Banking Risks Are Slowly Receding In Much Of The World, But Watch Out For The Hot Spots

Primary Credit Analyst: Louise Lundberg, Stockholm (46) 8-440-5938; louise.lundberg@standardandpoors.com Secondary Credit Analysts: Richard Barnes, London (44) 20-7176-7227; richard.barnes@standardandpoors.com Qiang Liao, PhD, Beijing (86) 10-6569-2915; qiang.liao@standardandpoors.com Devi Aurora, New York (1) 212-438-3055; devi.aurora@standardandpoors.com Naoko Nemoto, Tokyo (81) 3-4550-8720; naoko.nemoto@standardandpoors.com Jose M Perez-Gorozpe, Mexico City (52) 55-5081-4442; jose.perez-gorozpe@standardandpoors.com

Table Of Contents
How S&P Tracks Trends In Economic And Industry Risk For Banks THE EUROZONE Subpar Economic Growth Isn't Likely To Lift Banks A Vulnerable Banking Sector Is Working Through An Extended Adjustment Period Some Banks May Face Liquidity Squeezes If Markets Turn Sour Governments Will At Some Point Ratchet Down Support For Banks CHINA Slower Economic Growth Is Taking A Toll We See A Credit And Debt Bubble A Default In The Growing Shadow Banking Sector Could Spread

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Table Of Contents (cont.)

A Regional Banking Crisis Isn't Out Of The Question THE U.S. The Economic Risks For Banks Are Receding The Move To New Monetary And Banking Conditions Could Be Bumpy The Regulatory Overhang Remains A Source Of Uncertainty JAPAN EMERGING MARKETS India Brazil Continued Vigilance Could Prevent Risks From Taking Root Again Related Criteria And Research

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Banking Risks Are Slowly Receding In Much Of The World, But Watch Out For The Hot Spots
The worst of the global financial crisis, which started with the bankruptcy of Lehman Brothers in 2008, seems to be over. Five years ago, Western governments and central banks had little alternative but to bail out failing banks and pump massive liquidity into the financial system. Now, regulators are aiming to reduce the risk of another financial crisis by pushing through stricter capital, leverage, funding and liquidity requirements as they oversee the banking sector's overhaul. In response, banks are busy reconfiguring their business models to the new financial world order. It is too early to tell whether stricter rules and regulations can prevent another crisis, but their intent is to reduce the likelihood and scale of government bailouts in the future. Overview In the eurozone, we think the recovery is likely to be sluggish and fragile, which will not help banks much as they try to shore up their balance sheets and reduce dependency on government support. Although growth is slowing and imbalances are growing in China, we believe the government should be able to contain problems with regulated banks, but may be less adept at handling big unexpected risks in the shadow banking sector. In the U.S., current debt ceiling-related uncertainty and sequestration are putting a drag on the economic rebound, which along with the Fed's eventual move to taper the stimulus, could complicate banks' search for profitability.

Although credit and liquidity risks generally have lessened and in most regions have somewhat stabilized compared to five years ago, we see several hot spots. In the West, Standard & Poor's Ratings Services currently sees a number of risks in the eurozone's banking system, despite the first signs of a cautious economic recovery. While risks are abating in the U.S., the Federal Reserve's signal to taper off quantitative easing and fears of rising interest rates could have global repercussions, especially for emerging markets like India and Brazil. Over in the East, China's economy is cooling, credit and asset price bubbles look primed to burst, and the shadow banking system is brewing strong credit growth.

How S&P Tracks Trends In Economic And Industry Risk For Banks
To identify and incorporate rising and receding risks for banks consistently and globally, we use our Banking Industry Country Risk Assessment (BICRA) methodology (part of our criteria for rating banks, revised in 2011). Our BICRA scores range from '1', which we consider as having the lowest-risk, to '10', the highest-risk (see chart 1).

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Banking Risks Are Slowly Receding In Much Of The World, But Watch Out For The Hot Spots

Our view of banking industry risk takes on shape if we zoom in on the world's 15 largest economies, and size them according to total banking-sector assets (see chart 2). This shows that the world's largest banking sector is China, followed by that of Japan and then the U.S. (which is third because it has more developed debt capital markets and a higher share of nonbank credit than China and Japan, where bank credit still dominates).

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Banking Risks Are Slowly Receding In Much Of The World, But Watch Out For The Hot Spots

Earlier this year, we began to assign "positive," "stable," and "negative" qualifiers to signal trends in our view of BICRA economic and industry risk, to better capture emerging risks (see "S&P To Publish Economic And Industry Risk Trends For Banks," March 12, 2013). Except for the U.S., we believe that the downside risks in the top 15 banking systems outweigh the upside potential, mainly because of weak economic conditions (see chart 3).

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Banking Risks Are Slowly Receding In Much Of The World, But Watch Out For The Hot Spots

THE EUROZONE
The economy seems to be stabilizing, but the recovery is likely to be sluggish and fragile as governments, households, and banks need to consolidate their balance sheets. Banks still face asset quality and earnings pressure as they try to continue strengthening their balance sheets. Funding gaps are narrowing but still present large refinancing risks, especially if markets turn sour. Several banks still depend on support from governments and central banks, and require further material restructuring to reduce this dependency.

Subpar Economic Growth Isn't Likely To Lift Banks

We are seeing the first signs of stabilization in economic conditions in the eurozone (European Economic and Monetary Union), where our BICRAs range from '2' to '7'. However, we forecast weak and fragile growth for several more years. In much of the region, governments, households, and banks need to continue to deleverage, which puts a cap on growth. Our economists forecast a 0.8% rise in real GDP in 2014 and 1.3% in 2015, which points to historically subpar growth in the region's major economies, with the exception of Germany. A less restrictive fiscal stance by some

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eurozone governments is the primary driver of growth so far, and the healthier economic drivers--exports, corporate investment, and consumer spending--are yet to kick in. The weak macroeconomic conditions explain our assignments of mostly negative trends for economic risk in the region.

A Vulnerable Banking Sector Is Working Through An Extended Adjustment Period

Without a strong impetus from the economy, the banking sector faces a long adjustment period during which financial institutions will remain vulnerable to renewed downside risks. European banks are juggling many tasks: improving their balance sheets and strengthening profitability, while keeping up with evolving regulatory requirements and pending structural reforms, and dealing with losses from legacy assets. The key risk we see remaining on European banks' balance sheets is the potential for further large impairment charges on nonperforming loans (NPLs) and other problem assets. There are huge variations in NPLs across Europe, partly for definitional reasons, which suggest that some banks are being slow to recognize impaired assets and book provisions to protect capital and profitability. For these reasons, many of our industry risk trends in the eurozone are negative. In addition, 35 of the 50 outlooks on the biggest European banks we rate are negative or the ratings are on CreditWatch with negative implications. In a bid to dispel concerns, the European Central Bank (ECB) is to undertake an asset quality review of eurozone banks' balance sheets. ECB officials have urged EU member states to specify in advance of the asset quality review how identified capital shortfalls will be addressed if the banks concerned are unable to raise new capital independently. It appears to us that national governments are likely to be called upon in these circumstances, and there might also be a role for the European Stability Mechanism.

Some Banks May Face Liquidity Squeezes If Markets Turn Sour

European banks generally have made progress in strengthening their funding and liquidity profiles, but in our view still face higher refinancing risks than banks in other regions. We believe they are more vulnerable to emerging funding and liquidity risks in case of a turn of events and any sudden change of market sentiment. Within Europe, we see wide disparities in banks' funding and liquidity metrics, depending on their country of domicile, business model, and risk appetite. For example, banks based in Germany display less risky funding, in our view, because of high levels of deposits to loans, and the country's broadly balanced or positive net external creditor positions (see "Despite Relatively Calmer Markets, Systemic And Specific Funding Risks For Banks Have Not Gone Away," published on July 18, 2013). Banking systems in countries with weaker funding profiles rely to varying degrees on their authorities' ability to prop up market confidence and provide liquidity, in case their access to domestic and foreign wholesale funding markets were to become disrupted. Countries on the periphery are already heavily reliant on ECB funding but have better access to wholesale markets today even though at higher costs.

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Banking Risks Are Slowly Receding In Much Of The World, But Watch Out For The Hot Spots

Governments Will At Some Point Ratchet Down Support For Banks

One sign of the vulnerability of banks in the eurozone is that many are still dependent on government and central bank support. The ECB has been instrumental in providing funding through Long-Term Refinancing Operations and in calming the sovereign credit markets. EU authorities are currently negotiating the terms of a recovery and resolution directive that would introduce consistent rules across the region, including bail-in powers. Although governments aim to strengthen banks' stand-alone creditworthiness and provide less implicit support in the future, we believe that the formation of effective and credible resolution regimes for banks that fail is still a work in progress. In the interim, we believe that governments with sufficient financial capacity will maintain support for senior creditors of systemically important banks to preserve financial stability.

CHINA
Growth is slowing, which is primarily investment-led, but we see a slight risk of a hard landing. The credit and asset price bubble is set to backfire on banks. A rapidly growing shadow banking sector presents risks that could spread to other parts of the economy. However, because China has a very strong fiscal position, our main scenario is that the government will manage the risks and contain the impact.

Slower Economic Growth Is Taking A Toll

The Chinese economy has started to undergo a huge and lengthy transformation to a consumption-led economy from one fed by investment. We are projecting 7.3% real GDP growth in 2013 and 2014 (with a 55%-65% probability), which is high but represents a big step-down from the previous decade. Our downside scenario puts real GDP growth at 6.8% for 2013 and 2014 (with a 20%-25% probability) and we assign a low, 5% probability to a "hard downside" scenario where growth would slow to 6.5% and 5.0% in 2013 and 2014 (see "Credit Conditions: Increased China Downside Risk Dampens Asia's Growth," July 30, 2013).

We See A Credit And Debt Bubble

Years of very rapid credit expansion on- and off-balance-sheet, along with a strong increase in housing prices, is set to backfire on banks' asset quality, profitability, and possibly liquidity, as the economy slows and uncertainty about the government's policies for banks increases (see "China Credit Spotlight: Diverging Credit Quality Could Result In Varying Degrees Of Resilience For The Top 50 Banks," Aug. 28, 2013). Private-sector credit in nominal or absolute terms rose an average annual 20% over the past five years (to 138% of GDP in 2013 from 104% in 2008) and we estimate that the inflation-adjusted nationwide housing price index rose a cumulative 40% over the same period. However, we believe many banks have disguised sizable corporate loan exposures as investments in off-balance-sheet wealth management products or other receivables, which flatter data about NPLs and asset quality. It is highly likely, in our view, that banks could incur substantially higher credit losses in the coming years. The megabanks and national

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banks appear to be better placed to withstand the downturn than many smaller players, but liquidity management even at some top banks is becoming increasingly strained. If a few national and regional banks that are heavily reliant on interbank financing suffer severe credit losses and potential depositor runs, we would expect wider negative repercussions for the banking sector as a whole.

A Default In The Growing Shadow Banking Sector Could Spread

We estimate the size of the shadow banking sector at 44% of GDP in 2012. Even though that size is smaller than in more advanced economies, it has been growing at a rapid pace of 34% a year since end-2010, according to our estimates. And while it may decline somewhat, we believe growth will remain strong for some time. Shadow banking includes pockets with very high risk such as loans and finance extended to highly leveraged corporates, construction companies, and real estate developers unable to obtain loans from the regulated banking sector. In general, we believe major Chinese banks' capitalization, earnings, and liquidity provide a comfortable buffer to absorb a hit from shadow banking and credit risks in the wider domestic economy. But we cannot rule out the possibility that the risks won't run out of control.

A Regional Banking Crisis Isn't Out Of The Question

Our base case is that China, because of tight central government control of the economy and a very strong fiscal position, will be able to manage risks and prevent a crisis in the banking sector. However, shadow banking--developed to fill funding gaps and circumvent the central bank's controls over lending and deposit rates--is weakening government influence over credit conditions. Our views about banking industry risks in China, whose BICRA is '5', already incorporate a high degree of risk and volatility, which explains why we assess the forward-looking economic and industry risk trends as stable.

THE U.S.
Although economic risks are declining, and should as long as the impasses over the continuing resolution and the debt ceiling are resolved in a timely manner, a bigger bite from sequestration is impeding the force of the recovery. The Fed's tapering might affect financial and credit risks, and banks might increase their risk appetite as both move out of crisis mode to the new normal. The regulatory overhang is creating uncertainty in the key areas of the capital markets, especially regarding the Volcker rule.

The Economic Risks For Banks Are Receding

We believe the recovery is clearly underway and the banking sector has already absorbed most of the costs from the 2008 crisis. Because of this, we believe that the economic risks facing banks are receding, and view the economic risk trend for the U.S. as positive. However, the U.S. economy is still exposed to domestic and global risks, such as developments in the eurozone and the slowing Chinese economy. The bite from sequestration has started to take a

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considerable toll and the current impasse over the continuing resolution and the debt ceiling creates an atmosphere of uncertainty that could affect confidence, investment, and hiring in the U.S. (see "Credit FAQ: The Debt Ceiling Debate Is Unlikely To Change The 'AA+' U.S. Sovereign Rating," Sept. 30, 2013). Because of the larger fiscal drag, we now expect 2013 GDP growth to come in at 1.7% versus the 2.0% we forecast in July. We put the risk of another recession at 10%-15% (see "U.S. Economic Forecast: Legends Of The Fall," Sept. 13, 2013). Our rating outlooks on the non-operating holding companies of U.S. banks that we consider highly systemically important are negative, mainly because of the evolving resolution regime. Some others reflect the potential of yet-to-be finalized regulations like the Volcker rule. For most other banks, despite the overall improvement in credit quality, capital, and liquidity, most of the ratings carry stable outlooks as a reflection of the ongoing transition into a still not fully defined new normal.

The Move To New Monetary And Banking Conditions Could Be Bumpy

While the economic recovery is likely to provide a supportive backdrop, banks are still struggling to boost revenues and operating margins. We think there is a risk, though limited, that the Fed's now-delayed tapering could still provoke a spike in long-term interest rates later this year, which could further dampen profitability if banks take losses on their securities portfolios. Improved credit quality is helping bolster bottom lines, but near-zero interest rates and weak loan growth are holding back revenue growth. In search of profitability, banks' appetite for risk may grow, a behavior we typically see in an upturn, and we already observe signs of less stringent lending practices and underwriting standards for commercial real estate and leveraged loans. However, major players have revamped risk management, and are building up capital for riskier activities--or are shedding these operations. In addition, the amount of capital at the biggest U.S. banks has almost doubled since 2008, and the system is much less dependent on short-term funding. This is mainly why we consider that the industry risk trend for U.S. banks is stable in a country that we place in BICRA group '3'.

The Regulatory Overhang Remains A Source Of Uncertainty

With the Dodd-Frank Act of 2010, Congress enacted the biggest overhaul to financial regulation since the 1930s, which we believe is an improved framework for identifying and mitigating systemic risk in the U.S. financial system. Many major rules have been passed, but much work is yet to be done for full implementation, which engenders regulatory uncertainty. Moreover, a number of important regulatory initiatives are not yet final, including the Volcker rule, orderly liquidation, over-the-counter (OTC) derivatives reform, and money market fund reform. We expect clarity on some of these initiatives later this year. Overall, we believe regulatory risk is on the decline, and that risks for the banks will turn to the more familiar financial ones, those that relate to credit and interest risk, for instance.

JAPAN
Unless structural reforms succeed, we think Abenomics is unlikely to heal the economy or banks in the longer run.

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Abenomics holds the promise of lifting the economy out of 15 years of deflation. But without structural reform, we believe the improvements won't stick. So far, things are looking cautiously positive for Japan. The first two of the three parts of the reform package launched in April are on target. After the announcement of the Bank of Japan's more aggressive policy, the yen's depreciation and a stock rally sparked improved corporate earnings and increased consumption. Higher exports and public investment helped lift GDP to an annualized 3.8% in the second quarter and the CPI index excluding fresh food rose to 0.7% in August 2013 versus -0.4% in April. However, it remains to be seen whether Japan has permanently left deflation behind. The government won't be able to put the economy on a lasting path to growth unless it can institute structural reforms to soften the rigid labor market and consolidate the government budget. This, in our view, is one of the biggest concerns for banks. A healthier economy would certainly be more conducive for banks, but they are now passing through an uncomfortable transition where loan margins are even more compressed as a consequence of the Bank of Japan's increase in quantitative easing (see "Even If Abenomics Succeeds, Japanese Banks Will Need More To Prop Up Their Revenues; Overseas Expansion Is Likely To Continue," July 24, 2013). In addition, a meaningful rise in long-term interest rates--which rose from April through June but have since slightly leveled off--combined with an increase in holdings of government bonds, could pose a threat to the asset quality of Japanese banks. To counteract the impact of interest rate risk, we believe banks would need to enhance risk management, improve capital, profitability, as well as diversify their balance sheet. This may be more difficult for some regional banks that are facing a shrinking business and declining core earnings (see "What Is The Japanese Banking Systems Tolerance For Rising Interest Rates?" July 8, 2013). Our stable economic and industry risk trends for Japanese banks reflect the good possibility, in our view, that the authorities' measures will be supportive for banks over the short- to medium-term. The half of the 28 rated banks that have negative rating outlooks mostly reflects the negative sovereign outlook.

EMERGING MARKETS
The Fed's announced tapering has led to an outflow of investment from several emerging markets like India, Indonesia, Brazil, and South Africa, rapidly weakening their currencies.

India
Banks face a triple threat from the weak economy, rising interest rates, and a falling rupee. We view the weak economy, rising interest rates, and a falling rupee as a triple threat to banks over the next two years. We believe that deteriorating asset quality and earnings will constrain the credit profiles of Indian banks as adverse economic developments hurt the corporate sector--the chief recipient of banking credit. We expect an increase in NPLs, which exclude restructured loans that are set to remain high (see "Slack Economic Growth Dents Recovery Prospects For Indian Banks," Aug. 7, 2013). For these reasons, we place India in BICRA group '5' and view the economic risk trend as negative. All outlooks are negative on rated Indian banks, reflecting the negative sovereign outlook.

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Brazil
Sluggish domestic growth, rising interest rates, and a depreciating currency could further constrain asset quality and profitability. Increasing interest rates and currency depreciation have added to Brazil's domestic economic troubles. The economy is slowing, and credit growth and real estate prices have jumped in the past few years, pointing to rising economic risks. For these reasons, our view of the economic risk trend in Brazil, which is in BICRA group '4', is negative. So far, the impact on banks' asset quality has been limited thanks to improving underwriting standards, a strong labor market, and until recently, decreasing interest rates. Because of Brazilian banks' modest exposure to foreign currency lending, limited dependence on foreign funding, and adequate liquidity, we believe that the direct effect of the Fed's tapering will be manageable. However, a renewed rise in interest rates and currency depreciation, and the subsequent impact on the corporate sector and households, could further constrain asset quality and profitability. The outlooks on the largest banks that we rate in the country are negative, reflecting the outlook on the sovereign.

Continued Vigilance Could Prevent Risks From Taking Root Again

While banking risks have receded since 2008, we see several remaining and new hot spots around the world. In the eurozone, the risk is that the markets could erupt again and the economy could slide into another recession before the EU and its member governments stabilize the financial system. China is trying to find the "sweet spot" in the trade-off between financial stability and growth, which requires the right government policy responses to economic or banking system strains. In the U.S., we see risks around debt ceiling-related uncertainty and in the move to a post-crisis "new normal" monetary policy. The nascent economic recovery may help in the difficult process of slowly unwinding large global imbalances, which now carry their own risks. These imbalances resulted from the loose monetary policies meant to avoid the ill effects of the credit crunch, which the financial crisis caused. We believe that perhaps one of the biggest risks to the global banking system is that authorities become complacent about regulatory reform as the memory of the worst of the global financial crisis fades. Five years on, the global financial system may be safer, but not safe enough. Writer: Rose Marie Burke.

Related Criteria And Research

Despite Relatively Calmer Markets, Systemic And Specific Funding Risks For Banks Have Not Gone Away, July 18, 2013 Global Banking And Credit Trends: The Weight Of Frail Economies And Regulatory Reform, June 17, 2013 S&P To Publish Economic And Industry Risk Trends For Banks, March 12, 2013 Banks: Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

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Eurozone
Economic Research: Europe Is Moving From Subzero To Subpar Growth, Sept. 18, 2013 Credit Conditions: Europe Lacks A Vision For Growth As Traction From Other Regions Diminishes, July 29, 2013 The Curse Of The Three Ds: Triple Deleveraging Drags Europe Deeper Into Recession, July 30, 2012 The Five Key Risks For European Banks, April 11, 2012

China
Slower Growth In China: Inevitable, Necessary, And Now More Palatable, Sept. 25, 2013 Credit Conditions 3Q 2013: Asian Corporates Face A Rough Ride Going Into 2014, Sept. 18, 2013 China Credit Spotlight: Diverging Credit Quality Could Result In Varying Degrees Of Resilience For The Top 50 Banks, Aug. 28, 2013 Credit Conditions: Increased China Downside Risk Dampens Asia's Growth, July 30, 2013 Fast Growth Of Shadow Banking May Hasten China's Monetary Reform, July 19, 2013

U.S.
Credit FAQ: The Debt Ceiling Debate Is Unlikely To Change The 'AA+' U.S. Sovereign Rating, Sept. 30, 2013. Q&A: Five Years After The Financial Crisis, Some Things Have Changed For U.S. Banks, But Others Still Have Not, Sept. 17, 2013 Economic Research: U.S. Economic Forecast: Legends Of The Fall, Sept. 13, 2013

Japan
Even If Abenomics Succeeds, Japanese Banks Will Need More To Prop Up Their Revenues; Overseas Expansion Is Likely To Continue, July 24, 2013 What Is The Japanese Banking Systems Tolerance For Rising Interest Rates? July 8, 2013 Economic Research: All You Need To Know About "Abenomics" June 12, 2013 Japanese Banks Could Boost Revenues If BOJ Stimulus And Abenomics Put Economy Back On Sustainable Track, May 2, 2013

Emerging markets
Banking Industry Country Risk Assessment: Brazil, Aug. 15, 2013 Credit Conditions: Subdued Growth Is Increasing Downside Risks For Latin America, Aug. 9, 2013 Sector Review: Slack Economic Growth Dents Recovery Prospects For Indian Banks, Aug. 7, 2013 Slack Economic Growth Dents Recovery Prospects For Indian Banks, Aug. 7, 2013

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