Below is the latest KBRA comment on the travails affecting the largest global banks. Global capital levels are at the highest levels ever, but investor confidence in the big banks is at an all time low. Over a century ago, J.P. Morgan told a congressional hearing that commercial credit is not based upon money or property, but character. You could substitute the word confidence for character in the exchange between Morgan and Samuel Untermyer.
The economists who dominate the global regulatory community say that higher capital will prevent future crises, but this is a fallacy. The 2008 crisis was caused by a liquidity run, not a lack of capital. The liquidity run occurred as a result of securities fraud. Banks typically fail long before they actually consume capital. Failure is usually a function of reduced liquidity and/or operational risks. But in a market where fraud is tolerated or even encouraged, no amount of capital will suffice to maintain investor confidence. The full note with charts is available on the KBRA web site. -- Chris
Kroll Bond Rating Agency
February 12, 2016
The sharp downward move in global equity market valuations that began in January 2016 has taken its toll on a number of industry sectors and in particular on global financials. While the S&P 500 is down about 10% since the start of the year, the market capitalizations of some of the largest universal banks are down by more than a third, placing some names near all-time low equity market valuation levels not seen since 2009. Credit spreads for these institutions have widened to below investment grade levels.
KBRA notes that the deterioration in large bank valuations actually began last summer, when market fears about the continued risk of global debt deflation and flagging growth in China began to undermine investor confidence. KBRA believes that from a credit perspective, large banks are financially sound and are unlikely to see any volatility in credit ratings in the near term. However, substantial movements in equity valuations and credit spreads suggest that some large financial institutions may be facing reduced liquidity and market access.
While KBRA believes that large universal banks are financially sound, falling equity market valuations are significant and reflect increased investor concern over credit more generally, as illustrated by the expansion of credit spreads. Whereas the difference between high-yield and investment grade debt was less than 200 basis points (bp) in mid-2014, today that relationship is over 450bp.
The chart at right shows the Bank of America Merrill Lynch US High Yield Master II Option-Adjusted Spread since 2011.
As a result of wider spreads, new issuance activity in the high-yield sector has largely ground to a halt, depriving many sub-investment-grade credits of access to the capital markets. As credit spreads widen, the cost of credit intermediation also rises, reducing the ability of the global economy to generate growth and jobs. Increased spreads also are a function of investors’ uncertainty regarding the disclosure of future risks by both banks and corporates with credit exposure to these areas. Finally, changes in spreads are also due to changes in monetary policy since last year.
KBRA believes that there are several factors driving increased investor concerns regarding large globally active financial institutions:
• Direct Exposures: First and foremost, investors are concerned about the direct exposures held by banks in the energy and commodities sectors, both in terms of extensions of credit and other types of risk exposures such as credit default swaps. While some banks have dramatically reduced their energy exposure, others may still cause more concerns. The tendency of lenders to forebear with respect to energy-related exposures causes investors to discount bank disclosure when it comes to future risks.
• Indirect Exposures: Second, the potential for future loss due to the indirect impact of lower energy prices on other obligors is another area of concern for investors. The impact of lower energy and commodity prices on sovereign credits such as China, Australia and Saudi Arabia, to name just a few, are weighing on global markets and, indirectly, on financials. The economic impact of lower energy prices on markets such as Texas is wide reaching and will take months or even years to fully manifest in terms of credit experience. For example, oil’s current price range at or below $30 a barrel, is about one third of the level needed to balance government budgets among the Middle East and North Africa (MENA) oil exporters.
• Disclosure Quality: Finally and as a general matter, investors remain skittish about the quality of risk disclosure by both sovereign and private obligors. Revelations about the actual level of growth in China, for example, have badly shaken investor confidence, leading to sharply higher levels of volatility in many markets. In terms of global banks, investors remain skeptical that large financial institutions are fully disclosing all of the relevant risks on and off balance sheet. This skepticism is a legacy of the 2008 financial crisis. Despite the myriad of new laws and regulations, and the fact that banks have become more transparent, global banks have yet to fully restore their credibility with global investors and the public.
With total returns for high-yield debt in 2015 in negative territory, Barclays Bank is forecasting a 5–5.5% default rate for below investment grade debt in 2016. The bank provides a range of just 4.4% if oil prices rise to $60 per barrel or more, and to 6.4% if oil sinks below $40 per barrel. While KBRA notes that the default rate experience for energy credits held in bank portfolios is likely to be far less, investors remain concerned about how continued low energy prices will impact particular institutions.
As we have noted in previous comments, the divergence between the monetary policy of the U.S. and that of other nations is a significant source of market volatility. KBRA believes that policy makers need to focus on actions and policies that will calm global financial markets and help to reduce credit spreads. So far the actions taken by global central banks seem to be moving in the opposite direction. For example, the belated actions by the Federal Open Market Committee to raise interest rates are coming at precisely the wrong moment, when market concerns regarding credit quality are rising and most monetary authorities are easing policy.
The chart below shows the relative levels of government, investment grade and high-yield debt from 2009 through the start of February 2016. While the spike in credit spreads is far smaller than that experienced during 2008, the increase in spreads is sufficient to stifle for the ability of below investment grade credits to raise capital, to slow economic growth, and to contribute to higher levels of credit losses by banks.
So far, policy makers have responded to the decline in oil prices by embracing zero-interest rate policies, but this response may be making matters worse. KBRA believes that the leaders of the major industrial nations need to accept that the downward move in energy and commodity prices will result in sharply increased credit costs in 2016 and beyond. Keeping interest rates low or even negative will not likely be a sufficient response to the surge in defaults that KBRA expects to unfold in 2016. KBRA also believes that policy makers should be prepared to directly address default events in the energy sector. Where necessary, regulators should be prepared to facilitate restructuring efforts so that isolated credit events by relatively small obligors do not result in systemic risk events.