than 20%.
Despite this, it is important to recognise that risks remain. Smaller banks such as Silicon Valley do not operate in the same regulatory framework as large banks and their balance sheets are generally not as well capitalised. The current economic and monetary policy backdrop also represents a difficult operating environment.
Another risk for the banking system as a whole is the speed and scale at which deposits can be withdrawn in today’s digital economy. The day before Silicon Valley Bank closed on 8th March, customers withdrew $42 billion from their accounts at a rate of $4.2 billion an hour. The previous largest bank run in modern US history took place at Washington Mutual Bank in 2008 and totalled $16.7 billion over the course of 10 days. A “run on the bank” has the potential to be more severe than it has been in the past, and highlights the importance of maintaining confidence in the banking system as a whole.
Does this change our outlook?
Small regional banks play an important role in the US economy. Banks with less than $250 billion of assets currently provide around 50% of all corporate loans and 80% of real estate loans. Recent disruption could result in tighter lending standards and slower credit growth, feeding through to slower economic growth and increasing the probability of a US recession.
We have been concerned about the impact of higher interest rates and the reduced availability of credit for some time. We continue to expect the US to fall into a recession, albeit a relatively shallow one, later in the year.
Investors had been expecting further US interest rate increases as a result of the continued strength of US economic data. However, if it is felt that uncertainty surrounding the banking sector constitutes a threat to financial stability, and could result in weaker economic growth, the Fed may look to revise the current policy course.
Markets have been quick to price this scenario in. At the end of February, US interest rates were expected to end 2023 at above 5%. Today, expectations have significantly shifted with the market expecting US interest rates to end the year at 3.6%, implying up to four rate cuts later in the year.
In our view, it is likely that recent events will have implications for central bank policy and we could see the current rate-hiking cycle come to an end earlier than expected. However, we are conscious that inflationary pressures persist and while we could see a pause, we expect interest rates to remain higher for longer.
What was our exposure?
Within our core wealth management models, none of our active equity funds held exposure to Credit Suisse or UBS, whilst there was a combined 0.15% through the global equity ETF. Similarly, we did not hold any exposure to Silicon Valley Bank in our active funds, with only a small 0.05% exposure through an S&P500 ETF.
Over the past year, we have maintained a focus on investing in quality companies with strong balance sheets and the ability to navigate what we thought would continue to be a challenging environment for equity investors. This approach has helped us navigate recent challenges and we continue to believe this will prove to be the case as we move into the second quarter.
We did have limited exposure to Credit Suisse and UBS bonds through a number of our fixed income funds. However, the position sizes within the funds were small so on aggregate, our exposure was less than 0.25%.