The revenue setup heading into the fourth quarter is decidedly negative. Banks remain under pressure on three fronts: net interest income, fee income, and capital markets business.

Net interest income pressure

Between the end of July and the end of September, the yield on the ten-year Treasury fell 120 bps. Historically, asset yields have closely tracked the 2-year bond yield, but in the current environment, the 10-year is a better proxy for asset yield pressure. Based on our assumptions of the 10-year bond in the fourth quarter — 14 bps decrease compared to 15 bps in the third quarter — asset yield declines on bank balance sheets should be comparable to their levels last quarter.

What about the liability side?  The cost of liabilities fell by 6 bps in the third quarter, which isn’t too bad. But when you dig in further, roughly half of this improvement was due to a shift in their mix — increasing deposits relative to debt. Costs of deposits decreased by 3 bps in the quarter (in line with the minimal improvement typical of the last six quarters), and costs of liabilities decreased by 1 bps.

This distinction is important. Keep in mind that fear and market panic tend to increase bank deposits. In the third quarter, domestic banks benefited particularly from outflows from European financial institutions. These flows are not likely to repeat. (If they do, it would be because of renewed panic in the banking system – which would more than offset 3 bps of improvement from liability mix shift.) Accordingly, we would expect only 3 bps of further improvement in total liability costs in the fourth quarter.

Putting the pieces together, we estimate asset yield declines of 10 bps in 4Q, coupled with 0 – 3 bps of liability cost decreases. So interest spreads will see a decrease of  7 to 10 basis points in the fourth quarter, versus a 4 basis-point drop last quarter.

Net interest margin pressure was a major driver of downside in the 3Q reports. In 4Q, we expect that pressure to double.

No Such Thing as a Fee (Income) Lunch

Over the last week, every bank that had floated the idea of a debit card fee (JPM) has dropped it. This is striking to us – banks had spent months assuring investors that new fees would make up most or all of the hit from Sen. Durbin, statements that now appear not to be true. Banks had attempted to pin the blame for the fees on Senator Durbin, but customers didn’t buy it.

The way we look at it, a dollar of revenue is a dollar of revenue, and these companies were already attempting to maximize profits. If it were easy and profit-enhancing to charge a fee for debit cards, banks would have already done it. Yes, the Durbin amendment changes the environment – Bank of America initially told its customers that there was no point in switching banks, since everyone would institute the same fee. Customers and competitors both called that bluff.

We’re not trying to suggest that fee income won’t ever rise. In the current environment, with low rates and revenue pressure from many fronts, fee income will continue to be a focus. But what the full-scale retreat from debit card fees demonstrates is that the process of increasing revenue will be slow, painful, and complex.

Capital Markets Squashed by Volatility

On the Morgan Stanley (MS) third quarter earnings call, the company mentioned that the elevated level of the VIX is holding up deal execution, but that if that improves in the fourth quarter the company should be able to capitalize.  In the quarter to date, the VIX has averaged 32.8 as compared to 30.6 in the third quarter, so the environment has not improved.

An excerpt from the call:

Analyst: Lastly, just your outlook for the fourth quarter with the way the markets have been, should we expect something similar to this quarter?

CFO Porat: The wild card as I indicated continues to be the macro environment. The pipeline in banking overall is healthy. I commented on M&A. The equity pipeline continues to build and our view is that with some moderation in the VIX, we should start to see more of those deals working their way out of pipeline and into execution and the benefit is not just within banking, but clearly go through secondary trading and through to Morgan Stanley Smith Barney, so that is an important driver and hard to forecast. What we’re seeing, healthy volume on the banking side and I think a lot of the real challenge in credit hopefully starts to moderate given how tough it really was, the levels we’re currently operating. So if you can give me the outlook for the macro, I can answer more directly.

A Difficult Time for Revenue Pressure

Revenue pressure is hitting from these three fronts at the same time that credit costs are set to increase. The major driver of reserve release, credit cards, has been exhausted, and increasing delinquencies in card accounts means that provisions need to increase. Clearly, the large banks are most exposed, since they have big credit card books, capital markets exposure, and have pulled back on the fee side. This is a highly unfavorable setup coming into year-end.

The worsening fundamental pressures on the sector, coupled with Europe, makes for a very bearish setup. That said, Bernanke is making it increasingly clear that some form of QE3 will be brought to bear as needed, which could give the markets a kneejerk bounce as it has in the past.