The positive rate narrative for bank shares is over

Sentiment in markets has yo-yoed based on the reading of policymakers’ intentions but, as investors in Credit Suisse (CH:CSGN) found out, the powers that be are prepared to force a few ragged haircuts along the way. As part of the stricken bank’s state-engineered merger with UBS (CH:UBSG), investors in its additional tier one capital (AT1), were unceremoniously told to swallow a write-off.

The law of unintended consequences was already to blame for a series of banking failures that started with Silicon Valley Bank’s (SVB) woes. Aggressive interest rate hikes passed off as positive for lenders (as rates go up banks widen the spread between what they charge borrowers and pay depositors, thus increasing profits), also affected the mark-to-market value of assets creating liability-matching and then liquidity issues.

With its business model as the banker for cash-burning moonshot projects, SVB had idiosyncratic vulnerability, but its demise had wider implications. Issues around asset quality, stability of funding and leverage are universal; quantitative tightening and fluctuations in securities’ values create stresses in the system that will show up in core stability ratios.

Health-check for UK banks

Following the 2007-09 global financial crisis, regulators focused on controlling banks’ use of leverage and capital adequacy measures that set standards for liquidity (accessibility of capital for short-term needs) and solvency (ability to match long-term liabilities and maintain stable funding).

On the basis of measures emphasised since that crisis, large banks are on a solid footing, something establishment figures like US Treasury Secretary Janet Yellen have emphasised in a bid to prevent unease becoming panic. Yellen is probably right, but assuming the current situation is contained, how does a fresh risk appraisal answer the secondary question of whether bank shares can be a good investment?

UK banks are required to report the highly liquid parts of their capital structure as a percentage of assets (bank assets are mostly the interest-bearing loans they have made). This is the leverage ratio and a figure of above 5 per cent is considered a position of strength, ensuring a funding cushion in case stressful periods cause short-term liquidity issues in money markets or if a higher-than-usual number of loans deteriorate.

Common equity tier 1 (CET1) capital – the funds owned by common shareholders – makes up the lion’s share of Tier 1 capital used to compute leverage ratios. Taking CET1 alone, the UK banks are still well-capitalised.

More broadly, the proportion of high-quality liquid assets (HQLA) that banks own is the crucial determinant of the liquidity coverage ratio, which determines how well they can cover their reported net outflows, including meeting obligations on the liability side of balance sheets. Again, UK banks were in decent health at the end of their 2022 years, with scores comfortably above 100 per cent.

Importantly, a high proportion of their HQLA is cash on deposit at central banks, so there is a ready source of funding to meet net outflows before having to sell other assets such as government bonds. There is no SVB situation brewing at UK banks, but it is notable that the proportion of HQLA that is cash reduced over the course of 2022. Central bank quantitative tightening has meant a reduction in the availability of central bank reserves, meaning government bonds must account for a greater share of HQLA. In terms of credit, they are high quality but with rising interest rates a source of price volatility for bonds, they can lose value and are less suitable than cash for covering outflows, as SVB found to its cost.

UK banks are a long way from being in that situation, but the multitude of moving parts in their business models mean that the picture of health can deteriorate rapidly. Looking at longer-term funding, the picture was never quite as good. The adoption of Net Stable Funding Ratio (NSFR) reporting only happened at the start of 2022, but this requirement could serve to highlight the longer-term drawbacks of banks as investments.

High quality

NSFR is defined as the available stable funding as a percentage of that which is required. It is based on the make-up and credit profile of deposits and loans, and clearly there is potential for asset deterioration in times of recession and credit stress on the one hand. On the other, monetary tightening and customers running down their savings in hard times mean the liability funding conditions are deteriorating, too.

Is this all enough for us to worry about the stability of the UK banking system? Probably not, as the ratios going into this rough spell were robust. Yet, with the stresses being seen, the onus will be on maintaining and improving that cash solvency. That hits the investment case for bank shares as, although higher interest rates mean potential profits for lending, the competition for quality deposits may necessitate offering savers better rates, and the overall situation means banks must be ultra-conservative when employing leverage to boost returns on shareholder equity (ROE).

On the other side of the coin, cost of equity (COE) is rising. The rule of thumb is that if the ratio of ROE to COE is less than one, bank shares can’t make sustainably good returns. With the conflagration of events causing shares to fall in value, that cost of equity is rising further, which means a premium for opportunists chasing a value risk premium – but that does little to advance the case for long-term buy-and-holders.