'AAA' loss would cut bank ratings

Over recent days there has been much said in the media about the likelihood of Australia losing its ‘AAA’ credit rating from Standard & Poor’s. There has also been debate among ‘experts’ as to whether the loss of the rating would have any impact on the Commonwealth government’s cost of debt.

Dealing with the second point first, Australia is one of just a handful of nations around the world with a ‘AAA’ sovereign rating from S&P. Australia has benefited from this, with Commonwealth government bonds being highly sought after by central banks and other institutional investors around the world.

This demand for Commonwealth government bonds has been one factor in maintaining the high value of the Australian dollar. If this demand falls away, so will the dollar.

Although a fall in the value of the Australian dollar may not be a bad thing for the economy overall, reduced demand for Australian government bonds will result in an increase in the cost of government debt. What is unknown is how great that increase may be.

Some are saying there may be no increase at all – citing the example of the United States losing its ‘AAA’ rating from S&P in August 2011. But the US dollar is the world’s reserve currency, the Australian dollar is not.

Moreover, despite the high demand seen for Commonwealth government bonds, Australian dollar denominated assets remain a niche investment for global investors. Thus, the cost of selling Commonwealth government bonds will inevitably rise.

What is means for banks

In all this discussion and debate, a critical consequence of any loss of Australia’s ‘AAA’ rating has been missed. If Australia is downgraded, the four major banks and Macquarie Bank will also be downgraded.

Furthermore, the ‘AAA’ ratings assigned to covered bonds issued by the major banks could be at risk.

Under the revisions made to S&P’s bank rating methodology in late 2011, the major banks have a stand-alone credit profile (SACP) of ‘a’. To this, S&P applies two notches of rating uplift for a high likelihood of sovereign support for the banks, should they be in need.

This results in the ‘AA-’ ratings that are assigned to the major banks.

However, two notches of rating uplift are only available to banks with SACP of ‘a’ if the sovereign is rated ‘AAA’. If the sovereign rating falls to ‘AA ’ then only one notch of rating uplift is allowed.

Thus, if Australia is downgraded to ‘AA ’, the ratings on the ‘big four’ major banks will fall to ‘A ’. Macquarie Bank’s rating will fall to ‘A-’.

As for the ‘AAA’ ratings on covered bonds, S&P’s criteria allows for a rating uplift from four to six notches depending on an assessment of the asset-liability mismatch risk and market value risk residing within the cover pool. A reduction of the major banks’ ratings to ‘A ’ brings them to the edge of the four to six notch uplift range, where additional structural enhancement may be required to achieve a ‘AAA’ rating.

While the banks’ reliance on wholesale debt markets for funding has reduced in the years since the GFC, and deposits have become an increasingly important source of funding, debt sourced from wholesale markets still accounts for around 30% of the banks’ total debt funding.

Any cut in the credit ratings of the major banks and Macquarie, will result in a much more significant increase in their cost of debt than any increase felt by the Commonwealth government.

Any increase in the cost of debt for the banks will flow through to all of the banks’ lending and mortgage rates. This would have a dampening effect on the economy that could be sufficient to provoke another cut in the official cash rate by the Reserve Bank.

However, the risk of any of this happening depends on what S&P is really thinking.

The media controversy was sparked by comments reportedly made by an S&P sovereign analyst that there is a one-in-three chance of Australia’s ‘AAA’ rating being cut, if the bulk of the savings measures in last week’s federal budget are not passed in the Senate.

At the moment, there is not a one-in-three chance of the rating being cut. The outlook on the rating is stable.

If the outlook is moved to negative, then the one-in-three chance comes into play.

When S&P moves the outlook on Australia’s ‘AAA’ rating to negative, it will be time to worry.

This report was first published in Banking Day on May 22, 2014. www.bankingday.com. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.