The financial crisis of the last few years has created not just a perceived shift in the creditworthiness of our financial entities but a real crack in the foundation of their business model and more importantly any explicit or implicit supports or guarantees. Moody’s, in a special report on credit post crisis « The Great Credit Shift » look at the impact of the crisis on every major asset class within the credit space from sovereigns to corporates to structured finance.
Noting that this crisis has profoundly changed the credit picture for sovereigns and financials, Moody’s note there is some dispersion in the latter as banks have seen systematic downgrades while insurers (for now) remain on par with pre-crisis levels. More interestingly, large US regional banks represent an exception to this broad downgrade but we suspect that the continued low interest rate, low NIM, and high volatility spread environment will cause both insurers (we have long considered proxies for HY portfolios, no matter how well cushioned from vol their business models may be) and US regionals (consolidation will have the opposite effect of TBTF in our view as it will lead to more comfort with more risk-taking and expose them to more current-bank-like volatility) to face more pressure going forward (despite their lower apparent sovereign risk exposure). As BofA and Morgan Stanley trade at extreme ‘crisis’ levels in both CDS and equity markets, we suspect the raters have further to go and while the systemic shifts are apparent, we would expect less and not more differentiation going forward – especially if we sink into another solvency crisis.
Banks Fall Down the Credit Hierarchy, Insurers Hold On
Bondholders of most financial institutions are worse off today than they were before the 2008 financial crisis, with few exceptions. Nowhere is this more obvious than in Europe, where sovereign debt credit quality concerns hit banks at their heart, even though this debt class has traditionally been banks’ safest and most liquid asset. The stalling global economic recovery and a multitude of regulatory reforms amplify credit pressures, and consequently, banks and insurers globally face lower revenues and higher costs, when not an outright confidence and liquidity crisis.
The crisis has tested business models and analytical assumptions, revealing a fundamental shift in financial institutions’ credit hierarchy, which is reflected in our rating actions. Illustrating this shift is the absolute and relative fall of banks down the rating scale. Bank debt was generally perceived as safer than insurers’ before the crisis. As shown in the exhibit below, three years after, many insurers are perceived as equal to or above large banks in the credit hierarchy. Most importantly, current weakness in most banks’ credit profiles indicate that this shift could amplify in the coming years, leaving insurers’ bondholders far better off today than pre-crisis when compared to banks’.
BANKS’ BONDHOLDERS FACE FUNDAMENTAL CREDIT CHALLENGES
The crisis and the regulatory reforms that followed are transforming banks’ operating environment, leaving bondholders exposed to greater risks than was perceived just three years ago. Basel 3 and national-level reforms will temper some of the risks by building more robust defense lines (especially capital and liquidity), which are positive, but they will not heal the ongoing crisis.
Furthermore, the introduction of a new complex and costly set of regulatory requirements and restrictions at this point in the economic cycle could have unintended consequences, such as encouraging banks to
offset pressure on capital returns by taking greater on- and off-balance sheet risks.
We do not expect banks’ standalone credit quality to improve substantially anywhere, but a key game-changing development facing banks’ creditors is the rapid evolution of government policies on dealing with failing banks.
The fear that a bank’s failure would disrupt financial markets and threaten the stability of the broader economy has long compelled governments to bail out failing banks and avoid their liquidation. This is why we incorporate an assessment of the probability of external support in our bank rating analysis. Among our 1,022 rated banks, 473 currently benefit from rating uplift, reflecting our systemic support assumptions. To ignore government support would have resulted in overstating default risk for many banks during the crisis.
Systemic support noticeably dampened ratings volatility 2007-11, which turned out to be justified given the extraordinary government resources channeled into liquidity provision and capital injections. Without that support, large bank ratings would have been subject to significant downgrades because of their weakened standalone credit profiles. Consequently, there is a widening gap between these banks’ standalone credit strength (bank financial strength ratings) and their senior ratings (long-term debt and deposit ratings).
However, many governments and regulators, particularly those of the G-20 countries, have signaled a clear policy intent to impose losses on creditors, and several have established or plan to enact bank-resolution regimes that increase creditors’ risks. Moreover, fiscal constraints increasingly limit some government’s capacity to provide support, even where there is willingness. These developing forces point towards reduced probability of support and, by extension, potentially lower creditworthiness down the road.
EMERGING MARKET FINANCIAL INSTITUTIONS ARE NO EXCEPTIONS
Many investors have favored emerging market economies and financial institutions over the past few years, but their rapid growth, largely driven by exports and capital investment driven by domestic growth expectation, is now posing credit challenges. At home, the emerging market banks are faced with inflationary operating conditions and increased risk of burst bubbles after years of sprinting loan and other financial asset growth. Abroad, their export destinations are almost all affected by economic and fiscal difficulties, suggesting that business activities (and demand) will slow down across most segments of the economy, causing asset quality problems. Also, as rising inflation erodes real deposit returns, deposit stickiness may decline and pressure banks to raise deposit rates independent of policy rates, with clear negative effects on margins and liquidity.
Of all emerging markets, we view Eastern European bloc nations as the most vulnerable to deteriorating credit quality as their earnings, asset quality, and funding access and costs are negatively affected by their reliance on European Union (EU) bank funding, which increases their exposure to current EU sovereign crisis.
LARGE US REGIONAL BANKS REPRESENT AN EXCEPTION
Bondholders of large US regional banks are perhaps an exception among banks globally, with improved credit profiles compared to pre-crisis. The future will not be without challenge, but their thicker capital and liquidity buffers, de-risked balance sheets (and almost fully recognized crisis-related losses) as well as the stability of their core deposits is expected to help these banks maintain a steady credit worthiness through the next downturn.
On the risk side, we see income statement challenges that look to be enduring. In particular, continuing low interest rates undermine the value of their sizable base of noninterest-bearing and other low-cost deposits. In addition, new regulations and weak loan demand in a tepid economic environment have negatively affected large regional bank earnings. We expect management teams to react to these revenue pressures by pursuing acquisitions intended to diversify their franchises and lower their cost structures.
Over time, this will lead to further consolidation in the US banking system, with low-cost producers the survivors. The most likely acquirers are the better-performing large regional banks and foreign banks that have an interest in building their US businesses. The four largest US banks, Bank of America, Citigroup, JPMorgan Chase and Wells Fargo, will likely remain on the sidelines given political pressure against them getting any bigger, to the benefit of large regional banks.
INSURERS BENEFIT FROM THEIR BUSINESS’S INHERENT STRENGTHS
The global life insurers and their bondholders are better off today. Together with the risk management and capital requirements imposed in various areas (notably the coming of Solvency II for European insurers), lessons learned from the financial crisis prompted life insurers globally to rein in their risk appetites, de-risk and de-leverage their businesses and balance sheets. In most markets, products with more aggressive benefit guarantees and policyholder optionality have been repriced, redesigned, or discontinued. Higher-risk and structured assets have been written down and/or shed, and investment guidelines tightened. Financial leverage has been lowered and liquidity levels have been raised. As a result, while the financial crisis did highlight certain risks that were previously underappreciated, life insurers’ aggregate risk profiles have declined and their credit profiles have improved.
Global P&C insurers and reinsurers have modest balance-sheet leverage and are not much reliant on wholesale funding arrangements compared to most other financial institutions, which is why material rating actions in this sector were rare during the financial crisis. The few downgrades within P&C insurance and reinsurance during the crisis predominantly reflect credit issues with their affiliates (e.g., AIG, Hartford P&C and XL in the United States).
One category of insurers under particular pressure is the US health insurance industry. Most fared well during the financial crisis and are in a better overall financial position now than pre-crisis, but as a result of US healthcare reform legislation, we believe bondholders are worse off than they were four years ago.
Low interest rates remain a credit concern in the brave new post-crisis world. Most insurers’ earnings remain dampened by spread compression caused by persistently low interest rates. Nevertheless, the low interest rates now pressuring earnings would be problematic to capital only if they persist to the end of this decade.