One year ago, the collapse of Silicon Valley Bank in the US spread fear through the sector and contributed to the downfall of Credit Suisse, leaving regional banking in a valley. While the US system has struggled to recover, European banks have put themselves in a promising position for 2024, some investors believe.
In the wake of Silicon Valley Bank’s failure, the S&P 500 Regional Banks Sub-Industry Index dropped from 118.3 on 26 February 2023 to 74.6 by 12 March. A year later, the sector has recovered slightly, rising to 83.5 by 17 March 2024, but trails far below its value last year.
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Sam Hannon, investment associate at 7IM, called the failures a “wild ride” for US regional banks and European banks.
“An unwinding of the low-rate environment was supposed to be a positive for Banks – higher interest rates were supposed to lead to higher net interest margins (by charging higher interest on loans),” he said.
“But instead, the sharp move in rates, led to the biggest bond losses in decades. US regional banks, like SVB, were holding large amounts of those bonds which led to its downfall. What was more surprising was that it took down Credit Suisse too.”
The downfall of Credit Suisse rocked the European banking sector, with the STOXX Europe 600 Banks Index dipping from 166.8 at the beginning of March 2023 to 141 by midway through the month. However, in the past year, the sector has gradually worked its way beyond the March 2023 peak to 187.5 in March this year.
Ciaran Callaghan, head of European equity research at Amundi, said European banks proved resilient to the shocks, partially due to the stability of the systems and partially due to the setup of the sector compared to the US.
“No other bank in Europe really got into too much trouble,” he said. “Nobody needed any more capital. Quite the opposite. The regulators continue to let the sector pay out excess capital to buybacks over the last six or 12 months. We had a lot of focus on deposits, but largely, they stayed fairly stable in Europe and there was probably some market considerations there.
“Over in the US, you have money market funds and a lot more digital savvy customers. It’s a lot easier for a bank customer in the US to switch its money. In Europe, the bank sector is a lot more fragmented, domestic, and dependent on the market wouldn’t be as digital. It’s not as big of a switcher market. It didn’t really see the deposit runs or the volatility in Europe like it did in the in the US.
“I’m sure regulators are looking at the liquidity side, but there’s been no major regulatory overhaul here, and they didn’t have to give them an exceptional liquidity systems. So largely speaking, the European sector really navigated the whole period for quite strongly.”
Improved profitability
Edward Harrold, fixed income investment director at Capital Group, agreed that the European market looked promising, even beyond the obvious players, looking to Spanish, Irish, and Greek banks who have improved their profitability.
“Arguably, the most promising opportunity lies in Europe, where banks are trading with wider spreads than their US and Asian counterparts. This is despite European banks being at the end of the regulatory regime and therefore having high capital buffers and strong fundamentals.
“Moreover, the underlying economies of these countries are some of the strongest in Europe, marked by positive GDP growth, low inflation relative to other European nations, and corporate and household debt sectors that have undertaken significant deleveraging over the last two decades. All these factors bode well for banks’ asset quality in the years ahead.”
As markets continue to price in interest rate cuts across Europe and the US for 2024, the banking sector expects some headwinds. However, Callaghan said many elements still look promising for banking with reduced interest rates, allowing them to make money on deposits and avoid asset quality risk despite a slight dip in profitability.
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“There will be loan growth coming back. As rates go down, you should see a pickup in demand for mortgages and corporate loans, which allows the offset. The banks have all these hedging portfolios effectively to buy more bonds to lock in the higher interest rates.”
Callaghan noted that even rates of 2.5% to 3% are far more promising than the negative rates which caused turmoil in Europe five years ago. He said while return on equity may lower from a sector average of 13% to closer to 12%, this is still enough for profitability.
While European banks appear in a promising position despite rate cuts, US regional banks can’t seem to quite find their footing.
Worthy adversary
On the US side, Richard de Lisle, manager of the VT De Lisle America Fund, said while regional banks have slowly crept back up, the inversion of the yield curve proves a worthy adversary.
“The only investors who remain optimistic are the insiders, as patience has been lost elsewhere due to the slow recovery and ongoing setbacks. Nevertheless, insiders like the price-to-book ratio at the low end of the range where they traditionally buy,” de Lisle said.
“The consequence is that we are seeing continued slow progress to normalisation which will be speeded up when the Fed cuts interest rates. We presume there are no further shoes to drop.”
Following the fallout of SVB, regulators in the US also put forth stronger capital requirements. Harrold added that while this could create short-term changes by increasing the number of bank bonds, it would “ultimately have a positive credit effect”.
“Lessons from the crisis underscored the importance of deposit base stickiness and quality, along with the need for caution concerning liquidity position and composition. This experience also showcased the rapid response capability of central banks in providing liquidity during times of crisis and highlighted that size matters in banking,” Harrold said.
“The latter could potentially drive increased M&A activity in the sector, although current macroeconomic conditions make this prospect challenging and unlikely.”
