Day: 17 March 2023

Philip Straehl is the global head of research for Morningstar’s Investment Management group. In his role, he oversees the group’s capital markets research and chairs the asset allocation committee.

Tyler Dann, CFA, is head of research, Americas at Morningstar Investment Management, LLC.

Key Takeaways

• The closure and wind-down of Silicon Valley Bank SIVB has led to considerable stress in equity markets, particularly among shares of regional banks, as well as fear of contagion.
• There are unique elements to SVB that contributed to its demise, including its client base and risk controls.
• While we are likely not fully “out of the woods” yet, we view the regulatory response as appropriate and likely adequate, which should head off contagion fears.
• As long-term, fundamental, wisely contrarian investors, we’re exploring ways to benefit from a potential dislocation in banking stocks, while being mindful of the risks.

What Happened?

Silicon Valley Bank, one of the 20 largest banks in the United States in terms of assets, has collapsed. It was the second-largest bank failure in U.S. history. A second (slightly) smaller bank, Signature Bank SBNY, also folded in similar fashion. In the case of both banks, the FDIC—an independent agency of the U.S. government that provides insurance to bank depositors—was appointed as the receiver. Put simply, FDIC took over these troubled financial institutions, with the intention to create the best outcome for bank depositors.

The SVB/Signature story has a lot of components, but ultimately boils down to an old-fashioned bank run. A flood of withdrawals from depositors destroyed these banks. How could this happen? This type of situation, while complex-sounding, is fairly simple: There were not enough cash and liquid assets available that could be sold to fund deposit outflows, without wiping out the bank’s equity capital base. That’s in part because banks are not required to carry enough cash to fund 100% of their deposits. According to regulations, they’re allowed to invest multiple dollars (think $10, in round numbers) for every dollar of deposits. These investments, which could be in the form of loans to customers or invested in marketable securities such as U.S. Treasuries or mortgage-backed securities, are generally longer-term in nature, and are not always able to be sold or otherwise harvested at a profit.

Some people have made comparisons to gym memberships. If every gym member showed up at the same time, not everybody would be able to work out. Banks are similar: If every depositor wants to pull their money at the same time, not everyone can get their money back.

Why Is SVB Unique?

For SVB in particular, the growth trajectory of its deposit base, the concentration of its customers, the peculiarity of its portfolio, and the relative lack of risk controls around the portfolio are unique factors. Per public filings, SVB’s deposit base jumped from $49 billion at the end of 2018 to $189 billion at the end of 2021. Venture capital funding was at all-time highs during this period and startups receiving funding often put the proceeds into SVB bank accounts. Putting that growth in perspective, SVB’s deposit base grew by approximately 57% per year in this period while industry deposit growth was only 12% per year, according to Morningstar’s research. As well, close to half its deposit base originated from technology companies, and most of those were early-stage technology companies. Traditional retail deposits, which tend to be stickier and tend to be smaller than the $250,000 insured by the FDIC, composed a relatively small portion of SVB’s depositor base, making it more prone to a bank run.

As deposits grew rapidly at SVB, the bank increasingly purchased fixed-income investments. The bonds they purchased (predominantly mortgage-backed securities) were high-quality, but were long in duration, with the weighted average maturity over 10 years. Shortly after making these investments, the Federal Reserve began one of its most aggressive rate-hiking periods in history. As interest rates rose, the value of these bonds fell. While in theory, the bond losses only existed on paper (if SVB held the bonds until maturity, it would get all its money back, plus interest), the “mark-to-market,” or unrealized, losses from these investments were significant, exceeding the company’s tangible equity capital. Observing this, depositors became skittish, started redeeming their money, and SVB became a forced seller of many of those bonds to meet redemptions. The paper losses turned into actual losses and laid the foundation for the rush to the exit by SVB’s depositors.

Is This a Lehman Moment?

While the collapse of another bank (Lehman Brothers) was at the epicenter of the global financial crisis in 2008, we believe that the recent bank failures are significantly less likely to trigger a global banking crisis. The speculative excesses that caused the financial crisis of 2008-09 were rooted in an economywide bubble in the real estate market, propelled by a large amounts of cheap debt funding that flowed into real estate securities. These leveraged and insufficiently capitalized owners of real estate securities created a fault line in the financial system, causing a global banking crisis as the price of real estate assets started declining and leveraged investors faced margin calls.

This time around, the speculative excess appears to have been in concentrated in niche segments of equities and alternative asset markets such as companies related to cryptocurrencies. Unlike the economywide debt binge that dominated the period leading up to the global financial crisis, venture capital tends to be equity-funded. Consequently, if venture companies fail, the loss typically ends with the investor, rather than being transmitted through the financial system as a bad debt. Additionally, bank balance sheets are largely a function of the regulatory response to the global financial crisis, and are significantly stronger than they were in the period leading up to 2008.

We would argue that while the rapid rise in Treasury yields has caused some short-term losses for the banking industry that are substantive, industry capital levels are better positioned to weather the storm. We also believe the regulatory response from the Fed, the FDIC, and the Treasury Department has been quick, unified, and substantive. The addressing of insured and uninsured depositors at SVB and Signature, as well as the opening of a borrowing window for short-term collateralized funding available at very attractive interest rates and terms should head off any concerns around systemic risk of a collective “run on the bank” moment.

Investment Implications

First, let’s cover portfolio exposure to SVB. This stock was listed on the Nasdaq stock exchange and thus was held by many investors. Some indirect exposure is therefore likely for investors that hold a diverse portfolio using mutual funds or exchange-traded funds. In the case of Morningstar’s managed portfolio range, we expect the maximum exposure to be less than 0.5%, often far less, depending on the strategy used.

Regarding knock-on effects, in the short term, we would not be surprised to see market volatility remain elevated, reflecting the increased uncertainty around potential outcomes. In particular, the financial services sector, most notably regional banks, could remain under strain for some time. However, as long-term, valuation-driven, fundamental, and wisely contrarian investors, this type of setup is one that we would use to begin searching for opportunities. We would look for our valuation work, coupled with our assessment of fundamental risk and investor expectations, to be our guide in determining whether, when, and by how much to increase our investment in the banking industry, as well as other sectors that could be affected.

We currently have a balanced viewpoint of U.S. financials, with a “medium” conviction rating assigned. From a valuation perspective, the sector looks relatively cheap (the second cheapest, behind communication services) but recent events have increased uncertainty, so careful portfolio construction is warranted. One issue is that the earnings can be quite volatile and cyclical, but bargain prices can present themselves as investors flee from uncertainty. Armed with research, we stand ready to adapt, and will monitor both the opportunities and risks very closely.

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Implications of SVB and Credit Suisse on the European banking sector—check out highlights from Franklin Templeton’s recent panel discussion with Kim Catechis, Investment Strategist with the Franklin Templeton Institute.

How has the failure of Silicon Valley Bank (SVB) and concerns with Credit Suisse affected European markets? Franklin Templeton gathered their banking analysts, strategists and fixed income professionals to discuss recent events and the implications for markets in Europe and globally. The panel included Michael Brown, Global Head of Investment Strategy and Oversight Executive, Martin Currie, Annabel Rudebeck, Head of Non-US Corporates, Western Asset Management Company, and David Zahn, Head of European Fixed Income, Co-Chair of the Sustainability & Stewardship Council, Franklin Templeton Fixed Income.

• What is the connection between SVB and the events surrounding Credit Suisse? Without the SVB crisis, it is unlikely the liquidity of Credit Suisse would ever have been called into question. Credit Suisse has several issues: First, there were already concerns around planned strategic changes to its business announced last October. Then, this week, its annual reporting demonstrated material weakness in cash flow accounting. Then, we had what we would consider skewed media reporting about the Saudi National Bank not increasing their stake; so, by Friday, fears that the bank had more severe governance risks and no backstop liquidity naturally became a concern to the markets. In our view, Credit Suisse’s liquidity coverage is sufficient, but the market was reacting with fear, especially after what happened to SVB—that is why we saw the support announcement from the Swiss Central Bank Wednesday night.

• Is the announcement from the Swiss Central Bank enough to stem systemic risk? We think so, for the moment, and more support could be on the horizon. We believe authorities are poised to step in if needed to avoid further contagion—perhaps not on the equity side but definitely to protect depositors. Historically, banks like the Swiss National bank have intervened during times of crisis, like COVID-19 or the global financial crisis (GFC). We think the market likes the intervention, but the market is still questioning whether it is enough.

• Is the Credit Suisse situation idiosyncratic or systemic? We would argue the Credit Suisse situation is unique and not an indication of a systemic problem across the European banking industry. European banking regulations are tighter than in the United States, and we would argue for the better. The notion of what is cash on a balance sheet versus what are considered high quality assets is not a concern at European banks like Credit Suisse because of the way European banks are regulated. What matters for Credit Suisse is their liquidity coverage ratio (LCR), which reflects the bank’s high-quality liquid assets divided by their potential net cash outflows over a 30-day horizon in a stressed environment. This LCR is specific to each bank, customized—but on average across Europe, it is about 163%.¹ Currently at Credit Suisse it is about 150%.² The question is: What comprises a high-quality asset? SVB had high-quality assets—US Treasuries—but they were long-term and thus had duration risk and had fallen in value as interest rates rose. At Credit Suisse, more than half is cash held at central banks, and the rest is government credit risk, which is marked to market. The bottom line is that the notion of what is cash versus high-quality liquid assets is not a concern at Credit Suisse and other European banks generally, as opposed to what we may see in the United States.

• Will we see more regulation following on these events? Almost certainly, most notably in the United States and particularly for smaller banks. Up until recently there were loud voices in the marketplace clamoring for less regulation, but this past week has likely quelled that noise. We anticipate US banking regulations to become more European in nature. The bailout of SVB depositors, for example, is itself a European approach. Of note, institutions and corporations are now looking more closely at bank diversification, considering how they diversify where their cash is held, but also how to diversify across fixed income. This could mark the dawn of a new era as investors diversify their cash base to avoid this type of exposure going forward.

• What to expect from central banks and rates going forward? Despite the banking sector jitters, we don’t expect we will see interest rate cuts from central banks anytime soon. Inflation is still their number one priority, as is the job market. Both are still very high. The European Central Bank just raised rates 50 basis points (bps). We believe the US Federal Reserve (Fed) will also continue to hike rates, as just last week Fed Chairman Jerome Powell was talking about not just a 25-bp hike, but a potential 50-bp move.

• Who are potential winners against this backdrop? Presumably large US banks with cash on their balance sheets and excess deposits to liabilities. Flows will go to the big banks because everyone knows they are “too big to fail.” This is a problem in the United States, as there is already too much concentration in the big banks. Naturally, smaller banks will likely struggle. Structurally, Europe’s banking system is much more consolidated than in the United States, so there is not the same competition for deposits. The SVB situation also shined a bright light on the differences between European banks and US banks as it pertains to venture capital and technology, which require very different banking needs over time. Perhaps over time private debt investors will meet some of the venture capitalists’ needs.

• How reliable are the LCR’s for banks like Credit Suisse? Given its significance, the wholesomeness of any LCR information is of great concern to investors. A lot of the ratios that banks are required to measure are designed for semi-stress situations, so the question is: How do you define that environment? In our view, it is important to remember that even in the most extreme circumstance, banks like Credit Suisse have been offered a US$50 billion backstop, with likely more to follow. As such, any extreme outflows are most certainly protected. This should provide reassurance to all depositors. Central banks are making commitments so enormous that depositors should not feel panic about any bank names currently, in our view.

• What to do with any banking-related fixed income allocations in the European Union going forward? First and foremost, we will see heightened volatility—without question—for the remainder of the year. Just looking back at the diametrically opposed behavior of the markets from January to February, we can get an idea of what to expect ahead. We’re looking at short duration and see some good opportunities in the banking sector. We are also looking at companies in the industrials area, and we believe sustainable bonds will be a good opportunity going forward as well.

• What could happen for this to become a serious liquidity crisis that affects everyone? In our view, we would need to see an enormous and dramatic deposit flight from Credit Suisse, which we do not believe will happen. Other potential stress situations could include a ratings agency downgrade, which recently happened at First Republic Bank, as well as any counterparty risk exposure. In both cases, the current central bank liquidity back stops would be enormously helpful in calming depositors and avoiding a panic.

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This information has been accurately reproduced, as received from Franklin Templeton Investment Management Limited (FTIML). No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Information Document (KID), which may be obtained from MeDirect Bank (Malta) plc.

Johann Scholtz, CFA, is an equity analyst for Morningstar Holland BV, a wholly owned subsidiary of Morningstar, Inc. He covers European banks.

The CHF 50 billion liquidity injection from the Swiss central bank announced this morning could buy Credit Suisse CS some precious time to execute a more radical restructuring than it previously envisaged. It has become clear that the current restructuring plan does not go far enough to address the concerns of funders, clients and shareholders.

We believe that the key to restoring confidence and ensuring its viability is for Credit Suisse to close down its loss-making securities trading business in an orderly fashion. While we believe the liquidity injection is positive, the situation remains highly fluid, and we keep our fair value estimate and moat rating under review.

The confirmation from Credit Suisse in the announcement that its high-quality liquid assets bond portfolio is fully hedged against interest-rate risk is welcome. This should reduce concerns around potential mark-to-market losses of held-to-maturity bonds. Credit Suisse also reiterated that its lending book remains healthy, with 90% of it comprising secured loans.

Credit Suisse’s Profitability Problem

Credit Suisse, however, has a profitability problem, not an asset quality problem. Its current restructuring plan is too complex and does not provide enough detail on the future of the investment banking business. Investment banking has been the source of many of Credit Suisse’s past woes. Under the current restructuring plan, Credit Suisse will retain the perennially unprofitable securities trading business.

The carve-out of some of the more profitable parts of the investment banking businesses into a “new” CS First Boston vehicle seems like a cosmetic change, with only vague indications of a potential IPO in the future. We believe a more radical separation of investment banking activities from Credit Suisse is needed to restore confidence. Credit Suisse should shut down the securities trading businesses. It should also clarify the ultimate ownership structure of CS First Boston with a clear timeline for an IPO or other disposal.

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Morningstar Disclaimers:

The opinions, information, data, and analyses presented herein do not constitute investment advice; are provided as of the date written; and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this document. Except as otherwise required by law, Morningstar, Inc or its subsidiaries shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. It is important to note that investments in securities involve risk, including as a result of market and general economic conditions, and will not always be profitable. Indexes are unmanaged and not available for direct investment.

This commentary may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

The Report and its contents are not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Morningstar or its subsidiaries or affiliates to any registration or licensing requirements in such jurisdiction.

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MeDirect Disclaimers:

This information has been accurately reproduced, as received from Morningstar, Inc. No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. Any decision to invest should always be based upon the details contained in the Prospectus and Key Information Document (KID), which may be obtained from MeDirect Bank (Malta) plc.