Bank Contagion Fears Lead Stocks Lower

The US banking sector has been under pressure of late, and fears of contagion have driven a risk off mood into the end of the week. Global stock markets fell, bonds have found demand, and cracks are beginning to show in the soft landing narrative. Could this spill over into other assets and sectors?

Take a look at this chart of XLF, the US financials ETF. It fell by over 4% yesterday.

This ETF focuses heavily on the larger financial stocks in the sector, with Berkshire Hathaway, JP Morgan, Bank of America & Wells Fargo among the largest holdings.

Although the big banks showed some market weakness, the fears seemed to stem from elsewhere. We can trace a lot of this back to three smaller banks:

• Keycorp
• Silvergate
• Silicon Valley Bank

Keycorp fell short of expectations three days ago by downgrading their net interest income outlook. Basically the cost of deposit (interest out) vs the potential for larger credit losses are likely to weigh on earnings.

Silvergate never really recovered from the FTX debacle and “announced its intent to wind down operations and voluntarily liquidate the Bank in an orderly manner and in accordance with applicable regulatory processes” on the 8th of March.

But Silicon Valley Bank (SVB) seems to have been the final straw. Here’s how Bloomberg reported the news:

Santa Clara-based SVB’s ordeal began after its parent company, SVB Financial Group, announced that it sold $21 billion of securities from its portfolio and said it was holding a $2.25 billion share sale to shore up finances. The move was prompted by high deposit outflows at the bank due to a broader downturn in the startup industry, analysts say. SVB also forecast a sharper decline in net interest income.

When the market closed on Wednesday, SVB was trading above $260. Ahead of the open on Friday, pre-market pricing has the stock a little over $60, after closing yesterday in the $87 region.

So, three smaller, non-systemically important banks (non-GSIB) are in trouble for various reasons. Why does this matter to the wider market?

Contagion fears are being widely cited. Although the slew of regulations implemented in the wake of the GFC mean that a full on banking crisis is less likely this time, smaller banks are less protected.

Interactive Brokers Chief strategist Steve Sosnick saw the news as “A nasty reminder that this is not a great environment for smaller banks. An inverted yield curve is a huge headwind if you’re in the business of borrowing short-term and lending long-term. As for Silicon Valley Bank, their unique niche in the tech world is a real boon when that business is booming, but a problem when it’s not.”

In fact, major financial analysts and strategists are generally labelling this as idiosyncratic. However, even though the major banks are likely more able to weather the storm due to larger capital requirements, what does this news say about the business environment?

Is this how a credit crunch starts? Banks begin looking at their exposures, become more cautious with lending and the credit environment deteriorates?

If credit is the oil for the global economic engine, and banks turn more cautious, is it just a matter of time before the engine stops performing, and eventually seizes up?

Perhaps markets haven’t quite reached that conclusion yet, but caution has risen to the surface.

European stock indices could be more exposed to a drop in general risk sentiment. While US stock indices such as the Nasdaq (-29%) are trading significantly below their all time highs, Germany’s Dax is just 5.5% below the 2021 peak.