Climbing interest rates were supposed to prove a boon for banking and other financial services stocks. Interest rates at or around historic lows for over a decade since the 2008/09 financial crisis meant thin pickings for lenders, even if the economy and financial markets boomed during the record bull market they helped catalyse. Higher rates should have seen profit margins climb on newly issued and variable loans.

But banking stocks never really took off and suffered a sluggish 2022 and early 2023. And over the past week, banking stocks have plunged after the collapse of Silicon Valley Bank in the USA.

U.S. government intervention has steadied the ship and hopefully contained the risk of contagion spreading through the local and international banking systems. However, banking stocks have suffered fresh losses today after the ratings agency Moodys downgraded its outlook for the sector to “negative” from stable and warned of “a rapid deterioration in the operating environment”.

The overall message from individual banks, regulators and governments is that the SVB collapse looks like it has been contained. S&P Global, another major ratings agency, confirmed it has not seen evidence of runs on any other banks developing while cautioning “conditions remain fluid”.

But with interest rates expected to remain high for an extended period, even if the recent banking sector turmoil may see the Fed pause its rate rises at least temporarily when it meets next week, could other banks still be derailed in the same way as SVB?

Should investors who own banking stocks be worried or does the recent sell-off mean there are temporary bargains to be had in the sector after the valuation drops of the last week? Especially if higher interest rates mean lending, which retail banks make most of their income from, is likely to be more profitable over the near to midterm than in recent history?

Let’s examine the evidence.

Why have banking stocks slumped in value?

Banking stocks have suffered a sell-off since late last week after the collapse of Silicon Valley Bank (SVB), a major lender to the tech sector and the USA’s 16^th largest bank, sparked fear of contagion. The failure of the bank is the highest-profile U.S. banking failure since the Lehman Brothers collapse sparked the 2008/09 banking sector crisis.

It was brought about by over-exposure to mortgage-backed and government debt securities that have lost value due to rising interest rates. A run on the bank after news of potential issues broke late last week sealed its fate and on Friday, March 10, the Federal Deposit Insurance Corporation stepped in and shut down the bank.

After warnings that the SVB collapse had spooked savers and that nascent runs had started on other mid-ranking and smaller regional banks, the U.S. government stepped in over the weekend to guarantee deposits. The Fed also announced a programme offering cheap loans to other financial institutions to bolster liquidity in the banking system and head off the threat of rapid systemic contagion.

That saw banking stocks stabilise and recover some of their losses early this week before a new slump on Wednesday March 15. This morning major UK banking stocks are falling sharply with Barclays down almost 7% today, Lloyds Banking Group 4%, NatWest 4.5% and HSBC 4%.

The Nasdaq Bank Index, which tracks banks and savings and loans associations listed on the Nasdaq exchange, is down a little over 20% so far this year and almost 34% over the past 12 months. The KBW Nasdaq Bank Index, which tracks national and regional banks listed on both the Nasdaq and NYSE exchanges, is down around 17% for the year and 33% over the last 12 months.

However, banking stocks were performing poorly over early 2023 before the Silicon Valley Bank drama, suffering declines throughout February. 2022 also saw a drop in the valuations of a majority of banks, despite rapidly rising interest rates, which are typically seen as positive for lenders. The increase in loan book profitability was counteracted by concerns over the impact a looming recession would have on banks.

But it was ironically rising interest rates, something that should make banks more profitable, that got SVB into trouble. As the New York Times explains:

“Silicon Valley Bank failed because it had put a large share of customer deposits into long-dated Treasury bonds and mortgage bonds that promised modest, steady returns when interest rates were low. As inflation jumped and the Fed lifted interest rates from near zero to above 4.5 percent to fight it over the last year, the value of those assets eroded. The bank essentially ran out of money to make good on what it owed to its depositors.”

How likely is a full-blown banking sector crisis and more banks collapsing?

The general consensus is that while risks are currently elevated, there is not currently a significant danger of a domino effect taking out more banks. Morningstar equity strategist Eric Compton explains:

“Aside from crypto-related meltdowns, this is one of the first banks we’ve seen that has really suffered a liquidity crunch, which has forced it to restructure the balance sheet and realize losses on its securities portfolios.”

“SVB scores materially worse than any bank we cover on liquidity and unrealized-loss metrics. This makes us think that SVB could be facing a unique liquidity crunch that does not have to feed through the entire system; however, it does highlight that these risks are now more elevated. It also highlights that it can be very difficult to predict how funding pressure can change in any given quarter and when these risks can materialize.”

Other American banks appear relatively secure, even mid-ranking regional and smaller banks, despite reports of nervous depositors moving assets to larger peers. No other bank has unrealised losses that come close to SVB’s as a ratio against issued equity.

Fears for other banks are currently centred on the Swiss banking giant Credit Suisse, which saw its share price plunge by as much as 30% today before staging a recovery from lunchtime after the bank’s CEO Ulrich Koerner stated in an interview:

“Our capital, our liquidity basis is very, very strong. We fulfill and overshoot basically all regulatory requirements”.

Nervous investors will, however, note that the SVB chief executive also made bullish statements before the tech sector lender collapsed. He stated that the bank’s position was solid unless there was a sustained run on its assets. Which is exactly what happened.

Credit Suisse is, however, a much larger bank, the world’s 8^th largest investment bank, and Mr Koerner last week reassured shareholders and depositors

“it’s a very different situation, we are following materially different and higher standards when it comes to capital funding, liquidity and so on.”

Asset flows suggest big banks could be the winner from the SVB collapse

A recent report in the Financial Times suggests the largest banks in the USA such as JPMorgan, Citi Bank and Bank of America are being inundated with requests from clients of smaller banks wanting to move deposits. In a Monday research note, Wells Fargo banking analyst Mike Mayo wrote “Goliath is winning”, and pinpointed JPMorgan as one large bank benefitting “in these less certain times”.

That could be a clue for investors willing to take a risk on a full blown banking crisis not unfolding – a scenario that doesn’t look especially likely.

With all banking stocks taking a hit over the past week, large banks with relatively low levels of unrealised losses on bonds invested in before rate rises, and strong liquidity moats, should both be safe from danger and also likely to benefit by scooping up deposits being moved from smaller banks.

European and UK banks subject to stricter controls than smaller American banks like SVB

European and UK banks also look a little more secure than American peers. Since the first European banking regulatory stress tests in 2009, banks have been tested for their sensitivity to falls in value of government bonds. Poor tests indirectly led to the bailouts of Italian lender Monte dei Paschi. The UK has also maintained a practice of regular stress tests of its banks since leaving the EU and HSBC has already benefitted by picking up the loan book of the UK branch of SVB for £1.

In the US, when the Trump administration loosened regulatory requirements for regional banks in 2018, SVB found itself exempt from the strict liquidity regulations that were imposed on banks deemed “systemically important” in the wake of the 2008 financial crisis. The same can be said of other mid-sized and smaller banks in the USA.

Antonio Fatas, Professor of Economics at INSEAD business school, told Euro News he didn’t see a systemic risk in Europe yet either from SVB’s collapse, commenting:

“The fundamental difference is the type of regulation and stress tests that we do in Europe are more strict.”

It’s not risk free but the chances of major UK and Eurozone banking stocks being caught up in any contagion seem limited. Which could mean investors see the recent hit to valuations as an opportunity with buying activity quickly leading to a recovery of losses. And even if there is no immediate bounceback, the expectation would be for the valuations of banks that successfully assure markets they are not at risk to bounce back in the not too distant future.