Is the worst over after the sale of First Republic Bank in the US? finews.asia addresses the most important questions about the US and European banking sectors.
Has the banking storm abated? Earlier this week, the crisis-ridden US First Republic Bank (FRB) was sold to JP Morgan. The once high-flying regional institution is the latest victim of the banking crisis in the United States which engulfed Silicon Valley Bank (SVB), Signature Bank, and crypto bank Silvergate since mid-March. In Europe, Credit Suisse had to be rescued by an emergency takeover of rival UBS.
In the aftermath of the turmoil, one is tempted to ask about the stability of US and European banks. The key questions are:
1. Are other US banks facing the same problems as First Republic?
While many smaller and mid-sized institutions in the US continue to face difficult economic conditions, larger lending institutions don't appear to be facing challenges as pressing as those of FRB. Last week dozens of US regional banks reported quarterly results and assessed their outlooks less gloomily than investors and analysts had feared. For the time being, there is no evidence of industry-wide contagion, but it certainly can't be ruled out another time bomb is ticking.
FRB's problems became apparent immediately after the collapse of Silicon Valley Bank. US banking analysts believe no other large regional bank is in an obvious state of existential distress as FRB, and don't expect any further major distress sales in the coming weeks, although there are still numerous risks.
2. How are investors reacting to the stock market?
After the sudden collapse of the SVB, bank indices plummeted, dragging down the broader US stock market along with other major global stock market indices. Fears of a credit crunch and a deepening economic crisis unsettled investors worldwide.
They're reacting in a more nuanced way these days and seem to view the second-largest bank failure in the US not being a harbinger of further problems, but rather isolated to FRB. The US stock market is holding steady, and the KBW regional bank index has lost relatively little ground.
3. What are the biggest risks and which regional banks are currently exposed?
Credit risk presents the greatest danger to the banking system. Years of ultra-loose monetary and interest rate policies by central banks around the world led to capital misallocations. In the event of an economic downturn, there is a threat of higher credit losses.
The combination of risk aversion and tighter credit conditions is likely to slow the US economy. Now dormant risks, above all in commercial real estate portfolios of financial institutions, risk coming out of hibernation. Mid-sized US banks are the largest lenders to commercial real estate projects nationwide, and higher interest rates are putting pressure on transactions. More than $1 trillion in commercial real estate loans will mature by the end of 2025.
As banks tighten their risk assessments, borrowers could have difficulty refinancing their debt, and if asset price declines accelerate, the balance sheets of smaller and regional banks could face additional strain.
4. Will bank regulation be tightened in the US?
US banking regulation was changed in 2018 so that mid-sized and small banks are not subject to the same liquidity and capital requirements as large banks. Following the collapse of Silicon Valley Bank, regulations are likely to be tightened, with the Federal Reserve likely to push for regulatory changes after the recent fiascos.
There are numerous measures US banking regulators can take to address regulatory weaknesses, but Congress has to intervene in some cases like deposit insurance reform. In the future, improved risk management of liquidity and interest rate risks is to be expected, hurting the profitability of smaller and less diversified banks.
5. How does the situation differ for banks in Europe?
Apart from Credit Suisse, which went under mainly due to home-cooked problems, there were no visible signs of a weakening of Europe's banking sector during the stock market turmoil. European and US banks operate not only with different business models but also within different regulatory parameters.
In Europe, liquidity and capital regulations are already stricter than those in the US, with European banks in better shape today than they've been for much of the past decade. Their stability is thanks to measures enacted since the global financial crisis to strengthen the regulatory framework for banks in the European Union (EU). Credit institutions are now required to hold more and better quality capital and larger liquidity buffers to withstand stresses to the system.
The recent bank failures in the US and Switzerland could lead to better compliance with international capital standards by EU-domiciled banks, as recently analyzed by the Peterson Institute For International Economics.
6. Investors have suffered a total loss on Credit Suisse's AT1 bonds. What consequences are still looming here?
In the creditor hierarchy, bondholders are generally favored, while shareholders lose their investment. Credit Suisse's AT1 mandatory convertible bonds contained an explicit clause allowing Finma to write off the bonds without first asking the shareholders to pay up. Nevertheless, the drastic step caused an outcry among bondholders.
In general, the Finma decision makes the issuance of AT1 paper more difficult and expensive for any bank for the time being. Supervisory authorities in the EU and the UK immediately distanced themselves from Finma's AT1 decision, assuring investors that in the event of a bank failure, shareholders would suffer first and foremost.
Whether they will remember this in the future in a case similar to that of Credit Suisse remains to be seen. In any case, one thing is already certain: AT1 investors won't soon forget the risks inherent in the securities.
7. Rising interest rates have made life difficult for US banks. Is the spectacle repeating itself in Europe and Switzerland?
Rising interest rates are both a blessing and a curse for financial institutions. Banks can earn more on loans but are also under greater pressure to offer higher rates to retain or attract customer funds.
The benefits of higher interest rates are likely to gradually run out, with competition for deposits raising funding costs. Despite solid balance sheets, this is likely to lead to lower growth and earnings for banks in the future.
