This week’s update is written by Charles Carpenter in our Jersey office.
This month has seen the most significant banking failure since the Global Financial Crisis (GFC) as the run on Silicon Valley Bank (SVB) shook the banking sector. The US regulators quickly stepped in, and the Federal Deposit Insurance Corporation insured customer deposits as SVB’s holding company filed for bankruptcy protection. To reduce systemic risk, the Federal Reserve (FED) also used its FIMA Repurchase Facility to increase liquidity, a facility that allows banks holding US Treasuries to enter Repurchase Agreements with the FED.
Credit Suisse (CS), a pillar of Swiss finance and established in 1856, saw its share price collapse almost 70% before the Swiss authorities stepped in and brokered a rescue deal with UBS. Despite UBS agreeing to takeover Credit Suisse, what caused shockwaves across the market was the write-down of its Additional Tier 1 (AT1) bonds, to the value of around 16 billion Swiss francs about $17bn)1.
Following the GFC, banks are required to hold AT1 bonds to sure up their balance sheet. AT1s, also known as Contingent Convertibles (CoCos) are only available to professional investors because they are higher risk – they can be converted to equity to help absorb losses if a bank’s Common Equity Tier 1 (CET1) falls to a predetermined level. CET1 is the core capital that banks use to fund business activities and is the highest quality of regulatory capital. However, contractually the AT1 bonds issued by CS would be a ‘total write down’ if government support was provided to the bank. Following this decision, the European Banking Authority (EBA) and the Bank of England (BoE) released statements on the merit and hierarchy of AT1 bonds over common equity with European Central Bank President, Christine Lagarde, stating that “Switzerland does not set standards in Europe” 2.
While closer to home, contagion across the banking sector hit Barclays and Lloyds Banking Group, the second and third largest UK banks, negatively impacting their share price.
While the banking sector retracted, the AT1 market also suffered as investor sentiment turned sour after the fallout from CS. It is important that investors with UK banking exposure understand that since the GFC, in-scope banks are subject to stress testing to a level that is more severe than the conditions witnessed in the UK during 2008.
The BoE stress tests banks in two ways against various hypothetical scenarios. The BoE measures the outcome of these scenarios to ensure that banks hold sufficient capital to meet unexpected losses.
Each year the BoE carries out an Annual Cyclical Scenario (ACS), that looks at shock scenarios with different levels of severity. The ACS is not a forecast of macroeconomic or financial conditions but a series of events likely to stress banks’ capital levels. The 2022 ACS looks at a five-year horizon, stress testing banks against the following conditions: interest rates rising to 6%, UK GDP falling by 5%, and residential property prices falling by 31%. As well as inflation peaking at 17% and remaining inflated at an 11% average, unemployment almost doubling to 8.5%, and oil reaching near record highs of $160 per barrel. The stress test is designed to see how a bank’s capital level would withstand weaker household real income growth and lower confidence, with tighter financial conditions, resulting in a global recession. The 2022 ACS results will be published in summer 2023 and the 2021 ACS results showed that UK banks had sufficient capital3.
The second test takes place every two years and looks at an exploratory scenario of risks that are unlikely to happen but are still a concern, such as a large bank failing. The BoE has a range of powers that it can exercise should a bank not perform satisfactorily under stress testing and the BoE can order banks to strengthen their capital position within a given timeframe. In addition to the above, the Financial Services Compensation Scheme also protects bank deposits of up to £85,000.
Despite the contagion in the banking sector, it is important that investors remain focused on the fundamentals and understand that the main UK, European and US banks have strong capital and liquidity levels and are subject to a high degree of supervision. The authorities have also learned from past mistakes, and this is a very different scenario to the GFC in 2008, which was largely about the poor and deteriorating quality of bank assets, i.e. mortgages based on falling house prices. At current valuations, UK banks in particular look attractive and are likely to take further steps to strengthen their balance sheets. It may take a while longer for confidence in the sector to improve, and volatility will continue in the interim, but the highest quality banks should reward investors longer term through higher share prices, share buybacks and increased dividends.
We wish you a good week.