Last week's rescue of Credit Suisse by UBS followed by concerns over Deutsche Bank sparked fears that a crisis at regional U.S. banks earlier in the month might quickly spread into a global banking crisis. Yet, European bank stocks saw gains last week (1.5%) and so far this year. In fact, they are outperforming U.S. banks by about 10 percentage points year-to-date. As of Friday's close, the MSCI Europe Financials Index has a total return in U.S. dollars of +0.5% year-to-date, while the S&P 500 Financials Sector Index lost -9.0%. Why the big difference?
First, European banks seem better positioned to handle a potential bank run when comparing their liquidity coverage ratios (LCR). The liquidity coverage ratio (LCR) compares the amount of cash and bonds that can be easily and immediately converted into cash at little or no loss of value that banks hold with the volume of deposits they would likely lose over a 30-day period during a hypothetical run on the bank. A ratio of 100% means their most liquid assets exactly match their projected stressed outflows, a requirement for U.S. banks deemed systemically important. European banks have an LCR of 166%, on average. This applies not merely to systemically important banks, with the European Banking Authority undertaking stress tests on nearly all banks with a balance sheet of at least €30 billion ($28.9 billion). By contrast, the U.S. Silicon Valley Bank and Signature Bank were not considered systemically important, and therefore were exempt from LCR requirements, despite having $212 billion and $110 billion in assets, respectively.
Second, deposit growth has been much stronger in Europe over the past year. In general, total deposits have continued to grow in Europe, whereas in the U.S. they started shrinking, putting more pressure on funding costs and liquidity.
Bank deposit trend stronger in Europe than U.S.
Source: Charles Schwab, European Central Bank, Federal Reserve, Bloomberg data as of 3/25/2023.
Third, bank balance sheets are managed differently. Silicon Valley Bank in the U.S. ran into trouble because it invested its new deposits in 2021 into low-yielding longer-term bonds that fell in value as interest rates rose. In Europe, a significant share of bank deposits were held at the European Central Bank. As a result, European bank holdings of bonds only equate to about 12% of total assets, half of that of U.S. banks, according to Moody’s Investors Service. And, in Europe, swaps are used more systematically to hedge interest rate risk than at U.S. banks.
Finally, European banks have near-peak profitability and capital ratios, having benefitted from low-cost funding from stimulus programs like the European Central Bank's (ECB's) Targeted Longer-Term Refinancing Operations (TLTROs).
In a vote of confidence echoing the stock market, the European Central Bank raised interest rates by 50 basis points on March 16 despite the volatility in the banking sector. The Swiss National Bank raised rates on Thursday of last week by 50 basis points, just days after helping to coordinate the rescue of the second-largest Swiss bank.
So far, the fallout from the banking stress has been modest. Despite the hit to many bank stocks in March, the overall stock market has held up reasonably well. While corporate credit spreads rose sharply, they are still no higher than they were in the middle of last year. Other measures of market stress, like industry-wide European bank credit default swaps (CDS, a contract to purchase protection against losses from the default of a borrower), also rose to mid-2022 levels, as you can see in the chart below. In times of financial stress, the dollar is often considered as a safe haven, and has seen a rise in value. This time, the dollar has slumped, as safe-haven demand has been more than offset by lower expectations for the terminal federal funds rate. There could have been adverse consequences for global markets and economies if the dollar had spiked in value. But with credit conditions likely to see more significant tightening as banks shore up their balance sheets, the economic fallout of the banking turmoil may not be over just yet.
Europe CDS above average but below 2022 and 2020 peaks
Source: Charles Schwab, iTraxx, Bloomberg data as of 3/25/2023.
The Markit iTraxx Europe Subordinated Financial index comprises 30 equally weighted credit default swaps on investment grade European entities.
Fortunately, Europe is encountering this stress from a position of relative strength despite the ongoing global rolling recession. Friday's flash eurozone composite Purchasing Managers' Index for March—which includes surveys of business conditions from March 10-23 when the U.S. bank closures and rescue of Credit Suisse took place—was strong at 54.1, pointing to solid economic expansion and potential profit growth.
Strong eurozone economic activity in March
Source: Charles Schwab, S&P Global, Bloomberg data as of 3/25/2023.
Yet a potential drag on economic growth from the banking fallout may be felt from higher funding costs, weaker loan growth, and lower profits. With banks under pressure to shore up their balance sheets, the main risk is that lending standards–which were already being tightened to a degree seen in the 2020 recession and 2011 debt crisis, though nowhere near levels at the peak of the 2009-09 global financial crisis–will likely be tightened significantly further.
A quarter of Europe's banks were already tightening lending standards
Source: Charles Schwab, European Central Bank, Bloomberg data as of 3/25/2023.
If banks tighten lending conditions sharply in response to the events of the past couple of weeks, it's possible that a negative spiral develops, in which credit tightens, defaults pick up, the signs of recovery in the global economy get cut short, and the likely recession deepens.
We do not believe this is a repeat of the 2008 Global Financial Crisis. Relative to 2008, regulators globally have enforced higher capital and liquidity ratios, and lending standards are stricter. Banks have more ability to absorb losses and household balance sheets are heathier. Assets on bank balance sheets are more transparent than the opaque derivatives that contributed to the 2008 downturn. And bank regulators moved quickly to stem liquidity issues. In Europe, officials deserve credit for avoiding U.S. mistakes: their bank stress tests zeroed in on interest rate risk not central to U.S. stress tests. Also, they never backed away from regulating mid-sized banks as the U.S. did in 2018 when it exempted banks below $250 billion in assets from stress tests.
Our main theme this year remains unchanged: market volatility is likely to remain elevated. While the turmoil in the banking sector could help cool inflation, the amount and timing are unknown. We believe investors should stay focused on quality, which includes international stocks with short duration–having near-term cashflows rather than further in the future, which have continued to outperform this year. International markets have a higher weight in short-duration stocks than U.S. stocks.
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The MSCI Europe Financials Index captures large and mid cap representation within the Financials sector as per the Global Industry Classification Standard (GICS®) across 15 Developed Markets (DM) countries in Europe.
Markit ITraxx Europe Credit Default Swap Subordinated Financial Index is a credit derivative index covering the credit-default swap market in Europe measuring the performance of the on-the-run CDS contracts for 125 names, equally weighted.0323-3X4K