Rating agency Standard & Poor’s is a touch concerned the initial draft of the Financial Stability Improvement Act of 2009 might hurt the creditworthiness of US financial firms.
The draft bill, released in October by the Treasury and the US House Financial Services Committee, proposed a blueprint for reducing systemic risk and dealing with institutions considered “too big to fail.”
But S&P believes that aspects of the legislation, if enacted in its current form, “suggest that certain forms of government support for financial institutions may be less forthcoming under future distress scenarios than they have been to date.”
Consequently (emphasis FT Alphaville’s):
it is possible that our view of certain financial institutions’ creditworthiness could change as a result of the enactment of the legislation in its current form, and that we could lower our ratings on certain financial institutions.
…
It is also possible that the proposed legislation could affect our assessment of ongoing support for financial institutions, in the form of maintaining market stability and access to funding, both of which are important parts of industry risk as we see it. We believe the effects could be both positive and negative from a credit standpoint. Changing our views of industry risks and system-wide support could affect our ratings on smaller, less diversified financial institutions as well as the large ones, although the impact on ratings is uncertain at this time.
The aspects of the bill that pose a heightened downside risk to financial firms ratings are, according to S&P:
- proposal on how to deal with the potential failure or danger of failure of systemically important firms
the draft’s goal appears to be to allow large, complex financial institutions to fail in a controlled and orderly fashion rather than to provide ongoing extraordinary government support. The proposed legislation requires that institutions that need government assistance to survive be taken into receivership, where the regulators and the administration can provide such assistance. In such cases, the costs to the government would be borne by shareholders and unsecured creditors, rather than taxpayers.
…In our view, the conditions set forth in the proposed legislation would most likely cause us to view default as more likely, even for those institutions’ senior debt holders. As a result, we may adjust or remove the rating uplift provided for extraordinary government support if needed.
- the proposed legislation could impede the Federal Reserve Bank’s (Fed) ability to act swiftly to address a crisis
The Fed would be able to exercise its ordinary powers to extend credit to healthy financial institutions using liquidity facilities available to all on established terms–not to rescue specific firms in difficulties. This could alter our assessment of the strength of ongoing support the Fed could provide to the industry, not just extraordinary support for failing firms. The proposed legislation seems to suggest that financial institutions, including nonbanks, that are determined to be highly systemically important and that find themselves unable to function without support would be taken into receivership by the Federal Deposit Insurance Corp. (FDIC) or a different receiver if deemed appropriate to preserve systemic stability.
- proposed legislation would provide the FDIC with broadened powers within a receivership to extend credit, capital, or guarantees to troubled institutions upon a two-thirds vote of its board and that of the Fed, with written consent of the Treasury
This procedure, in our opinion, would present certain challenges to rapid response. It also could limit the possibility of so-called open bank assistance that might preclude default for a solvent but illiquid institution, requiring that the institution be supported only with a view to restructuring, selling, or liquidating it in an orderly way.
- the issue of shared costs
Specifically, any losses to the government from the failure of a systemically important bank would be repaid over time by fees assessed against a broad range of financial institutions, including nonbanks, with more than $10 billion in assets. Smaller ones would be exempted. It is difficult to assess exactly how this would play out. We believe it would depend largely on how onerous the fees become and their timing. The industry has generally repaid the costs of past banking crises through increased deposit insurance assessments, we believe, without incurring a significant undue burden. In the future, in our view, its ability to do this would depend on how often institutions fail and how much value is preserved in them given the method of resolution.
- provisions that regulators could set higher standards for systemically important institutions with respect to capital, liquidity buffers, concentration limits, and risk management that might not apply to others.
In our view, different regulatory standards for systemically important financial institutions could put larger institutions at a competitive disadvantage to smaller ones, or to foreign institutions with whom they compete in the global arena. This would render disadvantaged institutions potentially less creditworthy (with lower ratings) in our view.
The legislation, as initially drafted, would also empower the Fed to direct systemically important institutions to divest certain assets or discontinue specific activities if it deemed these to represent a threat to the safety and soundness of the institution or the wider financial system. All of these stipulations, in our view, may push the industry to be safer in the short term, but less flexible and less able to cope with the evolution of the industry, as we mentioned a year ago.
S&P also believes the draft legislation is potentially destabilising for bond holders:
From bondholders’ perspective, the proposed legislation’s stated goal to let unsecured creditors of troubled institutions suffer losses to avoid moral hazard not only increases the chances that individual institutions would default, but could make funding for the industry more volatile during periods of stress, in our opinion.
Related links:
‘Too big to fail’ is too dumb an idea to keep – John Kay / FT
S&P Makes High Ratings ‘More Difficult’ to Receive – HousingWire
Taleb on the fallacy of “too big to fail” and economies of scale – FT Alphaville
Bernanke does bank regulation and supervision – FT Alphaville