Why (most) Iberian banks are better prepared to face higher interest rates than US banks

A look into JP Morgan, First Republic, Bankinter and Caixabank loans' fair value

While I been working on a write-up on Vidrala for the past month and intend to publish it soon, I thought that a write-up on banking would have a better sense of timing. And, afterall, I’ve started my career as a banking analyst during the European Sovereign crisis of 2011 (what’s better timing than that!?) and I do own one bank in my portfolio ever since 2012 — Bankinter.

To understand why Portuguese and Spanish banks are better suited to deal with higher interest rates than most US banks, we first need to understand what is happening:

Banks are in the business of taking deposits and making loans — well, mostly… They also make plenty of commissions from other services such as distributing investment funds, advisory, brokerage and so on. Banks can also use their liquidity to invest in tradable bonds (mostly long dated government bonds with fixed coupons). These bonds are booked either at as Asset-For-Sale, AFS, or Held-To-Maturity, HTM. With rising interest rates, bond prices have declined, however, is important to note that changes in value of AFS bonds affect the banks capital ratios while HTM do not unless the bank sells them. Regulators allow it because as long as the bank holds these bonds to maturity they will recover its value (assuming there is no default). But… if a bank faces a run on deposits, it may be forced to raise liquidity by selling its HTM and crystallized its losses causing both liquidity and solvency problems.

When banks lend directly to companies and households we typically refer to this as the banks’ loan book. Therefore, most banks have a bond portfolio (AFS and HTM) and usually a much larger loan book. Similar to HTM bonds, loan book valuation changes due to interest rates does not affect bank’s capital position. However, as it seems, it does affect depositors and investors perspective on the banks’ solvency.

As Marc Rubinstein pointed out here, the main reason for the collapse of SVB has been two-fold:

We highlighted the asset side of its balance sheet, which was chock-full of long duration securities, most of which had been pushed underwater by rising rates yet did not have to be marked as such. And we highlighted its deposit base, which was heavily concentrated around a relatively small number of uninsured depositors, whose average deposit balance was $4.2 million (versus the $250,000 insurance threshold). (emphasis is mine)

That led to contagion as fear spreaded. There was a sell off of banks’ share prices and concerns with regard to whether other sizable regional banks such as First Republic would stay liquid as clients moved their deposits elsewhere. It also revived older concerns about Credit Suisse (CS) which ultimately led to Swiss authorities to intervene: CS shares lost most of their value as the bank was forced to merge with its Swiss rival UBS. The Swiss authorities also surprised by also deciding to completely wipe-out CS’s AT1 bond holders, apparently not following tacit pari passu rules — CS’s AT1 prospectus allowed for it.

Summing up, we have the following going on:

1. Increasing interest rates causing a value decline in assets that earn fixed interests;

2. Some banks facing a run on deposits as clients worry about their uninsured deposits.

I believe that (most) Iberian banks are better protected from both concerns, but I will focus on the point 1 in this letter.

In the case of First Republic and even of bigger US banks such as JP Morgan (albeit to a much lower extend), the problem is not only restricted to their securities portfolio but also includes their loan books. US banks’ loan book is also at fixed rates. While in Iberia, as Portuguese and Spanish households with mortgages know very well, most loans are made at variable rates. As interest rates increase (higher Euribor), Iberian banks earn higher interests and their loan book value is largely protected from interest rate risk.

Let’s look at four examples: JP Morgan, First Republic, Bankinter and Caixabank:

As you can see, the situation seems quite dramatic for First Republic. If it was to book its assets at fair value it would be insolvent (total loses amount to over 150% of its equity value). This also explains why it would be difficult for another bank to came and rescue it as some kind of bail-in (losses for debt holders) or bail-out (public assistance) would would be necessary to make the deal attractive. Even JP Morgan would see its equity chopped by ~20%.

As for the two domestic Spanish banks: Bankinter and Caixabank, the market to market of the HTM portfolio would largely be compensated by the increased value of their loan book.

With regards to point 2, the deposits outflow risk: The wider the retail base of deposits, the stickier are these deposits. It was remarkable to me that during the Sovereign crises of 2011-12 there has been no relevant deposits outflow in Iberia despite the collapse of several banks and the dire straits of public finances. It certainly helps that most domestic banks are in fact retail banks with dispersed (largely insured) deposit base.