Jun. 19 2019 — Global capital markets activity is off to a slow start in 2019--after relatively flat results in 2018--with revenue down 11% year over year in the first quarter. All components of capital markets revenue (fixed income, currencies, and commodities; equities; and investment banking) declined, largely due to lower client activity and low issuance volume compared with a robust first-quarter 2018. The U.S. government shutdown in the beginning of the year also didn't help matters.

Market conditions started to improve somewhat since the slow start to the year, but the escalation of trade disputes, coupled with tough year-over-year comparisons, point to a down second quarter. A continued flat and low interest rate environment will also likely pose a headwind to trading revenue. Notably, some of the large banks have already announced mid-single-digit declines in trading revenue for the first two months of the second quarter, with investment banking fees declining even further. Positively, comparisons become more favorable in the second half of 2019.

All in all, S&P Global Ratings looks for global banks' capital markets revenue to be down roughly 10% in 2019. Still, we expect most global banks' overall revenue to increase based on growth in other revenue streams, such as lending and other fee income.

In general, we view capital markets activity as riskier and more opaque than other bank business lines, such as retail and commercial banking and wealth management. As a result, all of our risk position assessments for banks with large capital markets operations (35% or higher of total revenue) are currently moderate (which weighs on our ratings). In addition, we are unlikely to assess the risk position of a bank with a sizable capital markets operation above adequate. Bank of America is an exception because, based on our measure, its market risk-weighted assets are a lower proportion of total risk-weighted assets than for most universal bank peers. This demonstrates the company's lower appetite for trading risk, in our view.

We have not taken any rating or outlook actions this year solely as a result of developments in capital markets business. Overall, we could lower the ratings on any institutions that take undue risk in the capital markets business or fail to adapt to the evolving landscape in capital markets and, as a result, find their profitability under undue pressure.

Banks Move To Diversify Their Revenues

As a result of regulatory changes driving up capital charges, along with the fickleness of capital markets revenue, most of the top global banks have made concerted efforts to diversify their revenue streams outside of capital markets business. As such, the percentage of capital markets revenue to total revenue has generally fallen for most of the banks, although the decline has not been substantial (see chart 2). Still, barring a strong rebound in capital market conditions, we expect capital markets revenue as a percentage of overall revenue to decrease further in the coming years as strategic initiatives in other business lines gain further traction.

In addition, some banks have accelerated their revenue diversification strategies. For example, Goldman Sachs, which has a strong market share in the capital markets, recently embarked on a more aggressive strategy to diversify its revenue stream to generate more stable revenues. The company's strategy includes expanding its retail client businesses, growing its fee businesses, expanding its wealth management business to a more mass affluent customer base, and developing a corporate treasury business. Over time, we believe this should result in a lower percentage of capital markets revenue and a steadier revenue stream.

Deutsche Bank's plan, of possible additional cost cutting in some of its underperforming capital markets businesses, could result in a lower reliance on capital markets revenue over time. But, its ability to improve performance from such a move remains uncertain.

Delving Into Some Of The Headwinds For Capital Markets Revenue

Seasonal factors and tough comparisons

The first quarter of the year is typically the strongest for capital markets revenue. And so, with revenue already down 11% in the quarter, even if momentum picks up the rest of the year, it will be challenging for revenue to turn positive for the year. Moreover, comparisons in the first half of the year are relatively tough. Capital markets revenue was up roughly mid-single digits during the same period in 2018. Comparisons should ease in the second half of 2019 as revenue was down in the mid-single digits during the same period in 2018 and in the high single digits in 2017.

A flat and low interest rate

In 2018, the Fed had been on a path to normalizing interest rates, raising rates four times last year and a total of nine times since 2015. The rate hikes resulted in a need for clients to reposition their portfolios and, thus, higher client engagement, which led to stronger client volumes in the U.S. market than in other regions. But early in 2019, the Fed signaled it would halt rate rises, opting to keep its target range for the fed funds rate at 2.25%-2.5%.

Our economists now expect the U.S. central bank to cut the federal funds rate 25 basis points, as opposed to their previous view of keeping rates flat. Although a rate cut could spur immediate volatility, sustained low and flat interest rate conditions--assuming there are no exogenous macro events--typically lead to lackluster client demand, dampen volatility over the long term, and narrow bid/ask spreads. The Fed also announced that by September, it will no longer reduce its bond portfolio, which it had been slowly unwinding, taking some of the excess liquidity out of the system.

This, combined with the European Central Bank (ECB) maintaining a prolonged negative interest rate policy, has quelled the need for investors to take action, particularly as it pertains to interest rates or currency products. Notably, G10 rates were the worst-performing component of fixed income, currencies, and commodities (FICC) in the first quarter, down 12% year over year.

Positively, low rates typically lead to higher asset valuations, which, in turn, spur IPOs, mergers and acquisitions (M&A), and underwriting. While we look for IPOs to increase, giving a boost to equity underwriting, debt underwriting will likely be pressured because a large portion of company debt needs have already been financed, and maturities are not coming due for a few years. Market confidence may also strain investment banking activity.

Investor confidence is strained

Trade wars.  The trade dispute with China and the U.S has reignited. In early May, the U.S. raised the tariff rate to 25% from 10% on $200 billion of goods imported from China. China retaliated, announcing four tiers of tariffs (ranging from 25% to 5%) on $60 billion of goods (see "Global Trade At A Crossroads: U.S. And China Exchange Tariff Blows," May 14, 2019). Although we believe the short-term impact of higher tariffs is manageable for both countries in terms of economic output, further retaliation may occur.

Our economists estimate that 25% tariffs, combined with reciprocal retaliation from China, if they hold for the year, will directly shave off only about 30 basis points from growth in the next 12 months but perhaps a bit more in secondary effects, such as tighter financial conditions and increased uncertainty reducing business appetite for investment. (See "Fed Likely To Cut Rates This Year As Trade Headwinds Blow Harder," June 12, 2019.) In addition, trade disputes may spread to other countries, as reflected by the statements by the U.S. of possible tariffs being placed on Mexico.

The uncertainty of the ramifications of trade disputes works to sap investor confidence and quell corporate spending. In addition, the industries directly caught in the crosshairs of the trade disputes (U.S. electrical machinery and equipment, base metals, plastics, transport, chemical products, and agriculture) will likely see a more pronounced pullback on capital expenditures. This would more substantially affect issuance, as well as M&A, and could even lead to credit issues for the banks exposed to these companies.

Brexit.  With Prime Minister Theresa May's resignation on June 7 as leader of the Conservative Party, the uncertainty of a no-deal Brexit, in which Britain leaves the EU without an agreement, has grown (see "United Kingdom Prime Minister May's Resignation Likely To Pave Way To A Harder Brexit Stance," May 24, 2019). Although a no–deal Brexit would have the most direct impact on the U.K. economy and banks (see "Countdown To Brexit: Rating Implications Of A No-Deal Brexit," Feb. 6, 2019), it is unlikely to be contained to the U.K. and, at the very least, would affect investor confidence globally. From a capital markets perspective, amid this uncertainty, client engagement is likely to be subdued, except for a short-lived pickup in trading as clients attempt to adjust their portfolios if a no-deal Brexit is the outcome. The next date that is looming is Oct. 31, the date when the U.K. is currently scheduled to leave the EU.

Leveraged lending.  Capital markets revenue over the last few years has benefited from a strong debt underwriting market, bolstered by record issuance of leveraged debt. The leveraged lending market took a hit in the fourth quarter as investors were spooked by the Fed's stance at the time to continue to raise interest rates, which could have resulted in a rise in defaults of heavily debt-laden companies.

The return to a low rate in the U.S. should rekindle demand for high-yield debt, but issuance remains low. Specifically, leveraged loans' lending volume is down roughly 50% through May, although the rise in high-yield bond issuance has provided some offset (the two combined are down 30% through May). A lot of the decline has to do with tough year-over-year comparisons, but the rise of macro uncertainties is also likely to take its toll on issuance. This will likely further pressure debt underwriting revenue.

In terms of risks from leveraged lending, we do not believe that banks have significant direct exposure, at less than 10% of loans (see "Six Key Risks In Leveraged Lending For Financial Institutions," Nov. 26, 2018). However, if credit issues from the leveraged lending market were to materialize, we believe they would also affect banks' speculative-grade holdings and could hit banks' investment-grade holdings as credit spreads would widen. And, the number of fallen angels (investment grade entities downgraded to speculative grade) would likely increase.

U.S. Banks Continue To Gain Market Share In The Capital Markets Business

Within the shrinking pool of capital markets revenue, U.S. banks continue to hold the top positions in terms of capital markets revenue market share (derived by taking each bank's share of the top nine banks). Notably, U.S. banks generate roughly 75% of the revenue of the top nine capital markets banks globally, versus around 60% in 2010 (see chart 6). This dominance helps the U.S. banks post decent profit margins in their capital markets businesses, even when capital markets activity is pressured, which currently seems to be the case.

Trading Risks Seem To Be In Check

The risks embedded in trading portfolios are difficult to determine, though there are a few metrics we use, which we detailed in "Ten Years After The Financial Crisis, Global Banks' High-Risk Trades Seem To Be In Check," Oct. 5, 2018. Here we update through 2018 three of the main metrics we monitor.

Level 3 trading assets/total adjusted capital

The fair values for Level 3 assets are model based, measured by the banks (because the valuation inputs used to derive fair values can't be observed in the market). Therefore, their valuation is sensitive to changes in management assumptions and to the way the models are calibrated. Private equity investments, loans and illiquid debt instruments, and certain types of derivatives often make up Level 3 assets.

All else being equal, a large proportion of Level 3 trading and derivative assets exposes banks to mispricing and to a future revision of the assumptions underpinning the valuation of these assets. Level 3 assets are also less liquid than other assets and could be susceptible to significant price declines, should credit issues arise, such as rising default levels. As such, a high ratio of Level 3 assets may suggest potential large tail risks, depending on the degree of conservatism in each bank's valuation model. (Our definition of Level 3 assets, for the purposes of this study, is the sum of Level 3 trading assets and Level 3 derivatives.)

Positively, the amount of Level 3 trading assets remains well below precrisis levels, when most banks' Level 3 trading assets to total assets adjusted capital exceeded 100%. They also remain well below 2015 levels for most banks (see chart 7). The higher amount of Level 3 trading assets to capital for some of the banks (Goldman, Credit Suisse, Morgan Stanley, and Deutsche Bank) is largely attributable to their heavier reliance on capital markets.

Several banks' Level 3 assets (Goldman, Citigroup, Deutsche Bank, and Barclays) rose on a year-over-year basis in 2018. We believe this largely reflects an increase in cash instruments, particularly equities. The increases were not outsize, and the amount of Level 3 assets is still below 2015 levels.

Stressed VaR/VaR

Banks calculate value at risk (VaR) on their trading books to estimate the level of loss they believe could occur in a given time period according to a given confidence interval based on recent market conditions and the current composition of their trading book. They calculate stressed VaR (SVaR) in the same manner but assume market conditions worsen substantially, often to 2008 levels.

Therefore, SVaR/VaR shows how significantly a bank's trading losses could rise if market conditions deteriorated sharply. It is an indicator of potential tail risk. A low ratio would indicate that, even if conditions worsened to 2008 levels, the bank's measure of its potential trading losses would not increase materially. The opposite would be true of a high ratio.

SVaR/VaR declined for most banks in 2018 (see chart 8). We believe this largely has to do with a pickup in VaR (the denominator in the metric), reflecting higher volatility in 2018. Positively, absolute values of SVaR seem to have held steady or declined for most of the banks. SVaR though did pick up for some (Goldman Sachs, Credit Suisse, Barclays, and Deutsche Bank), pointing to possibly more risk taking in their trading portfolios. For example, Deutsche Bank attributed the SVaR increase to a reduction in the diversification effect and a pickup in risk in credit spread and foreign exchange products.

We also track market risk as a percentage of trading assets (see chart 9). It has been declining for the largest global capital market banks since 2015, despite a rise in trading assets for some banks. This points to the likelihood that the trading assets added are of lower risk. Although, the decline in market risk could also be the result of lower market volatility and improvement in bank models that contribute to a reduction in market risk calculations--both of which are not attributable to a bank taking lower risk.

Despite Pressured Capital Markets Revenue, Investment Bank Ratings Should Remain Stable

Capital markets revenue is likely to remain under pressure in 2019. However, many global banks have been working to diversify their revenues outside of capital markets business. This should help offset any revenue pressure from their capital markets businesses. As such, we expect our ratings on most of the major investment banks to remain stable.

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