It finally happened. Financial stocks reacted in a relatively-volatile fashion - with Europe falling and Wall Street rising at open - a day after ratings agency Moody’s announced the long-awaited completion of its review of 17 global capital markets-orientated banks.
The results of the review, first mooted on February 15, were in line with market expectations: on average, the leading US banks were downgraded two notches from a holding company median rating of A2 to Baa1, while European banks were similarly downgraded by one to two notches.
Interestingly, Morgan Stanley was downgraded by two notches to Baa1 – a higher rating than Bank of America and Citi, but one lower than Goldman Sachs. This outcome for Morgan was better than expected, as Moody’s underscored the bank’s strong relationship with Mitsubishi UFJ.
The creditworthiness of the global banks at a holding company-level was also placed on negative watch, citing a lack of clarity about the regulations surrounding bank bankruptcies. But, in all, for the US banks, especially, it could been a lot worse, though, Moody’s ratings represent the lowest ratings across the three main ratings agencies.
Market players say the rating shifts were well-anticipated, and priced into stock and bond prices. In short, the moves won’t materially exacerbate the drought in banks’ long-term funding markets, reckon analysts. However, the move will further crimp global banks’ profitability prospects, widen the gulf between the top tier investment banks and dealers with lower market shares and, potentially, accelerate the shift among the dealer community to adopt central clearing for OTC derivatives.
Says CreditSights:
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"The risk of an outflow of funds is small, and we do not think the downgrades will have a material impact on funding costs – ratings are much less influential in this respect than they used to be – although the downgrade of some short-term ratings to P-2 will further restrict banks’ access to short-term funding markets.” |
US banks, in particular, have made dramatic shifts to their near-term capital, funding and liquidity ratios, and fewer European banks, in general, are dependent on ratings-sensitive short-term funding markets while they drink from the European Central Bank liquidity tap.
However, the broader significance of the move is that it throws into sharp relief whether financials are a viable investable asset class, given structurally weak profitability prospects – especially in ratings-sensitive fields in prime brokerage and derivatives – and fears over the integrity of global investment banks’ business models.
In short, has Moody’s added insult to injury – or just more injury?
Ratings are certainly backward-looking but ratings “are still, to a surprising extent, hard-wired into investment mandates, debt contracts and regulatory regimes, and banks will probably have to post more collateral against derivatives and covered bond contracts,” CreditSights concludes.
However, according to Credit Suisse, the collateral costs are manageable – for US banks, excluding Morgan Stanley, the collateral outflows from a two-notch downgrade is approximately 1-2% of available liquidity – while higher unsecured lending costs are structurally hard-wired into banks’ business models.
More profoundly, the downgrades could lead to a loss of derivatives business and expose a gulf in the profitability/creditworthiness of the top-tier investment banks, such as Goldman Sachs and JPMorgan, and the likes of Morgan Stanley.
“One of the more potentially significant impacts of a ratings downgrade is possible loss of business for those dealers that are at the lower end of the ratings spectrum,” says Credit Suisse.
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"While the exact magnitude of potential revenue loss or potential pricing concessions needed to remain competitive is incredibly challenging for us to gauge, we provide some broad revenue and earnings sensitivities. We estimate that each incremental 5% of derivatives revenues translate to 2% of average annual earnings for the major US dealers.” |
Moody's downgrades will have a constructive impact on the structure of the OTC derivatives market, concludes Credit Suisse:
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"We anticipate the downdraft in credit ratings for the entire dealer community could potentially accelerate the move towards greater adoption of central clearing ahead of mandatory clearing requirements as both buy-side and dealers seek to move exposures away from lower-rated counterparties while also attempting to avoid concentrating exposures to select number of higher-rated counterparties. We believe such a move would ultimately enhance risk adjusted returns as we anticipate potential pricing compression will be more than offset by RWA alleviation.” |
The impact of the downgrades won't be known until the next few quarters at least so we will wait to see if Goldman Sachs and JPMorgan enjoy greater market shares in fixed income, currencies and commodities and equities trading. For now, the news serves to, once again, shine a light on the new normal of banks’ lower return-on-equity levels compared to the pre-crisis heyday.
