Minimal risk for banking sector crisis to escalate

Oksana Patron

6 April 2023

Although there are similarities among bank crises, the global banking sector is currently safer than it has been in the past and presents “minimal risk” of escalation and contagion compared to the Global Financial Crisis (GFC) in 2008, according to Brandywine Global, part of the Franklin Templeton.

First of all, there is little similarity between the drivers of the US and European banking crises that are currently taking place.

Although six US large money center banks lost approximately 14% in market value, super-regionals and smaller regionals lost around 26% and 30% in value, respectively, and European banks fell 12% in market value for the same period, there are still several characteristics that distinguish European banks from the US ones.

Sorin Roibu, Portfolio Manager and Research Analyst at Brandywine Global, noted that European banks tended to more cash and therefore securities comprised a small portion of their balance sheets.  This means they did not have to sell securities at a loss to meet liquidity needs.

By contrast, the first domino of troubles for American banks was an investment portfolio comprised of Treasury bonds and government-backed securities, which by definition were assumed to carry no credit risk.

“They do, however, carry interest rate risk. Most of the time this risk is not a big deal, unless we see a significant rise in rates as we did in 2022 into this year. The Federal Reserve’s aggressive tightening cycle caused significant mark-to-market losses on these securities,” Roibu stressed.

“These are paper losses that over time will mature at par, resulting in recovery of the mark-to-market loss. The caveat here is that losses become real if the bank must liquidate the portfolio.”

On top of that, the first bank failure in the US exposed a significant number of uninsured deposits.

“Loss of confidence and liquidity shortages are the common killers of banks. History suggests that once a bank run starts, it is hard to contain and can spread to other banks,” the manager said.

“The panic spread quickly to the European banks, pushing a long-ailing financial institution over the cliff.”

However, Roibu noted that failure and arranged sale to a rival had nothing to do with the problems at US banks and more to do with mismanagement over the past decade.

“We believe this failure was going to happen sooner or later; the recent crisis of confidence just sped up the process.

“Despite the selloff in European bank shares, we see little similarity between the drivers of the US and European banking crises. In fact, for the first time in a long time, European banks’ liquidity situation appears in better shape than that of their US counterparts.”

“Despite the current fears in the marketplace, we believe that the global banking sector remains much safer than it has been in the past. Most importantly, the regulatory toolkit has evolved and allows regulators to address these crises quickly and more effectively.

“In other words, we believe this situation shall pass and with minimal risk of escalation and contagion like we saw during the financial crisis of 2008.”

Roibu also advised in response to what happened, he expected bank regulation in the US to likely increase with greater emphasis on small and mid-size regional banks and the earning power for smaller regional banks would decrease due to rising funding costs.

Following this, the European bank woes would be limited to one specific case and the risks in Europe would be largely idiosyncratic, with several characteristics that distinguish the European banking sector from that of the US helping to keep broad contagion at bay.

“Once investors realise that the current situation is not a repeat of the 2008 GFC, we think confidence will be restored, and banks can return to business as usual.

However, the manager said he remained the US market underweight, with exposure skewed more defensive and among the US banks, he preferred the large, money center banks.

On the other hand, European bank stocks remained attractive, but investors should be selective in which banks to invest.

“There is a wide difference between the quality of banks, as we have recently witnessed in Switzerland and in Germany over the past couple of years.

“There are also regional macro differences that carry implications for earnings of banks exposed to those respective countries. We prefer a select number of banks, predominantly in France and Spain, which have high-quality management and diversified business exposures,” Roibu said.