Projecting banks' capital markets revenue--an inexact exercise in a typical year--is even more difficult in 2023, with the global economy in flux, the path of interest rates uncertain, and the banking industry under duress after the failures of two sizable U.S. banks and UBS' emergency acquisition of Credit Suisse. S&P Global Ratings expects 2023 capital markets revenue for the 11 banks covered in this article to be flat to down 10% compared with last year, but a lot will depend on what happens to interest rates, inflation, and market volatility, as well as the depth and duration of a recession, should one arise. Changes to the Basel capital standards--and with it, the likelihood of rising market risk-weighted assets--could also influence capital markets revenue, since these changes might affect the types and quantity of trading assets that banks are willing to hold.

If interest rates were to diverge from current market expectations, it would likely benefit banks' fixed-income, currency, and commodity (FICC) trading businesses (and to a lesser degree, equity trading) since clients likely would need to reposition their portfolios for this new reality. However, higher-than-expected rates would simultaneously weigh on banks' investment banking businesses. Conversely, if rates were to stabilize or even decline without a significant recession, investment banking might rebound from soft 2022 results. Acquisition activity in the second half of 2023 could receive boosts from well-capitalized companies making acquisitions in their core businesses, financial sponsors deploying some of the record amounts of capital they have, and a possible pickup in cross-border mergers.

Most importantly, with so many variables at play, banks with stronger diversification and market share within capital markets should be positioned best to capitalize on the rapidly changing environment within this business. Capital markets performance will be an important contributor to banks' bottom lines this year, since some banks may see net interest income decline from fourth-quarter levels, and since many banks will increase provisions.

Our analysis of certain risk metrics looking at banks' trading activity found no outsize risk taking in 2022 by the large banks we follow, although some risk metrics modestly deteriorated for a few banks. And margin payment held up last year despite significant market volatility, which we believe points to ample liquidity in the system and good risk controls at the banks. That said, the risks embedded in banks' capital markets divisions are opaque compared with the risks in their lending businesses, and large losses could arise unexpectedly.

Capital Markets Business Supports Stable Rating Outlooks

From a ratings perspective, we believe capital markets revenue is a diversifying factor for a bank as long as it runs its capital markets business in a risk-controlled manner, and as long as its capital markets revenue isn't an outsize proportion of total revenue. All of the large banks we rate that participate in capital markets activity have stable rating outlooks, except for Barclays, Credit Suisse, and UBS (see the appendix). Part of the reason for the stable outlooks is the strong revenue contributions from the capital markets businesses and banks' ability to manage the associated risks well.

We recently revised our view of the industry risk trend in the U.S. banking sector--which is part of our Banking Industry Country Risk Assessment for the U.S.--to stable from positive, indicating that we don't expect to revise up the 'bbb+' anchor--the starting point for our ratings on banks in the U.S.--in the next two years. We simultaneously revised our outlooks on the ratings on four large U.S. banks--including Bank of America and JPMorgan Chase, two large capital markets participants--to stable from positive because we believe prevailing market and economic conditions have reduced the probability of an upgrade in the current environment (see "Outlooks On Four Large U.S. Banks Revised To Stable From Positive On Uncertain Operating Conditions; Ratings Affirmed," March 31, 2023).

Of the large capital markets banks, Barclays remains the only one with a positive rating outlook, which reflects its stronger business profile and financial performance, although the current ratings are still lower than the ratings on many other capital markets banks (see "Update: Barclays PLC," Dec. 2, 2022). In addition, the ratings on Credit Suisse are on CreditWatch with positive implications because of its pending acquisition by higher-rated UBS. UBS is the only bank with a negative rating outlook at the holding company level, which followed its agreement to acquire Credit Suisse and reflects integration and execution risks (see "Research Update: Outlook On UBS Group Revised To Negative On Execution Risk From Credit Suisse Acquisition; Ratings Affirmed," March 20, 2023).

Our Projections For Banks' Capital Markets Revenue In 2023

For the 11 banks covered in this article, capital markets revenue declined by 11% in 2022, with FICC trading the only category to show year-over-year revenue growth (see chart 1). This was largely due to clients repositioning their portfolios amid a rapid rise in interest rates as inflationary conditions took hold. Investment banking performed poorly, with equity and debt underwriting posting precipitous declines on higher borrowing costs, the widening of spreads, economic uncertainty, and tough year-on-year comparisons.

In 2023, we expect capital markets revenue to be flat to down 10% from last year. But even our downside scenario for 2023 envisions at least a 15% jump in capital markets revenue from 2019, bolstered by high volatility and an expanding global economy.

Chart 1

Banks' recent comments on capital markets revenue for first-quarter 2023

Comments by some bank officials at recent conferences regarding their companies' expected first-quarter 2023 results support our view that trading revenue is holding up (although a bit weaker compared with last year) while investment banking activity is still anemic.

• Morgan Stanley noted that first-quarter trading revenue has held up but won't be as strong as it was last year because of the lack of a tailwind from commodities trading.
• Deutsche Bank anticipates strong first-quarter fixed-income revenue, although it's still expected to fall short of last year's figure. The origination and advisory business is seeing improvement relative to third-quarter and fourth-quarter 2022, but first-quarter 2023 revenue will remain below the strong first-quarter 2022 level because of lower activity.

U.S. banks will begin reporting results on April 14, which will shed further light on capital markets activity so far this year.

Chart 2

The impact of Basel 3.1 on capital markets activity

Regulators around the world will be evaluating how to implement Basel 3.1 as it pertains to capital ratio calculations. Japan and Canada will likely be two of the earliest adopters of Basel 3.1, and it's scheduled to go live in the EU and U.K. in 2025. But the U.S. start date is yet to be determined, and this may wind up delaying implementation in other jurisdictions.

With respect to trading and capital markets activity, Basel 3.1 will revise the frameworks for credit valuation adjustment (CVA) risk (that is, the risk of losses arising from changes in counterparty credit spreads and market risk factors), which could play a part in derivative pricing and transactions. Basel 3.1 also eliminates the internal models approach for calculating CVA risk and allows only the standardized approach.

Another key component of Basel 3.1 that will affect banks' capital charges for their trading operations is the Fundamental Review of the Trading Book (FRTB), which changes the minimum capital requirements for market risk. FRTB aims to segregate trading books from banking books and address illiquidity risk. It uses expected shortfall, as opposed to value at risk, as a measure of risk under stress in an attempt to better capture tail-risk events. As a result, banks will be required to use a significantly more complex and risk-sensitive calculation than in the past to measure risk-weighted assets. FRTB is expected to increase the capital that large banks must hold against trading many products--in particular, products that are illiquid or have risk profiles that are difficult to benchmark, such as derivatives. This also could impact trading inventory, pricing, and transactions.

According to a February 2023 monitoring report from the Basel Committee on Banking Supervision, the prospective Basel 3.1 market risk capital requirements for global systemically important banks are 48.9% higher than the current market risk capital requirements.

Private lending could replace some capital markets activity

Generally, banks have managed well their commitments to originate and syndicate leveraged loans. But activity in this area declined significantly in 2022, and as rates and market volatility rose last year, banks were unable to syndicate some of their commitments. In some cases, they opted to bring those loans--including loans extended for Citrix, Tenneco, and Twitter--onto their balance sheets rather than selling them. Banks generally marked these loans down to various degrees, taking losses throughout the year, but the amount was insignificant compared with their overall capital markets revenue. In early 2023, market conditions improved, and banks were able to move some of these loans off their balance sheets, freeing up capacity for new loans. But it has become more difficult for banks to continue with this process amid the market volatility of the last few weeks. These conditions also likely led banks to become more cautious with originating new leveraged loans, which, along with the slowdown in new deals, will hurt underwriting for speculative-grade debt.

Meanwhile, banks are facing increased competition for leveraged loans from private credit providers–-mostly asset managers and business development companies. Private credit providers likely have taken some market share from bank syndicators. Private creditors have historically competed more for middle-market borrowers, but more recently, they have become more active in lending to large corporate borrowers, a market traditionally controlled by the banks through broadly syndicated loans (BSLs). A drop in competition in 2022 from the BSL and high-yield markets, amid rising interest rates and growing concerns about the economy, enabled private credit providers to find more opportunities to lend to larger companies. They funded most of the leveraged buyouts in 2022, according to Leveraged Commentary and Data from PitchBook, a Morningstar company.

Even if competition reemerges from the BSL and high-yield markets, we expect asset managers to move further into private credit, as well as credit in general. Private lenders are likely to be formidable competitors for commercial assets for the foreseeable future. Their growth has affected the behavior of other credit providers, including banks.

For instance, JPMorgan Chase, which historically has been a larger player in syndicating BSLs, indicated in 2022 that it had also begun to originate private credit assets for its own balance sheet. Rather than relying on syndication in a slow market, it chose to originate leveraged loans to hold. We believe those exposures make up a very small portion of JPMorgan's balance sheet, and we haven't observed similar strategies at other banks. Still, it's illustrative of the effect that private credit providers are having on banks' debt underwriting businesses.

Individual Banks' Capital Markets Performance

Market share

While there was little change in capital markets revenue market share for U.S. banks in 2022 versus 2021, European banks seemed to pick up market share (see chart 3). In fact, some large capital markets participants outside of the U.S. managed to increase capital markets revenue last year, helped by a strengthening U.S. dollar and more stable business models that focused on serving clients, capturing increased wallet share, and selectively growing product capabilities (see chart 4). Meanwhile, UBS' acquisition of Credit Suisse and its plans to downsize its investment banking business will likely impact market share going forward.

Chart 3

Chart 4

Capital markets revenue as a percentage of total revenue

In 2022, capital markets revenue fell as a percentage of banks' total revenue (see chart 5). Specifically, the median for the largest banks was 33% versus 38% the previous year. This was largely due to a significant pickup in net interest income, as banks benefited from higher rates and a drop in investment banking activity. We expect this percentage to decline further in 2023, since we expect capital markets revenue to fall, and since there's a chance that net interest income will rise, even if modestly, from full-year 2022.

Chart 5

Breakdown of capital markets revenue by bank

We expect that the main factors influencing capital markets revenue in 2023 will be different from last year. We expect investment banking activity (both advisory and underwriting) to bolster banks' capital markets revenue in the second half of the year, assuming interest rates and market volatility both stabilize by then. At the same time, trading revenue will likely be weighed down by lower volatility, and it will face a tough year-on-year comparison (see chart 6).

Chart 6

Volatility of capital markets revenue

Banks with simpler, more diverse capital markets businesses will generally post revenue that is more stable (that is, with less year-to-year volatility) despite changing market conditions. We note, however, that capital markets revenue volatility is skewed for the banks that are purposefully trying to shrink their capital markets businesses.

Chart 7

Risks

We believe capital markets businesses are more opaque than traditional lending businesses, and the risks are more difficult to quantify. We look at various risk metrics within banks' trading businesses to gauge whether risks are elevated.

Counterparty risk

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 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 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.

In regards to central counterparties, 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 the price movement of the underlying asset is severe. Conversely, for over-the-counter trades, banks typically charge an initial margin and a variation margin to reflect the 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.

To assess this risk of nonpayment of derivatives, we looked 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 only available for the U.S. banks in our sample. A few things are noticeable (see chart 8):

• Derivative receivables were stable to down for most banks last year.
• The amount of speculative-grade exposure decreased for these banks, which reduced their risk exposure.

Chart 8

Market risk-weighted assets

One 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 lower risk. An increase in this ratio could indicate a riskier trading book. The results of this analysis for 2022 are largely mixed, with market risk as a percentage of trading assets falling for some banks and rising for others.

Appendix

Related Research

• Outlooks On Four Large U.S. Banks Revised To Stable From Positive On Uncertain Operating Conditions; Ratings Affirmed, March 31, 2023
• Research Update: Outlook On UBS Group Revised To Negative On Execution Risk From Credit Suisse Acquisition; Ratings Affirmed, March 20, 2023
• After A Big Year, Banks' Capital Markets Revenue Will Likely Fall In 2022, April 12, 2022
• Capital Markets Revenue Should Remain Robust For Global Banks In 2021 Despite Risks, April 8, 2021