After a stellar 2021, capital markets revenue will likely decline in 2022 as geopolitics and rising interest rates push advisory and underwriting fees lower. Indeed, volatile markets have led companies to pause coming to market--weighing on investment banking revenues. These same market conditions, though, could support sales and trading activity if banks can navigate the associated risk. Changing market conditions underscore the importance of banks having a diversified capital markets business so they can capitalize as conditions change. All in all, we look for capital markets revenue to be down about 10% from last year's elevated level, with risk to our projection to the downside.

Revenue aside, S&P Global Ratings thinks risks within the capital markets business will be high this year in part because of increased volatility on the heels of the Russia-Ukraine conflict, which exacerbates inflationary concerns (see "Global Credit Conditions Q2 2022: Confluence Of Risks Halts Positive Credit Momentum"). Although high volatility is typically a boon for banks' trading business, it can also lead to a markdown of some inventory positions if not managed prudently. In addition, counterparty risk is elevated as steep changes in daily prices, particularly in energy, metals, and commodities, can result in clients and counterparties needing to post a steep level of daily margin, which raises the risk of a default.

Overall, we expect bank profits to be down this year for global banks largely because of higher provisions, rising expenses, and pressured fee income, due in part to lower capital markets activity. Notably, last year many banks posted negative provisions, having released the hefty loan loss reserves that they had built during the pandemic. This year, we expect banks to post positive provisions to offset charge-offs and to account for new loan growth. Still, we expect credit conditions to remain benign for most of the year unless inflation remains elevated, which could weigh on credit quality later this year.

Key Risks In Banks' Capital Markets Business In 2022

In general we believe capital markets businesses are more opaque than traditional lending businesses, with the risks more difficult to quantify. Unlike lending businesses, risks in capital markets businesses can be unexpected and create large losses quickly. That said, if it's well managed and in a measured amount, capital markets revenue can diversify a bank's revenue stream.

Banks take counterparty risk when they act as market makers in a couple respects. First, when they execute client trades through an exchange and provide clearing services, they are responsible for posting margin at the central counterparty (CCP) on behalf of the client and they rely on that client to post the margin to them. Second, when they trade directly with clients in over-the-counter (OTC) products--such as certain types of derivatives or more esoteric nonexchange trade products--they rely on the clients to honor the terms of the trade. Given the high level of volatility this year, particularly as it pertains to commodities, weaker counterparties--or counterparties caught on the wrong side of a trade--could struggle to post daily margin.

In regards to CCPs, banks that clear for their clients could be put in a position of posting margin on the client's behalf and then being unable to collect that margin from their client. If they are forced to liquidate the client's positions, they may find the margin they previously received is insufficient to protect against losses if price movement of the underlying asset is severe. Conversely, for OTC trades, banks typically charge an initial margin and a variation margin to reflect daily price movement of the underlying contract. The amount owed to a bank is accounted for as a derivative receivable. If a counterparty defaults on a derivative receivable, the bank may experience large losses. In addition, it may simultaneously suffer losses on any positions it used the derivative to offset or hedge.

Recently, activity in the nickel market has made clear the risks of posting margin on behalf of a client. Notably, nickel producer Tsingshan Holdings owed the banks facilitating its short trade to hedge nickel prices billions of dollars of additional margin after the price of nickel shot up (Tsingshan likely executed the trade to lock in the price of its future nickel production). Although the sharp rise in the price of nickel was a positive for Tsingshan's long-term prospects, it did not have the liquidity to cover its immediate margin needs. A group of banks are working out a secured lending agreement with Tsingshan. In the meantime, the banks are covering Tsingshan's immediate margin needs. Tsingshan has since lessened its short position.

Tsingshan's longer-term prospects and assets may ultimately protect the banks against losses. Still, it illuminates the risks in the trading business that can suddenly materialize. If the banks' client was not a nickel producer but rather, let's say, a nickel speculator, the banks would have likely needed to close out its trading positions if margin could not be posted, which could have incurred a significant loss if the banks' collateral was not enough.

In fact, last year something similar occurred when several banks' prime brokerage client Archegos, a family office, incurred significant losses on a few concentrated trading positions, forcing the banks to close out its positions. Some banks did not hold enough collateral and collectively incurred almost $10 billion of trading losses.

These situations were very specific, and the risks could not be gleaned from public disclosure in advance. That said, we do attempt to assess the risk of nonpayment of derivatives. To do so, we look at the amount of derivative receivables outstanding by each bank, along with the relative creditworthiness of the counterparties (investment grade versus speculative grade). Public disclosure for this data is primarily available for U.S. banks in our sample. A few things are noticeable:

• In 2021, derivative receivables remained relatively flat or declined for most U.S. banks, and
• Positively, the amount of investment-grade counterparty exposure increased for half the banks.

Chart 1

Market Volatility Can Also Lead To Markdowns Of Some Trading Inventory

Banks generally do not take proprietary positions on trades but do hold inventory in anticipation of client demand. As such, it's possible that if price movements on certain trading inventory positions are severe, banks may incur losses on some of the trading positions they hold. Notably, volatility is elevated this year--but not as high as the start of the pandemic.

Chart 2

Number of days with negative trading profits and loss

The number of negative trading days is another means to evaluating trading risk. Negative days of trading revenue picked up in 2021. A higher number of losses could signal a higher risk appetite, exposing the bank to a change of market conditions from one day to the other (for good or for worse). However, it could also reflect poor risk management. The bank may not have adequately quantified the risk it is taking and therefore hasn't put the appropriate hedges in place.

Table 1

Market risk-weighted assets

The absolute amount of market risk-weighted assets is another way to measure the amount of risk embedded within banks trading portfolios and whether a bank is increasing its trading risk or reducing it. Market risk seems to have declined for some banks year over year (Credit Suisse, Deutsche, Nomura, Morgan Stanley, Citigroup and JPMorgan, BNP, and Soc Gen) but rose for others (Barclays, Bank of America, and Goldman Sachs).

Chart 3

Another way to assess whether banks are holding riskier trading assets is to divide the amount of market risk-weighted assets posted in the quarter by the amount of trading assets at the end of the quarter. A low level of market risk-weighted assets relative to trading assets would indicate that the bank's trading activity is low risk. An increase in this ratio could indicate a riskier trading book. The results of this analysis for 2021 is largely favorable, with market risk as a percent of trading assets falling for most banks (BNP, Citigroup, Deutsche, Morgan Stanley, Nomura, Goldman, and Soc Generale), but rising for a few (Bank of America, Barclays, Credit Suisse, and JPMorgan).

Chart 4

We view derivatives and "other trading assets," which we believe includes commodities, as the riskier types of trading inventory. Several banks seem to have lowered the amount of derivatives in their trading inventory, but a pickup in other trading assets offset this (see chart 5).

Chart 5

Trading inventory is fluid, and the data is point in time. As such, unlike a loan portfolio, it is difficult to draw hard conclusions as to the riskiness of trading inventory, which underscores our views on the opacity of this business line.

Banks' Individual Performance In Capital Markets In 2022 Will Likely Be Dictated By Their Business Mix

Capital markets revenue increased roughly 9% in 2021 for the banks we surveyed with year-end data, despite robust activity in 2020. The big driver was a resurgence in advisory revenue , which rose roughly 75%, buoyed by pent-up demand that had been put on hold in 2020 due to the outbreak of the pandemic. Equity underwriting also had a nice showing, buoyed by an onset of IPOs amid strong equity markets and the special purpose acquisition company boom.

Chart 6

We expect that the main factors influencing capital markets revenue this year will be different than last year. Specifically, we expect sales and trading revenue to bolster banks' capital markets revenue while advisory and underwriting will be pressured. Easier year-over-year comparisons after tough comparisons in the first quarter should help banks' fixed income, currency, and commodities (FICC) business, along with diverging timing of interest rate hikes by central banks. Equity trading should also be strong given the volatility in the markets, but banks are up against tough comparisons from last year.

With investor confidence waning and asset prices falling, advisory will likely post weaker results this year after an extremely strong 2021. Equity underwriting, which also was strong last year, will likely weaken this year as IPOs and new issuances are being held up amid market volatility and price declines. Debt underwriting should be decent for investment-grade companies but speculative-grade companies may hesitate to issue debt if credit spreads widen. In addition, many speculative-grade companies front loaded their debt issuance in 2021, when market conditions were more favorable and rates were lower. Given our projections for the strengths and weaknesses within capital markets, it is important for a bank to have a well-diversified capital markets business to be able to capitalize on changing market conditions.

Chart 7

Capital Markets As A Percentage Of Overall Bank Revenue Likely To Decline Further This Year

Despite a strong year in capital markets revenue, capital markets business as percentage of overall revenue declined. Specifically, in 2021, at the median, capital markets revenue for the largest banks comprised 39% of revenue versus 41% the previous year. We expect this to decline further in 2022 given our expectation for further capital market revenue decline as well as the likelihood that net interest income will pick up as rates rise (see "When Rates Rise: Tighter Monetary Policy Will Provide A Lift To U.S. Banks," Feb. 10, 2022).

Chart 8

U.S. Banks Still Dominate Capital Markets In Terms Of Market Share

There was little change in market share for U.S. banks in 2021 versus 2020. (We calculate market share by dividing each bank's capital markets revenue by the sum of the capital markets revenues of rated banks that are significant players in this area. While we believe this captures most of the market, it excludes some players in this space.) Goldman Sachs picked up some market share in 2021, which we believe is due to its strong advisory business and the favorable market conditions last year for this business line. Goldman also added client-facing employees in capital markets with an aim of increasing penetration with its largest clients, an effort that appears to have had some success. Soc Generale also showed some gains largely due to the reversal of some losses incurred in 2020 in its equity derivative trading business.

Chart 9

Some Banks With Large Capital Markets Operations Could See Upgrades

Most of the banks that have large capital markets activity have stable outlooks, partially due to the strong revenue contribution from their capital markets business and their ability to manage the risk from this business well. We have a negative outlook on Credit Suisse in part because of its risk management lapses, some of which occurred in its capital markets business. Conversely, we have positive outlooks on three U.S. banks with large capital markets operations: JPMorgan, Bank of America, and Morgan Stanley. We also have a positive outlook on Barclays.

The positive outlook on JPMorgan is partly due to its leading market shares across many businesses, which has helped it deliver consistent solid financial performance. The outlook on Bank of America reflects its improving earnings, risk mitigation, and balance sheet strength. The outlook on Morgan Stanley is based on lower credit risk helped by some recent acquisitions of more stable businesses that are expected to reduce its capital markets as percentage of revenue. Our positive outlook on Barclays reflects our view of the growing momentum in its franchise and creditworthiness resulting from its more settled strategy and rebounding profitability.

Raising ratings on U.S. banks will likely hinge on the U.S. Banking Industry Country Risk Assessment (BICRA) moving higher. The U.S. BICRA currently has a positive trend based on more effective bank regulations. 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 upgrading some banks (see "Various Rating Actions Taken On Large U.S. Banks And Consumer-Focused Banks Based On Favorable Industry Trends," May 24, 2021).

Table 2

Related Research

• Global Credit Conditions Q2 2022: Confluence Of Risks Halts Positive Credit Momentum, March 31, 2022
• U.S. Financial Institutions Ratings See Some Indirect Increased Risk From The Armed Conflict In Ukraine, March 17, 2022
• How The Conflict In Ukraine Is Affecting Financial Institutions Ratings, March 4, 2022
• Capital Markets Revenue Should Remain Robust For Global Banks In 2021 Despite Risks, April 8, 2021
• European Investment Banks Face A Continued Fight To Remain Competitive, Sept. 28, 2020
• Capital Markets Revenue Should Be A Bright Spot For Banks In A Tough 2020, June 23, 2020