FINANCIAL INSTITUTIONS RESEARCH

Global Banking And Credit Trends: The Weight Of Frail Economies And Regulatory Reform
Primary Credit Analysts: Rodrigo Quintanilla, New York (1) 212-438-3090; rodrigo.quintanilla@standardandpoors.com Richard Barnes, London (44) 20-7176-7227; richard.barnes@standardandpoors.com Secondary Contacts: Naoko Nemoto, Tokyo (81) 3-4550-8720; naoko.nemoto@standardandpoors.com Angelica G Bala, Mexico City (52) 55-5081-4405; angelica.bala@standardandpoors.com

Table Of Contents
Three Key Themes Remain At The Forefront Key Credit Factors By Region Related Research

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Global Banking And Credit Trends: The Weight Of Frail Economies And Regulatory Reform
Brittle global economic conditions and growing momentum behind regulatory reform continue to weigh on global bank ratings as we take stock of first-half 2013 and look ahead to next year (see "Global Banking Risks And Credit Trends Dominated By Fragile Economies, Evolving Regulations, and Government Support," published Jan. 17, 2013, on RatingsDirect). The ongoing eurozone crisis and Europe's frail economic health remain key global credit risks for banks, in our view: Standard & Poor's Ratings Services has revised its economic forecast for Europe down to a 0.5% contraction in real GDP for 2013, from our prior forecast of zero growth, and we now expect Europe's economic recovery to begin in 2014 instead of in the second half of 2013 (see "Europe Continues To Be The Achilles' Heel For Global Credit Conditions," published May 13, 2013). Our growth outlooks for other regions are generally more favorable than for Western Europe, but with significant variations, and the broader economic upturn remains weak and uneven. The interdependence of bank performance and economic growth underlies the higher proportion of negative rating outlooks on Western European banks than in other regions (see chart). Moreover, the impact of the possible normalization of monetary policies in some countries remains a major credit concern. To be sure, central banks' policies have enhanced global liquidity for some time, but expected policy reversals or potential interest-rate hikes could pose financial challenges for banks. Moreover, funding markets in Western Europe have been supportive so far this year, partly on the back of the European Central Bank's (ECB's) actions. Nonetheless, Standard & Poor's is differentiating more between banks that have strong stand-alone funding and liquidity and those that benefit from extraordinary central bank support, which they will need to refinance at market rates or offset through deleveraging. Overview Our economic outlook for Western Europe in 2013 has become less favorable than at the beginning of the year, and we now expect its economic recovery to occur in 2014 rather than the second half of this year. Global regulatory reform appears to be gathering momentum, and some countries (such as China, India, Singapore, Switzerland, the U.K., and the U.S) are setting more stringent guidelines for banks than those recommended by international forums. For now, we continue to believe that most governments will remain supportive of senior creditors of systemically important banks. However, increasing rhetoric and proposals on how to resolve banks that are "too big to fail"--particularly in the U.S. and Western Europe--suggest that this may change in the future.

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Global Banking And Credit Trends: The Weight Of Frail Economies And Regulatory Reform

Three Key Themes Remain At The Forefront

Three broad trends are informing our outlook on the global banking sector: Economic and monetary conditions have been supportive, but may become less so. Economic conditions are stabilizing or improving in most regions, but a gradual recovery is unlikely to begin in the eurozone until next year. Some European banking systems--such as in Ireland, Italy, and Spain--are still grappling with high levels of nonperforming assets, which consume significant capital and may constrain lending. European Union (EU) banking supervisors will undertake asset quality reviews before next year's inception of the eurozone's Single Supervisory Mechanism (a single regulator to be based at the ECB) to confirm whether banks have appropriately classified and reserved against their nonperforming assets. This is in contrast with the U.S., where problem assets have been declining sharply since their peak in 2009 and banks have in fact been releasing loan loss reserves. In other regions outside Europe and the U.S., asset quality has also generally been stable or improving, but we still see pockets of potential risk in areas where easy monetary policies have fueled property markets and driven up prices on equities and other financial assets. Nonetheless, central bank actions in many countries have created abundant liquidity and a widespread search for yield, contributing to buoyant markets. Japan's "Abenomics" policy--which aims to address deflation and has weakened the yen--is a case in point. But despite a generally positive mood, markets have been jittery about the likely speed of the withdrawal of the U.S. stimulus, which illustrates that the normalization of global monetary policies may

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Global Banking And Credit Trends: The Weight Of Frail Economies And Regulatory Reform

be a bumpy ride. Low benchmark interest rates are also pressuring banks' net interest margins, making revenue growth a challenge (particularly for spread-dependent banks) and resulting in renewed emphasis on cost efficiency. Regulations are evolving and remain a work in progress. The global regulatory reform agenda is inching forward. Particularly in Europe, banks continue to reduce debt and adapt their business models to meet new regulatory requirements, repay central bank funding, and achieve acceptable returns on their bigger capital bases. Basel III has already rolled out fairly seamlessly in various countries across the world, including Australia, Canada, Japan, Mexico, Singapore, and Switzerland. The main laggards remain the EU, where implementation will begin next year, and the U.S., where coordination with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has slowed the process. Various countries--including the Nordics, Singapore, Switzerland, the U.K., and likely the U.S.--will require their banks to hold more capital than Basel III's recommended minimums. Some parts of Basel III are still a work in progress, particularly the leverage ratio and the net stable funding ratio. Global bodies are also working with national regulators to try to improve the consistency of regulatory risk-weighted assets under banks' internal models. A particular worry, however, is that some countries and regions, particularly the U.S. and Europe, are increasingly prioritizing local reforms over global cooperation. A high-profile example is the ongoing debate in the U.S. about whether to abandon Basel III in favor of a more straightforward and simple metric, such as a leverage ratio. The proposed Brown-Vitter Bill, which went before the U.S. Congress in late April 2013, outlined an extreme version of this approach (see "Brown-Vitter Bill: Game-Changing Regulation For U.S. Banks," published April 25, 2013). U.S. proposals to reform the swap market and tighten capital requirements on foreign banks' subsidiaries have also met with significant international resistance. The issues of extraterritoriality and the international reach of U.S. regulations are a particular sticking point. In Europe, a host of regulatory changes are in process. These include the Recovery and Resolution Directive (RRD), which aims to create a common framework for restructuring or winding down failing banks in an orderly way, without relying on taxpayer funds; the various elements of a proposed EU banking union to increase financial integration; and the proposed financial transaction tax. The muddling of the Cypriot deposit bail-in highlights the need for progress on pan-eurozone reforms (see "How The Cyprus Bailout May Affect Senior Creditors Of Eurozone Banks," published March 27, 2013). On the one hand, stronger regulation and higher minimum regulatory capital and liquidity requirements should increasingly support banks' stand-alone credit profiles (SACPs) over time. But on the other, the transition to a new regulatory regime may be bumpy, particularly while the global economy remains fragile. To illustrate, we believe that industry risks for U.K. banks have grown, relative to peers, reflecting the emergence of new failings after the 2008 financial crisis, the evolution of significant regulatory and legislative change, and profitability pressures. We have therefore assigned a negative trend to our assessment of the U.K. banking industry risk, which, in turn, negatively influences our view of rated U.K. banks and building societies (see "Various Rating Actions On U.K. Banks And Building Societies On Rising Industry Risk," published May 31, 2013). Furthermore, inconsistent national regulations and potential conflicts among different resolution regimes could also create practical difficulties for global banks, in our view. Government support is trending down. Regulatory changes can influence our ratings in several ways: They may change our view of the regulatory framework portion of the industry risk assessment in our Banking Industry Country Risk Assessments, as well as how we incorporate government support into issuer credit ratings (ICRs) and how we view debt security subordination. For instance, the political and regulatory debates over "too-big-to-fail" (TBTF)--whether the most systemically important banks have an implicit guarantee of government bailouts in times of stress--rage on in

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Global Banking And Credit Trends: The Weight Of Frail Economies And Regulatory Reform

the U.S. and Western Europe. If we believe a government may not provide support when needed, it may result in the removal of rating uplift. This is in contrast to the Asia-Pacific region and Latin America, where the banking operating environment is relatively stable. In Europe, the RRD is being finalized and would introduce consistent powers across regulators over bank resolutions in the region. Nevertheless, we think governments will remain supportive of senior creditors of systemically important banks, at least until domestic economies and bank balance sheets strengthen and the resolution of large, cross-border bank groups becomes a more realistic possibility. For example, during the recent nationalization of the Dutch banking group SNS Reaal, the government decided against using its bail-in powers because of concerns about contagion risks. In the U.S., regulators are considering resolution measures that would, in effect, bail in senior bondholders of a bank's holding company to recapitalize its operating subsidiaries--a move that would place holding company bondholders at greater risk than those in the operating company. Regulators in North America and Western Europe, in particular, recognize that resolution regimes can only do so much and are therefore considering minimum regulatory capital requirements that exceed those of either the Financial Stability Board or Basel III. In order for our ratings to reflect the likelihood of government support, we need to be confident that senior creditors would not have to contribute to the recapitalization of failing systemically important banks. Regulators in various countries are currently refining regulators' resolution powers and processes to enable the resolution and recapitalization of insolvent banks without destabilizing the economy or relying on public money. Living wills and structural reforms (such as ring-fencing of certain lines of business into separate off-balance-sheet legal entities) are similarly works in progress that intend to make the resolution of systemically important banks more practicable. If we were to judge that a government had become less supportive, or that a bank had become more "resolvable" without the need for extraordinary government support, we would reduce or remove the notching related to government support from the relevant ratings. We already exclude such support from our issue ratings on European banks' subordinated debt because banks have used these instruments to absorb losses in several cases. We may also reassess our rating approach for highly systemic U.S. bank holding companies if certain resolution proposals in the U.S. put their creditors at a particular disadvantage (see "Standard & Poor's Factors Evolving Nature Of Government Support Into Its Outlooks On Eight U.S. Bank Holding Companies," published June 11, 2013). Lastly, revisions to resolution powers, along with structural reforms, could also affect banks' SACPs to the extent that they influence their funding or business models. For example, ring-fencing could lead us to differentiate more between individual entities within the same bank group.

Key Credit Factors By Region

Western Europe: Economic prospects remain weak
Government and central bank support remains an important stabilizing factor for our ICRs on banks in Western Europe, and we believe governmental bodies will continue to provide it as long as necessary to promote financial stability and economic growth. For that reason, an increase in economic risk tends to show up first in weaker SACPs before leading to ICR downgrades. Weakening SACPs are behind the largely negative bias on our ICRs on Western European banks, with negative outlooks on 72% of the top 50 banks.

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Global Banking And Credit Trends: The Weight Of Frail Economies And Regulatory Reform

We believe the five key credit factors for this region are as follows: The eurozone will likely remain in recession in 2013 before entering a very gradual recovery next year. This could hurt revenues and cause nonperforming assets to increase. Banks continue to take steps to strengthen their balance sheets and refine their business models to meet stricter regulatory requirements. We believe that EU governments will continue to support banks if they have the fiscal flexibility (unlike Cyprus) to do so. For the time being, bank and sovereign creditworthiness remain closely linked. The less controversial elements of the banking union--including the need for a Single Supervisory Mechanism, the single rulebook, and the RRD--are gradually moving forward. While banks have repaid some ECB funding, about 700 billion is still outstanding, and several banks continue to rely on it to meet their funding needs.

The U.S.: The economy shows resilience, but a pullback in monetary easing would pose a risk
The moderate ongoing economic recovery in the U.S. has supported bank ratings, but banks are still struggling to boost revenues and margins. While ongoing improvements in credit quality are supporting banks' bottom lines, top-line growth remains challenging amid persistent low interest rates and weak loan growth. Bank ratings have been mostly stable through midyear, and there has been no meaningful change in our outlook for bank ratings: About 60% of rated banks have stable outlooks, while 32% have negative outlooks and the remaining 8% have positive outlooks. We believe the five key credit factors for this region are as follows: Historically low interest rates, a flattish yield curve, subdued capital-market activities, and tepid loan growth are making revenue growth difficult. Banks have devoted substantial effort to controlling expenses, and some have achieved positive operating leverage despite higher regulatory compliance costs. Loan losses have been declining to precrisis levels. As a result, loan loss reserve releases have been significant and have helped boost banks' bottom lines. However, banks' ability to take advantage of credit leverage is starting to diminish. Banks' building of capital has been tapering off, as regulatory stress testing has been satisfactory and regulators have allowed banks to return capital to shareholders. Looming regulatory changes could alter our view of government support and its impact on ICRs (holding companies, for instance) or securities notching for specific instruments.

Asia-Pacific: Moderate recovery continues, and external shocks pose the biggest risk
Most of the banking systems in Asia-Pacific have implemented Basel III without any disruption, and we expect banks' performance to be stable in the coming year, with support from a modest economic recovery and solid capital and liquidity. Nonetheless, we believe Asia-Pacific financial institutions will face some trials in the remainder of 2013. Although the region's economy is likely to show a moderate recovery this year after a sharp drop in growth in 2012, we expect several factors--including overcapacity of some industries and a high level of debt--to continue to constrain banks' asset quality. Changes in banks' credit costs tend to lag economic cycles, and some headwinds in the global economy, such as GDP contraction in the eurozone, continue to weigh on growth in Asia-Pacific. Meanwhile, some of the more debt-laden corporate and household sectors in the region remain susceptible to external shocks. We believe the five key credit factors for this region are as follows:

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Global Banking And Credit Trends: The Weight Of Frail Economies And Regulatory Reform Worsening asset quality resulting from still-slow economic growth could be the key risk for banks. The vulnerable eurozone economy and China's economic overcapacity and rebalancing process could constrain the economic growth of the region. Global monetary easing would add to the risks Asia-Pacific banks are facing. Low interest rates and intense competition will squeeze loan margins, and a hike in property prices and excessive loan growth pose risks to banks' credit quality in many countries. Japan's recent monetary policies--dubbed "Abenomics"--aim to lift the country out of deflation and have led to a sharp drop in the yen. This policy shift could affect the currencies and economies in other Asia-Pacific countries. Despite these potential sensitivities, the levels of nonperforming loans remain relatively low compared with the level in late 2010. We believe solid capitalization, liquidity, and government support should continue to underpin the ratings on many banks. The bail-in of senior debtholders is not an area of concern for banks in this region.

Central and Eastern Europe, the Middle East, and Africa (CEEMEA): Prospects vary widely, and political instability remains the key risk
The prospects for CEEMEA are as diverse as the region itself. Gulf banks are shrugging off tough international banking markets and eurozone woes to continue their steady recovery. Prospects for healthy economic growth for Gulf countries, with strong support from persistent high oil prices, should keep demand for bank credit high and expand banks' earnings. The leading banks will continue to strengthen their business this year through acquisitions and by tapping capital markets. The situation in North Africa and other parts of the Middle East offers a sharp contrast, with a marked deterioration in the economy and the region's political stability. Egypt has fared the worst, with continued pressure on the country's foreign currency reserves at a time when the authorities have yet to put forward a sustainable strategy to manage the country's fiscal and external financing needs. Weak economic prospects for Central and Eastern Europe this year mean the region's banks will likely continue to suffer from high levels of bad loans and credit losses, weak credit demand, and compressed margins. We also see wide disparities in the credit quality of the region's banks, with strong resilience in the Czech Republic, Poland, and Slovakia. We expect large Russian banks to maintain stable financial profiles in 2013. Growth in Russia's economy is slowing, though. We believe the rapid and untested growth in unsecured consumer loans in recent quarters could exacerbate credit risks for banks if the economy weakens and could erode the creditworthiness of small to midsize banks with weak loss-absorption capacities, low franchise value, and undiversified lines of business. The Kazakh banking sector has not entirely recovered from the 2008 global financial crisis, which put an end to a decade of strong credit expansion--most notably in the risky construction and real-estate segments, financed in part with wholesale cross-border debt. Banks will still be wrestling with higher-than-normal problem loans in the next two years, but we believe the country's economic prospects are relatively sound. The Ukrainian banking sector is one of the weakest in the Commonwealth of Independent States (CIS) region and remains highly vulnerable to the risk of depreciation in the local currency, which is facing growing pressure from weak sovereign external indicators and declines in foreign-exchange reserves. We believe the five key credit factors for this region are as follows:

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Global Banking And Credit Trends: The Weight Of Frail Economies And Regulatory Reform Gulf banks' financial performance continues to improve on the back of good economic conditions, a high level of consumer confidence, good liquidity, and strong capitalization. Political and economic crises are testing banks in North Africa and other parts of the Middle East. Central and Eastern European banks will likely face pressure from parent banks' weakening financials and credit quality or worsening global economic fundamentals. Banks in the Czech Republic, Poland, and Slovakia are faring better than those in Bulgaria, Croatia, Hungary, Romania, and Slovenia. The economic slowdown in Russia and untested rapid growth in unsecured consumer lending over the past two years could weaken banks' asset quality and profitability in 2013 from the strong but unsustainable levels we saw in 2012. The major downside risk for the Russian banking system remains an abrupt collapse in oil prices. Within the CIS, we view the Ukrainian banking sector as the most vulnerable, especially to a currency depreciation. We see less risk elsewhere in CIS, even though average ratings are low (in the 'B' category).

Latin America: Some banks enjoy firm economic prospects

Latin America, for the most part, remained resilient during the global downturn. The overall economy in Latin America is likely to improve in 2013 according to Standard & Poor's base-case scenario. We expect continued growth in countries such as Chile, Colombia, Mexico, and Peru. However, the region still faces external risks emanating predominantly from the eurozone, the U.S., and China, which could hurt economic growth and corporate performance if conditions worsen. In addition, Brazil's economy has been suffering from a slowdown in exports and private investments, which has been weakening growth. Increased public-owned lending in Brazil to stimulate growth, we believe, could put pressure on the financial sector's asset quality. Nonetheless, we expect loans to continue growing, although not at the same pace as in the recent past. Latin America's banking sectors have adequate capital, but sustained strong loan growth (between 12% and 17% during the past five years has placed some strain on capital. Banks in this region have focused on providing loans only domestically, and therefore their funding needs are mostly satisfied by domestic deposits; they have low dependence on external funding. We expect a slight deterioration in asset quality in 2013, although we do not anticipate nonperforming assets to reach the high levels of the past as a consequence of slower economic growth. Profitability has been stable, with returns on assets of between 1.5% and 2.5%, on support from growth in consumer loans and lending to small and medium enterprises. Banks receive strong government and regulatory support that aims to avoid external contagion.

Related Research
Industry Report Card: Increasing Global Monetary Easing Adds To The Risks Faced By Asia-Pacific's Top 40 Banks, May 28, 2013 Softer Traction In Some Asia-Pacific Economies But Growth Expected To Hold Steady, May 14, 2013 Europe Continues To Be The Achilles' Heel For Global Credit Conditions, May 13, 2013. Latin American Credit Conditions Remain Strong, But Are Tempered By Global Sluggishness, May 13, 2013 U.S. Credit Conditions Remain Favorable Amid Ongoing Sequestration Cuts, May 13, 2013

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