When Emotions Override Regulations

Global Financial Crisis was a great lesson for all, but primarily for the players and regulators of the financial industry, which have tightened the reigns and became much more critical in stress-testing. However, despite these efforts and all the lessons learned, we yet again face great turbulence in the sector.

Confidence in the continuity of banks’ operations seems to be much more crucial than Tier 1 and Tier 2 capital requirements. There were different causes (asset-liability mismatch, operational complexity, lack of risk control) that paved the way to the collapse of SVB, Credit Suisse and Signature Bank, but the major accelerator of that process was an emotional perception – money has always been a very sensitive topic causing an immediate reaction, the speed of which is eased by the modern technology.

The banking industry, per se, bears a great amount of risk, which is multiplied during uncertain times. Compare the capital structure typical for the financial industry with the average of all industries (Fig.1 & Fig.2). Leverage of financial industry players multiple times exceeds the median level of the market. These industry representatives expectedly have a much weaker Balance Sheet structure as hinted by the leverage and debt level.

Figure 1: Debt to Equity level of Financial Industry vs. the broader market

Source: Hérens Quality AM, Reuters

Figure 2: Asset Leverage of Financial Industry vs. the broader market

Source: Hérens Quality AM, Reuters

Overall, banking industry is objectively very difficult as the cost of a mistake can be huge and, despite tight regulations, the issues still pop up even with industry’s flagships. And the ‘Too big to fail’ saying is not really relevant here. Just consider the frequency and the amount of problems Credit Suisse experienced during the last decade, which ended in $17bn write-down of subordinate bonds.

Figure 3: Mounting problems of Credit Suisse

Source: Financial Times

Essentially, we have a good old principal-agent problem that caused Great Financial Crisis in 2007-8, but of a much smaller scale, and killed the worst players of banking industry – SVB managers were incentivized based on Return on Equity vs peers (the only way to do it is to take more risk), Signature had poor transparency and exposure to crypto, while Credit Suisse accumulated business relationships that were a source of revenue for managers, but not for the shareholders. So, we found out (or received a clear confirmation) who was swimming naked in the sea of free money.

Financial industry – our approach

We have a bottom-up approach to stock selection. Due to rather strict quantitative screening criteria, where capital structure is considered, usually we have very few financial industry players and even fewer banks on our investment radar. It leads to the historical asset allocation in Quality investing, where financial industry makes only a small fraction of the portfolio and banks are having none of it.

Figure 4: Global Quality Strategy

Source: Hérens Quality AM

Rest assured that it was tempting to add banking stocks to the portfolio when the conditions were favorable for this industry, and there was a constant downward pressure on the performance because of our underweight. In end, however, consistency always pays off. It paid off in 2007 and 2008, and it pays off now. Having said that, is financial industry a total taboo for us? In fact, no. Financial sector is represented not only by risky banking business, but also by insurance companies, by research companies, by stock exchanges. There is a certain number of worthy companies within the financial industry, which have strong management team, plausible business models not depending on the interest rate level, and robust capital structure.

Past winners of Corporate Excellence award, where the assessment framework includes only company’s quality status disregarding valuation, prove that financial industry can produce some Quality firms as well. 9 of 100 best companies are coming from financial industry, though it is still lower than 16% weight of financial industry in the benchmark.

Figure 5: Distribution of Global TOP 100 Quality Companies vs. MSCI All Country World Index by Sector

Financial industry is not an exception and is able to produce quality companies, which deliver sustainable returns. As we usually say, do your own analysis, acknowledge risks and invest safely!