In the past month, both Moody’s and Standard & Poor’s have indicated that they expect to remove the uplift for government support that is currently built into many banks’ credit ratings. This reflects the EU Bank Recovery and Resolution Directive (BRRD) and similar measures around the world, which legislate for investor bail-ins as the preferred alternative to taxpayer funded bail-outs at failing banks.
The three major rating agencies already publish shadow “unsupported” ratings for banks that ignore the possibility of extraordinary external support – Fitch calls these its “viability ratings”, while Moody’s use the term “baseline credit assessment” and Standard & Poor’s “standalone credit profile”. You may be surprised to see how low some of these shadow ratings are for the UK’s main financial institutions.
In the absence of any increase in these banks’ intrinsic credit strengths, or the rating agencies betting on the Government ignoring the BRRD, we can expect to see long-term credit ratings fall towards the above levels over the next one to two years.
Where would these downgrades leave your treasury management strategy?
National legislation around bail-in is already in place in the UK and Switzerland, while the BRRD is effective across the EU from January 2015.
The rating agencies feel that governments are not quite ready yet to impose losses on investors in the largest banks, for fear of triggering a crisis of confidence. Low risk local authority investors might not want to test that proposition with their own taxpayers’ money, though.
In response, our clients are diversifying away from the big banks, especially for the parts of their portfolio that balance sheet analysis shows will be available for several years. Popular instruments for long-term cash include:
- covered bonds, which are bail-in exempt investments in banks and building societies, backed by ring-fenced pools of mortgages or other loans,
- corporate bonds, either owned outright via a custodian or indirectly via pooled bond funds,
- loans to sectors that still enjoy extensive government support, such as local authorities and housing associations, and
- property investments, especially in pooled commercial property funds.
As well as reducing the exposure to bail-in risk, many of these investments also offer higher yields than the paltry rates currently available on short-term bank deposits. They can be more complex to use than traditional local authority investments, potentially introducing exposures to duration, corporate credit, liquidity and market price risks. Some will also present the complications of custodial arrangements, documentation requirements or additional accounting entries. Some local authorities may therefore need to employ either additional in-house expertise or further external advice in future.
But maintaining the status quo is not an option for the future. The government is committed to ensuring that investment can be a simple process for the proverbial granny with her couple of thousand pounds in savings. But sophisticated multi-million pound investors, including local authorities, are expected to undertake their own research and to bear the costs of future bank failures. The government expects this will encourage investors to hold the banks to account for their actions, even if just by withdrawing funds from those whose prudence or conduct is called into question.
David Green is Client Director at Arlingclose Limited. This is the writer’s personal opinion and does not constitute investment advice.