Fear of contagion follows bank failures

Investment strategists tend to write off recent banking turmoil as a crisis of confidence and liquidity, rather than one driven by fundamentals, which would make a repeat of the 2008 crisis unlikely. But emotional contagion can be equally damaging to markets and economies, making it difficult to see whether we are out of the woods. 

The macro-economic trigger that led to the collapse of Silicon Valley Bank (SVB), Signature Bank and Silvergate Bank in the US, and then Credit Suisse in Switzerland, was the fastest interest rate hiking cycle in 40 years. But the contagion effect has played an equally important role, says BNP Paribas Wealth Management’s global chief investment officer (CIO) Edmund Shing.

“Fundamentals are nowhere near 2008, but when you get mass hysteria, it can be very difficult to predict,” he says, highlighting social media’s role in fuelling a “a chain reaction” by disseminating information and rumours quicker than in previous crises.

“The problem is that misinformation can be spread just as easily as true facts, accelerating this whole cycle of psychological contagion,” he says. “This why authorities need to act immediately to counteract that.”

Mr Shing notes that while investors are looking for “the next Credit Suisse in Europe”, no such bank exists. Deutsche Bank, which suffered a sudden share price drop in March, was profitable in 2022 and will be even more profitable this year, having long completed its restructuring, he adds.

Emergency backstops

Widespread use of mobile banking, concerns about the safety of bank deposits and the massive gap in interest rates between US money market funds (which offer up to 4.7 per cent) and deposits (which deliver 0.5 per cent on average) have exacerbated issues with US regional banks, which are also perceived to be riskier because they account for three quarters of all real estate loans. This sector — especially office space — is increasingly under pressure, having not yet recovered from the pandemic’s lockdowns.

“The speed at which four banks failed on both sides of the Atlantic, within 11 days in March, was quite extraordinary,” states Nancy Curtin, CIO at global multi-family office Alvarium Tiedemann (AlTi). “But we don’t think this is a ‘Lehman Brothers’ moment. It was a classic bank run liquidity issue, exacerbated by social media and mobile banking in a way we didn’t see in the 2008 financial crisis.”

The failures of four banks were “idiosyncratic” events, due to poor risk management and exposure to riskier parts of the economy or business, Ms Curtin notes, adding: “Confidence in the banks is critical, because what starts as a confidence issue, like in the case of SVB, can end up as a solvency problem.”

Although the US Federal Reserve (Fed) stepped in and provided emergency backstops, US Secretary of the Treasury Janet Yellen has not been able apply "the Draghi principle" yet, she says, unlike European Central Bank’s president Christine Lagarde.

Nancy Curtin, CIO at Alvarium Tiedemann, does not think this is a ‘Lehman Brothers’ moment, but a bank run liquidity issue exacerbated by social media

“Markets may force a clearer statement as to what would happen to uninsured deposits — those above $250,000 — in the US, if there were further risks in the banking system,” says Ms Curtin. “And I do believe the Congress, the Fed and the Treasury will do 'whatever it takes' to protect the financial system and depositors.”

Even protecting uninsured deposits for at least six months would be helpful to get through the crisis, she adds, believing there is no trade-off between controlling inflation and pursuing financial stability. Central banks have different tools to pursue both objectives.

If depositors rushed to withdraw funds, 186 more US banks could fail, as they would be forced to realise heavy losses on long-term bond investments, according to recent analysis from Stanford University.

Banks in the EU look more attractive than in the US, where only banks with assets greater than $250bn, deemed to be systemic banks, go through a strict stress test. In the EU, all banks are regulated and in a stronger capital and liquidity position than US counterparts, adds Ms Curtin. AlTi has made no tactical change to client portfolios since the start of the banking sector turmoil, keeping its underweight to financial stocks and adopting a long-term view to investments for ultra-wealthy clients.  

Massive consolidation

BNP Paribas maintains overweight exposure to financial stocks, with a bias toward European banks and insurance companies, believed to be cheaper than US counterparts and more likely to face recession because of tighter credit conditions.

Europe’s improving economic outlook, having exited the energy crisis, is expecting a further boost from China’s reopening. The momentum is being fuelled by a wave of global liquidity, increasingly coming from the US and potentially Europe, aimed at supporting the banking system in the short term.

Despite concerns, investment strategists are confident that the US Congress, the Fed and the Treasury will do ‘whatever it takes’ to protect the financial system and depositors

Moreover, in Europe, the global financial crisis and sovereign debt crisis have already pushed massive consolidation in the banking sector, with many banks being swept into better capitalised institutions, says BNP Paribas’s Mr Shing. He predicts further consolidation among US banks to happen soon.

BNP Paribas recommends exposure to universal banks, particularly “more understandable” retail players with dependable business models, less volatility and “fewer nasty surprises buried deep within their activities,” compared to investment banks, Mr Shing notes. The latter do not offer an attractive risk reward outlook in the long term, he says. “Risk-taking can get out of control in an investment bank,” unless top management can get on top of it.

Attractive entry-point

But a different viewpoint comes from Darrell Cronk, CIO for wealth and investment management at the Wells Fargo Investment Institute, preferring US over European banks. The financial sector “has cheapened rather materially”, as a result of the latest banking strain, he says. “Historically, attractive valuations for banks have been levels where they approach one-times tangible book value, a level not far off for many larger banks today.”

While small and medium-sized banks sold off more than large banks, he favours the latter. Large, well-capitalised banks “are the beneficiaries of some of the deposits flight” from smaller players, he notes.

The sector’s immediate challenges focus on margins and earnings, says Mr Cronk, with banks forced to pay higher deposit rates to face down competition from US Treasuries, money funds and investment grade corporates.

Investors will be weighing cheaper valuations against longer-term challenges when deciding whether to buy into an economy “approaching stall speed,” he says. At current valuation levels, banking stocks can represent an attractive entry point for longer term investors, while offering “fairly robust” dividend yields, with the income component being “a nice complement to potential price appreciation”.

But tightening lending standards, which will particularly affect small and medium-sized banks, increase probability of a US recession later in the year. Although this is expected to be mild to moderate, and largely priced into markets, it prevents Wells Fargo from moving from today’s neutral position to overweight on banking stocks. “There will be a better price entry point at some point in the future,” explains Mr Cronk.

While systemic risk has abated, this latest episode resembles an echo crisis that bounces from one place to another. “There is always possibility of contagion risk, specifically because this is a crisis of confidence and liquidity, and not one of valuation or credit,” adds Mr Cronk.

The next ‘echo’ may show up in the banking industry, in the hedge fund community, in the commercial real estate world or other areas. It could also materialise in emerging markets, he says, where history shows problems often emerge under extreme strain when central banks follow aggressively tightening monetary policies.

Record debt

The recent banking turmoil was a “wake-up call” for central banks’ “relentless fight” against inflation, says Julius Baer’s group CIO Yves Bonzon, who believes it is “high time” for central banks to pause interest rate hikes. They should await further evidence of how inflation is behaving before deciding on the next step, he explains, considering that “every single inflation or growth indicator is pointing south at the moment”.

Fundamentally, the banking sector in the US and Europe remains sound, he says, but exiting financial repression after so many years of “high-dose asset purchases and zero- or negative interest rates” is highly risky and has to be done smoothly, to avoid destabilising the financial system. “Due to the record amount of debt in the world today, the frontier between an inflation problem and a deflation crisis is very narrow,” he says. “Admittedly, the fire is easier to put out when inflation is not a problem. But central banks cannot ignore the financial stability dimension.”