"Extending Credit: The Evolving Role of Wholesale Banks In Credit Markets" is the 2024 edition of our annual wholesale banking industry outlook with Morgan Stanley. We explore the global industry outlook, the generational shift currently underway in global credit markets, and what this shift means for wholesale banks. 

Wholesale banks have spent the years since the global financial crisis reshaping their business models to build resilience and generate sustainable returns. This transformation has been profound, as evidenced by the performance across the industry through a wave of very different market shocks. Credit is one area where the transformation of the wholesale banking business model is not complete. However, the transformation is now accelerating under the weight of increased regulatory pressure, product innovation, and the entry of new competitors.

Understanding the shift in wholesale banking value pools

Industrywide revenues have been virtually unchanged for the past three years, but the stable overall performance masks shifts at the business level — with significant erosion in investment banking, strong growth in transaction banking, and more resilient performance in markets consistently since the pandemic. A key driver has been the end of a prolonged period of easy monetary policy and fiscal stimulus across the world, as central banks raised rates and retired or reversed quantitative easing policies.

Key structural drivers supporting wholesale banks’ future growth

The critical question entering this tightening cycle was whether industry-wide revenues would snap back to pre-pandemic levels. We are confident that the industry is not at significant risk of returning to the pre-pandemic doldrums, thanks to three structural shifts: interest rates in line with historical norms across the globe, sustained levels of market volatility, and the ongoing change in demand from corporate clients. Together, these structural shifts should provide the foundation for a healthy revenue and returns outlook for the wholesale banking business, adding approximately $55 billion to $90 billion of revenues by 2027 versus a 2019 baseline.

In our base case, we estimate that industry-wide return on equity (RoE) will rise to approximately 14% by 2027, up from approximately 12% in 2023. The RoE improvement is driven by a strong recovery in investment banking — which delivers disproportionate RoE improvement in an upcycle, given the cost and capital structure of the business.

The potential impact of regulation on the outlook

Key to our positive outlook is the diminishing risk of a significant increase in capital requirements as part of the Basel 3 Endgame package in the US and other jurisdictions, especially in the wake of the US elections. While this remains a wild card worth monitoring — every 5% uplift in industry-wide capital would reduce RoE by approximately 60 basis points — it is an increasingly remote possibility.

The credit transformation and its impact on market dynamics

There has been an intensifying spotlight on the role of non-banks in the credit market over the past several years. Regulatory pressure, product innovation, and the entry of new competitors into the most attractive segments of the market has broken banks’ stranglehold on liquid credit trading and private credit origination.

The evolution of liquid credit markets

The emergence of liquid trading channels in credit markets over the past five years has been surprising and somewhat overshadowed by the high-profile growth of private credit. Waves of innovation, including electronification of credit trading, growth in satellite credit markets, data and pricing transparency, and trading automation, are generating opportunities for banks to serve a more diverse set of market participants — and generating new sources of competition for market making in these products. The electronification of liquid credit markets, supported by the growth of credit exchange-traded-funds as a source of liquidity, a rise in portfolio trading, and evolving trading protocols, has opened the door to non-bank market makers. As liquid credit market structures and dynamics start to resemble parts of equities and macro, value capture and market share is shifting toward these non-bank players. The equities markets were disrupted in similar ways many years ago, but a new business model emerged (or expanded significantly) to serve the new ecosystem: prime services. As the market matures, a similar model could emerge in liquid credit.

Drivers of the private credit value shift and the implications for banks

Several forces are converging to drive private credit toward its own inflection point. The banks active in lending to US middle market companies, through traditional commercial and industrial loans or asset-backed finance, face balance sheet pressure today that may intensify with new capital rules and/or elimination or softening of special tailoring provisions for smaller institutions. In parallel, private credit managers continue to expand their reach into product areas that have historically been dominated by banks, such as asset-based financing and infrastructure finance. Banks have already ceded share to private credit managers, particularly in middle-market direct lending, which competes directly with the broadly syndicated loan (BSL) market dominated by the leveraged finance teams of investment banks. However, banks have maintained their roles within the high-yield bond and BSL markets and remain critical to the broader private credit ecosystem. Future shifts will be across two dimensions: penetration into other types of credit and expansion outside the US.

Risks and opportunities in the new credit ecosystem

As the liquid and private credit markets continue to advance, we see an incremental $35 billion to $50 billion of existing revenues potentially at risk for wholesale banks. This represents 8-11% of the total credit revenue for these players today.
 

Despite the expected pressures on banking credit revenues, new opportunities are emerging for banks to position themselves as strategic partners, serving the needs of the evolving manager ecosystem. We expect up to $15 billion of incremental revenue will be up for grabs by 2027. Providing financing to the credit manager ecosystem is the largest opportunity in absolute terms, and an attractive one given lower regulatory capital requirements on exposures to funds versus individual assets in the portfolio. Banks will continue to play a key role in originating, distributing, and structuring private credit assets in partnership with managers, increasing balance sheet velocity and retaining a share of the economics through origination fees. Finally, banks can also capture opportunities to provide fund and loan servicing to private credit managers, and support trading and hedging of private credit assets as secondary trading becomes more common.

Banks with strong sponsor business models and well-established distribution networks are most likely to benefit from the shift in the market, tapping into the enormous demand for asset origination, structuring, servicing, and financing from a new set of market participants.

Navigating the credit transformation to position for future success

Banks have traditionally dominated the value chain for credit end to end. Banks extend credit to borrowers from their balance sheet, service the assets through the life of the agreement, and selectively distribute the risk to other banks and institutional investors. This remains the dominant model in the market today, but new structures are building momentum as banks face greater balance sheet pressure and innovations allow new intermediaries and investors to enter the space. Against the backdrop of a supportive environment for wholesale banking performance, the continued rise of non-bank players in liquid and private credit poses both risks and opportunities for wholesale banks. Banks need to holistically assess their position in credit and set a clear ambition across the business.