March 15, 2023
Credit Suisse and Banking Sector Update
After a brief reprieve yesterday, equity markets are selling off again this morning amid fresh turmoil at Zurich-based bank Credit Suisse Group AG (CS). CS released its annual report last night and today shares in the bank are trading roughly 20% lower. In this article, we will share our perspective on which issues appear to be unique to the failed US regional banks that made headlines last week, which issues appear to be affecting Credit Suisse, and which appear to be common across the entire global banking system.
Last week’s regional bank failures were due to, in a word, insolvency. In simple terms, these banks were unable to meet liquidity needs of their depositors. Depositors were undiversified and uninsured and withdrew funds more rapidly than the banks could raise funds to satisfy withdrawals. In communications delivered earlier this week, we shared our view that it would be unlikely for the same dynamics to bleed throughout the broader banking system – this remains true, in particular due to the Federal Reserve support programs announced earlier this week.
Solvency does not appear to be the primary issue affecting Credit Suisse. Credit Suisse’s deposit base, capital reserves, and investments look very different than what presented at SVB and Signature Bank last week and CS has communicated a liquidity coverage ratio (ability to repay depositors) of 150%.
Profitability, however, does appear to be a problem at Credit Suisse. Credit Suisse is just a few months into a restructuring plan wherein it plans to spin out its investment banking division in order to focus on its wealth management business. This second strategy pivot in two years has failed to impress investors or halt client outflows. The bank is also dealing with findings of material weakness in reporting and control procedures for the past two years after being queried by the SEC and after receiving an adverse opinion on their internal controls by accountant PwC and fallout after a complete equity liquidation by Harris Associates – a significant investor in CS for almost 20 years. Meanwhile, the bank’s current largest investor (Saudi National Bank; 10% shareholder) announced that it was not in a position to inject additional capital into the bank.
While likely solvent, Credit Suisse’s profitability may be at risk and the same may be true for other banks. To attract or retain depositors, banks may need to raise deposit rates. This could compress interest margins. In addition, profitability could deteriorate if recession leads to greater loan losses than the banks have reserved for. Profitability problems often cause share price declines. At banks, there can be a macroeconomic impact as well if lower profitability leads to tightening lending standards and worse credit availability across the economy. However, lower profitability does not typically cause overnight bank failures like those of SIVB and SBNY.
Lastly, there remains a risk that, regardless of profitability, regulators could require banks to raise additional capital to shore up balance sheets. Capital raises (i.e. issuing more stock) cause dilution of existing shareholders and have the potential to make an otherwise profitable bank a bad investment. If regulators do require banks to raise additional capital, they’ll be put in the position of diluting shareholders at a time that their share price is already depressed. Credit Suisse, for example, has nearly doubled its outstanding share count since the 2008 financial crisis. Existing shareholders have been diluted by nearly 50%. The expectation of dilution is likely weighing on banking sector performance today.
Correlation vs. Causation
It would be easy to read today’s headlines on Credit Suisse and conclude global contagion amid fallout from regional US banks last week. There are some common factors. Global bank profitability is being challenged by unrealized losses on investments, declining deposit balances, and increasing loan loss provisions. Investors may be anticipating additional dilution if regulators require capital raises. As a business and an investment, Credit Suisse is facing a number of challenges, but we would encourage clients to separate those concerns from recent developments in the regional banking space. That said, banks continue to face a number of uncertainties in the current environment and we cannot rule out additional surprises.
We will continue to monitor developments and communicate our views. In the meantime, please contact any member of our team if you have questions.