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Lower ratings, improved credit fundamentals
Contributors Gregory Reed, Stephen Mayes, Steve G. Sun
U.S. and European banks suffered severe ratings downgrades between 2007 and 2013. Although some of those ratings cuts reflected changing methodologies at the agencies, they were also due to higher loan and investment losses, sovereign downgrades and the impact of new regulations restraining future taxpayer support.
Bank credit fundamentals tell a very different story. Banks are reporting more and better-quality capital, enhanced liquidity and improved asset quality—the key components of far healthier bank balance sheets. Compared with their European peers, U.S. banks have made greater progress in balance sheet repair, but the deleveraging, de-risking process is very much under way at European financial institutions. It is likely that ratings of major banks in Europe and the U.S. are close to their bottoms.
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Liquidity funds are compelled to invest in high-quality short-term debt (typically mid-single-A or better), the majority of which is issued by global banks. In the wake of the 2008 financial crisis and the subsequent Eurozone sovereign debt crisis, U.S. and European banks have been transformed in many ways. Their debt should be viewed in this new context.
Many banks were hit by large investment and loan losses during one or both of the crises and subsequently restructured and recapitalized. Even those banks less affected had to increase capital buffers and boost liquidity measures as they responded to market and competitive pressures as well as far-reaching regulatory reforms. Across global markets, lawmakers, provoked by damaging fallout from the crises, took action to promote financial stability.
Today the global banking sector is in much stronger financial shape than it was in 2007, with higher capital levels, enhanced liquidity and improving asset quality, despite the fact that many banks experienced severe ratings downgrades between 2007 and 2013 (Exhibit 1). The lower ratings reflect a wide range of factors, including substantial loan and investment losses, sovereign downgrades, new regulations limiting future taxpayer support and changing methodologies at the rating agencies.
After reviewing their methodologies, the rating agencies are removing government support uplift at the holding company level for U.S. banks while some support uplift remains at the operating bank subsidiary level. (The uplift implies that the ratings would have been lower without the promise of extraordinary government support in the event of a significant threat to financial stability.) For European banks, the agencies have started to review government support uplift but have not yet removed it from their ratings.
U.S. and European banks are at different points on the path to balance sheet repair, and they operate in quite different macroeconomic environments. The U.S. economy has pulled ahead, growing at a steady if less than brisk pace, while the European Union (EU) has only recently exited recession and continues to grapple with disinflation. U.S. banks have mostly completed the process of balance sheet recovery. European banks are one step behind; the European Central Bank (ECB) asset quality review and European Banking Authority (EBA) stress test results that will be available in October 2014 will likely mark the beginning of the end of this process for major banks in core Europe.
"We explore how bank balance sheets have dramatically strengthened since 2007 and how bank ratings have declined."
This PDF analyzes the credit fundamentals of major U.S. and European banks. We explore how bank balance sheets have dramatically strengthened since 2007 and how bank ratings have declined. We also examine how tougher regulations and stricter oversight are pressuring bank earnings but generally making it safer for bank debt investors.
Although we cannot predict what rating agencies will do, as we assess improved credit fundamentals in the global banking sector, we believe it is likely that ratings of major banks are close to their bottoms in both the U.S. and Europe.