Macaskill on markets: Banks can use this crisis to repel boarders

The recent collapse in values across asset classes is disastrous for most investors. Banks could nevertheless see some upside from the crisis, as trading revenues receive yet another boost and shadow banking competitors are forced onto the defensive.

The bear market in equities that officially arrived in mid June, when indices fell more than 20% below their recent highs, is affecting sentiment differently than it did during the last comparable downturn at the start of the Covid pandemic in March 2020.

When prices slumped and markets become disorderly as the world went into lockdown in 2020, central banks acted quickly and decisively to restore confidence. Government spending also arrived on a timely basis and economic confidence revived surprisingly swiftly, given the unknown nature of the threat from the pandemic.

The current bear market is effectively being administered by central banks led by the US Federal Reserve as they try to combat inflation, and there is no consensus about how long this might take.

Central bankers who became used to delivering whatever stimulus it takes to support markets are now embarking on an unfamiliar task of withdrawing support, while hoping that any related recession is not too severe.

The collective market gloom about the likely effect of this policy on asset values is entirely logical.

One brighter side effect of the rise in interest rates and a related crash in equity values has been a revival in market revenues for banks.

Yet another 'one-off' boost in trading income for dealers from repositioning by clients will bolster second-quarter results for big banks and help to offset the impact of disappointing investment-banking fee generation and a deteriorating environment for credit quality.

The last full week of the second quarter also brought a boost for big banks as the Fed gave all the firms in its annual stress test a pass grade.

The strong aggregate performance of the sector in the Fed’s doomsday scenario underscored the extent to which new capital rules introduced in the wake of the 2008 global financial crisis have strengthened banks, especially in the US.

In contrast, the crypto trading market is effectively going through its own version of the credit crisis of 2008.

A series of hedge fund implosions and revelations of unexpected leverage by crypto lenders do not necessarily spell disaster for the entire sector.

Large crypto firms such as Binance and FTX have been quick to bail out distressed competitors in an attempt to play a role comparable to that of Warren Buffett in 2008 by projecting confidence with investments at beaten-down values.

And even central bankers have been willing to draw comparisons with an earlier market slump by endorsing the theory that the current crypto wreckage will eventually prompt the emergence of a few dominant players, as was the case after the bursting of the bubble in internet stocks in 2000.

Bank of England deputy governor Sir Jon Cunliffe gave an explicit endorsement of the long-term viability of crypto technology in a conference appearance on June 22. He also delivered an implicit vote of confidence in firms such as Binance and FTX by pointing out that the technology stock crash in 2000 was eventually followed by market leadership for firms such as Amazon.

Comparisons with previous crises have their limitations, of course.

The crypto market certainly bears a strong resemblance to the banking sector in 2008, complete with suspect valuation methods and uncertainty about where real risk lies.

It is not yet clear if the crypto bailouts seen recently are best compared to the takeover of Bear Stearns in March 2008 – with a much more serious Lehman Brothers-style failure still to come, however.

It is nevertheless probably safe to assert that there will not be serious contagion from the crypto crash to traditional financial market players, if only because regulation – or rather the lack of digital asset supervision – prevented most established firms from developing much trading or lending exposure.

Banks can now pursue their own digital asset experiments with much less concern that staff will be tempted to leave by the lure of potential crypto riches, in another upside of the recent downturn.

Big US banks are expected to celebrate their own central bank endorsement in the form of the Fed’s stress test results by launching substantial share buybacks over the coming months.

This should please shareholders, including the senior bank executives who take most of their compensation in stock.

But a wiser course of action could be to take advantage of temporary weakness in competitors such as crypto firms and fintech lenders before the emergence of any fresh Amazons.

Bankers such as JPMorgan’s chief executive Jamie Dimon regularly complain about the premium on the stock market valuations of new financial services competitors that can brand themselves as technology-based compared with share prices for established banks.

Disparities in the regulation of full-service banks and emerging competitors also prompt grumbling.

Now banks have an opportunity to monetise the upside of their own clear regulation in the form of greater confidence by taking steps to repel some of their upstart competitors, while the premium has been undermined by a slump in valuations for challenger firms, especially the more piratical entrants.

Banks can do this by deploying their formidable technology budgets aggressively, while spending by new competitors is constrained.

JPMorgan is expected to spend around $14 billion on technology this year. This budget is not based on assumptions about future share prices, as is the case for the many fintech firms that saw their nominal values first soar then slump as an asset bubble finally burst.

Other firms such as Bank of America have similar capacity to JPMorgan’s, and current market conditions present a chance to back up assertions that much of this money can be used to “change the bank”, as the phrase goes, rather than simply maintaining the IT needs of sprawling financial institutions.

Banks are far from immune to the effects of the current market downturn, of course.

The global recession that seems increasingly likely to accompany the central bank war on inflation has multiple potential downsides for banks, beyond simply affecting the credit quality of their loan books.

Discounts on leveraged loan and corporate bond packages are already emerging, with an associated cost for underwriting banks. Mortgage revenues are among a host of business lines that will be hit hard by the impact of higher interest rates.

Counterparty credit risk management across derivatives portfolios will present challenges. Trading blow-ups are almost inevitable, including via exposure to troubled clients.

This will lead to pressure to cut costs at banks, especially for high-budget spending items such as IT.

But there is also a chance that a recession will lead to a correction in course by central banks that helps banks by creating the right sort of volatility – where markets remain orderly, and most clients remain solvent.

A slowing in the upward pace of government bond yields in this scenario would probably lead to a recovery in equity valuations, eventually including firms such as fintechs that want to compete with big banks.

If banks don’t use this crisis to take active steps to repel the fintech boarders, they may regret it in the end when a new Amazon does eventually emerge.