Quick regulatory action to restore depositor and investor confidence reduced – but did not eliminate – the risk of contagion in the banking system.
We believe the banking crisis will further tighten credit conditions and accelerate the economy's path toward recession.
We expect to see new regulations for small- and mid-sized banks with a range of possible cost outcomes.
What's been your focus in the aftermath of the regional bank failures?
Raheel Hirji, Global Value: We've had frequent discussions with the banks we hold in our portfolios since events began unfolding. We're using these calls to determine whether the companies we own are experiencing any liquidity challenges. We are also attempting to ascertain capital levels, gauge uninsured vs. insured deposit levels, and determine whether our banks are facing incremental deposit pricing pressure.
Fear in the marketplace is a significant risk. Even unfounded liquidity worries could trigger a bank run that creates a problem where one did not exist before. That's why an important aspect of this is maintaining depositors' confidence.
Charles Tan, Global Fixed Income: Since we typically do not have significant exposure to regional banks in our bond portfolios, much of our focus has been on the impact of this crisis on the banking system and its effect on the broader economy.
In the banking system, the concerns relate to immediate liquidity to cover withdrawals, funding stability, profitability and capital adequacy. We believe the Federal Reserve's Bank Term Funding Program was a smart, surgical approach to solving the liquidity problem. However, it does not address the other issues. We'd also note that the highly publicized deposits from larger financial institutions into regional banks do little to address the funding and capital problems.
From a broad economic perspective, we think this crisis will accelerate the timeline toward a hard landing and recession. We expect banks to curtail the amount of available credit and be less willing to provide loans for riskier ventures. The effect will be similar to what the Fed has been trying to accomplish with its rate hikes – it will put a damper on economic activity and should help ease inflationary pressures.
Is there a risk of contagion?
J.T. Adlard, Global Value: Yes, the loss of confidence in the banking system has the potential to spread. However, the FDIC guaranteeing all deposits at the failed banks should lower the risk of contagion in the short term.
In addition to industry-wide pressure from mark-to-market losses on their investment portfolios, the banks making headlines have been experiencing company-specific problems too. For example, SVB's heavy exposure to tech-oriented venture capital assets and its large average deposit size are unique. Similarly, somewhat unusual exposure to the crypto industry brought down Silvergate Capital and was a factor at Signature Bank. Most other regional banks do not have comparable vertical concentration risks.
Raheel Hirji: Account size is a factor as well. Many regional banks we hold are community-oriented, with most assets below the FDIC coverage limit of $250,000. Unlike the large account holders who led the run on SVB, the owners of smaller accounts are less likely to move their deposits because their balances are covered by FDIC deposit insurance.
However, we don't want to downplay the risk altogether. If a relatively small number of very large account owners pull their cash, this could stress any individual bank we own.
How does the banking crisis affect your Fed and economic outlook?
Charles Tan: The banking crisis is effectively doubling down on the impacts of the rate-hiking regime the Fed kicked off a year ago. We expect banks will shift into survival mode, which means reigning in their risk exposure and tightening their lending standards. Fed governors weren't aiming to foment a banking crisis but limiting access to credit is precisely what they had in mind to cool the economy and bring down inflation.
Indeed, there's debate about whether March's quarter-point hike was necessary. However, it confirmed the central bank's commitment to taming still-high inflation while signaling policymakers' confidence in the U.S. financial system.
Ultimately, we think this event hastens the economy's path to the recession that could help solve the inflation problem. The downturn could turn out to be more severe than many expect. We must remember how far the economic pendulum swung with $5 trillion in pandemic stimulus pushing M2 to unprecedented levels. It's now swinging back in the other direction, and we think it's unrealistic to expect the economy to glide to a soft landing.
How could the crisis affect banking regulations?
Adam Krenn, Global Value: We expect more regulation on small- and mid-sized regional banks. One logical step would be to take large-cap bank liquidity requirements and apply them to mid- and small-cap banks in a tailored way. Regulatory reforms on liquidity and capital and deposit insurance fees would hurt returns on equity. The details of any legislation or regulatory action are to be determined, so there is a wide range of potential long-term cost outcomes.
Charles Tan: Due to regulations in place since the credit-driven 2008 financial crisis, banks are generally better capitalized and have higher credit quality. But let's not forget banking is an inherently unstable business due to its high leverage and maturity mismatch. So, we would expect even tighter liquidity, funding and capital rules in the aftermath of the recent bank failures.
Derek De Vries, Global Growth: Adam and Charles are exactly right regarding the U.S. It seems logical to expect tighter regulation around liquidity and mark-to-market hits to equity being applied to regulatory capital at all U.S. banks, not just the largest banks. I think the regulatory impact will be lower in other regions. Europe, for example, already deducts losses on securities held as available for sale from regulatory capital, and Europe requires banks to meet strict liquidity standards (e.g., a liquidity coverage ratio greater than 100%). Of course, we can't rule out a further tightening of regulations. At a minimum, I imagine the Basel committee will review its calibration of the Liquidity Coverage Ratio (LCR).
How are you approaching bank exposure in portfolios?
Adam Krenn: Our team focuses on high-quality companies emphasizing productive assets, low financial leverage and franchise stability. For banks, this includes sustainable returns from diversified sources, strong capital and liquidity ratios, better management and lower credit risk through a cycle. Our process focuses on downside risk, which is especially critical when evaluating leveraged financial institutions like banks. We are monitoring holdings closely, including active dialogue with bank management teams. In this volatile environment, we are actively adjusting portfolio holdings to reflect the evolving opportunity set at the stock level. This has included selectively adding to certain high-quality banks we view as oversold.
Derek De Vries: Our discipline always applies a bottom-up approach to stock picking. We look for inflections, sustainable growth, valuation and a differentiated view to consensus. Over the past few weeks, we have been stress-testing our assumptions. We're looking at the impact lower rates and higher credit losses could have and considering the various macro assumptions Charles mentioned earlier. On average, we have adjusted our earnings expectations to reflect events – but then we have considered the new outlook in the context of current valuations and expectations. In total, we have trimmed some of our bank exposure.
Charles Tan: Most of our bank holdings fall into the category of Globally Systematic Important Banks (GSIBs). We expect the GSIBs to be in a better position to navigate the current confidence crisis in banks. On the other hand, our positioning in regional banks is more defensive. We've been particularly conscious of recession and commercial real estate risks. So, our exposure is limited to what we regard as super-regional banks and select custodial banks, given our view that they are well diversified, high quality and have the capital strength to cushion losses.
We maintain a cautious approach in Europe, though we have not identified worrisome liquidity risks within the continent's banking sector. However, the concern around Credit Suisse demonstrates that market price reactions can overrun fundamental analysis and be sharp. We, therefore, maintain a cautious approach.
What are the implications of recent regulatory actions related to Credit Suisse?
Derek De Vries: Imposing a 100% loss on Credit Suisse's Additional Tier 1 holders will have implications on bank funding markets – obviously AT1 issuance and possibly senior issuance. However, as Charles pointed out, banks are in a better place from a funding and capital perspective than in 2008. So, while I think it is fair to say that the possibility of a credit crunch has risen, it is far from a foregone conclusion.
Regarding European banks in particular, I think the comparison to SVB and Signature Bank is less relevant as that was a combination of excessive interest rate risk in the banking book and a very concentrated deposit base. Those aren't significant issues in the European bank sector.
On the other hand, European banks have a profitability problem. Credit Suisse was the extreme example, having lost approximately $7 billion last year, with no profit expected this year and only a 6% return on equity target in 2025. That profitability problem, combined with a small portion of insured deposits and unfortunate news headlines, led to a loss of trust. Fortunately, Credit Suisse looks like an outlier, even in the less profitable European bank sector. Most European banks have much better profitability profiles and are expected to achieve close to cost of equity returns in the current interest rate environment.
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