Banks typically come under financial stress because of:

Banks Under Financial Stress: A Symphony of Folly and Opportunity

Sept 21, 2024

In finance, banks often teetered on the precipice of a crisis, their foundations shaken by the forces they sought to harness. As Jonathan Swift stated, “When a true genius appears in the world, you may know him by this sign, that the dunces are all in confederacy against him.” Genius seems to be in short supply in banking, while dunces abound in the boardrooms, leading institutions into dangerous waters.

The Roots of Banking Stress

Banks, those bastions of financial stability, paradoxically come under stress due to many factors. At the heart of their vulnerability lies the fundamental nature of their business model: borrowing short-term and lending long-term. This inherent mismatch in maturity creates a delicate balance that external shocks or internal missteps can easily disrupt.

One primary source of stress is economic downturns. When economies falter, borrowers struggle to repay loans, leading to an increase in non-performing assets. The 2008 financial crisis is a stark reminder of how a housing market collapse can ripple through the banking system, bringing even the mightiest institutions to their knees. Lehman Brothers, once a titan of Wall Street, crumbled under the weight of its mortgage-backed securities, triggering a global financial meltdown.

Regulatory changes can also exert significant pressure on banks. For instance, implementing Basel III capital requirements forced many banks to rapidly increase their capital reserves, straining their ability to lend and generate profits. The European banking sector, in particular, struggled to adapt to these new regulations in the aftermath of the 2008 crisis, leading to a prolonged period of weak performance and increased vulnerability.

Interest rate fluctuations represent another source of stress. Rapid changes in interest rates can erode a bank’s net interest margin, the difference between the interest earned on loans and the interest paid on deposits. The savings and loan crisis of the 1980s and early 1990s in the United States was largely precipitated by interest rate mismatches, as S&Ls found themselves locked into long-term, low-interest mortgages while facing rising costs of funds.

However, as Charles Munger, the sage of Omaha, once quipped, “It’s not the things you don’t know that get you into trouble. It’s the things you know that just ain’t so.” This brings us to perhaps the most significant source of banking stress: management hubris and poor decision-making.

The Folly of Management

Time and again, banks find themselves in dire straits not due to external factors beyond their control but because of reckless decisions made by their leadership. The allure of high-risk, high-reward investments often proves too tempting for bank executives seeking to boost short-term profits and personal bonuses.

Consider the case of Washington Mutual, once the most significant savings and loan association in the United States. In the years leading up to the 2008 financial crisis, WaMu aggressively pursued subprime mortgages and adjustable-rate loans, ignoring the growing risks in the housing market. CEO Kerry Killinger famously declared, “We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs, and Lowe’s-Home Depot did to their industry. And I think if we’ve done our job, five years from now, you won’t call us a bank.” Five years later, WaMu had ceased to be a bank – it had become the largest failure in American history.

Similarly, the collapse of Barings Bank in 1995 can be attributed to management’s failure to oversee its traders properly. Nick Leeson, a young derivatives trader in Singapore, accumulated massive unauthorized losses of £827 million, more than twice the bank’s available trading capital. The 233-year-old institution, which had once financed the Napoleonic Wars, was brought down by the actions of a single rogue trader and the management’s inability to implement proper risk controls.

As Niccolò Machiavelli wisely counselled, “The first method for estimating the intelligence of a ruler is to look at the men he has around him.” In the case of many failed banks, the intelligence quotient of leadership seems to have been sorely lacking.

Opportunity in Crisis

Yet, where some see disaster, others perceive opportunity. The old adage goes, “Buy when there’s blood in the streets, even if the blood is your own.” This principle, often attributed to Baron Rothschild, encapsulates the contrarian approach savvy investors can employ during banking crises.

John Bogle, the founder of Vanguard and champion of index investing, once said, “Time is your friend; impulse is your enemy.” This wisdom is particularly applicable when considering investments in stressed banks. While the masses may flee in panic, selling their shares at depressed prices, the astute investor recognizes that well-capitalized banks with strong fundamentals often survive crises and emerge stronger.

Take, for example, the case of Citigroup during the 2008 financial crisis. As the bank’s stock price plummeted from over $50 to less than $1 per share, many investors saw only impending doom. However, those who recognized the government’s commitment to preventing the collapse of systemically important institutions and dared to invest at the nadir were handsomely rewarded. By 2013, Citigroup’s stock had recovered to over $50 per share, representing a fifty-fold return for those who bought at the bottom.

Similarly, Bank of America’s stock price fell from over $50 in 2007 to less than $4 in 2009. Yet, under the leadership of CEO Brian Moynihan, the bank underwent a significant restructuring, shedding non-core assets and strengthening its balance sheet. Investors who recognized this turnaround potential and bought shares during the depths of the crisis saw their investments multiply several times in the subsequent years.

Refining the Approach: Mass Psychology and Technical Analysis

Investors can refine their approach by incorporating insights from mass psychology and technical analysis to capitalise on banking crises. As legendary stock trader Jesse Livermore observed, “The speculator’s chief enemies are always boring from within. It is inseparable from human nature to hope and to fear. In speculation, when the market goes against you, you hope every day will be the last day, and you lose more than you should have had you not listened to hope. And when the market goes your way, you become fearful that the next day will take away your profit, and you get out – too soon.”

Understanding the psychological factors that drive market behaviour can provide a significant edge. During banking crises, fear often reaches a fever pitch, driving stock prices well below their intrinsic value. By recognizing these moments of extreme pessimism, investors can position themselves to profit when sentiment inevitably shifts.

The “VIX” or Volatility Index, often called the “fear gauge,” can be helpful. Historically, extreme spikes in the VIX have frequently coincided with market bottoms, particularly in the financial sector. For instance, during the 2008 crisis, the VIX reached an all-time high of 89.53 on October 24, 2008. This period of peak fear presented an excellent buying opportunity for financial stocks, many of which would deliver multi-fold returns in the following years.

Technical analysis can enhance investors’ ability to time entries and exits in stressed banking stocks. Chart patterns, such as double bottoms or inverse head-and-shoulders, can signal potential trend reversals. Volume indicators can confirm the strength of price movements, while moving averages can help identify longer-term trends.

Consider the case of JPMorgan Chase during the 2008 crisis. As the stock price formed a double bottom pattern in March 2009, accompanied by increasing volume, technically oriented investors recognized a potential turning point. Those who acted on this signal captured the subsequent rally, which saw the stock price more than triple over the next two years.

However, it’s crucial to remember that technical analysis should be used with fundamental analysis, not as a replacement. As Munger wisely cautioned, “To say that something is a technically correct measurement is to say that you’ve probably found a way to be wrong with precision.”

The Wisdom of Patience and Preparation

In navigating the treacherous waters of banking crises, investors would heed Jonathan Swift’s words: “Vision is the art of seeing what is invisible to others.” This invisible opportunity often lies in recognising that well-managed banks with solid fundamentals will likely survive and thrive even in the darkest times.

Patience is key. As John Bogle advised, “Time is your friend; impulse is your enemy.” Banking crises don’t resolve overnight, and the road to recovery can be long and volatile. Investors who can maintain a long-term perspective, resisting the urge to panic sell during downturns or take profits too early during recoveries, will likely reap the most significant rewards.

Preparation is equally crucial. As Machiavelli counselled, “The wise man does at once what the fool does finally.” This means doing thorough research, understanding the fundamentals of the banks you’re considering investing in, and having the courage to act when others are paralyzed by fear.

In conclusion, while banks may periodically come under stress due to a combination of external factors and internal mismanagement, these crises often present unparalleled opportunities for the prepared and patient investor. By combining an understanding of banking fundamentals with insights from mass psychology and technical analysis, investors can position themselves to profit from others’ folly.

As we navigate the ever-changing landscape of financial markets, let us remember the words of Jesse Livermore: “There is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.” Banking crises, like all market phenomena, are cyclical. The wise investor recognizes this pattern and stands ready to capitalize on its opportunities.