Issues at smaller US banks and the collapse of Credit Suisse are not the makings of a new credit crisis, investors argue.
Stock markets are once again making front page news. Silicon Valley Bank (SVB) in California has been rescued by the US central bank, while First Republic Bank has had to be supported by large US banks. In Europe, the Swiss central bank had to step in to provide liquidity to Credit Suisse (SIX:CSGN) following customer withdrawals – and now UBS has announced that it will buy its struggling rival.
The collapses are sending ripples across financial markets. In the UK, where financials make up a quarter of the index, the FTSE All Share has fallen about 8% since the SVB news broke. The S&P 500 index has dropped about 3%. The S&P Global 1200 Financials Index, which owns about 200 banking companies from around the world, has fallen nearly 15% in two weeks.
One of the triggers has been rapidly rising interest rates. SVB held long-dated US government bonds on its balance sheet but did not update their real-time market value. This meant that when its customers took money out, it had to liquidate its bonds at a loss and it could not raise enough money to honour withdrawal requests. Worries about the solvency of regional banks in the US spread, and First Republic Bank, another California-based bank.
Credit Suisse said it found “material weakness” in its 2021 and 2022 financial reports. It has also been involved in a number of recent scandals, such as providing financing to collapsed US hedge fund Archegos Capital and failing to prevent money laundering to criminal gangs. Its share price collapse and huge losses last year forced the Swiss central bank to provide emergency liquidity, before rival UBS agreed to buy it for around €3 billion (£2.6 billion) over the weekend.
But despite the crises, professional investors are not worried about a banking crisis, similar to 2008, that will spread to the real economy and lead to more banks going under or being rescued.
Not a banking crisis, but consequence of rising rates
BlackRock Investment Institute, a research team at the world’s largest asset manager, argues that the market gyrations of past weeks are not rooted in a banking crisis, but rather are evidence of financial cracks resulting from the fastest interest rate hikes since the early 1980s.
It says that markets have woken up to the damage caused by rapidly rising interest rates and are now pricing in recessions.
It adds: “The trade-off for central banks – between fighting inflation and protecting both economic activity and financial stability – is now clear and immediate. The financial cracks are unlikely to deter central banks from trying to get inflation back closer to their targets.”
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As a result of the crises, markets are pricing in fewer interest rate rises, but BlackRock says that they are wrong and central banks will keep raising rates to fight inflation.
“We expect major central banks to keep hiking rates in their meetings in coming days to try to rein in persistent inflation,” it said.
Chris Iggo, AXA Investment Manager chief investment officer, also argues that the current problems are not reminiscent of 2008.
“My view is that the genesis of this crisis is an interest rate one. Higher rates have exposed some weak risk management practices and where there are duration mismatches between assets and liabilities, any requirement to make good on the liabilities is going to result in realised losses.
“The global financial crisis was a credit crisis – the problem was poor-quality housing related assets on bank balance sheets.”
However, Iggo adds that due to economic issues, the crisis could evolve from an interest rate crisis into a credit crisis.
“If so, the outlook for credit and equity markets becomes more difficult,” he said.
What about Credit Suisse’s collapse?
However, Credit Suisse’s collapse could have further ramifications for banking shares and bonds. As part of its acquisition by UBS, around £14 billion worth of “Additional Tier 1” bonds will be wiped out.
These AT1 bonds offered higher yields than other types of bank debt, but were riskier as they would not get priority for protection if the bank failed. They also convert to shares if certain conditions are met, such if a bank’s assets fall below a certain level.
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Charles-Henry Monchau, chief investment officer Swiss group Syz Bank, said: “This is an arresting development, given that even unsecured bondholders usually rank above equity holders in the capital structure. So for equity holders to get ‘something’ and contingent convertible bond (CoCo) holders to get ‘nothing’ raises serious questions about the real value of CoCo bonds.
“This is creating contagion risks on CoCos. There is also a risk of spillover effect on global bonds.”
Investors in banks can reduce risk when investing in banking shares by being prudent about the types of companies they invest in, according to the managers of the Polar Capital Global Financials investment trust.
They say that against the tricky backdrop of rising interest rates, investors should look at a number of factors before buying bank shares.
One is the liquidity of a bank’s balance sheet, as it is important that a bank can meet customer withdrawals. Another factor is the percentage of a bank’s assets that are in US government bonds and mortgage-backed securities.
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