Moody's downgrade gives edge to safe-haven banks

Major ratings downgrades by Moody's will further divide the world's biggest banks based on their strength and access to cheap customer deposits.

The ratings, released Thursday by Moody's Investors Service, gave a competitive advantage to "safe-haven" banks that fund themselves with stable, low-cost customer deposits, while worsening the outlook for weaker banks that rely more on capital markets for their funding.

Stock and credit markets reacted mildly after Moody's cut the ratings of 15 of the world's biggest banks, as the cuts had been widely anticipated.

The cost of insuring against default for each of the five biggest U.S. investment banks fell on relief that Moody's was not harsher, said Otis Casey, research director at Markit in New York.

 

The KBW index of U.S. bank stocks <.BKX> rose 1.4 percent on Friday in New York. European bank shares <.SX7P> rose 0.1 percent. Shares of New York-based Morgan Stanley were up 1.3 percent after initially jumping more than 3 percent in reaction to its rating having been cut less than feared.

Aside from the immediate market moves, the downgrades reinforce a trend that has seen weaker banks punished for their risk-taking, while stronger banks are rewarded for conservative funding models, ensuring lower costs and higher margins.

Not only will funding costs rise for the worst-rated banks, but trading partners are bound to ask for more collateral - and steer business to those perceived to be financially stronger.

"These downgrades will increase the cost of doing business for banks, either through reduced, or more costly, access to funding or the need to lodge extra collateral with creditors," said Daiwa Capital Markets analyst Michael Symonds

Moody's gave the highest ratings to HSBC, Royal Bank of Canada and JPMorgan, which it said had stronger "shock absorbers" than their peers.

All three are regarded as safe-haven banks, funded by deposits from millions of retail customers and relying less than riskier banks on capital markets for short-term financing.

Moody's gave the lowest credit ratings to banks that have been affected by problems with their risk management or whose capital buffers are not as strong as those of their rivals.

Those include Morgan Stanley and others with few retail deposits, as well as banks such as Bank of America , Citigroup and Royal Bank of Scotland , which despite having big deposit bases have gotten into trouble by combining their retail business with riskier investment banking.

Moody's placed Barclays , BNP Paribas , Credit Agricole , Credit Suisse , Deutsche Bank , Goldman Sachs , Societe Generale and UBS in a middle group of banks, which it said include firms that rely on unpredictable capital markets revenues to meet shareholder expectations.

For banks that rely heavily on markets for funding, the lower ratings make difficult conditions even worse at a time when they are suffering because of the euro zone crisis and a global slowdown in growth.

"Markets tend to discriminate more between issuers at lower ratings - in terms of funding costs - particularly during times of stress," said analysts from Citigroup.

The downgrades reflected a view in capital markets that was "something more structural and fundamental rather than what is just cyclical noise", Johannes Wassenberg, Moody's managing director of European banks, told Reuters.

"We tried to assess risk from capital markets... and the shock absorbers banks have," Wassenberg said.

Regulators have told investment banks to keep far higher capital buffers, making their business less profitable, while also taking a knife to some of their most lucrative businesses, such as trading for their own accounts.

The sector has been left with significant overcapacity, reports from consulting firms say, meaning the battle for the favors of clients can only intensify.

Risk management

The ratings agency looked at the banks where exposures to capital markets were the most pronounced, picking firms by the share of revenue generated by fees from debt and equity advisory, trading revenues and trading inventories.

Analysts say banks that will be most affected by higher funding costs as a result of the downgrades are those that were most likely to have to put more collateral on the table.

"Most directly, there are contractual provisions in agreements that would require a firm to post additional collateral, or to replace itself as the counterparty to transactions," said analysts at Execution Noble, part of Espirito Santo Investment Bank.

Moody's said some of the lowest-rated banks had undertaken considerable changes to their risk management models and were changing strategy to increase earnings from more stable activities such as retail banking. However, it said the success of these changes has yet to be tested.

Moody's said it had taken into account management action at firms like UBS, and it listed the bank's reduced ambition in investment banking as a positive factor.

The downgrades had been widely anticipated since Moody's said in February it was reviewing the risks in investment banking and said how much it might downgrade the banks. Since then, Morgan Stanley shares, for example, lost more than 25 percent of their value. The KBW index of U.S. bank stocks has gained 1.8 percent over the same period.

Some analysts believe the threat of additional downgrades has passed now that Moody's has completed its four-month review. Standard & Poor's overhauled its ratings for financial institutions late last year. Both reviews were the most comprehensive re-evaluations of risks at major banks by the agencies since the financial crisis.

"The rating agencies should have somewhat higher tolerance for volatile performance at these lower rating levels and therefore will ease up somewhat on these banks," bank analyst David Hendler of CreditSights Inc in New York said in a report on Friday.