US banking crisis: What happened and what now?

Introduction

0:00Welcome to the Denker Capital Podcast, where our highly experienced team of in-depth thinkers and other experts share their insights on a range of investment-related topics. In this podcast, we have conversations about developments in South African and global markets and what these may mean for investors. We analyze specific stocks and sectors and explore general themes relating to the fundamental principles that underpin sound investment decisions in an ever-changing world. It's the 27th of March, 2023, and in today's episode, Nigel Barnes chats

US Banking Crisis

0:40to Koki Koyman and Ben Koyman on the current US banking crisis. They talk about what happened earlier this month, why it happened, and how far the effects are being felt. Koki manages the Denker Global Financial Fund, and Ben is an equity analyst on the Global Financials team. So they'll also cover how the fund has been affected in the last two weeks and what we expect going forward. I'm joined this morning by the Koymans. Sounds like a title of a new Netflix series, actually, that one. But Ben is here with me in the office, and Koki is in Amsterdam in Northern Europe,

1:16joining us as part of his actual annual leave. So Koki, thanks for taking a bit of time out to speak to everyone. In terms of the content today, Ben, maybe we could start with you. I really want to get a handle on what's been happening in the financial sector over the last couple of weeks. There's been a huge amount of news flow, certainly around some of these banks in America, and some market pressure. So maybe we could just start there, just turn the clock back a week or two, and just give us what's happened and why. Thanks, Nigel. I think the important starting point is that

1:53these banks, at the end of Q4 results, were regarded as being well capitalized, healthy, they were quite profitable. What's now happened since then is there was a specific bank, Silicon Valley Bank, which was concentrated in Silicon Valley. So it led to a lot of bintechs, which were all not profitable generally, and they'd been a beneficiary of the low interest rate environments. They'd been taking risks that otherwise wouldn't have. And almost due to being hidden by this

2:24interest rate environment, the bank was growing incredibly quickly, and most people hadn't picked up on the risks of the bank. Everyone was quite happy with us. Well, now we start coming out that the Fed had picked up on potential problems, but the market in general hadn't picked up on these problems. But the banks, until this point, have been focusing on a solvency ratio, which means your ability to survive a longer period of stress. And capital ratios have generally been focused on that. And all the banks screened quite well on this. But what happened is, as Silicon, with our

2:58higher interest rates, as Silicon Valley Bank's customers, which as we mentioned, non-profitable tech startups, as they came under stress now with these higher rates, they started to withdraw quite quickly from the Silicon Valley-based deposit base. So that was quite a run on the bank, and this money started to go out. And as rumors started circulating on Twitter that there were potential problems there, one thing led to another, and it just kept on increasing. Then what made the problem also worse is the fact that they had a really high uninsured deposit base, 91%, which means that the

3:33clients were scared that if the bank goes under, they're not insured for it, and they'll lose everything. So this money quickly started leaving their system. But also, it's normally not a problem, but the banks have available for sale and held to maturity bond portfolios. These, as said, it's held to maturity, so they don't plan on selling it. But as Silicon Valley Bank had this liquidity problem, which is short-term cash required, they had to start selling this at a loss. And then as they sold that, they need to raise capital again, had to do a share issue. And as

4:08they're about to do that, the Fed stepped in and took them into supervision. So that was the end of Silicon Valley Bank as a listed company. Unfortunately, all these issues made the market worried about which other banks could have similar problems. The first bank in the headlines was Signature Bank. What made Signature Bank also more unique is they had crypto, well, not crypto exposure, but they facilitated crypto transactions on their Signet platform, and they took crypto deposits, which is stablecoin. So

4:41it was theoretically no real crypto exposure in their lending. But what made them worse in this regard is Silvergate had just fallen over a week prior. Unrelated circumstances to Silicon Valley Bank, except that crypto had also probably been fueled by the lower interest rates. Yeah. But Silvergate didn't make as much news because they managed to give all their clients back their deposits. So there was no loss for the general consumer, it's just the bank also closed down. So the market was quite skeptical about crypto. Then Signature Bank also had, so the next

5:15market then focused on which banks was high uninsured portion, was quite concentrated, and potentially been lending quite quickly into this environment. So maybe taking undue risks. Okay. So yeah, Signature Bank unfortunately fell in that category. On Wednesday, when Silicon Silicon Valley went down, they still gave an update, which showed they're quite well positioned, they still actually had deposit inflows in their main business. But with the fear that came through over the next two days, they lost 40 billion worth of deposits, which they then also couldn't withstand.

5:47And over the weekend, they also got closed down. Okay. On Monday, we then woke up and then obviously the market thought about the next bank and the next bank in line was First Republic, which is now the current name, which most of the news has been going on about. They are nowhere near as the rest. I mean, Silicon Valley and Signature both had 90% uninsured and very concentrated. First Republic was a lot less concentrated, been a much more established bank, been spun out of Bank of America, and had an only uninsured deposit base of 73%. But still, it was next in the

6:21cross lines. So there was quite a big withdrawal of their deposits as well. But between the Fed opening up a discount window, the large banks stepping in and giving them 30 billion worth of the cash lines to use, for the moment, it seems the situation has stabilized, but the market is still fearful of how this potentially ends and which other banks are potentially affected. Yeah, and that's almost where we stand now in the US is that a lot of the deposit flows have been sitting in these mid cap and small caps. The market is worried it's been going to the big banks. So JP Morgan Bank of America City have been

6:56getting huge inflows of deposits from these smaller banks. And we've got the Fed standing behind them now. But until we have certainty on where their deposit base stands and what their current deposit levels are, I think the market might be a bit worried. So yeah, the big number we'll see is on the Q1 results, then we'll get a proper standoff on where the banks stand. The Fed gave a facility for them to stand behind. In the first week, there was 160 billion worth of usage that banks tapped. First

7:26Republic was 110 billion of that. So that's a huge portion. The week on week now the numbers released now Thursday was that facilities actually stood still. So it seems as if it's stabilized, and no new banks had to tap that facility. Then, as happens with every the European banks and the rest of the emerging market banks on a totally different footing, and their balance sheets are structured very differently, which we won't go into detail now. But they obviously there's the one big bank in Europe, Credit Suisse, which has been having problems since 2015. So this is nothing new.

8:02As listeners will know, we've been following the bank, they've been in quite a few scandals and losses recently. Okay. And yes, so that's filled into them, which, unfortunately, Credit Suisse as a small as a big bank, but in a very small country of Switzerland, as international depositors also started fearing the worst, they started withdrawing a lot of the deposit base from Credit Suisse. And yeah, we came to the problem that they then have to be taken up by UBS due to this huge deposit withdrawal. So yeah, I think that's the big summary of where we are now.

Banking Sector Analysis

8:35Yeah, so just to summarise, we've got this group of, let's call them smaller niche banks in America, regionally based, specific client base in the tech sector, a lot of the deposits uninsured, and, you know, basically concerns over that segment. And that's caused the background or the foundation to this issue. You talk about the sort of larger bank components and the, you know, the biggest sort of blue chip names in the US as part of this process, Ben. Do you think that they are at risk

9:10here? No. So I mean, as I said, the previous crisis were all caused by a solvents, which is much longer. So this is a very much liquidity crisis, which also due to capital constraints and requirements, they actually are regulated differently. So they have to be much more strict on their liquidity. So they, before this already, they're in a much stronger liquidity position. Okay. And then with the fact that they are actually getting big inflows from deposits from the smaller banks, there is zero to no risk of them from that liquidity crisis. Okay. All right. Good. I want

9:42to come back to the, to the Credit Suisse situation, perhaps a little later. Koki, maybe just, just turn to you now. Thank you, Ben, for that, to that background. I mean, the fact is, we might see this in America continue on a little bit, but in terms of the individual banks that we've, or Ben has been talking about, which were held within the global financial portfolio, Koki, which did you hold, which didn't

10:13you hold? And can you just give us a bit of background there, which clearly, you know, is focused on the impact on the portfolio? Yeah, Nigel, thanks. We held Signature Bank. It was always one of the very entrepreneurial banks, fast growing. We really liked the business model in which they were doing things. And just with hindsight, you say, oh, they were very niche, but we actually, they understood their niche and we, and they were pioneers. But in, in essence, once trust in the system went,

10:50specifically the deposits as triggered by Silicon Valley Bank, then, you know, depositors just looked at, at their deposits with Signature and said, you know, I'm pulling as well. So we, we were with Signature Bank, we, not sure if one is going to get anything back. The bank is being dismembered, so to speak, in Solonov, but that was at a one and a half percent position. The other positions were

11:23on Key Corp, US Bank Corp, JP Morgan City, which are all very big banks and generally been benefiting with the exception of Key Corp. But the other three, Citi, JP Morgan, US Banker were part of the rescue package that helped to stabilize the system. Key Corp was a bit special, also more regional. We like it very much, very, very good bank, very good operating metrics. And it's the 22nd largest

11:55bank in the US when you go down to 4000 banks. So Key Corp took a bit of pressure. But it's coming back strongly. And also, the CEO has been stating that they are receiving deposits. So in the US, we, it's really sad about Signature Bank. Also, we really thought it was a very good bank. And they were swept away by the tide. Yeah, sure. And in terms of the portfolio copy over the last couple of weeks,

12:27have you been making any changes to the US component within the portfolio? Yes. So we, over the last few months, and almost a year, the property casualty component, the property casualty insurers or the PNC insurers have done exceptionally well as they benefited from the tailwinds. We're starting to get expensive. So we reduced those a bit and increased our weighting in US Bank or on Key. Both of them had fallen more than 30%. It's totally ridiculous where the share

13:02prices have gone to. So it gave us a very good opportunity to add to those. So we switched from the insurers that were expensive into the banks that we like that had fallen a lot. Yeah. Okay. Okay. Great. Thank you. Ben, coming back to you now, let's just unpack this sort of European banking situation and just give us a bit more background to Credit Suisse. Because from my understanding, I mean, the Credit Suisse story is a much longer story. I mean, you talk about going back to 2015. This is an organisation which has been, you know, struggling

13:35for want of a better term for a long period of time. So just give us a bit of background to that, you know, why it's in the spotlight now and, you know, all of that. Yeah. So, yeah, it's been struggling since 2015, as you've mentioned. And actually, in the last eight years, I think five of those years have been losses. So it doesn't just mean it's been really struggling. Yeah, sure. I think the original, when we were there, we were actually in London at the Invested Day in 2015. And the then CEO wanted to make, he decided he wanted, I think it was the original cause,

14:05he wanted to decentralise Credit Suisse a lot more and give each division a lot more autonomy. And obviously that works. The bank's running quite well. Each person has their own autonomy to do what they want. Unfortunately, in this case, it looks like each division weren't working well, the rest of the bank, and obviously the leaders weren't quite up to it. So, yeah, there was a lot of mistakes, especially with the, I think it's also a big mention is that they actually, Credit Suisse has make it four large parts. It's got its asset management division, which actually does quite

14:38well. It's got its wealth management division, which also does quite well. And then it's got its Swiss private bank, which helps Swiss private bankers, so it does well. But a lot of the problems have come from its investment banking division. Okay. The problem with investment banking is when you get things wrong, it can go horribly wrong. Sure. So they got quite a few bad clients, which they made huge losses on. And unfortunately, a good investment, which they tried to be, is all about scale. So as you start losing scale and you start making losses, the investment banks started running at a huge loss, which unfortunately

15:12does mean, in general, investment banking is a lot more risk, but normally you try and get the reward out of it. They had the risk and they weren't getting any reward, which is also why Deutsche Bank is now the next in line. Different bankers, but it's been running quite profitably, it's been running a lot smoother. But just as an investment bank, it will automatically carry more risk. So yeah, so Credit Suisse had those problems. And then due to a lot of these losses, they were always capitally a lot more constrained. I think they had three or four CEOs in the last period. As any business, when you're having problems, your staff starts leaving. So the guy who's in charge

15:47of UBS's wealth management now came for Credit Suisse, he left in 2019. So they struggled to retain talent. So I think one thing just led to another. And we got to the situation we are today. Okay. Have you ever held Credit Suisse in your portfolio? I think we've held it maybe for a month. Sometimes when it got, not for the last three years, I don't think. But I think we actually done quite well out of it once when it got to ridiculously cheap levels at that point for where we thought it was. Then it rebounded quite strongly, we sold. So yeah, never for a long period and never a big position. So it just, it was a short, yeah, profit.

16:22And it was actually worked out for, but yes. And it just didn't meet the criteria. It just doesn't. For long term investment, yeah. And UBS? So UBS, we've held on and off for a long time. It's actually also done quite well for us. It's been a great bank. We sold it towards the end of last year. Nothing specifically with regards to UBS. It's just as a wealth manager and asset manager, a large portion is quite exposed to the market. And it had done really well. And on a valuation metric, we saw better risk reward elsewhere. So at this point, after taking over Credit Suisse,

16:55it becomes huge, which is great for its scale, which is very important for its business lines. Sure. But with all the particulars and things which are going to run through the business now, it's taking over such a big bank with no planning, almost forced on them.

Credit Suisse Situation

17:10Yeah.

Credit Suisse Situation

17:10It's an interesting investment, but we, you know, I just, I wouldn't want to take that risk at this point when there's opportunity elsewhere as well, yeah. So you're going to keep an eye on things and see how it plays out over the course of the next few months before you. Yeah, definitely. Yeah, that seems fair. And you touched on Deutsche Bank there. Do you think there's any significant issues with Deutsche or other European banks that we might see in the course of the next week or two? So the other European banks first, I think what makes Europe, firstly, they've got different capital requirements, which helps a lot. And so they've come into this from a totally different

17:43position. But also US, as Koki mentioned, has 4,000 banks. There's a lot of competition, where the European countries generally have like two or three huge banks and the rest don't really. So your competition for deposits is a lot less. And this has been caused by a deposit run. So that automatically makes them a lot less risky for the current situation. So, and they've all generally got excess capital and quite liquid. So we're not particularly worried about any of the Pacific. You always have an Italian bank, very small, which could, but yeah, nothing we lose sleep over. Deutsche Bank, as an investment bank, is always potentially

18:19at risk due to the fact that you've always, you've got an investment bank with positions. But the last three years hasn't shown any particular stress. They've been profitable. They've done the right things. Their liquidity is a lot stronger than Credit Suisse's. They've also, as Credit Suisse's, a lot of international clients. Deutsche Bank is a lot more German focused as well. So, you know, we don't, I mean, a problem with the liquidity crisis is things can change overnight and there could be a risk. But at this point and with everything we've seen, I don't see any reason to fear Deutsche Bank is next in line.

18:53Yeah. Okay. All right. Thank you, Ben. Koki, to finish off, coming back to you. Obviously, you, you know, you have the responsibility that the buck stops with you in terms of the Denka Global Financial Fund. And, you know, for some time now, we've been talking about, talking to investors about the fact that, you know, with in a rising interest rate environment, there's a margin expansion, which is generally good for, you know,

19:23core components of the financial sector. And clearly, Koki, now we've, in the last couple of weeks, we've seen share price falls. And I'm sure that's, you know, attractive to you in terms of some of those valuations. So how do you see things sort of going forward? What's your view? Give us, give us a bit of background there to finish off. No, thanks, Nigel. So the rising interest rate environment was very good for banks, and it gave the extra icing on the top. But very important that

19:54also because they came from such very low interest rates in Europe and Switzerland, interest rates were negative. So coming from negative to zero to going back to, let's say, three, four and made a huge difference. That is most probably over, and we'll see interest rates going back, but not to where they were. So the bank status quo, where they will be in 23, 24, compared to, let's say, 2019, 2018, will still be a lot better. And you can see that in the returns on capital that they are delivering.

20:29The rest of banks have been focusing a lot on cost cutting during this year. So they're actually really sound and really solid now. And actually, with all the volatility, the prices have come back down to levels where they are just so attractive as they were in 2008, after COVID, after the Russian invasion. And in fact, we've had in the last five years, when you think about it, we've had three severe incidents in February, March, where the market tanked and banks tanked. And each time, we thought that

21:02it's a severe event, COVID, global economy being shut down, the Russian invasion, significantly higher oil, food prices, war. And each time the banks, from those low valuation levels, despite the risky environment ahead, still bounced back. And we think this time is going to be the same. The banks and insurers who invested in screen very attractive, and the market has become too negative on the prospect. So if it stabilizes, and we think it should, then you'll see a fairly strong pullback,

21:38as we saw in the past. But there are still risks. I mean, there's a lot of commercial real estate exposure, that's potentially still underwater. And a lot of work has been done also by us on which banks have commercial real estate exposure, none of them have very big exposures. Obviously, it's a problem that's been with us now, since COVID. And then there are a lot of emerging markets that are sitting with very high debt levels, with higher interest rates are going to battle to pay. We've already seen that in Ghana, we saw that in Zambia, we saw that in Egypt. So there's

22:14a lot of risks out there, and then potentially private equity firms, hedge funds. So all of those could still be shown up. But none of them should be big enough at this stage to really cause strain in the banking system at large, except when you can always have one bank who has a big exposure to a hedge fund or so that just causes problems. But we can't see anything on the horizon at the moment. So we think it should stabilise. But it will be a bit worrying for the next two or three

22:50weeks, and then I think you'll have clarity. But your best investments are made in times of stress.

Investment Outlook

22:56So it depends on investors' risk appetite. If you've got an appetite for risk, you should be investing now. If you haven't, then you should wait a few weeks. Yeah. I remember, Koki, when we talked through the pandemic, you know, what was the saying? It never wastes a good crisis. Absolutely. Yeah. So your message to investors would be, if you've got a risk appetite, then add to your position because valuations look good at the moment. If you're more concerned about risks, just sit tight for the moment and see how this plays out. Would that be your message to investors?

23:28Yeah. Yeah. Yeah. We're certainly using the cash that we did have in the portfolio. We've been starting to invest specifically in the US banks because they fell the most and they look the most attractive. But even in Europe now, again, things like IMG and so all starting to look really attractive again. So we're using our cash now. Okay. I think we might have lost a bit of a bit of Koki there up in Amsterdam. But so Ben, let me come back to you to finish off. I mean, would you concur with Koki's comments there

24:01in terms of your message to investors? Yes, definitely. I mean, he's mentioned the US banks and we'd actually been taking out some of our European exposure to the Europe. I mean, some of our European exposure to the US before, as it's unwound because it's the first year. Now, the European banks are also coming back quite strongly with less risk in most regards. So we haven't yet started reallocating to Europe, but it's definitely a potential thought process. But we're definitely quite happy with the upside at this point. Okay. All right. Brilliant. Thank you.

24:32We'll say thanks to Koki, although I'm not sure you can hear me now. We might have lost the link. But Ben, thanks to you for joining us this morning. I think this is, you know, it's a fast moving situation. And I know that you have a lot of focus on these banking organizations at the moment around the world. So things do change markedly in the next week or two. We'll do another quick podcast just to update people. But thank you for the background to what's been going on and for giving us that insight. Yeah. Thanks, Nigel. Thanks. Cheers, Ben. Cheers.

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