Banks' capital market revenue was an ace in the hole in 2020 for those global banks that held steadfast to this business. While other revenue streams faltered, capital markets revenue was a bright spot, rising 28% according to research provider Coalition, with some of the larger players posting even higher gains (see "Capital Markets Revenue Should Be A Bright Spot For Banks In A Tough 2020," June 23, 2020). Massive fiscal and central bank support from around the world provided capital markets both the confidence and liquidity to achieve last year's results. The big driver was a resurgence in fixed income, currency, and commodities (FICC) trading revenue, which rose 41%, driven by elevated market volatility and strong demand as clients repositioned their portfolios amid changing market conditions. Meanwhile debt and equity underwriting, along with equity trading, performed well as companies looked to shore up their balance sheets, fearing the worst as the pandemic took hold.

One weakness was advisory in the first half of the year. Many market participants put acquisitions on hold as confidence and aggression took a backseat to safety, but the merger and acquisition pipeline increased significantly toward year-end. Another weakness was structured equity derivatives. Banks that specialize in that area, particularly French banks, incurred material losses when a wide range of companies cut dividends in the first half of 2020 in response to the pandemic. S&P Global Ratings projects capital markets revenue to decline by 5% to 10% this year from 2020's elevated levels. This would still amount to a robust year for capital markets because it translates into revenue of 6% to 12% above 2019 levels.

Although revenue will likely remain robust this year, risk has risen so far in 2021 for some of the large capital market players. Toward the end of the first quarter, a prime broker client, a family office, (Archegos Capital Management) came under pressure after some of its concentrated long positions declined precipitously. This caused the banks financing those positions through their prime brokerages to require additional margin. When the client could no longer make margin calls, some of the banks closed out their positions, liquidating collateral and hedges, further pressuring the price ofthe stocks involved.

Although it's unclear whether all of the banks' collateral and hedges have been liquidated at this juncture, according to press and company announcements, two of the banks that helped facilitate these trades--Credit Suisse Group AG (BBB+/Negative/--) and Nomura Holdings (BBB+/Stable/A-2)--are facing significant losses on the sale of their collateral. The other banks involved in facilitating these trades seem to have had less material financial impact. More will likely be known when these banks report their first-quarter results, which start for U.S. banks April 15. In our preliminary opinion, the differences of the losses experienced across the breadth of broker-dealers financing the trades seems to stem from the amount of margin they each required, and the speed and finesse in which they exited their positions. The event, though, underscores our cautious attitude toward capital-markets-intensive banks, particularly those with profitability challenges, as the speed and magnitude of losses that could develop within capital markets businesses can be on a different scale than traditional lending businesses.

The events also underscore one of the risks we pointed to in our latest Global Credit Conditions report (see "Global Credit Conditions Q2 2021: The Risks Of An Uneven Recovery," published on March 31, 2021). Specifically, although the rise in long-term U.S. bond yields is an indicator of improving recovery prospects and is likely to be accompanied by controlled reflation rather than a dramatic reversal of a 40-year process of disinflation, the greater risks lie in the potential for market volatility and repricing given elevated asset prices, high debt levels, a desynchronized recovery and, ultimately, the withdrawal of extraordinary stimulus.

We have since revised our outlook on Credit Suisse to negative to reflect our view that potential material losses may stem from deficiencies in the group's risk management system or risk appetite that are not reflected in the current ratings (see "Credit Suisse Outlook Revised To Negative On Concerns About The Group's Risk Management," March 30, 2021, and "Outsized Hedge Fund Exposure Pushes Credit Suisse To A First-Quarter Loss," April 6, 2021). The loss has not immediately affected our rating or stable outlook on Nomura, whose stand-alone credit profile (SACP) and operating company rating is lower than our rating on Credit Suisse. We believe it has enough earnings and capital to absorb the loss at the current rating level (BBB+/Stable/A-2)--which incorporates an expectation of some earnings volatility--but we are continuing to monitor the situation (see "Nomura Can Absorb $2 Billion Shock," March 29, 2021).

Outside of this recent event, we maintained stable outlooks throughout the pandemic for most of the capital-markets-intensive banks, partially due to their capital markets businesses buttressing results. Two exceptions were Barclays and Deutsche Bank, on which we had revised the outlook at the onset of the pandemic (along with many European peers), reflecting economic and market stress. But we recently revised both outlooks upward--Barclays to stable and Deutsche Bank to positive--based on these banks' resilience during the pandemic, largely supported by their strong capital markets results (see "Deutsche Bank Outlook Revised To Positive On Improving Resilience; Ratings Affirmed And "May-Pay" Notes Upgraded," Feb. 26, 2021, and "Barclays Outlook Revised To Stable On Relative Resilience To Pandemic-Related Stress; Ratings Affirmed," Feb. 26, 2021. )

Drivers Of Capital Market Revenue In 2021

We expect that the main factors influencing capital markets revenue this year will be different than last year. Specifically, we expect advisory to pick up as financial sponsors remain active and companies move forward with acquisition plans, which they put on hold last year. Also a surge in investor interest in special purpose acquisition companies (SPACs) should bolster the acquisition market (see "SPACs And Credit Quality: S&P Global Ratings' Recent Ratings Experience," published on March 12, 2021). We expect the interest in SPACs, which expanded significantly in the fourth quarter in the U.S., to gain further interest in Europe, the Middle East, and Africa, and Asia-Pacific through this year. Most of the new SPACs that launched in 2020 will have 18 to 24 months to target a company to merge with, negotiate a deal, and close the purchase. One issue with SPACs, like with many financial innovations, is that things could go too far too fast and regulators could step in to ensure disclosures properly reflect the risks of these vehicles, which ultimately could affect volume. According to press reports, the SEC is looking into how underwriters are managing the risks to investors from SPACs, along with the due diligence and payout of the sponsors involved.

Separately, equity underwriting should also post another solid year as market levels remain high, which should help the IPO market. Meanwhile, equity trading should remain robust while market values remain high and volatility is still elevated, which provide a good backdrop for trading profits. However, we expect debt underwriting and FICC trading to be less buoyant than last year because of tough comparisons and the likelihood that debt needs were pulled forward in 2020. That said, leveraged finance markets look poised for a solid year as credit spreads have narrowed. The search for yield, along with concerns of rising rates, should help this market.

Notably, company comments from recent conferences seem to corroborate with our projections. Specifically, in the first quarter, bank management teams project investment banking fees will be up in the double digits, led by advisory and equity underwriting, while they expect trading revenues to decline to the mid-single digits. The pandemic-induced tough comparisons didn't begin until March 2020, so first-quarter results are a relative pass for banks in terms of year-over-year comparisons.

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The Year That Was

Bank profitability across the globe was strained in 2020, largely due to lower spread income and significantly higher provisions. For example, median U.S. bank profits were down roughly 35%. But banks with significant capital markets business performed much better than peers. Cumulatively, the eight largest capital-markets-focused banks' net income declined by only 16%. And two of these banks--Morgan Stanley and Goldman Sachs--actually increased profits last year, fueled by strong capital markets activity.

Table 1

Within capital markets, there were winners and losers in terms of capital market share gains. (We calculate market share by dividing each bank's capital markets revenue by the sum of the capital markets revenues of rated banks that are significant players in this area. While we believe this captures most of the market, it excludes some players in this space.) JPMorgan still leads in terms of market share (roughly 22% of the pool). Goldman Sachs had the largest year-over-year increase, with its market share rising to 17.1% from 15.6% in 2019. According to our calculations, three banks ceded some market share: Citi, Bank of America, and Credit Suisse. Still, these banks posted year-over-year capital markets revenue growth, just not as large as the other banks in the group.

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With the strong capital markets results last year and revenue from many other business lines waning, banks' capital markets business accounted for a much larger portion of overall revenue. In 2020, at the median, capital markets revenue for the largest banks comprised 41% of revenue versus 36% the previous year. We expect this to decline as capital markets revenue normalizes in the years to come.

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Elevated capital markets business didn't weigh on banks' capital ratios as much as we had expected. Capital ratios rose for these banks on a year-over-year basis, helped in part by limited share repurchases and dividends, and some easing of capital regulation. This year, we expect capital ratios to decline as shareholder distribution restrictions ease.

The Federal Reserve also announced that its temporary change to the supplementary leverage ratio (SLR), which allowed for the exclusion of Treasuries and cash parked at the central bank when calculating the ratios for U.S. banks, expired on March 31. This could result in some of the larger U.S. banks being more cautious regarding deposit intake and lending growth as the minimum required ratio is 5.0%. It could also result in some banks keeping a lower level of trading inventory, which could result in wider bid/ask prices and less liquidity for certain securities.

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Risk For Banks' Capital Markets Businesses Also Rose In 2020

We believe capital markets businesses are more opaque than traditional lending businesses and the risks more difficult to quantify. The trading losses some banks recorded in their prime brokerage business in the first quarter of 2021 is one example of the multitude of risks that can arise. Unlike the lending business, risks in the capital markets business can be unexpected and create large losses quickly. That said, we recognize that changes in the accounting of building reserves for loan books also increases the speed in which losses can arise for bank loans.

Despite higher revenue from capital markets businesses, risks also rose last year as volatility spiked, particularly in the first half of the year. Nevertheless, expansive support measures from central banks globally coupled with effective risk management resulted in most trading banks recording fewer days of trading inventory-related losses in 2020 compared to 2019, and reported substantial profits.

(Below we show a key metric we use to assess trading risk. In the appendix we run through various other metrics we look at to assess trading risk.)

Market risk-weighted assets as a percent of trading assets

One way to assess whether banks are holding riskier trading assets is to divide the amount of market risk posted in the quarter by the amount of trading assets at the end of the quarter. An increase in this ratio could indicate a riskier trading book. This appears to be the case last year as market risk rose more than the increase in trading assets. The reason for this is probably twofold: higher market volatility and the composition of the trading assets becoming riskier.

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Capital Markets Business Should Continue To Bolster Banks' Bottom Lines This Year

For the most part, we look for banks earnings to rebound in 2021 from suppressed 2020 levels. This will likely be driven by significantly lower provision charges, but a rebound in revenues for some could also play a part. Most capital-markets-intensive banks should also perform well this year, given our still relatively positive view of the revenue prospects for this business line and assuming they will manage their risks proficiently. The outlooks for these banks remain stable, with the exception of Credit Suisse, which is negative. In addition, Deutsche Bank has a positive outlook, but it's from a rating level that is lower than the other banks.

Going forward, we will continue to assess the role and riskiness of capital markets within a bank's business profile. Although we have typically viewed this business as riskier than traditional lending, we also see it is as a revenue diversifier, which certainly was validated during the pandemic. In addition, business done within capital markets is less risky than it used to be before 2008.

That said, it is also our view that without massive fiscal and central bank support last year, capital markets results would have looked a lot different. Every crisis is unique--particularly the pandemic--and there is no certainty such massive support will be forthcoming if a more conventional type of crisis were to evolve. Even without a crisis, capital markets risks can arise, sometime out of the blue.

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Appendix

Value at risk (VaR)

VaR measures the potential loss in value of trading assets due to adverse market movements over a defined time horizon with a specified confidence level (typically 99%). Notably, average VaR rose in 2020 across all banks to varying degrees spurred on by high levels of volatility and larger trading inventory levels.

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The creditworthiness of derivative counterparties

Although a significant portion of banks' derivative contracts is cleared by central counterparties, banks still face counterparty risk on over-the-counter (OTC) derivatives. Margin requirements can reduce that risk, although some trading partners (certain sovereign and corporate clients) may be exempt from those. If a counterparty defaults on a derivative receivable, the bank may experience large losses from the credit exposure. In addition, it may simultaneously suffer losses on any positions it used the derivative to offset or hedge.

Despite collateral being posted on a daily basis, it may not be enough to cover losses should the price of the collateral drop precipitously. In terms of banks' prime brokerage business, most of the lending to its hedge fund clients are akin to a margin loan. However, derivative receivables could occur based on how a bank facilitates the trade of a hedge fund client. For example, if a bank executes a total return swap for its client, which has become more common of late, this could appear on the bank's balance sheet as a derivative receivable, depending on the pricing action of the derivative.

To assess this risk of nonpayment of derivatives, we looked at the amount of derivative receivables outstanding by each bank, along with the relative creditworthiness of the counterparties (investment grade versus speculative grade). Public disclosure for this data is only available for U.S. banks in our sample. A few things are noticeable:

• Derivative receivables increased for most banks last year, particularly for Goldman Sachs and JPMorgan.
• In addition, the amount of speculative-grade exposure also increased for these banks, which added to their risk exposure.

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Level 3 trading assets to 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. (Our definition of Level 3 assets, for the purposes of this study, is the sum of Level 3 trading assets and Level 3 derivatives because we are focusing in this commentary on risks within capital markets.)

All else being equal, a large proportion of Level 3 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 volatility. 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.

Positively, the amount of Level 3 trading assets and derivatives remains well below precrisis levels, when most banks' Level 3 trading assets to total assets adjusted capital exceeded 100%. For most banks today it is well below 30%. But Level 3 assets did edge higher for most banks year over year, likely the result of a higher amount of trading inventories and growth in derivatives.

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Related Research

• European Investment Banks Face A Continued Fight To Remain Competitive, Sept. 28, 2020
• Capital Markets Revenue Should Be A Bright Spot For Banks In A Tough 2020, June 23, 2020