Moody's new thermometer for ailing banks

Moody’s decision to put on review for downgrade eight Australian banks, including the four majors, is at one level a technicality that has nothing to do with the underlying credit quality or riskiness. At another it points to a significant shift in the global approach to managing banks in trouble.

Moody’s said the subordinated debt ratings of the banks being reviewed (which include Macquarie, Bank of Queensland, Bendigo and Adelaide and Suncorp Metway) had previously benefitted from its earlier assessments of systemic support – an assumption that they would be supported by government if they were to get into difficulty.

"The review takes place in the context of a methodology update that has changed the way Moody’s looks at the probability of support, which has led to several sub-debt ratings in multiple banking systems being reviewed simultaneously," the agency said.

It said the changes to its methodology were driven by a conclusion that government policy dealing with ailing banks had evolved globally in a way that made support for bank subordinated debt less probable than before, with policy moving towards “burden-sharing” and away from the automatic bailouts of all creditors that had occurred in recent years.

Moody’s didn’t refer to Cyprus when it originally sought comment on its methodology last month but it might well have. Cyprus was forced to restructure its banking system earlier this year and as part of the terms of the deal with the eurozone, authorities imposed losses on uninsured depositors as well as wiping out other creditors.

The initial response to the deal from the European authorities was that it had set a precedent in pushing risk away from taxpayers and onto shareholders and bond holders and that regulators should aim to ensure that they would never need to consider direct recapitalisation of a distressed bank.

While the authorities backed away from those comments after they realised they increased the prospects of runs on other European banks the Cypriot recap did provide a precedent for how to deal with bank failure and one that is in tune with how bank regulators in the US and UK are also trying to approach the issue.

Thus the Moody’s action essentially reflects the real-world thinking of regulators, which has undermined its assumption that the Australian banking system and the tiers of creditors within the banks carried an implicit government guarantee. In fact the only explicit guarantee is for deposits of less than $250,000.

The demonstration effect of the Cypriot solution is important because it helps lessen the moral hazard created when there is an assumption that taxpayers will stand behind all bank liabilities. The behaviour of institutions may be more disciplined if they believe they have creditors, depositors and shareholders – as well as regulators – monitoring their risk-taking.

The US and UK authorities are developing an approach to how to deal with globally systemically important institutions (G-Sifis) deemed too big to fail and, apart from imposing capital surcharges on them or, in the UK’s case, contemplating ring-fencing core traditional banking activities from other riskier activities, are constructing a plan that would enable them to manage the failure of a G-Sifi.

They are actively contemplating an approach that would enable them to wipe out shareholder equity, impose losses on creditors and/or forcibly covert debt to equity in order to recapitalise institutions without recourse to taxpayers.

The UK’s ring-fenced entities, for instance, would have loss-absorbing capital – capital that could be forcibly converted into equity.

The experience of the global financial crisis in the US, UK and Europe was of massive transfers of funds from taxpayers to bank bondholders and shareholders, which reinforced the conviction that banks deemed too big to fail wouldn’t be allowed to have regardless of the cost.

The Moody’s review is a recognition of the newfound determination of authorities around the world to ensure that, while banks that are too big to fail don’t fail, their creditors are the ones with primary responsibility for bailing them out.

In future the ‘bail-in’ option is likely to be the preferred option for dealing with failing institutions.