Insight

Applied philosophy - Tighten until something breaks

Applied philosophy - Tighten until something breaks

When central banks tighten, something tends to break. Business models take time to adjust to a higher interest rate environment, thus the faster the tightening, the more likely that accidents happen, in our opinion. Higher financing costs can also make certain business models unsustainable, which looks evident in the banks sector. Although we think the probability of a large-scale crisis is low for now, an increasingly difficult macro environment and pressure on margins will be major headwinds for the sector. 

We think it is not coincidence that banks have hit turbulence around the one-year anniversary of the first rate hike in the current monetary tightening cycle by the US Federal Reserve (Fed). After a long period of ultra-loose monetary policy in not just the US, but in most countries around the world, a sharp rise in interest rates has exposed business models that are no longer profitable when financing costs are higher. 

In our view, it is telling that the first bank to fail this year, Silicon Valley Bank, was involved in an area that was hit first by rapidly rising interest rates. The next domino to fall was Signature Bank, also connected to the cryptocurrency world, while 11 of the largest US banks deposited $30bn into First Republic in an attempt to restore confidence. This series of events sent shockwaves through the banks sector and raised concerns over uninsured deposits and high potential losses in banks’ securities portfolios. 

In the meantime, Credit Suisse was rocked by comments by its largest shareholders, the Saudi National Bank, when they stated that they will not raise their investment in the bank citing regulatory limits (they want to avoid the regulatory burdens that come when a shareholding reaches 10%). This followed the delayed release of their annual report on 14th March 2023, which showed an increase in customer outflows to SFr 110bn in the fourth quarter of 2022. Pricewaterhouse-Coopers, their auditor, has also included an “adverse opinion” on the effectiveness of the bank's internal controls over its reporting. In the current environment of heightened sensitivity to loss of deposits after the collapse of several US banks, this drove a significant negative response from investors. In the end, a merger with UBS resolved the immediate threat and allowed financial markets to stabilise. 

Although these incidents look well-contained for now, considering that they are relatively small (combined total assets of $1.1tn as of end-2022 compared to $166tn for the broader financials sector based on Datastream World indices), we cannot rule out further incidents in the sector as long as interest rates remain high (the increasing pressure on Deutsche Bank, for example). Nevertheless, it shows the risk of unintended consequences when central banks make such abrupt changes in policy. It may also make them more cautious about further tightening, especially if their mandates require them to maintain financial stability alongside reaching their inflation targets. 

Figure 1 – Bank failures in the United States and Federal Reserve monetary tightening periods since 1934
Figure 1 – Bank failures in the United States and Federal Reserve monetary tightening periods since 1934

Note: Data as of 21st March 2023. The chart shows the total number of bank failures per year since 1934 in the United States based on Federal Deposit Insurance Corporation data and the total assets of those banks. Total assets are expressed in 2023 prices by deflating with the US consumer price index. Shaded areas indicate years during which the US Federal Reserve raised its target rates or their equivalents. Source: Federal Deposit Insurance Corporation, Global Financial Data, Refinitiv Datastream, Invesco.

How would we know that another financial crisis is brewing? First, monetary tightening does not automatically lead to financial crises; it is necessary, but not sufficient. As Figure 1 shows, not all Fed tightening cycles were followed by a large number of bank failures in the United States based on data from the Federal Deposit Insurance Corporation. There were only three periods between 1934 and 2022 when rate rises were followed by systemic financial crises. Interestingly, the largest number of total bank failures were recorded during the Savings & Loans Crisis (S&L Crisis) in the 1980s, but those banks were relatively small in terms of their total assets. It seems that the same applies to the wave of bank failures following the Great Depression in the 1930s. What made the Global Financial Crisis (GFC) in 2008 so dangerous was not the sheer number of financial institutions that experienced difficulties, but their importance to the functioning of financial markets. 

Second, serious crises usually followed periods of deregulation. For example, most banking regulations that we take for granted today did not exist in the 1920s. The S&L Crisis was also followed by a wave of deregulation allowing thrifts to offer a wider range of products and loosened financial reporting rules. By the early 2000s, banks were allowed to combine their investment and commercial banking operations, which contributed to the use of novel financial instruments that led to the GFC in 2008. More recently, although smaller banks were excluded from the strictest measures of oversight in 2018 in the US, the largest banks are still subject to regular stress tests, while most of the international regulations that were tightened after the GFC are still in place. 

Third, banking crises were preceded in the past by loosening lending standards, which increased revenue growth and profitability by allowing banks to lend to riskier borrowers and charge them higher rates. This was frequently combined with new methods to reduce risk or compete for customers. For example, before the S&L crisis, lenders offered mortgages on low rates and interest-bearing checking accounts to compete for customers, which became unsustainable as rising interest rates squeezed profitability. Also, securitising mortgages seemed like sensible risk management in the early 2000s, but it turned out to be just a way of spreading issues more widely after a housing downturn in the US reduced the value of those instruments causing a crisis of confidence in the banking system. For now, we see neither financial engineering causing problems, nor a loosening of lending standards (see Figure 2). In fact, we think that recent bank failures will make the sector more conservative, and we expect lending volumes and standards to remain tight or even tighten further. 

Finally, although banking relies on an asset-liability mismatch (for example, long duration loans financed by deposits), absent of a serious panic, this is unlikely to become a major issue. Unless banks are forced to cover major outflows, the $620bn of unrealised losses on the securities holdings at US banks at the end of 2022 will remain an accounting issue. Most of those securities are also in US Treasuries and Mortgage-Backed Securities with an implicit US government guarantee and are unlikely to face the same  downgrades as Collateralised Debt Obligations in 2007-08, for example. Also, we think that the recent rally in sovereign debt will have reduced the total amount of unrealised losses. 

Figure 2 – US Senior Loan Officer Survey Tightening Standards for Commercial and Industrial Loans
Figure 2 – US Senior Loan Officer Survey Tightening Standards for Commercial and Industrial Loans

Notes: Data as of 28th February 2023. The chart shows the net percentage of senior loan officers reporting tightening standards for large- and medium-sized firms in the United States. The data series starts in May 1990. 
Source: US Federal Reserve, Refinitiv Datastream, Invesco 

Figure 3 – Global banks sector net profit margin vs US yield curve
Figure 3 – Global banks sector net profit margin vs US yield curve

Notes: Data as at 28th February 2023. Past performance is no guarantee of future results. We use the Datastream World Banks Index to represent the global banks sector. The yield curve is calculated using the redemption yield on the 10-year minus the 2-year Datastream United States Treasury Benchmark Bond. 
Source: Refinitiv Datastream and Invesco 

For the moment, we think the probability of a serious banking crisis is low despite a sharp rise in interest rates. In our view, absent another energy or supply chain crisis, the global economy will avoid the toxic combination of high inflation and rising unemployment that contributed to the large number of bank failures in the 1930s and 1980s. Deregulation has been limited and lending standards have not loosened meaningfully. 

However, the banking industry relies on confidence and when that evaporates, a run on deposits can quickly turn a liquidity crisis into a solvency crisis. In our view, these deposit withdrawals can also happen faster than in the past with social media and online banking giving regulators and central banks less time to react to stabilise the situation. This makes the positions of individual banks more fragile.  

We also think that banks will face an increasingly adverse macroeconomic environment even if inflation moderates further allowing central banks to pause tightening policy (see The Big Picture for more detail). Rising interest rates have been a tailwind for banks so far, as they were able to increase lending rates to customers, but that may be reaching the limits of affordability. 

At the same time, deposit rates have remained relatively low thus increasing bank margins, though we think that will change especially if deposits fall. Consumers have been using up their pandemic-era excess savings to soften the impact of high inflation and that has driven upside surprises in economic data. However, that potentially means lower deposits, which may put pressure on banks to raise deposit rates as competition for customers increases, which can compress margins.  

Net profit margins of global banks have been under pressure for the last 12 months based on the Datastream World Banks index (Figure 3). That partly reflects the slowdown in investment banking, but we cannot shake the feeling that sector outperformance has been increasingly detached from fundamentals. In the past, net margins peaked around the time the US yield curve inverted, which also appears to be the case this time. We think that a potentially more difficult operating environment coupled with increasing fragility will make it unlikely that the sector will outperform and therefore we remain Underweight in our model sector allocation. 

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