What happens next for banks?
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What happens next for banks?

Our Global CIO and equity analysts look at the changes that may be coming for banks in the wake of recent events involving Silicon Valley Bank and Credit Suisse

Confidence, the bedrock of a functioning financial system, was tested in early March as news of bank failures and questions about liquidity shook depositors and investors. Here is our view on the near- and medium-term implications of recent events.

A rush for safety

It is relatively easy to move assets to a large money centre bank in the digital/mobile age, and in the current environment, many depositors and Chief Financial Officers (CFOs) perceive them to be less risky. Though it is unnecessary, in the short term, we would not be surprised to see deposits move from the regionals to larger banks. The US government may not like too big to fail financial institutions, but the market is heading in that direction and the big will become bigger. That doesn’t mean everything is necessarily rosy for the big banks. While they may be raking in deposits, they’ll also be on the hook to fund that deposit insurance. (The Federal Deposit Insurance Corporation, or FDIC, is not funded by taxpayers; banks and savings associations pay into the FDIC insurance fund in proportion to their size).

Regionals get re-regulated

In 2018, Congress exempted small banks from the regulatory scrutiny that the big banks still face, such as the Fed’s annual CCAR bank stress tests. We expect this to be reimplemented.

The tests, which assess whether a bank has the strength to weather large losses, are likely to be applied more broadly to regional banks, as regulators acknowledge that even banks that are not the largest can still destabilise the financial sector. Capital and liquidity rules that currently only apply to systemically important banks (ie, large money centre, super-regional, and trust banks) may also be pushed down to apply to regional banks. This includes total loss-absorbing capital rules that require (these larger) banks to issue senior unsecured debt1 as a bulwark against loss, and the inclusion of unrealised bond portfolio losses (those deemed available for sale) in the calculation of regulatory capital.

Greater regulation equals increased costs for the regionals, and while the application of these rules will likely be phased in over a few years to give the banks sufficient time to comply, they will likely reduce profitability and perhaps bank stocks’ valuations, though provide investors with more confidence.

We’re also likely to see a larger role for regulators generally as they seek to maintain confidence in the financial system. The brokered takeover of Credit Suisse by UBS is a good example of this, as is the Federal Reserve’s efforts (along with others) intended to stabilise First Republic Bank.

Peak NIM, for this cycle

Net interest income (NII) is the amount of money that a bank earns in interest on loans minus the amount it is paying in interest on deposits. NII drives a bank’s profitability. As rates have gone up, banks have been able to boost NII by earning higher yields on loans, whilst paying depositors less interest on their savings accounts.

Net Interest Margin (NIM) is NII divided by a bank’s interest earning assets. We think that NIM has probably peaked, as depositors have become aware of options paying higher rates, such as money market mutual funds. A bank that sees deposit outflows will either need to raise its rates or borrow money at higher rates, either way this drives NIM down. However, while NIM may have peaked, it is possible that NII has not, as some banks’ assets will rise more than NIM falls. The net-net for investors is that bank earnings and valuation may be impacted.

Consolidation

During the Great Financial Crisis (GFC), one common tool for regulators in resolving a struggling institution was to find a willing buyer (ie a strong bank). There are four reasons why this solution is unavailable to the Fed in this environment.

  • First, in the GFC, those banks that came to rescue failing banks found that they faced intense regulatory scrutiny after the fact, and concessions granted in the heat of negotiations were not honoured.
  • Second, under current accounting rules, the buyer must mark to market the acquired balance sheet: loans, securities and deposits alike. Given that all loans and securities were originated or bought at lower rates, these valuations would produce losses for the acquiror, which would hurt the acquiror’s capital ratios. Buyers would want this fact reflected in the acquisition price (ie it would be low) discouraging the seller and adding to negative psychology for the value of bank stocks.
  • The third reason is that the largest banks are prohibited from getting bigger through acquisition except with regulatory permission.
  • Last, the current crisis comes from depositors fleeing banks quite suddenly in large volume, often through online banking and mobile apps. This phenomena makes it very difficult for regulators to gather acquirors and provide them with the necessary data to make a confident, well-informed decision in a timely manner. Consolidation is unlikely to bail out a bank under pressure.

Ongoing importance of the rate backdrop

It’s only a small subset of banks that are seeing deposits flee and obviously there are significant implications for those banks from a profitability standpoint, especially if they are backfilling with expensive borrowing or swapping of assets with the new Fed facility. Another subset of banks is worthy of investor attention: those banks that are not seeing any deposits flee but have a high allocation of “held to maturity” investments and outsized bond losses in their “available for sale” bond portfolios, coupled with other liquidity constraints. We anticipate that many of these banks will seek to rebalance their bond portfolios as quickly as possible, which will mean selling longer duration bonds and buying shorter duration issues.

One catalyst that would bring rapid relief to the bond portfolio situation is lower rates. The Fed’s rapid increases after many years of zero interest rates created liquidity mismatches and any reduction in rates would take the pressure off and allow banks to shorten their duration. So, by extension, any relief found in the inflation data will eventually translate into a better backdrop for banks.

Continuing social distortion

The speed of Silicon Valley Bank’s collapse was breathtaking – the bank announced its plan to raise capital on 8 March, and by 10 March it was seized by the FDIC. More recently we saw Credit Suisse come under pressure after a Saudi investor indicated that they would not commit incremental capital to the bank. In both cases, the speed of information on the internet created a “shoot first, ask questions later” environment as CFOs and Risk Officers sought to limit exposures.

The internet is not going away so the onus is on banks to have business models that can stand up to internet scrutiny, and the motivations of bad actors who may manipulate those platforms. No one has perfect insight into what businesses will come into the crosshairs, or when emotion may overwhelm logic. The flip side of this dynamic is that these distortions also create opportunity. The dislocations created by market volatility (especially when driven by emotion) can create buying opportunities for those willing to put in the research. Diving in and doing the analytical work may uncover great opportunity in some cases.

Balancing long-term investments in a short-term-minded market

Banks take in deposits and lend them out to companies that want to expand (eg buy equipment and hire employees). In the past, banks could rely on these deposits to remain for years, so they felt comfortable lending money to companies to make long-term investments. Deposit outflows in recent weeks occurred as market participants began to question the valuation of long-term loans and investments that were meant to be held for years, which resulted in concerns over bank viability. Banks need to be able to diligently provide long-term capital to growth-minded borrowers without fear of short-term factors inhibiting their ability to do so. Policy makers should focus on the root causes of how we got here and help figure out a path forward.

12 April 2023
Peter Tiletnick
Senior Equity Analyst
Dick Manuel
Senior Equity Analyst
William Davies
William Davies
Global Chief Investment Officer
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What happens next for banks?

1First in line to get paid from the assets of a company that goes bankrupt, excluding any pledged assets for secured senior debtholders.

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This document may be made available to you by an affiliated company which is part of the Columbia Threadneedle Investments group of companies: Columbia Threadneedle Management Limited in the UK; Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.
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Risk Disclaimer

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). For marketing purposes.
This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.
In Australia: Issued by Threadneedle Investments Singapore (Pte.) Limited [“TIS”], ARBN 600 027 414. TIS is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth) and relies on Class Order 03/1102 in respect of the financial services it provides to wholesale clients in Australia. This document should only be distributed in Australia to “wholesale clients” as defined in Section 761G of the Corporations Act. TIS is regulated in Singapore (Registration number: 201101559W) by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289), which differ from Australian laws.
In Singapore: Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: 201101559W. This advertisement has not been reviewed by the Monetary Authority of Singapore.
In Hong Kong: Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香 港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission (“SFC”) to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No. 1173058.
In Japan: Issued by Columbia Threadneedle Investments Japan Co., Ltd. Financial Instruments Business Operator, The Director-General of Kanto Local Finance Bureau (FIBO) No.3281, and a member of Japan Investment Advisers Association and Type II Financial Instruments Firms Association.
In the UK: Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.
In the EEA: Issued by Threadneedle Management Luxembourg S.A., registered with the Registre de Commerce et des Sociétés (Luxembourg), No. B 110242 and/or Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.
In Switzerland: Issued by Threadneedle Portfolio Services AG, an unregulated Swiss firm or Columbia Threadneedle Management (Swiss) GmbH, acting as representative office of Columbia Threadneedle Management Limited, authorised and regulated by the Swiss Financial Market Supervisory Authority (FINMA).
In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.
This document may be made available to you by an affiliated company which is part of the Columbia Threadneedle Investments group of companies: Columbia Threadneedle Management Limited in the UK; Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.
Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.

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