Credit Market Barometer

Transcription

1 Credit Market Barometer Tour of North American credit conditions Third quarter 2018

2 Welcome to the seventh edition of the EY Credit Market Barometer (CMB). Our breakouts of loan balance data across our three bank size composites are pointing to widening differences in growth rates among banks. Universal banks, as a group, are growing at a slower pace than regional banks. Some of the distinctions may be due to lesser appetite for chasing deals, and some of the difference may be due to competition from non-banks impacting larger banks more than smaller banks. Undoubtedly, the economy s strength is supporting healthy lending conditions. The third quarter s advanced estimate of real gross domestic product growth was 3.5%, down from the second quarter s reading of 4.2%, but still stronger than any reading since Unemployment held at 3.7% in October, and the most recent Manufacturing ISM Report on Business, a leading indicator of health in the economy, reflected continued expanding business strength, albeit at a somewhat slower pace than September readings. We cover two special topics in this edition: the possible impacts of Current Expected Credit Loss (CECL) accounting and the coming transition away from interbank offer rates (IBOR). We hope you find the CMB informative, and we encourage you to reach out to the contacts on the back cover for further insights on the state of North American lending conditions. ii Credit Market Barometer

3 Credit Market Barometer Table of contents 02 Overview Snapshot of credit conditions The US macro view 05 View on US macro indicators Interest rates 08 Major lending rates and the yield curve Wholesale lending 09 Trends in C&I and CRE lending Consumer lending 18 Trends in consumer lending Bank financial performance 29 Bank earnings Capital and funding 34 Capital ratios, loan-to-deposit, efficiency The Canadian market 37 Macro picture and bank performance in Canada Special topics 45 Assessing CECL s impact; Readying for IBOR transition Regulatory snapshot 48 The latest regulatory developments 51 Appendix Bank composites used in this report Credit Market Barometer iii

4 Executive summary Credit Market Barometer Q Since 1950, the US economy has experienced periods of low, stable inflation and periods of very low unemployment, but never both for such an extended time as is seen in these [macroeconomic] forecasts. Jay Powell, Chairman of the Board of Governors of the Federal Reserve System What we re seeing Strong macroeconomic conditions should support modest near-term loan growth. Other key performance drivers supportive of overall bank performance include realizing process efficiencies and competitive strengths. The Office of the Comptroller of the Currency (OCC) released its 2019 examination priorities in September, highlighting that commercial and retail credit loan underwriting, concentration risk management, credit risk management and Current Expected Credit Loss (CECL) preparations would be among its areas of higher focus over the coming year. Macro picture Real gross domestic product (GDP) growth climbed to 4.2% in Q2 2018, the best reading since Q The first estimate of Q3 s real GDP growth rate was also strong at 3.5%. Most macro indicators today are supportive of strength in the economy. The flattish yield curve is one of very few negative indicators in the economy right now, although the curve s steepness did hold well in October, as 10-year Treasury rates climbed slightly. Risks to the economy According to the U.S. Office of Financial Research (OFR) Financial System Vulnerabilities Monitor, the area of greatest risk in the financial system today is market risk specifically, high valuations and risk premiums. The OFR scores credit risk as a medium-level risk vulnerability. Concerns about the current economic expansion ending soon are driving many firms interest in identifying and understanding current economic vulnerabilities. Loan growth The loan and lease balances of US commercial banks grew at a seasonally adjusted 3.8% rate year over year (YoY) in Q3 2018, after growing at rates of 5.0% and 3.6% in Q2 and Q1 2018, respectively (based on Fed H.8 data). Commercial and industrial (C&I) loans and closed-end residential mortgages led loan balance growth in Q3, rising 4.9% and 4.7% YoY, respectively. Bank performance Commercial banks Q return on average equity (ROAE) was very strong. Overall bank ROAEs ran 2.81% higher in Q2 versus averages across all quarters between year-end 2011 and Q Earnings are likely to remain strong for the balance of We are watching deposit and loan betas i.e., the percentage of rate rises passed on to deposit holders and borrowers, as a focal point how earnings will evolve over the near term. 1 Credit Market Barometer

5 Overview System leverage and loan growth Overall leverage in the US financial system generally has moderated, as measured relative to US real GDP. Residential mortgage debt, which had greatly shrunk relative to GDP, has leveled in recent quarters. US commercial banks loan and lease balances grew 3.8% YoY in Q3, down from a 5.0% YoY growth rate in Q2. Public, corporate, home mortgage, consumer debt-to-gdp (%) Public debt to US GDP Home mortgage debt to GDP Consumer debt to GDP Nonfinancial corporate debt to GDP Leverage relative to GDP Total US government-related (public) debt-to-real GDP dropped slightly to 103.8% in Q2 from 105.2% in Q1 2018, but was up slightly from 102.5% one year prior. Household mortgage debt was 55.1% of real GDP in Q2, compared with 55.2% one year prior. Nonfinancial corporate debt-to-real GDP ratio was 33.6% in Q2, up slightly from 33.5% one year prior. Consumer debt (non-mortgage)-to-real GDP ratio was 21.1% in Q2, up from 20.7% one year prior. Source: Federal Reserve Economic Data, latest available Fed Z.1 data Total credit held by commercial banks 14, ,778 12, ,000 9,185 9, ,000 6, , , Total credit ($b) Total loans and leases ($b) Total loans and leases to real GDP (%) Total credit and total loans and leases Total US commercial bank credit holdings were $12.79 trillion at the end of Q2 2018, up 4.2% from one year prior, which was a slower growth rate than the fouryear CAGR of 5.9%. Total loans and leases held by US commercial banks were $9.35 trillion at Q2 2018, up 5.0% YoY; also slower than the four-year compound annual growth ratio (CAGR) of 5.8%. US commercial bank loans and leases relative to GDP were 50.5%, up from 49.5% one year prior. Source: Federal Reserve Economic Data; total credit is all fixed income securities plus loans and leases held by US commercial banks Credit Market Barometer 2

6 Credit weather snapshot The 12-month average of nonfarm payroll increases reached 210,000 in October, the highest level since April The US unemployment has held at 3.7% for two consecutive months, marking a 50-year low. Hourly wages have risen 3.1% YoY to $27.30/hour, also a relatively good number. Inflation fell to 2.3% YoY in September, down from 2.9% in July, as measured by the Consumer Price Index. US macro US nonfarm payrolls, mo. change (k) Unemployment rate, U-3 (%) (Oct) 3/ 09 Peak and trough since / (Oct) 5/ 18 Peak and trough since / 09 Real GDP, ann. change (%) 3.5(3Q) Q 08 Peak and trough since Q 00 Inflation, CPI, ann. change (%) (Sep) 7/ Peak and trough since / 08 Case-Shiller US housing pr. index (HPI) Expenditures, PCE, ann. change (%) (Aug) 1/ 00 Peak and trough since / (Sep) 5/ 09 Peak and trough since / 00 US rates LIBOR 3 mo. (%) 2.46 (Oct) / Peak and trough since / 00 Mortgage rate US avg., 30-yr. fixed (%) (11/8) 11/ Peak and trough since / 00 2-yr. 10-yr. UST spread (%) 0.29 (Oct) / 00 Peak and trough since / 10 Fed funds effective rate (%) 2.19 (Oct) / Peak and trough since / 02 US bank credit growth Ann. change loan/lease, comm. banks (%) Ann. change, total consmr. credit (%) (2Q) 1Q 10 Peak and trough since Q (2Q) 1Q 10 Peak and trough since Q 01 3 US bank asset quality NPLs, all loans, comm. banks (%) 1.02(2Q) US bank performance ROAA, >$100b banks (%) 1.43(2Q) US bank capital Sources: EY, Federal Reserve Economic Data, S&P Global Market Intelligence Note: Generally favorable or trending favorably for banks Credit Market Barometer Q 06 Peak and trough since CET1 ratio, >$100b banks (%) (2Q) 3Q Q 08 Peak and trough since Peak and trough since Q Q Q 17 NPLs, commercial loans (%) 0.74 (2Q) ROAE, >$100b banks (%) 12.9 (2Q) 9.34(2Q) 0.49 Generally not favorable or trending unfavorably for banks Q 14 Peak and trough since Leverage ratio, >$100b banks (%) Q 08 Peak and trough since Q 06 Peak and trough since Q Q Q 18 Generally neutral for banks

7 Uniform Bank Performance Report Uniform Bank Performance Report (UBPR) data provides a stratified view of bank performance by asset size. Size group >$100b $10b $100b $3b $10b $1b $3b Banks in group Profitability H ROAE (%) H ROAA (%) Yield on assets and cost of funds H Interest income (% avg. assets) H Interest expense (% avg. assets) Non-spread income H Non-int. income (% avg. assets) Efficiency H Efficiency ratio (%) Funding H Net loans lease/total deposits (%) Asset quality H PD non-accruals loans (%) Capitalization H Common Equity Tier 1 ratio (%) Source: Federal Financial Institutions Examination Council, UBPR Notable points US corporate tax code changes are providing meaningful lifts to return on average equity (ROAE) and return on average assets (ROAA) levels. Yields on earning assets are generally benefiting from rising rates, which are helping net interest margins, but the benefit will likely slow as deposit betas are expected to rise. Overall asset quality, based on serious delinquencies (90d PD and non-accruals), is still trending favorably for banks. Credit Market Barometer 4

8 The US macro view Executive summary There are currently no material signs of slowing in the US economy. Core inflation, as measured by the personal consumption expenditures (PCE) price index (ex-food and energy), was 2.0% in August, exactly on the Fed s targeted rate for the measure. Wage inflation, while still low relative to historical averages between 1990 and 2007, has held above 2% on a monthly YoY basis for the past two years. The most recent reading was 2.8% as of September, well above the average of approximately 1.8% in the period, when the economy was emerging from the financial crisis. Consumer confidence is near all-time peaks, as measured by the University of Michigan Survey of Consumers. If and as consumer confidence remains high, GDP growth will be more likely to stay healthy across Q3 and Q US GDP and the unemployment rate are healthy and stable. Real GDP growth (third estimate) for Q was 4.2%. Real GDP growth (%) Average: 2.4% (1.0) (2.0) Real GDP growth GDP growth was 4.2% in Q2 2018, up sharply from 2.2% in Q1. GDP growth is at its highest level since Q The acceleration in real GDP growth in Q2 reflected accelerations in personal consumption, exports, federal government spending, and state and local government spending, as well as a smaller decrease in residential fixed investment. Economists expect GDP to remain strong over the balance of 2018, mostly because personal consumption growth remains high. Source: Federal Reserve Economic Data Last shown reading Q Credit Market Barometer

9 I think we need to make the right decisions based on our analysis of where the economy is and where it s heading. If that were to require us to move interest rates up to the point where the yield curve was flat or inverted, that would not be something I find worrisome on its own. John Williams, President and CEO of the Federal Reserve Bank of New York, quoted by The Wall Street Journal on September 13, 2018 Unemployment rate (%) Unemployment rate The September monthly unemployment rate (released Oct. 5) was 3.7%, the lowest reading in 50 years and well below the quarterly average of 4.0% in Q2. The U.S. Labor Department reported in October that August job openings had topped 7m, outnumbering active job seekers by 100k the most ever. The number of unemployed persons decreased by 270k to 6m in September. 3.0 Unemployment rate Employment in professional and business services increased by 54k in September and has risen by 560k over the year. Source: Federal Reserve Economic Data Last shown reading Q2 2018, shows avg. of monthly readings over quarter US housing prices nationally are at an all-time peak. Corporate credit spreads for low-investment grade rated credits are still conducive for corporate issuance; however, spreads rose sharply in Q Case-Shiller national housing price index (HPI) (%) peak: HPI The US housing market continues to exhibit strong pricing, as the U.S. National Home Price Index reached in June (and in July), up from in March and in December trough: July s reading represents a 6.0% annual gain in housing prices, slightly down from a 6.2% reading in June. 120 Seattle, Las Vegas and San Francisco are seeing the highest year-over-year gains. 100 HPI Source: Federal Reserve Economic Data Last shown reading Q Average US home prices are 11.2% above the 2006 peak, but only somewhat over pre-crisis peaks for many larger, highercost urban areas. Credit Market Barometer 6

10 The US macro view continued BBB corp yield (%) BBB corporate yield Average effective yields among BBBrated bonds rose by 30 basis points (bps) to 4.39% as of the end of Q2 2018, and up 80 bps from 3.59% at the end of Q The move marked a reversal of a tightening trend in BBB Corp Yield Source: Federal Reserve Economic Data, ICE BofAML US Corporate BBB Index Last shown reading Q What the Fed is focused on On September 26, the Federal Open Market Committee (FOMC) raised the target federal funds rate to the 2.00% to 2.25% range. The FOMC also updated its summary of economic projections, shown in the table below. We call out real GDP, unemployment and inflation measures noting that insofar as these projections, there are no overt signs of an economic downturn. We highlight the FOMC s comments on the effects of tariffs in the underlined portion of the meeting minutes quotes below. Variable Change in real GDP March 1 projection Unemployment rate March 1 projection PCE inflation March 1 projection Core PCE inflation March 1 projection Federal funds rate March 1 projection Median Central tendency Range Longer run Longer run Longer run Source: Summary of economic projections, FOMC (Sep 2018) 1 Prior forecast projection from March 2018 The FOMC noted in its September meeting minutes that Evolving trade-related risks and other international developments reportedly weighed somewhat on market sentiment. However, domestic economic data releases came in a bit above market expectations, on net, with the stronger-than-expected average hourly earnings in the August employment report notably boosting Treasury yields. Nominal Treasury yields moved up over the intermeeting period, with the 10-year yield rising above 3 percent. The FOMC also noted that Relative to the forecast prepared for the previous meeting, the projection for real GDP growth this year was revised up a little, primarily in response to stronger-than-expected incoming data on household spending and business investment. The projection for the medium term was not materially changed, in part because the recently enacted tariffs on Chinese goods and the retaliatory actions of China were judged to have only a small net effect on U.S. real GDP growth over the next few years. 7 Credit Market Barometer

11 Interest rates Short-term rates have rocketed higher in 2018, tightening the spread between the longer and shorter ends of the curve. Implications for banks include likely growing pressures on deposit rates. Treasury yield curve (%) m 3m 6m 1y 2y 3y 5y 7y 10y 20y 30y Most recent One month ago One year ago Three years ago Data as of Sep 7, 2018 Key rates (%) Key rates As of mid-october, 10-year U.S. Treasury (UST) yield had climbed to its highest level since May 2011, reaching 3.19%. The 6-month and 1-year UST rates have risen 100 and 108 bps, respectively, over the past year (as of September 7). The 1-month and 3-month LIBOR rates have risen by about 92 bps and 101 bps, respectively, to 2.11% and 2.32% over the past year (as of September 7). The Prime rate is up about 100 bps over the past year (following the September 26 rate rise). The table below shows US deposit and consumer lending rates, with 1-year changes over the past year at commercial banks: Product US avg. 1-yr chg. Interest checking 0.12% 0.02% Money market $10k 0.29% 0.10% New car loan 36 mo. 4.08% 0.33% New car loan 60 mo. 4.30% 0.33% Classic credit card 12.50% 0.29% Rewards card 12.94% 1.00% 30-yr fixed mortgage 4.79% 0.75% month LIBOR 3-month LIBOR Prime rate 10-year Treasury 30-year fixed 6-month Treasury 1-year Treasury Source: Federal Reserve Economic Data Credit Market Barometer 8

12 Wholesale lending Executive summary Wholesale loan balances nationally have grown steadily over the 12-month period ending Q2 2018, but on a quarter-over-quarter (QoQ) basis, results were surprisingly tepid given higher strength in the economy. US universal banks showed especially weaker QoQ growth in Q2 versus regionals (<$50 billion banks) (0.4% vs. 2.9%, respectively). Similar relative results have been seen between universals and regionals for several quarters now. Delinquency rates (all nonperforming loans) generally remained very low, with the only notable increase coming in C&I loans in our universal bank composite, up 5 bps to 1.12% for Q2. Interest among commercial banks for buying loan portfolios is generally healthy, based on what we see in the market. A notable influencer on wholesale bank lending, especially in the middle market and the small and medium enterprise space, is the continued proliferation of private credit funds managed by nonbanks, especially large alternative investment managers. While these funds can actually be clients of banks (providing leverage into the funds), investment money raised by private funds lending to borrowers had reached $638 billion as of mid-2017, according to Preqin data. That level equates to nearly 15% of the total commercial credit extended by US commercial banks. 9 Credit Market Barometer

13 On private equity [and] nonbank competition, I would say that is evident in some of the wholesale categories. I think it s probably most prominent in our CRE category, where some of the paydowns that are occurring are because of nonbank competition coming into the marketplace. Super-regional bank CEO responding to an analyst s question regarding commercial lending competition during a Q earnings call Among all US commercial banks, C&I and commercial real estate (CRE) loan balances each grew by over 5% YoY in Q2 2018, the strongest growth rates seen since Q Higher economic activity contributed to some of the renewed strength. Corporate tax relief, which arguably is helping economic growth, also may be causing a marginal reduction in the need for borrowing, especially on revolving line balances. Rate rise impacts may also increasingly drive borrowers to more judiciously utilize loan facilities. Total wholesale loan exposure ($b) 2,400 2,200 2,000 1,800 2,219 2,139 Wholesale lending, all US commercial banks Total wholesale exposure rose to $4.36 trillion as of Q2 2018, a 5.2% increase YoY. C&I lending grew by 5.34% and 3.20%, YoY and QoQ, respectively, while CRE lending rose by 5.04% and 1.32% YoY and QoQ, respectively. The Fed s July 2018 Senior Loan Officer Opinion Survey reported that banks had eased their lending standards on C&I loans to firms of all sizes in Q2, but kept CRE lending standards unchanged. 1,600 1,422 Overall, lending standards for C&I loans are on the easier end of ranges seen since 2005, whereas lending standards for CRE loans are on the tighter end of the range. 1,400 1,200 1,306 1,000 C&I loan exposure CRE loan exposure Source: Federal Reserve Economic Data; last shown reading end of Q Credit Market Barometer 10

14 Wholesale lending continued C&I lending encompasses a significant number of loan subcategories (e.g., vendor equipment finance, small business loans, middle market) that together make the loan class somewhat of a bellwether for lending overall. Growth across C&I overall, among our 3 bank composites, was especially strong in our regional bank composite. Note: the composites below include 6 banks in the universal group, 16 banks in the super-regional group and 46 banks in the regional group. C&I lending by bank segment ($b) 1, C&I lending, US composites C&I loan balances grew 5.06% YoY for universal banks, 3.64% for super-regional banks and 10.49% for regional banks, respectively, in Q Universal banks surprisingly experienced the weakest quarterly growth in C&I balances, at just 0.37% in Q2. Wells Fargo s CEO noted in the company s Q2 earnings call that C&I was good, but not great. 0 Universal banks Super-regional banks Regional banks BB&T s CEO noted the following regarding Q2 earnings: We had very strong [overall growth] in C&I, which was up 6.3%. Strong performance in a number of areas our corporate banking and mortgage warehouse lending. C&I loan delinquency rate (%) C&I delinquency rate, US composites Delinquent loans fell 7 bps and 18 bps in Q for super-regionals and regionals, respectively, but rose by 5 bps for universals Universal banks Super-regional banks Regional banks 11 Credit Market Barometer

15 Wholesale lending continued C&I asset quality across all US commercial banks generally improved in Q2 and remains very strong. Delinquency rates and (NCO) are off the cycle troughs reached during the period. The reduced tax rates have provided new capacity for debt servicing for profitable commercial borrowers. C&I delinquency rate vs. cycle peak and trough (%)* C&I delinquency rate, all US commercial banks The overall C&I delinquency among US commercial banks dropped by 4 bps during Q to 1.07%, the eighth consecutive quarterly drop in delinquencies. C&I delinquencies remain above the current cycle trough level of 0.72%. The current trend is attributable to both the healing of the oil and gas sector and the economy s strength. Delinquency rate Cycle peak (Q3 2009) Cycle trough (Q4 2014) Source: Federal Reserve Economic Data C&I NCO rate vs. cycle peak and trough (%)* C&I NCO rate, all US commercial banks The C&I NCO rate fell by 5 bps to 0.26% in Q Q2 s NCO rate was 12 bps lower than the 0.38% rate recorded at the end of Q NCO rate Cycle peak (Q3 2009) Cycle trough (Q1 2015) Source: Federal Reserve Economic Data * Data captures all US commercial banks Credit Market Barometer 12

16 Wholesale lending continued The leveraged loan market saw record volume in 2017 as high appetites for yields among institutional investors drove many issuers to take advantage of robust conditions. The market s appetite for leveraged loans has continued in Lending providers among the nonbank universe, large alternative investment managers notably, continue to express emphasis on putting credit fund money to work. Volume of annual US dollar-denominated new-issue global leveraged loans ($b) Leveraged lending Global leverage loan new money production volume was $372 billion through Q2 2018, on pace to break last year s level of $652 billion, according to S&P Global Market Intelligence data Institutional volume (generally, term loans with bullet repayments sold to institutional investors) represented 74% of leveraged issuance in the first two quarters of Pro rata Institutional Technology, financial (services and leasing), oil and gas and health care sectors have been among the largest sectors borrowing leveraged loans. LTM default rate of all leveraged loans (%)* Default rates The prior 12-month default rate by dollar volume for leveraged loans as of June 30, 2018, stood at 1.95%, dropping 47 bps from last quarter. iheartcommunications remains the largest defaulter of the year, with $6.3 billion default in March * Source: Thomson Reuters LPC Leveraged Loans monthly report in April Credit Market Barometer

17 Wholesale lending continued Leveraged loan spreads also reflected the high appetites for non-investment-grade corporate debt, driving spreads to post-crisis lows. Quarterly average new-issue B+/B spreads (LIBOR+X bps) Leverage loan spreads (single-b) High and mid single-b rated leveraged loans sold to institutional buyers at a 360 bps spread to LIBOR in Q2 2018, a 17- bps increase QoQ. The pro rata leveraged loan market also saw prices widen, by 7 bps in Q Pro rata Institutional Quarterly average new-issue BB/BB spreads (LIBOR+X bps) Leverage loan spreads (double-b) Pro-rata spreads dropped by 72 bps to 193 bps after a 40-bps increase in Q2, while institutional spreads dropped to 219 bps Pro rata Institutional ; data not available for Q and Q data points Credit Market Barometer 14

18 Wholesale lending continued CRE lending growth among our tracked bank groups was mixed. Super-regional banks took less part in the overall good conditions. CRE lending by segment ($b) CRE lending, US composites Universal and regional banks grew their CRE portfolios by 1.56% and 8.78%, YoY, while super-regional banks experienced a 0.61% YoY decline. CRE exposures at regional banks have grown at a four-year CAGR of 12.4% in comparison with CAGR of 7.20% and 4.45% for universal and super-regional banks, respectively Universal banks Super-regional banks Regional banks JPMorgan Chase comments from Q2 earnings: CRE loans were up 4% year on year and flat versus last quarter, as there continues to be a lot of competition for high-quality assets and we are selective given where we are in the cycle. CRE loan delinquency rate (%) CRE delinquency rate, US composites Delinquency rates remained flat for super-regional banks through Q on a QoQ basis, while universal banks saw a decline of 13 bps and regionals saw a decline of 2 bps. YoY, delinquencies have declined at universal and super-regional banks, although marginally. 0.0 Universal banks Super-regional banks Regional banks 15 Credit Market Barometer

19 Wholesale lending continued The graphs below show total CRE lending across our three bank composites, with breakouts of multi-family and construction and land development loan types. The data shows how multi-family has begun some tapering after rapidly growing during the period. Asset quality remains uniformly very good. CRE lending by loan type ($b) CRE lending, loan types within US composites A YoY comparison reveals growth of 3.01% for nonfarm/nonresidential exposure, 2.49% for multi-family CRE and 4.58% for construction/land development exposure. 0 Nonfarm/nonresidential CRE loan exposure Multi-family CRE loan exposure Construction/land development CRE loan exposure CRE loan delinquency rates by loan type (%) CRE delinquencies, loan types within US composites Delinquency rates declined and were 0.75% for nonfarm/nonresidential loans, 0.20% for multi-family residential loans, and 0.62% for construction/land development loans, as of Q Nonfarm/nonresidential CRE loan exposure Multi-family CRE loan exposure Construction/land development CRE loan exposure Credit Market Barometer 16

20 Wholesale lending continued The asset quality of CRE loans across all US commercial banks is also in very good health, with delinquencies below pre-crisis levels and at current cycle lows. Net charge-offs did tick higher at the end of 2017, but remain exceptionally low overall. CRE delinquency rate vs cycle peak and trough (%)* Delinquency rate Cycle peak (Q2 2010) Cycle trough (Q2 2018) Delinquency rates, all US commercial banks Commercial real estate delinquencies hover at very low base levels, as loan volumes continue to rise. Delinquencies on all CRE loans outstanding at commercial banks dropped slightly in Q2 2018, to a new low of 0.72%, compared with 0.74% in the previous quarter. Delinquencies were 5 bps lower in Q versus Q Source: Federal Reserve Economic Data CRE NCO rate vs cycle peak and trough (%)* Net charge-offs, all US commercial banks The net charge-off rate on CRE loans was 0.01% in Q2, down from 0.03% in the previous quarter The CRE NCO rate has been no higher than 0.02% every quarter since Q (0.01) NCO rate Cycle peak (Q4 2009) Cycle trough (Q3 2016) Source: Federal Reserve Economic Data * Data captures all US commercial banks 17 Credit Market Barometer

21 Consumer lending Consumers have significantly altered their approach to retail credit following the Great Recession. With hundreds of thousands of homeowners going underwater on their mortgages, and the ability to gain access to credit becoming more difficult for millions of consumers, a massive shift in how consumers prioritized and pay their debts has taken place. Lead researcher for a major credit reporting agency Executive summary Consumer loan balances across all US commercial banks were up 4.2% YoY at the end of Q2. Non-mortgage-related loans drove the growth, with regional banks leading the way. A study on consumer retail behavior 10 years after the start of the Great Recession notes several interesting observations: A significant increase (improvement) in credit scores, with over 60% of consumers having a score of 661 or higher, up from only 51% in 2008 A 50% decrease in subprime mortgage originations as compared to 2008 The highest credit card ownership level, at 176 million, but with the largest portion of annual credit card (over 8%) occurring in the super-prime/reward card space Unprecedented growth and acceptance of unsecured consumer loans, primarily provided by financial technology (FinTech) firms and used for low-rate debt consolidation Numerous industry publications indicate that consumer debt is now either near or at record levels. Yet consumer loan growth for universal, super-regional and regional composites we track is weaker than broader industry averages across the major product areas (mortgage, auto, credit card and other consumer). A new joint report by the Federal Reserve Bank of New York (FRBNY) and NYU Stern suggests that originations by FinTech firms are becoming more meaningful. The report indicates that in 2014, FinTech firms held a little less than 2% market share in consumer loans, but by 2016, that share had grown to 8%. Some are now estimating it could reach as high 20% by the end of 2018, especially in the mortgage and other consumer product lines. FinTech firms may also be picking up a disproportionate share of the subprime market. Credit Market Barometer 18

22 Consumer lending continued Loan growth in the consumer space continues to advance at an accelerating rate to historic levels. Additionally, the level of true consumer indebtedness may be even higher due to the growing presence of FinTech lending in both residential real estate and consumer installment lending. Total consumer loan exposure ($b) 2,400 2,085 2,200 2,000 1,800 2,208 Consumer loan exposure, all US commercial banks Total consumer loan balances at US commercial banks grew by 1.2% QoQ and 4.2% YoY in Q The period ended at $3.67 trillion. The growth was driven by nonresidential loans, which rose 7.1% YoY versus 4.5% YoY growth one year prior. The acceleration is notable in part because interest rates have continued to rise over the period. 1,600 1,464 1,400 1,103 1,200 1,000 Residential real estate exposure Consumer loan exposure Source: Federal Reserve Economic Data; quarter-end data, last shown reading Q Residential real estate loan balances grew just 2.2% YoY in Q slightly better than the 1.6% prior YoY rate ending Q Growth is modest due to the inclusion of the home equity line of credit (HELOC) in this series. There is evidence to suggest that US commercial banks slower growth in the residential mortgage is in part caused by the continued rise of nonbank originators. Research by the Federal Reserve Bank of New York and NYU Stern has highlighted how FinTech firms are often winning the race on ease of service with traditional mortgage lenders. Nonbank FinTech lenders (as classified by FRBNY research) had achieved $161 billion origination volume, and an 8% share of the total residential mortgage market in 2016, based on Home Mortgage Disclosure Act data. The resulting report predicts significant further increases in origination share. 19 Credit Market Barometer

23 Consumer lending continued Residential real estate (RRE) lending continued its trend of weak growth, with the universal and super-regional composites posting YoY declines, while asset quality continued improving. Note: the composites below include 6 banks in the universal group, 16 banks in the super-regional group and 46 banks in the regional group. See Appendix for more information on these composites. RRE lending by composite ($b) RRE lending, US composites 1, ,174 1, RRE loan balances among the universal banks have declined by 0.23% CAGR over the past four years ending Q Regional banks, on the other hand, have grown RRE balances at a 7.5% CAGR over the same period Universal banks Super-regional banks Regional banks RRE loan delinquency rate (%) Universal banks Super-regional banks Regional banks On a dollar-volume basis, the impressive growth rate of the regional banks is less impressive when considering that represents just $28 billion in balance increases among the 46 banks in the last two years ( ). Universal banks and super-regionals saw balances decline by $3 billion and $8 billion, respectively, over last two years. The evidence of rising FinTech disruption in the mortgage market is clearer. A recent study by the Mortgage Bankers Association showed that declining loan volumes, rising interest rates and increased competition have led the ratios of current pretax income-to-loan balances to drop to 31 bps, the lowest point since fall RRE delinquencies, US composites Delinquency rates for RRE for all bank types slightly improved in Q2, with the universal composite at 4.54%, the regionals at the same level and the superregional composite at 2.97%. ; data includes delinquencies of loans held with federally backed guarantees Credit Market Barometer 20

24 Consumer lending continued The steady decline of the HELOC is continuing. The limited availability of interest-only HELOCs and the steady rise of interest rates are driving demand for HELOCs far lower. Meanwhile, homeowners capacity for HELOCs is climbing to an all-time high at current home valuations. Asset quality for closed-end, one-to four-family mortgages overall continues to improve, while HELOCs hold steady. RRE lending by loan type ($b) 1,600 1,181 1,327 1, RRE loan types (within our three composites) HELOCs continued to decline, down $70 billion or 10% YoY. According to the Mortgage Monitor Report, tappable equity held by homeowners grew by $820 billion over the last 12 months (ending March 2018) at $5.8 trillion nationwide. This represents the highest rate of untapped equity recorded (16% above 2006 levels), and yet HELOC portfolios continue their double-digit decline. Total closed-end, 1- to 4-family HELOC ; HELOC balances are included in the overall residential mortgage values shown in the graph RRE loan delinquency rates by loan type ($b) RRE delinquency rate (within our three US composites) Delinquency rates on closed-end, one- to four-family residences continued their steady improvement, declining to 4.51% (a new seven-year low), while delinquency performance in HELOC loans remained steady at 3.58% Total closed-end, 1- to 4-family HELOC ; HELOC delinquencies are included in the overall residential mortgage values shown in the graph 21 Credit Market Barometer

25 Consumer lending continued Delinquencies and losses in the RRE continue to decline. NCO rates for residential mortgages reached a new low in Q2. RRE delinquency rate vs. cycle peak and trough (%)* RRE delinquencies, all US commercial banks Overall 30-day+ delinquency rates for residential real estate (including HELOCs) continued to decline, dropping 22 bps to end Q at 3.25%. Although continuing to trend downward, albeit at a slower pace from the previous years, delinquencies remain above their prefinancial-crisis low of 1.41%, recorded in Q Delinquency rate Cycle peak (Q1 2010) Pre-crisis trough (Q4 2004) Source: Federal Reserve Economic Data RRE NCO rate vs. cycle peak and trough (%)* RRE net charge-offs, all US commercial banks With recoveries exceeding losses in Q2 2018, the annualized NCO rate for RRE is negative this quarter at -0.01%, which is a new low in the current credit cycle. 1.0 (0.01) (0.01) NCO rate Cycle peak (Q4 2009) Cycle trough (Q2 2018) Source: Federal Reserve Economic Data * Data captures all US commercial banks Credit Market Barometer 22

26 Consumer lending continued Delinquency rates have moderated in 2018, rising by only a few basis points and ending a trend toward sharp second-quarter increases. This was particularly true at the universal banks, which only saw a modest five-bps increase in Q2. At the same time, growth in this space has stalled. Auto lending by composite ($b) Auto lending, US composites Overall growth in consumer auto has stalled with total exposures of $353 billion in line with last year s Q total of $355 billion. What little growth that exists is coming from the super-regional banks, up $10 billion YoY to $205 billion, up 5.1% YoY. Conversely, universal lenders decreased in size in Q2 2018, declining by almost 8% to $135 billion. 0 Universal banks Super-regional banks Regional banks Auto delinquency rate (%) Universal banks Super-regional banks Regional banks Auto delinquencies, US composites While up across all composites, auto delinquency rates rose at a slower pace than typically observed in Q2. For example, delinquency rates in universal banks rose by 17 basis points to 1.65% in Q2 2017, but only increased slightly to 1.77% in Similar examples were also observed in the super-regional and regional composites. A recent report by Credit Karma indicated that 1/5 (19%) of all new auto loans had FICO scores below 620, suggesting that there is significantly lower credit quality building in auto. 23 Credit Market Barometer

27 Consumer lending continued The five-year trend of increasing auto loan delinquencies continues into the first half of 2018, but there is some indication that this advance may be slowing. The auto NCO rate in Q2 decreased, YoY, for the first time in at least seven years. An additional indicator that auto defaults may be nearing the end of their increasing trend: a recent Equifax report indicated that auto lenders have reduced subprime lending by almost 10% since January Auto delinquency rate vs. cycle peak and trough (%)* Delinquency rate Cycle peak (Q4 2017) Cycle trough (Q1 2012) Auto delinquencies, all US commercial banks Although still below the seven-year high delinquency rate set in Q4 2017, the second quarter saw a modest increase in overall delinquencies, from 2.16% in Q to 2.31% at the end of Q2. Auto delinquencies were also up YoY, climbing 22 basis points from last year s rate of 2.09%. Recent Bloomberg reports cite subprime lending as the principal cause of the rise in auto delinquencies, with 60-day pastdue levels for subprime accounts at a 20-year high of 5.8%. Auto NCO rate vs. cycle peak and trough (%)* Auto net charge-offs, all US commercial banks Second-quarter YoY losses in consumer auto are down for the first time in seven years, decreasing by one basis point to 0.69% NCO rates follow a consistent seasonal pattern of first- and second-quarter decreases, followed by increases in loss rates in the later half of each year. 0.0 NCO rate Cycle peak (Q4 2017) Cycle trough (Q2 2012) * Data captures all US commercial banks Credit Market Barometer 24

28 Consumer lending continued Credit card balance growth remains moderate, with a 12-month increase of about 5%; average usage is up about 3%, and delinquencies are up only slightly versus last year. Credit card lending by composite ($b) Credit card lending, US composites Credit card loan outstanding balances increased YoY by only $37 billion, ending Q at $697 billion; an annual growth rate of just 5.3% Universal banks Super-regional banks Regional banks The majority of the YoY growth originated within our super-regional composite, up $23 billion, or 9.3% YoY. Although up about 3% YoY, credit card growth at the universal banks has been essentially unchanged since Credit card delinquency rate (%) Credit card delinquencies, US composites Credit card delinquency rates ticked up slightly versus Q2 2017, with the universal composite up three bps and the super-regional and regional composites up eight bps each. A recent Business Insider report on credit card usage showed overall consumer credit card indebtedness up only 2.6% to $5,472 as of Q Universal banks Super-regional banks Regional banks Usage patterns, not surprisingly, are very different among generational groups, with Gen-Xers posting the highest average credit card debt of $7,029 and Gen-Z users having the lowest at only $1, Credit Market Barometer

29 Consumer lending continued Delinquency and loss performance, while clearly above the cycle lows seen in 2015, remains relatively strong. Credit card delinquency rate vs. cycle peak and trough (%)* Credit card delinquency rate, all US commercial banks The delinquency rate for credit cards dropped 19 bps to 2.35% from Q1, and was equal with the level from the previous year. Q (2.57%) saw the highest delinquency rate since Q Delinquency rate Cycle peak (Q4 2009) Cycle trough (Q1 2015) Source: Federal Reserve Economic Data Credit card NCO rate vs. cycle peak and trough (%)* Credit card NCO rate, all US commercial banks Credit card net charge-offs of 3.74% were up slightly (10 bps) from the previous year but down (6 bps) from the previous quarter. Q (3.80%) saw the highest delinquency rate since Q NCO rate Cycle peak (Q4 2009) Cycle trough (Q3 2015) Source: Federal Reserve Economic Data * Data captures all US commercial banks Credit Market Barometer 26

30 Consumer lending continued Loan balances within other consumer loans have overall trended lower among universal banks, consistent with trends seen for universals in mortgage and auto portfolios. The decline in the universal composite was in part due to Citi s selling of its OneMain subsidiary in late The super-regional and regional groups, in contrast, continue to push into this space. The rise of loan balances in the super-regional composite in 2016 was due to a reclassification of American Express s loan balances from other loans to other consumer loans. Other consumer lending by composite ($b) Universal banks Super-regional banks Regional banks Other consumer loans, US segment composites The other consumer loan category remains a mixed story, with concerted focus on the space among several of the super-regional and regional banks. Universal banks achieved just 1.3% YoY growth in other consumer balances, whereas super-regionals were up 7.9% YoY, and regionals were up 12.3% YoY. American Banker analysis covered earlier in 2018 indicated that consumer installment lending, primarily point-ofsale loans, were up 30% since 2012, with US regional banks leading the way. Other consumer delinquency rate (%) Other consumer loan delinquencies, US segment composites Delinquencies continue their downward trend for other consumer loans, with YoY declines across all bank groups (universal banks down 27 bps, super-regionals down 35 bps and regional banks down 20 bps) Universal banks Super-regional banks Regional banks 27 Credit Market Barometer

31 Consumer lending continued Delinquency and loss performance in the other consumer loan category across all US commercial banks is at or very near historic lows. Other consumer delinquency rate vs. cycle peak and trough (%)* Other consumer loan delinquencies, all US commercial banks Other consumer loan overall delinquencies declined further by 20 bps to 1.91% in Q2 2018, hitting a seven-year low. Delinquencies have dropped 25 bps compared to the previous year Delinquency rate Cycle peak (Q4 2011) Cycle trough (Q2 2018) Other consumer NCO rate vs. cycle peak and trough (%)* Other consumer loan NCO rate, all US commercial banks Charge-offs remained flat at 1.14% from the first quarter of 2018 and are up only 21 basis points from their record low of 0.93% NCO rate Cycle peak (Q4 2010) Cycle trough (Q3 2015) * Data captures all US commercial banks Credit Market Barometer 28

32 Bank financial performance Executive summary Net interest income (NII), net interest margins (NIM), net income and ROAA and ROAE mostly continue to trend favorably due to rising rates, lower tax rates and the continued favorable economy. Early Q3 earnings are generally beating analyst expectations, driven by strong growth across segments (e.g., consumer and capital markets). As rates rise, analysts are watching deposit and loan betas, which measure the percentage of benchmark rate increases that are passed on to depositors and borrowers. Thus far, deposit betas have been very low, but they are expected to rise. Loan betas have been higher. The effects are reflected in stronger NII levels shown in our composites. With capital levels holding strong, many banks are aiming to boost capital distributions via both share repurchases and dividends. The NASDAQ banking index had outperformed the S&P 500 Index through the first half of 2018, but the index has lost ground in the Julythrough-October period. The market appears concerned about the benefits and risks of rising rates and the impact on loan growth. Net incomes of banks have strongly risen YoY in 2018, due in large part to reduction of US corporate tax rates. NASDAQ bank index, S&P 500 Index year-to-date price changes % % /2017 3/2018 6/2018 9/ /2018 NASDAQ bank S&P 500 NASDAQ bank index The NASDAQ IXBX index had risen 2.2% for the nine-month period ending Q3 2018, recently diverging with the performance of the S&P 500 Index. Bank valuations, as measured by price-totangible book values of 329 public banks in the SNL Bank Index, averaged 1.99x as of the end of Q That was up from a level of 1.94x one year prior, but down from the peak of 2.17x seen in the third week of January Source: NASDAQ 29 Credit Market Barometer

33 Of the 5,542 insured institutions reporting second quarter financial results, more than 70 percent reported year-over-year growth in quarterly earnings. The percent of unprofitable banks in the second quarter declined to 3.8 percent from 4.3 percent a year ago. FDIC Quarterly Banking Profile for Second Quarter 2018 Net income by composite ($b) Net income YoY earnings at all bank groups increased in Q Earnings at universal, superregional and regional banks increased 16.5%, 31.7% and 49.0%, respectively, YoY. This was due to higher rates, a lower effective tax rate since January 2018 and the continued favorable credit environment. The dip in Q can be attributed to the earnings impacts of the 2017 Tax Cuts and Jobs Act. -10 Universal banks Super-regional banks Regional banks NII and NIM continue to increase steadily in 2018 primarily due to loan growth and the Fed s rate increases. Net interest income by composite ($b) Net interest income NII for Q increased YoY across all bank groups. Regional banks experienced a 16.8% increase, followed by superregional and universal banks at 8.1% and 4.9%, respectively. The increase in NII was due to a continued increase in interest-bearing assets Universal banks Super-regional banks Regional banks Credit Market Barometer 30

34 Bank financial performance continued Net interest margin by composite (%) Net interest margin NIMs expanded YoY across all bank groups as the increase in earnings for interest-bearing assets continues to outpace the increase in funding costs. Universal banks experienced a 5-bps increase in NIM while super-regional and regional banks experienced an increase of 8 bps each Universal banks Super-regional banks Regional banks Source: Federal Reserve Economic Data Non-interest income by composite ($b) Non-interest income YoY, non-interest income rose across all composites at rates of 4.1%, 10.3% and 4.5% for universal, super-regional and regional banks, respectively Universal banks Super-regional banks Regional banks 31 Credit Market Barometer

35 Bank financial performance continued Non-interest expense by composite ($b) Universal banks Super-regional banks Regional banks Non-interest income YoY, non-interest expense increased 4.6%, 6.6% and 13.7% for universal, super-regional and regional banks, respectively. Efficiency programs, including branch closures, continue across the US while firms make targeted investments into customer-facing and non-customer-facing technology. Efficiency ratio (%) Efficiency ratio Efficiency ratios improved across each composite, with the super-regional banks experiencing the biggest improvement of 136 bps, followed by universal banks at 132 bps and regional banks at 93 bps. The efficiency ratio, which measures the non-interest expenses relative to net interest income and non-interest income, helps contribute to earnings strength when the ratio declines Universal banks Super-regional banks Regional banks Credit Market Barometer 32

36 Bank financial performance continued As expected, ROAA and ROAE continue to improve in 2018 due to a number of reasons, but most clearly due to the significant decrease in corporate tax rates. Return on average assets by composite (%) Return on average assets ROAA for Q rose on a YoY basis for all bank groupings. Universal, super-regional and regional banks increased by 15 bps, 34 bps and 31 bps to 1.11%, 1.64% and 1.28%, respectively, on a YoY basis Universal banks Super-regional banks Regional banks Return on average equity by composite (%) Return on average equity ROAE also increased on a YoY basis for all bank groups in Q Universal, super-regional and regional bank ROAEs increased by 209 bps, 293 bps and 229 bps, respectively, on a YoY basis Universal banks Super-regional banks Regional banks 33 Credit Market Barometer

37 Capital and funding Executive summary Capital levels remain strong through Q Firms are looking for opportunities to reduce what they perceive as excess capital. Many Comprehensive Capital Analysis and Review (CCAR) banks plan to increase capital returns to shareholders following the most recent CCAR cycle. The Fed s proposed Stress Capital Buffer may require some firms to re-assess their capital strategies. Deposit betas are anticipated to increase, which likely will contribute some pressure on bank earnings strength over the coming year. CET1 ratio (%) Universal banks Super-regional banks Regional banks CET1 capital ratio In Q2 2018, the industry CET1 capital ratio remained relatively flat after a slight decline in Q (tax reform). Increasing payout ratios combined with balance sheet growth helped keep capital ratios flat in Q2. Universal banks, super-regional banks and regional banks reported 12.2%, 10.2% and 11.8%, respectively, in Q2 2018; well above the statutory requirements. Leverage ratio (%) Leverage ratio Over the past few years, leverage ratios of super-regionals and regional banks have remained relatively flat. Universal banks leverage ratios, however, have increased by almost 200 bps between 2011 and 2015 due to postcrisis capital retention. Ratios remained mostly flat in before decreasing slightly due in part to the Q tax reform. 7.0 Universal banks Super-regional banks Regional banks Universal banks, super-regional banks and regional banks reported 8.6%, 9.6% and 9.7%, respectively, in Q Credit Market Barometer 34

38 Capital and funding continued Total capital ratios have begun declining in recent periods for smaller firms, but not for the largest banks. Total capital ratio (%) Universal banks Super-regional banks Regional banks Total capital ratio Over the past few years, total capital ratios have been steadily declining for super-regional and regional banks as firms focused on capital efficiency. Universal banks total capital ratios, however, have remained relatively elevated at around 16%, which is in part due to their higher capital requirements. In Q2 2018, universal banks, superregional banks and regional banks reported their total capital ratios as 16.1%, 13.5% and 13.8%, respectively. Credit RWA to loans and leases by composite (%) Credit RWA to loans and leases Credit risk-weighted asset (RWA) to loans and leases has remained relatively flat over the past several years. On a QoQ basis, the ratio declined by 157 bps for universal banks, while superregionals and regionals saw increases of 70 bps and 25 bps, respectively Universal banks Super-regional banks Regional banks 35 Credit Market Barometer

39 Capital and funding continued Rising interest rates are expected to further increase competition for deposits. Loan-to-deposit ratio (%) Universal banks Super-regional banks Regional banks Loan-to-deposit ratio Longer-term trends show that superregionals have eased away from the near- 100% ratio level seen several years ago to a more normalized level in the mid-90% range. Rising interest rates are expected to further increase competition for deposits; sustained credit growth could impact ratios in the coming quarters. In line with Q2 seasonality, on a QoQ basis, the loan-to-deposit ratios increased for most banks: 119 bps, 73 bps and 112 bps for universal, super-regional and regional banks, respectively. Reserves/NPLs (%) Universal banks Super-regional banks Regional banks Reserve-to-NPL ratio Reserve balances in relation to nonperforming loan (NPL) balances have been trending higher among universal banks (86.4%). Reserve balances are actually still declining for universals, but NPL balances are declining at a faster rate, leading the ratio to increase. Reserve-to-NPL ratios are building most rapidly in our super-regional composite. Super-regionals are building reserves at a higher pace, even as NPLs are continuing to decline. Reserves and NPLs have held steady over the past several years for regionals, but the ratio jumped in Q to 56.2%. Credit Market Barometer 36

40 The Canadian market Executive summary The Canadian economy continues to operate close to full capacity, and GDP is expected to expand somewhat faster than potential. The new B-20 regulations and higher interest rates appear to be having a moderate impact on bank credit. Commercial lending is benefiting from strong macroeconomic momentum, while retail lending growth is stabilizing. Bank credit performance demonstrates the stable conditions from which companies Canadian and US loan portfolios are benefiting. Banks strong financial performance reflects their diversified revenue mix, the good economic environment and their focus on cost reduction. Banks maintain their strong capital position, reflecting their disciplined approach to capital allocation. Following the implementation of IFRS 9, we observe a large dispersion in expected credit loss distribution and coverage ratios. Staging criteria is responsible for large discrepancies between banks. Furthermore, technical accounting interpretations and modeling of behavioral lifetime are also contributing to differences. In terms of momentum in Canada, we are encouraged that the economy is adjusting well to higher borrowing rates and tighter guidelines for mortgage financing. We are also pleased with the continued shift in the composition of growth toward exports and business investment. Carolyn A. Wilkins, Senior Deputy Governor of the Bank of Canada (September 6, 2018) 37 Credit Market Barometer

41 Overview The new B-20 regulations and higher interest rates appear to be having a moderate impact on bank credit. Total bank credit* (CA$b) 2,500 2,265 System-wide leverage Total credit outstanding at banks rose by 4.9% in Q2 2018, on a YoY basis. 2,000 1,500 1,000 1,195 This represents a slower growth pace compared to last year (6.5%). The new B-20 regulations and higher interest rates appear to be having a moderate impact on bank credit Source: Bank of Canada Total bank credit* to GDP (%) Credit-to-GDP ratio Credit to GDP rose marginally by 60 bps compared to the prior quarter. YoY, the ratio has remained relatively flat. Slowing mortgage growth helped tame the rise in bank credit to GDP. However, household debt servicing costs continue to move higher in line with borrowing costs, according to Bank of Canada Source: Bank of Canada; Statistics Canada * Includes only domestic exposure Credit Market Barometer 38

42 The macro view The Canadian economy continues to operate close to full capacity, and GDP is expected to expand somewhat faster than potential, according to the latest Monetary Policy Report. GDP growth rate (%) GDP GDP rose by 2.1% in Q2 2018, compared to 1.3% in Q The Bank of Canada stated in its latest Monetary Policy Report that The Canadian economy continues to operate close to full capacity, and GDP is expected to expand somewhat faster than potential Real GDP growth is projected to average 2% over 2018 to 2020, according to the same report Source: Thomson Reuters Eikon Unemployment rate (%) Unemployment rate The unemployment rate jumped marginally, 20 bps to 6.0%, after remaining flat in the previous quarter. Ontario remains the main driver of relative job strength in the country. The recent employment trends confirm Bank of Canada s statements that the economy is operating at full capacity. The majority of economic forecasts suggest the bank will likely execute a rate hike in October. 4.0 Source: Statistics Canada 39 Credit Market Barometer

43 Loan exposure Commercial lending is benefiting from strong momentum, while retail lending growth pace is stabilizing due to slowing residential mortgage growth. Retail loans* ($b, CAD) 1,800 1,700 1,600 1,500 1,384 1,400 1,714 Retail exposure Consumer loan exposure for the Canadian banks rose by 4.5% YoY. On a QoQ basis, the increase was more modest (1.0%) due to seasonality. We have seen a healthy normalization in Canadian housing and our mortgage portfolio continues to grow, said Rod Bolger, RBC s CFO, during the bank s latest earnings call. 1,300 1, Source: Bank Investor Relations * Includes retail mortgages and HELOCs Retail and wholesale loan exposure includes exposure to Canada, the US and other countries Wholesale loans ($b, CAD) 1, Wholesale exposure Wholesale lending exhibited a sharp increase of 5.4% over the quarter. On a YoY basis, the growth was 6.2%. The commercial business for Canadian banks is benefiting from strong momentum, mostly in the US, driven by a fierce competitive market for drawing assets, according to comments from TD Bank (TD) Source: Bank Investor Relations Credit Market Barometer 40

44 Loan credit quality Retail delinquency and impaired ratios levels are at their lowest since Wholesale credit quality is also strong. Retail loans* Delinquency rate and GIL ratio** (%) Retail loans credit quality 30-day+ delinquency rate improved by 4 bps YoY and QoQ. Gross impaired loans ratio also decreased by 4 bps YoY. Retail delinquency and impaired ratios levels are at their lowest since 2013, reflecting improved performance in the retail portfolios day+ delinquency rate (excl. impaired loans) Gross impaired loan(gil) ratio Source: Bank Investor Relations Wholesale loans Delinquency rates and GIL ratio** (%) Wholesale loans credit quality The continuous improvement in loan credit quality is also observed in the wholesale segment, where delinquency rate improved by 2 bps YoY and QoQ. Impaired ratio is down 2 bps sequentially and 10 bps compared to last year day+ delinquency rate (excl. impaired loans) GIL ratio Source: Bank Investor Relations * Includes retail mortgages and HELOC **GIL as a percentage of gross loans and acceptances 41 Credit Market Barometer

45 Bank credit performance Bank credit performance demonstrates the stable conditions from which their Canadian and US loan portfolios are benefiting. GIL ratio* (%) 0.80 Gross impaired loans Gross impaired loans ratio has remained stable at 0.57%. It is down 8 bps YoY The performance of retail and wholesale segments has been consistent over the last two years. Favorable macro environment, high portfolio diversification and strong quality (high average portfolio credit scores) are the key drivers of the strong performance Source: Bank Investor Relations *GIL as a percentage of gross loans and acceptances PCL ratio** (%) Provision for credit losses Provision for credit losses ratio declined modestly by 1 bps QoQ and YoY to 28 bps. PCL performance demonstrates the stable conditions from which Canadian and US loan portfolios are benefiting As an example, TD s improved PCL performance was due to credit cards and auto portfolios Source: Bank Investor Relations **Provision for credit losses (PCL) as a percentage of average net loans and acceptances Credit Market Barometer 42

46 Bank financial performance Banks strong financial performance reflects their diversified revenue mix, the good economic environment and their focus on cost reduction. Net income ($b, CAD) Net income Net income rose by 11.1% in Q on a YoY basis, and increased by 6.6% on a QoQ basis. For the majority of the banks, YoY net income growth was recorded in all segments and geographies (Canadian property and casualty, US and capital markets) supported by higher revenues, lower PCL and lower expenses Net interest margin (%) Net interest margin Net interest margin remained stable in Q at 1.77%. Comments gathered from the latest quarterly earnings conference calls suggest that the rising rate environment will help banks improve their net interest margin in the future, mainly due to higher deposit margin and steady state competition Credit Market Barometer

47 Capital and funding Canadian banks maintain their strong capital position reflecting their disciplined approach to capital allocation. Common equity tier 1 (CET1) ratio (%) Tier 1 capital ratio The banks continue to raise their CET1 equity. The ratio stands at 14.62% as of Q1 2018, up 362 bps over the year. Bank s earnings strength provides us with the optionality to invest in our businesses and to return capital to our shareholders through share buybacks and dividend growth, according to CIBC s CEO, regarding the bank s capital position Loan-to-deposit ratio (%) Loan-to-deposit ratio Loan-to-deposit ratio was 78.3% as of Q2 2018, up 198 bps YoY. Loan growth observed in both personal and business segments continues to outpace deposits growth, which contributed to stable NIM growth YoY Credit Market Barometer 44

48 Special topics CECL: impact concerns coming into wider view As the impacts of Current Expected Credit Loss (CECL) become more widely discussed, concerns are rising about how the market will respond to capital revisions and new patterns of provision expense. Worries expressed by many lenders are across three impact areas: capital levels, the future volatility of earnings and the lenders willingness to extend credit amid the complex dynamics that will exist among loan growth, positioning in a credit cycle and the tendencies to place more emphasis on nearer-term profitability metrics. Background: CECL represents a major change to how lenders set reserves for future loan losses. The standard will have the effect of not only increasing and frontloading loan reserves, leading to various measures of capital reduction (assuming no further regulatory capital relief measures), but it will also substantially increase the number of variables that financial statement preparers must consider in establishing their expense provisions to maintain reserve balances. Capital: The primary effect of CECL is that as lenders book new loans, an estimation of the life-ofloan losses will immediately run through the income statement as a provision expense. The front-loading of reserves represents a dollar-for-dollar loss to firms equity capitalizations. With capital strength being a major determinant of overall credit strength, lenders that may be viewed as marginally capitalized for a given level of credit strength will appear weaker (by some measure), possibly threatening their credit standing with counterparties and their credit ratings with rating agencies. While most counterparties and credit analysts recognize that changes to accounting standards do not change the economics of a business, GAAP accounting remains a critical input to most evaluators of credit. Thus far, regulators and rating agencies have signaled little willingness to alter their approaches to crediting some measure of higher reserves generated under CECL toward equity capital. The impact of CECL on reserves will vary widely by loan type. Longer-life assets and higher expected loss assets will drive relatively higher reserving on the front end of loan life. Whether the lender is a bank or a nonbank will also matter for the resultant impact on capital. US bank capital rules allow an add-back of Allowance for Loan and Lease Losses to Tier 2 capital up to 1.25% of a bank s risk weighted assets (RWA). Banks currently under the 1.25% limit will receive this benefit, but CET1 and Tier 1 capital ratios will each be affected without offset. A modest fraction of the top 360 banks in the US (banks >$3 billion) already exceed the limit of 1.25% of RWA. For nonbank financial institutions, which do not fall under US bank capital rules, capital metrics will generally all suffer some measure of weakening. Earnings volatility: The effect of CECL rules generating day-one provision expense on newly booked loans will also lead to meaningfully higher reserve releases over loan life as the asset amortizes and ultimately is paid in full. For loans that experience a loss, on balance, CECL reduces the provision bump expected near the time of the loan s default under today s incurred loss reserving approach. The concern that lenders are expressing with regard to earnings volatility is linked to CECL s requirement that reasonable and supportable forecasts be a contributor to ongoing reserve valuation allowances. While it is relatively easy to envision scenarios in which macroeconomic conditions hold steady and drive little need to make changes to reserve levels, a more aggressively changing environment could lead to substantial changes in provisions as statement preparers revise outlooks and successively ramp provisions. The potential need to reverse such decisions through reserve releases exists if provisions were overestimated. Unlike the incurred loss reserving approach, where the provision runs through the income statement when the loss reaches a probable threshold, CECL requires both a more a forward-looking (and potentially uncertain) view and delete the application of that view to the entire loan portfolio (not just the deteriorated loan approaching default, as is the case more so under incurred loss approach). 45 Credit Market Barometer

49 Extension of credit: CECL, quite simply, results in higher-growth lenders appearing less profitable as the provision expense that accompanies the newly originated loans makes earnings more impacted relative a firm experiencing slower loan growth. This effect will be magnified if the lender is experiencing its growth near the onset of a downturn in the market. A possible and potentially protective response (protective for the lender s credit health) could be that some lenders will simply lend less as credit conditions worsen. On the other hand, some market participants have expressed concerns that reducing available credit due to lenders concerns about near-term profitability (as well as lending to weakened borrowers) could lead to a sharp reduction in credit supply just as credit demand is rising in response to a macroeconomic downturn. There is a further consideration related to the extension of credit that we are hearing from lenders, which deals with the effect of CECL on their potential willingness to extend certain forms of credit even under steady state conditions. The worry specifically applies more to longer life, higher-credit loss loans (e.g., longer-dated consumer loans, in particular) where the day-one capital effect is of such a significant magnitude that time to replenish the up-front capital hit for the loan in other words, the time it takes for the loan s profits to recoup the original capital outlay will be uncomfortably longer relative to incurred loss accounting. The concern expressed applies most directly to firms that are both thinly capitalized and already operating with very thin profit margins. A transition away from interbank offered rate (IBOR) In July 2013, the Financial Stability Board (FSB) established the Official Sector Steering Group, composed of senior officials from central banks and regulatory agencies, to focus on interest rate reform. The following July, the FSB recommended the development of alternative reference rates (ARRs) and a transition away from IBORs across all major currencies. In addition to the FSB report, the IOSCO Principles for Financial Benchmarks (2013) and European Union Benchmark Regulation (2017) provided additional impetus for interest rate benchmark reform. Since then, working groups across all major currencies have been formed to select ARRs and provide an orderly transition. ARRs have been selected for currencies around the globe, including: Country/ ARR jurisdiction Current IBOR(s) Name Abbreviation US USD LIBOR Secured overnight financing rate SOFR UK GBP LIBOR Reformed Sterling overnight index average SONIA EU EURIBOR, Euro LIBOR Euro short-term rate ESTER Switzerland CHF LIBOR Swiss average rate overnight SARON Japan JPY LIBOR, JPY TIBOR, EUROYENTIBOR Tokyo overnight average rate TONA Credit Market Barometer 46

50 Special topics continued IBOR (continued) The transition from IBORs to ARRs is complex and will require firms to assess and manage several significant business, operational, valuation and risk management processes in order to successfully manage the transition. To start, firms need to assess the structural differences between ARRs from their respective IBORs and the impact that the proposed solutions the industry is developing to remediate these issues would have on their business profile. The two key differences between select ARRs and IBORs are the absence of (1) a credit premium and (2) term rates. Current IBORs are based on unsecured lending, which means they include a bank credit spread premium, whereas ARRs (e.g., SOFR in the US and SARON in Switzerland) are secured rates and do not include this premium as they are backed by collateral. Another key difference is the absence of a term rate for certain ARRs as currently IBORs are quoted for multiple defined floating-rate tenors, while most of the proposed ARRs currently do not and are only quoted for overnight tenors (e.g., SOFR in the US). Because of these differences, transfer of market value could occur if firms transition existing transactions referencing IBORs by simply selecting an alternative reference rate (ARR) in its current form as a new reference or fallback rate if IBORs are discontinued. To manage this risk, firms will need to determine appropriate spreads to be applied to ARRs to mitigate the potential of a significant value transfer. While the mechanics of determining appropriate spreads to ARRs remains a work in progress, the launch of ARR-based underlying futures and the evolution of the ARR swaps market will assist market participants with price discovery through market-implied basis spreads between ARRs and IBORs. In addition to the ARR-IBOR basis risk that will need to be measured and managed, firms will monitor market liquidity across different products and have the ability to identify interrelated products in order to maintain hedge relationships when transitioning (e.g., derivative hedge linked to an underlying commercial loan). When preparing to trade new cash and derivative products referencing ARRs, firms should take immediate action to update or implement new front-to-back processes for origination, trade capture, confirmation, loan accounting and risk measurement, starting with developing new ARR-based cash flow forecasting and discounting curves used for pricing. When updating these processes and building new capabilities, firms should plan to support a dual- or multi-rate environment where certain products, or subsets of the same product, would remain to reference IBOR while others will be ARR-based. For risk and exposure modeling, firms will need to determine historical market data proxies in the absence of full empirical historical time series. Such market data can be used for value-at-risk, counterparty exposure modeling (such as potential future exposures or valuation adjustments), asset-liability management (ALM) modeling, loan forecasting and stress testing, among other models. With IBORs potentially being discontinued and cash and derivative product liquidity moving to other benchmarks, firms may need to re-assess their ALM hedging strategies and limits to manage the possibility of increased basis risk arising from asymmetry in bank credit spreads or tenor resets in asset, liability and hedge products. Similarly, firms may have to monitor the risk of contingent asset-liability basis risk in cases where certain legacy cash products have fallback language that differs from derivatives hedging instruments in the event of IBOR discontinuation. Even if IBORs are not discontinued, firms will have to manage valuation risk by actively monitoring the liquidity of longer-dated legacy positions linked to IBORs, and assess whether valuation adjustments need to appropriately reflect bid-ask spreads and the extent to which firms are able to exit such positions. Approved products and desk mandates will have to be reviewed and potentially updated for new ARR-based products, and limits will need to be appropriately calibrated to reflect the market depth of new ARR products. Credit limits will also need to be reviewed and potentially re-calibrated when evaluating the potential value transfer scenarios to assess the impact that a transition from IBORs to ARRs will have on current utilization levels. To fully understand the broad implications on their business, operations, valuation and risk management infrastructures, it will be important for firms to perform an assessment that references all types of IBORs across the enterprise. This will facilitate an understanding of the holistic uses of the relevant IBORs for cash and derivative products and in areas such as loan origination, loan accounting, mortgages, ALM and funds transfer pricing. This will allow firms as much lead time as possible to plan for the significant amount of work required to modify or create new business processes, systems and models to support the new ARR environment before the end of 2021, when banks will no longer be compelled to make LIBOR submissions. 47 Credit Market Barometer

51 Regulatory snapshot Executive summary Credit issues remain a supervisory priority at the US banking agencies. The OCC s FY 2019 Supervisory Operating Plan specifically notes heightened attention will be placed on commercial and retail credit loan underwriting, concentration risk management, credit risk management, and the allowance for loan and lease losses, including preparations for CECL accounting. Additional areas of focus in the OCC s FY 2019 supervisory plans: Cybersecurity and operational resiliency, with emphasis on maintaining information technology systems and remediating identified concerns Bank Secrecy Act and anti-money laundering (AML) compliance, with emphasis on determining whether AML compliance programs keep pace with changing risk environments and regulatory developments Consumer-compliance-related change management process, with emphasis on implementation of regulatory requirements, including the Home Mortgage Disclosure Act, the integrated mortgage disclosure requirements under the Truth in Lending Act and Real Estate Settlement Procedures Act, and the Military Lending Act Internal controls and end-to-end processes necessary for product and service delivery (This may include emphasis on implementation of new or revised products or strategic partnerships.) In addition, the during the quarter, the agencies issued guidance on the role of guidance for examiners and the industry, and a Notice of Proposed Rulemaking on the definition and capital treatment of high volatility commercial real estate (HVCRE). Interagency guidance on supervisory guidance On September 11, the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, the Office of the Comptroller of the Currency and the Bureau of Consumer Financial Protection (Agencies) issued a statement clarifying the role of supervisory guidance. The Agencies seek to explain the role of supervisory guidance and the Agencies approach to guidance. This publication is consistent with the Agencies efforts to be more transparent (including subjecting standards, even if they are not regulations, to public notice and comment) and predictable. The statement outlines the differences between laws and regulations and supervisory guidance. The distinction is important in that a law or regulation is a legal obligation with which financial institutions must comply they have the force and effect of law. Supervisors will cite a violation for noncompliance with laws and regulations, which can be the basis for an enforcement action. Supervisory guidance, on the other hand, is not a legal obligation, and the Agencies do not take enforcement actions based on guidance. Supervisory guidance comes in many forms, including interagency statements, bulletins, alerts, questions and answers, and so on. Guidance typically provides regulatory expectations for safe and sound practices, and may include examples of activities or practices that are consistent with these expectations. It is unclear whether supervisors will reference noncompliance with guidance in supervisory feedback and findings such as matters requiring attention. The Agencies intend to limit the use of quantitative measures and benchmarks, such as those found in the Interagency Guidance on Leveraged Lending. When developing guidance, the Agencies may seek public comments on quantitative and qualitative matters to help evaluate particular issues, and they will attempt to limit the issuance of multiple guidance documents on the same topics. The Agencies clarified that they will continue to make use of guidance as part of their industry communications. The Agencies view guidance as an important mechanism to communicate supervisory expectations to both the industry and supervisory staff. Bankers should refer to guidance to obtain industry insights and better understand supervisory expectations. Examiners will continue to reference the principles outlined in supervisory guidance and may cite guidance for examples of safe and sound practices, consumer protection, risk management or other relevant activities. Credit Market Barometer 48

52 Regulatory snapshot continued Regulatory capital treatment for high volatility CRE (HVCRE) exposures On September 18, the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Comptroller of the Currency issued a notice of proposed rules (NPR) to amend the definition of HVCRE to comply with the requirements of the Economic Growth, Regulatory Relief, and Consumer Protection Act (the banking bill). The banking bill amends the Federal Deposit Insurance Act by adding a new section (51) that gives a statutory definition for HVCRE Acquisition, Development, or Construction loans (HVCRE ADC). The NPR seeks to align regulatory capital rule and HVCRE definitions to be consistent with the intent of the new law. The banking bill is important as it dictates that the regulatory agencies may only require a higher risk-weighting for HVCRE loans that fit the new statutory definition. The bill defines an HVCRE ADC loan as a credit facility secured by land or improved real property. Other land loans (secured by vacant land except when for agricultural purposes) would be included in the scope of the revised HVCRE definition according to the agencies (helps with consistency with the call report s inclusion). We expect that the change in definition will significantly reduce the volume of reported HVCRE loans. As HVCRE loans are assigned a risk weighting of 150%, this will result in a reduction in required capital in many banks. The banking bill outlines three criteria that must be met for a loan to be considered an HVCRE ADC loan: The credit facility must primarily finance or refinance the acquisition, development or construction of real property. The purpose must be to provide financing to acquire, develop or improve real property into income-generating property. The repayment is dependent on future income and sales proceeds from the property. 49 Credit Market Barometer

53 Regulatory snapshot continued The determination (of whether the loan qualifies as HVCRE ADC) will only be made at the loans origination. Loans that meet the above three criteria may be excluded if they meet one of the following exclusion criteria: 1 4 One-to four-family residential properties Loans on existing incomeproducing properties that qualify as permanent financings The revised HVCRE exposure definition will exclude credit facilities for the acquisition or refinance of existing incomeproducing real property secured by a mortgage on such property, so long as the cash flow generated by the real property covers the debt service and expenses of the property in accordance with a depository institution s underwriting criteria for permanent loans. The Agencies may review the reasonableness of a depository institution s underwriting criteria for permanent loans through the regular supervisory process. 2 5 Community development investment Four criteria for certain commercial real property projects Loan-to-value ratio is less than or equal to the applicable maximum. The borrower has contributed capital of at least 15% of the appraised value to the project. The 15% is contributed before the institution s advanced funds (other than a nominal sum to secure the lien on the real property). The 15% is required to remain in the project until the loan can be reclassified as non-hvcre exposure. 3 6 Agricultural land Reclassification as a non-hvcre exposure This occurs when the substantial completion of the development or construction has occurred and cash flow generated by the property covers the debt service and expenses in accordance with the bank s loan standards for permanent financings. Until the Agencies issue a final rule, institutions may continue to report HVCRE exposure in accordance with current call report instructions. Loans made prior to January 1, 2015, are grandfathered from the new requirements. For newer loans, banks have the option of reporting on a best-effort basis or according to the superseded definition until the final rule is issued. Credit Market Barometer 50

54 Appendix 51 Credit Market Barometer