Valuations of financial instruments have plummeted since the start of the year, leaving investors wondering whether a wave of bank write offs – be it from exposure to the energy sector or to fast deteriorating Emerging Markets – is about to start hitting some lenders.
In our opinion, this fear has simply been the trigger for a repricing of the banking sector, once investors have started to realize how regulation and central banks’ unconventional policies will have an impact on both earnings and the likelihood of default.
Starting with the latter, learning from the government bail-outs during the financial crisis, banking regulators worldwide have successfully introduced into their legislations the concept of a private debtors’ “bail-in”, first with the replacement of old Tier-1 securities by convertible-contingent subordinated bonds (CoCos), and later by forcing systemically important banks to issue “bail-in-able” senior debt. As a result, the implicit “put option” that banks (particularly those deemed “too big to fail”) enjoyed for free from governments has been effectively removed, and the inherent default risk of investing in bank debt has accordingly increased, turning senior financial debt more akin to high yield rather than investment grade.
As investors start to price in the new regulatory environment, banks’ financing costs are naturally increasing. This coincides with a period of very low and even negative interest rates that is in turn significantly reducing banks’ margins. As it seems that both effects will last for a long time, bank profitability looks badly impaired and thus explains the current low valuation of bank stocks. Furthermore, price corrections and surging volatility have increased the negative value of the put option implicitly sold by holders of CoCos, and thus have negatively impacted their prices, creating a feedback-loop.
In summary, at MWM, we consider that the present tribulations of the financial sector do not herald a repeat of 2008, but are rather a consequence of the actions taken to avoid it.
Fernando de Frutos, MWM Chief Investment Officer
(This article will be publish in Citywire Magazine)
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