This article was originally produced in conjunction with Boring Money for their Investment Trust Hub.

Some information contained herein has been obtained from third party sources and has not been independently verified by Polar Capital. Neither Polar Capital nor any other party involved makes any express or implied warranties or representations.

It's been over a year since the banking sector was splashed across the headlines for all the wrong reasons, thanks to the infamous Silicon Valley Banking Crisis. Now, despite some lingering apprehension amongst retail investors, the financials sector has demonstrated its resilience in the face of systemic challenges - and low valuations could make it an interesting opportunity to buy in.

2023 banking crisis debunked

The spring of 2023 saw a flurry of failures in the United States banking system. In the space of just five days in March, three banks collapsed in quick succession, leading to urgent intervention from the Federal Reserve (the central bank of the US) in an effort to protect depositors and stabilise the system at large.

First to go was Silicon Valley Bank (SVB), which collapsed after a bank run (when customers simultaneously withdraw their funds over fears of an institution’s solvency). It had sold its Treasury bond portfolio at a significant loss, leaving depositors anxious about the bank’s liquidity. Compounding the issue, much of SVB’s clientele were technology firms and wealthy individuals with large balances which exceeded the $250,000 threshold for insurance by the Federal Deposit Insurance Corporation (FDIC).

Meanwhile, Silvergate Bank and Signature Bank suffered in the midst of turbulence in the cryptocurrency market, to which both had significant exposure. San Francisco-based First Republic Bank (FRB), which specialised in private banking for wealthy individuals, was also the victim of a bank run – echoing the earlier one at SVB. It too had a large proportion of uninsured deposits exceeding the $250,000 limit; These plummeted by $100 billion in the course of the first few months of 2023 alone.

Despite a $30 billion effort from other major banking groups to rescue FRB, it would eventually shut up shop and sell to JPMorgan Chase in May.

The Federal Reserve (Fed) was forced to intervene, taking the extraordinary measure to guarantee all deposits at SVB and Signature Bank. It also led to the establishment of the Bank Term Funding Program (BTFP), which offers loans of up to one year to eligible institutions to prevent the same scenario happening again.

Nevertheless, concerns grew that the crisis would trigger a domino effect in other economies around the world. Several national banks - including the Bank of England, Bank of Canada, Bank of Japan and the European Central Bank – intervened with liquidity packages to ensure stability.

Stage one or one-off?

Despite the impact of the 2023 banking crisis, there weren’t as many failures as in previous years. 2023 saw a total of five banks shut their doors, whilst 2009 and 2010 recorded 140 and 157 respectively in the aftermath of the financial crisis, according to FDIC data. So although there were fears that the events in Silicon Valley might trigger wider instability, 2023’s closures fortunately concluded as a relatively isolated phenomenon.

“That said,” says Matt Reed, Fidelity Sector Portfolio Manager, “it was the most significant year on record in terms of the total assets of the institutions involved, largely due to the sizes of Silicon Valley Bank, First Republic Bank, and Signature Bank.”

Indeed, with assets of around $550 billion, 2023’s failures far outweighed those even at the height of the 2008 financial crisis – even 2010’s 157 closures amounted to losses of a comparatively meagre $96 billion. First Republic Bank was the 14th largest bank in the United States just months before its collapse. Silicon Valley Bank was 16th, having leapt from 34th place following a period of rapid growth during the Covid-19 pandemic. FDIC figures show SVB alone had total assets of over $200 billion as at December 2022.

These hefty numbers understandably were a cause for concern. After all, if such large institutions could fail seemingly overnight, what did that mean for the banking sector at large? Reed maintains that the five failures in 2023 can be attributed to an unfortunate combination of unique risks which left them particularly vulnerable.

“SVB and First Republic focused much of their lending activity on startups, many of which ran into trouble when interest rates began rising rapidly in 2022,” he explains. “These banks also had significant exposure to long-dated securities and loans, which quickly lost value when rates spiked. Signature Bank had an unusually concentrated deposit base, as opposed to the diversified deposit base that is more common among regional banks. The 2 smaller institutions that closed later in the year faced similarly idiosyncratic issues - one due to alleged fraud and the other due to losses on a narrow portfolio of loans.”

On top of this, the smaller banks were also disproportionately funded by uninsured deposits, thanks to a high number of customers with deposits over $250,000 FDIC limit (meaning anything over this amount is not guaranteed to be recovered in the event that the bank fails).

“Those uninsured deposits created additional risk when volatility hit the sector, as many of these high-balance customers grew fearful and began withdrawing their money,” Reed says.

A resurrection story

Over a year on and the banking sector has by and large avoided a global-scale catastrophe. In fact, despite lingering pessimism amongst retail investors, recent months have seen renewed faith in the strength of financials from within the industry itself.

In a May 2024 survey, advisory firm HLB Poland commented, “after demonstrating resilience and adaptability during a period marked by a flurry of crises, the financial sector is experiencing a resurgence in business confidence. According to our survey, 41% of financial sector leaders express confidence in economic growth, and 85% believe in their company’s capacity to grow.”

European banks... have had a revival in relative performance following a prolonged period in the wilderness

Indeed, the fund managers at the Polar Capital Global Financials Trust (PCFT) believe that something of a “resurrection” has taken place in the sector, particularly in regard to European banks.

“European banks [...] have had a revival in relative performance following a prolonged period in the wilderness,” says George Barrow, fund manager at PCFT. “We consider this reassessment of the sector’s prospects as justified and continue to see an attractive risk/reward for European banks (we are overweight in the Polar Capital Global Financials Trust). We expect the strong relative performance to continue.”

So why are the experts so resolute in its potential in 2024? The answer isn’t just because of a recovery from the Silicon Valley crisis. In fact, at the time of writing, the banking sector boasts a strong set of credentials – years in the making – which combine to make an attractive investment opportunity for even the most discerning of investors.

First of all, as interest rates have risen from record lows – it was not so long ago that we saw even negative interest rates in some scenarios - European banks in particular have become more profitable. Investors are seeing average returns of 12.3% on equity compared to an average return of just 4.9% in the post-financial crisis decade from 2009 – 2019.

While the general consensus is that interest rates have likely peaked, this doesn’t automatically mean a poor outlook for bank profits as soon as rates start to fall. Banks are more sensitive to the first few rate rises and so typically see the most benefit from the initial 2.5% increase on the base rate. After the first 2.5%, higher funding costs reduce the benefits of increased asset yields, so the gains in Net Interest Margins become smaller.

As interest rates rose from such a low starting point to what is probably a high of 5.25%, the fund managers at the Polar Capital Global Financials Trust expect bank profitability to remain “attractive” at more normal rates of between 2-3%, as much of the boost to the bottom line was delivered in those initial increases from the very low starting point.

Beyond interest rates, recent years have seen some settling in the regulatory environment, which had been tumultuous for much of the preceding decade as institutions attempted to prevent a repeat of the 2008 financial crisis. More recently, many banks have shifted the focus from pumping profits back into their coffers to rewarding shareholders in the form of dividends and buybacks.

Commenting on the newfound regulatory stability, Barrow explains further, “It was a full-time job for sector specialists just keeping up to date with all the new acronyms coming out of the European Central Bank (ECB) as part of their regulatory tightening. In contrast to the previous decade, when capital generation was used to strengthen balance sheets (rather than reward shareholders), European banks now offer a yield of >10% (including dividends and buybacks), a level we also expect to be sustained next year.”

Current valuations do not reflect the shift in the sector’s risk and earnings profile, providing an attractive risk/reward for shareholders

On top of this, while many European banks have outperformed, valuations generally remain low – offering a tempting investment opportunity for those interested in getting their foot in the door before share prices begin to climb back up.

Barrow is sensitive to the concerns of investors who may feel residual wariness from previous banking system upsets, but insists that current low valuations are disproportionately cynical.

“While the experience during the [financial crisis] lingers long in investors’ memories, current valuations do not reflect the shift in the sector’s risk and earnings profile, providing an attractive risk/reward for shareholders”.