Banking at the Crossroads

The role of S&P’s new rating criteria

Originally published in the March 2012 issue

The global banking sector is at a crossroads, following the unprecedented turmoil of the past four years. As it seeks to reinvent itself, the sector faces several critical inflection points that will affect the future creditworthiness of banks. It is too early to tell how each one will play out but we believe that our new banking criteria provides a coherent, globally consistent framework to assess how these developments are likely to affect the creditworthiness of banks.

The first major inflection point currently facing the banking sector is a potential shift in the power balance of global banking between banks in the developed markets of Western Europe and the US on one side, and the larger emerging countries in Asia and Latin America on the other. The developed banking markets in the US and Western Europe are under pressure and a recovery is still not assured. At the same time, banking systems in Latin America, Emerging Europe and Asia-Pacific are growing but, in our view, remain constrained by relatively weak financial infrastructure, institutional and legal frameworks, underwriting standards, payment cultures and rules of law.

The second inflection point is the continuing regulatory uncertainty facing banks. While many attempts at regulation on a global basis have been tried, devising a universal system promises to be a thorny and potentially elusive quest. The prospect of unintended consequences is high, the impact of which will take years to manifest. This developing regulatory backdrop may set the scene for a decline in revenues for traditional regulated banking and a growth in volumes for shadow banking and disintermediation.

The third inflection point is the potential consequence of a change in the nature of government support for banks. The intervention of governments and central banks around the world has succeeded in creating an interim period of stabilization for many of the Western European and the US banking systems. But, as the events of the last few months have shown, it is a fragile peace.

We believe that governments are looking for ways to reduce their contingent risk to the banking sector, but not at the expense of undermining the financial system. The recent bailout of Dexia, alongside the extension of new liquidity measures and the expected €108 billion capital raising for Eurozone banks, demonstrates the economic realities that governments face and the real support they need to provide despite any longer term political will to reduce it. Consequently, we expect many governments will continue supporting banks until they are strong enough to stand without support. For some this could take years, if ever.
Our new bank criteria aim to provide greater transparency and consistency to reflect this evolving market. It is a refinement of our analysis rather than a reinvention. It builds on what we knew before the financial crisis and incorporates what we have learned about how banks, investors and governments respond. It is the result of extensive market consultation, during which we met with over 2,500 interested parties and spoke with more than 10,000 users of ratings.

We have heard the market feedback about increased transparency loudly and clearly. Therefore, we are explaining very clearly the ‘building blocks’ of our ratings for investors and other market participants, who can then agree or disagree with our assumptions when doing their own analysis.

To borrow an analogy from the insurance market, a person’s home address can impact their house or car insurance premiums. In the same way, our new criteria are placing a greater emphasis on the country in which a bank operates, through an enhanced version of our existing banking industry country risk assessment (BICRA) methodology. By doing this, we will give more weight to the risks associated with growing economic imbalances, the resilience of the economy, and the importance of system-wide funding and the role of governments and central banks in this funding. This analysis will be a consistent starting point for our rating. It creates a framework to evaluate the relative strengths of banking systems and to recognize how these trends affect our bank ratings.

This starting point is then adjusted up or down the rating scale to reflect our assessment of a bank’s specific strengths and weaknesses in business position, capital and earnings, risk position, and funding and liquidity. After this, we assess the potential for government support and/or group support (for example, a parent company to a subsidiary). Following final analytical adjustments and a vote by a rating committee, this then leads to the issuer credit rating.

Our new criteria will allow us to clearly separate the stand-alone credit profile and the impact of government support in our ratings. This means that a change in the likelihood of future government support for banks will be clearly identified and articulated.

The new criteria introduce clear guidance on how our own measure of bank capital, the risk-adjusted capital (RAC) ratio, influences our ratings. Despite significant deleveraging in the US and Western Europe over the past two years, we believe capital is at most neutral to a slight weakness for the ratings. In Asia and Latin America, we see rapid growth that has prevented any meaningful build up of capital.

At the same time, bank funding and liquidity has strengthened since 2007, but it is too early to tell whether this represents a structural improvement. Our new criteria recognize that some banks are more sensitive to shifts in confidence than others based primarily on their dependence on short-term wholesale funding.

In conclusion, regardless of governments’ recent and emerging policy responses, the historic pattern of banking sector boom and bust and government support will likely repeat itself in some fashion. New laws put in place following previous crises, such as deposit insurance, have not prevented subsequent downturns. Banking crises will likely happen again.

The outlook for the global banking industry is clouded by the potential shift in the balance of power among banks, the emergence of a more significant shadow banking sector, and the potential for a different relationship between banks and governments.Our revised criteria will enable us to provide opinions that reflect the impact of these major systemic changes on the banking sector.