Moody's downgrades of 15 of the world's largest banks represents an interesting thought experiment, based as it is on a theoretical proposition that investment banking is inherently more risky than traditional banking. The real fall-out will come when we see whether a major financial institution that has credit-sensitive business lines and relies heavily on capital markets funding sources survive at a rating of less than a2 at the operating company level? It has never happened before. Yes, Bank of America (NYSE:BAC) fell below that level in the late 1980s, but it enjoyed a domestic substantial deposit base, so managed to fund itself. On the other hand, Credit Lyonnais and Drexel Burnham failed the following day after being downgraded below that point. The best hope is that because all financial institutions are lower rated today than in the past, clients' internal yardstick for acceptable ratings may change. Or they may decide that rating agencies' opinions are no longer relevant. This experiment is a dangerous one.
There are several reasons why survival below a2 for large financial institutions is in jeopardy. Markets have focused on the more tangible, quantifiable aspects, about which banks have been able to make sensible disclosures, namely, that funding costs will go up, and that counterparties will demand more collateral. Those issues are, unfortunately, the least of the problems. The more potentially devastating are:
- Certain clients for not-centrally-cleared, long-dated derivatives are not willing to do business with lower rated banks on any terms
- Asset management and custody clients also tend to shy away from lower rated banks
- The availability of some types of funding is sharply curtailed, regardless of the higher yields. Commercial paper markets are barely existent below a2. Money market funds cannot hold paper rated below A-1/P1. They and other credit-sensitive institutional investors are important buyers of commercial paper and institutional deosits. Insurance companies may be less interested in holding lower rated long-term paper because of the higher capital charges they would incur.
- The real question may be, what will repo counterparties do? Traditionally, they had not been credit sensitive; they relied on the collateral to mitigate their risk. When institutions were under stress, the repo market was typically the last to close for them. That may be changing, as repo counterparties demand intrinsic credit-worthiness of their counterparties as well as collateral.
These issues affect the non-traditional businesses of banks. However, there is a fundamental problem posed for the traditional lending businesses as well. Banks must be able to lend money at a higher rate than their own cost of funds. That is, banks must be seen by the markets to be more creditworthy than their clients, to be able to command better pricing on their funds than do their clients. This is especially problematic for the banks who serve the larger, higher rated corporate clients. A banking system that is lower rated than its clients is a broken banking system.
The thought experiment should have been turned around. The question Moody's should have sought to answer is not how to incorporate the volatility of investment banking revenues of the past few years into the ratings of today; it should have been, what would an a2 or better rated banking system have to look like.
- Capital is one important element to which Moody's gave short shrift. The stand-alone ratings are higher for some less well capitalized banks like Credit Suisse (thinking prospectively of Basel III standards) than they are for some better-capitalized banks like Citigroup.
- Eschewing investment banking is not the answer. The global financial system needs market makers and underwriters. Surely there is some way to make it a safe operation.
- Moody's did not consider that Investment banking profits/losses have tended to be imperfectly correlated to traditional banking profits and so, as a general rule, can be expected, paradoxically, to add stability to a universal bank's earnings.
- Moody's is in denial as well of the fact that most systemic banking crises have been caused by traditional lending activities. Taken from a broad historical perspective, commercial banking is more volatile than investment banking.
- Moody's is right, however, in flagging the role of governments in protecting the liquidity of markets and supporting major players in times of systemic (rather than idiosyncratic) stress. Without that assumption, it would be hard to get to an a2 rating on any institution.
Where this thought experiment will lead is of course uncertain. If the markets follow Moody's (NYSE:MCO) in their rank ordering of the global banks, Morgan Stanley (NYSE:MS), Citigroup (NYSE:C), Bank of America (BAC), Barclays (NYSE:BCS), RBS and maybe even Goldman Sachs (NYSE:GS) will cede market share to the likes not only of JPMorgan (NYSE:JPM) and Deutsche Bank (NYSE:DB), their traditional peers, but HSBC (HBC), Royal Bank of Canada (NYSE:RBC), BNP (BNP), and Credit Suisse (NYSE:CS) . That would represent a slow demise for the lower rated banks. But we must also watch for a more sudden collapse in their funding. That would trigger an early test of various governments' thought experiments, which are their beliefs that they can effect an orderly liquidation of these types of institutions.
Disclosure: I am long JPM.