European banks: in the spotlight

Global banking analysts, it seems, are burning the midnight oil. Fresh from working through the implications of the failure of Silicon Valley Bank (SVB) in California, the focus of attention has now shifted to Credit Suisse,* with the troubled institution asking the Swiss National Bank for support to restore market confidence in order to avoid a liquidity crunch and avoid contagion for other Swiss banks. This has rightly caused investors to question whether there is a read-across in the European banking sector more generally.

Despite the volatility so far witnessed in financial markets, while the impact of the SVB fallout on the European banking sector is limited, European banking investors are not out of the woods yet, in our view. While, on the surface, the woes of Credit Suisse seem to have been driven by a series of scandals and specific events, the overall question now is one of a lack of investor confidence. Of course, if Credit Suisse were to fail as a result of this, it would inevitably change the dynamics of the European banking system given its ‘too big to fail’ status.

How exposed are European banks?

Comparisons between the dynamics of US and European banks, while inevitable, are unfounded in our view. Even though there may still be a potential risk of contagion in the global banking sector, resulting from higher funding costs, our view is influenced by the fact that European banks are healthier than their smaller US counterparts.

Courtesy of different accounting standards and the Basel regulatory framework, European banks are obliged to carry less interest rate risk. In addition, all European banks, regardless of size, are required to mark-to-market their securities portfolios: not a requirement for smaller US banks. At the same time, every European bank must comply with liquidity coverage ratios¹, while in the US only banks with more than US$250 billion in deposits are covered².

Furthermore, outside of some extreme cases, there have been very limited deposit outflows in Europe. Smaller European banks tend to be retail-based deposit franchises, serving a market that is much more ‘sticky’ in nature.

Will we be changing our investment stance?

Despite the idiosyncratic nature of both the SVB and Credit Suisse crises, banking is a confidence business and investor nerves are understandable. Let’s not forget that this drama is being played out in an environment where the global economy is potentially going from stagflation towards recession – arguably a situation ripe for event risk across a range of sectors. We continue to believe that European bank balance sheets are fundamentally sound but think the, “Who’s the next Credit Suisse?” question will linger over financial markets for the foreseeable future.

In Active Strategies, we continue to concentrate our efforts on credit research, ensuring that we identify issuers which are fundamentally sound. This period of volatility may be causing sleepless nights for bank analysts, but it’s also creating alpha opportunities for our portfolios.

*For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

1. https://www.bis.org/publ/bcbs238.htm 

2. https://www.occ.treas.gov/topics/supervision-and-examination/capital-markets/balance-sheet-management/liquidity/liquidity-coverage-ratio-final-rule.html