A more prudent risk management framework for central banks ( Why central banks should move from headline credit ratings to intrinsic bank ratings )
As international investors central banks invest their foreign reserves in an ever increasing range of currencies, asset classes and sectors. One of the sectors (if one can call it thus) that has gone in and out of fashion over the years is commercial bank deposits. Some central banks have almost eliminated their exposures to commercial banks (since the Global Financial Crisis) but the majority continue to place a portion of their reserves with commercial banks. As guardians of their country’s foreign reserves, central banks have a fiduciary duty to be unadventurous investors and as such, they typically adopt risk-averse investment policies in terms of their exposures to commercial banks. These entail, among other things, conservative credit rating guidelines. In practice, when evaluating commercial banks, central banks will typically make reference to the headline credit ratings (long term and/or short term foreign currency) of one or two of the main credit rating agencies. In essence, a credit rating is a tool to help investors understand the credit risks of a given asset (or commercial bank). Therefore, when a central bank seeks to avoid exposures to a headline credit rating below a given (usually high) threshold, the implication is that it wants to steer clear from a given level of credit risk… So far so good, but how suitable is this benchmark (for central banks)? The trouble is that the Global Financial Crisis showed that this tool did not work in the way that central banks supposed that it would. Exhibit 1 shows the credit default swap (CDS) price evolution for five of the better known global megabanks (all central bank deposit takers) during the worst of the sub-Prime debacle, plotted against the timeline of their (headline) credit rating downgrades (by the three major rating agencies). The graph also shows two key events in the saga: the collapse of Lehman Brothers and the near-collapse of two British banks. Exhibit 1 7,000 6,000 5,000 4,000 Oct–Dec 07 3 downgrades, 3 notches
3,000
Nov 09 1 downgrade, 1 notch
Dec 08–Mar 09 14 downgrades, 20 notches
Sep - Oct 08 6 downgrades, 7 notches Lehman’s collapse (Sep) UK major banks near collapse ( Oct¹) June –Jul 08 3 downgrades, Apr 08 3 notches 4 downgrades, 4 notches
2,000 1,000 0 May-07
Jul-07
Oct-07
Jan-08
Apr-08
¹ According to Mervyn King testimony to Parliament
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Jan-10
From the graph one can see that the majority of the rating downgrades took place from three to six months after Lehman Brothers had folded and the two British banks had been close to following suit. It is also worth noting that at the time of their near-collapse, these two British banks enjoyed headline credit ratings of “AA” and above. Hence, credit ratings proved to be, at best, lagging indicators. On the other hand, one observes that credit default swaps had been providing more timely signals to risk managers. Therefore, in this instance, headline credit ratings were of no use to central banks, because they need to make timely decisions about where and how to invest the precious foreign reserves. Consequently, the Global Financial Crisis led to global efforts to cut reliance on credit ratings, which was acknowledged by the International Monetary Fund (IMF) in the latest amendment to their «Foreign Exchange Reserves Management Guidelines», where they added the following phrase to one of the clauses dealing with the management of credit risk: “Management of credit risk should aim at not relying solely and automatically on credit rating agencies’ assessments” There is another concern with credit ratings (particularly headline credit ratings), which is the fact that by their construction, they provide investors with inaccurate or opaque indications of actual credit risks. Headline credit ratings are basically made up of two components: (a) an intrinsic credit rating which relates to the actual credit risks of the balance sheet and (b) a boost given to this baseline rating by virtue of the agency’s assumption of government support. The assumption will be driven by the extent to which the commercial bank is a «Too Big to Fail» institution in its home jurisdiction; and the extent of the boost will be enhanced or diminished depending on the credit rating of the relevant sovereign. To illustrate the problem… say a given German Landesbank is sufficiently large to have systemic importance in its home jurisdiction and consequently, the rating agencies will assign a boost to its intrinsic credit rating... in reflection of the fact that, were it to get into trouble, the home authorities would step in and rescue it. Accordingly, although the bank’s intrinsic credit rating might be say “BB-” its headline credit rating could be “BBB+”… a boost of 6 notches to reflect the assumption of government support. This dynamic makes it more difficult for central banks to evaluate the actual credit risk of commercial banks but also, to track worsening profiles, because the boost can mask a deteriorating credit risk. For example, exhibit 2 illustrates the deterioration of a large US bank’s intrinsic credit rating (Bank Financial Strength Rating) during the sub-Prime debacle (expressed in the nomenclature of headline credit ratings) relative to its own headline credit rating. Although its headline credit rating fell from “AAA” down to “A-” during the period covered, the intrinsic credit rating had actually fallen to the equivalent of somewhere between “BBB-” and “BB+”.
Exhibit 2
AAA A+ ABBB BB+
Headline credit rating
Intrinsic credit rating
The above dynamic coupled with the fact that a bank’s headline credit rating can never be above that of its sovereign, leads to further complication, because it drives wedges between commercial banks (in terms of their headline credit rating) that do not reflect true relative credit fundamentals. This opacity is hazardous for central banks, which are frequently shifting exposures among counterparties. For example, in response to a nominal increase in credit risk (i.e. a bank’s headline credit rating falls by virtue of a reduction in the credit rating of its sovereign, while its intrinsic credit rating remains unchanged) a central bank could end up in the bizarre situation of having to shift its reserves to more risky counterparty! For example, a commercial bank with an intrinsic credit rating of say “BBB+” could be deemed, at first glance, as a worse credit than the above-referenced German Landesbank with an intrinsic rating of “BB-” (if the first bank’s sovereign is rated at say “BBB-”). One may say that none of this matters in practice because the rating agencies’ assumption of government support was proved right during the course of the Global Financial Crisis. In other words, the pertinent governments did step in, poured hundreds of millions of US dollars and saved the failing banks. However, as conservative investors central banks ought to take a more conservative line. It is true that governments stepped in and saved the banks, but would they be able to do so again? I would argue that some of the more fiscally challenged governments do not have the fiscal ammunition to do so (or even to save individual systemically important banks). Furthermore, their electorate has little appetite for further «banker bailouts» and this has led to well-known official efforts to do away with the “Too Big to Fail” problem. But even if one were to hope that governments would be inclined to step in again in future… should central banks rely on that possibility? I would argue that, as fiduciaries, central banks ought to disregard the assumption of government support.
The whole thing is complicated further, because of the (some might say capricious) way in which the main rating agencies have adjusted sovereign ratings in the last few years. In sharp contrast with the decisiveness with which some of the rating agencies downgraded Japan back in the 90s (when one could argue that the global macroeconomic backdrop had been much more constructive and Japan’s internal difficulties were less severe than some of today’s worse affected countries)... this time some of the rating agencies have appeared to be less assertive and timely in downgrading some highly rated and highly influential sovereigns, whose credit profiles were devastated by the Global Financial Crisis. At this stage it might be fair to ask… but what else is there? As a matter of fact some rating agencies provide alternative credit ratings (Bank Financial Strength Rating and Individual Rating) which exclude the assumption of government support and hence, not only provide a more accurate picture of a commercial bank’s intrinsic credit risk but also, ought to provide more timely «signals». Some central banks have already moved to these benchmarks already, but I am surprise that the change has not been more widespread… or that institutions such as the IMF (who have significant influence over central banks) have not encouraged more debate on the subject. However, this is not a panacea. These alternative ratings are not without their flaws and therefore, central banks explore other alternative solutions… but that and other related topics are reserves for another time.
Virgilio Mendoza