A Year of Uncertainty, Collapses, and Opportunities.
Overview
The banking sector has clearly experienced a rollercoaster of a year for much of 2023. Amidst a backdrop of economic uncertainty and a looming (and still pending) recession, the banking sector started the year 2023
Then came the collapse of Silicon Valley Bank, a mid-size regional bank that then held the spot of the 16th largest bank by total assets, and shortly afterwards that of Signature Bank. An astoundingly quick loss of confidence and ensuing flight of capital saw these banks mark losses on fixed-income instruments that they otherwise wouldn’t have had depositors not collectively flock to demand their money back.
As the tide began to go out and investor confidence started to drop as weaknesses and vulnerabilities became exposed, investors rushed to decide which financial institution would be the next to fall and immediately started doing the same thing that had brought down SVB and Signature Bank. Such was the fate of long-time investment banking darling Credit Suisse, an established and somewhat reputable whose previous scandals finally did the bank in.
Once the “weak” had been herded from the crowd, the sector seemed to stabilize as consumer confidence slowly but surely began to restore.
This banking fright had investors truly worried the situation would be hard to contain and there would be more big banks to fall.
Actuality
Fast forward to July 2023, and the biggest U.S. banks’ earnings could easily have investors forgetting there was a major crisis for the sector earlier this year. Earnings calls from the likes of JP Morgan and Wells Fargo are showing signs of a soft landing, with profits in the second quarter up by more than 50% from a year earlier. Citigroup’s earnings, despite a fall in profits of 36%, still positively surprised investors as they beat analysts’ estimates.
A major bright spot for all of these three banks has been their net interest income, this being the difference between the interest rate banks charge on loans and the one they pay to depositors and a major source of revenue for commercial and retail banks. In fact, collective second-quarter net interest income figures for these three banks were up 31% from a year earlier, when interest rates were half of what they are now
This goes to show that the rise in interest rates that caused the demise of the likes of Silicon Valley Bank and Signature Bank has been largely beneficial to big banks, mainly due to the flight of capital to these banks that came from regional banks that were perceived as more vulnerable.
“I don’t know whether it’s going to be a soft landing, a mild recession or a hard recession” - JP Morgan chairman Jamie Dimon
Why is this Significant?
Although earnings from big banks show a much more positive outlook for the U.S. economy than initially feared, both economists and insiders agree that there is still much uncertainty to predict the short-term evolution of the economy. “I don’t know whether it’s going to be a soft landing, a mild recession or a hard recession,” JP Morgan chairman Jamie Dimon declared shortly after the bank released its Q2 earnings.
On another positive note for big banks, NPLs and loan defaults are still historically low, despite growing slightly during this three-month period.
Despite the encouraging economic figures, the outlook for the banking sector is not particularly rosy. We have already begun to see big banks having to step up their payment to depositors.
July Outlook
Earlier this year, we saw the failure of three mid-sized banks (including Silicon Valley Bank) in the US and the failure of a large bank (Credit Suisse) in Switzerland. There have been no lasting effects from these global banking stresses on UK banks.
However, in recent months, interest rates have continued to increase as central banks around the world act to tackle persistent inflation. The future path of interest rates is also uncertain.
Higher interest rates are making it harder for households and businesses in many countries to service their debt.
Certain sectors face particular challenges, including highly indebted businesses and global commercial property markets.
Latest Fed Decision
Federal Reserve raises the key interest rate to the highest level in more than 20 years to 5.5% as it continues to fight persistent inflation in the U.S. economy. Fed Chair Jerome Powell affirmed that central bank staffers no longer expect a recession to occur as a result of the rate hikes.
Source: Statista
We expect that the following Federal Reserve moves will be based strongly on unemployment data. As seen above, there were nearly 5 unemployed people for every job opening in April 2020, when most of the country was locked down due to the pandemic. That figure, as of May this year (2023), is 0.6. Banks will keep a close eye on their inflation forecasts.
EU Snapshot
As for the European banking sector, Banks maintain strong capital levels and abundant liquidity (the average CET1 ratio was 15.4% on a fully loaded basis by the end of 2022). Asset quality improved with banks reporting lower NPL ratios as well. However, asset quality remains the greatest concern looking forward. Thus, higher rates and consistent portfolios have led to profitability being stabilized at levels higher than in the pre-pandemic period. But some present risks are: (I) The sanctions imposed on Russia represent a high operational risk (including legal and reputational risks for banks). (II) And the growing trend towards digitization is causing concern about a higher risk of cyberattacks.
Written by: Alfonso Sepulveda (Lead Portfolio Analyst & Partner), Ignacio Paz (CEO)
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