It’s been a whirlwind of a week in global markets. Concerns over the stability of the global banking system emerged after a few sudden U.S. bank failures and signs of stress at a larger European one. Policymakers responded quickly and the situation has stabilized, for now. We discuss this below, and reiterate our confidence in the investment outlook for the Canadian banking industry.

History has taught us that some investors, consumers, or businesses find themselves caught in a vulnerable position nearly every time financial conditions have tightened. This has largely resulted from complacency or dependence on cheap financing to enhance returns, fund spending, and grow profits. This time appears to be no different. Interest rates began their ascent nearly a year ago and the first signs of challenges emerged within the venture capital industry, as some early stage companies saw their access to low cost capital vanish quickly. A surprise then emerged last fall when the Bank of England stepped in to rescue a number of U.K. pension funds that had their bond portfolios marked down meaningfully as a result of higher interest rates and leverage. More drama unfolded over the past week as a few regional U.S. banks were shut down as a result of a classic “bank run”, in which an overwhelming number of depositors (clients) lost confidence and decided to withdraw their funds.

The banks in question this past week shared a combination of attributes: a clientele that was tied to certain industries like venture capital, a disproportionate amount of client deposits that was uninsured, bank assets that were concentrated in fixed income securities like government bonds with unrealized losses due to higher interest rates, and less stringent regulation compared to larger banks. These factors ultimately led to the banks’ demise. The situation in Europe on the other hand is different as the bank in question, Credit Suisse, is significantly bigger and has been plagued by challenges for years.

Central banks, governments, and other commercial banks have taken swift action. They announced guarantees of all deposits at the failed U.S. institutions, and injected deposits to other banks in an effort to shore up confidence in the banking system. Moreover, a new lending facility was created to allow U.S. banks to exchange securities like bonds for emergency funds. Meanwhile, the Swiss National Bank has stepped in to lend Credit Suisse a sufficient amount of funds to support it for the time being.

We believe the past week’s events have two near-term implications. First, financial conditions are likely to tighten further as banks prioritize liquidity and capital. This will inevitably weigh on growth as some consumers and businesses may have a more difficult time accessing credit. The second implication is that central banks like the U.S. Federal Reserve may think more carefully about future policy moves as they now have to balance the stability of the financial system along with inflation and growth. That said, the European Central Bank still raised rates over the past week and markets still expect the U.S. “Fed” to do the same once it meets over the coming days.

Not surprisingly, shares of the Canadian banks have been volatile as they have moved in sympathy with U.S. and global peers. But, we remain confident in the stability of the Canadian banking industry. Unlike some of the U.S. regional banks, the Canadian banks have a few advantages: a deposit, asset, and customer base that are all very well diversified, elevated liquidity positions, and high capital levels. While heightened regulatory scrutiny over the past few years may have limited the Canadian banks’ profitability, it has left the group better positioned to deal with periods of stress.

Following the collapse of Silicon Valley Bank (SIVB), it’s understandable that investors may feel anxious, but when a bank or any other company falters, your investment plan shouldn’t.

This week, we have been considering a saying attributed to Nobel laureate Harry Markowitz that diversification is the only free lunch in investing. When we incorporate core investment principles in your investment plan, such as global diversification, it can give you respite from concerns about the fate of individual companies.

Investors with a broadly diversified global equity and bond allocation (typical of the investment portfolios held by our clients) can have exposure to thousands of companies, issuers in dozens of industries, and countries around the world. For instance, as of February 28, SIVB was just one of more than 9,000 companies in the MSCI All Country World IMI Index (MSCI ACWI IMI) and represented a mere 0.03% of the index.¹ As of the same date, US regional banks in total represented only 1.15% of the index, with the largest at 0.10%.²

Global diversification may not make headlines, but thanks to financial innovations over the last century in the form of diversified mutual funds and ETFs, it’s an accessible, affordable strategy for investors.

 

1. The MSCI All Country World IMI Index is a broad market-capitalization-weighted index of public companies across developed and emerging markets globally. As of February 28, 2023, the MSCI All Country World IMI Index included 9,010 companies. MSCI data © 2023, all rights reserved. Silicon Valley Bank weight represented by its parent company SVB Financial Group.

2. Regional banks weight reflects the weight of the “Regional Banks” GICS Sub-Industry as of February 28, 2023, as defined prior to March 17, 2023. GICS was developed by and is the exclusive property of MSCI and S&P Dow Jones Indices LLC, a division of S&P Global.