Tuesday, 24 December 2013

EU downgraded by S&P's but UK rating affirmed

On 20th December, Standard & Poor's, one of the 'Big Three' credit rating agencies, downgraded the European Union's long term rating to AA+ from AAA, citing reasons of contentious budget negotiations. This signals a slight heightening of the risks that the EU's borrowing capacity on the international markets will not be supported by its Member States. However, S&P's states that the stable outlook on the rating indicates that there are still highly rated sovereigns within the EU who are prepared to support the supranational organisation. The short term credit rating on the EU is affirmed at A-1+ with a stable outlook. 

The deteriorating credit conditions within the EU have also played a role in the downgrade, with weaker credit positions among several of the Member States. This economic appraisal is accompanied by the more political assessment that cohesion across the Union has weakened, elevating the risk profile. The long term rating on the EU was revised to a negative outlook in January 2012, however since that time the average ratings of the net contributors to the EU budget has decreased from AA+ to AA. Also, the downgrade of the Netherlands in November 2013 means that there are now only six Member States with AAA ratings. Moreover, since 2006, S&P's claims, the revenues contributed by AAA-rated sovereigns as a proportion of total revenues contributed, has nearly halved to 31.6 percent. 

Currently, 80 percent of EU loans to Member States that are outstanding are to Ireland and Portugal. The CRA believes that the chance of the EU being unable to access credit markets to extend these loans is "remote". However many of the other reasons stated for the increase in risk of long term EU supranational borrowing is notably political. S&P's notes that the willingness of Member States to contribute to meeting the EU's financial commitments on a pro rata basis could be tested in future. Added to this is the proposed referendum in the UK about continued membership of the Union, which the ratings agency describes as an unprecedented step for a sitting Parliament to take, and which could - by implication - have ramifications both for the UK and the EU. 

The EU is currently rated AAA by Moody's with a negative outlook.

A couple of days later, S&P's affirmed the UK's AAA/A-1+ (unsolicited) rating, which apparently sits on the back of "exceptional monetary flexibility". However, the negative outlook is retained as the sustainability of the recovery - built on private consumption and property investment - is of questionable sustainability.

Tuesday, 17 December 2013

Sovereign Risk and Bank Ratings

This post discusses the interplay between ratings assigned (principally by S&P's) to sovereigns and their banks. Bank Industry Country Risk Assessments (BICRA) ratings are the starting point for understanding risk in the banking industry. There is a previous blog post on BICRA methodologies here. BICRA ratings are relative measures of the industry risk and economic risk of a country's banking system. For BICRA, analysis of economic risk is based on similar indicators to those used by sovereign ratings experts. In sovereign ratings, CRAs look at economic structure, growth prospects and macro policy flexibility to assess the sovereign's ability and willingness to repay its public debts. For banks, the same factors are important in helping to form assessments about loan growth, asset quality and borrowers' ability to repay. The relationship between sovereigns and banks is a relationship that goes both ways - banks play an important role in channeling savings into investment, while operating in a financial system that is regulated by governments. At the same time, the embedded risk from the banking system can be important in gauging the contingent liability of a sovereign. So the relationship is an important one for the resulting ratings of both banks and sovereigns.

The impact of sovereign risk is most clearly seen in the economic risk assessment part of BICRA. Four out of the five analytical areas of sovereign analysis factor in to the 'economic resilience' assessment. The fifth sovereign factor, which is about external performance, features in the 'economic imbalances' score. Sovereign stress can also be factored into the assessment of credit risk in the case where a sovereign rating is falling sharply. At the same time, a sovereign in distress can weigh on the assessment of system wide funding within BICRA if it causes a negative feedback in the wholesale or cross border funding mechanism or the conditions for banking in a particular country. 

Some banks can be directly affected by a change in the sovereign rating. This can be the case where banks receive extraordinary government uplift in their ratings (if the government has provided a solid guarantee to the bank -it is "too big to fail") then a change in the rating of the sovereign may see an immediate change in the rating of the bank. At the same time, for banks whose SACP is at or above the sovereign rating, (there are not many of these but they do occur) there is a direct relation between the sovereign and the bank and once again, ratings can change very quickly on news of a downgrade. There can also be a more indirect impact in cases which involves evaluating how the new conditions in which the banks are operating affect the BICRA. At the same time, if the economic risk score changes, this can impact on a bank's capital position. Similarly, if asset quality worsens, it may also affect the bank's risk position and capital and risk position are some of the bank-specific factors in S&P's analysis. 

Bank Ratings and the Role of Government Support

The credit crisis changed the way S&P's factors government support into its bank ratings. Going back to 2008 at the height of the credit crisis, it is fair to say that many people were surprised at the level of support given to banks not just in the US but globally. Until that time, government support of US banks was not explicitly incorporated into the ratings given to those banks. But towards the end of 2008 and following a series of government bank support initiatives, the extraordinary support given to the large, systemically important banks was included in the ratings. 

In November 2011 new bank rating criteria was introduced, making the criteria more transparent, and including for the first time explicit reference to government support. The Stand Alone Credit Profile (SACP) was also revised and tightened and altered to include either group support or government support. Governments were identified as 'high support' or 'supporting' (as in the US) in certain instances and banks were defined as being of high, moderate or low systemic importance. 

The potential for extraordinary government support continues to be factored in to the ratings of high systemic importance banks in the US. This is because despite progress made under the Dodd-Frank Act with regards to liquidations, S&P's believes that a crisis today would still require some form of government support to minimise contagion risk. However, there is the possibility that support could be removed from the ratings of the banks' holding companies and depending on how regulation evolves on resolution, support may be removed from the ratings of high systemic importance banks. Government support is not set to be removed from the ratings assigned to operating companies though.

Monday, 16 December 2013

2013 round up

During 2013 there have been 18 downgrades and only 8 upgrades, which has mirrored the preponderance for more downgrades since 2011-12. The balance of outlooks hasn't really changed - about 2/3 are stable, and of the remaining 1/3, most are negative non-stable outlooks. In Europe, there are now - at the end of 2013 - far fewer negative outlooks than there were at the beginning of the year, although some of these are due to downgrades having taken place. There are a few more positive outlooks at the end of 2013 in Europe than had been the case in January. The opposite has occurred in the Asia-Pacific region, where there are more negative outlooks at the end of 2013 than the beginning.

There have been drives by both S&P's and Moody's to make their sovereign rating methodologies more transparent and generally clearer, as global bond yields showed that investors actually ignored 56% of Moody's and 50% of S&P's rating and outlook changes last year. This was in particular when the CRAs said the governments were becoming more or less safe. The revised methodologies haven't seen vast alterations in sovereign ratings, and are readily accessible. The CRAs state that they want their methodologies to be so transparent that investors can use them to estimate their own version of a sovereign rating that should be no more than three tranches away from the rating assigned by the CRA.

This poses questions, not least surrounding the changing role of CRAs in the sovereign bond markets. By making their methodologies so transparent that any investor can use them to assign their own rating, have S&P's and Moody's become simple providers of a list of pointers investors should consider when summing up the risks of investment? Moreover, when using the CRA methodology, the CRAs claim that investors should be able to estimate "within a three notch alpha numeric range" the likely rating assigned to a sovereign. But this indicates three notes above or below, which covers quite a wide variation in rating. The difference between three notches - according to the alpha numeric ranges set out by any of the Big Three agencies - encompasses a substantial variation in the level of risk. Added to this, once an investor has taken the time to use the methodology for herself to estimate the sovereign risk rating, she then finds a potential three notch divergence between her result and that assigned by the CRA. And there appears to be little she can do to square this circle. In short, the transparency ends here.