Saturday, 24 September 2011

Bank of America - Too Big To Fail No Longer?

Can a bank ever be too big to fail?

After a three month review the rating of long term Bank of America debt has been downgraded a couple of notches from A2 to Baa1. Moody's have cited the reduced chance of a full-scale bailout by the US government should the bank run into difficulties, although the rating agency concedes that should trouble occur, it is still likely that some government help would be likely. According to Moody's, allowing a troubled bank to fail is now more likely than previously because of a realisation that this approach reduces the risk of contamination. Citigroup's long term rating and Wells Fargo's rating have also both been downgraded.

So are taxpayers safe from future bailouts? Are the big banks now no longer "too big to fail"? In its report, accessible here, Moody's states:

"Moody's continues to see the probability of support for highly interconnected, systemically important institutions as very high, although that probability is lower than it was during the financial crisis. During the crisis, the risk of contagion to the US and global financial system from a major bank failure was viewed as too great to allow such a failure to occur -- a view borne out in the aftermath of the Lehman failure. This led the government to extend an unusual level of support to weakened financial institutions and Moody's to incorporate the expectations of such support in its ratings. Now, having moved beyond the depths of the crisis, Moody's believes there is an increased possibility that the government might allow a large financial institution to fail, taking the view that contagion could be limited."

So Moody's believes that the worst of the financial crisis is over and that we are emerging into the sunny uplands of recovery? Maybe not, however there seems to have been a shift in perception that contagion can now be stopped not by bailing out huge financial institutions, but by letting them fail. There are obviously political implications in protecting the taxpayer from more massive bills (more on this later), however provisions in the Dodd-Frank Act that work to reduce interconnectedness among financial institutions can also explain this. Under rules recently finanalized by the Federal Deposit Insurance Corporation (FDIC), the orderly liquidation authority set out in Dodd-Frank sets out a clear intent to impose future losses on bond holders in the event that a systemically important bank - such as the Bank of America - was nearing failure.

However, as yet the parts of Dodd-Frank that would serve to reduce interconnectedness among financial institutions, such as resolution plans or changes to over-the-counter derivatives markets, are still pending. It would therefore be extremely difficult for an orderly liquidation of an institution the size of Bank of America to occur at the present time, and consequently Moody's believes that for this reason, should disaster strike, the government would still be compelled to provide some financial support. Reliance on the ordinary liquidation authority to resolve a systemically important bank would prove too disruptive to the marketplace and wider economy, leading to a situation almost as undesirable as those Dodd-Frank was designed to avoid.

Bank of America, according to Moody's is still exposed to "potentially significant" levels of risk related to both residential mortgages and home equity loans that are still languishing on its balance sheet. Moreover, while Bank of America has taken steps to improve its capital and liquidity positions, and while Moody's believes that it has an ample buffer to absorb any losses that might occur as a result of bad debts, a deterioration in the economic environment or adverse legal rulings on claims against it might serve to tip the balance against the bank's long term financial stability. Of course, these latter are not within the direct control of management of the Bank, meaning that short of further increasing their "modest" capital and liquidity, there is little more the Bank can do except weather the storm out. Of course, following a downgrade of long term debt by the CRA, this one option available to the Bank of America is now just that little bit harder.

So can a bank ever be too big to fail? The obvious answer has to be yes, however the political climate in which a financial crisis materializes should not be underestimated. Is Moody's taking into account the rise of the Tea Party movement in the US? Considering Obama's difficulties in raising the debt ceiling, and the way in which a left-leaning congress balked at previous bailouts, the increasingly vocal right wing in American politics is likely to signal the end for taxpayer support of financial institutions.

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