The eight U.S. global systematically important banks (GSIBs) reported weak second-quarter 2020 earnings. Elevated credit provisions and a meaningful contraction in net interest margins (NIMs) weighed on earnings, though noninterest revenues held up reasonably well. For example, GSIBs' median earnings declined slightly more than 50% year over year in the second quarter--with some banks experiencing much steeper declines. Still, most banks reported revenue growth and remained profitable amid the pandemic-induced economic downturn, supporting our ratings.

The eight GSIBs are Bank of America Corp., Bank of New York Mellon Corp., Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley, State Street Corp., and Wells Fargo & Co. (We also include Northern Trust Corp., which is a peer of the trust banks--Bank of New York Mellon and State Street.)

Capital markets performance was the bright spot for GSIB earnings in the quarter as global markets rebounded on the heels of government and central bank stimulus measures.  Outside capital markets, noninterest income was buttressed by higher mortgage banking revenues. Net interest income (NII) declined as low rates affected NIMs, and growth in average earning assets was driven largely by the lower-yielding assets, which rendered the growth less meaningful.

Credit provisions rose substantially--more than 8x times for the median bank compared with second-quarter 2019–-as the banks continued to build their allowance for loan losses.  Under the Current Expected Credit Losses (CECL) accounting methodology, banks have to use economic forecasts to guide their estimates of lifetime losses across their credit portfolios. The primary reason for the large allowance build was the weighting that banks placed on a gloomy economic scenario amid the continued spread of the coronavirus, potentially lower U.S. government fiscal support, and the uncertain outlook and internal risk rating downgrades of companies operating in industries most directly affected by COVID-19. This occurred despite the positive credit performance of the banks in the second quarter, as measured by net charge-offs, outside of pockets of deterioration, such as energy-related loans. This signals that banks view still-benign asset quality performance trends as temporary and reflective of forbearance measures and government stimulus.

Balance sheet trends were mixed in the second quarter.  Loans declined from the first quarter as growth in Paycheck Protection Program (PPP) loans was offset by paydowns in commercial loans and declines in consumer loans. (Growth in average loans during the period was more substantial.) The decrease in loans and associated risk-weighted assets, however, has helped preserve capital ratios, which generally moved higher and remained well above regulatory minimums. (All banks also exceed their indicative stress capital buffer requirements, except Goldman Sachs.) Deposit growth remained robust and supported banks' liquidity as they experienced substantial deposit inflows on the heels of the Fed's massive quantitative easing since the onset of the pandemic.

Although the Fed's accommodative monetary policies and government fiscal measures mitigated any immediate net charge-off risks, we expect loan losses will rise over time.  But if allowance levels need to rise substantially from here, capital ratios for some of the banks could decline meaningfully, and rating actions could ensue (see "What Lies Ahead For U.S. Bank Provisions For Loan Losses,” Aug. 12, 2020). The resilience of the U.S. economy and effectiveness of the government support programs will also be major determinants of future rating actions (see "For Large U.S. Banks, Loan Loss Expectations Will Be Key To Ratings," May 5, 2020). Risks include an economic downturn that persists longer or a rebound more tepid than we currently assume (see "Global Banks Outlook Midyear 2020: Temporary Shock, Profound Implications," July 9, 2020).

Table 1

Our Outlooks On The GSIBs Are Stable

We recently lowered our long-term issuer credit rating on the holding company of Wells Fargo to 'BBB+' from 'A-'. The outlook is stable. This rating action followed the company's ongoing regulatory challenges and preprovision earnings pressures in the midst of the economic downturn (see "Wells Fargo & Co. Downgraded To 'BBB+/A-2' On Weakened Preprovision Earnings Amid Elevated Risks; Outlook Stable," July 22, 2020).

Our outlooks on all of the GSIBs (both at the holding companies and operating companies) are now stable (see table 2).

The ratings on Goldman Sachs remained unchanged after the company announced the resolution of criminal and regulatory proceedings in Malaysia, an important step in the company's efforts to put the 1Malaysia Development Berhad (1MDB) scandal behind it (see "The Goldman Sachs Group Inc.'s Malaysia Settlement Is Progress Toward Resolving 1MDB Troubles," July 25, 2020).

The stable outlooks reflect our expectation that GSIBs' operating performance will remain largely resilient to the economic fallout from the COVID-19 pandemic. Although earnings and credit quality will likely deteriorate meaningfully, we expect GSIBs will remain profitable while maintaining good capital and liquidity. Nevertheless, any potential outlook or rating actions will depend on the duration of the economic downturn and the pace of recovery.

Table 2

High Credit Provisions And Ultralow Interest Rates Limited Earnings

Money-center banks reported weak core earnings in the second quarter (see table 3) owing to substantially higher credit provisions and meaningful compression in NIMs. Positively, better-than-expected revenues from capital markets, particularly in fixed income, currencies, and commodities (FICC) and investment banking (broad-based), provided some offset. As a result, most banks reported revenue growth--median year-over-year revenue growth was a modest 2%. A few banks reported special items, which somewhat skewed their net earnings. Wells Fargo reported $2.4 billion in operating losses, with continued customer remediation accruals and litigation reserve build contributing to the loss. Goldman Sachs added $945 million to its legal reserve (total $2.9 billion since the fourth quarter of 2018), with the preponderance related to 1MDB.

Table 3

The yields on earning assets declined sharply following the Fed's 150 basis points (bps) rate cut in March--reflective of GSIBs' asset-sensitive balance sheets. Deposit costs declined too, albeit at a slower pace given its lagged effect (see table 4). Average earning assets increased from the prior quarter primarily because of solid growth in lower-yielding assets, such as cash equivalents, investment securities, and PPP loans.

Money-center banks, being the largest providers of PPP credit, held a significant portion of outstanding PPP loans. The lower yield on these assets rendered their strong growth less meaningful to interest income. Consequently, NII declined from the prior quarter and year over year. Further, ultralow interest rates and flattening yield curves squeezed NIMs--as the median NIM declined by a sharp 36 bps quarter over quarter.

Expenses were generally well controlled. Still, for some banks, expense growth more than offset the modest revenue growth. Nevertheless, we believe most GSIBs have sufficient preprovision net revenue (PPNR), if not better, compared with the Fed's severely adverse stress PPNR, reflecting their good earnings capacity.

Table 4

Capital markets revenue increased substantially for all banks, reaching its highest level in several years. Capital markets benefited from heightened client activity spurred by companies seeking to raise capital in both the equity and debt markets to fortify their balance sheets for economic duress of an unknown duration. In addition, widened bid-ask spreads (due to sharp changes in market prices) and massive central bank support also contributed to the strong capital markets results.

Within capital markets, trading revenues rose sharply, by more than 65% (see chart 1) compared with the second quarter of 2019. While strong performance in rates, credit products, and commodities boosted FICC revenues, equity trading revenues benefited from improved cash and derivatives performance. Although, Citigroup and Bank of America reported lower equity trading revenues relative to the prior quarter because of weaker derivatives performance.

Chart 1

Investment banking revenues were up nearly 50% year over year. Equity underwriting benefitted from an increase in industrywide deal volumes, particularly follow-on offerings and convertible issuances. The drawdowns of corporate revolvers slowed significantly and were replaced by large debt issuance, which aided debt underwriting. Issuance of both investment-grade and speculative-grade debt surged during the quarter. The modest increase in advisory revenues reflected a slowdown in mergers and acquisitions as companies focused on internal operations amid the pandemic. Overall, the pace of economic recovery, continuation of Fed support, and level of business confidence will influence capital markets activity for the remainder of the year (see "Capital Markets Revenue Should Be A Bright Spot For Banks In A Tough 2020," June 23, 2020).

Beyond capital markets, mortgage banking activity was strong, as refinancing volumes and mortgage originations accelerated, a trend we expect to continue as borrowers take advantage of lower interest rates. However, as a partial offset, GSIBs reported subdued income from cards and service charges because of lower card spending and client activity. Assets under management (AUM)/wealth management fees were pressured given their lagged pricing in relation to the underlying securities, though asset valuations improved in the latter part of the quarter.

Trust Banks' Performance Highlights Resilient Fee-Based Business Models

U.S. trust banks' (Bank of New York Mellon, State Street, and Northern Trust) profitability held up well in the second quarter as the banks' predominant source of revenue--asset servicing fees--generally benefited from a higher level of transactions and a rebound in market values that aided average assets under custody and administration and AUM. Otherwise, NII declined because of the sharp drop in rates. We expect NII to continue to decline in the third quarter, partly from lower reinvestment yields in the trust banks' large securities portfolios.

Trust banks' balance sheets continued to be bloated by excess deposits, possibly reflecting the surge in liquidity in the monetary system and institutional clients placing their excess liquidity with banks. We expect the trust banks will continue to hold substantial assets in cash equivalents that should provide ample liquidity to address an eventual outflow of excess deposits.

We continue to believe that trust banks' overall credit quality will withstand this economic downturn because the companies have much less loan credit risk than commercial banks. However, elevated loan loss provisions could somewhat crimp profitability. For example, Bank of New York Mellon and Northern Trust increased their loan loss provisions in the first half of 2020 to build reserves, but further elevated provisions should not overwhelm otherwise solid fee-based profitability, in our view. If market distress or a liquidity squeeze were to reemerge (which we do not expect because of the market support from the Fed), that could hurt trust banks' risk positions because of their large (albeit secured) counterparty exposures.

Risk-adjusted capital ratios rose for all three banks in the second quarter, as a result of earnings retention and the suspension of common share repurchases. Otherwise, the Tier 1 leverage ratios are pressured by the larger balance sheets from the deposits and corresponding cash surge. We believe regulators might allow the trust banks to resume common share repurchases earlier than most commercial banks because of their good actual and stress test performances. We expect that the increase in risk-based capital ratios for the trust banks will be temporary and they will retreat to solid, but not high, levels in 2021.

Balance Sheets Will Shrink Modestly In The Second Half Of 2020

The GSIBs' balance sheets have grown notably since the pandemic began. In the second quarter, average assets increased substantially while period-end assets actually declined. (Median loans at money-center banks declined by 5% from the previous quarter.) Although commercial loan drawdowns surged and PPP loans grew strongly in the first part of the quarter, the majority of commercial loans were paid down, and PPP loan growth moderated by quarter-end. Outside of loans, securities and cash balances also rose (see tables 5 and 6).

Table 5

Table 6

Consumer loans also declined across the board, particularly credit cards. The federal government's income replacement initiatives left consumers flush with cash, and widespread stoppages in economic activity restricted opportunities for spending, particularly for travel and entertainment. Mortgage origination volumes picked up, but banks remained hesitant to hold long-duration assets on their balance sheets given the likely trajectory of interest rates.

At the median, banks reported strong broad-based growth in deposits, both from the previous quarter and year over year. Commercial deposit growth reflected the accumulation of liquidity gained through commercial drawdowns and PPP loans. Subdued consumer spending and government stimulus payments drove retail deposit growth. The migration of commercial deposits into interest-bearing accounts from non-interest-bearing accounts has decelerated, resulting in overall lower deposit costs (see chart 2). We expect the pandemic to accelerate digital adoption by consumers, particularly for deposit gathering. (Banks reported quarter-over-quarter increases in both online and mobile banking users in the second quarter.)

Chart 2

Liquidity at the GSIBs remains robust, helped by the Fed's accommodative monetary policy and management teams' conservative risk postures--in part because of more sophisticated contingency funding planning/liquidity risk management and the need to meet regulatory benchmarks such as the liquidity coverage ratio. GSIBs have been the primary beneficiaries of the large inflow of deposits and cash balances since the start of the pandemic. Growth in investment securities has further buttressed liquidity. The continuation of the Fed's accommodative policies and banks' limited cash deployment opportunities will likely ensure liquidity remains strong through the remainder of 2020.

We believe GSIBs entered this stress period from a position of strength with adequate capital buffers. GSIB capital ratios rose from the previous quarter, partly from the suspension of common share repurchases (see table 7), as well as from lower-risk weighted assets as less risky assets (cash, PPP loans, and investment securities) drove asset growth.

In its June 2020 stress test, the Fed projected that GSIBs have sufficient capital to withstand a traditional severely adverse scenario, but in new COVID-19 stress scenarios, some banks might approach minimum requirements (see "The Fed's Latest Stress Test Points To Limited Bank Capital Returns," July 1, 2020). The Fed's restrictions on shareholder distributions should help preserve capital. GSIBs will need to update and resubmit their capital plans later this year.

In addition, the stress capital buffer (SCB) will be implemented in fourth-quarter 2020. Per the most recent Fed stress test, three GSIBs--Goldman Sachs, JPMorgan, and Morgan Stanley--have SCBs higher than the 2.5% capital conservation buffer.

Table 7

Asset Quality--The Calm Before The Storm

The COVID-19 pandemic and government response to it will have a meaningful impact on banks' asset quality. We view that 2019 marked the end of a multiyear period of benign credit quality for banks.

Median nonperforming asset and net charge-off ratios deteriorated modestly from the benign levels of 2019, though still remain relatively good (see table 8). At the same time, banks reported large credit provisions in anticipation of worsening asset quality. Incorporating CECL, all of the banks built significant allowances in the first half of the year. However, some banks' management teams indicated reserves may remain stable, though it will depend on the economic outlook.

Table 8

In response to prospective asset quality deterioration, banks have been tightening lending standards. According to the July 2020 Federal Reserve Senior Loan Officer Survey, banks tightened their lending standards across all loan categories for the second quarter 2020, particularly within commercial and industrial loan books, which saw the most tightening since 2008. We believe banks are cautious in commercial lending, particularly given the risks associated with exposure to industries vulnerable to the pandemic, energy, and commercial real estate.

The risk arising from leveraged lending at GSIBs remains manageable in our view, though not insignificant. Leveraged loans are a small portion of GSIB-funded loans, but the banks bear the risks associated with syndicating these loans. Some banks also have portfolios of collateralized loan obligations, although these tend to be small and consist of highly rated tranches.

We believe forbearance efforts banks implemented have largely been successful at forestalling asset quality issues. This is evidenced by a decline in the percentage of borrowers remaining in forbearance from the inception of the programs through the banks' second-quarter earnings release dates. So far, delinquencies for GSIBs have remained benign. Nevertheless, the forbearance and government stimulus programs will likely serve as a temporary alleviator but not a permanent fix.

Overall, we believe the efficacy of forbearance efforts and government programs designed to supplement consumer income and prop up commercial enterprises are key in determining the ultimate severity of credit losses. The cessation or maintenance of these initiatives, trajectory of unemployment, and the strength of the economic recovery are also important. Lastly, we expect loss recognition may be extended beyond the traditional time frames given the deferment options available to consumers. We also believe that the Fed's programs designed to stabilize financial markets may help reduce financial pressure large commercial borrowers. Nonetheless, we still expect certain speculative-grade companies to struggle, particularly those exposed to vulnerable industries.