May 2019 – Issue 4

Credit Journal Global Banking Private Placement

1 2 3 Regulation Non- Financial Institutions

PAGE 2 PAGE 8 PAGE 11

4 5 6 Meet the Analyst Global Focus News & Events Q&A with Kevin Duignan, Global Head of Financial Institutions Ratings

PAGE 14 PAGE 16 PAGE 20 Welcome to Journal – a curated compilation of Fitch Ratings’ in-depth research and commentary. This latest edition takes a deep dive into banks and non-bank financial institutions (NBFIs). With coverage of close to 3,000 banks, securities firms, and leasing companies, infrastructure companies, business development companies (BDCs), and investment managers, we are a leading force in bank and NBFI ratings.

We hope this issue, as well as future ones, serve as reliable resources and help you make more informed investment decisions. We welcome comments for future issues, including suggestions for topical or credit-specific research.

For our latest insights, please visit fitchratings.com Welcome

In this new edition of Fitch Ratings’ Credit Journal, I am pleased to share with you a snapshot of Fitch’s credit views in the Bank and Non-Bank Financial Institution (NBFI) sectors.

With heightened challenges of growth, stability, and risk at the end of the credit cycle, creditworthiness considerations are a main focus for 2019, providing significant opportunity for us to convey value-added opinions and publish insightful bank and NBFI research.

Covering close to 3,000 banks and NBFIs worldwide, we are proud to be a leading force in financial institutions ratings, widely accepted by issuers, investors, and other debt capital markets participants. In 2018, we rated approximately $900 billion in bank and NBFI debt issuance globally and further developed our extensive relationships with global Financial Institution investors through ongoing collaboration.

Fitch has established itself as a leading voice in regulatory research, with consistent updates on the credit implications of supervisory initiatives, macro-prudential policies, conduct issues, and resolution outcomes, among other topics, some of which are included in this issue.

The recent introduction of ESG (Environmental, Social and Governance) Relevance Scores transparently and consistently displays the relevance of ESG elements to the credit rating decision. Although ESG risks tend to have limited direct impact on bank ratings, nearly 20% of global financial institutions ratings are currently influenced by governance risk. As a result, this key initiative adds another dimension to Fitch’s offerings that will provide more comprehensive and robust commentary.

We very much welcome any feedback that you may have on our bank and NBFI ratings and research offerings. If you have any suggestions on research topics that you would like us to cover, please do not hesitate to reach out to us, as we are always eager to address topics that are of interest to our readers.

Happy reading!

Erwin van Lümich, CFA, Head of Banks Business & Relationship Management

Sector Research Sector Research Banks Regulation Non-Bank Financial Institutions Sector Research

Banks leveraged market participants. Negative rating Banks actions could be further exacerbated if the banks did Leveraged Lending: Where is the Risk in not adjust capital management practices to reflect weakening market conditions. the U.S. Banking System? Online Bank Deposit Betas Trend Up as U.S. banks are exposed to leveraged Regulation Competition Intensifies lending risk in four ways: as underwriters and distributors through the syndication Deposit betas for the largest U.S. online banks have steadily increased following a series of Federal Reserve process; as holders of these on interest rate hikes in 2017 and 2018. Deposit betas Non-Bank Financial Institutions balance sheets; as providers of financing for traditional banks, while rising, continue to lag their to nonbank leveraged loan market online-only competitors. Traditional banks have had slower loan growth than online banks and already participants active in this space; and as have a high proportion of their funding coming investors in CLOs. from deposits.

Leveraged loan risks to the U.S. banking system are We estimate that cumulative deposit betas for online manageable in the near term. Negative rating actions banks ranged from 43%-61% from the point of the for banks would become more likely in the event of Fed’s first rate hike in December 2015 through Q3 a significant market disruption for institutions, with 2018, with a median beta of 50%. Synchrony came large on-balance sheet leveraged loan portfolios and in at the low end of the range, while Sallie Mae was considerable outstanding credit lines to nonbank at the high end. Still, cumulative betas remain within expectations relative to assigned ratings. Consolidation to Continue for U.S. Regional Banks

M&A activity in the U.S. banking sector could remain strong over the next 12-24 months for most banks. Although the majority of consolidation has been in the community bank and midsize bank space over the past decade, average deal sizes have risen almost every year since 2010. Recent sizable transactions indicate that M&A could be on the table for larger regional banks as well.

The announced merger of equals involving BB&T Corp. and SunTrust Banks, Inc. could serve as a template for further consolidation among regional banks looking to compete directly with the largest national banks. However, the financial and strategic benefits associated with the deal are compelling and could prove difficult to replicate.

Fitch Ratings | Global Banking – 3 Sector Research

Southern European Banks’ Funding Will Asset Quality Review Benefit From TLTRO-III

Credit Stabilizes for U.S. Credit Card Issuers The ECB’s new targeted longer-term refinancing operations (TLTRO-III) will reduce refinancing risks Increases in net charge-offs (NCOs) and early stage and costs for Italian banks at a time when their access delinquencies continued to moderate for U.S. to wholesale markets is challenging, and will provide credit card issuers in 3Q18, but the respite in credit funding flexibility to Spanish banks. The Italian and performance was partially driven by temporary factors. Spanish banking sectors are the two largest takers of Net charge-offs for general purpose and retail card ECB funds in Europe. issuers increased 13bps and 10 bps on average, respectively, year over year. The new series of two-year facilities also aims to encourage lending as it is designed as a still relatively U.S. Auto Loan Credit Improves cheap source of funding for banks. In Italy, however, The credit performance of U.S. auto loans strengthened the cheap funding is likely to contribute to continued in 2018 with net charge-offs for the largest auto lenders weak loan pricing and depressed net interest income. declining year-over-year in 4Q18. Delinquency trends TLTRO-III could also affect loan pricing in other markets, were more mixed among auto lenders in 4Q18 but if take-up is significant. In other western European also declined on a year-over-year basis. We believe the markets, we expect TLTRO-III take-up to be mostly favorable credit performance in 2018 largely reflected opportunistic, except in Greece and Cyprus, where a stronger U.S. economic backdrop, but we expect there is a more structural need given the high cost of weaker trends to emerge this year. . Anti-Money Laundering Scrutiny Catching Up with Nordic Banks

Nordic banks’ cross-border operations in the Baltic region are under increasing scrutiny as EU authorities enforce stronger anti-money laundering (AML) regimes. The EU crackdown on money laundering should ultimately be positive for the European banking sector as it addresses past shortcomings and reduces litigation risk.

Investigations that reveal money laundering or governance failures may, however, cause reputational damage for the banks directly affected and faltering investor confidence could spread to other banks, particularly in banking systems with a high degree of wholesale funding, concentration, and interconnectedness. Banks would typically be subject to negative rating action if fines, business restrictions, and remediation actions more permanently weighed on capitalization, franchise and funding profiles. Findings

Fitch Ratings | Global Banking – 4 Sector Research

that reveal broad-based weaknesses or failings in risk including the Royal Commission, that identified management or governance could also lead to negative shortcomings in conduct, governance, and compliance, rating actions. and will all be engaged in remediation that could distract management from day-to-day business. These Turkish Banks Have Notable Cushion challenges come amid other near-term pressures Against Weaker Asset Quality on earnings from a generally tougher operating environment. The Turkish banking sector’s profitability and capital buffers still provide a significant cushion against a The four major banks–Australia and New Zealand potential marked deterioration in asset quality, driven Banking Group, Commonwealth Bank of Australia, by the weaker operating environment. We stressed National Australia Bank, and Westpac–have large market the sector’s capital ratios over two years for a sharp shares across most products in Australia and New rise in non-performing loans (NPLs), a weakening in Zealand, which support strong earnings and balance profitability and Turkish lira depreciation. These factors sheets, and help moderate risk appetite compared with constitute the key risks to solvency, in our view. many international peers. However, it may be difficult for the banks to exercise these advantages fully in Our analysis shows that loss-absorption buffers remain an environment of increased public and regulatory solid, despite moderate erosion mainly due to the scrutiny, as well as pressure to increase their focus on weaker lira. In only two of the six scenarios do sector customers rather than shareholders. capital ratios fall below required minimum levels. Capital ratios remain above these levels in the other scenarios, Indian Banks Benefit from Lower but NPLs significantly above 10% would pressure Slippages but Challenges Remain solvency, and potentially ratings, depending on specific banks’ resilience. The Indian banking sector’s non-performing loan (NPL) ratio improved in the first nine months of the Conduct and Compliance Issues Weigh on financial year to March 2019 but slow NPL resolution Australian Banks and weak capital are likely to keep the banks’ overall pace of recovery tepid. Lower fresh slippages and better Australia’s major banks will continue to face heightened recoveries were instrumental in lowering the Indian regulatory scrutiny following recent public inquiries,

Fitch Ratings | Global Banking – 4 Fitch Ratings | Global Banking – 5 Sector Research

banking sector’s gross NPL ratio to 10.8% during the global economy. This is balanced, however, by same period from 11.5% at March 2018. their leading domestic franchises, sound domestic asset quality on the back of a stable economy Indian banks, however, continue to face challenges on with forecasted GDP growth of 1.9% in 2019, low multiple fronts. The banking sector’s weak earnings, in unemployment, and satisfactory corporate profitability. particular state-owned banks, and thin capital buffers, Fitch sees the banks as making progress in arresting remain at risk from aging provisions, which stem from the downward trend of net interest margins on the slow resolution of the sector’s USD150 billion domestic and overseas loans. NPL stock. Overall credit costs, despite a decline in percentage terms from previous years, remained high The mega banks’ search for loan growth overseas will compared with most state banks’ weak pre-provision raise their overall risk profiles in 2019, while vulnerability profits. As a result, several state banks reported losses to credit and market risk could rise in line with seeking while the common equity Tier 1 for nearly half of the higher returns on foreign securities investments. 21 state banks was below the minimum 8% required by We believe the banks will continue to balance risk- fiscal 2020. taking and capital retention, but rapid expansion without corresponding buffers would have negative Japan’s Mega Banks in Search for Profit; implications for the ratings Shift to Higher Risk Continues in 2019 Slow Profit Growth at China Banks to Japan’s “mega banks” are expected to face challenges Pressure Capitalization from low domestic interest rates, rising foreign- currency funding costs, competition and an uncertain Latest financial results from Chinese banks show that their net profits continued to be weighed down by the challenging operating environment, despite regulatory efforts to support their profitability. Net profit growth should be in the single digits in the medium term, and this slow profit growth is likely to put Chinese banks’ capitalization under pressure as growth in their risk- weighted-assets continues to outpace that of net profit and assets.

We have a negative sector outlook on Chinese banks, reflecting banks’ struggles to meet regulatory requirements while sustaining adequate loan expansion to support economic growth. Banks’ profit growth in 2018 was also dragged down by higher impairment charges, due to increased efforts to resolve NPLs subsequent to tightened NPL recognition against overdue loans and also partly due to IFRS 9 adoption.

Fitch Ratings | Global Banking – 6 Sector Research

Most Deals Involving Small Community Banks

($ Mil.) Assets $100 Mil.–$1 Bil. (RHS) Assets > $1 Bil. (RHS) Assets < $100 Mil. (RHS) Assets per Bank (LHS) 4 12,000 10,000 3 8,000 2 6,000 4,000 1 2,000 0 0 2000 2005 2010 2015 2016 2017 3Q18

Source: Fitch Ratings, FDIC.

Indian Banks’ Gross NPL Ratio

(%) 9MFY19 FY18 FY17 32 24 16 8

0

SBI BOI IOB Axis IDBI PNB BOB ICICI UCO Union Kotak Indian HDFC Central Andhra Canara Federal Syndicate Allahabad

Public banks (large) Public banks (medium) Private banks

Source: Banks, Fitch; banks in each sub-category arranged in descending order of 9MFY19 gross NPL ratio. 9MFY= Nine-month fiscal year.

Fitch Ratings | Global Banking – 6 Fitch Ratings | Global Banking – 7 Sector Research

financial crime. We have researched comprehensively Regulation into anti-money laundering and sanction evasion, thus For banks, it is regulatory action which highlighting the implications for banks’ credit ratings. tends to lead to default-like situations, –Monsur Hussein, Head of Bank Regulatory Research unlike other credit sectors. Our research Global Bank Regulatory Outlook: Tighter cuts through the complexity, by providing Supervision, Focus on Pillar 2 and primers on regulatory topics and regional Macroprudential Policies, Conduct Risks compendium guides that highlight With no new significant regulation expected in jurisdictional differences and key trends. 2019, there’s a stable outlook for the global bank regulatory environment. Authorities within key banking Significant post-crisis reforms to reduce bank failure jurisdictions will focus on implementing in-flight risk mean that sovereign support cannot be relied regulations and strong supervision. In developing on for North American and Western European banks. markets, financial stability topics may be prioritized over Alongside thorough analysis of banks’ financial credit regulatory reforms, due to spill-over effects from U.S. metrics, insights into the regulatory playbook and the policy rates and U.S. dollar foreign-exchange liquidity applicable legal tools are key. Our research reports concerns. and commentary on bank resolution, including bail-in regime updates, enable market participants to keep up-to-date with changes in the regulatory and political What to Watch environment, and to gauge the risk of bail-in on senior • Regulatory guidelines and supervisory practice debt instruments. changes more likely than new rules The focus on capital rules that characterized the • U.S. regulatory roll-back that loosens standards for early years after the financial crisis has shifted toward larger banks would be credit negative, but U.S. G-SIBs supervision and conduct, and increasingly toward have been excluded from much of the proposed relief for midsize banks Outlook Summary

Global NA LATAM WE CEE MEA APAC

Capital Numerator Stable Looser Tighter Stable Stable Stable Stable

Capital Denominator Stable Looser Stable Looser Stable Stable Tighter

Leverage Ratio Looser Looser Stable Looser Stable Stable Stable

Macroprudential Stable Stable Stable Stable Stable Stable Tighter

Liquidity Stable Looser Tighter Looser Stable Stable Stable

Supervision Tighter Looser Tighter Tighter Tighter Tighter Tighter

Resolution Stable Stable Stable Stable Stable Tighter Tighter

Source: Fitch Ratings

Fitch Ratings | Global Banking – 8 Sector Research

• Supervisory tweaks to increase model RWAs, e.g., input parameter floors, particularly for real estate and high-risk exposures-more likely in APAC and EU than elsewhere • An IFRS 9 Stage 2 significant increase in credit risk definitions that diverge from bank to bank, and incorporation of restructured loans into Stage 3, which may vary loan provisions • Scrutiny of regulatory arbitrage and “optimization” may lead to sudden ratio changes • Financial and non-financial penalties and remedial actions linked to conduct issues, e.g. anti-money laundering or sanctions evasions can take time to materialize

ECJ Opens Door to Deposit Guarantee Schemes for Failing Banks

The European Court of Justice’s (ECJ) ruling that support from a private-sector deposit guarantee scheme did not constitute illegal state aid will make it easier to use these schemes to restructure failing banks. We believe that private deposit guarantee schemes could be an attractive way to deal with small failing banks. This is particularly the case as banks with total assets below EUR100 billion will not be subject to mandatory subordination requirements under EU Minimum Requirements for own funds and Eligible Liabilities rules. The ruling also served as a reminder that EU State Aid rules only apply where a public authority intervenes, Global NA LATAM WE CEE MEA APAC or where it can be shown that the private body is under Capital Numerator Stable Looser Tighter Stable Stable Stable Stable the influence or control of the public authorities.

Capital Denominator Stable Looser Stable Looser Stable Stable Tighter IBOR Transition Gains Momentum, but Key Risks Not Yet Addressed Leverage Ratio Looser Looser Stable Looser Stable Stable Stable Substantial progress in recent months will better Macroprudential Stable Stable Stable Stable Stable Stable Tighter prepare financial markets for the discontinuation of Liquidity Stable Looser Tighter Looser Stable Stable Stable IBOR indices, but transition risks remain. Our ratings address the payment of interest (and principal) in Supervision Tighter Looser Tighter Tighter Tighter Tighter Tighter accordance with the underlying terms of an obligation and would not be directly affected by transition from Resolution Stable Stable Stable Stable Stable Tighter Tighter one reference rate to another or any accompanying

Fitch Ratings | Global Banking – 8 Fitch Ratings | Global Banking – 9 Sector Research

spread adjustment. However, elements of IBOR Basel Committee on Banking Supervision. The step- transition could, if not appropriately addressed and up is mainly due to a requirement for some EU banks managed, become rating relevant through operational to reflect their history of operational risk losses as an costs, valuation, hedging, legal risks, and increased add-on when calculating how much capital to hold basis risk. for potential future losses. The impact is significant because several banks’ recent history includes large Whether these risks crystallize will depend on further fines for misselling and other regulatory breaches. progress addressing these issues on a sector, issuer and transaction basis. We believe the financial institutions CECL Implementation Expected to and securitization sectors are most exposed to be Ratings Neutral to U.S. Financial transition challenges. Institutions

Operational Risk Capital May Rise for EU The pending implementation of the U.S. accounting Banks but Fall in the U.S. standard for current expected credit loss (CECL) reserves by the Financial Accounting Standards Board EU banks may need to hold significantly more capital is not expected to result in ratings actions on adoption. for operational risk under the final version of Basel That said, CECL is expected to be more impactful for III reforms than under current requirements, while banks than NBFIs as banks will need to meet regulatory U.S. banks may see a reduction in requirements. This capital ratios post-CECL implementation, whereas NBFIs would bring operational risk-weighted assets (RWA) as are not bound by similar regulatory constraints. a proportion of total RWAs more into line between EU and U.S. banks. Currently, the average ratio for large EU CECL implementation is viewed as broadly credit banks is less than 15%, compared with about 30% for neutral, as the fundamental creditworthiness of large U.S. banks. financial institutions and the underlying loans remain unchanged following adoption, with no effect on the For large EU banks, capital requirements for operational timing or realization of cash flows. However, the longer- risk would, on average, be about 35% higher than at term rating effects are unclear and will depend on how present, adding 4.7% to their overall Tier 1 minimum financial institutions respond to, and operate under, the required capital, according to recent analysis from the requirements of the new standard.

Fitch Ratings | Global Banking – 10 Sector Research

In effect, these NBFIs are seeking to become like the Non-Bank Financial very banks they sought to disrupt. Time will tell how meaningful of a competitive threat this may pose Institutions (NBFIs) to traditional banks, although new entrants face Fitch Ratings believes that NBFIs of steep regulatory compliance hurdles, not to mention incumbent players with far greater scale, diversity, and various types are increasingly relevant financial resources. in the context of bank credit analysis, –Nathan Flanders, Global Head of Non-Bank Financial both in terms of the competitive threats Institutions they may pose, as well as the direct and indirect risks they may introduce. Private Equity Appetite for Aircraft Lessors Takes Off The rapid growth of NBFIs post-crisis has been fueled by increased , low interest rates, a Alternative investment managers have become benign economic backdrop, and expanding financial increasingly active investors in the aircraft leasing technology. Alternative investment managers, aircraft industry as they seek to deploy capital into a growing lessors, and business development companies are sector that could provide attractive investment returns. three notable examples of NBFI sub-sectors that have However, the typically fixed-life nature of private equity benefited from these dynamics, although still with ownership can increase -term strategic and a meaningful reliance on bank lending to finance financial uncertainty for owned aircraft lessors, while their activities. Central clearinghouses are another the business’s cyclicality and sensitivity to exogenous beneficiary of post-crisis regulation, albeit resulting shocks exposes sponsors to heightened execution risk in banks having more concentrated counterparty surrounding investment realization. exposure. These types of lending and counterparty dynamics suggest that future credit pressures at NBFIs could potentially find their way back to banks’ balance sheets.

Regulators are increasingly turning their attention to NBFIs, noting rapid growth, more aggressive underwriting, and limited transparency. Furthermore, while individual NBFIs are typically not large enough to be systemically important, their collective behavior could have systemic impacts, such as if multiple entities with material asset/liability mismatches were forced to sell assets simultaneously.

In a somewhat ironic twist, certain NBFIs have obtained (or are pursuing) bank licenses as a means to access lower-cost deposit funding, while seeking to capitalize on and the absence of legacy branches/infrastructure to drive greater efficiency.

Fitch Ratings | Global Banking – 10 Fitch Ratings | Global Banking – 11 Sector Research

Investing in aircraft leasing is not a new concept for profiles. Managers selling stakes can demand higher alternative investment managers and, in fact, many valuations and more flexible structures, resulting in of the largest aircraft lessors today were once owned higher investment risk for investors in a market facing by private-equity sponsors. AerCap, now the second- the potential for normalized returns. largest aircraft lessor by managed fleet count, was purchased by Cerberus in 2005 and subsequently went Higher Business Development Company public in 2006, while Avolon, the third-largest lessor, (BDC) Leverage Increases Focus on was owned and formed by a consortium of sponsors in Senior Loans, Funding 2010 before going public in 2014. Leverage has slowly increased for BDCs following Competition for Alternative Investment passage of The Small Business Credit Availability Act, Manager Minority Stake Sales on the Rise which, directionally, we view as a credit negative. However, ratings have been largely stable for the sector The growth of the market for buying and selling as BDCs utilizing higher debt capacity have opted to minority stakes in alternative investment managers improve portfolio risk composition by moving into has continued to accelerate, and has become more first-lien positions. increasingly competitive. These tie-ups can benefit the general partners selling the equity stakes and the Industry-average leverage has slowly increased as BDC investment managers or funds buying them. Buyers boards and/or shareholders have approved reductions are increasingly attracted to the recurring fee income in asset coverage requirements, which effectively allow these platforms can generate, while sellers can use firms to double leverage to 2.0x from 1.0x. Average the minority sale proceeds to raise capital to seed new leverage was 0.83x at year-end 2018, up from 0.73x a and existing strategies and boost liquidity through the year ago. Leverage is expected to increase further in monetization of ownership and investments. However, 2019 as BDCs with board approval had a 12-month general partners’ stakes can also introduce risks due to waiting period before the incremental debt capacity the relative illiquidity of the investments. can be used. Several firms will see their waiting periods expire by June of 2019. Increasing appetite for the asset class has led to elevated deal pricing, which could alter the risk/return

Fitch Ratings | Global Banking – 12 Sector Research

Potential Non-Bank Move to Bank Status Could Be Credit Positive

The potential move by NBFIs to get a banking license would be more credit positive than negative. Bank status brings several credit benefits, including the ability to diversify funding by offering deposit accounts, access to central bank funding in a severe liquidity shortage, and a stronger governance framework associated with extra regulatory oversight. However, it also brings extra compliance costs and constraints on operational flexibility that typically necessitate greater scale.

NBFIs are becoming more interested in obtaining a banking license to offer retail bank deposit accounts, as the rise in online banking makes it easier to attract customers across a greater geographical area. Retail deposits would diversify NBFIs’ funding and are typically cheaper and more stable than the wholesale funding they currently rely on. China’s Shadow Banking Sector to Shrink Further in 2019

China’s shadow banking sector is likely to decline for a second consecutive year in 2019, albeit more gradually than in 2018, as Chinese regulatory authorities balance reining in excessive leverage and supporting economic growth. The regulatory crackdown on shadow banking should, if maintained, support the long-term stability of the financial system and reduce risks for asset managers, but is likely to continue to create funding challenges across the economy in the near term, particularly for private-sector enterprises.

China’s shadow banking assets are estimated to have shrunk to just below 60% of nominal GDP in 2018 from a peak of around 70% in 2017, and we expect a further drop to around 50% of GDP this year. Leverage outside banks is rising at a noticeably slower pace, and contagion risks between banks and NBFIs are also falling with the drop in shadow banking activity, although they still remain relatively high.

Fitch Ratings | Global Banking – 12 Fitch Ratings | Global Banking – 13 Meet the Analyst

One asset class in particular, leveraged loans, is Q&A with Kevin Duignan, drawing a lot of scrutiny from us as well as investors and regulators. Our analysis so far indicates that major Global Head of Financial banks’ direct exposure to leveraged loans and related CLOs appears manageable, although the risk clearly Institutions Ratings has not left the financial system more broadly.

Governance and conduct risk are also high on our list of Kevin Duignan risks to watch. We have seen the ratings and outlooks Global Head of Financial of highly rated banks in the U.S. and Australia impacted Institutions Ratings by governance-related issues, including questionable +1 212 908 0630 sales practices and weaknesses in operational and [email protected] compliance frameworks. In the Nordics, we have seen the regulatory focus on anti-money laundering efforts put pressure on the ratings of some well-known and well-regarded financial institutions. Q: As we come into the later phase of the credit cycle, what are the credit risks for banks and how Finally, all financial institutions and, for that matter all are they positioned to mitigate these risks? corporations, face a growing number of operational risks that are unrelated to the timing of the credit Kevin Duignan: It would be a lot easier if there were cycle. Cybersecurity, privacy considerations, model and just one set of risks that we were looking at globally, vendor management and IT infrastructure spending but of course the range of risks for banks varies by size are all key risks that we increasingly consider in our and region. With that said, there are certainly some key analysis. themes associated with late-cycle behavior that we are constantly analyzing. Despite all of these risks, major banks are clearly far better capitalized and better positioned to weather Asset quality and its potential impact on liquidity, a downturn in the credit cycle than was the case at profitability, and capitalization top the list of things the last peak. However, signs of regulatory easing, we are watching. Fortunately, asset quality in most particularly in the U.S., could come at an inopportune developed markets continues to look manageable. time if the cycle turns sooner or faster than anticipated. Asset quality measures for most consumer and commercial assets remain near historical or multi-year Q: What are the key risks to watch around lows, particularly in the U.S., but also in those parts of consumer lending for the rest of the year? Are Western Europe that were not at the epicenter of the some areas more of a risk than others? Eurozone crisis. But that also means that performance in these countries can’t get any better. Kevin: Banks are active consumer lenders on numerous fronts: residential mortgages, credit cards, We expect that most banks will be able to readily auto loans, and unsecured consumer loans, to name handle asset quality deterioration as it inevitably returns a few. Like banks, consumers in many markets are to the mean. However, there are still jurisdictions where generally better financially positioned today than they NPLs remain high, even if on a steadily declining trend were at the previous peak 10 or more years ago. (Italy, for example) and there is less of a margin for error as banks try to manage their NPLs down in an That said, there are substantial differences in the increasingly challenging credit environment. Similar riskiness of the various consumer asset classes and challenges exist in China, India, and frontier markets in there are also regional differences in how those same Asia where there is more opacity regarding the actual asset classes are performing and will perform in the level of NPLs. next downturn.

Fitch Ratings | Global Banking – 14 Meet the Analyst

Residential mortgages are clearly better underwritten benefits and advantages that banks have and therefore, today than they were 10 years ago, especially in the are looking to partner with banks or are applying for U.S. As a result, performance should be less volatile bank charters themselves. under stress, but some countries are still dealing with inflated home prices and highly indebted consumers We see a bigger potential for fintechs to disrupt making them more vulnerable to a downturn. Canada traditional banking in the payments space. Credit, debit, and Australia stand out on this front. and mobile payments continue to grow relative to cash spending. M&A activity in the payment space is Credit card assets have generally performed better growing, creating very large, sophisticated companies than expectations, so banks have some headroom that may have the ability to take on or disintermediate when performance begins to deteriorate, although traditional banks. On top of that, broader technology elevated competition more recently could impact companies like Amazon, Google, Apple, Facebook, performance and/or profitability. Unsecured consumer and Alibaba are increasingly offering banking-related loans or installment loans present a higher risk, services and have the resources to compete with banks particularly as banks face competition from non- on a much larger scale. bank lenders, particularly those aided by financial technology (fintech). Q: Environmental, social and governance (ESG) factors are starting to play more of a role These loans are likely to drop to the bottom of the in capital markets and investment analysis. repayment priority list for consumers when their Can you talk about their impact on the global come under stress because, unlike credit financial institutions space? cards and auto loans, there is little utility value in keeping these unsecured loans current. Positively, Kevin: One of Fitch’s most important projects this year unsecured loans are typically not a large component was the roll-out of ESG Relevance Scores for Financial of banks’ lending portfolios. We are also watching the Institutions globally. We recognize that this is an area of auto loan and lease space closely. Performance has keen and growing interest for investors and we wanted generally been good around the globe, in part, because to make sure that investors understood how E, S, and G used car values remain strong thus limiting loss risks impact our credit rating analysis. severity. A significant decline in residual values, which What our analysis has shown is that Governance- seems somewhat overdue, could cause losses in bank related risks are by far the most influential in portfolios to spike. determining credit ratings for financial institutions Q: Do you see Fintech disrupting traditional relative to Environmental and Social risks. In fact, nearly banking? 20% of global financial institution ratings are currently influenced by Governance risk, meaning they scored Kevin: The buzz around fintech companies ‘4’ or ‘5’ on our five-point scale in one or more of the dramatically disrupting traditional banking, at least Governance categories. as far as lending goes, has started to fade. Instead, we are seeing banks adopting some of the tools and To some degree, this isn’t too surprising as corporate interfaces developed by fintech lenders. All of the major governance, management strategy, and financial banks have greatly enhanced their consumer-facing transparency are important considerations in the credit technology and while they may not be as innovative rating process. In fact, some of the most visible credit as some of the fintechs, in most cases they have far rating actions in the bank universe over the past couple deeper pockets to buy or build competing offerings. of years have focused on conduct issues including At the same time, many fintechs are recognizing the the heightened regulatory focus on anti-money laundering efforts.

Fitch Ratings | Global Banking – 14 Fitch Ratings | Global Banking – 15 Global Focus Sector Research Growing Risks to Central Bank Independence Governance Most Relevant of ESG Risks for Banks Global Shadow Banking Sees Heightened Regulatory Scrutiny Global Focus

between countries’ external liabilities and domestic Growing Risks to Central assets overwhelmed central banks’ foreign currency reserves, causing sharp depreciations and widespread Bank Independence financial distress. The subsequent accumulation of Recent challenges to central bank independence in foreign reserves was one of many changes in the a number of countries mark only the beginning of an Asian policy landscape, and a lesson of the crisis extended macro policy debate that is likely to play out that emerging market central banks elsewhere took in the years ahead, especially where economic growth to heart. Excluding China, emerging market foreign is slowing. reserves have increased nearly ninefold since 1996, more than double the expansion of GDP. In emerging and developed markets alike, strong central bank balance sheets compared with those of In developed markets, it was the 2008 global financial governments, combined with well-earned central bank crisis that set central banks apart. Monetary authorities policy credibility in many jurisdictions, are attracting in several countries enacted emergency measures to the attention of fiscal policymakers. Investors would be cope immediately with financial sector dislocation and wise to consider the potential implications of mounting then to support economic activity where fiscal space political pressures for greater contributions from was perceived to be limited. A critical point to reflect monetary policy to support economic growth, possibly on is that central banks were accepted as credible by unconventional means. economic and financial market stabilizers in large part due to previous policy successes in their most Reinforced central bank balance sheets in emerging commonly shared core mandate of delivering low and markets can be traced back to the 1997 Asian financial stable inflation. crisis, when currency and maturity mismatches A combination of factors that looks set to intensify points to central banks being called on again to provide at least counter-cyclical economic support, and possibly more. Growth is slowing in most major economies and many governments’ debt levels have not been meaningfully reduced, if at all, during the recent strong growth period. Fiscal space is again limited, and — critically — central banks, having contributed to lifting emerging and developed markets out of crises in the last two decades, are being increasingly viewed by governments as ripe for a broadening of their remit beyond controlling inflation. Governance Most Relevant of ESG Risks for Banks While most ESG risks tend to have limited direct impact on bank ratings, they do influence bank analysis. For

Fitch Ratings | Global Banking – 17 Global Focus

Fitch-rated global banks, 22% have ESG relevance over business model evolution, corporate structure, scores that indicate ESG factors influence the rating and the overall governance framework of emerging (‘4’ or ‘5’ on the 1-5 scale). market banks.

Governance considerations are by far the most Relative to NBFIs and insurers, banks tend to have significant ESG risk. Approximately 85% of the ‘4’ or ‘5’ greater ESG relevance related to Governance areas ESG relevance scores assigned in the global financial such as heightened regulatory focus, conduct institutions space are related to Governance with issues, and anti-money laundering concerns. These corporate governance, strategic implementation, and factors have received heightened attention in several financial transparency among the factors most material developed markets in recent years. to credit ratings. Of the 638 global bank issuers in our rated universe, five have an ESG relevance score of ‘5’ for Social ESG scores represent just 9% of the 4-5 ESG governance, indicating that it has driven a rating change. relevance scores for global financial institutions overall. These tend to have lower relevance to banks Governance tends to be a higher relevance factor for than NBFIs, and relate to Customer Welfare, Product banks in emerging markets than those in developed Safety, and Privacy & Data Security elements, as well markets. In emerging markets, this is often associated as Exposure to Social Impacts, which can stem from with financial transparency and the implementation lending activities with higher interest rates or weaker and/or execution of corporate strategies and borrowers, or that potentially increase the risk of social structures. Developed market considerations related or political disapproval. to Governance also include transparency, as well as complex group structures, key person and conduct risk. Environmental factors are rarely influential on global bank ratings, as most banks have financial asset- and/ Geographically, ESG relevance is highest for banks in or service-oriented business models. They account APAC emerging markets, where 56% of issuers have for only 6% of ESG relevance scores of 4-5 for banks, credit relevant ESG factors, followed by Americas NBFIs and insurance globally, and for banks relative to emerging markets at 38%, and Middle East and Africa at exposure to environmental impact in the developed 31%. Execution risks and evolving regulatory backdrops, and emerging Americas and emerging European amidst rapid growth, can have an important influence geographies.

Fitch Ratings | Global Banking – 18 Global Focus

Global Shadow Banking Sees Heightened Regulatory Scrutiny Continued increases in shadow banking regulation should be a net positive for systemwide stability and liquidity, if maintained over the medium term. Overall shadow banking asset levels have remained manageable. However, more rapid growth in certain regions and activities is expected to attract additional regulatory scrutiny, given the potential indirect effects of market interconnectedness and/or asset price volatility on the overall financial system.

Shadow banking assets were $52 trillion, as of fiscal 2017, or 13.5% of total global financial assets, according to the Financial Stability Board (FSB). This marked an increase of 8.5% over the previous year. In the U.S., shadow banking assets remained relatively stable at $14.9 trillion, or 28.9% of total global shadow banking Globally, banks continue to have modest direct assets. Conversely, China’s shadow-banking assets exposure to Other Financial Intermediaries (OFIs), the increased to $8.3 trillion, rising from 1.1% of total global FSB’s broad measure of shadow-banking activity, both shadow-banking assets in 2010 to 16% in fiscal 2017, a in terms of lending to and borrowing from such entities. 58.1% compound annual growth rate on an exchange Aggregate funding and credit interconnectedness rate-adjusted basis. Euro area shadow-banking assets between banks and OFIs as of fiscal 2017 approximated were $11.8 trillion, falling to 23.0% of total global pre-crisis levels, after several years of decline. Banks’ shadow-banking assets from 26.2% in 2010. claims on OFI assets were $8.1 trillion, or 5.5% of total bank assets, while funding from OFIs was $8.4 trillion, or Of the $52 trillion of global shadow-banking assets, 5.7% of total assets. That said, given the level of broader 71% were held by collective investment vehicles, such interconnectedness between banks and shadow bank as open-end fixed income, , and credit participants, and the potential for regulatory arbitrage to funds, up from 41% in 2008. The inherent be employed by market participants, global regulatory redemption risk of these vehicles could pressure scrutiny is expected to continue. asset prices in the event of runs, particularly if material leverage is employed.

Fitch Ratings | Global Banking – 18 Fitch Ratings | Global Banking– 19 News & Events

Company News

A New Approach to -Term Ratings AAA We’ve published our finalized criteria for short- AA+ term ratings across our corporate, financial AA F1+ institution, and portfolio. The AA- criteria reflect a major review of the function A+ and utility of our short-term rating scale and a A broad-based market dialogue. A- F1 Our enhanced short-term credit analysis offers a BBB+ F2 more appropriate reflection of a company’s near- Grade Investment BBB term credit risk. It improves transparency into the BBB- F3 attribution of short-term ratings, and ensures the short-term rating scale provides increased value to investors.

Events

Global Banking Conference 2019 – May 23, New York

FT-Fitch Global Banking Conference 2019 – June 4, London

Global Banking Conference 2019 – July 9, Hong Kong

Global Banking Conference 2019 – July 11, Singapore

Fitch Ratings | Global Banking – 20 Transparently displaying how ESG impacts every rating

Environmental, social and governance (ESG) factors are increasingly important for investment decisions. That’s why we’ve introduced scores to show the relevance and materiality of ESG to our rating decisions.

Learn more about our new ESG Relevance Scores

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Fitch Ratings | Global Banking – 20 Business Contacts

Aymeric Poizot, CFA, CAIA Jose Santos Global Head of Global Head of Business & Relationship Investor Development Management – Financial Institutions +33 1 44 29 92 76 +34 93 323 9044 [email protected] [email protected]

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