Following the fifth anniversary of the collapse of Lehman Brothers and the ensuing Global Financial Crisis (GFC) - arguably the most calamitous event to hit financial markets and economies since the Great Depression of the 1930s - it seems appropriate to ask two questions: have things got better? And, could this happen again?
In the years prior to the GFC, both domestic and international banks ramped up lending, driven by an abundance of low-cost funding, rising profits and asset prices, along with surging economic growth. For too long, banks were running unsustainable business models, masked under the so-called safety net of risk diversification known as securitisation, or ignored under the term 'off-balance sheet'. Many were overleveraged, overdependent on wholesale short-term funding and significantly more interconnected than their risk models showed, rendering them more vulnerable to systemic shocks.
A changed landscape
Five years on, the global financial landscape has changed for the better. Since the beginning of 2013, conditions in the financial markets have improved markedly, primarily owing to the unprecedented monetary easing in the US, UK, continental Europe and Japan. Other initiatives, such as the Funding for Lending Scheme in the UK, have started to boost credit availability for homeowners and businesses.
To improve the robustness of the financial sector, global regulators and policymakers have made huge efforts to overhaul supervisory mechanisms and the international regulatory framework. Banks are undergoing more regulation and are under more scrutiny than ever, with the introduction of the 'Volker Rule' limiting proprietary trading activities, the Dodd Frank Wall Street Reform and Consumer Protection Act, reforming oversight and supervision, and the more conservative Basel III capital requirements.
In the UK, the Banking Reform Bill aims to separate retail operations from the more risky investment arms, so even if a bank fails it can continue essential operations. There are also greater efforts to coordinate standards and promote effective regulation internationally, via the Financial Stability Board.
In this new environment, financial institutions have realigned their business models by focusing on attracting core deposits as a funding source, boosting capital ratios (see chart) and curbing excessive lending practices. Capital, however, is only one part of the equation. Amid the significant asset writedowns following the GFC, many banks had huge loan losses. The US is further ahead on writing down the value of these assets, while in peripheral Europe, especially in Spain, the process is ongoing. In the UK, however, banks have generally taken a conservative stance to reserving for losses.
The healthier outlook
In our view, therefore, things are definitely getting better. In the immediate aftermath of the GFC, the US injected billions of dollars into the banks to help recapitalise balance sheets and stop many of them failing through the Troubled Asset Relief Program (TARP) and forced some of the weakest institutions to merge with stronger banks.
A few years later, the European Central Bank introduced its Longer-term Refinancing Operations (LTROs) to lend to banks at attractive rates, again to support their balance sheets. Several of these financial institutions have sufficiently recovered and are starting to repay these bailouts as well as resuming dividend payouts.
Amid this backdrop, our global funds' financials weighting has risen as high as 30 per cent, although it currently stands at 17 per cent. We purchased UK-based Lloyds Banking Group as we believe its earnings power is underestimated. The UK mortgage market continues to rebound, while profit margins are improving, as broader demand for loans from individuals and businesses grows; this is being supercharged by Lloyds' aggressive focus on reducing its cost footprint.
Lloyds, like the Belgian lender KBC Financial, is benefiting from its dominant position in its home market, which is still growing and where competition remains relatively benign.
As bottom-up investors, we look for change in the companies we invest in. There is continuing evidence of restructuring and transformation in many Southern European banks such as Italian bank UniCredit. Conversely, our weighting to US financials is minimal, having sold the position in Citigroup earlier in the year. In the US, we do hold Charles Schwab, which stands to benefit from higher US interest rates as many of its clients move funds away from low-yielding, low-margin cash and fixed income into higher-margin products, such as equity funds. We also own Sumitomo Mitsui Financial Group in Japan, which is well positioned to benefit from Prime Minister Abe's reflationary efforts.
Could the crisis recur?
Although the likelihood of another similar financial crisis is now less likely, risks remain. The process to realign the banks' business models and comply with stricter international regulatory requirements will take years rather than months. Meanwhile, European banks are not making as much progress compared to their US and UK counterparts in terms of deleveraging and balance sheet strength. However, for diligent investors, this may be where some of the best investment opportunities lie.
Matthew Beesley is Head of Global Equities at Henderson Global Investors
