“We’re going to need a bigger boat.”
Chief Brody (Jaws 1975)

On 5 December 2006, 15 years ago, HSBC Holdings gave the first hint of trouble to the market on its US mortgage business in what would morph into the biggest financial crisis since the 1930s. Two months later, the bank warned on profits, raising provisions by $2bn, as sub-prime borrowers in the US were hit by much higher interest costs on their adjustable-rate mortgages as initial teaser rates fell away. Much like the beginning of the film Jaws, the seriousness of the situation was not appreciated. The bank’s shares fell by around a mere 1.5% that day in December and by even less on the February announcement.

HSBC was widely criticised, at the time in 2002, for its acquisition of Household Finance, a US sub-prime lender that was the driver of its woes a few years later. However, the strength of its balance sheet meant the bank weathered the global financial crisis well, so well in fact that anyone who had bought its shares on that day in 2006, after taking into account dividends, would not have lost any money, assuming the shares had been held to the end of 2009. By comparison, the average US or European bank’s share price was still down by over 50%, with many much worse.

At that time, the “smart” money in Wall Street was also packaging and selling sub-prime mortgages and an alphabet soup of structured products to unsuspecting German bank treasury departments and Norwegian municipalities. Even if Citigroup CEO Chuck Prince had stopped dancing then1, it was too late for regulators to have acted even if they had seen what was coming. For example, the Bank of England had reduced staffing levels in its financial stability department in 2004 so it was not surprising it did not see what was coming. In a May 2007 report, it stated that “the UK financial system remains highly resilient”.

Today, banks have strong balance sheets, plenty of liquidity and are more cautious in their lending appetite.

Moving on to today, the resilience of the banking sector during the pandemic highlights the steps regulators have taken since the global financial crisis that have made a significant difference. Today, banks have strong balance sheets, plenty of liquidity and are more cautious in their lending appetite. Consequently, in 2020 they were able to facilitate government-guaranteed lending programs such as CBILs in the UK and PPP loans in the US and are well positioned to benefit from the continuing recovery of economies, notwithstanding any short-term impact from COVID-19 variants.

Also due to the actions of central banks and governments, banks are very sensitive to interest rates due to the excess liquidity on their balance sheets. This means their earnings may rise sharply as and when central banks start removing the punch bowl, something that nine central banks have done already – and one famously has not. In an equity market where most companies trade on rich multiples, the shares of banks offer excellent value and are returning excess capital built up in 2020. Times have changed and the beaches are open again.

1Despite market concerns over sub-prime mortgages and reduced liquidity, Charles ‘Chuck’ Prince said of Citigroup’s commitment to leveraged buyouts: "As long as the music is playing, you’ve got to get up and dance."  The New York Times, 10 July 2007