Big Banks: The Dreadful Downgrades

Moody's this week downgraded 15 banks, including top names such as Morgan Stanley, Citi, Bank of America, Goldman Sachs and JPMorgan Chase. This was not unexpected. Morgan Stanley's rating (Baa1) is now barely a notch above "high yield" status (or whatever the nomenclature today is for non-investment grade, "junk" or "non-prime" issuers).

Banks, analysts, and equity markets have tried--even until now--to determine and quantify the impact of the downgrade on each bank's profitability, ROEs, deployment of capital, liquidity, and access of funding, although banks all over are arguing they are stronger, better capitalized, more averse to risks and subject more to oversight and regulation than they were five years ago.

Ratings, for example, have impact on trading activity, as much as access to funding and the interest rate they pay on outstanding debt. When ratings decline, banks must pledge more in collateral for derivatives and trading-related activities (swaps of all kinds and forms, currency transactions, deposits at exchanges and clearinghouses, etc.).

That's collateral they pledge (normally in the form of low-yielding government securities) to support existing trading activity that could be capital deployed for more profitable purposes (corporate or small-business lending, international expansion, higher-yielding investments, etc.). Among the five large banks, estimates range from $1-3 billion in the amount of incremental collateral the ratings decline will force a bank to pledge for existing trades.

At each bank, that's $1-3 billion in capital that will be deployed for pledged securities earning less than 2% and capital not supporting incremental business in the form of more loans to support middle-market and small businesses, more investments in corporate projects, and more commitments for corporate- or municipal-bond underwritings.  And this doesn't include the impact of permitted leverage, where $1 million in extra capital can result in, say, over $5 million in actual business activity (loans, investments, etc.) because of the bank's ability to use debt and capital to fund activity.

Hence, banks squeal and squirm, when they hear about the threat of a ratings decline or experience the actual confirmation of one.

The ratings agencies rationalize banks are more interconnected to all the vagaries and turmoil in markets all over the world (including Europe). Others say these are downgrades that should have occurred long ago, even if the banks have stronger balance sheets and substantially more in capital today than in 2007.  When Greece, Spain and Italy cough, U.S. banks can get a cold, too--because of complicated lending, funding, and trading arrangements with institutions in every corner of the globe.

The banks have known since the beginning of the year downgrades were pending. Nonetheless, it  adds to a long list of headaches, as somehow they try to grow profits, remain stable, endure tricky economic times, and get ready for the flood of new Dodd-Frank and Basel III regulation. While regulators and many market watchers want banks to simplify their business models (engaging in old-time deposit-taking and community-based lending), running and managing a bank--particularly a giant, money-center institution--becomes mind-numbing complex every year.

Tracy Williams

Click also:

CFN:  Risk management at major banks
CFN:  Banks and regulation
CFN:  Basel III and Capital
CFN:  The Volcker Rules, Part II
CFN:  The Volcker Rules, Part I

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