Market Volatility
SVB: Is there contagion risk for European banks?
Matteo Merlo
Equity investment analyst

Fund holdings in Credit Suisse, Signature Bank and SVB Financial Group

As of 2/28/2023

Events at Silicon Valley Bank (SVB) and Signature Bank in recent days appear to be a classic bank run with potential contagion issues – and the US Federal Reserve has moved quickly in an attempt to restore confidence, introducing an extended backstop for depositary institutions.

Over the coming days, there are several factors that will determine if this situation is contained: a) the action of stock and bond prices of other at-risk banks, b) any ratings downgrades of at-risk banks, c) depositor actions at other banks, and d) emergence of buyers for the existing assets of SVB and Signature (in the UK, the government has struck a deal for HSBC to buy SVB’s UK operations).

Looking beyond the immediate, even if the Fed’s actions are sufficient to address contagion risk for now, they do not deal with the broader question of whether the current level of interest rates is compatible for the global economy as a whole.

From a European banking perspective, exposure to the fallout appears limited as banks are heavily regulated and have far less presence in areas such as cryptocurrency, fintech and venture capital than US peers.

More broadly, European banks have a completely different structure on both the funding and asset side and there are no real ‘small cap’ or ‘niche’ listed operators in the region – they all tend to be relatively well diversified, with large funding bases built on retail branch deposits. Assets are also typically better matched to funding duration, shorter term and more liquid in case there is a need to cover deposit outflows, and a large part of securities held will be rates swapped (and so less impacted by rising interest rates).

Equity investment analyst Matteo Merlo says share price falls among European banks in recent days are difficult to reconcile with these solid fundamentals and investors may be using events at SVB as a chance to take profits after the sector was up around 20% over the year to mid-last week.

Compared to US equivalents, he says EU banks, in general, have:

- Less interest rate risk as IRRBB (interest rate risk in the banking book) regulation limits what they can do

- Better liquidity ratios

- So far, less quantitative tightening: in Europe, it is only 0.1% of the deposit versus 0.5% in the US

- Lower and less volatile system loan and deposit growth in recent years.

“SVB seems a very idiosyncratic case with a unique business model, where the deposit level increased threefold from $61 billion to $190bn between December 2019 and December 2021. That growth is unique and something I have not seen see at any European bank,” he adds.

European banks also have ample liquidity buffers: to give two high-profile examples, BNP has €461 billion in terms of buffer (assets or eligible assets in central banks) and Barclays £318bn.

“In line with IRRBB rules, EU banks do not take on large amounts of interest rate risk, with implicit limits on how they can run their asset-liability management,” says Merlo. “Most EU banks are subject to these rules, as well as liquidity coverage ratio requirements, and Europe is tightening regulations further by adding a maximum net interest income loss hurdle. Under this regime, relatively small banks, with around €50bn in assets, are under European Central Bank (ECB) supervision, whereas in the US, SVB, with more than $200bn, has a different regulatory framework to larger names like JP Morgan.

“European banks’ Common Equity Tier 1 capital (the highest quality of regulatory capital) came under pressure during the Italian sovereign crisis, and since then, the ECB has focused on banks’ sovereign bond portfolios. It has run regular stress tests on the risk from higher rates on these portfolios, including the part held to maturity and accounted at amortised cost. Today, the ECB is signing off on dividend and share buybacks from banks, which suggests it sees no major risk on the horizon.

“Finally, European banks are not seeing any deposit outflows so far and customer deposits are still growing. We do expect outflows as quantitative tightening progresses but it will be co-ordinated.”

Overall, the European banking sector is arguably in its strongest operating position since the Global Financial Crisis. Capital ratios and profitability are at all-time highs and names such as BNP, Barclays and UniCredit have all built up excess capital. All of this does not imply an accident cannot happen but risk of contagion on the deposit side in Europe looks small today.

Matteo Merlo is an equity investment analyst at Capital Group with research responsibility for banks and asset managers in Western Europe. He has 12 years of investment industry experience and has been with Capital Group for two years. Prior to joining Capital, Matteo worked as an executive director at UBS Asset Management. Before that, he was a senior equity and credit analyst at Generali Investment Europe. He holds both a master's and bachelor's degree in economics and finance from Cà Foscari University of Venice, graduating cum laude. Matteo is based in London.

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