S&P Global Inc. (SPGI) Earnings Call Transcript & Summary

Hello, and welcome to S&P Global Ratings webinar. Today, our focus is U.S. banking update. Thank you for joining us. My name is Jeff Sexton, Senior Director of Communications, and I'll be leading today's webinar discussion. Also joining me are Devi Aurora, Senior Director and Analytical Manager; Brendan Browne, Senior Director; Stuart Plesser, Senior Director; and Robert Hansen, Director. On the screen now, you will find an overview of our platform as well as housekeeping notes. You can find the materials on the screen. And at this point, we're looking forward to a very intriguing discussion and hearing from a variety of perspectives. Please remember that you can submit your questions in the Q&A box. At this point, I'm going to turn things over to Devi Aurora, our first speaker.

Good morning. Good afternoon, everyone, and thank you, Jeff. Thanks for joining us today. We'd like to take the next several minutes to present you with our latest views on U.S. banks following 1Q results as well as the latest thinking around our industry expectations for the remainder of 2022 before we open up for Q&A. Let's start, as we do with a couple of lifeful questions. Thank you in advance for participating. The first poll question is, do you believe that the risk of an asset bubble bursting in residential real estate is highly likely? Moderately likely? Less likely? Or not at all likely? I'll give you a couple of seconds to place your answer in the queue. Let's move now to our second poll question. In your view, how likely is it that the combination of higher interest rates and high inflation will trigger a recession? Do you think it's highly likely? Moderately likely? Less likely? Or not at all likely? As you've punched in your results, a quick reminder that we'll revisit the poll results together at the end of the webcast. Let's turn now to Slide 2, which lays out some of the actions we've taken since we last spoke to you. Not on the page, but we announced this morning an upgrade to our long-term ratings on Morgan Stanley's holding company and a financing subsidiary to A- from BBB+, the outlook is stable. The ratings on the operating subsidiaries were unchanged. We believe Morgan Stanley has transformed its business model over several years, capped off by the successful integration of E*TRADE and Eaton Vance acquisition, diversifying its revenue stream, while lowering risk and stabilizing its earnings generation. Prior to that, on April 26, we raised our rating on FirstBank Puerto Rico and on Popular, Inc. Despite difficult operating conditions in Puerto Rico over several years, the banks on the island have remained profitable, have seen improved asset quality and experienced large deposit inflows. Capital ratios have held up better than we expected, particularly for FirstBank and Popular, and we expect them to remain elevated. On April 14, we affirmed our BBB+ rating and revised our outlook on Huntington Bancshares to stable from negative and is the same for its bank subsidiary, Huntington National Bank. This reflected our view that the company has successfully integrated TCF Financial Corp, a significant acquisition that increased its asset size by 40%. We think the risks of potential operational, regulatory and cultural complications associated with the acquisition have receded, and Huntington is well positioned to benefit from the enhanced scale and expanded diversification from the merger. The next 3 actions that are listed on this slide are all in response to the close of announced mergers. On April 7, post completion of acquisition, we raised and subsequently withdrew our issuer credit ratings on Investor Bancorp, Inc. and its primary bank subsidiary to align them with our ratings on Citizens Financial Group and Citizens Bank N.A. respectively. Similarly, post-merger, we affirmed and then withdrew our ratings on People's United Financial and People's United Bank, which are now the same as our ratings on M&T Bank and Manufacturers & Traders Trust Company. Also, we lowered our long-term issuer credit rating on Bank Leumi USA by a notch to align it with our rating on Valley National Bank and subsequently withdrew that rating. On March 1, we placed our unsolicited BBB- long-term rating on First Horizon Corporation and the rating on First Horizon Bank on credit watch with positive implications following the announcement of its pending acquisition by the Toronto-Dominion Bank expected to close in early '23. In addition, all issue ratings were also placed on credit watch with positive implications. And then finally, on February 25, we raised our ratings on Texas Capital Bancshares to BBB- stable from BB+ positive based on our view that the company has reduced certain higher risk loan portfolios and significantly boosted many of its capital funding and liquidity ratios. Let's turn now to Slide 3, which lays out our latest ratings and outlook distribution. Note that as of May 16, yesterday, 16% of the portfolio is either on positive outlook or on credit watch positive and 4% are currently listed on negative outlook. A quick reminder, I guess, is this, in the May of 2021, we announced a change in parts of our Banking Industry Country Risk Assessment, or BICRA for the U.S., after observing positive development in the banking system relating to the country's improved regulatory track record, the good financial performance of its banks and improvements in the economy. We used the BICRA to set the anchor or starting point for our ratings on financial institutions in any given country. We said at the time that the announced changes to the U.S. BICRA could, within 1 or 2 years, result in a higher anchor for the U.S. and therefore, higher ratings on some banks. We said we may revise up the anchor if the current stringency of regulation remains in place, the economy continues to grow and banks maintain strong balance sheets and good asset quality. Obviously, the world has changed since that time and new challenges and risks have emerged, most notably relating to Russia/Ukraine, higher-than-expected inflation and rising interest rates. We are monitoring these new factors as well as the factors we discussed when we made the original announcement on the BICRA last year. But for now, we have not announced any further changes in our BICRA or the bank anchor. So let's turn to Slide 4. A couple of key things to mention here. The first is that the considerable tightening of financial conditions that we are seeing being priced into the markets today do not necessarily cause us to view the banking sector more negatively. What is going to be critical for the ratings is the underlying strength in the macro economy and whether or not the risk of rates rising will test the economy into a significant recession that is negative for banking. And I'm looking forward to reviewing what you, the audience, believes the risks are on that front at the end of the session when the poll results are placed on the screen. Second, on this point, our in-house economists have raised the risk of recession to a range of 25% to 35%, but continue to believe that while financial fragility risks have increased, both household and nonfinancial corporate indicators remain on average well below their historic averages, indicating relatively healthy balance sheet. With respect to GDP, our economists have lowered their forecast, but it is still in firmly positive territory. While the slide references the last economic forecast from our in-house economists, they are subject to some flux and we will continue to stay on top of further revisions when these forecasts are updated for the next month. Finally, let's turn to Slide 5, which lays out our expectations for the banking industry in the remainder of the year. For revenues, we're expecting incrementally greater loan demand and rising NIMs from multi-decade lows to boost net interest income for banks. But we offset -- we expect fee income to decline owing to declines in mortgage volumes, capital markets and financial asset valuation. On expenses, lower fees have pressured operating leverage. So expenses will need to remain in sharp focus as a tighter labor market and the need for tech spend offset some of the gains from digital initiatives and branch consolidation. With regard to profits, we expect profits will fall from 2021 as reserve releases are now a thing of the past. That said, industry ROE and ROA should remain below the pace we saw in 2019 or, for that matter, last year. In terms of credit quality, we continue to expect modest deterioration to become visible and a gradual normalization of credit. But in general, we're not expecting a material slide in what remains a pretty healthy trend in asset quality so far, unless the economy slides into a more meaningful recession, which is, as I mentioned earlier, is not our base case. Capital and earnings. We expect capital ratios will decline gradually as payout restrictions have been lifted. This will be less relevant for the biggest banks, and we'll talk about that a bit later. On funding and liquidity, we certainly expect deposit growth to slow meaningfully as the Fed tapers and ceases to purchase assets. Funding and liquidity ratio should start to weaken gradually though from historically strong levels. My team will walk you through the details during this call. Brendan will discuss our expectations for net interest margins, loan growth, deposits and earnings. Robert will focus on our key considerations in terms of asset quality, and Stuart will wrap up with thoughts on capital funding and some key risks. With that, I'll turn it over to you, Brendan.

Thank you, Devi, and hello, everyone. We can turn to the next slide, please. Bank earnings fell in the first quarter in large part because provisions moved back into positive territory. Pre-provision net revenue also fell modestly from the prior year as higher expenses and a modest drop in fee income more than offset an improvement in net interest income. Despite the decline in earnings, it appears the industry still generated a return on equity of about 10%. Turning to the next slide. Even though banks reported positive provisions, the ratio of allowances to loans dropped further. We believe it is now almost in line with where it was prior to the pandemic when CECL was implemented. At about 1.5% to 1.6%, the ratio has fallen from a peak of 2.3% in 2020. We don't think the ratio for the industry will fall much further, given some increased uncertainty in the economic outlook. That said, there has been divergence in how quickly banks have reduced their allowances relative to loans. Some banks still have allowance ratios well above the pre-pandemic level, while others are well below. This is illustrated on the next slide. Here, we show banks with the greatest positive and negative differences in the ratios of allowances to loans relative to day 1 of CECL. The banks at the top of the chart, with the bars directed to the left, have reduced their allowance ratios to well below the pre-pandemic level. The banks at the bottom of the chart, with the bars directed to the right, have maintained their allowance ratios well above the pre-pandemic level. Banks may be holding allowances well above or below pre-pandemic levels for a variety of reasons, potentially reflecting changes in asset quality or in the nature of their portfolios related to acquisitions or growth. Banks may also simply have varying levels of optimism about the economy and their portfolios, all else equal. In other words, we can't draw firm conclusions about allowance efficiency based simply on the data on this chart, but it does provide spotter for further analysis and help inform forecast for provisions. Let's discuss that further on the next slide. In the first quarter, provisions were positive overall, though fairly modest. About 1/3 of rated banks still reported negative provisions. As Devi discussed earlier, we continue to expect further increases in provisions. Our base case for 2022 provision remains $35 billion to $45 billion for the industry, based on an expectation that allowance ratios won't change much further, net charge-offs will tick up a bit and loan growth will be about 5% to 7% this year. On this slide, we shared 2 sensitivity tables for provisions that we published earlier this year. You can see how provisions might change with variation and allowance ratios, charge-offs and loan growth this year. Banks should be able to offset some of the impact of higher provisions with increased net interest income. Let's talk about NIMs and net interest income starting on the next slide. After bottoming last year at multi-decade lows, NIMs are now on the rise. The moderate increases in NIM in the first quarter partially offset other earnings pressures. You can see on the chart on the right that profit margins fell, but a higher NIM kept them from falling lower, allowing the industry to earn that ROE of around 10%. So more on NIMs on the next slide. On the chart on the top, you can see the beginning of the rise in some key rates this year as well as a flattening of the yield curve. On the bottom chart, we show the median change in NIMs for our rated universe in each quarter. NIMs rose by a median 4 basis points in the first quarter for rated banks, which is the largest improvement in many quarters and probably signals further increases to come. The question now is what will rising NIMs mean for net interest income, which we tried to answer on the next slide. Here, we have updated our base case forecast for net interest income for the industry. We also presented this table on our last quarterly webinar in February, but we have now updated it for the change in the interest rate environment. The key takeaway is we now expect net interest income to rise about 10% to 12% this year and even faster next year. The 3 key assumptions that drive that growth are: the Fed raises its target range to 3% to 3.25% by early next year, this mid-single-digit earning asset growth this year and modest growth in 2023, and lastly, a greater earning asset beta and liability beta, meaning, we think banks are asset sensitive. If we are roughly correct, a 10% growth in net interest income this year would equate to more than $50 billion in additional revenue, helping the industry earn an ROE of 9% to 10% in our base case. Let's turn to the next slide. Loan growth has continued at a good pace. Excluding PPP loans, loans rose 9% compared to the prior year and 5% to 6% sequentially on an annualized basis in the first quarter. Commercial loans, excluding PPP, have driven the biggest piece of that growth, and we're up 14% from the prior year. But consumer and CRE are also up at a good rate. Economic uncertainty may slow this growth, but data from the Fed indicates loan growth has continued into the second quarter. Let's turn to noninterest income on the next slide. Fee income was roughly flat for the industry compared to a year ago, but most banks reported declines. Mortgage origination revenue fell sharply from last year and is likely to remain limited given rising mortgage rates. Underwriting is also down in investment banking. Overdraft fees are on the decline as some banks have made changes there, and lower asset prices may impact wealth and asset management fees. As a result, we expect this to be a more challenging year for noninterest income. Let's turn to the next slide to talk about Sales and Trading and Investment Banking. Revenues from those capital market sources in total fell about 11% from the prior year in the first quarter compared to a strong first quarter of last year, largely on a drop in underwriting revenue. Trading revenue remained in good shape with higher volatility in volumes, and advisory also did well with continued M&A. While it's difficult to project capital markets revenue, in our base case, we expect about a 10% drop for the full year this year. Turning to the next slide. While expenses were roughly flat with 4Q, they rose at a mid-single-digit pace compared to the prior year. Compensation has risen in a tight labor market. Banks are spending materially on technology and other ventures, and inflation is driving up costs in general. The rise in expenses has also now resulted in negative operating leverage on a quarterly basis, which we can see on the next slide. Here, again, we believe banks may be able to achieve positive operating leverage as their net interest income rises for the full year. But clearly, there's been some pressure in the recent quarters. And with that, I will pass it to Robert to discuss asset quality.

Thank you, Brendan. Next, we'll discuss asset quality, which continues to perform better than expectations and much better than worst-case scenarios contemplated a couple of years ago. The improvement has been helped by the large and fast fiscal response in 2020 as well as very accommodative monetary policies. In addition, regulatory guidance regarding loan deferrals and restructured loans helped banks defer borrower loan payments, which help borrowers challenged by the pandemic or those seeking to boost liquidity. However, asset quality concerns about COVID infections, supply chain shortages and staffing challenges have been augmented by new concerns over high inflation rates, surging market interest rates amid recent Fed hikes, tightening financial conditions and geopolitical conflicts. So please turn to Slide 20. We will start with traditional asset quality metrics. Here on this slide, you can see that NPAs, net charge-offs and delinquencies have declined over the past 2 years and remain unusually low. Criticized loans, which peaked in the third quarter of 2020, continue to decline, aided by the recovery in the energy sector as well as other economically sensitive portfolios. Not shown in this chart, deferred loans have declined at negligible levels among rated banks in recent quarters from the peaks in the second quarter of 2020. In general, rated banks remain confident in the economic outlook as well as in their economically sensitive loan portfolios. While some banks have reduced exposures in higher risk loan portfolio, such as energy, either due to paydowns or charge-offs. However, we think there is not much room for further improvement, and we expect loan performance to deteriorate gradually and modestly over the next 2 years. Please turn to Slide 21. Here, you can see that net charge-offs remain well below historical levels. and loan losses declined further in the first quarter for almost every loan category shown here. Furthermore, rising real estate prices for both commercial real estate and residential properties, which we will discuss later, has helped borrowers refinance their mortgages, thereby improving their credit metrics or incur additional debt, if needed, for weaker borrowers. High and rising property valuations are also reducing losses on bank's OREO, foreclosed real estate and tempering banks loan loss assumptions, which can affect the reserve levels and the reserve releases. However, we expect loan losses will gradually rise as the credit cycle eventually normalizes with its typical lag relative to the economy. More specifically, we think borrowers with adjustable rate loans, very high leverage or already weak credit scores could be most vulnerable in an economic downturn. Turning to Slide 22. According to the Senior Loan Officer Opinion Survey, lending standards have eased in recent quarters from very conservative levels a couple of years ago. Though easing has diminished or stalled in recent months, banks eased some lending terms in CRE, including maximum loan sizes, loan maturities, loan pricing spreads and the length of interest-only periods. In C&I, banks reduced the use of interest rate floors and reduced loan pricing spreads. Banks also eased standards across residential real estate, home equity lines of credit, and in auto, which is not surprising, given rising and strong collateral values and low loan losses. However, despite easing in recent years, we think lending policies and loan structures remain generally conservative and consistent with pre-pandemic levels across most loan categories based on generally conservative loan-to-value and interest coverage ratios, prudent advance rates and still strict documentation requirements. On the CRE side, we continue to hear about LTVs in the 60% to 65% range with office, hospitality and construction loans typically on the low end or well below this range, while fully leased industrial properties can be well above this range. Despite more aggressive competition from nonbanks, which tend to be more lenient on terms and collateral, we think banks have not excessively eased lending terms, but instead are competing more aggressively on pricing. In fact, we think most banks would prefer to keep lending standards conservative and increase shareholder returns if loan growth doesn't materialize as expected. Turning to Slide 23. So in general, we think the potential for large CRE loan losses has declined for most rated banks given generally rising rental rates and rising property values, which we will discuss on the next slide. More specifically, COVID-impacted property types, such as hotels, retail and health care, have seen meaningful recoveries and rebounds in demand, while office could eventually struggle given secular trends towards work from home. However, office loans at rated banks remain relatively de minimis relative to their capital levels. Delinquency rates on real estate loans remain modest, given relatively low loan-to-value ratios, Borrowers are motivated to stay current to preserve their equity. In the left chart, you can see that under potential stress scenarios, banks generally have more than sufficient capital to absorb much higher potential loan losses. Turning to Slide 24. Here, property prices you see have been rising quickly in recent years, which has helped loan performance and reduced loan losses. Residential borrowers have locked in loan rates, while commercial borrowers have also fixed a large proportion of their debt and have also been able to increased rental rates, which could offset higher rates on variable rate borrowings. However, interest rates could eventually hurt valuations and selling prices even though supply remains tight, particularly for residential real estate. Residential mortgages remain in good shape, given low unemployment rates, healthy balance sheets and rising property valuations. In addition, many homeowners have refinanced at much lower rates in recent years, even though we are seeing an increase in borrowers opting for ARMs in recent weeks. However, higher mortgage rates could hurt new borrowers or those with ARMs or if property prices fall materially, which we think -- which some people think is unlikely given the lack of supply. Turning to Slide 25. As shown in this chart, leverage ratios have trended gradually higher over the past decade in a somewhat negative story. Also, our ratings are now more concentrated in the lower rating levels than in 2019. However, interest coverage ratios, not shown here, have risen, aided by lower loan rates and it suggests a more positive story. In fact, commercial lending has been a strength for most banks over the past decade, and we think most commercial borrowers are generally well positioned. Thus far, corporates have been able to pass along higher cost to customers and maintain profit margins. In addition, most large corporates have locked in low-cost debt and pushed out maturities in recent years and, therefore, have room to absorb higher interest rates. Please turn to Slide 26. As shown here, negative bias for U.S. companies, which we define as the percentage of S&P Ratings with negative outlooks or that are on credit watch with negative implications, has declined materially over the past 2 years from elevated levels in 2020 and is now at its lowest level since 2014, and negative bias is declining for both investment and speculative grade issuers. However, upgrades in positive momentum in corporate ratings could stall or could reverse, which could suggest an inflection. Turning to Slide 27. Shown in the first chart below, U.S. speculative-grade defaults have plunged in recent quarters, consistent with global trends. More specifically, U.S. corporate defaults declined to 1.5% in December 2021. However, we're projecting they will rise to 3% by December 2022. Within speculative grade, the lowest rate category of CCC has the highest negative bias and it appears to have reached an inflection point already after reaching a low in December 2021 and having moved modestly higher since the start of the year. Furthermore, leveraged loan and speculative grade bond issuance volumes, on the bottom chart, were strong in January, but plunged in February and March, which suggests that markets are less receptive to speculative grade issuers. Please turn to Slide 28. Consumer debt expanded across virtually all loan types in 2021, and we expect further growth if the economy remains strong. Not surprisingly, mortgage debt grew the fastest in 2021 and in the first quarter of this year. However, we think consumers are well positioned to absorb higher debt balances. For example, the unemployment rate, as shown on the next slide, fell to 3.6% in April, the lowest rate since February 2020 and is well below the peak of nearly 15% in April of 2020. Based on the large number of job openings and supply constraints, it's possible, the unemployment rate could remain low for a while. Finally, conservative spending habits in 2020 have helped consumers' balance sheets, although inflation could hurt borrowers, particularly lower income borrowers. Please turn to Slide 29. Credit card balances increased from 2021 after plunging in 2020, and we expect them to continue to rise unless consumer spending slows meaningfully. After paying down credit card debt early in the pandemic, consumers are now spending and borrowing more again. Inflation is somewhat of a natural hedge to these companies. The yellow line on the graph shows system-wide net charge-offs with credit cards, which declined last year and were probably near historic low. However, despite the currently low unemployment rates, we expect card asset quality to gradually and moderately normalize this year based on recent trends and forecasts. Turning to Slide 30. Auto originations are trending higher, aided by strong demand, but supply constraints, so things like labor and semiconductors continue to weigh on sales and growth. Like many other loan types, auto loan losses have been modest, had a gradual shift towards longer maturities. We think strong used car prices, healthy balance sheets, low unemployment and the long-term trend towards borrowers with higher FICO scores are largely responsible for the very low loan losses. Nonetheless, we expect used car prices will eventually ease and asset quality will eventually normalize. Now I'll turn the call over to Stuart.

Thanks, Robert. I will start on Slide 32, discussing capital. For all rated banks, capital ratios declined in the first quarter due largely to capital return and risk-weighted asset growth, spurred on by loan growth and an increase in market risk RWA. The declines are largely within our expectations. The biggest decline in capital pertained to the money-centered banks and the trust banks. For these banks, unrealized security losses in their available-for-sale securities portfolio has also played a part. Notably, unrealized losses does not impact our RAC ratio calculations, and so we expect to see a further disconnect between our RAC ratio and regulatory ratios for these larger banks. For the most part, we believe capital ratios will continue to decline for regional banks, but at a moderate pace. The extent of share repurchases will likely hinge on loan growth and new business opportunities. In addition, for the larger banks that participate in the annual stress test, the results of that test will also dictate where capital ratios will head. If you turn now to the next slide, 33. On this slide, we share more details on the capital ratios of the larger banks. As can be seen, capital ratio declined for all the banks -- larger banks, except for Goldman Sachs. Some of the capital decline was outsized greater than 100 basis points in the quarter and pertain largely to the unrealized available-for-sale security losses, capital return and RWA growth. Also, the adoption of SA-CCR, Standardized Approach to Counterparty Credit Risk, also played a part for some. We note that all of the G-SIBs have risk-based capital above their minimum requirement, but to varying degrees. Going forward, capital return will likely hinge on how these banks bear in their -- in the upcoming stress test as well as loan growth prospects and nonrisk-based capital constraints that I will speak to in an upcoming slide. If you turn now to Slide 34. As I have mentioned, unrealized losses for the largest banks in their AFS portfolios had an impact on their capital ratios. The unrealized losses have arisen due to the rising rate environment. Unrealized losses are an immediate hit to capital for the larger banks, but not to the smaller banks, such as regional banks, but do affect all banks' book value. Notably, the unrealized losses should be made up over time as banks earn higher net interest income through their P&L. On this slide, the numbers on the slide show the larger bank CET1 ratios in the first quarter and the fourth quarter. The blue rectangle shows the net unrealized losses in the bank's AFS portfolio divided by its RWA. The larger the size of the rectangle, the larger the impact of unrealized losses contributed to the capital decline in the quarter. For banks in which AFS had a larger impact on capital decline, we attribute this to the size of their securities portfolio as measured as a percent of assets. Higher unrealized losses could also reflect higher duration in a bank's securities portfolio as well. Banks have attempted to alleviate the impact of unrealized losses in their available-for-sale security portfolios by moving some of their securities to a held-to-maturity portfolio. Although this move helps alleviate volatility of their capital ratio, it also takes away from the bank's financial flexibility by limiting its ability to sell these securities either for liquidity purposes or for investment decisions. Turn now to Slide 35. Another factor weighing on some bank's capital return decisions is nonrisk-based capital constraints. On this slide, we showed the binding capital ratios for each of the G-SIBs at the consolidated level and the bank level. The majority of the G-SIBs still have a risk-based capital constraint at a consolidated level with JPMorgan being the one exception, it's constraint is SLR-based. However, at the bank level, the binding constraint for all the G-SIBs is the non-risk base due to the influx of deposits and the growth of their balance sheets. As noted on the slide, asset size would have to grow considerably for some and moderately for others for these banks to breach their regulatory buying constraint. For some banks, their nonrisk-based capital constraint could crimp share repurchases. The Fed's announcement to unwind its balance sheet could help reduce balance sheet size if deposits were also to decline. Turning now to the next slide, 36, we'll talk about funding and liquidity. Funding and liquidity ratios continue to look as strong as they have in many years. For instance, the chart on the right shows that the loan-to-deposit ratio is still hovering around historic low of 55%. The chart on the left shows that liquid assets make up nearly 35% of total assets. The left chart also shows that cash is a portion of liquid assets, the yellow line grew further down in the quarter as banks started positioning more of the liquid assets and securities as yields started to rise. We expect this trend to continue as rates continue to rise. We also expect that as loan growth continues that the deposit-to-loan ratio will start to move higher as well as the Fed unwinding its balance sheet, and this ratio should normalize, but will take a longer time. Moving now to Slide 38. We'll talk about key risks for the U.S. banking sector. A lot of our key risks remain the same as last quarter. One change I'd like to flag is our economists estimate of the probability of recession has increased, as Devi mentioned, and they are now looking for a range of 25% to 35% chance of recession. A recession, if it would occur, would weigh on bank's earnings and it would likely curtail loan growth, fee income and could also negatively impact credit. I'll speak in more detail on some of the risks we see on the next few slides. If you move to 39. On this slide, I'll talk about bank sales and trading portfolios and how we measure this risk. We recently published an article regarding our revenue expectations and capital markets for the banks this year, which is our expectation of down 10% with further risk to the downside and also symmetrically used to manage risks in their trading portfolio. On this slide, we show one way we measure trading risk. The pink lines on the chart show the absolute amount of trading assets over time for each of these larger banks. These figures are as of 12/31/21 end of the year of last year. We take that figure and measure it by each bank's market risks. We show that on the right side of the chart. The percentage is going up, it means that the bank's trading portfolio is getting riskier. Although this percentage has risen for some banks year-over-year, it has come down from where it stood in 2016. But we expect this to get a rise this year as volatility in the market has increased and trading assets will also rise as customers use -- trade more in this new environment. If you turn now to Slide 40, another area we are watching closely is counterparty risk as it pertains to banking's trading portfolios. We note that margin requirements, particularly in the commodity space has been front and center. Given the spike, some counterparties are -- in prices in commodities, some counterparties are needing to post a high level of margin, which has put stress on the financials of some of these entities. One way we measure counterparty risk, as it pertains to derivative receivable, is by seeing how much of the counterparty risk is investment grade versus noninvestment grade. In 2021, which is where these figures end, the amount of derivative receivables came down from those banks, which is a good thing for credit and investment-grade counterparties rose, which is also a positive. We will continue to watch this metric closely in 2022. If you turn now to Slide 41. On this slide, I will talk about the market levels and their impact on bank profitability. It's unfortunately not a pretty picture of the slide as many indexes are down sharply. This could pressure bank's income in various ways. For example, loan growth could be hampered if CEO's confidence wanes. In addition, with equity markets under pressure, IPOs and the raising of additional equity could slow, hurting fee income in those areas for the banks that participate. On the debt side, if spreads widen, debt underwriting could also slow, particularly for noninvestment-grade companies. Although higher market volatilities, shown on the right side of the slide, favors trading revenue, it usually needs to be accompanied by a clear trend up or down. Holding inventory also becomes more precarious for banks as inventory write-downs could ensue. Moving outside of capital markets, wealth management and trust businesses are largely priced over market levels. So if they fall, the fee that is generated will also come under pressure. So in short, although net interest income will likely be a good story for banks this year, this could be offset by pressured fee income, largely hinging on how markets perform from a pricing standpoint. And if a recession ensues, loan growth and credit quality will also enter the crosshairs. With that, I will now turn it over to Devi to wrap up and go over the poll questions.

Great. Thank you, Stuart. Let's bring up the results for the first live poll question. So it appears that just under half of you think that there is a moderately likely chance of an asset bubble bursting in resident real estate, followed by the next most popular category seems to be that it's less likely. Although a significant chunk of you, about a 1/5 of you believe that it is highly likely. So clearly, an area that we're going to have to keep on top of as we look ahead. Let's turn to the second poll question here. In terms of the likelihood of a recession being triggered? Again, the most -- I guess, the most popular answer is most of you think it's moderately likely, which -- and a significant chunk of you. A 40% of you, however, think that the downside risks are substantially greater of a recession, with only 14% of your thinking that this is something that is less likely. So again, lots of flux. But hopefully, we've got a chance today to fill you in on our latest views on the various aspects affecting the industry. With that, in the interest of time, I will turn it back to you, Jeff, for running us through the Q&A.

Thank you, Devi. I appreciate that. I'm going to start with Stuart Plesser, on the most pertinent relevant news this morning. Stuart, can you explain our rationale and key factors for the action announced this morning on Morgan Stanley? Why did we upgrade Morgan Stanley, but take no action on the other big banks listed with positive outlooks? Could you talk a bit about that?

Sure, Jeff. So we had Morgan Stanley holdco ratings and one of its financing subs on positive outlook. This morning, we upgraded those entities to A- from BBB+. And so I guess the question is why did this bank's rating go up? And the others, as you mentioned, continue to stay on positive outlook? First point I'd make is unlike the other large banks, Morgan Stanley has completed a major business transformation and now relies on less risky fee businesses, such as its wealth management business and investment management. So we looked at this as a business transformation. The other banks are doing well that I mentioned that have a positive outlook, but did not have this kind of outsized business transformation going on. As well, we don't think Morgan Stanley is exposed to credit risk from a lending standpoint as much as the traditional banks. They have a much lower percent of their balance sheet comprised of loans. So if the recession flares up and it hurts credit, it would likely hurt Morgan Stanley much less than some of the other traditional banks. Given this new credit profile of Morgan Stanley, we believe it can perform as well as similarly rated peers where it moved up to in varied economic conditions, including the one we're laying out of higher rates, higher inflation and possibility of a recession. The outlook is stable on the holdco, and we are not considering raising the rating again if we were to move higher on the anchor. So I just want to make that point clear. The operating entity ratings did not change. And the reason for that is, going into the rating actions, they were unstable. They incorporated 2 notches of what we're calling additional loss absorbing capacity, ALAC, similar concept of TLAC, in those ratings. And all what we did is we moved that to a one-notch uplift instead of the 2 because of their new rating threshold. So they stayed at A+. No rating change for any of the operating entities. There is a research update that's published, if you'd like more detail. And of course, you can reach out to me and the team as well for those who want to discuss this further. Back to you, Jeff.

Thank you, Stuart. I appreciate that insight into that action. I'm going to go to Brendan Browne next. Brendan, I wanted to ask from one of our audience members. Any concerns regarding crypto exposure?

Regarding crypto exposure, to our knowledge, exposure is very limited for rated banks and probably banks in general. We have seen some banks looking for ways that they can offer services related to crypto or maybe to take very small exposures in different types of ways, like crypto-backed loans, but it's very minor to our knowledge at this point. It is something that we're watching closely, but not a major concern at this point.

Got it. Thank you, Brendan. Another question for you. You still see much risk from COVID-19 shutdowns or changes in behavior? When will we know if the excess liquidity in deposits are sticky or not?

Okay. A couple of different questions there. From the COVID-19 shutdowns or changes in behavior, I guess that would be most relevant for commercial real estate. Robert talked about this. Clearly, office and hotels are probably the 2 biggest asset classes that, that would relate to. Office in the office market, we do look closely at which banks have exposure there and the nature of those offices and geographies and other details on them. I would say that's something that still to a degree remains to be seen. There's still companies figuring out how much office space they need, how much of their workforce is going to be coming back and how many days a week, those sorts of things, leases have to build turnover. We do think there'll be some pain there. As Robert illustrated though, we think that's manageable overall for the banking sector, but there will be office loans that probably will need to go through workouts, and we'll have some pain. The hotel market, it very much depends on the type of hotel and locations. Some types of hotels are doing quite well and others that may be in central business districts and rely on business travel are still probably struggling. So you got to kind of really drill down to underlying data there. In terms of the excess liquidity and cheap deposits, Stuart talked a bit about liquidity in the system and the banks, or the Fed's plans for quantitative tightening, through that they will take some liquidity out of the system, but you'll also have loan growth creating new deposits, and that will pump a little bit of liquidity into the system. We do think that the loans-to-deposits ratio, which is at the moment about as good as it's ever been, will pick up over time. It's still quite a bit -- or it's materially below where it was pre-pandemic. So it probably take quite some time to get back up to the pre-pandemic level, which wasn't a bad level to start with. But over time, that will deteriorate from the very strong level it's at right now. And I'll turn it back to you, Jeff.

All right. Thank you, Brendan. Brendan, I'm going to stay with you for a moment. And actually -- no, I'm sorry, I'm going to switch to Robert. Robert, going off what Brendan said, thinking about those COVID-19 shutdowns, things of that nature, different areas office and such. Can you talk a little bit about the outlook for CRE, especially considering those factors that Brendan mentioned?

Sure, Jeff. Yes. I mean -- so I would say, in general, the outlook for CRE is pretty good as long as the property prices don't plunge and the economy doesn't deteriorate for a protracted length of time, neither of which we expect currently. Office CRE, I'd call it a long-term concern, construction to some extent, but neither is a big concern in the near term. Big office properties could see some challenges given the delays returning to work and the adoption of hybrid and work from home policies while suburban office looks fine. Keep in mind, the terms on the leases are typically pretty long, maybe 5 to 10 years, depending on the size of the tenant. So I think the trends will take years to play out. And also, I think that the impact will be more felt by the equity owners of the properties rather than the lenders or the debt holders given the equity cushion as we talked about, which could be at least 35% to 40% or higher on office and construction. Also banks underwrite by stressing the interest rates. So it's fairly common for perhaps maybe 2/3 of the loans on CRE to be fixed rate or fixed either through the rates or the swaps with maybe 1/3 of the debt floating. And rental growth may be able to offset some higher interest costs over time. Construction, still doing well from a credit perspective. Although the demand has weakened for some economically sensitive projects, single-family residential and multifamily still benefiting and strong sell-through and high occupancy. Also, office and construction exposures have declined for some banks, either as construction projects have been completed and rolled off and rolled into permanent loans. And pricing has also gotten better as banks adjust their prices relative to the higher perceived risk for those 2 categories. And then also office and construction tend to be relatively small for most banks, especially the large complex and the large regional banks. But certainly, there are some small and midsized regional banks, which may have much larger CRE concentrations or construction exposures. But we already considered those concentrations, either by loan type or geography in our assessments. Okay. Thanks. Hopefully that helps.

Thank you, Robert, and I'm going to stick with you for a moment, And ask if you can give kind of view on how the current elevated levels of inflation are expecting to impact the banking sector, taking into account the comments you just made in the activity of consumers and behavior?

Yes. I mean, I think Brendan commented on this to some extent, feel free to jump in after. But certainly, inflation could pressure borrower asset quality to some extent, particularly some of the lower income borrowers. But on the other hand, the inflation should benefit both rental rates, wage rates, property prices. So it's sort of a mixed impact to some extent from a banking perspective in terms of the inflation itself. So if there's not anything I'll ask, if Brendan wants to add anything?

Not too much beyond what, Robert, you just said as well as what we had in the prepared remarks. We talked about NIMs and net interest income and expecting a pretty material increase this year because of rising rates. Obviously, if higher rates tip the economy into recession, then you would have other earnings pressures that build, which might more than offset the improvement in net interest income. So obviously, that's one of the big questions out there and then what the polling question got to as well, that I think I'll leave it there, Jeff.

It's good, Brendan. You just kind of anticipated my question, which was on NIM, deploying NIM and potential for the impact on earnings going forward. So instead, we're going to switch and talk a little bit about the recent rise in risk-weighted assets and direct impact on CET1 ratios. Can you -- do you see this trend continuing? Can you talk a little bit about that?

Yes. And Stuart talked about capital. We saw the capital decline in the first quarter. I talked about loan growth. You had pretty good loan growth. You also had a lot of trading activities. So you have market RWA and banks paid out. And then lastly, you had, for the G-SIBs and Northern Trust, we have that slide. You have the impact of unrealized losses and available-for-sale securities. We're still expecting kind of mid-single-digit loan growth, which will add to RWA, but not at a kind of outsized rate, but you'll probably continue to have some RWA growth. The Fed is shrinking its balance sheet may go the other way and you might take some of the lower risk assets out of the system. But you probably going to have continued RWA growth. Then the question is how much the banks pay out? If they pay out a very high percentage, then obviously, you're going to have some more declines in capital. But there are limitations on that as well, especially for the larger banks following the stress testing. But all in all, you might have some modest further declines in capital, especially for the smaller banks. Back to you, Jeff.

Thank you, Brendan. I'll make that our last word. And with that, we'd like to thank you for joining us for today's webinar. As a reminder, today's webinar was recorded for replay and will be placed on our website, and it will be available there for 1 year from today. You'll also receive an e-mail later today with a link. So you may access it at your leisure, if not, the website spglobalratings.com/events. You can find the replay there. Thank you to my colleagues for a great discussion today. This concludes today's webinar. Remember, you feedback is important to us. So a survey is available at the bottom right side of your screen is going to pop up automatically once the session ends. So we appreciate you taking the time to join us and for filling out that survey and providing us with your feedback. Thank you all for the robust questions. On those we did not get to, we will follow up with you one-on-one and enjoy the rest of your day.