Alison Savas, investment director at Antipodes Partners, a global long and short equities manager, answered Portfolio Adviser‘s questions on the nuances in the global banking sector and factors to be aware of.
What’s your view on the recent events within the banking sector? Could this have been avoided?
Three key points have come together to lead us to where we are today:
- – regulation
- – the structure of the US banking system, and
- – arguably an “unintended consequence” of dealing with the inflation hangover, as a result of Covid stimulus.
An important part of the failure of Silicon Valley Bank was a failure of the regulatory framework. Regional banks should not have been exempt from mark to market rules on available-for-sale securities portfolios. If these banks were forced to mark to market their losses, then these banks would have had to manage their balance sheets more proactively, and they may not have seen such a fierce deposit run. Further, regional banks should not have been allowed to hold such a large proportion of their liquidity in long duration assets.
At the heart of the issues in the US banking sector, however, is the structure of the system. It is a very fragmented market. It has a deep money market which creates competition for deposits, and it has a high degree of fixed-rate lending which can exacerbate the asset-liability mismatch. For example, in the US around 60% of assets are fixed rate with a duration in excess of five years – so there’s a limit to the extent to which higher rates can be passed on to borrowers. To protect net interest margins, banks are reluctant to pass on higher cash rates to their deposit customers, so customers have sought out higher yielding money market funds instead of leaving their cash at the bank.
We are in this position today because the Fed Funds Rate has seen one of the fastest and sharpest increases in history. The cash rate in the US was 0% at the beginning of last year, now it is 5%. The seeds of the current stress in the US financial system were sewn during Covid. The US, and other Western central banks, ran extremely loose monetary and fiscal policy – and the US was the worst offender. The result was extreme inflation, and the pace of the current hiking cycle is a consequence of that. Whether or not the pace and extent of this tightening cycle was avoidable is a bigger debate for another time.
See also: Credit Suisse reveals £55bn haemorrhage before UBS rescue
You have an overview of the global banking sector. What are the nuances for the varying regions that is useful for investors to be aware of?
The structure of the European banking system is very different from that of the US outlined above, which is why Europe hasn’t seen the same issues. European banks have a dominant share of savings and lending which means deposits are less likely to leave the system and competition for deposits is relatively benign. European banks also have a much better asset-liability match due to more variable rate lending. Higher cash rates are more easily passed on to depositors and borrowers which protects European banks’ net interest margin. Most importantly European regulators have been stricter since the 2008 financial crisis and the subsequent European sovereign debt crisis which resulted in higher capital requirements and more conservative lending practises. Capital ratios are also cleaner because they include mark to market losses on bond holdings.
Asian banks, to generalise, are relatively consolidated systems and again have a relatively better match of floating rate assets and liabilities. Importantly, credit penetration as a percentage of GDP is still relatively low in emerging Asian economies and there is a long runway for penetration with scaled digital players taking share. The key area to watch in emerging market countries are externalities and shocks to the balance of payments, which can then potentially trigger a credit crisis.
Why are regional banks an important part of the system? Why are they essential?
Firstly, the US definition of a regional bank is less than $250bn in assets so this will include some very large deposit funded franchises.
Regional banks are important because they account for nearly 40% of total credit in the US system, and often this credit is directed towards small and medium sized businesses which are critical for the economy. Some sectors have an even greater dependence on regional banks. On the Antipodes definition of a regional bank, which is less than $100bn of assets, regional banks account for a whopping 70% of commercial real estate loans, or almost 40% of total debt funding to commercial real estate (i.e loans + bonds and other sources like insurance companies).
Commercial real estate – office and the more economically sensitive parts of CRE – are already under stress because they never really recovered from Covid and/or they are feeling the pain of the slowing economy. CRE has high private market leverage, rising rates, a high degree of variable rate funding, and falling occupancy. And now the banks the sector relies on for funding and refinancing are under pressure.
What is your outlook for the banking sector? What would you like to see?
We’ve been underweight US banks for some time now due to the structure of the US banking system, and we continue to remain underweight with no meaningful exposure to US financials.
Even if we don’t get tighter regulation in the US, we expect to see banks focus on liquidity and risk management, which could impact credit creation as banks become more cautious around lending. We expect to see the profits of US banks come under pressure due to a net interest margin squeeze, which is happening against a backdrop of a system that no longer has surplus capital because of these mark-to-market issues. On our simple analysis if deposit rates increase 100bp from the current 1.5%, the ROE for the US banking system will fall from over 12% to around 8%. The US banking system is shifting from one of excess capital which supported shareholder returns via buybacks and dividends (in turn supporting share prices and valuations) to one of potentially needing to raise capital. We don’t believe this structural change in profitability of US banks has been factored into valuations.
We are more constructive on European banks as we don’t see the same challenges. We don’t think European banks will tighten lending as aggressively as US banks and they are very well capitalised.
How are you playing this in portfolios?
We have around 4% exposure to European financials in the Antipodes Global Portfolio and Antipodes Global Long Portfolio, anchored by our exposure to Italian bank UniCredit.
UniCredit has a core tier 1 capital ratio of 16% – which could be double the average US bank on a mark to market basis – implying 30% of current market cap in excess capital. Net interest revenue is growing 15% p.a. and non-performing loans have meaningfully fallen. The company is priced at 4x earnings and 0.5x book with a payout yield of 20%, and a well-communicated capital management plan which could see 80% of the market cap returned to shareholders over the next four years. Even after doubling over the last 12 months, it remains extremely cheap.