One of the biggest questions that investors in the U.S. want the answer to is when the Federal Reserve is going to begin raising the base interest rate again. However, the Fed itself seems determined to keep interest rates at or near zero for at least a few more years, conforming with the downwards trend that the U.S. federal funds rate has been in since the 1980s.
Given this trend, big banks have been increasingly turning to investment banking as a source of income in the hopes of continuing to grow their profits this way. However, the fallout from a margin-call rout at the end of last week forced the liquidation of positions held by multibillion-dollar family office Archegos Capital Management, according to CNBC. The failure of this one single hedge fund caused two major banks, Credit Suisse (CS, Financial) and Nomura Holdings (NMR, Financial), to warn of steep losses for the quarter, raising an important question for investors: zis an increasing reliance on investment banking a red flag for bank stocks?
Are interest rates likely to remain low?
After each recession, the Fed has become more and more reluctant to raise interest rates, as shown in the below chart. While this does not necessarily mean rates will remain low forever, it does mean that a significant change in monetary policy would need to occur in order to stabilize or reverse the trend.
Unsurprisingly, this has resulted in banks having a harder and harder time turning enough of a profit on traditional banking activities (i.e., deposits and loans). Commentary such as the following taken from a Wall Street Journal article on Bank of America's (BAC) recent earnings results have become common for nearly every bank in recent quarters:
"A drop in interest income helped drag down earnings at Bank of America Corp., BAC 2.71% which fell 22% in the fourth quarter. The second-largest bank in the U.S. said Tuesday that its profit totaled $5.47 billion in the final three months of the year, versus $6.99 billion a year earlier."
With the long-term trend in the federal funds rate indicating that monetary policy will almost certainly favor permanently low interest rates going forward, banks will need to look to other sources such as investment banking and share buybacks in order to keep profits increasing and investors happy.
An unpredictable outcome?
The more of a bank's assets are in investment banking versus traditional banking, the more exposed it is to the unpredictable fluctuations of the markets and all their moving parts via its fund managing clients – not just through common stocks, but also through things like swaps, options and futures as well, many of which have higher leverage and risk.
On Monday, Credit Suisse and Nomura Holdings warned investors of "significant loss" at one of its U.S. subsidiaries resulting from a client. Though the banks did not officially disclose which client it was, those close to the matter reported it was Archegos Capital Management, a family office founded by former Tiger Management equity analyst Bill Hwang.
So what mistake did this hedge fund make that resulted in significant pain to two large-scale banks? The answer lies with swaps. Archegos had used this type of over-the-counter derivative to build significant positions in ViacomCBS (VIAC, Financial) and Discovery (DISCA, Financial). Swaps allow highly leveraged bets that are not required to be disclosed to the public.
Unfortunately for Archegos and the banks it partnered with, there was broad selling of ViacomCBS and Discovery stocks in the past week due to negative news for both companies.
Weakness in both of these stocks caused a massive margin call for the hedge fund, meaning the fund was required to put up more money to cover the losing positions as they were trading on leverage. When Archegos failed to pay up, the banks that it was partnering with to hold these positions were forced to liquidate them and cover the losses with their own cash, amassing a forced liquidation worth more than $20 billion.
Following the news, shares of both Credit Suisse and Nomura tanked approximately 15% as investors anticipate the decrease in earnings:
This situation may come as a surprise to those investors who were not aware that such sudden and devastating turns could happen at banks that operate on an international level. Following the 2008 financial crisis, regulation on banks has increased, and banks themselves have also typically sought to avoid extremely high-risk scenarios.
However, this is mostly in regard to traditional banking activities, not investment banking. Investors who are aware of the moves and higher-risk trades that money managers are allowed to make without reporting to regulatory authorities know that risks such as the above situation exist and could easily happen given the right conditions.
A red flag?
Given the risks associated with higher exposure to investment banking, should investors begin to re-evaluate their holdings in big banks as these institutions increasingly turn to Wall Street to mitigate their low-profit woes?
Some big banks that still have low or nonexistent involvement with hedge funds are still available for those looking solely for exposure to a mostly traditional banking system. Those who invest in stocks of companies that are heavily involved in investment banking should also (ideally) already be aware of the risks.
However, it would benefit investors to keep a close eye on the investment banking of any bank stocks they hold as a shift to higher investment banking profits is a shift to a whole different risk-reward profile.
Regulators also seem to have been made aware of this particular investment banking risk during the recent debacle. "We have been monitoring the situation and communicating with market participants since last week," said a spokesperson for the Securities and Exchange Commission.
Conclusion
Banks are certainly not immune to "surprise" issues that develop quickly and can devastate their profits over a matter of days or less. History has shown this time and time again, one of the more recent examples being how a single hedge fund's $20 billion mistake cost several large-scale banks big time.
As interest rates are set to remain low and stock prices keep testing all-time high valuations, the incentive to take on higher risks in search of yield is something investors should keep a very close eye on.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.
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