The fallout from Silicon Valley Bank’s (SVB’s) failure is likely to remain an issue for smaller US regional banks and is driving negative sentiment among investors, according to Newton Investment Management global financials research analyst Vivek Gautam. However, he does not think it likely contagion will seep into the wider global banking sector, with the balance sheets and liquidity positions of larger US and European banks remaining strong.

Gautam thinks the collapse of SVB was largely symptomatic of two key factors: central bank tightening to address inflation and light touch US regulation of smaller banks.

On the first point, he notes the past decade saw a flood of easy money and low interest rates which meant during that period interest rate risk was not an issue banks had to face. Now, however, with interest rates higher, it is a different story.

Gautam says: “These smaller regional banks saw a large inflow of deposits during Covid and periods of quantitative easing, leading some to invest in long-dated securities. The onset of quantitative tightening from the Federal Reserve and the availability of better rates elsewhere, has meant some of these banks have seen deposit outflows, creating liquidity issues. The mistake these banks made was to not hedge their interest rate risk because they were not forced to.”

Gautam thinks light touch regulation in the US around smaller banks played a part in SVB’s collapse. Banks with assets of less than US$250bn in the US have lighter regulatory requirements, including stress tests, and capital and liquidity requirements. “The light touch regulatory treatment of smaller banks in the US has led to limited oversight of this issue,” adds Gautam. “For that reason, I believe this specific issue is localised.”

At the other end of the scale, Gautam believes large bank balance sheets are stronger than the market thinks. “We believe large US banks are in a much better liquidity position given they have tighter regulations and after recent events they are seeing inflows of deposits,” he says. “In Europe, we have tighter regulation around liquidity, including the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) that European banks need to adhere to. This is an important point in the context of this week’s European banking share price volatility.”

In the wake of SVB’s demise, Gautam would like to see more stringent measures applied to smaller banks in the US. These include, for example, reducing the threshold for stress tests, as well as tighter liquidity regulations.

“Once we are through these issues, I do think there will be a regulatory tightening on how these banks manage interest rate risk, extending the stress testing regime to smaller US banks,” he says.

Addressing recent share price volatility, Gautam adds the banking sector investors do not like uncertainty. Gautam believes negative sentiment and changing interest rate expectations could be behind market volatility following SVB’s capitulation.

However, if credit spreads widen and deposit outflows ramp up, it would be a source of concern and could cause further Fed action.

But he reiterates it is unlikely to become a global contagion, saying there are opportunities in financials despite the SVB episode. In addition to large cap US and European banks, Gautam says certain financial institutions in emerging markets could provide opportunities as inflation is under control. There are also potential opportunities in exchanges, he adds, because they could benefit from volatility.

“At times like this we always focus on the negatives, but some of these events could provide the opportunity to buy high quality companies at distressed valuations and these are the times to look for those rather than go risk-off completely,” he concludes.