By Stephen H. Dover, CFA, Chief Market Strategist and Head of Franklin Templeton Institute, Franklin Templeton; and Lukasz Kalwak, CFA, Senior Analyst, Franklin Templeton Institute, Franklin Templeton

Following recent efforts by central banks and regulators to alleviate the banking crisis, Franklin Templeton Institute’s Stephen Dover and Lukasz Kalwak discuss their thoughts on the implications and outlook for the banking industries in the United States and Europe.

The repercussions of the Silicon Valley Bank (“SVB”) (SIVB) collapse continue to put the entire global banking sector under pressure. The US and European bank stock indexes, as measured by the S&P 500 Investment Banking & Brokerage Index and the Europe STOXX 600 Banks Index, dropped 15% and 12%, respectively,¹ from March 8, 2023, through March 22, 2023. Central banks and regulators have rushed in to provide liquidity to the banks, with the US Federal Reserve’s (Fed’s) balance sheet expanding by US$297 billion to US$8.64 trillion in the past week, reaching its highest level since November 2022.²

Here are some of the implications of the current crisis to the US and European banking sectors:

US regional banks may face higher operating costs as regulators reevaluate the existing capital/liquidity risk framework. Regulators at the Fed are weighing rules that could bring capital and liquidity thresholds for US banks with between US$100 billion and US$250 billion in assets closer to requirements that the largest banks face. The large banks are subject to Liquidity Coverage Ratio (LCR) rules, which require them to maintain minimum amounts of liquid assets to withstand cash outflows over a 30-day horizon. If similar requirements were imposed on mid-sized banks, they would likely need to replace their long-duration funding sources with more cash and more short-term securities. Shorter-duration liquid assets will most likely reduce banks’ profitability, Net Interest Margins (NIM), when rates start to decline.

Cash deposits moving from banks to money market funds. As clients look for higher returns on their investments, more deposits have been leaving the banking system with the biggest beneficiary being money market funds. There has been over US$100 billion of inflows into money market funds since the SVB crisis began, bringing money market balances to the highest level on record.³

The lack of availability of credit could start to negatively impact consumer spending. Historically, in our analysis, a high willingness of banks to lend money has been a good leading indicator for consumer spending.⁴ Should borrowing become more difficult, small businesses could be particularly hurt as they primarily use regional banks. Since US small businesses account for two-thirds of all jobs, falling availability of credit could result in significant job losses and a surge in unemployment.⁵ In addition, following a prolonged period of rising credit card debt levels and record high commercial banks interest rates on US credit cards,⁶ tightening of lending conditions may now negatively impact consumers.

Despite recent challenges, the US banking industry remains on a healthy footing with plenty of access to liquidity. In just the last week, the Fed and many other government programs added over US$500 billion of liquidity into banks’ balance sheets.⁷ Banks can now also get loans of up to one year by pledging US Treasuries, agency debt and mortgage-backed securities as collateral, which are valued at face value. This reduces the asset/liability mismatch that caused problems for SVB. This is important as it eliminates the need to quickly sell those securities (and incurring significant losses) in times of liquidity stress.

The Fed and several other major central banks also announced last Sunday a coordinated central bank action to enhance US dollar liquidity globally. US dollar agreements between central banks to exchange their countries’ currency with one another will now be offered daily (instead of weekly). This is important because it allows all banks who are counterparties to central banks locally to have access to US dollars and reduces dollar-based liquidity issues.

The long-term outlook for the US banking industry remains positive. We do not believe the events of the past week reflect a liquidity crisis comparable to those of the global financial crisis in 2008 or the pandemic year of 2020. Funding, liquidity and capital positions are generally much stronger now than in the past. While the banks’ NIM may come under pressure in the near term (due to a rising cost for deposits), the structural outlook is much better. Higher interest rates and an eventual normalization of the yield curve will offer banks a tailwind in the form of improving NIM and returns on assets. Higher regulatory capital requirements will be a headwind in the short term but should help ease stresses and funding costs longer term. Finally, digital transformation and other innovations should be supportive for the banking sector in the long term.

European banks should be resilient too. The implications of the SVB collapse are far less worrisome for the European banks, which have stronger regulation, typically hold bond portfolios to maturity, and are less exposed to interest-rate risk. European banks’ funding is also much more diversified as 40% of funding comes from stable retail deposits (as opposed to just about 7% for SVB).⁸ Capital levels are significantly above the regulatory minimums, and only about 4% of bond holdings in Europe are not marked to market (for SVB it was about 50%).⁹ As a result, there are fewer concerns on asset valuations and investment portfolios of the European banks.

UBS (UBS) acquires Credit Suisse (CS) for US$3.2 billion as regulators looked to stem a contagion threatening the global banking system. The framework of this deal has been designed by Swiss regulators to provide maximum stability to the country’s banking system, does not require shareholder approval and was already welcomed by the Fed, the European Central Bank and the Bank of England. The Swiss National Bank also pledged a loan of up to US$108 billion to support the takeover. We think that the issues around Credit Suisse were unique and are not reflective of the European banking system.

Understanding the impact of liquidity stress on conditions in the banking system is not straightforward. If we assume that the actions taken by central banks and regulators in the past week can temper depositor concerns, then the underlying health of European banks may offer long-term investors with attractive entry points.

What Are The Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions.

Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. Buying and using blockchain-enabled digital currency carries risks, including the loss of principal.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

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1. S&P 500 Investment Banking & Brokerage, Index, Total Return, USD. Calculation of the return as follows: 302.41(March 17^th)/364.17(March 8^th) -1=-16.96%. Europe STOXX 600 Banks Index, Price Return, EUR. Calculation of the return as follows: 141.03(March 8^th)/167.74(March 17^th) -1=-15.45%. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator of future results. See www.franklintempletondatasources.com for additional data provider information.

2. Federal Reserve, “FEDERAL RESERVE statistical release,” March 16, 2023. Bloomberg FARBAST Index.

3. Crane data accessed via Bloomberg News, March 16, 2023.

4. Analysis by Franklin Templeton Institute.

5. Source: U.S. Small Business Administration Office of Advocacy, “Small Business Facts: Small Business Job Creation,” April 26, 2022.

6. Franklin Templeton Institute, Federal Reserve, Macrobond.

7. Source: Federal Reserve, “FEDERAL RESERVE statistical release,” March 16, 2023.

8. Source: Morningstar UK, “What the SVB Collapse Means for European Banks,” March 13, 2023.

9. Ibid.

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