From Standard & Poor's
2011 Midyear Outlook: Global Financial Institutions Face Increasing Regulations Amid An Uneven Recovery
Quintanilla, Rodrigo
28 Jul 2011
28 Jul 2011
In early July, CreditWeek editors sat down with some of Standard & Poor's Ratings Services' leading analysts for a roundtable discussion about global financial institutions. Panelists shared their views on the prospects for continued consolidation in the industry, the impact of new regulations, and the potential effects of a rise in interest rates in the U.S., among other key issues.
Analysts in the U.S. and Europe generally expect a gradual recovery for the sector to continue, but noted that the cost of complying with new regulations could cut into banks' profits. The outlook in Asia and Latin America is generally stable and more upbeat, with expectations for continued lending and growth in profits, although inflation remains a significant downside risk in emerging markets. Consolidation appears to have largely played out among the largest banks in most regions, although there is some room for more, particularly in some emerging markets in Asia—but tight regulations in these areas remain a big obstacle.
Participants in the discussion included Standard & Poor's Managing Directors Scott Bugie, Santiago Carniado, Ritesh Maheshwari, Craig Parmelee, Rodrigo Quintanilla, and Charles Rauch of Financial Institutions Ratings; Managing Director and EMEA Financial Institutions Criteria Officer Michelle Brennan; Senior Directors Devi Aurora and Daniel Koelsch of Financial Institutions Ratings; and Directors Barbara Duberstein and Stuart Plesser of Financial Institutions Ratings.
CreditWeek: What is our global outlook for the banking industry, and what do we see coming up in the U.S., Europe, Asia, and Latin America?
Rodrigo Quintanilla: For the U.S., we currently see five key areas of risks and challenges.
The first is that the fragile economic recovery is creating headwinds for balance-sheet growth. In fact, Fed reports indicate that bank balance sheets are not growing, and the only new loan growth we're seeing is in the commercial and industrial segments.
The second area we're watching closely is real estate, both residential and commercial. For residential real estate, which is a major component of banks' balance sheets, prices are still coming down, and there is a backlog of inventory in foreclosures. With commercial real estate, or CRE, although losses have been very low, cap rates have also been very low because of continued very low interest rates. We're concerned that if rates were to rise, there could be a rise in delinquencies and losses, especially for some construction projects.
The third theme is that credit leverage has been responsible for a big turnaround in profitability for the banks. What this means is that loan-loss provisions have lagged net charge-offs; another way of saying this is that there have been loan-loss reserve releases. This has propelled pretax, preprofit returns on revenues for the Federal Deposit Insurance Corp. (FDIC) group of institutions to about 26% in the latest quarter, up from 20% at the end of fourth-quarter 2010.
This brings us to the fourth theme, which is the prospect for lower profitability. Top-line growth for U.S. banks remains slow and tepid: Earning assets are not growing very quickly, and institutions are redeploying any growth from deposits into security portfolios at lower rates. In addition, the potential for higher compliance costs related to the Dodd-Frank Act and other regulatory changes may also hurt banks' revenue-generating activities and profitability.
The fifth area we're watching is the impact of increased regulation and related surveillance on banks, including the burden-sharing that the Dodd-Frank act is imposing on bank debt. Various discussions are under way about capital and liquidity requirements under Basel III, capital buffers for large financial companies, and even an extra 1% surcharge for very large financial institutions. Absorbing these costs will be a key challenge for banks.
CreditWeek: And what about our outlook for the banking industry in Europe?
Scott Bugie: Because Europe is such a large region, with a highly developed financial sector that has expanded globally, there is a global aspect to our outlook for Europe. European financial institutions have made significant investments in Latin America, Asia, and emerging Europe, as well as in the Middle East and Central Asia, and they have widespread networks in these regions.
Like the U.S., Europe is in a period of rebound and is still restructuring after the financial crisis and deep recession of 2009. Financial institutions, by and large, performed better in 2010 and so far in 2011, mostly due to a decline in credit-risk charges rather than growth in revenues.
The European economic recovery since 2009 has been slow but steady overall. Our forecast for real GDP growth in the eurozone in 2011 is 1.9%, which is not much higher than the 1.7% growth of 2010, but enough to support a continued recovery in the credit quality of bank borrowers.
The story isn't the same across Europe, however. The north has generally fared better than the south. Economic growth has been stronger in Germany, where export industries and a recovery of investment expenditures are driving the expansion. Credit-loss rates have been lower than expected in Germany. The story is much the same in the Nordic countries and the Netherlands, and we believe these trends will continue, if external demand remains relatively firm.
The growth prospects for Spain and Italy, where the recovery has been slower, are lower than those for the larger economies. This is true for Ireland as well. The boom-and-bust cycle of the real estate industry—in particular, real estate construction and development—has resulted in significant property supply overhang in Spain and Ireland, and to a lesser extent in the U.K., and these countries are still working through CRE losses related to this cycle.
As in the U.S., one result of the deep recession and financial crisis in Europe has been a reinforcement of bank regulation—essentially, regulators want more capital to cover risks and wider liquidity buffers. Regulations on liquidity ultimately may have the biggest impact. The net stable funding ratio under Basel III, in particular, could have a longer-term impact on the cost of funds. Maintaining more-balanced asset-and-liability maturities may result in narrow net interest margins in the industry. In addition, governments are imposing new bank levies and taxes—some are already in place. And the plethora of new regulations could raise compliance costs. Although it's still uncertain what the final impact of the various new regulations and taxes will be, it appears that they will result in somewhat lower bank returns. We're keeping our eye on how the changing regulations will affect the credit profiles of European financial institutions.
CreditWeek: What is the situation in Asia?
Ritesh Maheshwari:: Our outlooks on most Asian banks are stable, and we believe most can expect a bright economic future. The Asian systems in general are very well positioned, having had no housing bubble-type legacy problems, and we think most can continue to earn profits and grow their books while maintaining good asset quality.
Learning from the Asian financial crisis, the Asian banks have been continuously improving their risk-management processes, and regulators have tightened regulations. This has helped boost institutional strength overall—and that, not surprisingly, has kept the Asian banks in good shape, even through the global financial crisis. Therefore, they have maintained a strong, from their perspective, financial profile. Their capitalization remains sound. The funding bases—mostly domestic and deposit-related—have been a pillar of strength for Asian banks.
Earnings streams have also continued to be healthy, to the extent that even some foreign banks based in the U.S. and Europe are looking to Asia to expand their operations and garner earnings from this region. In addition, the outlooks for sovereigns in Asia, unlike in other regions, are generally either stable or gradually improving. Given that most are classified as "interventionist," this also bodes well for Asian banking systems, in that sovereigns won't be a liability; rather, they will be a source of support, if needed.
At the same time, inflation remains a significant risk for Asian banks. Emerging markets are highly sensitive to inflation due to the low incomes in these populations, so these governments are quick to respond to inflation. And that, in our view, is the source of the risk: A policy that is too fast or too drastic could cause asset prices to plummet or bring about a sudden hard landing for certain economies. That could present difficulties for banks, although we think most are well-placed in terms of capitalization, earnings, and funding to meet this challenge, should it arise—and in the most likely scenario, we don't think growth would slip by a significant degree.
CreditWeek: What is our outlook on banking in Latin America?
Santiago Carniado: We're expecting a stable situation overall, with well-capitalized banking systems and continued lending and growth in profits. But Latin America is also a diverse region, and the situation varies country by country. For instance, for 2011, we're expecting credit growth in Mexico of around 11%, whereas we expect about 15% growth in Brazil and perhaps less than 10% growth in Panama and Chile.
We think Mexico, Brazil, Panama, and Chile should maintain sound capitalization measures, with risk-adjusted ratios ranging between 8% and 10%. We're also expecting returns on assets to remain between 1.5% and 2%, on average, which will allow banks in general to continue streaming up dividends to shareholders.
On the down side, we are looking at what could happen if inflation goes above current levels in countries like Brazil, where such an increase might put some pressure on loan payment. Nevertheless, banks are still strongly capitalized and should be able to weather a moderate increase.
CreditWeek: Is our outlook on regional banks in the U.S. similar to our outlook on the larger, more-complex institutions?And how do we view the prospect for increased consolidation in the sector?
Barbara Duberstein: For both the larger U.S. banks and the regional banks, we see a similar, constructive theme of a gradual recovery for the sector. The trends for the regional banks, however, are much more of a pure play on trends in the U.S. economy. That's because, obviously, regional banks don't have the global systemic issues–at least not directly–that the larger banks are facing, including exposures to some of the weaker European economies and trading revenue volatility and litigation issues. Their fundamentals tend to mirror the U.S. economy and reflect where we are in the credit cycle, with the concomitant uncertainties about the strength of the upturn.We continue to see encouraging asset-quality trends for the regional banks—not only for nonperforming assets, or NPAs, but also for more forward-looking indicators, such as classified assets and new NPA inflows. However, we are seeing divergence in the performance of some of the regionals. The biggest distinguishing factors continue to be loan underwriting and geography; for example, some of the banks with exposure to the Southeast aren't performing as well.Regional banks' buildup of capital is a positive for the sector, although we're watchful for a possible decline. But at this time, the regional banks haven't announced large dividend raises or share buybacks. There is also some uncertainty about U.S. regulators' final capital rules for the regional banks, which we think should limit any substantial leveraging.
Lastly, like some of the larger institutions, the regional banks have faced some significant challenges in growing their loan books. Still, from a credit perspective, we can live with low loan growth. Our bigger concern is that the regionals will eventually loosen their underwriting standards to generate stronger loan growth. We're not seeing this yet, but we're watching for this potential asset-quality risk.
As to consolidation, we're seeing a moderate amount of mergers and acquisitions among the regional banks, and the environment for M&A appears favorable. Because asset quality is stabilizing, potential acquirers can be more confident about what they're getting into with an acquisition. However, we're not seeing a huge amount of deals among healthy, midsize U.S. regionals, and we've heard anecdotally that bid/ask spreads on those kinds of deals are a bit too far apart. Interestingly, however, we saw a phase when stronger banks were acquiring some seriously weakening banks: for instance, M&T acquired Wilmington Trust, and the Bank of Montreal acquired M&I. Those transactions turned out to be very positive in terms of event risk for the bondholders of the target companies.
The repositioning of some European institutions is also having a subtle impact on the regional banking sector in the U.S. For instance, Capital One plans to acquire ING Direct; and HSBC has put its upstate New York retail bank branches on the block, and some of the regional banks are rumored to be potential acquirers.
I would also add that the number of small FDIC-assisted acquisitions has declined—but that, of course, is a good sign that the industry is healing.
I would also add that the number of small FDIC-assisted acquisitions has declined—but that, of course, is a good sign that the industry is healing.
CreditWeek: Among the large banks in the U.S., will we see an increase in M&A now that the financial crisis is over and banks are looking to boost profits? And are the trends that we're seeing there the same globally, or are there variations from one region to another?
Quintanilla: We think the new capital rules coming into play could have two negative results on M&A in the U.S. One is the impact of the Collins Amendment, which will raise holding companies' capital requirements and thus could make foreign institutions less inclined to participate in the U.S. Although this hasn't affected the Bank of Montreal's acquisition of M&I, we have observed that some foreign banks may be changing their structures. For instance, Barclays PLC and Barclays Bank PLC have each elected to be treated as a financial holding company under the Bank Holding Company Act. Financial holding companies may engage in a broader range of financial and related activities than are permitted to registered bank holding companies that do not maintain financial holding-company status.
The other impact is from the potential capital surcharge on the largest financial institutions. Essentially, the regulators are creating a disincentive for large institutions to become even larger. For this reason, we expect to see less consolidation among larger banks as acquirers, although we may still some M&A among midsize institutions.
Bugie: One way for governments and regulators to deal with the "too big to fail" issue is to limit the size of financial institutions. But the global industry trend in recent years is the opposite.
During the financial crisis and afterward, a number of large institutions that were relatively healthy took over more-troubled institutions—resulting in the emergence of even larger financial conglomerates. Spain, hit harder and for a longer period by the recession than many other countries because of its large construction industry, has seen regulatory and government-driven consolidation among its regional savings banks, or "cajas." These mergers are an effort to build more mass and capital and achieve operational economies of scale. A couple of fairly big combinations of Spanish cajas are just coming to market this year. Examples of recent mega-mergers abound: BNP-Paribas taking over Fortis Bank, the joining of Commerzbank and Dresdner Bank in Germany, and Lloyds taking over HBOS plc in the U.K., to name a few.
From the vantage point of 2011, we don't see much more large-scale European bank M&A on the horizon. Looking forward, we expect to see some fill-in acquisitions for sought-after areas in the financial industry, including asset management and private banking. There are still many large financial institutions that are looking to build out—whether domestically or internationally—and expand their client base and scale. The emerging markets are still attractive because they offer better growth prospects, so we may see some action there among large global banking groups looking to move into these markets. Some financial institutions that want to exit certain markets may sell their operations to other institutions looking to enter.
CreditWeek: Are those the same trends we're seeing in Asia and Latin America?
Maheshwari: In Asia, the picture is a bit different. Although Australia, Japan, Hong Kong, Singapore, and China already have some large, global-scale banks, I would argue that there is a need for more consolidation in certain emerging markets. And although there has been some progress, regulatory restrictions in those regions are a big obstacle to M&A.Learning from the Asian financial crisis, many systems actively fostered consolidation, and some of them—including Singapore, Thailand, and Malaysia—actually achieved good results. Other nations, such as Indonesia and Taiwan, embarked on consolidation but didn't fully carry it through, while still others, such as India, never gave it any serious push.
However, the progress toward greater consolidation in the Asian emerging markets isn't encouraging. The regulators in these areas tend to be very prescriptive and conservative in their approach, and the banking markets are not so open to market-driven M&A. Majority ownership by foreign entities generally isn't permitted—in fact, a 10%-30% share is typically the limit—and this level of ownership doesn't give management sufficient control or provide enough incentive for significant M&A activity. In addition, the asking prices in certain markets, such as Taiwan, Indonesia, and Vietnam, are too high to make these deals feasible.
For these reasons, although I think there is need for further consolidation, I don't see a great deal of potential.
Carniado: In Latin America, the banking industry is already highly concentrated: In most countries, at least 70%-80% of total assets belong to the largest five or six institutions. Nevertheless, we have seen some acquisitions in the past year. Some Colombian banks have purchased assets in Central America, and in Brazil, certain stronger banks have bought other troubled banks. In Mexico, there was a merger between Mexican-owned banks. We expect some acquisition activity to continue, but we're not expecting significant consolidation.
CreditWeek: Which lines of business—such as auto loans, credit cards, real estate, or general business loans—will contribute most to banks' profitability?
Quintanilla: In the U.S., the most profitable product lines traditionally have been related to consumer lending, regardless of the cycle. And although that hasn't changed, an increase in losses related to consumer assets may have hurt net profitability a bit. But by and large, in terms of gross profitability, the consumer product lines are typically more profitable.
Nevertheless, some of the commercial lines could be very profitable on an aggregate basis: That is, banks may be able to grant some business loans at a preferential rate, but other products could be associated with that loan origination, including deposits, cash management, fees, and so forth. So profits in this area will depend on how quickly the banks can cross-sell different products to enhance the profit profile of a customer.
Revenue growth for the U.S. banking system has been kind of tepid overall, and we haven't seen a lot of loan growth. The only loan category that has shown any signs of life is commercial and industrial lending. We don't expect this to change dramatically this year, although we do think the leverage in the industry will decrease over time.
CreditWeek: Would that be the case in other regions as well?
Michelle Brennan: In Europe, several institutions have come through several years of flattened results from some of their investment-banking operations, or from taking on interest-rate risk exposure as a response to the relatively accommodating actions by the authorities in terms of interest rates. We expect to see a reduction in the contribution of some investment-banking operations, in particular interest-rate-driven earnings, for some banks in Europe this year and into 2012. Heightened regulation, including tighter capital requirements against trading activities, will also likely restrain investment-banking earnings.
As for retail and commercial-banking profitability, the picture varies between markets. In some markets where the consumer and the private sector are under more pressure, the level of new business activity is still quite low, and this is hurting earnings. We're seeing this, for example, in countries where the housing markets are still working through their corrections, and profits from mortgage lending are still relatively depressed, such as in the U.K.—Ireland in particular—and Spain to some extent.
Some new restrictions on fees and investigations into misselling are also hitting profits. For example, in the U.K., some misselling cases are related to sales of insurance products to particular borrowers, and that is having quite a noticeable impact on retail earnings in some situations.
Maheshwari: In Asia, we're seeing two distinct trends.
In high-growth markets that are investing in infrastructure and industry, such as China and India, we are seeing more growth in commercial lines than in consumer assets. The growth opportunities in China, for instance, are such that some of the other systems are trying to capitalize on them. Hong Kong Bank, for example, is clearly trying to expand its books by branching out into China, and the same is true for banks in Taiwan and even Singapore. In India, too, portfolio growth is happening more in the commercial lines and, to some extent, in infrastructure loans.
In other systems that are maturing and where growth has stabilized—including Australia, Malaysia, Korea, Thailand, Japan, and Hong Kong—bank margins are gradually narrowing. These banks are trying to boost margins by penetrating further into small and medium enterprises and consumer asset classes: namely, residential mortgages, followed by auto loans and unsecured credit. That is typically the order in Asia, with the exception of some outliers, like Indonesia, where there is no significant residential mortgage market and auto loans and unsecured credit dominate consumer assets.
Carniado: In Latin America, as in the U.S., consumer lending generally contributes the most to profitability, with a return on assets close to 2% overall. Personal payroll loans dominate in Panama, while in other areas, including Central America and Mexico, credit cards are a prominent contributor. In Brazil, auto loans and payroll loans are important contributors to profitability.
Although commercial lending has been a target for banks and is increasing, it's growing much more slowly than consumer lending did. So although we expect growth in commercial lending to continue, consumer lending will remain the greatest contributor to profitability.
CreditWeek: Many economists are predicting a rise in interest rates during the next year. How would this affect the banks?
Quintanilla: Standard & Poor's recently conducted a study on the likely impact of rising interest rates across the financial services, including asset managers, banks, and money-market funds. We concluded that unlike in other cycles of tightening, because rates have been so low for so long, and credit has practically been free, banks and most financial companies would actually benefit from higher interest rates. Typically the concern is that higher rates would hurt banks that are more spread-dependent, but with rates so low, the value of free funds is extremely low as well. So we believe that a rise in interest rates accompanied by a strengthening economy could actually provide a revenue boost for many financial institutions, at least initially.
We're also coming off a cycle in which credit losses have been very high. This suggests that further along in the tightening cycle, credit losses could start creeping upward as well.
In general, however, we would expect most financial companies to benefit from higher rates, at least initially.
Maheshwari: A rise in interest rates in the U.S. could have a profound impact on Asian banks. The recent low interest rates have caused investors to put their money into high-growth markets in Asia, which has been boosting some of the asset markets here. When interest rates start to rise, we expect these capital flows to slow down and maybe even reverse. And local banks leveraging to buy those assets at higher interest rates will translate into higher holding costs and could put pressure on asset prices. So we might see some pressure on some banks' profitability or asset quality.
CreditWeek: Both in the U.S. and elsewhere, are there signs that bank lending might be picking up? And to what extent are banks going to be able to help nonfinancial corporate borrowers meet their refinancing needs?
Bugie: In Europe, we expect credit to remain flat in 2011, but it may start to pick up a bit next year. We're still in a period of recovery and absorption of the credit bubble that burst in 2008. In the so-called peripheral countries, however, real credit growth is likely to be negative.
In Europe, it's not so much that banks lack the liquidity to lend into the economy, but more that borrowers are deleveraging. Certainly, banks are more reluctant to lend into the construction industry—there's been more significant deleveraging in that area. But at this point, we don't anticipate a big credit crunch due to regulatory changes or any other factors during the next few years—except in systems that have agreed to reduce the overall size of their balance sheets under EU-IMF programs, specifically in Ireland and Portugal.
Quintanilla: In the U.S., lending standards appear to have eased in the past year, according to the Fed's quarterly senior loan officer survey and the Office of the Controller of the Currency's annual report and survey on credit conditions. But this is, of course, compared with the very tight conditions of 2008-2009. So although the easing has not reached precrisis levels, the banks seem to be more willing to lend at this time.
The Fed's reports on banks' balance sheets—which indicate growth only in commercial and industrial lending, in particular—also bear this out. However, outside of commercial and industrial lending, there hasn't been much growth, and we think that the new capital requirements are also making bank management teams more cautious. The final rules about the new minimum capital standards are not out yet. There has also been a lot of capital-planning reporting to the Fed, including stress testing, in response to mandates from the Dodd-Frank act, and liquidity requirements still need to be ironed out. Overall, the combination of higher capital requirements and potentially very high liquidity requirements has made banks more cautious about new lending than they would normally be in this part of the credit cycle.
Maheshwari: We're seeing two general lending trends in Asia. In the high-growth markets, where there is activity and demand, the regulators are actively trying to contain emerging inflationary pressures by tightening monetary conditions. For instance, just recently China increased its interest rate again, as regulators attempt to contain inflation by limiting the availability of credit. Indeed, China, India, and even Australia to some extent have continued to tighten their systems a bit to put the brakes on current growth.
In the rest of the Asian markets, which are generally either maturing or matured, current growth has been very gradual. So essentially there is demand, but the regulators don't want all that demand to be satisfied, because they think it would lead to some unfavorable consequences for the economy.
Carniado: In Latin America, the story is a little bit different, because growth in lending continued during the crisis. Thus, for most of these countries, we're not seeing a scenario in which growth needs to return to precrisis levels. Instead, there was a slow-down in growth in some countries that is now reversing.
Nevertheless, we may not see the same level of growth as in previous years in countries such as Brazil and Chile that have raised interest rates, which could hurt demand for credit. In other countries, we think growth will resume at a healthy pace. In general, we're expecting growth in the region to average between 13% and 15% during 2011.
CreditWeek: How is the banking sector positioned in terms of housing? If there were to be a full-scale double-dip in housing prices, how would that affect the banking sector?
Devi Aurora: Housing assets make up about one-third of aggregate bank portfolios in the U.S., so it is obviously a very important category. And although we're now in the sixth year of the housing correction, there is still uncertainty as to exactly how well this segment is going to hold up.
To gain some insight, we conducted a study that estimated the impact of a double-dip in home prices on U.S. banks—specifically, a decline of 15%, as opposed to the baseline 5%—coupled with an increase in mortgage rates to 6.5% and a substantial steepening of the yield curve.
The study showed three general areas of impact. One is that a correction of this nature would push delinquencies, loan modifications, and foreclosures higher, and the combined impact of the increases could cause credit losses to rise anywhere from $30 billion to $35 billion for the sector as a whole.
Secondly, we assumed that the severity of losses related to some of the legacy loans made in 2005 though 2008 that the system is still working through could cause representation and warranty expenses for banks to increase by roughly $30 billion to $33 billion.
And thirdly, the higher interest rates would cause originations to drop, contributing another $6 billion-$12 billion loss.
Taken together, these outcomes would yield another potential hit of about $70 billion-$80 billion for the banking sector overall, which would work out to roughly one-third of banks' projected pretax operating income. So this is no small impact that we're talking about in terms of what could conceivably result from a double-dip.
CreditWeek: And that segues into our next question: How do you view the regional banks' exposure to real estate losses? And are the trends in CRE similar to or different from the trends in housing?
Duberstein: By their nature, the U.S. regional banks have a lot of exposure to real estate lending. And for the U.S. banks as a whole, CRE is a major focus for us in both good times and bad—we always closely monitor the risk characteristics and performance of banks' CRE portfolios. We think the good news is that the regional banks have already dealt with the worst losses and the worst of their CRE loan types; the residential construction loan portfolios have accounted for the largest part of the regional CRE losses during this cycle.
That said, many regionals still have substantial NPAs in their income-producing CRE portfolios, including loans in the retail, office, and hospitality sectors—although we've been a little surprised to see that for many banks, nonconstruction CRE appears to have stabilized, particularly in the past few quarters, with declining inflows into NPAs.
We think this stabilization is probably tied to improvement in the sponsors' and borrowers' liquidity and financial health, and to small upticks in property values and cash flows as the economy has slightly improved. The low interest rate environment has also probably helped a lot.
We're still cautious on CRE, and particularly if the economy does not pick up further, we think CRE would see the greatest impact. We think a scenario combining a sluggish economy with a rise in interest rates would be particularly problematic for CRE borrowers and those loan books.
On the residential side, we think that most banks have already identified and taken losses on the poorly underwritten product originated before 2008, and that the newer originations have been much better underwritten, with lower loan-to-value ratios. Of course, another substantial decline in housing prices would definitely put pressure on even these newer, better-quality loans. However, although it is a risk, a major further decline in housing prices is currently not built into our ratings expectations for the regional banks.
CreditWeek: How about investment banking and trading? How are those contributing to banks' bottom lines?
Stuart Plesser: In 2009 and 2010, investment banking and trading were significant contributors to global banks' bottom lines—and they still are in 2011 so far, but less so than in the two prior years. There was less competition in trading back then, particularly in 2009. As a result, bid/ask spreads were wider, as some of the less financially sound banks were just getting back on their feet at the time. Easy money from the government also helped drive profits. This, combined with losses in the retail-banking segment, helped make investment banking and trading very important in terms of global banks' profit generation.
But let's remember that in 2008, this was not the case. Indeed, sales and trading, which we consider to be a volatile, less-stable source of business, was the segment that actually got the banks into the most trouble in terms of depletion of capital. The marks on this business when it goes wrong come quickly, and can deplete capital much quicker than a held-to-maturity book of business.
This year, we expect trading revenues to decline as a percentage of banks' bottom lines. This is due to a combination of improving profitability in the banks' retail segments as credit losses abate—which on its own will lessen the percentage of overall profits for investment banking and sales and trading—as well as macro concerns, including sovereign and debt-ceiling issues that will likely lower trading volume in 2011. Trading profits for the rest of the year will likely hinge on the way sovereign issues are resolved and whether there is conviction in the markets to take more risk and trade more. Right now, a lot of investors seem to be in a defensive mode. What may help a bit is that there were also macro issues in 2010, so year-over-year comparisons are not that difficult.
Some trends in the just-completed second quarter include significantly higher advisory activity, weakness in commodities, and riskier mortgage products compared with the first quarter, largely due to price declines for these products. We believe that banks that rely on a pure, "plain vanilla" flow trade to service existing clients likely performed better than those partaking in more exotic products and those that still engage in some proprietary trading.
There are a lot of legislative and capital changes that are going to hurt profitability in the sales and trading business. For starters, as Basel 2.5 is implemented, there will be higher counterparty capital charges, which will likely hurt volume and margins. In addition, legislation calls for many over-the-counter derivative contracts to move to clearinghouses. This is likely going to reduce margins, as pricing will become more transparent.
So overall, although we think that investment banking will contribute less to global banks' bottom lines, we still consider it an important business, as it's necessary to help facilitate the banks' large multinational clients. This segment, at the very least, helps bring in business for which banks collect fees in segments outside of sales and trading.
CreditWeek: China is becoming an increasing economic factor for many global industries. What do we see as the future for banking in China?
Maheshwari: We expect economic growth to remain strong in China, which will create continued strong demand for credits and banking services and keep the Chinese banks in a prominent position in the economy. Indeed, the economic growth in China has become a magnet for banks in even the mature Asian markets, which are trying to enter however they can. Most of these banks have set up local subsidiaries and then grown organically, and many Western banks are also following this path.
Because banks all around the world are chasing the Chinese credit markets, regulators in China are keeping continuous control of credit delivery to avoid the inflationary pressure that excessive credit might cause.
Essentially, this also means that if anything were to go wrong with the Chinese banking system, or if asset quality were to decline because of a slow-down, even of a temporary nature, the impact would extend far beyond China to the many systems that are increasing their exposure to the country.
CreditWeek: We've said that current capital levels are not an indication of credit strength. Are there countries where bank capital levels might not meet regulatory minimums?
Brennan: As a preface to this discussion, I'd like to emphasize two key points. One is that regulatory capital measures are still inconsistent across countries globally. Although Basel III may lead to greater consistency, it will only happen during an extended period of time. Currently, we still see significant differences between the conservatism or stringency of different regulatory capital definitions in various countries.
The second main point is that, because of the limited comparability of regulatory capital measures, we focus primarily on Standard & Poor's own measures of capital—in particular, our risk-adjusted capital framework, which we use to assess banks' capitalization. Our belief is that capital is still a relative weakness for the credit quality of many midsize and large banks globally, particularly in Europe. Because the regulatory capital measures are not necessarily as tough in some countries as in others, we really try to look past them when assessing capital.
However, regulatory capital ratios are important because they're part of the licensing arrangements that enable banks to operate, and they can also be important drivers of market confidence in various banks.
At the moment, there is a lot of debate about the quality of capitalization for various banks in Europe. Last year, the Committee of European Banking Supervisors, or CEBS, which was akin to an umbrella group for European banking regulators, carried out a round of stress testing. Many believe the stress test on capitalization was not harsh enough and failed to identify some cases where banks were clearly undercapitalized.
The successor organization to CEBS, called the European Banking Authority, or EBA, is now working on a set of capital stress tests of various European banks. We expect the results of those tests to be published within the next few weeks, and many in the market believe some banks will fail the capital stress test. [The EBA subsequently published the stress test results on July 15, 2011.]
It's important to think through what failing the EBA stress test means. First of all, an institution has to achieve a 5% core Tier 1 ratio after the application of the stress, which is higher, or more demanding, than the current regulatory capital requirements. That is, this benchmark of a 5% core Tier 1 ratio is tougher than what is currently required for a bank to be legally in accordance with the terms of its license.
We see the EBA's use of a core Tier 1 ratio as useful because one of the problems with the 2010 stress test was that the capital ratio measurements, which included various hybrid measures for different banks, were pretty inconsistent. In some cases, they allowed banks to fare relatively well under the stress scenario despite having instruments that had a limited ability to absorb losses and that wouldn't be considered part of the capital base under our criteria.
In addition to considering the 5% core Tier 1 ratio, we also have to think about what type of stress the EBA is applying. The scenario that the EBA's stress test incorporates is relatively harsh, so it's not the expected or most likely outcome for banks. Still, we think it could be even harsher—it does not represent an extreme event.
Institutions that fail the test may then have to show what actions they are taking or plan to take to improve their capital measures. In some cases, it may also be important for governments to indicate the means of support that might be available to those institutions. There have already been various actions in Europe in recent months in which certain governments sponsored or helped encourage either the restructuring or the recapitalization of various entities. We have also seen some private-sector capital-raising in countries like Italy, for example.
In Germany, a range of institutions looked at converting certain elements of their capital bases—for example, silent partnerships—to make them more compliant with the future Basel III requirements. So there is a theme emerging that banks are trying to improve the quality and size of their capital bases.
A risk for the market is that this transition toward better capital takes time, and not all institutions are able to build capital at the same pace or to the same extent. I think that for the rest of 2011, we're likely to see a range of institutions increase their efforts to strengthen capital. However, for some banks, weak capitalization will continue to hold back ratings. Concerns about capital may also lead to fragile market confidence in those entities, which might affect access to funding in some circumstances.
CreditWeek: Do we believe that the increasing consolidation of the world's stock exchanges will likely alter their credit quality significantly? If so, why?
Charles Rauch: The exchange and clearinghouse industry has entered a period of rating volatility. We took more rating and outlook actions in the first half of 2011 than we did for all of last year. Most of the rating actions during the first half of 2011 were negative in direction.
Earlier this year, we entered what many consider to be a second round of industry consolidation. The first occurred in 2006, when we saw a number of transatlantic and cross-border mergers among stock exchanges looking for geographic and product expansion, especially into derivatives trading and clearing.
We're still seeing these themes in round two, but we're also seeing an emphasis on cost-cutting—not just in the back office, but also in the front office. A good example would be Deutsche Boerse and NYSE Euronext, which plan to combine Deutsche Boerse's Eurex and NYSE Liffe to create a trading platform in Europe that covers both the short end and the long end of the interest-rate curve. This is similar to the CME-CBOT merger in the U.S.
We've placed our ratings on a number of companies on CreditWatch or taken other rating actions after their merger announcements. However, some of these deals have fallen apart. For example, London Stock Exchange Group and unrated TMX Group scratched their planned merger after it became clear that TMX Group shareholders would not approve the deal. Also, NASDAQ OMX Group and unrated IntercontinentalExchange had made an unsolicited offer to acquire NYSE Euronext, but gave up due to regulatory roadblocks.
The NYSE Euronext-Deutsche Boerse transaction is the only significant merger among rated exchanges pending now. This transaction will take place under a new holding company based in the Netherlands, which will own the two subsidiaries. We placed NYSE Euronext on CreditWatch Positive and Deutsche Boerse on CreditWatch Negative. As we stated in our Research Update, it's very possible that we will assign separate ratings to the two entities after the transaction closes because they have very different financial profiles and operate under different regulatory jurisdictions.
I don't think you can make any overarching generality that consolidation is either good or bad for the industry. However, consolidation within the broader financial industry is having a growing impact on exchanges and clearinghouses, since their membership mostly consists of banks and brokerage firms.
The growing consolidation among the membership means that more and more revenues and counterparty credit exposures are concentrated among a few large members, and these large members can put pressure on the exchanges to reduce fees, or worse, weaken their financial safeguard systems.
CreditWeek: Under the terms of Dodd-Frank, it seems that some financial institutions in addition to banks might be considered "systemically important." What impact would that have on our view of these institutions, specifically in terms of ratings?
Craig Parmelee: Simply being named a systemically important financial institution, or SIFI, would not necessarily affect our ratings on these entities. However, we expect systemically important institutions to be held to higher regulatory standards. If they are required to maintain more-conservative financial profiles due to the regulatory requirements, it could have a net positive impact on our view of these companies, and in some cases, this could benefit the ratings.
Although the question is directed toward nonbank financial institutions, I think our bank criteria proposal offers a good example here. Under our proposal, we have set a certain range of capital that would be neutral to the ratings; if an institution were to maintain capital above that range, it would benefit the rating directly. Thus, if SIFIs are required to maintain capital above this threshold, it would directly benefit their ratings. The offset is that the higher regulatory burden for SIFIs could hurt profitability and even competitiveness, in some cases.
However, in the U.S. under Dodd-Frank, the specific prudential regulatory standards for systemically important nonbank financial institutions—and, for that matter, for banks as well—have not yet been established. So it's a bit of a wait-and-see as to exactly what their impact will be on credit quality.
Rauch: I'd just like to add our view about some of the clearinghouses. We believe the large clearinghouses in the U.S. are already systemically important, because they have effective monopolies in the separate markets they serve, and none, in our opinion, has the expertise or capacity to take over a failed clearinghouse.
Section 802 of the Dodd-Frank act states that financial-market entities that conduct multilateral clearing and selling activities—in other words, clearinghouses—may reduce some risks, but may also create others.
We've identified some new risks that may emerge from the Dodd-Frank mandate for central clearing of over-the-counter derivatives. First, entities that wish to enter this space will need to develop new risk and margining methodologies, which may not have been tested in the real world. Second, OTC derivatives, for the most part, are less liquid than listed futures and options. This could be problematic if a member defaults and the clearinghouse has to unwind less-liquid derivative products to make counterparties to the trade whole. Third, clearing of OTC derivatives offers a very big profit opportunity, which is bound to attract new entrants and could upset the current market equilibrium, which could destabilize the ratings.
Because Dodd-Frank acknowledges that there are new risks, regulators are specifically looking at clearinghouses as systemically important and recommending new financial controls and regulations for them.
Daniel Koelsch: I'd like to add an interesting Canadian perspective here, regarding the point that regulators may hold these institutions to higher standards. In Canada, rather than designating the Canadian Directors Clearing Corp., or CDCC, as systemically important, regulators more likely are going to declare what they call the Canadian Derivatives Clearing System as systemically important. Although they will still hold the CDCC to higher standards to ensure that the system is not in jeopardy, the actual "systemically important" designation will not apply directly to the entity we actually rate.
CreditWeek: Do we expect banks, particularly those in developing markets, to encounter difficulty in meeting measurements of market risk to comply with Basel III?
Bugie: Nothing we've seen indicates that regulators in developing markets will take actions that would fundamentally change how financial institutions engage in their capital-market activities. These businesses can be rather concentrated in the global investment banks and certainly contribute less than the commercial banking lines of domestic banks in those markets. Most developing countries—such as Brazil, China, India, Russia, and Turkey—are trying to expand their capital markets, make them more liquid, and broaden the investor base in both equity and fixed income. We don't anticipate regulation that would run counter to that trend.
In developing and mature economies alike, the basic model of market-based economies with open borders and significant cross-border investment flow looks to continue. Regulations that require more capital for trading operations or that limit proprietary trading may result in some business migrating toward institutions that have a different regulatory charter, and that may affect banks specifically. But overall, we don't think the new regulations will reduce capital-market volumes. In fact, regulations that require standard derivative contracts to be traded in central clearinghouses may narrow bid-ask spreads in certain products and increase trading volumes.
Maheshwari: The banks' capital-market activities are generally not yet playing a big role in developing Asian market economies, with the exception of Japan, Australia, and Korea. I don't expect regulators to spend a lot of energy looking at these markets and trying to make regulations more stringent. In fact, the regulators are in more of a developmental mode, trying to expand the banking systems so that they can play a bigger role in the economy.
As for Basel III, considering the developing nature of these markets, the banks have been capitalizing on the abundance of credit opportunities, and not really dabbling in market-related activities so much. When we look at these banks' risk-weighted assets, it's no surprise that credit risk makes up more than 90% of them, rather than market risk or operational risk. So meeting the market-risk requirements doesn't seem to be a big area of concern at all.
Carniado: In Latin America, countries are at various stages in applying the Basel guidelines. The largest countries, like Mexico and Brazil, already consider the measurement of market and operational risks in their regulatory frameworks. Some others, for instance in Central America and the Caribbean, will require more time because of potential difficulties from local-market participants, as many of those countries are not yet in Basel II.
In midsize countries, we have a mix. Whereas Chile and Peru should be able to meet the requirements under Basel III, Argentina, for example, has not yet moved into Basel II. In general, we believe only a few countries are prepared to adopt Basel III in the next few years, whereas most of the systems will require an extended period of time to meet these guidelines.
CreditWeek: Keeping the focus on developing markets, what do we see as the key risks for banks in countries with less-developed economies?
Bugie: For most developing countries, the risk of debt-driven expansion leading to economic overheating and a potential disorderly correction is timeless. Clearly, many developing economies are at a different point in the business and credit cycle than mature economies, which are going through a restructuring and cooling-off phase with some deleveraging. Many developing countries—Turkey and Brazil are good examples, but we could cite others—are in a credit boom that is accelerating economic growth.
The risks are not visible during the expansionary period, but they may emerge during a slow-down and correction.
Maheshwari: Most of what Scott just said is true for Asia as well, but in some countries more than others. India and Vietnam are already showing signs of overheating, and while China is not yet at that level, it is another one to watch, considering its rapid growth.
I'd also like to highlight that capital inflows into Asia have been giving rise to another risk factor: namely, that the eventual collapse of any asset bubbles that form later in the cycle could damage those economies, and a slowdown or reversal in these capital flows might lead to a slump in such asset markets.
However, we aren't seeing these issues to any significant degree in any markets as of yet, but the prices have gone up significantly in China and India, for instance, as well as in some of the smaller systems, like Hong Kong and Singapore.
Carniado: In Latin American, in general, the two risks banks will face is the level of resilience of the country's economy overall and the credit risk derived from variables in the legal frameworks. The main challenge for banks in Latin America will be to sustain high levels of capitalization and profitability while trying to increase market penetration of still-underbanked economies.
CreditWeek: What are regulators doing to put the brakes on the banking systems' growth? They have been pretty active in the past with raising reserve requirements. Are they doing the same thing in China and India now?
Maheshwari: The reserve requirement tool is only being used in China, and that's partly because they have to use a tool that essentially "mops up" surplus liquidity. The tools that other systems have been using are policy-rate increases, which have had varying levels of effectiveness. India, for instance, has already done more than 10 such changes during the past three years.
In addition, China has done a little bit of tightening on the property side, and Hong Kong and Singapore have tried to tighten their lending norms—and to some extent even taxation—to keep bubbles from forming in the property markets in these smaller systems.
CreditWeek: When Standard & Poor's rates banks and other financial institutions, how does it take into account sovereign risk?
Aurora: Factors such as economic resilience and imbalances and credit risk in the economy tie in directly to the analysis and insight that inform sovereign ratings. In addition, in evaluating industry risk, we assess the government's ability to provide funding support to the banking systems in general, although this element is not explicitly linked to the sovereign rating. This feedback loop works both ways: Although sovereign ratings are linked with certain aspects of our banking industry country risk assessments, or BICRA assessments, we also look at the contingent liability to the sovereign of the risk posed by a systemic crisis in the banking sector.
Maheshwari: I'd like to add one more point here, which may seem obvious but I think is worth noting. Standard & Poor's does not rate banks higher than the associated sovereign foreign currency ratings, which ends up being a real hurdle for bank ratings in some systems. This is just one other way sovereign ratings end up affecting the ratings on financial institutions.
CreditWeek: Will the increase in bank regulation in developed nations that followed the financial crisis tend to push more risk away from banks and into other financial institutions?
Koelsch: Looking at the clearinghouses specifically, by taking on more over-the-counter business, they are assuming a lot of the risk that used to reside within the banks.
Among alternative asset managers, we've seen business-development companies and hedge funds, for example, moving into credit—areas that the banks previously occupied or that securitization used to cover.
If regulation limits what banks can do, and proprietary trading would be such a case, risk could indeed move to hedge funds, but that is not a forgone conclusion. And some of the risk might even go away entirely, in the sense that, for example, traders might trade far less capital at hedge funds than they would have in a bank environment.
Bugie: New regulations should not result in a decline in capital-markets activity. The decade-long trend of expansion of the market-driven global economy with significant cross-border investment flows is well established. We believe the trend of disintermediation will continue—this means that more debt securities will be issued and will change hands. And the markets will need intermediaries to facilitate purchases and sales, and services to help manage risks. There is a good case for the regulators' push for banks to maintain very high capital to back certain business lines such as securities sales and trading. The proposed increases in risk weighting of counterparty credit risk in the trading book are substantial. But if the increased capital requirements push banks away from certain segments, the business may simply move to other nonbank players in the market.
Maheshwari: In Asia, we're not expecting any significant tightening of regulations because there is no particular problem that the regulators need to address at present. They continue to introduce monetary tightening measures in high-growth economies, however, including hikes in policy interest rates, a bit of control on the credit growth of banks, and, in the case of China, a hike in banks' reserve requirements.
To the extent that these measures increase the cost of credit and reduce the availability of credit, they could push lending to other, unregulated sectors. However, it's very difficult to put a finger on the extent of this "shadow banking" market, given the lack of information available. We're continuing to look at it and believe it may not be immaterial in size, but we are not yet able to gauge the risk it could pose to the whole system.
CreditWeek: What is our outlook for private equity funds?
Koelsch: We see a bifurcated picture for private equity: The big funds will continue to attract money and get even bigger, while the smaller ones may struggle with the rising tide of regulatory compliance and capital-raising. The operating environment clearly supports a structurally larger fund.
There's also a lot of dry powder in the system currently. According to PitchBook, of the $1.5 trillion the industry raised during the past 10 years, $477 billion of undrawn commitments from investors remained as the industry entered 2010. The fund-raising was driven primarily by demand from limited partners and the private equity firms' desire to maximize the fund sizes. Oaktree Capital recently returned $3 billion in funds to its investors, citing difficulties finding investment opportunities for one of its distressed-debt funds as the economy improves. It will be interesting to see how the industry deals with the challenge of finding good investments and meeting performance expectations.
At the end of the day, returning funds to investors really means giving up fee income. But competing for investments could put pressure on valuations and, eventually, performance. The financing capacity of the large, established private-equity firms, like Carlyle, Blackstone, Blackrock, and the like, has enabled them to fund huge new pools of investments, and a lot of that money is now flowing to emerging markets, including some markets in Asia.
CreditWeek: How will 2011 be remembered for the financial sector?
Brennan: For the European financial institutions, the number-one topic to look out for this year has been funding, specifically the funding pressures and refinancing issues that banks are facing.
I also see two big themes for the European financial institutions in 2011. The first is that 2011 has been the year when the interdependencies between the various sovereigns' fiscal and budgetary situations and the banking system became very apparent in parts of Europe. We've seen a range of countries in which the banks are working through the impact of tighter sovereign positions.
The second is that 2011 is when we've really seen the kick-off of the race to improve capital. Some of the stronger institutions are taking steps to raise capital and strengthen their balance sheets. And some national authorities are also encouraging some of their small to midsize banks to strengthen their balance sheets.
It's the start of what we believe will be a long-term transition. The worry is that some institutions may start a bit too late and end up falling behind in the race to improve capital—and for that reason, these entities may find investors are less willing to take on more exposure to some banks in various European economies.
Plesser: I think in the U.S., 2011 will be remembered as the year of the lobbyist for the U.S. banking industry. There has been a spate of public outcry about pending regulations and what that could mean for the banking businesses as they attempt to compete in a global world. I think the banks understand what's at stake and that if certain regulations in Dodd-Frank and Basel III, for that matter, are enacted in a punitive way, the banks' ongoing profitability could take a big hit.
This is their year to fight it and to protect their businesses—maybe even in an overtly aggressive way, including challenging politicians and regulators publicly, if need be.
Bugie: 2011 may be remembered as the year that the global regulators hammered out an agreement on the best set of regulations for financial institutions. There are several important meetings for the rest of the year in which the financial authorities will work together on global coordination—a critical issue. Maybe they'll nail it—and we'll all remember 2011 as the year they figured things out and agreed.
CreditWeek: A peaceful note to end on.
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Thanks, Sean..
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