Assessing risks as banks face new pressures—and the end of easy money
Recent systemic stresses on U.S. and European banks have made it increasingly clear to us that the era of easy money is over. With this month’s bank failures and emergency regulatory responses in mind, financial vulnerabilities now present greater risks of fueling contagion, and these elevated risks therefore demand greater scrutiny. For equity investors, assessing risks in the banking sector requires a new playbook of sorts, with the flexibility to adapt to a rapid pace of change, in our view.
How did we get here?
In response to the COVID-19 pandemic, global central banks provided unprecedented quantitative easing by expanding their balance sheets and maintaining very low or near-zero interest rates. On the fiscal side, governments flooded consumers and businesses with stimulus payments. We believe this, in turn, has driven a commensurate increase in global bank deposits, higher levels of risk-taking, and a strengthening of both consumer and corporate balance sheets.
The reversal of these easy money policies started after inflation began rising in early 2021. Throughout 2022 and into early 2023, global central banks shifted to quantitative tightening by shrinking their balance sheets and raising rates. In our view, these less accommodative stances are reshaping the global economy at a time when pandemic-related stimulus payments have come close to being spent, leading to today’s volatile environment.
A new era exposes previously hidden risks
This reversal of easy money has revealed critical failures by two U.S. regional banks, Silicon Valley Bank and Signature Bank, to adequately monitor risks in their management of assets and liabilities. In our view, these banks were assessing risks as if the high deposit growth that they experienced since 2019 had extended into 2022 and early 2023, when rising rates made for a much less hospitable environment. We believe these banks wrongly projected the impact of higher rates on both their deposit bases (outflows were higher than expected) and investment securities (unrealized losses affecting capital), leading to a liquidity crisis.
These concerns extended to Europe, where the yearslong restructuring of Credit Suisse, a major Swiss bank, was significantly affected by its short-term liquidity needs, triggering counterparty risk on its derivatives exposure. The risk of contagion eased as the Swiss National Bank intervened to provide support and UBS, another Swiss commercial lender, agreed to an emergency acquisition of Credit Suisse in a government-brokered transaction. However, we believe that the crisis of confidence will continue until global markets once again believe that contagion risks are ring-fenced. From our perspective, the issues that arose at Credit Suisse are less about liquidity needs and more about uncertain earnings and return outlook for that bank. This view is supported by the fact that Credit Suisse was a globally systemically important bank, a regulatory designation that imposes strong liquidity requirements.
An updated checklist for bank equity analysis
As equity investors in this challenging environment, we’re actively monitoring five potential risks to the global banking system.
1 Bank runs are by definition a crisis of confidence, and we’re monitoring how much more global central banks must do to regain investors’ confidence in commercial banks’ liquidity, capital ratios, and counterparty risks.
2 We’re focused on banks’ deposit flows, mix, and pricing. These factors not only determine bank liquidity changes but also help us to forecast net interest income and therefore earnings.
3 We’re assessing the impact of both higher and lower interest rates on liquidity, investment securities, earnings trajectory, and capital ratios.
4 If the recent loss of confidence persists and results in lower loan growth, this challenge may lead to slower economic growth and higher credit losses.
5 Recent events suggest a higher likelihood of increased global bank regulation focusing on asset and liability management and core deposit calculations, with the potential for higher capital and liquidity requirements.
Why quality matters now in equity selection—for banks and the broader market
Within banking, we’re focused on attractively valued global banks that have strong core deposit franchises and more stringent rules for stress testing liquidity and capital. That focus is part of a broader approach that we take across global equities, emphasizing the quality characteristics of companies—strengths that we feel enable select firms to distinguish themselves from their peers. We define quality companies as those that can produce high returns on capital in excess of their cost of capital and, over time, can sustain and grow those returns. These quality companies are competitive and often have a commanding position in their respective market segments. They also possess proven track records for growing their returns on invested capital and have consistently performed well throughout successive stages of economic cycles. In essence, these companies offer sustainable free cash flow growth and provide the potential for downside protection when the external environment deteriorates—attributes that we believe will become increasingly important in today’s challenging markets.
The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Past performance does not guarantee future results.
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