On 20 March, investors awoke to news Swiss authorities had used emergency measures to push through a hastily arranged merger of Credit Suisse and UBS. Following two recent bank failures in the United States, the announcement raised questions over the health of European banks and the broader economy. While market pressure on another European financial institution cannot be ruled out, we don’t view the sale of Credit Suisse as an indication of widespread vulnerabilities in the financial sector. That said, recent events are likely to further tighten credit availability, exacerbating existing headwinds for economic growth and risk assets.
The Credit Suisse/UBS merger has several unique elements that limit its relevance to the broader European banking sector. In recent years, Credit Suisse suffered from a string of scandals that resulted in just under CHF 9 billion of profit losses between 2021 and 2022. While capital levels looked adequate, the bank was in the middle of a complex restructuring that raised questions around future profitability and shareholder support. As such, an apparent acceleration of deposit outflows may have left Swiss authorities with limited choices, given the systemic risk presented by Credit Suisse to the broader Swiss economy. The combined assets of Credit Suisse and UBS total around 200% of Swiss GDP, roughly 8x the comparable ratio for the two largest US banks.
Prior to the collapse of Silicon Valley Bank (SVB), European financials were outperforming broader European stocks in 2023. Rising interest rates had boosted profits, while non-performing loans were at a near-record low. In fact, listed European banks had an 8.7% return on equity over the last 12 months, the highest since the Global Financial Crisis (GFC). This helped increase the sector’s Tier 1 capital ratio to roughly twice the levels seen before the GFC. Additionally, European regulators, unlike US equivalents, had not rolled back post-GFC requirements for stress tests of smaller banks, meaning fewer are likely to suffer the asset-liability management issues of SVB.
As rates have increased, banks’ lending standards have tightened sharply, to levels last witnessed during the sovereign debt crisis. The impact of recent events in the banking sector could see banks turn incrementally more conservative, as they look to further solidify their position and absorb higher funding costs. European Central Bank (ECB) survey data showed that demand for credit had contracted sharply even prior to this month’s banking turmoil, while lending data showed an acute slowdown in lending to corporates, as well as for mortgages. Though consumer loans have held up relatively better, negative real wage growth presents a continued headwind for that portion of the economy.
Elevated inflation may also mean the ECB will be slow to cut interest rates this year in response to decelerating economic activity, which will further weigh on growth. In a recent ECB press conference, President Lagarde referenced the ‘separation principle’, whereby financial stability objectives are considered as separate from its inflation objective, with each addressable via their own instruments. The ECB has liquidity provisions, if necessary, to help manage banking stability, while interest rates remain the primary tool to fight inflation. As such, the market expects the ECB to deliver approximately two more hikes between now and August. However, the market now expects rate hikes of 25 basis points instead of 50 basis points.
The latter stages of an economic cycle often reveal areas of vulnerability, be they market-based or in the real economy. The recent events at Credit Suisse (and other banks like SVB) are redolent of this experience, though we do not believe they are indicative of widespread vulnerabilities across the financial sector. Nonetheless, elevated macroeconomic uncertainty dictates that investors should carefully monitor holdings and be particularly mindful of risk exposures within portfolios.
Managing Director, Capital Markets Research
Senior Investment Director, Capital Markets Research