Why Leading EM Banks Don’t Present the Same Risks as SVB and Credit Suisse
Contributors
In light of the recent developments with Silicon Valley Bank (SVB) and Credit Suisse, many clients have asked us if emerging markets (EM) banks are exposed to similar risks. The answer, as we explain here and in a related article, is a resounding “No.” EM banks, in fact, have more growth opportunities and less risk exposure than many of their developed market (DM) counterparts, including those that do not face the challenges confronted by Silicon Valley Bank and Credit Suisse. Be sure to read Why We Prefer EM Banks Over Their DM Peers in which we explore how leading EM banks can create a foundation for sustainable earnings growth simply by focusing on core banking functions of taking deposits and issuing credit.
May 2023
The collapse of Silicon Valley Bank and the efforts needed to save Credit Suisse, which will now be acquired by UBS, have raised concerns about the risks in the banking sector. Many clients are asking us whether emerging markets banks also have heightened exposure to these risks. At Sands Capital, we prefer EM banks over their peers in the developed markets and believe many of the leading EM banks that we invest in possess three key advantages that meaningfully differentiate them from SVB and Credit Suisse, likely making them less vulnerable to the risks exposed by the recent collapses.
What Happened at SVB
While multiple articles, including one by former hedge fund manager Marc Rubinstein, provide a detailed analysis of SVB’s collapse, we can provide a quick overview of the core issues. SVB had two challenges that proved to be fatal. First, its assets and liabilities were not well matched. The bank had 60 percent of its assets invested in securities rather than loans. Of this amount, nearly 80 percent was invested in long-duration illiquid bonds, that is, held-to-maturity assets.
The second issue was that SVB had a highly concentrated depositor base. Close to 90 percent of its deposits were held by just 25 percent of its customers in accounts that were, on average, 17 times over the Federal Deposit Insurance Corp-insured limit. These customers were also highly concentrated in specific sectors, with 50 percent of SVB’s deposits held by technology startups.
How the Crisis Unfolded
As interest rates rose sharply during 2022, in one year, SVB’s investment book lost about 15 percent of its value. These losses were substantial enough to place the bank in technical insolvency. Still, because those assets were categorized as held-to-maturity, the losses might never have been realized if the bank had not been forced to sell them prematurely. Unfortunately for the bank, though, that worst-case scenario played out. In a situation beyond SVB’s control, the availability of financing for the tech startup sector significantly declined in 2022. In response, many of SVB’s clients pulled their deposits from the bank to continue funding their businesses. When word got out that these withdrawals were placing the bank under stress because of the bank’s limited available liquidity to meet this demand, depositors lost confidence in the bank. That set off a classic bank run. As a result, SVB was deemed both illiquid and insolvent by regulators. It could not meet its customers’ demand for their deposits without selling its investment book, and that, in itself, would have created losses for the bank in excess of its equity.
What Happened at Credit Suisse
Credit Suisse (CS) did not have the structural risks of asset/liability mismatches and concentrated deposits that SVB did. Instead, CS had a tarnished reputation because since the Global Financial Crisis of 2008-2009, it has had a string of scandals and regulatory actions taken against it. These issues, combined with many years of weak performance, brought close scrutiny of CS by alarmed investors. With the market jitters that followed the collapse of SVB, many believed CS had a heightened risk of failure. These concerns expressed themselves in a severe decline in the company’s stock price and a widening credit spread for its debt, but also, more importantly, a sharp increase in deposit outflows. During the fourth quarter of 2022, the bank lost close to 40 percent of its deposits, and the pace of withdrawals accelerated in 2023. While the bank had still been technically above regulatory capital and liquidity levels, it became clear that CS was on a trajectory to breach them. Regulators preemptively acted to stem any further repercussions.
Very Different Circumstances for Leading EM Banks
We believe there are three key advantages that meaningfully differentiate the EM banks that Sands Capital invests in from SVB and Credit Suisse.
1. A Diversity of Funding Sources
Largely because of lower competition from alternative sources for savings and investments, leading EM banks benefit from having both sizable and granular deposit bases. That helps reduce the potential for a rapid and large-scale withdrawal of funds. While not entirely immune to this risk, these EM banks, unlike SVB, generally do not have a concentration of deposits from any individual source or industry. For instance, HDFC Bank’s top 20 depositors account for only 4 percent of its total deposits, and 85 percent of the bank’s total deposits are sourced from its retail customers, whose average account size is relatively small. In addition, just 5 percent of the bank’s liabilities are denominated in foreign currencies, limiting the bank’s foreign exchange risk.
BCA in Indonesia has a similar situation, given that 65 percent of its deposits are sourced from “sticky” transactional accounts that are diversified across retail (60 percent) and business (40 percent) customers. An additional 10 percent of its deposits are tied up in certificates of deposit, and just 7 percent of its deposits are denominated in foreign currencies. Similarly, deposits at Brazil’s Nubank are dispersed across more than 53 million accounts, and 89 percent of them are insured deposits. Only about 7 percent of SVB’s deposits were insured. [1]
Ultimately, SVB’s collapse was caused more by a crisis of confidence than a liquidity problem. Depositors’ lost faith in the bank’s ability to honor their withdrawals. That lost faith initiated a bank run that turned the customers’ fears into a reality. During this same period, many of the mega-cap banks and other trusted financial institutions were the beneficiaries of the deposit outflows.
We saw evidence of this same dynamic at play in India and Indonesia during the pandemic, as HDFC Bank and BCA both experienced strong gains in deposit market share (see exhibit below). In fact, the strength of BCA’s deposit flows during the pandemic enabled the bank to experience its lowest loan-to-deposit ratio in more than a decade.
Leading EM Banks Saw an Increase in Deposit Market Share During the Pandemic
2. Diversified Assets with a Higher Loan Mix
Given the substantial opportunity for credit growth across EM countries, banks in these markets are far more incented to allocate capital toward loans rather than investment securities. In total, Indian private banks operate with 60 percent of their assets in loans. For leading Indian private banks such as HDFC Bank, this ratio is even higher, at 65 percent. At U.S. banks, this number is 50 percent. For SVB, the number was just 35 percent.[2]
Additionally, loans at EM banks generally tend to be well diversified by borrower type. That helps reduce the banks’ credit risk. For example, as of December 31, 2022, HDFC Bank’s credit book is split 45/35/20 across retail, small and midsize enterprises (SMEs), and corporate credit. The loan book is further segmented across loan types, with no category accounting for more than 15 percent. Finally, the mix of floating- versus fixed-rate loans is also diversified 55/45. For BCA, the split between loans and investment is 60/40, and these loans are split 45/30/25 across corporate, SMEs and retail customers. Within corporate and SMEs, the industry exposure is also diversified, with no one sector representing more than 25 percent. Finally, while Nubank invests 70 percent of its funds in securities rather than investments, these securities are predominantly floating rate and not booked as held-to-maturity. As a result, Nubank’s unrealized losses are immaterial (less than 0.5 percent of equity). Moreover, its loan book has a very short duration. While duration in banks is often measured in years, for 80 percent of Nubank’s credit, the loan duration is just 6 to 8 weeks.
This emphasis on credit over investment and the diversity of credit allocation at the EM banks significantly reduces their exposure to the solvency risk that SVB experienced. SVB had a significant share of its assets allocated to illiquid securities that lost their value as interest rates rose. In contrast, HDFC Bank may see spikes in credit losses in segments of its loan book, but this book is sufficiently diversified. There would have to be a near-cataclysmic event across the Indian economy to generate the magnitude of losses SVB experienced over a 12-month period.
3. Significant Capital and Liquidity Positions
Owing to a combination of conservative management and significant profitability, leading EM banks tend to operate with much higher capital and liquidity positions relative to their developed market peers. In Indonesia, for example, banks have an average 25 percent capital adequacy ratio (CAR), compared with an average of 15 percent for U.S. banks. Similarly, BCA has a CAR of 26 percent versus 16 percent for J.P.Morgan. The same is true for liquidity coverage, with BCA and HDFC Bank standing at 400 percent and 130 percent, respectively, versus 112 percent for J.P.Morgan. This can provide the EM banks with a larger buffer to absorb asset losses or rising deposit withdrawals. That buffer should enable them to avoid the situation that embroiled SVB. [3]
Indian Banks Have Historically Exemplified Strong Financial Positioning of EM Banks
An Attractive Risk/Reward Tradeoff
While banks in both DM and EM have leverage, credit and liquidity risks, the leading EM banks are not seeing some of the heightened risks that DM banks do. We also believe investors in the leading EM banks stand to benefit from the more limited risks they do assume. Given their strengths, the leading EM banks should be able to take full advantage of the substantial growth opportunities in their markets.
[1] All data as of December 31, 2022.
[2] Source: HDFC and RBI as of December 31, 2022.
[3] All data was as of December 31, 2022.
Disclosures:
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients. There is no assurance that any securities discussed will remain in the portfolio or that securities sold have not been repurchased. You should not assume that any investment is or will be profitable. A full list of public portfolio holdings, including their purchase dates, is available here. A full list of private holdings is available upon request to qualified investors.
Unless otherwise noted, the companies identified represent a subset of current holdings in Sands Capital portfolios. HDFC Bank, BCA, and Nubank were chosen because they are the three largest EMG holdings classified as “banks” by GICS industry designations.
J.P.Morgan is used for illustrative purposes because it is the largest U.S. bank by market capitalization.
As of March 31, 2023, HFDC, BCA, and Nubank were held in Emerging Markets Growth. J.P.Morgan, Silicon Valley Bank, and Credit Suisse were not held in any Sands Capital strategies and is referenced for illustrative purposes only.
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