A question mark over US banks

Perhaps the major surprise in the decision by Moody's to cut the credit ratings of 15 of the world's key banks that contributed to the tremors in financial markets overnight was that among them there are half a dozen of the big North American banks.

Given that Moody's had foreshadowed the ratings review of banks with global capital markets operations back in February, the fact of the review wasn't a shock. The decision to downgrade Citigroup, Bank of America, Morgan Stanley, JP Morgan Chase, Goldman Sachs and Royal Bank of Canada, however, raised some eyebrows and triggered a backlash from some of the US banks.

A recurring theme in commentary about the eurozone crisis has been the disturbing fragility of the European banks. In the last few days it has become evident that the Spanish banks alone need at least $125 billion of new capital.

That puts into perspective the findings of last year's eurozone stress testing of its banking system, which concluded there was a capital shortfall of about €115 billion ($A143 billion) and tends to confirm the views of the cynics who believed that the Europeans had consistently underestimated the levels of capital required to shore up their banking system because the numbers were too big to contemplate.

In the US, by contrast, the several rounds of severe stress-testing undertaken by the Federal Reserve board resulted in the big US banks raising and generating more than $US300 billion of new capital while downsizing their balance sheets. Despite the extreme scenarios that underpinned the tests if another financial disaster occurred the tests found that the aggregate post-stress tier one capital ratio would only fall from 10.1 per cent to 6.3 per cent.

While Citigroup, which was downgraded by Moody's last night, was deemed to have narrowly failed the tests that was only on the basis that it went ahead with capital management initiatives it had mooted, otherwise it, too, would have passed the tests comfortably. It hasn't proceeded with those buy-backs.

In a KGB Interview with Citi's chief country officer for Australasia, Stephen Roberts, earlier this month Roberts said Citi was a totally different institution to that which it was pre-crisis, with far greater capital strength and a lower risk profile because it had returned to the basics of banking.

In the US last night Citigroup made similar points, saying Moody's approach was backward looking and failed to recognise Citi's transformation. At the end of the March quarter Citi was holding more than $US420 billion of surplus liquidity, almost all of it in cash and government securities. Citi has been solidly profitable for the past two years.

Moody's analysis was directed to the banks' exposures to the volatility and the risk of 'out-sized' losses in the banks' capital markets operations after taking into account the size and stability of their other activities, their capital and their liquidity. It also included their exposures to Europe.

Citi and Bank of America were the hardest hit by the ratings agency, with both of them downgraded two notches. Both the banks have effectively said Moody's is rating them on the basis of what they used to be rather than what they are today.

BA, like Citi, is holding record capital ratios and all the big US banks, under some pressure from the legislators and regulators, have been trying to scale back their riskier activities even though, as Roberts said in his interview, the nature of banking inherently involves intermediating and managing risk.

Interestingly JP Morgan was one of a small group of banks (HSBC and Royal Bank of Canada were the others) that lost only one notch on the basis of their strong buffers, or shock absorbers, from other businesses. JP Morgan, of course, recently revealed losses from principal trading of at least $US2 billion and potentially as much as $US5 billion.

Moody's actions have real-world consequences for the banks. The funding will cost more and be available from a smaller pool of prospective lenders and they could have to post a lot more collateral with counter parties in their trading activities.

That, and the impact on their reputations and perceptions of their strength during another moment of fragility within the global system, is why some of the banks are seething – and making disparaging comments about the credibility of rating agencies. Moody's and Standard & Poor's are seen as being far more aggressive post-crisis as they try to redeem reputations ravaged by their roles in the original financial crisis.

It is interesting that even as the Fed's stress-testing has shown a continuous improvement in the strength of the US banking system Moody's has lowered the US banks' ratings.

If Moody's assessment were regarded as appropriate, it would raise something of a question mark over the quality of the Fed's tests despite the draconian assumptions that underpinned them or the real actions, in the form of raising capital and liquidity and exiting some activities, that the banks have been forced to take in response to them.

It would also add significantly to the already acute concerns about the fragility, or otherwise, of the global financial system that have been raised by the escalating difficulties in the eurozone economies and their banking systems.

The rest of the world may be able to quarantine itself to a degree from the fallout of a full-scale crisis within the European system, but not if the fallout hit the big end of a weaker-than-perceived US system. The debate the ratings review has sparked in the US as the mega-banks defend themselves is a critical one.