Our established investment framework related to banks remains largely intact following several recent bank failures. Regulators and bank managements have both learned valuable lessons and helped to significantly de-risk the banking business model since the global financial crisis (GFC), but more work needs to be done. We believe markets will increasingly differentiate banks among regions and securities, as follows: (a) US vs. Europe; (b) large, highly rated US banks vs. regional banks; (c) US bank preferred securities vs. European bank AT1s and (d) security structures and terms for various types of deeply subordinated securities.
The current stress in the banking system is extremely complex, but in our view it is likely not systemic. The market appears to be in a price discovery phase trying to predict if the crisis can be contained or whether the contagion will spread. The general consensus is that we face tighter financial conditions, greater regulation and increased costs to banks. Importantly, the ongoing banking crisis has triggered a broader concern for a potential recession and, depending on the day, outright contagion.
We believe the market will increasingly conclude that banking regulation has been largely successful for the highly regulated global systemically important banks (GSIBs), that regional bank business models will need to be de-risked, and that regulators have the tools, willingness, and ability to stabilize the banking system’s confidence crisis. We expect projected earnings of GSIBs to increase year-over-year (YoY) to near-record levels in 2023 given higher rates and low credit losses. We continue to believe that large, well-capitalized and highly regulated banks in the US and Europe are a compelling investment for bond holders across the capital structure. We will maintain exposure to senior and, where appropriate, subordinated debt issued by large, well-regulated banks. We continue to maintain a significant underweight to smaller, less-regulated financial entities such as US regional banks that we believe will face challenges in the current environment. Here’s a breakdown of our outlook for both US and European banks.
Our thesis has not changed, but on the margin, we now favor maintaining our large overweight to the US GSIBs, and we favor maintaining our significant underweight to the US regional banks even more. For the foreseeable future, we believe “the strong will get stronger” as deposits flow from regional banks to the largest banks while recent events will create new profitability and regulatory headwinds for regional banks.
Debt issuance for regional banks is likely heading higher given the forthcoming increased regulatory environment and the larger capital cushions that will be required. Other earnings headwinds likely to affect regional banks include higher deposit costs, higher Federal Deposit Insurance Corporation (FDIC) fees and increased staffing needed to comply with additional regulatory oversight.
Large US Bank Outlook
We continue to favor a large overweight to the largest US banks across the capital structure given the following:
1. Strong balance sheets/highly regulated—In the decade following the GFC, these large GSIBs dramatically increased their capital levels and liquidity cushions to record levels and de-risked their funding profiles. Led by Dodd-Frank and the Department of Justice, regulators levied massive fines and established a comprehensive maze of new and tougher rules and requirements since the GFC.
2. Diversified assets and liabilities—The largest banks have diversified product lines (e.g., credit cards, investment and wealth management, loan books diversified by geography, business types and investment banking, etc.), and a diversified liability base with a large proportion of sticky retail deposits.
3. Near record earnings expected—US banking industry profits (driven by the money center banks) were near record highs of $263 billion in 2022 (-5.8% YoY). Prior consensus estimates for 2023 earnings forecast a rise of roughly 10% given higher interest rates and margins, according to Barclays Research estimates and company reports.
4. Benign future technicals for largest banks—US banks issued much more debt than expected in 2021 and 2022.
5. Conservative credit ratings—For the largest banks, we had expected positive ratings momentum with one-notch upside across the board, but rating upgrades are likely on hold in 2023. In contrast, regional bank ratings are too high versus the major money center banks and brokers, and we expect downgrades for the vast majority of small to medium-sized US regional banks in 2023.
6. Attractive valuations—The banking sector trades wide of the overall credit index and recent price volatility has made it all the more attractive for the strongest names.
We maintain our long-standing view that the decade-plus journey of de-risking the banking business model following the GFC has led to a fundamentally simpler, safer and stronger sector. What’s more, the recent banking stress may serve as an additional tailwind for these largest banks as deposits, investors and businesses seek the comfort of size and stability in the flight to safety.
Regional US Bank Outlook
We consider the Silicon Valley Bank (SVB) episode to be a unique, idiosyncratic situation based on: (1) a business strategy exposed to rapid growth along with an aggressive investment strategy, (2) the bank’s unusual and highly concentrated business model focused on the technology sector in Silicon Valley, and (3) its unique balance sheet structure (e.g., high percentage of corporate, as opposed to retail, deposits that were uninsured and with a concentration in the tech/VC sector).
While the emergency measures implemented on March 12 should help to stem further sentiment contagion and potential deposit outflows at other regional banks, recent events will create marginal headwinds for this sector. We expect debt issuance for these banks is likely heading higher given the forthcoming increase of scrutiny, regulations and the larger capital cushions that will be required. Other earnings headwinds likely to come include higher deposit costs, higher FDIC insurance fees and increased staffing needed to comply with and manage to a much stricter regulatory framework.
We continue to maintain a significant underweight to regional banks with exposure largely concentrated in the largest regional banks.
We believe the US regional bank business model will evolve in three ways: (1) much more regulation with an emphasis on deposits, liquidity, interest-rate risk and commercial real estate loan exposures, (2) increased consolidation, and (3) more ratings dispersion as the small to medium-sized regional banks face downward ratings pressure.
Our investment framework for bank analysis remains unchanged in that our process focuses on the country of domicile, the banking system and finally the individual bank itself, in that order. Unlike non-financial corporate analysis, we contend that bank analysis is more about the probability of default and less about loss given default. In the global context, European banks have relatively strong economies (in their respective countries) with strong regulatory frameworks, which is why we believe they remain attractive. In recent years, the European banking system’s profitability and asset quality has improved while its liquidity profiles and capital levels remain robust. As such, we favor having meaningful positions in select European banks that have well-established business models and are large in country footprints of retail banking deposits. That said, going forward we expect markets to better differentiate between different regulatory environments and different capital structures.
Risk premiums on subordinated debt for European banks, with an additional Swiss “regulatory risk” premium, are likely to remain high for some time. We view the recent spread widening in European banks as being driven largely by negative sentiment toward the overall industry and not because of any specific concern about credit fundamentals.
Specifically, regarding how the situation with US regional banks unfolded, we would like to emphasize the following points for European banks:
- European banks have extremely limited exposure to the sectors that have sparked intense attention on the affected US regional banks (i.e., limited exposure to tech/VC/crypto).
- The bulk of deposits in the European banking system is made up of very sticky retail deposits, of which the vast majority is covered by government guarantee schemes, which further increases stickiness.
- Given their asset and liability mix, European banks are positively geared toward rising rates, unlike SVB. As a result of higher rates, European banks have generally seen double-digit increases in net interest income and their return on equity (RoE) has increased as a result.
Credit Suisse and UBS Outlook
We view the collapse of Credit Suisse (CS) as an idiosyncratic event in that a crisis of market confidence overwhelmed the bank’s longer-term fundamental trajectory; FINMA (the Swiss banking regulator) and the Swiss National Bank issued a joint statement as recently as March 15, just days before the forced takeover of CS by UBS, stating that “CS meets the capital and liquidity requirements imposed on systemically important banks.”
The acquisition of CS poses short-term execution risks for UBS. However, longer term we consider this transaction to be immensely positive for the strength of UBS’ core domestic Swiss and Global Wealth Management businesses. In many segments, especially in the low-risk/high-return Swiss domestic market, UBS will have a dominant (near monopolistic) market position. As a result of its even greater importance to the Swiss economy and financial system, UBS will face an even tougher regulatory framework and even more intrusive supervision. Rating agencies have affirmed UBS while putting CS notes on review for upgrade. CS senior notes are already recovering in anticipation of the closing of the merger and on a tactical basis we believe that UBS securities are now even more attractive given recent repricing.