Consequences of Downgrading Banks by Credit Rating Agencies

Introduction

When a credit agency decides to downgrade the rating level of a bank, the message being communicated across is that the bank affected is less likely to attract investors during a crisis. Nobody would want to invest in an institution where his/her money is not safe. During the recent global financial crisis, we saw governments coming to the rescue of big financial institutions that had fallen victim to the crisis, in the form of financial bailouts. However, this was not replicated to building societies owing to their small size. As such, government can let them to fail when they encounter financial difficulties. Still, the government may at times be less willing to assist banks whose credit rating is poor. The implication is that investors and depositors will start to avoid such banks (Levich, Mainoni and Reinhart 18). A credit rating simply refers to the opinions of credit rating agencies given on a certain date about a certain security, company, or obligation. Usually, such an opinion has to do with the creditworthiness of the institution in question. Over the last couple of years, quite a number of renowned banks in Europe and the United States have had their credit rating downgraded by credit rating agencies. We need to note that a downgrade has the potential to increase the borrowing costs of the bank in question, in addition to increasing pressure on the bank’s already shaky finances. The current paper is an attempt to explore the consequences of the downgrading of banks by credit rating agencies.

Main body

The credit rating of a bank entails the safety and security of lending from insurance companies and other banks, as opposed to customer deposits. Credit ratings are nothing more than opinions and there is the possibility that they could be wrong or misguided. Nonetheless, international regulators now recognise credit ratings as a vital tool for regulating banks (Alcubilla and Del Pozo 256). When credit rating agencies downgrades a bank, what this tells us is that the government may gamble with the idea of letting banks faced with a financial crisis to fail, as opposed to stepping in to support them with a financial bailout. A case in point in the collapse of the Lehman Brothers in 2008, when the government had to come in and inject credit guarantees and capital in a bid to slow down the spreading panic.

In 2010, Congress passed the Dodd-Frank financial regulatory reform. Under this reform, financial institutions are obliged to file a living will in which they state the measures they will take should they encounter a financial collapse (Alcubilla and Del Pozo 257). The goal is to ensure that the government does not have to step in the future to bailout financial institutions, as happened with the Layman Brothers in 2008. However, because the United States and the other countries are almost out of the crisis, credit rating agencies are convinced that the government could let large banks to fail.

Standard’s and Poor’s and Moody’s are two of the three largest credit rating agencies. The third credit rating agency is called Fitch. The credit rating agencies are charged with the responsibility of vetting the trading environment of financial institutions with a view to issuing a clean bill of health so that potential investors can know how safe their money would be if invested in these institutions (World Bank 76). The highest rating level is AAA. Credit ratings are very important to financial institutions because they reflect the ease with which the financial institutions (in this case, a bank) is able to obtain credit on the money market so as to maintain liquidity and the desirable cash-flow. However, credit ratings could also impact negatively on the perceptions held by investors, depositors, and the government about the bank in question, on the level of safety of the financial institution. For this reason, credit rating agencies are right to downgrade banks immediately they realize that they are no longer creditworthy.

In 2011, Fitch downgraded the credit ratings for a number of banks in Europe and the United States. The mass downgrade raised a lot of concern about a possible new credit crunch because it came at a time when the global banking system was still reeling from the effects of the recent global financial crisis, not to mention that most of them were still faced with massive debts that they have to repay. The banks that saw their ratings slashed by Fitch are the Bank of America and Morgan Stanley. Others are Barclays and Credit Suisse. In the same year, Standard & Poor’s, another leading credit rating agency, also downgraded the credit rating of a number of leading financial firms in the U.S and Europe as well (Alcubilla and Del Pozo 256). They include Bank of America, Barclays, HSBC, and Goldman Sachs. So, how does the downgrading of the credit rating of a bank impacts on it? To start with, we need to note that the direct impact could be actually very minimal. Banks get their funding from various sources, such as long-term bonds.

When a bank loses its credit rating through a downgrading, what this means is that the long-term bonds shall then become very expensive. However, some banks such as the Bank of England made it possible for banks to sell securities in exchange for cash in what is called quantitative easing ((Levich 21). In this case, even with a downgrade, loan, card, and mortgage borrowers may still get access to credit, and neither will the rates increase. A downgrade is also not a good thing for borrowers who have been banking on mortgage rates coming down, although it is not easy to quantify such an effect (Rose and Hudgins 134). However, once a bank has been faced with a downgrade, it becomes very difficult for the institution to obtain money from the market for lending out as mortgage. Not only does such a downgrading affect the liquidity of a bank adversely, but it also means that the bank cannot access the credit market as it previously did. Banks find it more expensive to borrow money once their credit rating has been downgraded. In addition, a downgrade is also likely to hurt the businesses of a bank, especially in areas where creditworthiness is crucial.

Another credit rating agency, S & P, reduced the rating of Bank of America from A to A- with a negative outlook. At the same time, Wells Fargo saw its rating drop from AA- to A+ but its outlook remained negative. Such an action is bound to stir investors, at least in the short-term. However, analysts are optimistic that in the long-term, investors will comes around. On the other hand, the decision by Moody’s to downgrade some three banks in the United States back in May 2011 resulted in a negative reaction from the market. This was in spite of the fact that Moody’s had issues prior warning back in June that it was thinking of downgrading the credit ratings of the bank affected. The downgrading saw the shares of Morgan Stanley on Wall Street drop by 1.7 % within hours of the downgrading, while those of Goldman Sachs dropped by 1 % (Alcubilla and Del Pozo 259). However, Bank of America was hit hardest by the downgrading exercise, as the bank’s shares fell by a massive 7.5 %.

Conclusion

Credit rating agencies are charged with the responsibility of ensuring that banks remain credit worthy. This is meant to protect investors from losing money in case the financial institution is faced with a crisis. In the month that followed the 2008 global financial crisis, we saw the government stepping in to bail out cash-strapped banks, such as the Layman Brothers. On the other hand, the recent downgrading of varies banks in Europe and the United States by Moody’s and S & P’s is a clear sign that the government could be ready to let big banks collapse, rather than bail them out. The credit rating of a bank has to do with the safety and security issues of lending from other banks and insurance companies as well. When the credit rating grade of a bank has been reduced, such a bank may find it hard to get credit. Consequently, the bank may find it hard to maintain cash-flow and liquidity. As a result, investors may lose confidence in the bank because their investments are at risk.

Works Cited

Alcubilla, Raquel and Del Pozo, Javier. Credit rating agencies on the watch list: analysis of European regulation. Oxford, Mass: Oxford University Press, 2012. Print.

Levich, Richard, Mainoni, Giovanni, and Reinhart, Carmen. Ratings, rating agencies and the global financial system. New York: Springer, 2002. Print.

Rose, Peter, and Hudgins, Sylvia. Bank management and financial services. New York: McGraw-Hill/Irwin Series, 2006. Print.

World Bank. Credit Rating Agencies. 2010. Web.

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