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European bank sell-off hard to reconcile with fundamentals
Anita Patel
Investment Director

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

As of 2/28/2023

While immediate fallout from the Silicon Valley Bank and Signature Bank failures remains firmly US centric, markets are moving quickly to assess potential read across to the rest of the world.

As expected, a major focus is on possible contagion across the banking sector, especially if people start panicking about the safety of deposits. On the surface, this looks to be a concentrated issue, with SVB and Signature both having unique business models, but experience shows bank runs can spread fast. Meanwhile, there are also larger questions to answer around how these events could affect central bank policy and economic growth.

In the following piece, investment director Anita Patel examines the possible impact on European banks: while the sector looks fundamentally solid, there are many potential derivative effects to consider.

To provide some context, we have seen a re-rating in European banks: over the last six months to the end of last week, the sector was up 32% and has been one of the strongest performers in the MSCI Europe Index, compared with a 7% decline in US banks (figures in US dollars).

European banks have enjoyed a strong earnings season, with profitability at almost 15-year highs, and also continue to look attractively valued. From the latest reporting season, there seems to be no sign of asset quality deterioration and low deposit beta (sensitivity of deposit rates to changes in short-term interest rates). However, banks are predicting higher-than-expected costs and we are also seeing significant dispersion between them; those able to keep costs flat will ultimately be best positioned to capitalise on higher interest rates. Meanwhile, loan growth remains positive but slowing, and most banks expect low but positive growth in 2023.  

The evolving situation with SVB has resulted in a sharp sell-off in European banks this week, with trading in names including Credit Suisse, Société Générale and Italy’s Monte dei Paschi and UniCredit temporarily halted before shares fell again as problems around Credit Suisse worsened. Credit Suisse said it had found ‘weakness’ in its financial reporting and markets reacted badly as a major investor, the Saudi National Bank, confirmed it would not inject further funds into the Swiss lender. The situation remains fluid but, as things stand, Credit Suisse has announced it will borrow up to $54bn from the Swiss central bank to shore up its finances as it looks to become ‘simpler and more focused’.

Given the idiosyncratic nature of SVB’s problems, European banks were not expected to face a similar crisis of confidence to US regional names. While we continue to find the selloff difficult to reconcile with fundamentals, our analysts and portfolio managers are actively monitoring and discussing this situation.

To reiterate the backdrop, what is ultimately underappreciated is the level of regulation in the European banking sector: these institutions are subject to tougher liquidity requirements and have higher liquidity coverage ratios (LCR) than US banks. During the Italian sovereign crisis, the capital ratios of many European banks came under stress, and since then, the European Central Bank (ECB) has focused on their sovereign bond portfolios and the risk these can create. Basel III rules allow for banks’ P&L and capital to be stress tested for sudden and quick rises in interest rates, curve, and spreads − lessons have been learned.

While there has clearly been spill-over from SVB, there is a sense Europe could end up surprising positively, based on having a more robustly regulated, capitalised and liquidity-stressed banking system than the US. However, we should acknowledge it remains vulnerable to widening sovereign bond spreads in some of the periphery countries and the lack of an EU banking union.

Across Capital Group, we are generally underweight European banks and have been structurally so over the last 10 years. These stocks have generally been poor absolute and relative investments since the global financial crisis, being heavily influenced by political turmoil (sovereign debt crisis, Brexit), increased regulation and lower interest rate expectations. The sector is now emerging from a decade of financial suppression into a world of positive interest rates, however, and profitability should remain structurally higher versus the previous decade.

‘Higher for longer’ rates signal a paradigm shift for European banking and consensus also suggests that any risk of economic downturn is already reflected in their share prices. Elsewhere, solvency and liquidity are much better, many balance sheets have been repaired, and capital ratios and profitability are at multi-year highs. While loan losses will hurt during a downturn, the impact will be offset by high levels of reserves and cleaner balance sheets.

Once any economic weakness passes, banks should benefit from higher rates versus the previous NIRP (negative interest rate policy) environment. Meanwhile, regulatory headwinds are limited and the ECB has become open to share buybacks.

Our view on European banks is constructive although being selective is key: well-capitalised operators with strong asset quality, robust management teams and longer duration balance sheets are areas where we see opportunities. 

Anita Patel is an investment specialist at Capital Group. She has 13 years of industry experience and has been with Capital Group for 12 years. Earlier in her career at Capital, Anita worked as an investment product specialist manager. Prior to joining Capital, she was a client data & portfolio data specialist at Schroders. She holds a master's degree in financial mathematics from King's College London and a bachelor's degree in business administration and mathematics from Aston University. She also holds the Investment Management Certificate. Anita is based in London.


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