Astra Asset Management questions the wisdom of FINMA Decree

Shikha Gupta, Portfolio Manager at Astra Asset Management, shares her insights on the European Banking sector. In this article,

Shikha Gupta delves into the challenges faced by the European Banking sector in the current interest rate environment and impact of forced acquisition of Credit Suisse by UBS.

Astra Asset Management, founded by Anish Mathur in 2012, is a leading investment management firm specializing in a wide range of financial products ranging from credit and structured credit. With over a decade long extensive expertise in securitisations backed by financial exposures in European and US banks.

Through one stroke, have the Swiss gifted the European banking sector to America? 

On 19th March 2023, Swiss FINMA declared a complete wipe out of the $17 billion, Credit Suisse AT1 bonds. The resulting legal battle may take years to conclude; rendering discussion of the legality of the decision to wipe out Credit Suisse’s AT1 bonds, purely speculative. However, the fall out of this decision does have immediate implications beyond the Swiss Banks, reaching the broader European Banking Sector. As a portfolio manager of Astra Asset Management, a leading European Credit Manager, we are vested with a significant interest in the financial strength of the European Banks.

Increasing differences between US & EU banking sectors since the hay days of 2006-07

Ms Gupta, at Astra Asset Management, highlights that for anyone following the sector, it is evident that since the aftermath of the previous financial crisis, now fondly remembered as the GFC (The Global Financial Crisis), European banks such as Credit Suisse and Deutsche Bank lagged far behind their American counterparts. With revolving doors between the bankers and traders, it is clearly not the talent that puts them apart. Doubtless, some of US banks may have better systems and practices, but the real differentiator is the regulation.

Post GFC, regulator’s overzealous approach to making the European system watertight may have suffocated the system itself. The teams working to ensure compliance with regulation, accounting standards and other control support staff far outnumber those tasked with revenue generation for the banks.

American regulators put the brakes on in the aftermath, targeting proprietary trading with the Volcker rule / Dodd Frank Act; under the Trump Administration, the Fed rolled back these rules to allow investment in venture capital and credit funds. However, credit risk retention rules, still require European issuers to retain no less than 5% of their issuance.

Surprise! Surprise! Profitability has taken a dive; for European Banks.

Astra Asset Management’s views on spiralling capital costs

Put simplistically, banks profit from the difference between the interest they charge their borrowers and the interest they pay to their depositors and bond holders. The Net Interest Margin (NIM) is therefore merely a function of the base costs and financing costs (base costs being infrastructure and credit losses).  In the event that base costs remain broadly the same, the biggest differentiator between banks is the financing cost at which they borrow money from the market.

Occupied by regulatory fines, scandals, and governance challenges, European banks have faced incrementally higher financing Costs compared to their American counterparts. Considering the cost of AT1 capital denominated in US dollars, JPM and Citi pay spreads of 1.55% and 2.43% over forward rates, respectively. Whilst in Europe, UBS and HSBC have significantly higher spreads of 4.14% and 3.36% when calculated to maturity (using the Bloomberg terminal). In addition, equity investors of European banks have consistently lost capital since the crisis and very little hope seems to capture investor’s imagination. After forced alliance of CS with UBS, Help is not likely to come from the Middle East. If larger investors decide to sell their stakes in the banking sector, we could be looking at further stress as banks struggle to meet future capital requirements. This does not paint a pretty picture.

AT1s have provided a steady capital base for the European banks and, in the low yield environment that we have been in; have been a great source of high-risk capital for banks; swapping growth and low dividends for general stability and higher coupons.

The write-off of the CS AT1 bonds has repriced the risk for all European banks. In addition to the higher interest rate environment, investors now demand a significantly higher risk premium for investing in these bonds. This repricing is justifiable, considering the write-off occurred just a few days after CS reported a Tier 1 capital ratio of 20% and FINMA provided comfort to the market that CS was stable.

Under the leadership of the chief investment officer Anish Mathur, as a manager, Astra believes that these risks may have been overpriced and lessons may have been learned by the regulators. Therefore,  some AT1s could still be very interesting and provide attractive short / medium term returns for investors.

Implications for European banking competitiveness

Europe lacks a knight in shining armour, with help not likely to come from anywhere obvious. With higher compliance costs, higher financing costs and now higher Tier 1 capital costs, European banks face a much higher cost base. European banks will have to either charge a greater premium, be less competitive and lose business to their American counterparts, or maintain competitiveness and sacrifice profitability further, if that was even possible.

Astra Asset Management’s Shikha Gupta Compares European and US Banks

US banks are not without their own set of problems. The stark increase in interest rates and the resulting nose-dive of their own treasury holdings in Hold-to-Maturity books have already claimed a few casualties, including the second largest bankruptcy after Lehman. While European rate hikes have been steady, the sheer size and speed of increase in the USD rates coupled with lack of hedging regulations around US banks, have caused great damage. The issue of their exposure to low rate 30yr fixed mortgages also looms large in the US. The cost of this exposure alone would create a substantial dent to profitability, yet equity investors have not dramatically penalized them. Despite the recent challenges faced by some US banks, such as SVB and First Republic, the overall cost of equity capital for US banks has not experienced a significant increase.

This can be attributed to a combination of factors, including a stronger and more stable banking system, improved risk management practices, and greater investor confidence. Our American counterparts enjoy much healthier equity, a slimmer cost-line, and strong core of regulatory support.

Confidence that exists in the US banking sector, despite the challenges above is what keeps their cost of capital lower. The higher cost of equity capital for European banks therefore presents a sustainable challenge to their profitability. The outlook is weak, with European banks at a further disadvantage from cost of capital impacts on their lending activity, to other key aspects such as talent acquisition. In order to keep the NIM stable, they will need to cover their elevated cost of capital.

Expecting intervention and protection of European banks through trade barriers and political obstruction is not even an option and hence I rule it out completely.  Large borrowing costs do not just impact the banks but put significant pressure on the competitiveness of the European Banking industry in general. In the medium term, if European banks are not able to maintain their NIM, their higher lending rates can put pressure on borrowers beyond large international corporates to individuals and SME businesses. This may have implications for economic growth and can potentially limit borrowing activities, impacting investment and consumption.

End Game

Shikha Gupta at Astra Asset Management believes that while investors can benefit from the current AT1 disarray, the European Banking situation needs a rethink, primarily from regulators, otherwise the American banks will prevail, having indeed proven resilient in the face of fines and scandals.

Disclaimer

Astra Asset Management UK Limited is authorised and regulated in the UK by the Financial Conduct Authority and by the Securities and Exchange Commission, in relation to US persons only, as a Registered Investment Adviser.

The information in this article is for general information purposes only and does not comprise investment advice or an investment recommendation. It is not (nor is intended to be) particular to any investors’ individual circumstances and does not (nor is intended to) constitute either an offer to buy or sell or a solicitation of an offer to buy or sell any securities, in any jurisdiction. Forward-looking statements are not guarantees of future performance and undue reliance should not be placed on them: the value of an investment may fall as well as rise over time, and there is no certainty of any given return. It is possible to make a significant, including total, loss on any investment. Before making any investment decisions, prospective investors should take such investment, legal, financial, tax and other professional advice they deem necessary. Astra accepts no liability and assumes no duty of care in relation to the information contained in this article.

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Astra Asset Management questions the wisdom of FINMA Decree