Given today’s economic uncertainty, investors are understandably asking how banks would perform in the event of a recession. In his latest paper, Romain Miginiac, Head of Research at Atlanticomnium S.A., looks back at the Global Financial Crisis (GFC) and argues that banks’ performance during this period may offer a strong source of comfort regarding the resilience of the sector.
It is understandable that investors are currently raising the question of how banks would perform in the event a recession. Banks are macro-sensitive by nature, given their lending activities and securities holdings. In a downturn, losses on loans increase as borrowers’ capacity to service debt declines, and the value of securities declines as a result of weaker markets. Profitability is impacted as a result as banks need to absorb higher losses. In case losses exceed earnings, excess capital is used to absorb losses while the scale of losses depends on the severity of the recession, as well as the risk on banks’ balance sheets.
We believe, however, that the stigma from the GFC (and other crises) continues to overshadow the banking sector and leads to an underappreciation of its resilience. The scale of losses, capital raising, and bailouts during the GFC was stratospheric – showcasing the vulnerability of the sector at that time. Systemic risk emphasised vulnerabilities in the financial system, hence the widespread impact of the crisis. This continues to overshadow the sector today and, in our view, leads to an underestimation of its transformation since the financial crisis. More than a decade of regulation has led to de-risking, capital accumulation and the reduction of other vulnerabilities (reliance on short-term funding etc.), fundamentally reshaping the sector. For bondholders, the focus should be on de-risking rather than capital accumulation, the former making the latter less relevant.
The de-risking journey that banks have embarked on since the GFC will materially reduce the scale of losses in a future downturn, in our view. This is driven both by banks’ exit from more risky investment banking activities and their increased focus on lower risk lending portfolios, namely residential mortgages. In our opinion, banks have become boring, which is exciting for bondholders. Ultimately, if losses are significantly lower and manageable through earnings, excess capital may prove redundant. This is an excellent problem for a bondholder to have: sitting above a significant amount of capital that is unlikely to be needed as the magnitude of potential losses has been slashed. In summary, banks today are overcapitalised and de-risked, utility-like entities.
In our latest paper, we analyse the GFC more deeply through a lens of “which activities are banks still involved in today”, which we believe provides good insight into the banking sector and may indeed be the strongest source of comfort regarding the resilience of the sector. As with many topics, we show that the angle taken can significantly alter the conclusion. UBS’s headline cumulative net loss in the years from 2007 to 2009 was around CHF 28 billion, but at the same time, the group’s wealth management and retail banking units delivered an estimated return on equity above 15%1 throughout the crisis. UBS was not an anomaly; rather, a significant number of banks were profitable throughout the crisis and raised equity defensively in the face of rising capital requirements. In the paper, we dig beyond the headline trillions of losses from activities no longer core to European banks’ business models to show that banks’ performance during the GFC indicates their strong ability to absorb losses in a stressed scenario without negatively impacting bondholders.
We argue that the European banking sector’s resilience and ability to absorb losses even in a tail scenario should be highly supportive of valuations compared to other sectors. Quarterly earnings should continue to act as a catalyst for a re-rating of the sector – as higher rates feed into higher profitability. In case a downturn materialises, this is also likely to act as a positive driver of valuations, as these would reflect a high ability to manage higher loan losses. While in the short term a downturn is likely to lead to continued market volatility, longer term, we believe banks showcasing their resilience should materially improve the perception of the sector and demonstrate its transformation over the last decade. The ability to navigate a downturn without impairing bondholders’ war chest (excess capital) should imply banks trading at the tighter end of the market. Subordinated debt of banks offers investors the ability to add exposure to a highly resilient sector in an uncertain environment while capturing some of the highest yields available in the market.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not a reliable indicator of future results or current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented and are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realised.