Introduction
The instinctive movement of our eyes towards a sudden stimulus is known as a reflexive saccade. To understand what it sees quickly, the brain halts some of its normal visual processes so the image we perceive isn’t blurred. For an example, we can look at ourselves in a mirror and switch our focus from one eye to the other; we will not see our eyes move, but others will.
Fears about SVB’s solvency sparked a bank run whose effects are still being felt across the world’s financial sector.
This ability to focus quickly on a new exogenous phenomenon undoubtedly helps us to identify and respond to risks in the physical world, even if it can mean we miss some parts of the picture. I suspect few of us were staring at the minutiae of how banks account for their assets prior to this month, but it quickly commanded the investment community’s attention. One likely trigger was the announcement on 8 March that Silicon Financial Group (‘SVB’) had sold “substantially all” of its Available for Sale (‘AFS’) securities portfolio and was attempting a capital raise. The resultant fears about SVB’s solvency sparked a bank run (saccade is derived from the French word for jerk) whose effects are still being felt across the world’s financial sector.
But in investors’ collective reflexive saccade towards banks’ AFS and Held to Maturity (‘HFM’) portfolios, what have their brains missed in their urge for instant clarity?
A Model Bank
Let’s start with a stylistic illustration of a hypothetical retail bank’s balance sheet. Figure 1 shows this in the zero-rate environment that prevailed until the current hiking cycle began, with fixed-rate liabilities of 60 billion and fixed-rate assets of 60 billion (the units are purely notional in this simplified example). The bulk of the liabilities are in 0% current accounts, balanced by loan and security assets which also have a fixed rate. On top of the 0% current accounts we have variable-rate saving accounts, matched on the left by floating-rate loans and securities plus cash.
In general, banks don’t like to take large interest-rate risks (excluding some notable cases) and in this example they are not taking them. Fixed-rate assets match fixed-rate liabilities, and floating-rate assets match floating-rate liabilities.
Figure 1. A Simplified Hypothetical Bank Balance Sheet in a Zero-Rate Environment (No Hedging or Conservatism)
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Source: Man GLG; as of 21 March 2023. For illustrative purposes only. Please see the important information linked at the end of this document for additional information on hypothetical results.
Figure 2 updates this model to reflect a 2.5% interest-rate environment. The liabilities on the balance sheet remain the same, but the reflexive saccade draws our eyes to the unrealised losses in red on the left. These illustrative losses are modelled in this example on the fixed assets having a duration of 4.2 years; we multiply that duration by the 2.5% interest rate to calculate a loss on the fixed unhedged assets of around 10%.
Figure 2. A Simplified Hypothetical Bank Balance Sheet in a 2.5% Interest-Rate Environment (No Hedging or Conservatism)
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Source: Man GLG; as of 21 March 2023. For illustrative purposes only. Please see the important information linked at the end of this document for additional information on hypothetical results.
By focusing only on the HTM book, we believe market participants are missing the real risks and are perhaps punishing the wrong banks.
Much consternation seems concentrated at the moment on the unrealised security losses (the 1.6 billion in this example). In fact, they miss the much larger loss that is not visible due to amortised cost accounting. There are also unrealised losses in the loan book; these have yet to be scrutinised, but they are not hidden. It isn’t actually hard to work out the loss here: 45 billion x 4.2 x 2.5% (the same as the fixed-income portfolio). Some banks refer to this unhedged portfolio of their loan book as the “structural hedge” or “replicating portfolio”. It is there by design to hedge the fixed-rate liabilities. By focusing only on the HTM book, we believe market participants are missing the real risks and are perhaps punishing the wrong banks.
Superficially, it does seem alarming – together the unrealised losses are more than 100% of the equity capital! Does this tip the bank into insolvency? Not in our view, as there is another asset that has risen in value but isn’t on the balance sheet.
This is the deposit franchise – an intangible asset that represents the net present value of the future profits the bank will realise from having a “deposit beta” relative to the increase in interest rates, as portrayed in Figure 3. The bread and butter of banking, after all, is making a spread between the interest you charge on your loans and the cost of your borrowing (including from depositors).
Better Deposit Beta
One critical presumption here is that those deposits are sticky without demanding an interest rate that is in line with market rates themselves. This is what makes a bank’s deposit franchise so important, even if it is intangible and off balance sheet. Equity investors value this, as they recognise the benefit to banks’ future profit and loss from a higher rate environment. But we do not see it on the balance sheet for accounting purposes. As we see in Figure 3, higher rates result in additional net interest income for the bank. Encouragingly, deposit betas do seem low this cycle: Europe’s deposit flows have been very stable, with banks passing on little of recent rate rises (only 9% of the rate increase versus 35% in the US, and 61% in the European rates cycle of 2005) while maintaining deposit volumes.1
Figure 3. Illustrative Example of Effects of Higher Rates and Deposit Beta on a Hypothetical Bank’s Net Interest Income
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Source: Man GLG; as of 21 March 2023. For illustrative purposes only. Please see the important information linked at the end of this document for additional information on hypothetical results.
If banks are going to be criticised for taking interest-rate risk they should also be given credit for the value of their deposit franchise.
If banks are going to be criticised for taking interest-rate risk on their HTM portfolios (and indeed, their loan portfolio), then for consistency they should also be given credit for the value of their deposit franchise that has been built over many years and on which banks spend billions each year to maintain. Deducting unrealised losses but adding the greater net present value of their deposit franchise suggests that most banks are not only solvent but more viable. Indeed, a strange quirk of the recent panic is that until this month, it was received wisdom among investors (particularly equity managers) that banks benefitted from rising rates; the banking sector had duly performed relatively well through this hiking cycle.2
The Moral of the Tail Risks
Integral to this thesis, however, is deposit stability. The minute deposits start to walk out of the bank, the deposit franchise goes too. The challenge is that fear of bank weakness becomes self-fulfilling if it induces deposit flight; losing deposits en masse tips the scales on the balance sheet back towards insolvency.
This is precisely the reason why we are now hearing European officials talk about increasing the deposit guarantee and their US counterparts discussing guaranteeing small banks’ deposits. US Treasury Secretary Janet Yellen announced this week that “similar actions [to protecting all depositors at SVB and Signature Bank] could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion”
Equally, we should acknowledge that guaranteeing all deposits could introduce greater moral hazard into the financial system: banks could be incentivised to take more risks if they didn’t face the jeopardy of losing their deposits through mismanagement. On the other hand, though, bank runs are extreme threats to the economy and would likely create a particularly hard landing. The need to balance these two risks is why we expect any new policies on safeguarding deposits to be limited – by time, institution or both – rather than perpetual and universal.
We expect any new policies on safeguarding deposits to be limited – by time, institution or both – rather than perpetual and universal.
An additional nuance in this discussion is the differences between US and European banks. In the US, for example, it is far more common to use money-market funds to obtain a higher interest rate. The capital-markets structure in Europe is less developed, with much less “near-risk-free” alternatives for your money. European banks have also remained more tightly regulated than their smaller US peers, and in general they have already deducted losses on their AFS portfolios from their capital ratios. Small US banks by contrast were able to add these losses back, flattering their capital ratios. It was the crystallisation of losses in this portfolio at SVB that spooked the market in early March, which we would not expect to happen in Europe given they are already marked down.
Conclusion
There’s an old joke about banks in crisis: “The left side of the balance sheet has nothing right, and the right side has nothing left.” Despite some feverish speculation, we think the majority of banks today are orders of magnitude away from such a situation. The anxiety that has stemmed from focusing exclusively on HTM portfolios misses the fuller picture, in our view, penalising banks for losses that are starkly visible but have not necessarily materialised. The true challenge for all involved is now protecting deposit franchises; part of the answer lies with investors valuing them correctly and part of the answer depends on policymakers acting to protect deposits where needed.
1. Source: FDIC, ECB, Bloomberg and Autonomous Research estimates; as of 14 March 2023.
2. The MSCI ACWI Banks Index outperformed the MSCI ACWI by 350 basis points in the 12 months to the end of February 2023 (Source: MSCI; as of 28 February 2023).
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