European bank stocks are also attractive, but we would be selective in which banks to invest.
Brandywine Global, part of the Franklin Templeton, notes this was a banking crisis that Europe hoped to avoid even as panic spread from the US.
“Still, we believe the global banking sector remains much safer,” says Sorin Roibu, Portfolio Manager and Research Analyst at Brandywine Global.
Roibu says: “The recent banking industry events in the US and Europe have brought back memories of the 2008 global financial crisis (GFC). In the span of just over one week, two banks failed in the US while another remains on life support, and one bank failed in Europe. For the week ending March 10, the top six US large money center banks lost approximately 14% in market value; US super-regionals lost around 26% in value; and smaller regionals lost over 30% in market value. European banks lost 12% in market value for the same period, according to FactSet research.
“This crisis was not supposed to happen. After all, banks today are significantly better capitalised than they were going into the GFC. Risky exposures also have come down significantly and some, like subprime mortgages, have been essentially eliminated. Every year, banks undergo rigorous stress tests that model their businesses through severely adverse economic scenarios, and banks generally pass with flying colours. So, what went wrong? And do we see further risks to the outlook for the banking sector or opportunities in the aftermath? There are plenty of similarities among bank crises, but each one is a little different. It is especially important to understand the differences.”
“The first domino fell in an area that was never thought of as a significant risk: an investment portfolio comprised of Treasury bonds and government-backed securities, which by definition are assumed to carry no credit risk. They do, however, carry interest rate risk. Most of the time this risk is not a big deal, unless we see a significant rise in rates as we did in 2022 into this year. The Federal Reserve’s aggressive tightening cycle caused significant mark-to-market losses on these securities. These are paper losses that over time will mature at par, resulting in recovery of the mark-to-market loss. The caveat here is that losses become real if the bank must liquidate the portfolio. In addition to unrealised losses on the banks’ available-for-sale (AFS) and held-to-maturity (HTM) portfolios, the failed institutions also had other idiosyncratic risks. The first bank failure exposed a significant number of uninsured deposits, deposits in excess of the $250 thousand FDIC insurance limit. Company filings for Silicon Valley Bank showed approximately 88% of total deposits at year end 2022 were uninsured.1
“Further concerns about concentrated bank clientele, either limited to specific sectors or narrow geographic regions, also emerged, putting smaller US regional banks under pressure. As nervous depositors looked to withdraw uninsured accounts, a perfect storm emerged. The banks had to liquidate portfolio securities at current bond prices, taking big losses, which reduced the banks’ liquidity. Mounting losses resulted in a panic among depositors, who all rushed for the door. The result was a textbook definition of a run on the bank.
“Loss of confidence and liquidity shortages are the common killers of banks. History suggests that once a bank run starts, it is hard to contain and can spread to other banks. There is a self-fulfilling nature to bank panics, and as we saw over the past few weeks, in this digital age they can spiral rapidly.
“The panic spread quickly to the European banks, pushing a long-ailing financial institution over the cliff. To be clear, this failure and arranged sale to a rival had nothing to do with the problems at US banks and more to do with mismanagement over the past decade. We believe this failure was going to happen sooner or later; the recent crisis of confidence just sped up the process.
“Despite the selloff in European bank shares, we see little similarity between the drivers of the US and European banking crises. In fact, for the first time in a long time, European banks’ liquidity situation appears in better shape than that of their US counterparts. Post-GFC, European bank regulators introduced liquidity requirements to hold banks to standards aimed at ensuring lenders could survive substantial stressed liquidity outflows. In the US, large-cap banks, those with assets above $250bn, also known as Systemically Important Financial Institutions (SIFI), have similar liquidity requirements in place. However, in 2018, the US regulators rescinded some of the requirements for banks with assets under $250bn, including some of the short-term liquidity requirements. This is where the problem started, and where, we believe, it will remain contained.
“Despite the current fears in the marketplace, we believe that the global banking sector remains much safer than it has been in the past. Most importantly, the regulatory toolkit has evolved and allows regulators to address these crises quickly and more effectively.
“In other words, we believe this situation shall pass and with minimal risk of escalation and contagion like we saw during the financial crisis of 2008.”
He adds: “In the US: In response to what happened, we expect bank regulation in the US will likely increase with greater emphasis on small and mid-size regional banks. We also expect the earning power for smaller regional banks to decrease due to rising funding costs.
“In Europe: Meanwhile, we expect the European bank woes to be limited to one specific case. Not only do we feel the risks in Europe are largely idiosyncratic, but we see several characteristics that distinguish the European banking sector from that of the US, which should keep broad contagion at bay:
“European banks generally hold more cash, and securities comprise a smaller portion of balance sheets for these banks. Therefore, European banks have not had to sell securities at a loss to meet liquidity needs. The European Central Bank (ECB) maintains established facilities to provide liquidity, which can be accessed quickly by banks. European banks’ lending and deposits were more constrained post-pandemic, and they did not grow as rapidly as in the US.
“Once investors realise that the current situation is not a repeat of the 2008 GFC, we think confidence will be restored, and banks can return to business as usual.
“Given our bearish outlook for the US economy and the US dollar, we generally remain more constructive on global equities. We see growth in China, with its recent reopening, continuing to recover post-pandemic, which should shift relative growth away from the US. Furthermore, we expect the European economy to fare better than the US economy on a relative basis, which should also be positive for European banks.
“The US market remains our biggest underweight, and our exposure here skews more defensive. Among US banks, we prefer the large, money center banks. These banks have much stronger deposit franchises than their regional peers. In fact, they have been the beneficiaries and recipients of deposit flight from smaller banks. These banks are also considered safer and carry an extra regulatory burden to prevent failure, unlike banks with $250bn in assets or less, which are not subject to the same standards and rigorous oversight requirements.
“European bank stocks are also attractive, but we would be selective in which banks to invest. There is a wide difference between the quality of banks, as we have recently witnessed in Switzerland and in Germany over the past couple of years. There are also regional macro differences that carry implications for earnings of banks exposed to those respective countries. We prefer a select number of banks, predominantly in France and Spain, which have high-quality management and diversified business exposures.”
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