The recent banking bailouts get some academic underpinning in a new working paper from the International Monetary Fund.
“Banking bailouts in periods of significant financial distress may be justified to avoid an economically costly and persistent credit crunch,” the paper finds.
While not official IMF policy, the paper by Fabien Valencia suggests that the financial health of the banking system may be a significant contributor to the propagation of economic shocks, especially negative ones. “Banks’ precautionary motive insulates lending from shocks up to some size, but for larger shocks the economic consequences of the ensuing credit crunch may be significant.”
The paper develops a bank model to study credit crunches and their real effects. In the model, banks maintain a precautionary level of capital that serves as a smoothing mechanism to avert disruptions in the supply of credit when hit by small shocks. “However, for larger shocks, highly persistent credit crunches may arise even when the impulse is a one time, non-serially correlated event.”
From a policy perspective, the model justifies the use of public funds to recapitalize banks following a significant deterioration in their capital position.
Technorati Tags: bailout, banking-system, credit-crisis
What a difference six months makes. The Bank of England’s latest semi-annual Financial Stability Report might be better titled Financial Instability Report. In May Research Recap highlighted the Bank’s concern that subprime-related losses by financial institutions may be overstated. Seeing signs of an improvement in credit market sentiment, the Bank wrote then that “As uncertainty falls and market liquidity improves, it should become clearer that some assets appear cheap relative to credit fundamentals, which should in turn encourage a recovery in confidence and risk appetite by speculative and long-term investors… In that environment, firms may find that previous mark-to-market loss estimates have been overstated and some writebacks of reported losses may occur.”
Now, the Bank’s October report graphically illustrates the seismic changes that have taken place in the financial sector. One startling graphic shows the funding gap of UK banks:
Another illustrates the woes of hedge funds:
The report also summarizes and analyzes rescue efforts to date:
Taken together, perhaps as much as £5 trillion has implicitly or explicitly been made available by central banks and governments since April 2008 to support wholesale funding.
“While temporarily helping lengthen funding maturities, this cannot be a source of funding for banks in the medium term. It will need to be replaced from private sector sources. Given the scale of this intervention, reducing reliance on the official sector as a source of funds is likely to be a significant constraint on banks’ activities over the medium term.”
Looking further ahead, the Bank says “the events of the past year or so clearly highlight the need for a fundamental overhaul of the regulatory safeguards used to mitigate systemic risk within the financial system.”
The report also compares mark-to-market and credit losses, and analyses counterparty credit risks in OTC derivatives markets.
Technorati Tags: Bank-of-England, banking-system, credit-crisis, derivatives, Hedge-Funds, subprime
French bank liquidity is much improved from a year ago when the credit crisis began, and credit ratings remain stable after initial downgrades, but the worsening economy and continued financial market distress are clouding the outlook, said Fitch Ratings Service in a report this week.
Fitch applauded the French government’s commitment to stabilizing the banking system through capital injections to France’s six-largest banks this week, and the agency affirmed the ratings of those banks earlier this week.
Although the outlook for all long-term issuer default ratings assigned to leading French banks is “stable,” Fitch considers market stress to be sufficiently high and warns that rating changes may prove to be more sudden than those experienced in the past.
Among the worrisome economic signs, Fitch said home sales have fallen sharply and retail banks can no longer count on strong real estate loan demand to fuel growth.
The ratings agency said French banks with well-established commercial bank activities outside of France may be in a stronger position than their domestic-only counterparts. However, housing is also slowing in Central and Eastern Europe and Russia, where investment has been sizeable, Fitch said.
Fitch has downgraded a total of 12 French bank and financial company issuer default ratings since the beginning of the credit crisis in mid-2007. Individual bank ratings that were downgraded in the wake of the credit crisis include Natixis (KN), Groupe Caisse d’Epargne (CENCEP), Groupe Banque Populaire (GBP), Calyon and Societe General (GLE).
For details, see “Major French Banks.”
Technorati Tags: banking, banking-system, Calyon, credit-crisis, credit-ratings, French banking, global-credit, Groupe Banque Populaire, Groupe Caisse d'Epargne, Natixis, Societe General
With the jury still out on the effectiveness of the myriad bank bailouts, topics related to the ongoing credit crisis and its fallout dominated the top posts this week. Visitors continued to come to Research Recap to keep up to date with ratings actions on financial companies in the new through our regular “Ratings Roundups.” Visitors were very interested in the OECD’s comparison of the differences in bank deposit insurance across countries. They might have taken comfort from Floyd Norris’s analysis in The New York Times showing that the impact of the banking crisis on the broader economy should be less in the US than in many other countries.
On a gloomier note, visitors were drawn to Moody’s warning that the credit crisis is likely to result in significant state and local budget cuts, including usually off-limits areas such K-12 education. Likewise there was strong interest in Fitch Ratings’ prediction of higher commercial real estate loan defaults.
Research Recap Quote of the Week:
We would be skeptical that a GM-Chrysler transaction could easily address our primary concern by resulting in a substantial increase of current liquidity for the parties involved.- S&P
Technorati Tags: (GM), banking-system, CMBS, commercial-real-estate, credit-crisis, municipal-bonds, state-and-local-government, structured-finance, Zeitgeist
Standard & Poor’s says there continues to be downward ratings pressure on major US banks, even though the risks of a “credit cliff” have receded in the wake of the government rescue plan.
S&P said it will likely not change banks’ ratings at this time as a result of the government’s actions.
“However, while we believe these actions will help restore confidence in financial institutions and help stabilize funding markets, the very real issue of deteriorating asset quality as the economy slows, continues to pose risks to the banking system in our view.”
We expect earnings to suffer from continued write-downs on market-disrupted securities and, more importantly going forward, from provisions for loan losses.
Thus, there continues to be downward ratings pressure on the major banks, even though the risks of a credit cliff have receded.
S& P said it is in the process of reassessing both industry risk and individual bank and bank holding company debt ratings in light of recent events. Specifically, there are eight issues that we will be addressing in this industry reassessment:
- How the business of banking may fundamentally change;
- Level of capitalization, asset quality, and estimated loss projections;
- Rating to fundamentals in irrational markets;
- Actual and potential government support or intervention;
- Operating company and holding company notching, including notching for hybrid securities and differences between senior and junior instruments;
- Appropriate leverage;
- Risk management issues such as risk appetite; and
- Funding/liquidity management and preparedness for dislocated markets.
S&P anticipates that the reassessment of the industry and rating actions, if any, will be completed within the next several weeks.
S&P said if banks are permitted to recognize losses over the next few years, rather than having to accelerate lifetime losses on loan portfolios into the current period, capital requirements, at least current regulatory ones, should be manageable. “However, fire-sale valuations could lead to widespread insolvencies not contemplated in ratings. We expect that the recent pronouncements by the Financial Accounting Standards Board and the SEC on mark-to-market valuations of illiquid securities should stabilize the markets even further, as will the confidence-boosting efforts of central banks and market regulators.”
For more, see U.S. Banks: Back to Fundamentals.
Technorati Tags: banking, banking-system, credit-crisis, credit-ratings
The “extraordinary support” provided by the UK government stands a good chance of succeeding in rebuilding confidence in the UK banking system and stabilizing UK banks at their current rating levels, Standard & Poor’s says.
S&P on Oct 13 affirmed its ‘AA-/A-1+’counterparty credit ratings on Barclays NYSE: BCS) and Lloyds TSB Group (NYSE: LYG) and its ‘A+/A-1′ counterparty credit ratings on HBOS (NYSE:HBOS) and The Royal Bank of Scotland Group PLC (NYSE: RBS). The outlook on RBSG was revised to stable from negative. The counterparty credit ratings on Barclays and Lloyds TSB remain on CreditWatch with negative implications, where they were placed on Sept. 17, 2008 and Sept. 18, 2008, respectively. The long-term counterparty credit rating on HBOS also remains on CreditWatch, where it was placed on Sept. 18, 2008, but the implications were revised to positive from developing.
This massive aggregate capital increase and the related funding and liquidity measures are intended to rebuild confidence in the UK banking system, ensure the continued provision of credit to the real economy, support banks while they continue to de-lever, and reinforce their balance sheets in preparation for the full impact of the sharp downturn in the UK economy and property market, S&P says in a Research Update.
“The steps taken by the government are comprehensive and, in our view, stand a good chance of achieving these goals…. it materially increases the capital cushion available to absorb future credit impairments and write-downs. The government’s actions provide material support to ratings that could otherwise have been vulnerable to a crisis of confidence and an associated credit cliff.”
Rather than upgrade the ratings, we consider that the extraordinary support provided by the government stabilizes the banks at their current rating levels.
Furthermore, although we expect the government’s support to remain in place for a sustained period, it does not intend to be a permanent shareholder.
Technorati Tags: (HBOS), (LYG), (rbs), bailout, banking-system, Barclays, credit-crisis, european-banks, Lloyds TSB, royal-bank-of-scotland, UK
Moody’s welcomes the “uniquivocal commitments to support their banks” by Heads of State of the Eurozone and the UK, but does not expect the moves to result in widespread ratings upgrades of European banks.
In a Special Comment, Moody’s said it believes the measures will collectively help to restore financial flows within the banking system. “With these announcements, Moody’s considers that a substantial de-risking of the banking system is being achieved by providing significant capital and transferring banks’ credit risk to their supporting governments for the period necessary to restore confidence and normal financialmarket operations.”
“With implementation of this very clear systemic support, Moody’s expects that bank debt and deposit ratings of large European banks will stabilize; capital and liquidity support, which was previously at issue, is now being secured. At the same time, Moody’s does not expect widespread ratings upgrades.”
To varying degrees, systemic support already had been incorporated into our ratings, and the provision of support is likely to be temporary, with the result that the implications for long-term ratings are more limited.
“The exception will be for obligations of banks for which there is clear substitution of risk by the government for that of the bank, as in the case of explicit guarantees. Here, Moody’s will de-link the risk assessment from the bank and apply the appropriate government rating to the specific obligations. Selective rating actions (positive or negative) could still occur and would be driven primarily by long-term strategic and franchise considerations.”
Technorati Tags: (HBOS), (LLY), (rbs), banking-system, credit-crisis, european-banks
Despite the absolute size of the credit crisis in the US, it appears to present a much smaller threat to the overall economy than in many other countries, Floyd Norris points out in the New York Times.
The United States has a banking system that is the largest in the world but is small in relation to the national economy, Norris writes.
In the United States, the banks have total short-term debt that is equal to 15 percent of G.D.P. But in some countries where banking systems have grown to international proportions, the debt exceeds G.D.P. That is true in Switzerland, Belgium, Iceland and Britain.
Norris also looks at the short-term bank debt in relation to each country’s national debt. The relationship is not direct, because a country may have excellent credit that would enable it to borrow much more, but large numbers still raise questions.
“Can they guarantee the deposits if the bank owes 3.5 times the national debt?” asked Bob Prince, the co-chief investment officer of Bridgewater Associates, which provided the data.
Finally, the leverage ratio gives a rough indication of how risky a nation’s banking system might be. It is the ratio of total bank assets to the net worth of the bank. That could be misleading if the assets are very safe — government bonds, for example, versus subprime mortgage loans — but in general the higher the ratio the smaller the margin of safety.
There again, the United States appears to face a relatively small problem, with an average leverage ratio of 12. The figures range up to 52 in Germany. Theoretically, a 2 percent drop in the value of all German bank assets would wipe out the net worth of the banking system.
These figures will be meaningless if the governments retain the trust of depositors and creditors. “It becomes a matter of psychology,” Mr. Prince said. If governments say the deposits are safe “and the market believes them, then they don’t have to have any money to back up their promises.”
Technorati Tags: banking, banking-system, credit-crisis, sovereign-debt
The level of government guarantees of bank deposits varies greatly across countires, even more so as a result of actions in the wake of the credit crisis, OECD data shows.
Until the latest statements suggesting unlimited guarantees, legal coverage was highest in Norway, France, Italy and Mexico. In the US the amount covered has been raised temporarily to $250,000 from $100,000 per account. The following graphs show coverage in early 2008 and the position as of 8 October 2008, based on government statements:
“Unlimited ?” is an interpretation of the implication of recent announcements or policy statements for effective coverage limits and that the data shown may not be identical to existing legal limits. As such the data may not be strictly comparable across countries.
Technorati Tags: banking-system, credit-crisis, deposit insurance
With the exception of Iceland, the measures taken by European governments to support banks do not pose a threat to their sovereign debt ratings, according to Moody’s.
To date, the responses to the credit crisis have included full nationalisations, capital injections, firm declarations of support and formal blanket guarantees. Other initiatives are possible given the continued fluidity of the situation. In addition, a reshaping of EU-wide financial stability arrangements is now being considered as a matter of urgency, and a relaxation of the Maastricht budget rules is increasingly probable.
With the exception of Iceland, where the unprecedented seizing up of global credit markets has compounded the difficulties of Icelandic banks and considerably complicated the task of the government to restore financial stability, Moody’s response has so far been very measured.
“Our view is that, in most cases, the rescues do not involve outsized and/or immediate debt increases, and remain manageable within the respective government’s current rating category. Government balance sheets are not yet materially affected, while less prompt reaction to protecting banking systems could have durably weakened the countries’ economic strength, upon which the governments’ taxing power is based.”
“That is why it is Moody’s view at this stage that European governments are taking calculated risks with public finances with the ultimate aim of protecting the vitality of their respective economies.”
In a Special Comment, Moody’s says the nature of the rescue operations poses a number of complicated questions. “In particular, three considerations require heightened vigilance. Firstly, the crystallisation of contingent liabilities at the current scale is a process that is difficult to control. Secondly, the deleveraging that will probably result from the current dislocations will deepen the downturn in many countries. Thirdly, the relaxation of budgetary rules will add uncertainty with regard to the medium-term orientation of public finances, although Maastricht ceilings have never played a critical role in Moody’s assessment of governments’ creditworthiness.”
Technorati Tags: banking-system, Belgium, credit-crisis, France, Germany, iceland, Ireland, Italy, Luxembourg, Netherlands, sovereign-debt, Spain, UK