On Tuesday, Standard & Poor’s (S&P) lowered its credit ratings for many U.S. and European banks. Out of 37 banks reviewed by S&P, ratings for 15 were downgraded, ratings remained unchanged for 20 and the remaining 2 were awarded upgraded ratings.
The banks whose ratings fell, included Wall Street giants – Bank of America Corporation (BAC), JPMorgan Chase & Co. (JPM), Citigroup Inc. (C), Wells Fargo & Company (WFC), The Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS). Apart from these U.S. banks, the credit ratings of few European banks, such as Barclays Plc (BCS), Lloyds Banking Group Plc (LYG), HSBC Holdings Plc (HBC) and The Royal Bank of Scotland Group Plc (RBS) also downgraded. Ratings for these 15 banks were downgraded by one notch.
However, S&P did not revise the ratings of some European financial institutions, like Credit Suisse Group (CS), Deutsche Bank AG (DB) and ING Groep NV (ING). Bank of China Ltd. and China Construction Bank Corp. were the only banks to receive a ratings upgrade by S&P.
Reason for Revisions
Though one may think that the primary reasons for the ratings revisions are the weak economic environment and financial institutions’ inability to withstand it, this is not the case.
Actually, the latest alterations in the credit ratings by S&P are mainly based on the criteria modifications that the rating agency has been planning since the financial crisis in 2008. S&P’s reputation was hugely damaged as higher ratings were placed on various securities that were backed by subprime mortgages and this did not reflect accurate risk of investments.
Also, it is believed that S&P’s faulty ratings primarily led to the fall of Lehman Brothers Holdings Inc. and Bear Stearns Cos. Hence, in December 2008, S&P started reviewing its rating methodology. Additionally, earlier this year, the rating agency had published its proposed criteria and requested feedback from issuers and investors. S&P had also announced that it would start publishing revised ratings from the fourth quarter of 2011.
New Criteria
S&P’s new methodology to evaluate financial institutions is based on industry and economic risks, company specific strengths and weaknesses, and possibility of government bailout in case of another financial crisis. The ratings would reflect the health of the banking sector in the country where it operates. It will also consider the strength of financial institutions in emerging economies compared with Europe and U.S.
With the new criteria, it will also be possible to compare banks across the globe easily by applying consistent measurements of companies’ capital stability.
Good or Bad
With most of the financial institutions reeling under European debt crisis and sluggish economic recovery, the ratings downgrade could increase the already high funding costs for some of the banks. It is expected to lead to liquidity crisis for the banks and many of the banks might have to increase the collateral and termination payments on trades. Many banks may even end up with losses in the quarterly results.
However, it might not be as bad as we think. In fact, the ratings revisions and changed methodology will present a clear picture of the banking industry to the investors. Also, this new criteria will give S&P better understanding of the various scenarios faced by the banks.
Additionally, this might help the financial institutions to prepare for another financial crisis. Most importantly, these could ultimately translate to less involvement of taxpayers’ money for bailing out troubled financial institutions.
