investment insights
US’s ‘March’ bank crisis is likely to linger longer
Key takeaways
- US banks posted solid first-quarter earnings, but concerns over smaller lenders’ balance sheets persist
- Fed steps to stem contagion to the financial sector have helped; further actions may include higher deposit guarantees. However, tighter regulation is likely, and it will weigh on US banks’ profitability
- Tougher lending conditions are slowing economic activity. We believe that this increases the likelihood of a mild US recession
- While risks of contagion appear limited to smaller lenders, we remain cautious on the US banking sector, and prefer European bank stocks.
March’s banking crisis is not over yet. Investors are closely watching US bank stocks as worries about the deposit outflows of regional lenders drag on. Higher interest rates and tightening credit conditions are curtailing smaller lenders’ ability to reinforce their balance sheets, and all US banks face the possibility of higher regulatory costs. Still, the crisis looks limited, and the European banking sector is much healthier.
Amid these concerns, US banks posted solid earnings for the first three months of 2023. That is largely thanks to rising interest rates, leading to a 33% gain in net interest income and a 15% improvement in revenues. However, earnings per share estimates were slightly trimmed as investors took into consideration lower net interest income guidance. Many banks report that they plan to halt, or at least slow, share buy-backs in the face of current economic uncertainties and rising regulatory costs.
Overshadowing the quarter’s earnings however were worries about balance sheets. After the failures of Silicon Valley Bank, Silvergate Bank and Signature Bank in March, the Federal Reserve’s efforts to contain investor fears looked to be working. The US central bank introduced a lending facility to give banks access to liquidity to meet customer demands for cash. Then JPMorgan stepped in to buy First Republic Bank’s assets on 1 May, and last week, following reports that it was exploring its options and holding talks with potential investors, Pacific Western Bank reported withdrawals of 9.5% of its deposits.
What could stop this negative feedback loop? The Federal Deposit Insurance Corporation (FDIC) is studying options to lift the existing USD 250,000 guarantee on deposits to boost customers’ faith in the banking system. Banks with high levels of deposits over this existing threshold, including PacWest, have to date borne the brunt of outflows, that customers then mostly placed with larger institutions (see chart 1). The FDIC’s preferred option looks to be an increase in the guarantee for specific segments, notably for business payments accounts. Federal insurance already covers a record USD 10.4 trillion in customer savings and any changes to the insurance ceiling, including removing the limit entirely, would require Congressional approval. That carries political risk at a time when the nation’s debt ceiling is in question.
Banking profitability in the US will also be challenged by tighter regulatory demands. Stricter requirements will especially impact lenders with assets of less than USD 250 billion. These banks benefit from looser regulation: they are for instance not subject to the US’s Total Loss Absorbing Capital (TLAC) requirements, dating from 2015, and designed to make sure that systemically important banks have adequate equity to absorb or ‘bail in’ losses, rather than depend on a government ‘bail out.’ Large US banks, and most European lenders of every size, are already subject to ‘bailable debt’ requirements. This is likely to change and tighter regulation on a number of fronts has the potential to reduce profitability and lead banks to build capital, which will also slow loan growth. If phased in over several years, it should prove manageable.
While it is too early to say whether we have seen the last US bank failure, we do not see any signs of contagion set to sweep the US banking sector and create widespread economic damage.
Tighter monetary policy, tightening credit
From a macroeconomic perspective, more restrictive credit may be one of the roads that increases the likelihood of a mild US recession before the end of 2023. Lending conditions are now consistent with historic downturns. Weaknesses are visible in the most interest-rate sensitive economic sectors, such as manufacturing, housing, and private investment, as well as commercial real estate. That said, the Fed has taken note of the banking system’s stresses, and adjusted its policy. The risk of further aggressive monetary policy tightening has decreased significantly after it signalled a pause on 3 May, following a 25 basis point increase in the policy rate to 5.25%. We expect this to represent the peak of this hiking cycle.
The lenders most vulnerable to pressure on deposits are those small and regional banks with less than USD 250 billion in assets. They are also key to financing the US real estate market. Since the Great Financial Crisis, small banks have increased their share of the commercial real estate market from 55% to 70% of all loans and leases.
The Fed’s latest weekly data suggest that while loans by small banks are not growing rapidly, they have not collapsed. Similarly, while loan and small business surveys point to tighter credit ahead, we see little evidence of serious risk of a systemic crisis (see chart 2).
Still, unlike many economic cycles of the past, the current strength in the US is not driven by credit. Despite stresses in the banking system, loans continue to be made, and so the impact of tighter monetary policy on the wider economy may remain modest. We continue to expect the US to experience a mild recession later in 2023, making it likely that the Fed will pause its rate hikes for the rest of this year at least.
The ramifications of March 2023’s banking crisis will be felt for months to come. The US banking sector faces numerous headwinds, and while the country’s regional lenders will be most affected, large American banks should emerge relatively unscathed. Even without the events of March, at this point in the interest rate cycle deposit pricing typically increases, while deposit growth slows or even turns negative. While that should be manageable, we remain cautious on US banks’ equities, which, in the medium term, face profitability pressures from more expensive deposits, and higher charges for deposit insurance after the recent bank failures, and a likely increase in regulation.
Within global financials, we prefer European and Japanese banks. Europe’s banking sector looks healthier. The continent’s interest rate cycle lags the US, and large and small European banks are already subject to quite stringent capital requirements, have more liquid balance sheets, and are returning capital to shareholders. So do Japanese lenders, which are increasing their stock repurchase plans. Elsewhere, while the asset management industry continues to deal with structural challenges of declining fees, we see secular tailwinds for exchange platforms and opportunities in payment companies.
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