March witnessed the failure of certain regional banks in the US together with the collapse of Credit Suisse and its subsequent takeover by UBS.\u00a0 A repeat of the 2008 Global Financial Crisis was thankfully avoided as central banks together with some large banks intervened timeously to protect depositors. However, equity investors in these banks suffered write-downs in the order of 80-98%, while ironically AT1 bondholders in Credit Suisse saw their entire capital written down to nil.<\/p>\n
Of some comfort is that Dynasty clients were spared from the carnage in this global banking crisis, as our portfolios are extremely underweight to this sector. In support thereof, we recently quoted an extract of an article by Terry Smith, chief investment officer at Fundsmith (one of our core offshore funds), where he explained why he never invests in bank shares\u201d. We\u2019re including the full article below, which is actually an updated version of an article Terry had published in the Financial Times on November 1st, 2014, entitled “I do not buy shares in banks because I understand them.”<\/p>\n
It\u2019s a provocative and relevant read in which he argues that banks deliver poor returns on equity, are easily infected by their peers\u2019 woes, and are ripe for fintech disruption.<\/p>\n
\u00a0Terry Smith \u2013 20 March 2023<\/em><\/p>\n Having spent the first decade of my career working in a bank and then becoming a top-rated bank analyst, I find that people often express surprise that I never invest in bank shares.<\/p>\n But I think it is precisely because I understand banks that I never invest in their shares. The recent events surrounding the collapse of Silicon Valley Bank (\u201cSVB\u201d) and Credit Suisse reinforce this stance. Why?<\/p>\n Firstly, I never invest in anything that requires leverage to make an adequate return. Banks have a very small amount of equity to support their balance sheet. Here are the actual numbers for NatWest Group for 2022. To make it easier to understand I have reduced them to percentages:<\/p>\n Nat West Group\u00a0<\/strong> Loans<\/strong>\u00a0 373,479\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 52% Total Assets<\/em><\/strong> : 720,053\u00a0 \u00a0 \u00a0100%<\/p>\n ———————————————-<\/strong><\/p>\n Equity\u00a0 \u00a0 \u00a0<\/strong> \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a036,496\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 5% Total Liabilities<\/em><\/strong> 720,053\u00a0 \u00a0 \u00a0100% NatWest has \u00a35 of shareholder\u2019s equity to fund \u00a3100 of assets – it has gearing or leverage of 20 times. If 10 per cent of the \u00a352 of loans in every \u00a3100 of assets prove to be bad then the whole of the shareholders\u2019 equity is more than wiped out.<\/p>\n Frankly, long before that happens, depositors are likely to spot the problem and panic and cause a run on the bank, as we saw with SVB. Nor are these circumstances unimaginable. Author Nassim Taleb in his book The Black Swan points out that in the 1982 Latin American debt crisis the large American banks lost all of their cumulative past earnings.<\/p>\n In contrast, the average company in the S&P 500 Index (which includes banks which distort the numbers) has $26 billion of assets and $8.5 billion of equity – they are on average geared 3 times.\u00a0 Falls in asset value are not their main risk but their assets would have to fall by more than two thirds in value to impact the value of their equity.<\/p>\n Next, despite this massive leverage and the risk which accompanies it, returns from the banking sector are inadequate. The average Return on Equity (\u201cROE\u201d) in the S&P Banks Sector over the past five years is just 10.9 per cent. This compares with the ROE on the S&P Consumer Staples Sector over the same period of 17.9 per cent. These poor fundamental returns unsurprisingly translate into poor share price performance. The Total Return on the S&P Banks Sector over the past five years was -15.1 percent per year, whereas Consumer Staples returned +12.1 percent annually. So much for the theory that you need to take more risk to get higher returns.<\/p>\n Finally, surely there must be some good banks to invest in which are better than the average?\u00a0 That brings me onto another problem: systemic risk. Even if the bank you are invested in is well run it can still be damaged or destroyed by a general panic in the sector.<\/p>\n There is an anecdote which illustrates this. In the early 1980s doubts first set in about the future of Hong Kong with the looming handover of control to China and a crisis soon developed in the property sector which provided the collateral for much bank lending.<\/p>\n In the midst of this, there was a local bank which had an awning open over its front window to keep the sun out. It was by a bus stop and as heavy rain shower developed, the bus queue moved to take shelter under the awning. In the febrile atmosphere passers-by thought this was the beginning of a bank run and as a result one soon developed.<\/p>\n That\u2019s banking for you. Banks can be brought down by the actions of their peers. Look at what happened to some US regional banks in the wake of the SVB disaster. Lord Mervyn King, the former Bank of England Governor, encapsulated this when he observed that it made no sense to start a run on a bank but once one has started you should join in.<\/p>\n That encompasses my long-standing reasons for avoiding bank shares but another has emerged in recent years – Fintech. What are the essential functions of a bank? To take deposits, make loans and effect payments. All of these essential roles are now being supplanted by so-called fintechs. Bank loans are being replaced by peer-to-peer lending platforms and credit funds. You don\u2019t need a bank for payments or deposits. You can get your salary paid straight into your Mastercard or Visa account and they are far better at payment processing for which you can also use your Apple or Android phone.<\/p>\n Technology is supplanting traditional banking. Have you noticed that your local bank branch has become a Pizza Express, in which role, by the way, it makes more money. Not only that but the banks are often handicapped by legacy systems which do not trouble new entrants and at least until recently fintech start-ups enjoyed a seemingly endless supply of funding with little or no requirement to show a profit.<\/p>\n As Paul Volcker, the infamous former Chairman of the Federal Reserve Bank, said the only innovation of any consequence by the banking sector in the 20 years running up to the Global Financial Crisis was the ATM, and we don\u2019t even need those any more.<\/p>\n Terry Smith is chief executive of Fundsmith LLP.\u00a0<\/em><\/p>\n","protected":false},"excerpt":{"rendered":" March witnessed the failure of certain regional banks in the US together with the collapse of Credit Suisse and its subsequent takeover by UBS.\u00a0 A repeat of the 2008 Global Financial Crisis was thankfully avoided as central banks together with some large banks intervened timeously to protect depositors. However, equity investors in these banks suffered…<\/p>\n","protected":false},"author":14,"featured_media":66525,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[175],"tags":[],"class_list":["post-66524","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-opinion","category-175","description-off"],"_links":{"self":[{"href":"https:\/\/www.dynasty.co.za\/staging\/wp-json\/wp\/v2\/posts\/66524","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.dynasty.co.za\/staging\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.dynasty.co.za\/staging\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.dynasty.co.za\/staging\/wp-json\/wp\/v2\/users\/14"}],"replies":[{"embeddable":true,"href":"https:\/\/www.dynasty.co.za\/staging\/wp-json\/wp\/v2\/comments?post=66524"}],"version-history":[{"count":0,"href":"https:\/\/www.dynasty.co.za\/staging\/wp-json\/wp\/v2\/posts\/66524\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.dynasty.co.za\/staging\/wp-json\/wp\/v2\/media\/66525"}],"wp:attachment":[{"href":"https:\/\/www.dynasty.co.za\/staging\/wp-json\/wp\/v2\/media?parent=66524"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.dynasty.co.za\/staging\/wp-json\/wp\/v2\/categories?post=66524"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.dynasty.co.za\/staging\/wp-json\/wp\/v2\/tags?post=66524"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}
\n(\u00a3mn)<\/p>\n
\nCash\u00a0<\/strong> \u00a0 144,832\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 20%
\nBonds\u00a0<\/strong> \u00a030,895\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 4%
\nOther<\/strong>\u00a0 \u00a0170,847\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 24%<\/p>\n
\nLoan Capital\u00a0 \u00a0 \u00a0<\/strong>58,585\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 8%
\nDeposits\u00a0<\/strong> \u00a0 \u00a0 \u00a0 \u00a0 \u00a0470,759\u00a0 \u00a0 \u00a0 \u00a065%
\nOther\u00a0 \u00a0 <\/strong>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 154,213\u00a0 \u00a0 \u00a0 \u00a0 22%<\/p>\n
\nSource: Bloomberg<\/p>\n