Tougher banking scrutiny by ratings agency has its pluses and minuses

THE credit rating downgrade of some of the world's biggest banks has turned out to be a positive for Australia, with the dollar bouncing back above parity and financial stocks rising against a falling bond market.

This partly reflects the fact that the Australian banking system is in far better shape than its global peers and the big four banks are trading on an attractive fully franked dividend yield of 7 per cent. But during times of volatility it is dangerous to read too much into the market's positive reaction in any one day.

The credit rating downgrade by Standard & Poor's reflects the firm's new criteria for banks, which incorporates shifts in the industry and the role of governments and central banks worldwide.

It is part of a bigger picture attempt by all credit ratings agencies to repair their damaged credibility after being exposed during the global financial crisis as being captured by the financial system in terms of the AAA credit ratings they meted out to some ticking financial bombs that became known as collateralised debt obligations.

While it is good that the ratings agencies are trying to restore their image, they still have a long way to go and S&P's timing to release the downgrade couldn't get much worse.

It came as British Chancellor George Osborne's autumn statement highlighted the troubles of the global economy. He warned that Britain's debt challenge was ''greater than we thought'' and that his darkest outlook could turn out to be optimistic if the euro zone crisis worsened. Fitch Ratings followed up with a warning that Britain's AAA credit rating could be at risk from further economic shocks unless the country took fresh measures to cut debt.

S&P cut its credit rating on Bank of America, Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley, Wells Fargo, Barclays, Lloyds Banking and Royal Bank of Scotland.

It is part of a planned credit rating update on a universe of 750 banks worldwide that will kick off over the next few weeks. If Australian banks get caught in the credit rating downgrade crossfire, it will have a negative impact on them.

In the meantime, the credit rating downgrade yesterday cannot be underestimated. It comes as concerns build in the US about whether Bank of America has enough capital to withstand another downturn in the US economy or further trouble in Europe.

In the past year, its share price has fallen more than 60 per cent. On November 3, it issued a warning in a statement to the Securities and Exchange Commission that a credit rating downgrade ''could likely have a material adverse effect on our liquidity''.

The biggest threats to the global economy right now are uncertainty - what is going to go wrong next - and lack of confidence.

As the weight of the US and European economies drags on fixed interest, currency and equities markets, a credit rating downgrade of some key US and European banks will have longer-term implications on the financial system.

The downgrades come as the euro zone hangs on a knife's edge and investors, governments and businesses battle to work out the impact directly and indirectly from the unwinding of the debt binge. Will China ride through it again and carry Australia with it? The Organisation for Economic Co-operation and Development believes Australia will ride through it and grow at 4 per cent next year, but if Europe and the US topple, the longer-term consequences for Australia are not good.

On a sombre note, while Australia is largely quarantined as long as China continues to grow and demand our commodities, Australia still exports a lot of products to Europe and the US - as does China.

The other reality is the financial system is global and as credit markets continue to dry up a credit rating downgrade of some of the biggest banks in the world will have a circular downward effect on the entire system.

With so many high-profile banks with their tentacles around the world, a credit rating downgrade increases the risk in the banking system, which leads to a reduction in the availability of funding, which leads to a reduction in the profits of the banks, which weakens their capital position, which leads to another credit rating downgrade, and so it goes.

After massive government bailouts of European and US banks and monoline insurers during the global financial crisis, debt became like pass the parcel, with taxpayers left to foot the bill. If the GFC was caused by corporate debt out of control, then this latest crisis has been caused by sovereign debt and the governments.

The various governments in Europe and the US began eroding financial laws in relation to the requirement that companies mark their assets to market - those governments didn't change the laws they just ignored them. To enforce them would have sent many companies into financial oblivion.

But there are virtually no more chairs left in the game of pass the parcel and the world is left facing the latest attempt by European governments to pretend that credit default events will not occur when the banks are finally forced to confess their holdings of Greek debt are worth less than half their face value.

If Australia's banks manage to keep their current credit rating, they will be in a stronger position than their peers, but the potential longer-term consequences of a weaker financing environment, slower growth and higher risk aversion are negative factors for Asia-Pacific region sovereign ratings.