A Q&A in which we examine the reasons for the recent weakness of banks' securities

Banks’ securities have been plagued in recent weeks by exceptionally high volatility. For instance, the Bloomberg European bank equity index fell 28%* in the first six weeks of the year while the Markit iTraxx European senior financial credit default swap index – a measure of default risk – rose over 80%* over the same period. While prices have recovered rapidly since, market conditions remain skittish.

Lenders’ riskiest debt was among the hardest hit, amid uncertainty about just how new regulations – designed to avert a repeat of the Global Financial Crisis (GFC) – would operate. That recently prompted European regulators to review the way these new securities work to potentially reduce the likelihood of investors facing a surprise loss of interest payments.

In light of these events, our financial services credit analyst Oliver Judd explains what is going on in a two-part question and answer session. In this, the first part, he examines the factors behind the sell-off at the start of the year. In the next, Oliver will attempt to demystify the changing regulatory environment.

Banks’ securities were among the worst affected during the recent sell-off. Why?

It boils down to fear of a global recession, which has been fanned by a slowing Chinese economy and a plunge in the price of oil and other commodities. Provisions for bad loans are likely to rise. And with the fear of a recession comes the spectre of lower interest rates. In recent weeks we have seen interest rates turning negative in a number of countries. This is in turn likely to put further pressure on banks’ profitability.

The lack of confidence in banks has been building – are markets overreacting?

Yes, to a large extent. Banks are highly complex companies. That makes their securities hard to value. This, together with banks’ role in financing wider business activities, means they can be prone to big shifts in sentiment as investors sense changes in the economic outlook.

The market had become too optimistic about banks in recent years, to some extent forgetting the lessons of the financial crisis. It is inevitable that the quality of banks’ assets, especially their loan books, will deteriorate at some stage. But the bottom line is that we don’t see a repeat of the run-up to the financial crisis. Whereas before it was difficult to value most banks given the amount of assets they were hiding in special purpose vehicles (off their balance sheets), know we have a clearer picture of balance-sheet risks.

Balance sheets look strong enough to withstand some defaults and late payments. Just as the market was previously too bullish, it now appears too bearish. Non-performing loans are unlikely to rise nearly as fast as financial markets seem to be predicting.

Ultimately, we’re unlikely to see any banks fail, although investors would be advised to think about what weak economic growth and low interest rates might mean for profits.

Are some banks in a worse position than others?

Undoubtedly, most banks look to be in reasonable shape having in recent years significantly strengthened their balance sheets. But almost eight years after the climax of the GFC others still have a lot of work to do. Credit Suisse recently took a big restructuring charge, but Deutsche Bank is probably the prime example. Although the German lender has been restructuring its business since the crisis, most notably by reducing the size of its investment-banking arm, it has a lot more to do. And it remains heavily undercapitalised compared to its peers.

Disappointing results in January, coupled with a steep decline in equity and bond markets, led investors to speculate the bank may not have sufficient reserves to make coupon payments on its riskiest debt. This led to Deutsche Bank’s lowest ranked debt instruments plunging 16%* in the first six weeks of the year.

Indications that Europe’s banking regulator was considering changing some rules, which would reduce the risk of banks missing coupon payments, helped ease the sense of crisis surrounding the German bank. But the episode was a timely reminder of the need for urgent action.

How concerned are we about the financial sector’s exposure to oil and commodities risk?

Banks are exposed to a wide range of sectors given their role in financing business activities. While disclosure from US and European banks is not uniform, the information that is available suggests loans to the energy sector account for between one and four per cent of different banks’ balance sheets.

While there is an obvious risk that more and more of these loans turn sour if oil prices remain at current levels for a protracted period, this is unlikely to jeopardise any bank’s survival. Ultimately, while it’s an issue for equity investors, it’s less of one for bond markets.

*Source: Bloomberg

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 24 March 2016. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

Important notice: DIFC

This document is intended for distribution only to Persons of a type specified in the DFSA’s Rules “Professional Clients” and must not, therefore, be delivered to, or relied on by, any other type of Person. This document is for the exclusive use of the persons to whom it is addressed and in connection with the subject matter contained therein. This communication is distributed in the DIFC by Aviva Investors Global Services Limited Regulated by the Dubai Financial Services Authority as a Representative Office with its address at Office 108, Al Fattan Currency House, DIFC, Dubai, UAE, and entered on the DFSA register under Firm Reference number F001481. The Dubai Financial Services Authority has no responsibility for reviewing or verifying this document. The Dubai Financial Services Authority has not approved this document nor taken steps to verify the information set out in it, and has no responsibility for it.

Issued by Aviva Investors Global Services Limited, the Investment Manager to the Fund registered in England No. 1151805.  Registered Office: St. Helen’s, 1 Undershaft, London EC3P 3DQ.  Authorised and regulated by the Financial Conduct Authority and a member of the Investment Association.  Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London EC3P 3DQ.

Approved for Austria, Belgium, Denmark, DIFC, Finland, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, Switzerland and the UK.