Aussie versus US banks: How credit quality measures up

With the recent forced takeover of Credit Suisse by UBS and the failures of US Banks Silicon Valley Bank, Signature and Silvergate, the natural tendency is for investors to think immediately of "contagion".

• What will this mean for banks in my jurisdiction? 
• Have they made the same mistakes? 
• How would we know?

While these are important questions and appropriate to ask, the market often overshoots in terms of de-risking positions only for others to take advantage when relative value metrics look out of position. 

Investors need to ask themselves these questions and more, with the first being – do I have sufficient information and/or professional knowledge to appropriately assess the situation? Running to cash may seem the best solution, but it can lead to significantly compromised investment outcomes.

Investors always need to exercise a high level of due diligence when selecting any assets - credit included. The fact that interest rate volatility is at long-term highs, as seen in the whipsawing nature of risk-free bond yields, suggests credit manager selection requires particularly close attention in this environment. Recent events should simply act as a reminder of this.

How do they do that? Given the many nuances of credit investing, the best way to do this is to ensure experienced credit managers are the ones making the decisions and remaining disciplined in their investment decision-making processes.

With elevated levels of rates volatility, we would suggest this is a time for active management, not passive. This allows for quick adjustments across various performance factors, including duration or credit risk.

To assist in answering some of those earlier questions, the assessment of bank credentials, capitalisation, liquidity positions and funding capabilities, etc are crucial measures that should be top priority for a prudential regulator. 

Regulator quality a standout difference

One of the stand-out comparisons between the Swiss regulator and the Australian Prudential Regulation Authority is the fact that Credit Suisse, with all its negative baggage – huge losses, financial reporting irregularities, investment disgraces (Greensill), among numerous other issues over the last decade - was delivered into a situation that it is hard to imagine happening in Australia, with the appropriately conservative APRA regulating the banking industry.

APRA’s guidance through the GFC, negative global credit concerns of 2015/16, the Pandemic and recent economic impacts from cash and mortgage rate rises have been nothing short of exemplary. 

Australia’s well-rated banks are highly focused on deposits and lending – the bread and butter of banking - while remaining true to APRA’s stringent rules around capital levels (increasing further between now and January 2026), liquidity and funding requirements. 

Quite frankly the outcomes in the US and Switzerland have been an embarrassment for regulators in those countries.

Any time there is such a blatant breakdown in corporate governance and internal risk management processes, events like those seen with Credit Suisse and the US banks are inevitable. You can only hide it or ride the wave of luck for so long. In these instances, we believe the key drivers of the end results were not due to central banks. More so poor risk management and regulatory oversight when it came to ensuring adequate internal processes were being followed.

What can be done differently? 

Improving internal risk controls is the obvious place to start, followed by the regulator doing the same with regard to the level of regulatory oversight required to ensure confidence in their banking systems is maintained. 

The times for criticising APRA for its conservative approach to prudential regulation are well and truly over. 

To some extent, APRA should be a model for other regulators, however, noting that the breadth of non-standard bank business progressed by these other banks (notably Signature and Silvergate had material exposure to Crypto Companies and much of the risks built into these businesses remains less comprehensively understood) means that a regulator needs to be up to speed on how to limit risk appropriately. Australia does benefit from a broadly traditional banking sector compared to the level of risk being taken on offshore.

From the point of view of the economy and considering the expedient nature of the resolutions applied, we don’t think the events pertaining to these bank failures alter the global economic outlook materially. 

Of course, it does highlight the potential risks in the banking systems and what happens when regulation is not appropriately applied. However, the events are changing some shorter-term investor behaviour. 

Evidence is suggesting that recent events are pushing investors into high-quality assets, as witnessed by the high inflows into money market funds in the US. Ironically, this is coming at the expense of deposits of smaller financial institutions as investors move to what they perceive as safe havens.

With elevated levels of risk-free rates in the form of government bonds or even high investment grade bonds, these are the asset classes that appeal most in this environment. Particularly as the lagging nature of monetary policy begins to play out.

Press the "duration" button?

There remain storm clouds looming on the horizon. While it has made sense to add some duration to portfolios in recent weeks, we would caution against pressing the duration button too hard given the persistent levels of elevated inflation globally and the tendency for it to take time to control. 

In Australia, the capacity for housing costs to lift inflation is becoming more sensitive to the economy. The recent monthly measure of CPI showed housing costs increasing almost 10% representing a continuing out-sized contribution to persistently high inflation. 

While the overall number descended, it will be the official quarterly number that we must now look to for real signs of the journey back to 2-3% inflation. Meanwhile, rates still have the capacity to be driven up and this will mean even tighter household liquidity.

It could well be that the effects of "the great ease" which saw mountains of cheap money injected into the economy in 2020 and 2021 were sufficiently large to hinder more materially the RBA’s capacity to use blunt monetary policy as a means to control the predictable inflation outcome. 

The lag in repairing the situation seems to be definitely longer and this can assist in making it difficult to negotiate a ‘soft’ landing or at least avoid a particularly ‘hard landing’ in the economy. The outcome may well be very well-performing banks in an economy at a standstill. The RBA has the whip hand here and while it stands ready to continue acting, investors stand by with a heightened focus on its actions.

This article was jointly authored by Nicholas Chaplin, portfolio manager and John Likos,  partner, BondAdviser.