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The Weakness In Capital Markets Revenues Appears More Structural Than Cyclical

Publication date: 02-Jul-2012 05:46:35 EDT

When the major global investment banks report their second-quarter earnings in the coming weeks, all eyes will be on the resilience of their capital markets revenues amid the weakening economic and market environment. Their aggregate return on capital currently lags their cost of capital by a distance, and we believe that a key question currently facing the industry is whether this is merely a temporary phenomenon. Standard & Poor's Ratings Services believes that investment banks have yet to demonstrate that they can generate satisfactory and sustainable returns on capital while subject to tougher regulatory requirements and difficult funding conditions. More favorable macroeconomic conditions would support earnings growth, but we see significant short-term uncertainties. In addition, widespread deleveraging (not only by banks) in many countries could remain a drag on global GDP growth for some time to come. For 2012, our base-case assumption is now for capital markets revenues to decline by up to 10% in the full year compared to 2011. (Watch the related CreditMatters TV segment titled "Is The Pressure On Investment Bank Revenues Structural Or Cyclical?," dated July 4, 2012.)

We consider that a long-lasting improvement in performance hinges on the effectiveness of the restructuring measures that investment banks are taking to adapt their risk profiles, funding models, and expense bases to the emerging regulatory and market context. This multiyear transformation is a fundamental shift to a less profitable, but somewhat lower risk, business model, in our view, and it is difficult to envisage the industry earning materially more than its cost of capital. Accordingly, we think the slowdown in capital markets revenues is more structural than cyclical.

As investment banks seek to adapt their business models to tougher regulatory and funding conditions, we have seen them place particular emphasis on increasing balance sheet turnover and cutting inventory positions (see chart 1). Deleveraging activity has concentrated on higher risk and less liquid assets since they are more RWA (risk-weighted asset)-intensive under Basel 2.5 and Basel III. From a strategic perspective, banks are refocusing their capital and funding resources on markets and geographies in which they have comparative advantages, while downsizing or exiting others.

Chart 1

In a world characterized by flow trading, centralized clearing, and thinner margins, we see scale and technology as particular competitive strengths. We expect that the industry will steadily become more concentrated and that the performance of the larger players may benefit from a reduction in overcapacity as smaller banks retrench, particularly in Europe. In the medium term, in addition to an eventual lifting of the current macroeconomic gloom, organic growth opportunities may come from sources such as developing countries and a deepening of European capital markets (which should increasingly replace bank financing). We expect that quarterly changes in revenues will likely be greater than the pre-2007 period as carry trades and repo (repurchase agreement) portfolios, which historically had a smoothing effect, have been managed down and there is now greater dependence on underlying customer transaction volumes. More importantly from our perspective, there should be less potential for extreme earnings volatility such as that experienced in 2008-2009 since banks are reducing their holdings of illiquid trading assets that are subject to market price risk.

Capital Markets Revenues In The Second Half Could Be Only Marginally Better Than In The Same Period Last Year

We believe that capital markets revenues are likely to follow a similar quarterly pattern this year as in 2010 and 2011, when a healthy performance in the seasonally-strong first quarter gave way to a marked slowdown over the remainder of the year. In December 2011, when market concerns over sovereign creditworthiness were particularly acute, we assumed a 20% decline in global capital markets revenues this year relative to 2011. In the following weeks, market sentiment received a short-term boost from the European Central Bank's long-term refinancing operations (LTROs) and more encouraging U.S. economic data, which contributed to a favorable environment for capital markets businesses in the first quarter of 2012.

Market conditions have deteriorated since April, however, as concerns over the eurozone and global economic prospects have resurfaced. Since a quick fix to these challenges appears unlikely, in our view, we assume that capital markets revenues in the second half of this year will be only marginally better than the very weak performance in the same period in 2011. Still, because the investment banking industry had a more buoyant first-quarter performance than we expected at the time of our original forecast, we now assume a 0%-10% decline in revenues in the 2012 full year rather than our original 20% projection. Our revised view does not affect our current ratings. However, a material adverse event, such as an exit of a country from the eurozone, would likely trigger a sharper fall in global capital markets revenues and could also lead to negative rating actions.

Markets Are Now In "Risk Off" Mode

The first quarter of the year is typically the strongest for capital market revenues due to seasonal factors, and 2010 and 2011 were no exceptions to this trend (see chart 2). The fall off in revenues after the first quarter was unusually pronounced in both of those years, however, as sentiment among investors and corporate clients became more risk averse due to macroeconomic and sovereign concerns. A similar pattern is likely this year, in our view.

Chart 2

In our view, the fragile macroeconomic environment is the primary factor weighing on the performance of banks' capital markets businesses at present. Markets have lurched between "risk on" and "risk off" modes as newsflow and speculation have triggered changes in confidence over the likely path of future events. For the most part, however, there has been widespread risk aversion, not least in the second quarter. This was demonstrated by large cash positions and sustained tightening of government bond yields for perceived safe havens. This has reduced banks' transaction volumes and also adversely affected the cost and availability of the funding they need to support their inventory positions.

We consider that the ongoing transition toward stricter regulation is a secondary, but still material, factor behind the current pressure on capital markets revenues. Many details of the emerging regulations are not yet final and lack global consistency, but the broad direction and intent is unambiguous. Once fully implemented, the new regulatory environment will have a profound effect on investment banks' business models, balance sheet profiles, and earnings potential, in our view.

The regulatory changes include tougher capital, funding, and liquidity limits under Basel 2.5 and Basel III; limitations on proprietary trading under the U.S. Volcker rule (a section of the Dodd–Frank Wall Street Reform and Consumer Protection Act that restricts U.S. banks from making speculative investments); and stronger market infrastructure, including greater usage of collateral and central counterparties. Balance sheet capacity and RWAs have already become far scarcer resources for banks than was historically the case. As a result, banks are more selective when deciding on which markets to focus their attention. The "shadow banking" sector is increasingly competing for the revenue pools in a number of market segments, but, in our opinion, has not significantly filled the void left as banks have retrenched.

Fixed Income Was A Strong Performer For Many In The First Quarter

The first quarter of 2012 was a relatively healthy trading environment thanks to the temporary relief provided by the LTROs, which helped to trigger a "risk on" investment phase and opened debt markets to a wider range of issuers. By our measure, first-quarter capital markets revenues for 16 leading global banks were 5% down on the same period a year earlier, but this was less notable in our view than the significant rebound from the industry's weak performance in the second half of 2011.

Looking in more detail at revenues in the first quarter of 2012, fixed income was a strong performer for many banks, particularly in rates, foreign exchange, and emerging markets. Transaction volumes recovered from the virtual lockdown of global debt markets in the second half of 2011, and bond spreads tightened. However, these positive developments were offset by smaller mark-to-market gains on banks' reduced inventory positions, and securitized products also suffered from lower client demand. As a result, overall fixed income revenues were little changed from the first quarter of 2011. Equities revenues for the 16 banks in our peer group were 18% lower as transaction volumes declined despite higher index values. Origination and advisory revenues were 16% lower due to fewer acquisitions and subdued equity issuance, only partly offset by relatively strong debt underwriting activity.

European Banks Lag Behind Their U.S. Counterparts

In our view, a notable feature of global investment banks' recent results is the stronger performance of U.S. players relative to their European counterparts. For example, on average, the U.S. banks in our peer group experienced a 2% decline in our measure of capital markets revenues between the first quarters of 2011 and 2012, but the fall was 8% for the European banks.

We believe that the relative underperformance of European banks was primarily due to stronger demands from markets and regulators for them to deleverage and restructure to address concerns regarding capital, funding, and returns.

In terms of capital, European banks generally lag other regions at present according to our risk-adjusted capital ratios and the Basel III metrics, and they are under pressure from regulators and some investors to close the gap as quickly as realistically possible. It is easier for banks to cut trading portfolios than customer lending because trading assets are less politically sensitive and also tend to be shorter term and more liquid. Preparation for the introduction of Basel 2.5 at year-end 2011 added to the impetus on EU banks to manage down trading RWAs, but this was not the case in the U.S. because of its delayed implementation. With regard to funding, the reduced availability of U.S. dollars to some European banks required certain asset portfolios to be scaled back.

We see the stronger performance of the U.S. economy as a secondary factor for the more resilient revenues of U.S. banks given that they and their main European competitors are truly global players.

We Expect A Decline In Second-Quarter Revenues

Following the generally upbeat first quarter, market prices and transaction volumes weakened in the second quarter of 2012 as renewed concerns over the eurozone and global economic growth weighed on investor sentiment and prompted renewed risk aversion. Consequently, we expect capital markets revenues in the second quarter to decline relative to the first quarter, but not reach the lows of the second half of 2011. We also expect revenues in the second quarter to be lower than the outcome for the second quarter of 2011.

In fixed income, spread widening and lower global trading volumes (see chart 3) are set to push second-quarter revenues down from the seasonal peak in the first quarter. This view is supported by the results reported by U.S. institutional broker Jefferies Group Inc. (BBB/Negative/--), which, to some extent, provides an indication of the likely performance of the wider industry since its quarterly reporting periods end a month earlier than those of its larger competitors. In its second quarter, which ended on May 31, 2012, Jefferies announced a 14% fall in fixed income revenues from its first quarter, indicating the weaker market conditions. We expect that subdued market activity in the month of June could drive a slightly larger decline at the global investment banks, for which June 30 marked the end of the second quarter.

Chart 3

There was a reasonably similar picture in the global equities markets in the second quarter, although the first-quarter comparative was less strong in equities than in fixed income. We expect that falls in equity indices, continued lackluster trading volumes (see chart 4), and funds outflows will likely contribute to a relatively poor second quarter for equities revenues at the global investment banks. For example, we note that Jefferies reported a 12% fall in equities revenues in its second quarter relative to the previous quarter.

Chart 4

Global bond and equity underwriting was notably weak in the second quarter as economic uncertainties fueled widespread caution on the part of both issuers and investors (see chart 5). Global debt capital markets deal values were almost 40% down on the first quarter, and the large Facebook IPO in May could not prevent a further fall in equity capital markets volumes from the relatively weak first-quarter outturn. Various transactions were reportedly postponed or cancelled due to the unfavorable conditions.

Chart 5

Announced M&A activity was relatively low in the second quarter (see chart 6), particularly outside the U.S., and reported deal pipelines are also weak. The global corporate sector's large cash balance creates potential for strong M&A volumes once confidence improves, but this does not appear likely in the near term.

Chart 6

We Assume Up To A 10% Drop In Capital Markets Revenues Under Our Base Case For 2012

The factors that have weighed on capital markets revenues in the second quarter of 2012 are likely to remain significant obstacles in the second half of the year, in our view. A swift resolution of concerns over the eurozone appears unlikely to us, and we expect global economic growth will remain materially below the long-term trend. Consequently, although we do not believe that capital markets revenues will be as weak as they were in the second half of 2011, we assume that the outcome for the second half of this year will be only marginally better. We understand that banks are already implementing targeted headcount reductions as they revise their financial projections for each of their businesses and trim costs accordingly. We expect that cost cutting could become somewhat more widespread, mirroring the experience of last year, if our relative pessimism over revenues in the second half is justified.

Our expectations for 2012 global capital markets revenues were particularly downbeat in December 2011, when we assumed a 20% decline. Since then, the first quarter turned out to be stronger than we had imagined, due in no small part to the short-term boost to global sentiment and liquidity provided by the LTROs. The second quarter is set to be softer and we expect a further weakening of revenues in the second half. Our base-case assumption is now a 0%-10% decline in capital markets revenues in the 2012 full year relative to the 2011 outturn. This change does not affect our current ratings. Our new base-case assumption may prove to be overly cautious if economic concerns are addressed more decisively than we currently expect. On the other hand, it could underestimate the decline in revenues that would likely result from a material adverse event such as a country leaving the eurozone.

The long-term trend in the investment banking industry's return on equity illustrates to us its unsustainably high earnings in the lead-up to 2007 and the subsequent pressures on its performance (see chart 7). With regard to the outlook for 2013 and beyond, an easing of the current macroeconomic pressures would support investment banks' performances by increasing market activity, but we see potential for global GDP growth to remain below its long-term trend for some time. Therefore, an important factor in our view is the effectiveness of the management actions currently being implemented to adapt banks' business and funding models to the current regulatory and funding environment. We believe that this represents a structural shift to a less risky and less profitable industry than was historically the case, certainly prior to 2007. We consider that there is scope for its performance to improve in the medium term, but we do not foresee it earning materially more than its cost of capital.

Chart 7

Capturing Capital Markets Activities In Our Bank Ratings

For banks with material capital markets businesses, we take into account the risks and returns inherent in these activities in all four of the bank-specific factors in our rating methodology, which was implemented in late 2011 (see “Banks: Rating Methodology And Assumptions,” published on Nov. 9, 2011):

  • Our assessment of each bank's business position takes into account a range of quantitative and qualitative matters including revenue stability and risk appetite.
  • Our assessment of capital and earnings primarily reflects our base-case expectation for the change in the risk-adjusted capital ratio over the next 12 to 24 months. These expectations incorporate our assumption for capital markets revenues as well as any planned balance sheet deleveraging that we believe each bank will achieve.
  • Our assessment of risk position includes our view of certain factors, such as future growth and changes in exposures, risk concentrations and diversification, complexity, and loss experience. We assess risk position as "moderate", at best, if a bank has material investment banking activities that are likely to contribute more than 50% of total revenues over the long term, according to our expectations. Although there is no such automatic cap when the revenue share of investment banking is less than 50%, our view of each institution's risk profile and risk management could still result in an outcome of "moderate" or lower (see table 1). For banks active in capital markets that have proven risk management capabilities and clear risk diversification across other business lines, there is potential for a risk position assessment of "adequate" or possibly higher.
  • Our assessment of funding and liquidity considers, among other factors, the relative reliance on short-term wholesale funding sources and the adequacy of liquidity resources in the event of a market shutdown.

Table 1

Rating Components For Selected Banks With Capital Markets Businesses
Country Institution Operating company long-term rating/outlook Anchor Business position Capital and earnings Risk position Funding and liquidity SACP Type of support No. of notches of support
Australia Macquarie Group Ltd.* A/Stable a- Adequate (0) Adequate (0) Moderate (-1) Average/Adequate (0) bbb+ Sys.Imp. 2
Canada Royal Bank of Canada AA-/Stable a Strong (+1) Moderate (-1) Strong (+1) Average/Adequate (0) a+ Sys.Imp. 1
France BNP Paribas AA-/Negative a- Very Strong (+2) Moderate (-1) Strong (+1) Average/Adequate (0) a+ Sys.Imp. 1
France Societe Generale A/Stable a- Strong (+1) Moderate (-1) Adequate (0) Average/Adequate (0) a- Sys.Imp. 1
Germany Deutsche Bank AG A+/Negative a- Strong (+1) Adequate (0) Moderate (-1) Average/Adequate (0) a- Sys.Imp. 2
Japan Nomura Holdings Inc.* A-/Stable a- Moderate (-1) Adequate (0) Moderate (-1) Average/Adequate (0) bbb Sys.Imp. 2
Spain Banco Santander S.A.$ A-/Negative bbb- Very Strong (+2) Moderate (-1) Very Strong (+2) Above Average/Adequate (0) a- None 0
Switzerland Credit Suisse AG A+/Negative a- Strong (+1) Adequate (0) Moderate (-1) Average/Adequate (0) a- Sys.Imp. 2
Switzerland UBS AG A/Negative a- Adequate (0) Adequate (0) Moderate (-1) Average/Adequate (0) bbb+ Sys.Imp. 2
United Kingdom Barclays Bank PLC A+/Stable bbb+ Strong (+1) Adequate (0) Adequate (0) Average/Adequate (0) a- Sys.Imp. 2
United Kingdom HSBC Holdings PLC* AA-/Stable bbb+ Very Strong (+2) Adequate (0) Strong (+1) Above Average /Adequate (0) a+ Sys.Imp. 1
United Kingdom Royal Bank of Scotland PLC (The)$ A/Stable bbb+ Adequate (0) Adequate (0) Moderate (-1) Average/Adequate (0) bbb Sys.Imp. 2
United States Bank of America Corp.* A/Negative bbb+ Strong (+1) Adequate (0) Moderate (-1) Average/Adequate (0) bbb+ Sys.Imp. 2
United States Citigroup Inc.*$ A/Negative bbb Strong (+1) Adequate (0) Moderate (-1) Average/Adequate (0) bbb Sys.Imp. 2
United States Goldman Sachs Group Inc. (The) A/Negative bbb+ Strong (+1) Adequate (0) Moderate (-1) Average/Adequate (0) bbb+ Sys.Imp. 2
United States JPMorgan Chase & Co.* A+/Negative bbb+ Very Strong (+2) Adequate (0) Adequate (0) Average/Adequate (0) a Sys.Imp. 1
United States Morgan Stanley* A/Negative bbb+ Strong (+1) Adequate (0) Moderate (-1) Average/Adequate (0) bbb+ Sys.Imp. 2
*Holding company. The rating shown reflects that of the main operating company. $Bank's ICR includes an additional notch adjustment (see paragraph 22 of "Banks: Rating Methodology And Assumptions", published on Nov. 9, 2011). ICR--Issuer credit rating. SACP--Stand-alone credit profile. Sys. Imp.--Systemic importance, meaning that the ICR incorporates a positive assessment of the likelihood that a bank would receive "future extraordinary support" in a crisis from a sovereign government.

Our current ratings anticipate further actions by banks to address the structural challenges arising in their capital markets businesses. Accordingly, we expect additional moderation over the coming years of the industry's past excesses in terms of leverage, risk appetite, and funding mismatches. However, we consider that investment banking remains a cyclical, complex, confidence sensitive, and somewhat opaque business that is inherently prone to sizable loss events (see “Industry Risk For Investment Banking Is Generally Higher Than For Other Financial Institutions,” published on Jan. 6, 2011). In our view, the unauthorized trading incident announced by UBS in September 2011 and the hedging loss disclosed by JPMorgan Chase in May 2012 are recent illustrations of the risk management challenges inherent in wholesale markets. Consequently, we do not anticipate much upward rating action as investment banks continue their transition toward more sustainable business models. Indeed, the negative outlooks on several of our ratings on banks with material capital markets activities signify that the difficult macroeconomic outlook and the unresolved issues in the eurozone could potentially trigger further rating downgrades.

Related Criteria And Research

Primary Credit Analyst:Richard Barnes, London (44) 20-7176-7227;
Secondary Contacts:Kenneth J Frey Jr, CFA, New York (1) 212-438-4415;
Stuart Plesser, New York (1) 212-438-6870;
Additional Contact:Financial Institutions Ratings Europe;

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