Securities Firms Can Handle Larger Revenue Hit Than In 1998
Standard & Poor’s says it is possible that continued stock market turmoil could cause a greater decline in revenues at major securities firms than after the stock market drip of 1998. However, most firms should be able to manage such a drop with no impact on their credit ratings.
In the second half of 1998, overall net revenues for investment banking and trading fell 31% from the highs of the first half of that year, S&P says. Fixed income, currencies, and commodities revenues were practically zero or even negative for some broker-dealers in the final six months of 1998. Equity and investment banking revenues suffered much less, but were still down.
S&P conducted a “harsh, but plausible,” stress test for investment banks’ earnings based on a similar environment. The results show aggregate investment banking and trading revenues for the largest firms down 47%. This is more severe than in 1998, reflecting in particular potential mark-downs on leveraged finance exposures and structured credit.
In such a scenario, S&P would expect flexible cost bases to limit the decline in pretax profits from investment banking and trading to about 70%, resulting in a pretax margin of 21% compared with 36% in the first half of 2007.
This stress test is neither our central expectation nor a forecast but is indicative of the ability of investment banking businesses to withstand such scenarios.
S&P would regard a scenario like this as testing, but manageable, within current ratings on the large securities firms. Many capital markets businesses are part of broad diverse financial groups, cushioning the impact of a decline. S&P estimates that the aggregate 70% decline in pretax profit at the divisional level would be diluted to 40% at the consolidated group level.
Given the still-favorable economic fundamentals, an extended downturn seems unlikely at present, S&P says, and late 1998 was followed by a strong bounce back. S&P also notes that it made few downgrades to securities firms even during the bear market of 2001-2003.
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