Investor interest in the banking sector has surged as global interest rates continue to rise. While higher rates are generally seen as favourable for banks, Nick Clay, Head of Global Equity Income at Redwheel, takes a closer look that sheds a very different light for investing in the sector.
Like other capital-intensive businesses banks often suffer from market disinterest due to their seemingly modest growth prospects. Their ability to compound at a rate modestly exceeding their cost of capital can often go unappreciated.
Over the years, our fundamental research has taught us a crucial lesson: even slight changes in operating conditions faced by capital-intensive businesses can rapidly undermine dividend payments. Financial leverage, political interference, and the impact of technology, social media, and globalisation complicate the understanding and anticipation of these operational changes.
Financial Leverage
The combination of capital intensity and extremely high financial leverage within the sector means that tiny changes in non-performing loans (NPLs) can wipe out shareholders’ equity with frightening speed. The global financial crisis serves as a stark reminder, as non-performing loans (NPLs) surged to just 1.3% of loans at the Royal Bank of Scotland, leading to its poster-child status for bank bailouts in the UK.
While current data indicates record low NPL ratios in the banking sector, historical instances of bank failures and bailouts caution against complacency. Over the past two decades, 564 banks in the US alone have failed, with prominent institutions such as Wells Fargo, JP Morgan, and Goldman Sachs requiring significant government intervention during the 2008 financial crisis.
Political Interference: Political interference and state bailouts create long-lasting implications for capital allocation and dividend payments, making it politically difficult for banks to return capital to shareholders, as witnessed during the years following the global financial crisis.
Government coercion and its influence on capital allocation can come in other forms too. At times of stress, banks may be coerced into takeovers, the terms of which, are rarely favourable. For instance, Lloyds were encouraged to buy struggling Halifax Bank of Scotland (HBOS) during the height of the global financial crisis of 2008/09 and more recently, UBS being coerced into buying a failing Credit Suisse.
Impact of Technology and social media: Recent problems within the US banking system represent powerful evidence that banks are becoming increasingly sensitive to operational challenges. While it took two weeks for over $17bn of deposits to flee Washington Mutual in 2008 (the largest bank failure in US history), Silicon Valley Bank lost 2.5x that in a single day in 2023. This is a stark reminder that depositor behaviour can now correlate with frightening speed in a social media-driven, viral world. And, with suitable irony, it is the banks themselves that have created the conduit for this in the form of their online banking apps and technology.
This online conduit is important because banks’ key funding source, deposits, has historically been docile and slow to demand higher rates of interest due to the historically low correlation in depositor behaviour. It remains to be seen whether this stability, and its associated low cost, can be relied upon in an online world.
The interplay of technology, social media, leverage, and global interconnectedness amplifies the “butterfly effect” within the banking system, where minor events can trigger non-linear impacts with far-reaching consequences. An example of this related to events at Silicon Valley Bank in California which ultimately led to the collapse of Credit Suisse in Switzerland within a few short days in early 2023.
As we consider the current positioning, it becomes clear that banks are most attractive during times of peak non-performing loans. Since NPLs are near record lows around the world, we believe caution must be exercised. However, one bank stands out as a unique and resilient entity in the sector—Svenska Handelsbanken, our strategy’s only bank holding. Its corporate structure resembles that of a utility, prioritizing profitability, customer satisfaction, and cost management. This strategic focus has enabled Svenska Handelsbanken to weather financial crises without resorting to bailouts, maintaining historically low levels of non-performing loans.
