Investment banking will play a reduced role in the earnings of big banks in coming years as retail and commercial returns improve, says Standard & Poor’s. The banks currently best positioned for balanced earnings are BNP Paribas, JPMorgan Chase, UBS, HSBC and Credit Suisse, S&P’s data shows.
We may be looking at the beginning of the end of investment banking’s preeminence in the world’s biggest global banks.
Excerpts from For Universal Banks, The Recent Dominance Of Investment Banking Is Giving Way To More Balanced Earnings
Investment banking has dominated the earnings of the world’s large universal banks since 2009, but the other main business divisions–retail and commercial banking and asset and wealth management–are regaining traction and catching up. Over the next several years, the earnings of these three major divisions are likely to strike a better balance, more because of their cyclical nature than any drastic change in the risks these universal banks might undertake.
Of course, the investment banking divisions of these same groups suffered large write-downs of securities in 2007 and even greater losses in 2008, when the industry hit bottom with the default of Lehman Brothers. The crisis of that period highlighted the risks and cyclical nature of underwriting, sales, and trading of securities, which we view as less stable than retail and commercial banking or asset and wealth management. Retail and commercial business divisions–particularly in U.S. and U.K. banks–also suffered during the financial crisis and recession. But unlike the concentrated mark-to-market losses from securities write-downs, which hit banks relatively quickly and contributed to the economic shock of 2008, the losses from delinquent loans and bankrupt borrowers in retail and commercial lending lines are occurring over a longer period.
We believe that returns on retail and commercial banking will improve as the rate of loan losses normalizes, but this will be a slow process and other factors may limit the improvement.
While investment banking is on the defensive, it remains a vital source of earnings. Global banks need to service their client base with an investment banking arm. Indeed, some institutions that abandoned or cut back certain investment banking lines during the crisis are now returning to the segment. Nonetheless, the opportunistic profits from the wide bid-ask spreads of the transition period of 2009-2010 appear to be gone. We may be looking at the beginning of the end of investment banking’s preeminence in the world’s biggest global banks.
Entrepreneurship has recovered more quickly from the economic crisis in France and Australia than in the US and the UK, according to the OECD.
From Entrepreneurship at a Glance 2011
The impact of the crisis was particularly long-lasting in Denmark and Spain, where the number of new firms being created during 2010 was still well below the high point before the crisis, but also in Finland, Germany, the Netherlands and the United States.
At the other end of the scale, entrepreneurship in some countries, like Australia and France, and to a lesser extent the United Kingdom, has bounced back from the crisis, with the number of firms being created actually higher in 2010 than it was at the pre-crisis peak.
Venture capitalists in Israel allocate more financing to young companies than any other country in the OECD, with the equivalent of 0.18% of GDP dedicated to seed, start-up and early development capital. The United States, Sweden and Finland are among the other leading providers of venture capital, and are not surprisingly also among the most entrepreneurial nations.
Fitch Ratings believes that Solvency II, the new regulatory regime for European insurers from 1 January 2013, is set to transform how insurers allocate their investments.
European insurers are the largest investors in Europe’s financial markets, holding EUR6.7trn of assets, including more than EUR3trn of government and corporate debt. Any reallocation of insurers’ asset portfolios could therefore lead to fundamental shifts in demand and pricing for several asset classes. The new rules will force insurers to value assets and liabilities at market value when determining their solvency position, and to hold explicit capital to reflect shortterm volatility in the market value of assets.
Fitch expects a shift from long-term to shorter-term debt; an increase in the attractiveness of higher-rated corporate debt and government bonds, and shift away from equity; and a preference for assets based on the long-term swap rate.
From Solvency II Set to Reshape Asset Allocation and Capital Markets
Standard & Poor’s has already disputed Meredith Whitney’s alarming outlook for municipal debt. Now a new working paper from Harvard Business school adds to the argument that fears of a muni meltdown are overblown.
While acknowledging that states do face challenges, S&P last month said it does not expect a crisis similar to the European sovereign debt situations. S&P said “The state sector has weathered a broad range of bond market challenges and in our view has retained its relatively strong credit profile.”
Now Daniel Bergstresser of HBS and Randolph Cohen of MIT conclude that “In sum, fears of widespread municipal default are overblown. Although spreads have tightened somewhat since December, doomsday scenarios have already been incorporated into market prices. While there is a good chance that negative investor sentiment will lead to further spread widening, the probability of the kind of widespread default that would be required to justify current municipal bond yields is low.”
Selected excerpts from Why fears about municipal credit are overblown (complimentary download)
Highly publicized predictions of 50-100 municipal defaults have caused anxiety among municipal bond investors. These recent predictions must be placed into appropriate context, looking both forward and to history:
- In 2009 municipal issuers defaulted on 178 individual bond issues. The aggregate face value of the defaulted issues was $3.5 Billion. In 2010 issuers defaulted on seventy-five municipal bond issues, with an aggregate face value of $1.7 Billion.
- The municipal credit market is a $2.5 Trillion market. Thus the prediction of hundreds of municipal defaults has already been realized. Losses have amounted to a tiny fraction of market value.
- As of December 31, 2010 the MCDX 5-year index spread was 218 basis points. With seventy percent recovery for investors in default, this spread is consistent with 3.63 defaults per year out of the index’s fifty names, or a seven percent annual default rate.
- Market spreads as of December 31 were already consistent with approximately thirty percent of municipal issuers going into default over the next five years. In that sense, the worst of the doomsday scenarios had already been incorporated into market yields.
- This doomsday scenario is very unlikely. States, counties, and cities face long-term budget stress, related in large part to employee retirement benefits. These problems, though large, are long- term problems and are unlikely to create across-the-board short-term liquidity crises that could lead to widespread municipal default.
Moody’s on Friday placed Italy’s Aa2 local and foreign currency government bond ratings on review for possible downgrade, while affirming its short-term ratings at Prime-1.
Moody’s review of Italy’s sovereign rating will focus on the growth prospects for the Italian economy in coming years, and particularly the prospects for a removal of important structural bottlenecks that could hinder a stronger economic recovery in the medium term.
The review will also examine the government’s ability to achieve ambitious fiscal consolidation targets and to implement further plans to generate substantial primary surpluses in the medium term. This will include an analysis of the vulnerability of the Italian government debt trajectory to a rise in risk premia, as well as the options for the government to react. The government’s new fiscal plan, which is expected to be announced shortly, will be considered during the review.
The main drivers that prompted the rating review are:
- Economic growth challenges due to macroeconomic structural weaknesses and a likely rise in interest rates over time;
- Implementation risks surrounding the fiscal consolidation plans that are required to reduce Italy’s stock of debt and keep it at affordable levels; and
- Risks posed by changing funding conditions for European sovereigns with high levels of debt.
Key Drivers of Moody’s Decision to Place Italy’s Aa2 Rating on Review for Possible Downgrade is available at the Alacra Store, along with a complimentary summary.
The wind, solar, biomass, and geothermal energy sector has grown in fits and starts during the last 30 years — but now may finally have the momentum to become a self-sustaining industry.
Guest Post excerpted from Renewable Energy at a Crossroads
by Christopher Dann, Sartaz Ahmed, and Owen Ward of Booz and Company
Renewables have been a hotbed of activity in the past decade, attracting a wide variety of companies — asset developers, domestic and international utilities, technology companies, and financial companies among them. The evolving environment continues to present opportunities for investment.
However, given the uncertainty and complexity in the renewables marketplace, investment decisions are now much more difficult, requiring decision-making skills and tools that were not essential before the economic downturn. Going forward, investment decisions will need to explicitly address uncertainty through effective risk management and contingency planning.
Going forward, the continued growth of smart grid companies and energy storage providers will play a critical role in enabling the next wave of renewables development.
Successful development of economical energy storage technologies would solve many of the intermittence challenges faced by wind and solar, improving project economics. Meanwhile, the widespread adoption of smart meters and variable pricing will make solar power more attractive, given that its greatest output is during the day, when demand is at its peak.
For utilities, renewables are not viable baseload technologies. Even as a complementary energy source, they carry costs that are not competitive without subsidies. Power source decisions will therefore depend largely on local conditions, including the presence of renewable energy mandates, government incentives, and site availability.
Meanwhile, for large energy users, rooftop solar PV remains the only alternative to the grid. Although that is historically the most expensive renewables option, solar PV costs are falling, in part because a growing number of installers are willing to take on the investment risk. In locales with sufficient tax and other incentives (for example, those offered by the California Solar Initiative), investments are NPV positive.
Furthermore, it will be critical for companies to develop the capabilities needed to both evaluate and add value to the assets and technologies that are likely to reenter the market in the months and years ahead. The relatively favorable investment climate of the past decade attracted a number of companies that ultimately lacked the expertise to endure and win in this more difficult investment environment. For example, a number of small utilities and other companies made subscale investments in renewables where they could add little value, and they may soon be forced to divest those assets.
The companies that can pick up the assets and position them to create a sustained competitive advantage will be the ones that establish the right to win in this market. Clear industry leaders are already starting to emerge, but plenty of opportunity remains for those with the vision and the capabilities to power the next era for global energy markets.
Avis Budget Group Inc.’s agreement to acquire Avis Europe PLC has pushed year-to-date volume of foreign acquisitions by U.S. acquirers to its highest point since 2007, according to Standard & Poor’s Valuation and Risk Strategies research group.
The present dollar volume of such M&A deals is at $92.8 billion on 828 transactions, the highest since the comparable period in 2007 when U.S. acquisitions of foreign targets reached $171.7 billion on 905 deals. In terms of deals over $1 billion, 24 have occurred this year, compared with 11 in the year ago period.
According to the data, Europe is the most popular geographic location for U.S. foreign M&A deals, representing 45% of transactions so far in 2011, compared with 50% last year at this time.
Although Europe is the most frequent location for U.S. foreign M&A deals, growth has recently accelerated in developing markets; Africa/Middle East targets deal volume has jumped 85%, while Latin America and Caribbean deals have climbed almost 58%.
With regard to industry sectors, information technology is the most popular, accounting for 23% of deals, slightly off from the 25% in the same period last year. Also of note is the28.6% year-over-year decline in the number of U.S. foreign acquisitions in the health care sector.
As anxiety surrounding the financial market reaction to recent weaker-than-expected economic data has caused some investors to doubt the durability of the global recovery, the upswing in foreign acquisitions by U.S. corporations presents some evidence of confidence among the corporate buyers.
For details see Cross-Market Commentary: U.S. Foreign M&A Trends Show Evidence Of Corporate Confidence In The Recovery
Standard & Poor’s noted yesterday that commercial lending continues to lag demand, but Fitch Ratings expresses concern that US banks may be loosening lending conditions to boost growth in loans. At the same time low loan activity risks reversing the growth in the economy.
Total loans on U.S. bank balance sheets have declined in each of the last 11 quarters after peaking at just under $8 trillion in mid-2008, according to Fitch Ratings. Loan balances are down 12% from the peak and now approximate levels seen at year-end 2006.
The absence of new loan activity has raised concern that the recent, albeit tepid, growth in the domestic economy may reverse. Furthermore, Fitch believes the lack of loan growth has cast a shadow on both the banking industry’s willingness and ability to extend new credit.
In a special report, Fitch examines the trends in loan growth to assess the implications for bank performance and Fitch’s bank ratings. The primary concern from Fitch’s perspective is not the lack of loan growth, but the growth and accompanying competitive pressures being reported in commercial loan portfolios.
The overall lack of loan growth at this point in the economic cycle is not unprecedented. Fitch believes it is reasonable that weak overall loan growth may continue for the remainder of 2011. Fitch does not believe weak loan growth in isolation will cause the economy to reverse course in the immediate term.
In contrast to the trends in overall loan growth, Fitch highlights that commercial loans have increased in each of the last three quarters. The emergence of growth is notable and potentially concerning given the still uneven conditions in the overall economy.
Fitch is more concerned that the banks are reporting an immediate need to loosen terms, conditions and pricing to obtain growth.
While the trends in credit terms and pricing may represent a movement toward normalcy from previous very tight conditions, the immediate emergence of these trends does raise concern for the risk/return dynamics of commercial loans in future quarters.
Banks possess both the ability and willingness to lend as evidenced by trends in commercial loans. The execution of disciplined loan growth will be a key factor in future rating decisions. The immediate impact on earnings will be easy to detect and quantify. The assessment of the new loans representing the proper risk/return dynamic will be more challenging and a more significant factor in determining if rating changes are warranted.
The full report U.S. Bank Loan Growth: Implications for the Economy and Bank Ratings is available at the Alacra Store.
Despite the doomsayers, recent revenue results for US states have been strong, particularly for states that benefit from income taxes on high earners, according to Fitch Ratings. But although this represents a welcome change of pace for states, there is the risk that extra revenues will provide the temptation to reverse some of the positive structural budgeting measures that states have taken in the downturn, Fitch warns in the June 2011 edition of its U.S. Public Finance Credit View – States.
On the other hand, an unexpected interruption in the economic recovery would have a direct effect on the states’ economically sensitive revenue streams and create new gaps to be addressed in the coming year.
The June newsletter also talks about Fitch’s recent revision of the rating Outlook on New York State’s debt to Positive from Stable while New Jersey’s rating is going in the opposite direction with an Outlook revision to Negative.
This monthly newsletter offers timely commentary on topics affecting U.S. state government credit and highlights recent rating actions taken by Fitch on state-level credits. The full report is available at the Alacra Store.
International Monetary Fund policies are unlikely to change much assuming French Finance Minister Christine Lagarde replaces Dominique Strauss-Kahn, according to The Economist’s Views Wire.
Under Strauss-Kahn, “the IMF has also adopted a more flexible response towards countries facing liquidity constraints, recognising that some may really be “innocent bystanders” that have suffered because of contagion from more vulnerable economies.”
These shifts certainly appear to have been assisted by the pragmatic and politically adept leadership of Mr Strauss-Kahn, whose political background is on the centre-left. However, they also reflect deeper shifts, notably the lessons drawn by the Fund from its honest assessment of its failings during the Asian crisis; and broader shifts in economic orthodoxy. Particularly following the 2008-09 global financial crisis, this orthodoxy is increasingly moving away from the traditional prescriptions of the Washington consensus.
As such, the IMF’s policy shifts of the past couple of years can be expected to continue under the successor to Mr Strauss-Kahn, even though that successor now appears likely to be the centre-right Christine Lagarde, the French finance minister.
Whether this will be enough to make still-suspicious emerging economies, especially in Asia, view the Fund as a desirable back-stop against financial crisis (so allowing them to end the amassing of vast reserves) is questionable. One important way in which the IMF has not changed is that Europe and the US, through the balance of their voting rights at the Fund, still exercise too much sway in its deliberations–a fact that the likely choice of another European head, rather than an emerging-market candidate, is set to emphasise and that ongoing quota reform is moving to address too slowly. The IMF has softened many of its more controversial policies, but the issue of its ownership will remain an impediment to its global role.
The full analysis is available at the Alacra Store.