When Standard & Poor’s (S&P) downgraded Barclays, Credit Suisse and Deutsche Bank to A on Tuesday, the agency made it clear these top global investment banks still enjoyed ample sovereign support.
Citing the volatility, potential for lower returns and capital-intensity of the investment-banking model as rationale for the downgrade of Barclays, the agency said: “The long-term counterparty credit rating includes two notches of support over and above the ‘BBB+’ stand-alone credit profile, reflecting our view of Barclays’ ‘high’ systemic importance in the UK and our assessment of the UK government as ‘supportive’.”
It employed similar language for Deutsche Bank and Credit Suisse. In other words, these banks are still too big to fail, in S&P’s view, despite the upcoming bail-in legislation, policymakers’ rhetoric to the contrary, cross-border resolution mechanisms, and the recent banking crises in Cyprus and the Netherlands, in particular.
Citing the imposition of a punitive leverage ratio, regulatory fragmentation – the Fed’s surcharge on the US subsidiaries of Deutsche and Barclays, in particular – and the eurozone crisis, among other factors, S&P’s move reflects fears over global banks’ profitability prospects amid a new market and regulatory normal.
Crucially, however, in the case of Barclays and Credit Suisse, S&P explicitly made it clear the prospect of sovereign support propelled the bank up the ratings spectrum by two notches.
In any case, S&P’s ratings are largely in line with Moody’s, which last June downgraded 15 global banks, with the leading US institutions downgraded by two notches from a holding company median rating of A2 to Baa1, while European banks were similarly cut by one to two notches.
While Moody’s bank ratings represent the lowest across all three main agencies – given changes to its adjusted Bank Credit Assessments methodology – the agency, like Fitch, has signalled it would consider further reducing the prospect of implicit sovereign support later in the year once new regulations see the light of day, particularly Dodd-Frank and the Orderly Liquidation Authority.
Or in S&P’s words, after the downgrade on Tuesday: “We could lower our ratings on Credit Suisse if we saw diminished prospects that the government would provide support to the bank’s senior creditors.”
In sum, while the rating agencies acknowledge that legislators and regulators are trying to progress along the path to eliminating implied state support for systemic banks, they cannot ignore the reality that they remain contingent liabilities of the sovereign.
The agencies’ efforts to overhaul their bank rating methodologies to accommodate the theoretical elimination of state support, while noting its de facto continuation, underscore their inherent subjectivity.
Enter Scope
Rising from the ashes of these legacy methodologies, however, is Scope Ratings, a Berlin-based family-owned company, with expertise in real-estate fund ratings, which aims to become the first dedicated global bank-ratings agency based in Europe.
Samuel Theodore, a veteran of Moody’s and latterly of the European Banking Authority, heads up the fledgling London-based side of the operation.
Scope’s emergence to challenge the natural oligarchy of the top three agencies – given the high barriers to entry and need for strong reputation before winning clients – has been aided by European Union policymakers, who are keen to boost competition by encouraging issuers to mandate agencies with low market share.
Whether it is stand-alone ratings or reviewing the level of systemic support for banks in AAA and non-AAA home jurisdictions, alike, agencies need to aim for forward-looking assessments of bank capital ratios, and place greater emphasis on systemic factors – such as business models – that affect underlying risk, rather than second-guessing policymakers’ intentions, says Theodore.
He thinks bank ratings remain dramatically over-reliant upon backward-looking data while understating the emerging era of diminished sovereign accommodation for banking systems in Europe.
“Rating analysts put a lot of emphasis on default methodologies – all of these are constructed in the rear-view mirror,” Theodore tells Euromoney in his first wide-ranging interview. “You can’t use that to assess the likelihood for future defaults, because unlike non-financial corporate credit, banks [historically] have not really defaulted.”
He has a point. State support, according to Fitch, has reduced bank default risk by a factor of eight over a five-year period. The failure rate and default risk of banks will eventually converge, Fiona Macnab, executive director in global fixed income at Goldman Sachs Asset Management, said last month.
“The sovereign has typically backed up banks so default has, historically speaking, been less than 1%,” she says. “We are now moving from 1% to a world of 7% [during economic downturns] or 4% [during upturns].”
However, Theodore concedes there is a still a large gap between regulators’ perceptions of support and that of market participants. Underscoring this point, Roger Doig, credit analyst at Schroders, said last month: “By and large, there is very little credit risk at the senior level in European banks any more. As a senior investor, you are not taking on credit risk – you are providing duration and funding.”
Theodore disagrees: “It’s a naive view to expect senior bond holders in bank [that has experienced credit deterioration from cross-border activities] to be protected by taxpayers in Italy? It’s naive because the discourse has changed from ‘government support’ to ‘taxpayer bailout’.”
Theodore, accordingly, disagrees with S&P’s mechanistic upgrade of banks from their stand-alone rating by attaching sovereign support. “To say this is a stand-alone rating and then say this bank is rated X thanks to sovereign support is difficult because banks have enjoyed ex-ante sovereign support pre- and mid-crisis,” he says. “But we are in a new era now.”
Although Scope is at a nascent stage of developing its methodology, Theodore also thinks it is a mistake to attach weightings to assign the relative importance of factors that determine creditworthiness.
“It is a mistake to give weights because then you get yourself into a model mindset, when factors are really interconnected,” he says. “For example, few analysts looked pre-crisis at banks’ funding. Now, funding becomes more important and so banks then change the weighting, accordingly.”
He adds: “Instead, if you do the whole analysis, and take an holistic approach, that works better. In any case, the weakest factor becomes the most important.”
Instead, Scope’s methodology will be “narrative-based, focused on a bank’s business model”, before reviewing funding risk, business risk – including asset quality, regulatory risk and reputation – as well as provisioning, earnings, liquidity, capital, management and exogenous support, among other factors.
“Scope will bring a new opinion untied to legacy rating systems,” says Theodore.
Scope will even attempt to assess a woolly concept: risk culture. “If you have a bank with perfect fundamentals as well as beautiful funding and liquidity but then it runs a rotten trading operation that gets into trouble with the authorities, then all of sudden that becomes a credit problem [not captured by the weighted methodology],” says Theodore, without naming institutions, though it sounds like an apt description for JPMorgan.
This mix of quantitative and qualitative analysis is fundamentally different from the heavily quantitative score-card approach adopted by S&P, in particular, which, says Theodore, fulfils investor demand for forward-looking ratings opinions without strongly empirical pretensions. It sounds a little like a blend of credit and equity research.
Nevertheless, rating agencies are alive to the need to temper market expectations about what their models can capture, in part, thanks to their catastrophic failure to capture bank-credit risk in the run up to the global crisis.
As S&P ominously said in its downgrade of Credit Suisse on Tuesday, without elaborating further: “Credit Suisse remains a highly leveraged institution with a risk profile that is not completely captured within our capital framework.”
When determining capital strength, Theodore says risk-based capital ratios need to be looked at in conjunction with the leverage ratio and an assessment of banks’ business models.
Theodore is in the process of hiring a team of ratings analysts across Europe and says Scope will aim to have a US bank-ratings franchise since “ratings are a compare-and-contrast framework, which requires a global view”.
In any case, while institutions globally are grappling with tougher supervisors, regulators and investors, Europe, in particular, faces the challenge of overcapacity.
“[In Europe] there are too many people working in banks, too many products and too many banks,” says Theodore. “The demand for sophisticated products has fallen. There is excess capacity. ROEs won’t normalize. Banks won’t grow. And in five years we will have a totally different banking landscape.
“I hope banks will become more like utilities. So when I see bankers talk about the growth of investment banking, I get worried.”
By contrast, the growth of European bank-ratings providers should be welcomed by all quarters, though clearly markets and investment mandates are less ratings-sensitive these days.