Revenues Stay Soft For Large Banks And Trust Banks In The U.S.

Industry Credit Outlook

Despite further signs of recovery in the U.S. economy, large banks continue to grapple with the effects of high unemployment, the weak housing market, the European sovereign debt crisis, and new global financial regulations. Their reported earnings in fourth-quarter 2011 were weak. Still, credit fundamentals continued to improve across loan categories for most large complex banks in fourth-quarter 2011. As a result, lower credit provisioning and higher cost controls allowed them to build capital while preparing for new regulations. Meanwhile, U.S. trust banks' profitability remained satisfactory, but low interest rates and subdued capital market activity continued to hamper their revenue growth.

In 2012, we expect large banks and trust banks to continue to build capital. But the sluggish U.S. economic recovery, the subdued capital markets, and the low interest rates are likely to keep earnings growth down.

The Pressure Is On Revenues

The U.S. unemployment rate fell to 8.3% last month, but our economic outlook remains tepid. Stresses in Europe, including sovereign debt concerns and their potential impact on financial institutions and the general economy, have combined with the U.S.'s housing market struggles and tenuous economic recovery to sap activity from the capital markets. The equity and bond markets' trading volumes were down in the fourth quarter as many risk-averse investors stayed on the sidelines. The pace of mergers and acquisitions also slowed during the second half of 2011.

Many banks have reacted by reducing the risk taking in their trading operations. This, along with seasonally lower activity and clients' own risk aversion, resulted in lower trading results for the quarter. We believe these results could improve in first-quarter 2012, partly due to the positive impact of the European Central Bank's liquidity infusion. However, we believe this is just a temporary solution, and that the capital markets will likely remain volatile until a more permanent solution is proffered.

Loan growth in sectors such as auto and education has resumed at some banks. (See "U.S. Bank Loans: Battling Back From The Recession As Growth Remains Weak," published Feb. 7, 2012, on RatingsDirect on the Global Credit Portal.) Many banks have expanded their commercial and industry loan portfolios, partly because of seasonal demand and the void European banks have left in the market. Credit card lending also increased. And while this could reflect seasonal demand, it could also be a sign of loosening lending standards, which would be a positive for consumer spending but a potential longer-term risk from a credit perspective. Still, the uncertain economic recovery will likely constrain loan growth overall.

Low interest rates have been squeezing banks' net interest margins (NIMs)--the higher yielding assets on their balance sheets continue to run off, only to be replaced by lower yielding U.S. treasuries and other safe investments (see table 1). This will likely continue for the foreseeable future, since the Federal Reserve recently announced its plans to keep short-term interest rates near zero through late 2014. Although banks' funding costs declined as they paid down debt and their deposit balances increased, it wasn't enough to offset the decline in investment yields. We expect flat or falling NIMs, combined with weak loan growth, to result in mostly flat net interest income for banks over the next few quarters.

Table 1

Banks are experiencing the effects of new regulation as well. The Durbin Amendment, which limits debit interchange fee income, took effect in the fourth quarter and was partly responsible for the drop in the banks' noninterest income. In addition, Regulation E (which limits the amount of overdraft fees banks can charge) and the CARD Act (which limits fee and rate hikes for credit card borrowers) will continue to pressure banking revenues this year (see table 2).

Table 2

While we expect that banks will try to mitigate the loss of these fees, those revenues may not be easy to replace. Public push-back has already caused some banks to rethink their strategies. We also expect new regulations stemming from the Dodd-Frank Act (DFA), such as the Volcker Amendment, to result in less trading revenue and higher compliance costs. However, we will not be able to assess the regulations' specific impact on banks until the rules are final. Furthermore, repurchase and warranty costs related to mortgage underwriting will likely continue to pressure banks' top line in 2012, mostly through requests from government-sponsored entities, as was the case in fourth-quarter 2011. The full-year 2012 impact, however, should be milder than in 2011.

The Pace of Credit Improvement Has Slowed

Nonperforming loans remained high on a historical basis in most categories, even though charge-offs and the formation rate for new nonperforming loans have declined.

The foreclosure process is the main culprit: Delays mean borrowers that have been delinquent on their payments can't be foreclosed on in a timely manner, which keeps those bad loans on banks' books longer. However, the recent mortgage servicer settlement could help to loosen some of the blockage in the foreclosure process we've seen in some states (see "U.S. Mortgage Servicers' $25 Billion Settlement Shouldn't Affect Ratings," published Feb. 10, 2012). That said, banks have continued to push foreclosure alternatives such as short sales and deed-in-lieu transactions, which are intended to help keep borrowers in their homes and reduce losses. Banks also have continued with other loss-mitigation efforts, including various modification programs. We include these foreclosure alternatives, which are classified as troubled debt restructurings, in our nonperforming loan ratios. This is an appropriately conservative approach, in our opinion, that reflects the risk inherent in a borrower that has already required a restructuring of his obligation once, amid a relatively weak housing market and economic recovery.

Despite the ongoing weakness in home prices, banks have been less apt to reduce loan loss reserves for their residential mortgage and home equity portfolios. Some banks also increased their reserves in 2011, which keeps them "well reserved" for the potential losses embedded in their portfolios.

The pace of credit improvement in banks' credit card portfolios has slowed noticeably in recent quarters, and net charge-off rates are nearing historical average levels (see table 3). The delinquency rates are also at or near historical averages. As a result, we expect negligible reserve releases in this segment for the foreseeable future.

Table 3

The charge-off rates in most other loan categories have also declined--though not as quickly as in the bank credit card segment--and are still higher than normal. Overall, we expect banks to make smaller marginal reserve releases this year.

Reserve Releases Aren't Enough To Offset Banks' High Costs

Large banks' expense ratios continued to increase and constrained earnings in the fourth quarter. The main culprit was weak revenues, which we expect to continue through 2012. In addition, regulatory compliance costs are likely to remain high for the foreseeable future, so banks must look elsewhere to improve efficiency.

The lower capital markets revenue and higher regulatory costs are causing banks to look for cost-cutting opportunities, which could mean more layoffs and employee compensation cuts. Furthermore, as banks implement the cost-cutting initiatives they've previously announced, many have already confirmed that those efforts may not be enough. Overall, we expect that efficiency ratios will remain high on a historical basis until the banks' expense reduction efforts take hold and the poor performing legacy assets are removed from the portfolios or the banks experience sustained improvement in revenue generation.

Yet, despite the obstacles to increasing their preprovision earnings, the largest U.S. banks have reported higher profits on average due to reserve releases (see table 4). We expect this benefit to wear off during the next few quarters. Conversely, if the economy strengthens more than we anticipate, revenues and earnings could improve due to strengthening loan demand, rising long-term interest rates, and more widespread reserve releases.

Table 4

Banks Continued To Increase Capital, But Capital Management Actions Will Slow The Pace

The new capital requirements that Basel III and the DFA have prescribed are shaping banks' capital plans. We believe the higher quantity and quality of capital banks aspire to will support the current issuer credit ratings, since we've already incorporated these future capital levels in our forward-looking analysis of capital and earnings.

Banks are still wrestling with estimating potential capital and liquidity ratios (see table 5). But they have generally moderated capital building exercises to take advantage of the protracted implementation of Basel III. To this end, banks have been returning more capital to shareholders, assuming regulatory approval.

Table 5

Meanwhile, the Federal Reserve's Comprehensive Capital Analysis and Review for 2012 is underway. The results are expected in March and will guide banks' capital management actions in the year ahead. We expect some banks to accelerate the pace of their share buybacks to boost stock prices, but we don't anticipate much in the way of higher dividend payouts. Instead, many banks may focus on redeeming the hybrid capital securities that will be phased out of regulatory capital between 2013 and 2015, as mandated by the Collins amendment in the DFA.

Some banks have been actively redeeming eligible trust preferred securities, though many of these hybrid securities cannot be redeemed until the regulatory proposals are finalized as rules. Measured capital management actions should not hurt the ratings on banks, but a bank's more aggressive capital management actions could hurt the ratings. In general, we expect that banks will be able to meet new regulatory minimums within the timelines allotted through a combination of earnings growth and risk mitigation.

Revenues Remain Soft For Trust Banks, But Profit Margins Are Fine

The three rated U.S. trust banks, Bank of New York Mellon Corp., State Street Corp., and Northern Trust Corp., continued to post satisfactory profits in the fourth quarter. Although revenue trends were a bit disappointing, the companies' pretax operating margins, which were in the mid-20% range, were within our expectations for the ratings. The companies' asset servicing and investment management fees declined from the third quarter, reflecting factors such as lower transaction volumes and shifts by clients into less risk assets that generate lower fees. Still, the assets under custody and administration and assets under management held fairly steady, reflecting market appreciation during the quarter and net new business. Equity market trends should help increase fee revenue in the coming quarters.

NIMs were either flat or down, reflecting lower asset yields. However, net interest revenue increased for the third consecutive quarter at each of the trust banks, reflecting the larger average balance sheets from their custody clients' deposit inflows. We expect that these deposit inflows, which stem from the money managers' risk aversion, could remain high in the short term but decline to more normal levels over time.

Still, the trust banks' fee waivers in their low-yielding money market-related businesses have been hurting revenue. We believe that, combined with the very low interest rates, will cut into revenue generation in coming quarters.

Foreign exchange trading revenue declined during the quarter, reflecting lower market volumes and high volatility. We believe that Bank of New York Mellon and State Street have stable client volumes in their foreign exchange business, despite legal issues pertaining to their foreign exchange pricing practices.

The trust banks' operating expense trends were mixed, but each bank has said it intends to remain focused on expense growth controls in 2012 and through the next few years. Northern Trust announced its efficiency plan, becoming the third of the three trust banks to institute cost-cutting initiatives. Each bank took restructuring charges in the fourth quarter.

The trust banks' capital trends are a key rating factor because share repurchases are affecting capital accumulation. The Bank of New York Mellon substantially slowed its share repurchases during the quarter, mainly addressing the need to build its Basel I leverage ratio. Still, in 2012, we expect that each banks' capital, which is deployed in common share repurchases and common stock dividends, will be fairly high at about 60%-65% of net income. Our ratings on the trust banks assume that the companies will implement share buybacks at a measured pace, conservatively managing their capital levels in light of the volatile market conditions.

Outlook

Our outlook remains negative for the majority of large banks and trust banks. We are encouraged by the banks' increasing capital and improved credit fundamentals. But we will continue to evaluate the effects that housing market weakness, regulations from new legislation, higher representation and warranty costs, low interest rates, and litigation concerns could have on the industry. For most banks, our outlook reflects the negative outlook on the sovereign rating on the U.S., and the likely impact a potential downgrade of the U.S. would have on the support we factor into those ratings, in addition to bank-specific factors.

Our base case expectations for 2012 include:

• Lower revenue due to continued low interest rates and weak capital markets results.
• A modest reduction in operating efficiency as costs remain high, largely as a result of regulatory changes, and revenue declines.
• A continued improvement in credit quality.
• A moderate rise in net income, fueled by reserve releases.
• Increasing capital, subject to the pace of hybrid capital retirement and returns to shareholders.

The risk of a recession in Europe and the potential impact on large U.S. banks also temper our outlook. The banks' direct loan and counterparty exposure to the European Economic and Monetary Union seems manageable as long as collateral quality remains strong and risk hedges work as intended. However, the scenario would worsen if potential liquidity and funding issues in Europe spread to the U.S., negatively affect the wholesale funding markets, which U.S. institutions rely on. A shock to the system could also hurt U.S. institutions because of a rise in the probability of a global recession. In addition, if the pace of distressed asset sales increased, it would likely hurt global asset values. Ultimately, if these events occur, we believe they would pressure large U.S. banks' creditworthiness. However, although we consider these risks in our analysis, our ratings on those entities currently don't incorporate a high probability of a global recession or system shock.

Industry Credit Outlook

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Table 7

Table 8

Related Criteria And Research

• U.S. Mortgage Servicers' $25 Billion Settlement Shouldn't Affect Ratings, Feb. 10, 2012
• U.S. Bank Loans: Battling Back From The Recession As Growth Remains Weak, Feb. 7, 2012