The Reality of Brexit: Farewell to the UK's last AAA rating

Moritz Kraemer, chief ratings officer for S&P Global Ratings (the new name for Standard & Poor’s), stated today that the UK’s AAA rating was no longer “tenable” under the circumstances and would be downgraded at least one notch “within a short period of time”. While it is unclear what effect this downgrade will have, the only certainty is that it will heap insecurity upon insecurity, adding to the markets’ troubles and further raising the cost of government borrowing.

Other leading CRAs, notably Moody’s and Fitch, had already downgraded the UK prior to the start of the referendum campaign. Moody’s, which currently assigns the UK a rating of AA1, one notch below a AAA score, had previously warned of further downgrades following a vote to leave the EU. Moody’s has also warned that a UK exit of the EU could also see downgrades of UK businesses, impacting on their ability to borrow and, consequently, reducing their ability to invest. The referendum outcome is “credit negative” and could “increase the risk of political fragmentation within the EU if popular support for the bloc fades among member states”.

Fitch had also downgraded the UK prior to the Brexit debate, and has assigned a rating one notch below AAA since 2013. However it has also warned of short-term disruption and long term risks for the UK. In less dramatic language, Fitch Ratings described Brexit as “moderately credit negative” for the UK, and expects knock-on downgrades for UK entities to be relatively limited in the short term.

All three CRAs, while repeating the negative effect of the vote, stress the importance of the deal that Britain can strike with the EU as a principal factor in determining mid to long term ratings, both for the sovereign and entities. 

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. 

The state of Europe after the Eurozone crisis - a round up of developments

The longest recession in 40 years in Europe appears to have stabilised, but the search for recovery continues. Greece is taking delivery of a third bailout from the Eurozone, albeit tiny in comparison to previous loans. However, exports, consumer spending and corporate investment are still low, hinting that a recovery is still some way off. 

In the banking sector, Basel III minimum leverage ratios are being welcomed, having been recognised as a buffer against future crises. In the US, for example, minimum leverage requirements well in excess of 3% have been proposed, hinting that the Basel requirements are still seen as inadequate. It does also hint that the implementation of a globally comparable leverage ratio - as set out in Basel III - is unlikely to be met with uniform regulations around the world. 

In the EU, an agreement reached between the Member States on June 27th 2013 on a proposed directive states that in future financial crises, bank and financial institution bail-ins will be the default position, preserving depositors' money and sparing the taxpayer. Bail-outs are not ruled out, however, as the agreement gives national governments substantial flexibility to determine how best to resolve a situation. As such, governments can still determine that a taxpayer-funded bail-out is the best solution, and considering that the agreement on bail-ins is not likely to come in to force until 2018, there is still plenty of time for taxpayers to be left firmly on the hook.  Moreover, S&P considers that EU member governments with sufficient financial capacity will continue to support major creditors of systemically important banks, at least until balance sheets recover, and banks are made more resolvable through structural reforms. 

While mortgage agreements and real estate sales are increasing again in the US, the same is beginning to take place in the UK. US new home sales were up 7.9% in August, and were up 13% on the year. (Source: Census Bureau, from S&P Ratings Direct). Lower interest rates in the UK have been partly responsible for the increase in lending, along with the Bank of England "Funding for Lending" scheme which aims to target lending to the real economy, in particular SMEs. Moreover, the govenrment-backed mortgage scheme, has also aimed to boost lending to those who could otherwise not afford to get on the housing ladder, although this has been met with accusations that it will only fuel, rather than address, the housing bubble.

This all sounds remarkably positive, given the travails of the past few years. However a recent report by S&P on the state of the Eurozone is less optimistic. The report concludes that slowdowns in emerging markets, and an economic rebalancing in China, may "start to reduce the credit support provided by global diversification in recent years". The mantra that a diversified economy will weather economic storms better may prove little use should China - along with other developing economies - slow down their consumption, leaving demand stagnant throughout the global economy.

China's growth has slowed noticeably and perhaps more significantly, expectations for China's growth have also fallen. The consensus is that forecasts have fallen by one percentage point over the last year to 7.5%, however this continues to decline. This compares to a GDP of over 9% in 2010-2011, and although the Chinese leadership seems comfortable with current figures, their focus will be on balancing internal demand and consumption with international trade. 

A Eurozone slump, along with negative US fiscal policy developments, slower growth in China or a disorderly reduction in quantitative easing are currently the top risks for global credit conditions. This has had implications for European sovereign creditworthiness, along with corporate credit ratings above the sovereign. Corporate trends in Europe are still mainly negative. Fifty-six percent of S&P rating actions in the second quarter of 2013 were ratings downgrades, while over two-thirds of industry sectors carry "stable-to-negative" or "negative" outlooks. Moreover, S&P expects the Eurozone to remain in recession for the rest of 2013 and has downgraded its real GDP forecast from minus 0.5% to minus 0.8% for this quarter. The ratings agency expects a weak recovery in 2014 with a GDP of 0.8%, but expects that potential growth will remain impaired long in to the future. Furthermore, according to S&P, there is still a one in three possibility that the Eurozone could experience a sharper and deeper recession in the remainder of 2013 that could last into 2014, seeing the recovery pushed back even further into the future. Owing to the structural nature and depth of the Eurozone crisis, the agency estimates that it is unlikely for a recovery to occur earlier, or for GDP figures to improve substantially in the short to mid term. 

A recent report by Moody's affirms the provisional AA1 rating of the European Financial Stability Fund (EFSF) based on the contractual elements, including the "irrevocable and unconditional" guarantees by the Eurozone member states, as well as their creditworthiness and commitments to the EFSF. The strong political commitment of Eurozone member states to the Fund is also important, as Moody's assesses that any default would entail "significant pecuniary and political costs" for Europe. However, the rating is subject to a negative outlook, reflecting the negative outlooks on euro area sovereigns that are guarantors to the Fund. The three largest shareholders in the fund, Germany, the Netherlands and France, all have negative outlooks, with Finland being the only eurozone country with a stable outlook currently.