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26 July 2023

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In our March issue of Market Insight we covered the path to collapse of the previously unknown Silicon Valley Bank. At the time, UK bank shares were down sharply, erasing the returns of early 2023 and Credit Suisse teetered on the edge with significant deposit outflows while markets were nervous and asset price performance reflected the concerns. To highlight the fear surrounding Credit Suisse, several emails from bond traders found their way into inboxes offering the bank’s bonds at deeply discounted prices. One of which, in a rare moment of humour from a bond desk, came with the title “One for the brave”. The article concluded with expectations of issues being centred around individual names as opposed to a system-wide problem. Since publishing that issue in March, developments within the sector have included the snap takeover of Credit Suisse by fellow Swiss banking giant UBS and the more recent closure of First Republic Bank, the third and largest regional US bank failure in little over two months. A system-wide issue continues to feel unlikely considering the strength displayed by the larger names in the space.

Credit Suisse’s takeover by UBS in March caused some controversy, in part due to the equity holders having no say in the takeover, but mostly with regards to the wiping out of some US$17bn of regulatory debt as part of the deal. Additional Tier One (AT1s) bonds are likely to be unknown to many retail investors, but they quickly hit the headlines as part of the takeover. Introduced to the banking sector after the financial crisis as a regulatory capital buffer, they sit just above common equity in the capital structure of the bank. If the bank’s shares are assigned zero value, these bonds convert to equity and protect the more senior bonds higher in the capital stack. As part of the UBS takeover, Swiss regulators enabled the cancellation of these AT1s, causing some US$17bn of losses in what has been a controversial process. Regulatory bonds of UK banks took a nosedive as contagion fears spread; Natwest’s 5.125% Perpetuals fell from near £91 to c.£74 in a matter of days. UK and European regulators quickly stepped in to assure the market they would not repeat the actions of Swiss regulators, but this failed to calm the market with the financial sector of bond markets experiencing further volatility. In the run up to its final annual general meeting, Credit Suisse’s earnings report highlighted CHF61bn of outflows in the first quarter alone, a significant figure for a bank already battling with internal control issues and the fallout of events linked to firms such as Greensill and Archegos. Clearly the bank was under considerable strain and the decision to cancel the debt from the takeover deal was required to get it over the line and prevent further concerns.

After the takeover of Credit Suisse, banking share and bond prices partly recovered in a period of relative calm. Concerns seemed to ease until the May 1st announcement of First Republic bank being taken over by the Federal Insurance Deposit Corporation (FIDC), making it the third regional US bank closure since March and the second largest in US history having been valued at US$20bn at the beginning of April. JP Morgan stepped in to take over, with CEO Jamie Dimon announcing in the aftermath that the near-term problems looked to be over, with any knock-on effects yet to be seen. These second order effects are likely to play out through tighter credit lending conditions. In Europe this is already beginning to be seen with the ECB Credit Conditions survey highlighting more banks tightening their lending rather than easing it. In the US, The April Senior Loan Officer Opinion Survey reported on tighter lending standards in all areas from household to enterprise lending. Tighter lending conditions generally result in fewer loans being written and, as a result, a slowing of economic activity.

While nerves remain within the sector, many banks are quietly showing signs of strength. Both UniCredit and Deutsche Bank signalled positively with the early redemption of some of their bond issues, and other larger names such as Barclays continue to show a solid financial position. At the end of 2022, the bank had loans to customers of £399bn against deposits of £526bn and a cash liquidity pooling in the region of £370bn that would enable it to cover nearly half of the deposit base. Clearly the larger banks in the sector are displaying significant strength in relation to some of the smaller regional US banks which have been experiencing issues.

Recent events in the sector have clearly caused some alarm, but we retain our positive outlook, seeing the issues confined to individual names as opposed to what is considered a robust system, at least for the larger players. Knock-on effects remain to be seen and, as such, we continue to watch developments with interest.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.

This article was taken from the May 2023 issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
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