March proved to be a very difficult month for financials, as fears of contagion spread rapidly following the failure of Silicon Valley Bank, Signature Bank and the weekend forced sale of Credit Suisse to its domestic rival, UBS. Against this background, the Trust’s net asset value fell 9.9%, led by falls in bank shares which fell around 10.9% over the month, while our benchmark index, the MSCI All Country World Financials Index, fell 8.5%.
Gearing and an overweight position in bank stocks were the principal reasons for underperforming during the month, more than offsetting holdings in payment companies which held up well. Holdings in the subordinated debt of European financials were also weak, falling by 5.5% over the month albeit well below the 11.5% fall in European bank AT1 bonds, on the back of the decision by Swiss regulators to wipe out AT1 bond holders of Credit Suisse.
The question that this episode raises is why, when the sector is so much better capitalised with significantly greater levels of liquidity and no signs of stress, did they fail in quick succession? Ultimately the catalyst for all three was sharp outflows of deposits no different to what was seen during the global financial crisis but critically this has not been about toxic assets sat on weak bank balance sheets as it was then.
Silicon Valley Bank, which was a huge beneficiary of growth in venture capital funding for the technology sector over recent years, failed to hedge the interest rate risk on its large portfolio of US Treasuries and mortgage-backed securities it built up from the inflow of deposits into the bank. So, as interest rates rose this led to large unrealised losses, no different to that of a pension fund or bond fund but which, as a percentage of equity, due to the leverage inherent in a bank’s balance sheet, was 4x most other banks, making it very vulnerable to any loss of confidence.
Signature Bank was almost unique for a bank having significant exposure to the crypto industry, via a payments platform it owned. This resulted in significant inflows of deposits and while these were not quite on the scale as seen at Silicon Valley Bank and therefore did not leave the bank sitting on similarly sized losses, it had been under pressure over the last year as these deposit flows reversed. However, the failure of Silicon Valley Bank along with continued negative news around crypto was then sufficient to start a deposit flight in short order.
Similarly, there were never any material concerns about the assets sat on Credit Suisse’s balance sheet especially after it was strengthened by a CHF 9.7bn equity raise in October. However, weak profitability and risk management ultimately put paid to the bank staying independent as even though it had close to CHF 100bn of capital that would need to be burnt through before depositors lost a cent, the bank had lost the confidence of its investors and depositors as there continued to be a stream of negative news.
Importantly, all three stood out in having a high exposure to uninsured depositors. For example, the three US banks with the largest concentration of uninsured deposits as a percentage of total deposits were First Republic, Signature Bank, and Silicon Valley Bank, with the former at 67% and the latter two at close to 90%. This compares to a median for the US banking sector of approximately 40%. First Republic was in a stronger position than the latter two but not sufficiently so as its share price still fell 89% in March.
Against this background US authorities acted swiftly, with the launch of the Bank Term Funding program (BTFP). The program enables banks to pledge US Treasuries, mortgage-backed securities and other qualifying assets at par in return for a loan of up to one year. Crucially, the par value of collateral enables banks to access liquidity without having to sell securities at a loss. Further changes were also made to the discount window which similarly result in higher lendable values against securities eligible for BTFP.
We took the opportunity during the month to add to holdings in the subordinated bonds of banks and insurance companies which we believe continue to offer very attractive returns.As a result, we see the probability of further US bank failures in the short-term as very low, albeit not zero. Data around deposit flows would suggest that outflows from smaller banks has slowed materially, while large banks were beneficiaries of inflows. Nevertheless, banks that have suffered outflows, notably First Republic, will see a sharp contraction in their net interest margins, i.e. the difference between what income a bank receives on loans versus what it pays out for deposits, as they have had to pay up for funding to replace that lost. This will significantly reduce profitability and explains the weakness in First Republic's share price over the month.
We therefore remain cautious on smaller US regional banks. They represented 8.5% of the portfolio at the end of 2021 but we had significantly reduced our exposure over the last year, in part due to capital concerns and during the month we took the opportunity to sell the remaining holdings in smaller US regional banks while adding to JP Morgan and Wells Fargo as relative beneficiaries of the volatility. Longer term US regional banks will face higher regulatory costs, albeit any increased capital or liquidity requirements will likely be phased in over several years.
Concerns on US banks led to pressure on European financials over the month with the sell-off resulting in the region’s banks giving up all of their outperformance year-to-date. We do not consider what has happened in the US a valid read-across to European banks. In terms of balance sheet structure, European banks’ deposit bases have a higher share of guaranteed deposits, are subject to heightened liquidity regulation post Basel III and either already mark to market any unrealised losses on their securities portfolios or where they don’t already it would have an immaterial impact on capital.
Consequently, while the sell-off in the sector is understandable we see some of the share and bond price moves as excessive with the sector trading at historic lows relative to wider equity markets, which will not be immune from any second-order impacts of the banking crisis. Nevertheless, we took the opportunity during the month to add to holdings in the subordinated bonds of banks and insurance companies which we believe continue to offer very attractive returns.