No room for complacency

It has been a busy few weeks for the global banking C-suite. The Institute of International Finance’s Annual Membership Meeting (IIF AMM) in October included several discussions with senior bankers that focused on the economic outlook and evolving trends across the sector. Those discussions were a prelude to the start of the Q3 reporting season, in the US, followed by European banks over the last week.

What do recent results and C-suite discussions tell us about the state of global banking? Let’s start with the good news.

Net interest income growth – a strong positive

US banks continue to benefit from the Federal Reserve (Fed) raising interest rates, as assets are repriced faster than liabilities. Major banks reported a 30% rise in their net interest income year over year (YoY). The average net interest margin for major banks increased by 600bps YoY. However, while there was moderate YoY lending growth in Q3, higher interest rates may lead to slowing loan growth in some areas; for example, consumer mortgages, where substantially higher rates are leading to a decline in volumes. European banks also benefited from rising interest rates which led to an average increase of 19% in their net interest income YoY. Loans increased marginally in Q3 yet European bank management teams are not optimistic about lending growth due to subdued consumer credit demand.

But non-interest?income declined

Aggregate non-interest income for major banks in Q3 fell by 14% YoY, as a sharp decline in deal-making activity hit investment banking fees. Merger and acquisition volume and value fell 6% and 17% quarter over quarter respectively, with the rising cost of debt forcing some companies to postpone buyouts. The shift to a tightening environment has also hit issuance fees as IPO activity has slowed and debt issuance has proved sluggish. Equity and debt underwriting volumes fell 30% and 70% respectively from Q2. For European banks, non-interest income declined marginally by 3% YoY due to weaker wealth management and private banking results being only partially offset by an increase in trading income. ?????

Costs increased?due to inflation and transformation

Nearly all US banks reported a rise in operating expenses, significantly influenced by a combination of inflation and investment spending. The overall costs of the major banks increased by 7% YoY. The overall C/I ratio of the major banks rose from 65.6% in 3Q21 to 68.6% in 3Q22. European banks on average saw expenses stay flat YoY due to cost cutting initiatives and a decline in litigation and remediation costs.?More broadly, the persistence of high inflation and its potential impact on individuals and businesses, with its feed through into banking, remains a primary concern of most C-suite executives. Tight cost control is a given, drastic cost cutting measures may be on the horizon if growth proves elusive.

Provisions were up, but strength of the consumer is a positive

There were frequent discussions at the IIF AMM about the (high!) probability of a coming recession and its likely depth and duration. Capital adequacy is no longer a core concern for global institutions. Q3 results show that US banks are prudently building loan loss reserves, even though the consensus view of the C-suite is that the US is likely to see only a shallow recession, with stable high employment and strong consumer balance sheets acting as buffers. Indeed, US banks are generally not yet seeing elevated consumer distress in their books. The fact that many consumers were able to strengthen their financial position through the pandemic means they are likely to be reasonably well positioned to weather a downturn.

As with US banks, the capital position of European banks is strong. Increased interest rates by the European Central Bank are giving European banks some hope they will get beyond single digit returns on equity in the future. But asset quality issues may be seen earlier in Europe than in the US. While European consumers and businesses have strengthened their balance sheets in the last two years, that protection is likely to be eroded faster than for US consumers given greater exposure to rising energy prices. Provisions for European banks increased significantly on a YoY basis in 3Q22 as a result of concerns about the outlook, while the ECB also cautioned some banks to keep 2022 bonuses in check.

Beyond inflation, banks are focused on supporting the net zero transition

If inflation was the hottest topic at the IIF AMM, sustainability was a close runner up. An estimated USD275 trillion of spending will be needed over the next 30 years to transition to net zero. Global banks are financing roughly 80% of the transition (compared with 20% from the capital markets). One consequence of this is a concern that regulators may seek to influence capital allocation, especially using pillar 1 capital requirements. The good news for banks is that several regulators speaking at the IIF AMM expressed their reluctance to use pillar 1 as a tool to manage climate risk. Moreover, they recognized that temporarily increased capital allocation to “brown” industries will be required to accelerate transition. There was consensus that just investing in green does not move you closer to a transition, but likely shifts financing of brown industries to the non-bank sector, which should give regulators cause for concern.

Digital currencies

Another big topic last month was digital payments. With an estimated US$150 trillion of cross-border money flows , there were extended conversations around digital currencies as a low-cost reliable solution to traditional transfers, particularly for emerging markets, where approximately 800 million people are reliant on remittances to pay for basic necessities.

However, despite widespread recognition of the potential for digital currencies to lower costs and improve cross-border payments, regulatory uncertainty and cybercrime remain the key challenges to adoption. Regulators highlighted key questions about how to classify digital assets (i.e., as a security, commodity or currency); their tax and accounting treatment and the regulation of crypto intermediaries as areas of concern. But I was pleased to note that there is a continued commitment of resources and capital to solve these questions.

Key reflections

Overall, the mood in management earnings calls and C-suite conversations was cautious. The current inflationary environment presents a real challenge for central banks to manage through, but the strength of consumers, especially in the US, gives hope that any downturn will not be too deep and long. The discussions of the banking C-suite around sustainability and digital currencies meanwhile highlight a significant opportunity for banks to help build a better future world, but within a complex and evolving regulatory environment, where a major misstep could set back progress. Overall, the outlook for banks is solid, but there is certainly no room for complacency with the executive teams.

Disclaimer: The views reflected in this article are the author’s and do not necessarily reflect the views of the global EY organization or its member firms.