The third-quarter earnings of most of the eight U.S. GSIBs fell from a relatively strong level for the same quarter last year due largely to lower NII. However, earnings substantially improved from the prior quarter on lower credit-loss provisions and continued strength in capital markets. The median return on equity of 8.7% for the group in the quarter supported our ratings on the banks.

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. as a GSIB, which is a peer of the trust banks--Bank of New York Mellon and State Street.) Our outlooks on all of these banks--both at the holding companies and operating companies--are stable (see table 1).

Although regulators ordered Citigroup to remediate significant longstanding deficiencies in its risk management and internal controls, we affirmed our ratings on the bank during the quarter. We don't expect the deficiencies to damage Citigroup's reputation, franchise, or ability to conduct business (see "Citigroup Inc. Ratings Affirmed On Efforts To Address Regulatory Orders; The Outlook Remains Stable," Oct. 14, 2020).

The ratings on Morgan Stanley remained unchanged after its announced plans to acquire Eaton Vance, an asset manager with more than $500 billion of assets under management (AUM). Notably, the proposed acquisition comes on the heels of Morgan Stanley's recent closing of the acquisition of E*TRADE Financial (see "E*TRADE Financial, LLC Assigned 'BBB+' Rating Upon Close Of Acquisition By Morgan Stanley; Outlook Stable," Oct. 6, 2020).

The stable outlooks on GSIBs reflect our expectation that they will largely remain profitable, and maintain good capital and liquidity even amid the pressures created by the coronavirus pandemic. Nevertheless, any potential outlook or rating actions will depend in large part on the trajectory of the U.S. economy and its eventual impact.

Table 1

Earnings, Down From The Prior Year, Rebounded Sharply From The Second Quarter

Third-quarter earnings fell by a median 12% from the prior-year quarter level, mostly due to a median 9% drop in NII. Ultralow interest rates and growth in lower-yielding assets have caused NIMs to fall precipitously. Most GSIBs saw NIM declines of more than 50 basis points (bps) in the last year.

Table 2

Shrinking or limited growth in lending exacerbated the impact of lower NIMs on NII for the money center banks. Wells Fargo, Bank of America, JPMorgan, and Citigroup reported NII declines of 19%, 17%, 9%, and 8%, respectively. It appears banks started redeploying excess liquidity into securities to boost spread income.

Table 3

Morgan Stanley and Goldman Sachs, which are far less dependent on NII than the money center banks, fared better. They reported good earnings growth compared to the year-ago quarter on the back of strength in capital markets. Outside capital markets, noninterest income was buttressed by higher mortgage banking revenues and asset management fees.

Higher expenses weakened earnings compared to the year-ago quarter. Banks have worked to control expenses, but they still have risen. We believe that relates in part to certain one-off items as well as COVID-19 servicing expenses. For instance, Wells Fargo reported $961 million in customer remediation accruals and $718 million in restructuring charges, mostly related to severance charges. JPMorgan reported $524 million in firm-wide legal expense, while Citigroup reported $400 million civil money penalty related to Consent Orders.

While earnings were generally lower than in the year-ago quarter, a drop in provisions bolstered the money center banks' earnings compared to the second quarter. Banks took hefty credit provisions in the first half of the year, triggered by the onset of the coronavirus pandemic, downgrades on internal credit grades, and a surge in loans on deferral. The Current Expected Credit Losses (CECL) accounting standard, implemented this year, forced them to set allowances equal to expected lifetime losses.

However, in the third quarter, banks reported sharp declines in loans on deferral, particularly consumer loans, amid a fairly brisk recovery in the economy. For instance, the proportion of consumer loans on deferral fell 350-500 bps among the four money center banks. We believe fiscal support also greatly aided borrowers. That allowed banks to roughly hold allowances flat and for provisions to fall by a median 92% compared with the prior quarter.

Though the economy continues to rebound, we believe asset quality risk remains high. S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that at least two experimental vaccines are highly effective are promising, but this is merely the first step toward a return to social and economic normality. Equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Therefore, for now, we have maintained our base-case estimate for pandemic-related credit losses for the U.S. banking system at 3%. At such a loss rate, banks would be far from done with pandemic-related provisions. At the same time, we believe the probability that losses will reach or exceed 3% has dropped. If our base-case forecast proves roughly accurate--which will depend largely on the economy and government support measures--we would expect rated banks to report positive, but muted, earnings in roughly the next four quarters, because of the continued need for loan-loss provisions.

As we gain more clarity on the economy, we will continue to consider this estimate. We view a 3% loss rate as an adverse case and much less severe than the loan losses from the 2008-2009 financial crisis. In an optimistic scenario, with more government stimulus and a continued meaningful economic recovery, we could lower that estimate for losses. However, if COVID-19 cases keep rising and the economy slows, we could maintain or even raise the loss estimates.

Capital Markets Remained A Positive Story This Year

Capital market revenues have been a bright spot in GSIBs' earnings this year (for Morgan Stanley, Goldman Sachs, Citigroup, JPMorgan, and Bank of America), aided by a more favorable market backdrop. High volumes and wide bid-ask spreads have supported sales and trading, and investment banking revenues have benefited from robust client activity spurred in part by companies seeking to raise capital to fortify their balance sheets.

While capital market revenues were higher than in the year-ago quarter, they were not as strong as in the outsized levels of the second quarter given that volumes, spread, and volatility normalized somewhat. Capital market revenues declined 28% sequentially, whereas revenues increased 19% from the prior-year quarter. Still, third-quarter revenues are among the highest seasonal quarterly revenues in several years.

Within capital markets, trading revenues rose 21%--FICC (fixed income, currencies, and commodities) increased 25% while equities rose 15%--compared with the third quarter of 2019 (see chart 1). Strong performance across products, particularly credit and securitized products, and commodities boosted FICC revenues. Equity trading revenues increased owing to solid cash and derivatives performance benefiting from strong volumes and more favorable market conditions, partially offset by lower revenues in prime finance. Only Citigroup reported higher equity trading revenues sequentially as a result of strong client activity and continued market volatility, particularly in North America.

Chart 1

Investment banking revenues were up 14% year-over-year, largely driven by strong equity underwriting, partly offset by lower advisory fees. Equity underwriting benefitted from an increase in industrywide deal volumes, particularly a surge in IPO issuances driven by a strong equity backdrop. Follow-on offerings continue to hold up well even as secondary block share trades increased. Debt underwriting fees decreased year-over-year, reflecting declines in large event-driven issuances and acquisition financing, though trends among GSIBs generally varied. Compared with the prior-year quarter, Bank of America and Morgan Stanley reported lower debt underwriting fees, whereas Citigroup, JPMorgan, and Goldman Sachs reported higher fees. While investment-grade issuances normalized from higher volumes, the leveraged finance market continued to recover.

Advisory revenues declined 22% sequentially and 25% year-over-year, largely impacted by muted M&A transactions since the start of the pandemic. Nevertheless, banks reported a spurt in M&A activity pipeline towards the latter part of third quarter as companies began to shift their focus from day-to-day operations to more strategic and opportunistic thinking.

Uncertainty about the economy and other factors and the level of business confidence will continue to influence capital markets revenue (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 low rates continue to spur origination volume. Asset and wealth management fees benefitted from higher client transactional activity, higher market valuations, and positive net flows, partly offset by margin compression. As a partial offset, GSIBs reported subdued income from cards and service charges because of lower card spending and client activity. However, cards and service charges started to recover toward the latter part of the third quarter as impact of fee waivers began to wane and consumer spending started to pick up.

Trust Banks' Performance Highlights Resilient Fee-based Business Models

Profitability of U.S. trust banks (Bank of New York Mellon, State Street, and Northern Trust) held up well in the third quarter. This is because the banks' predominant source of revenue--asset servicing fees--generally benefited from net new business, inflows, and favorable market values that aided average assets under custody and administration and AUM. Foreign-exchange revenues eased from the very high levels in the second quarter as trading volumes backed off. Otherwise, NII declined further because of the sharp drop in rates. We expect NII to continue to decline in the fourth quarter, partly from lower reinvestment yields in the trust banks' large securities portfolios. Lower rates are also causing the trust banks to have lower revenue in their cash management businesses because of money market fee waivers.

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 to continue to hold substantial assets in cash equivalents that should provide ample liquidity to address an eventual outflow of excess deposits.

We believe that trust banks' overall credit quality will withstand the economic downturn because the companies have much lower 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 provision expenses were minimal in the third quarter, and any future elevated provisions should not overwhelm an otherwise solid fee-based profitability, in our view.

As processing banks that are subject to operational risks, the trust banks have apparently adapted well to the remote work environment necessitated by the pandemic. However, in the third quarter, Northern Trust had an unusually high charge of $43 million related to a corporate action processing error. We believe that this was an isolated incident and note that Northern Trust still had satisfactory profitability, despite this outsized charge.

Regulatory risk-adjusted capital ratios have risen for the three banks in the past couple of quarters, as a result of earnings retention and the suspension of common share repurchases. Otherwise, the Tier 1 leverage ratios continue to be 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 the increase in risk-based capital ratios among the trust banks to be temporary and they will retreat in 2021 but remain at solid levels.

Balance Sheet Growth Has Abated And Capital And Liquidity Remain Robust

The GSIBs' balance sheets grew substantially in the first half of the year with a surge in deposits and loan growth driven by commercial borrower line draws and PPP loan origination. However, those trends tailed off in the third quarter with assets down modestly and net loans down 2.1% among the money center banks. Banks reported that commercial utilization rates have eased considerably and are now below pre-pandemic levels.

Consumer loans have also fallen, given that a meaningful drop in credit card loans has offset growth in other types of consumer loans. However, the drop in credit card loans slowed somewhat in the quarter as card spending picked up. Outside of loans, the securities portfolios of GSIBs grew as they redeployed some cash, looking to generate more spread income.

Table 4

Table 5

Deposit growth also slowed for most banks from the outsized levels of the first half of the year. The reversal of commercial line draws and a slowdown in the growth of the Fed's balance sheet weighed on that growth.

Positively, deposit costs have continued to fall and banks have seen a higher share of non-interest-bearing deposits. 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 among 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. We expect liquidity to remain robust into 2021.

Regulatory capital ratios of GSIBs rose in the quarter as the Fed's prohibition on share repurchases and dividend increases, at least through the end of the year, helped capital retention. The regulators have also allowed banks to delay the impact of CECL on regulatory capital ratios, which has supported those ratios. The slowdown in loan growth has also limited risk weighted asset expansion. However, if the Fed lifts the restrictions on payouts next year, GSIBs may look to lower their capital ratios, which generally are well above regulatory minimums.

Their ability to lower capital ratios will hinge in part on performance in future stress tests. 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 also is requiring large banks to resubmit and update their capital plans in November 2020 based on the Fed's updated supervisory stress test scenarios. The Fed said it will publish the results of the additional supervisory stress tests by the end of 2020. It's unclear if the Fed will use those results to change any of the stress capital buffers that resulted from the June test. Those SCBs, which are floored at 2.5% and derived from performance in the stress test, replaced the 2.5% capital conservation buffers in the standardized regulatory capital ratio requirements.

Table 6

Other Asset Quality Indicators Remained Relatively Stable

Asset quality trends for the money center banks in the third quarter 2020 remained fairly stable--net charge-offs (NCOs) improved modestly while nonperforming assets (NPAs) rose somewhat sequentially. Commercial NCOs benefited from improved lending market conditions, while the consumer borrower was aided by loan deferrals and fiscal-support programs. Allowance as a proportion of total loans did not change materially in general.

Table 7

In response to potential erosion in asset quality, banks have been tightening lending standards. According to recent Federal Reserve Senior Loan Officer Survey, banks have tightened their lending standards across all loan categories, particularly in commercial and industrial loan books, which saw the most tightening since 2008 in the second quarter. 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 that banks implemented have largely been successful at forestalling asset quality issues. This is seen in a decline in the percentage of borrowers remaining in forbearance from the inception of the programs through the banks' third-quarter earnings release dates. So far, delinquencies for GSIBs have remained benign. Nevertheless, if the economy stalls, delinquency levels likely would rise materially.

Table 8