- Banks and nonbank financial institutions (NBFIs) in North America are generally performing well, with earnings up sharply on lower provisions for credit losses and balance sheets in good shape.
- The proportion of banks and NBFIs with negative outlooks has plummeted in the last year.
- However, the mix of risks has changed. While the pandemic still poses risks, financial institutions also face threats related to elevated home prices, a booming leveraged loan market, advancing fintech, and an impending change in monetary policy.
Financial institutions in North America have entered the fourth quarter benefiting from robust economic growth and continued monetary stimulus, as well as improved earnings, asset quality, and funding conditions relative to a year earlier. Banks' performance and balance sheets look solid, thanks in part to prudent regulation--a factor that may cause us to revise up our anchor, or starting point for the ratings, for U.S. banks next year. Meanwhile, nonbank financial institutions (NBFIs), aided by open funding markets, in general have found largely favorable operating conditions.
As a result, the proportion of our outlooks on U.S. bank and NBFI ratings that are negative has fallen to about 7% and 10%, respectively, from more than one-third each a year ago. In Canada, all of our bank ratings have stable outlooks.
That said, risks haven't completely dissipated, but the makeup of risks has shifted. While we expect stability for most financial institution ratings into 2022, we see risks relating to a frothy leveraged loan market, rapidly rising housing prices, a changing commercial real estate market, the pandemic, and disruptive advances in fintech, among other areas. NBFI subsectors face idiosyncratic risks, and all financial institutions will have to prepare for a likely change in monetary policy amid higher inflation.
With The Economy And Inflation Hot, The Fed Is Likely To Taper Soon
S&P Global Economics in September revised its forecasts of U.S. real GDP growth for 2021 and 2022 to 5.7% and 4.1%, respectively, from 6.7% and 3.7% in June. It did so after the economy cooled somewhat, likely due to supply disruptions and an increase in COVID-19 cases related to the delta variant. However, our economists still expect a strong economy, with our current 2021 GDP forecast, if correct, the highest reading since 1984.
Inflation has also been running hot, but our economists think average core CPI inflation will likely slow from 5.5% in 2021 to 2.7% and 2.5% in 2022 and 2023, respectively.
They also expect the Fed to begin tapering asset purchases late this year and to raise the federal funds rate in December 2022, followed by two rate hikes each in 2023 and 2024.
In Canada, the economic recovery remains on track, and risks to the outlook have become more balanced. We forecast real GDP growth of 5.4% this year and 3.8% in 2022. We expect inflation to remain higher than 2% until the second half of 2022 (when we anticipate policy rate liftoff), which will help the domestic systemically important banks' (DSIB) profitability.
Improved Economic And Industry Risk Trends In The U.S. Have Resulted In Favorable Outlook Revisions
We use our assessments of economic risk and industry risk, the two main factors in our Banking Industry Country Risk Assessment, to set the anchors for our bank ratings. In May, following several months of economic growth and improvement in asset quality, we changed the trend on economic risk for the U.S. to stable from negative.
We also revised the trend on industry risk to positive from stable to reflect our view that bank regulation has improved greatly since the global financial crisis of 2008-2009 and the balance sheets of U.S. banks look as strong as they have in many years. We believe the regulatory and supervisory enhancements implemented since the global financial crisis have benefited U.S. banks' financial performance leading up to and during the pandemic.
Because we have gained confidence in the strength and resilience of the U.S. banking system, we may revise the anchor for our ratings on banks in the U.S. to 'a-' from 'bbb+' in the next one to two years, which could result in higher ratings on some banks.
With the changes in the economic and industry risk trends, we revised our rating outlooks on Bank of America Corp., JPMorgan Chase & Co., Morgan Stanley, Truist Financial Corp., and PNC Financial Services Inc. to positive from stable in May. Those banks compare well with similarly or higher-rated peers, including banks domiciled in other countries with 'a-' anchors. (For more, see "Various Rating Actions Taken On Large U.S. Banks And Consumer-Focused Banks Based On Favorable Industry Trends.")
We also revised rating outlooks to stable from negative on 11 regional banks because of declining economic risks and more favorable oil and gas prices for some, and we revised our rating outlooks to positive from stable on three regional banks based on more favorable industry trends and these banks' stronger credit profiles. We indicated that a higher bank anchor most likely will not result in a change in our anchors of NBFIs because the improvement in bank regulation has less relevance for them. (For more, see "Various Rating Actions Taken On U.S. Regional Banks Based On Improving Economy And Favorable Industry Trends.")
U.S. Banks Will Likely Report Strong Earnings And Balance Sheet Metrics This Year
U.S. banks' earnings have rebounded in 2021, largely on a sharp drop in provisions for credit losses and a release of reserves. Federal Deposit Insurance Corp.-insured banks reported negative $25 billion of provisions in the first half of the year, down from positive $114 billion in the same period of 2020, which helped drive a return on equity for the industry of 13%.
We expect positive, but low, provisions in the second half of 2021--though early reports of third-quarter earnings have shown further negative provisions--before a normalization in 2022. Banks probably still have some room to reduce their ratios of reserves to loans, which were still well above pre-pandemic levels, but any drop should be more gradual going forward. With ultra-low interest rates still weighing on spread income, we expect the U.S. banking industry to report a return to equity in the high-single to low-double digits in 2022.
Positively, balance sheets look very strong. Capital ratios have risen for most banks, in part due to regulatory restrictions on shareholder payouts implemented early in the pandemic. Now that those have expired, we expect a moderate reduction in capital toward pre-pandemic levels for many banks. Funding and liquidity also look as strong as they have in many years. Deposits have risen roughly 30% since the start of the pandemic as a result of the Fed's quantitative easing, pushing the ratio of loans to deposits to its lowest in decades. However, deposit growth has slowed and should slow further when the Fed begins tapering.
Nonbanks Are Also Generally Performing Well, Though Risks Vary By Subsector
Nonbank financial institutions
Like banks, NBFIs have also generally performed well and found greater stability thanks to the expanding economy and favorable funding conditions. As a result, we have revised a number of outlooks on NBFI ratings to stable from negative.
For instance, in June, we revised our outlooks on all commercial real estate (CRE) finance companies and now have stable outlooks on all those companies. With the improvement in the economy, we think the likelihood of substantial further deterioration in the loan portfolios of CRE finance companies has lessened. Nevertheless, we still expect some challenges, particularly in areas like office properties and hotels in central business districts.
We also have stable outlooks on the nine business development companies we rate, many of which are among the strongest competitors in that industry. Their portfolio valuations have substantially recovered from the depths of the pandemic. Loans on nonaccrual status are starting to decline, although payment-in kind income remains elevated in some cases.
Rated consumer lenders also look relatively stable, since they too have benefited from the rebound in the economy as well as the government stimulus extended to their borrowers.
Earlier this year we upgraded most of the residential mortgage companies we rate following an incredibly strong year of originations and profitability. We expect favorable conditions for them to mostly continue, even though gain on sale margins are returning to historical levels and industry volumes are poised to decline as interest rates rise and refinancing slows. Although delinquencies remain low, we continue to monitor changes as mortgage forbearance and eviction moratoriums come to an end.
Aggregate payment volumes for money payment services companies are now exceeding their pre-COVID-19 levels, although cross-border payment volumes remain weak. Companies in the space are increasingly turning to credit, such as Buy Now Pay Later programs, to boost transactions.
For traditional and alternative asset managers, market appreciation--spurred by monetary stimulus--has led to higher assets under management and supported performance and stability. Overall, we expect rating actions to remain idiosyncratic and dependent on factors such as leverage management and mergers and acquisitions. We have already seen significant activity of asset managers merging with other managers, banks, and insurance companies.
The long-term headwinds traditional managers face--such as the shift to passive from active strategies and the associated fee pressure--are spurring some of that activity, and it's likely to continue. Alterative managers, which we see as better positioned than traditional managers due to larger amounts of locked-up capital, are also pairing with insurers, with the managers gaining access to perpetual capital and the insurers getting higher-yielding investments.
Retail and institutional securities firms too have benefited from favorable market conditions, and we expect those ratings to be largely stable. Trading volumes and volatility remain above pre-pandemic levels, and assets under management have risen, supporting revenues. However, higher volatility, which markets have been experiencing recently, can create risk, increasing the odds of market losses, the margin they must post to clearinghouses, and the capital needed to support their trading books.
We expect regulation to be an area of increased focus for securities firms. The Biden administration is likely to increase regulatory scrutiny and protections, in particular for retail investors. Also, over time, it may push regulatory reforms that could increase costs and limit some revenue sources.
The Mix Of Risks Has Changed
While pandemic-related asset quality risks have declined, other risks have built. For instance, the strength of the economic rebound and the accommodative monetary policy have resulted in a booming leveraged loan market and a sharp rise in asset prices, including in residential real estate.
Leveraged loan origination volumes have surpassed even the strong pre-pandemic levels this year, with borrowers on average taking on higher leverage. The large banks syndicate most of these loans, and most of the balances end up outside of the banking sector. We view the associated risks as manageable but not insignificant for banks. Banks still bear the risk associated with syndication, among other areas. The risks can be greater for certain NBFIs we rate that have large exposures to leveraged lending, including the BDCs.
In the housing market, residential real estate prices have risen in the mid- to high-teens over the last year. While that results in more equity on existing residential mortgages, it also creates a risk that recent buyers are overleveraged and could end up with limited equity in their homes if prices correct.
Positively, we don't believe lax underwriting is causing the rise in prices. A combination of other supply and demand factors is probably responsible. Those include low interest rates, people moving for pandemic-related reasons, household formation, and a limited amount of home construction over the last decade. Still, we will continue to watch such prices and the risks that could result.
We also see risk in parts of CRE, particularly the office market and certain types of hotels. It remains unclear to what extent corporate tenants will reduce their usage of office space. As leases expire in the next few years, there could be further pressure on the value of office buildings and the creditworthiness of building owners. We don't view that as an outsize risk for most banks, but believe it could cause asset quality challenges for some. NBFIs that focus on CRE may be more affected.
A tightening of monetary policy, if done smoothly, could benefit banks by boosting their spread income and lifting net interest margins from very low levels. That said, in a more pessimistic scenario, it could also cause volatility in markets, higher charge-offs, and potentially a slowdown in the economy.
Other risks we continue to watch relate to the LIBOR transition, fintech, and regulation. While most U.S. dollar LIBORs will remain in effect until June 2023, regulators have instructed banks to mostly cease using LIBOR on new originations starting in 2022. With less than three months until 2022, it is unclear what rate banks will coalesce around on each product that currently uses LIBOR materially.
The term of the Fed's vice chair for supervision recently ended. His successor--dependent on who the Biden administration nominates and Congress confirms--will have significant sway over application of regulation and supervision. While we don't expect that to result in any major changes in regulation, it could bring a more conservative approach to supervision.
Lastly, advances in technology continue to present threats and opportunities. Banks, striving to make their own advances, are coping with competition from fintechs and sometimes partnering with them. They also face a long-term threat from cyber attacks.
In Canada, Bank Profitability Has Strengthened But High Home Prices And Low Rates Are Risks
Approaching fiscal year-end 2021, Canadian DSIBs are showing much stronger operating performance than in 2020 on a better economy and declines in provisions for loan losses, and their capital ratios have risen meaningfully. Still, DSIBs are not completely out of the woods as elevated consumer indebtedness and high home prices pose risks should the rebound in domestic economic activity slow or unemployment remain high, or if house prices unexpectedly correct significantly.
Similar to 2021, we expect the main profitability drivers in 2022 to be DSIBs' retail and commercial banking businesses, supported by strong growth in mortgage loans and a pickup in credit card spending and business loan growth. Wealth management and capital markets businesses may continue to be strong contributors if markets remain robust.
However, there are a number of key global factors to contend with, including geopolitical issues, the pandemic, and supply chain disruptions. Also, DSIBs are likely to continue to cope with net interest margin compression from low rates for at least half of 2022. Focus on costs will remain paramount, though the need to spend on fintech will require some expense growth.
We see net charge-offs rising in 2022 but remaining manageable. Loan growth and an end to some government support measures could cause that increase. We remain vigilant around certain segments of CRE but note that DSIBs' exposure to CRE and construction loans is only 9%, on average, of loans.
We view elevated consumer indebtedness and high home prices as risks to DSIBs, even though about one-third of their mortgages are backed by insurance, and the average loan-to-value ratios on the uninsured portions are low. Higher consumer savings rates have also lessened risk.
The DSIBs' risk-adjusted capital (RAC) ratios, based on our measure, could fall but should remain in the range we consider adequate. Those ratios have risen on stronger profitability and regulatory restrictions on payouts. When the regulator lifts those restrictions, RAC and regulatory ratios should tick down.
This report does not constitute a rating action.
|Primary Credit Analyst:||Brendan Browne, CFA, New York + 1 (212) 438 7399;|
|Secondary Contacts:||Devi Aurora, New York + 1 (212) 438 3055;|
|Sebnem Caglayan, CFA, New York + 1 (212) 438 4054;|
|Elizabeth A Campbell, New York + 1 (212) 438 2415;|
|Matthew T Carroll, CFA, New York + 1 (212) 438 3112;|
|Thierry Grunspan, Columbia + 1 (212) 438 1441;|
|Robert B Hoban, New York + 1 (212) 438 7385;|
|Stephen F Lynch, CFA, New York + 1 (212) 438 1494;|
|Stuart Plesser, New York + 1 (212) 438 6870;|
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