S&P downgrades hit bank funding, counterparty cost

LONDON Wed Nov 30, 2011 9:46am EST

The Standard and Poor's building in New York, August 2, 2011. REUTERS/Brendan McDermid

The Standard and Poor's building in New York, August 2, 2011.

Credit: Reuters/Brendan McDermid

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LONDON (Reuters) - Banks face a double hit to costs and revenues from a spate of credit rating downgrades, another burden for a sector already struggling because of the European Union's failure to deal decisively with its financial crisis.

Standard & Poor's cut its ratings on 15 big banks such as Bank of America Corp (BAC.N) and Morgan Stanley (MS.N) on Tuesday, as it seeks to give more insight into its methods and repair its reputation after the credit crisis.

While the downgrades were driven by a revision of the agency's internal models and not because of a change in the banks, they will have a real impact on funding costs for the sector, already on edge because of Europe's debt crisis.

"It will likely raise concerns about their short-term funding because they will be sidelined by money-market funds who are the traditional buyers of that short-term paper," said Andrew Fraser, investment director at Standard Life.

"The timing of the... statement is perhaps more significant than its content because it comes at a time when liquidity is under pressure at banks," Fraser told Reuters in an interview that took place ahead of the S&P statement.

European Union talks to save the single currency limped ahead this week, with a key functionary saying the region was entering a "critical period" of 10 days to come up with plans to stave off the crisis once and for all.

Interbank markets have largely frozen up as commercial banks grow increasingly wary of lending to one another. They rely on the European Central Bank for most of their short-term funding.

Ahead of the S&P downgrades, rival Moody's said on Tuesday it could downgrade the subordinated debt of 87 European banks, concerned that governments are too cash-strapped to bail out holders of riskier bank debt in times of stress.

TRADING MORE EXPENSIVE

British banks RBS (RBS.L) and Lloyds (LLOY.L) were the only European banks to have their short-term credit ratings cut -- to A2 from A1 -- by S&P. When this happens, it can be a step change that increases funding costs, analysts said.

The S&P move could moreover force the banks to put up more scarce collateral in their daily trading activities. A downgrade can trigger clauses in contracts underlying derivative trades, forcing banks to put up more collateral.

That makes trading more expensive for investment banks in derivative markets such as interest rate swaps and credit default swaps, denting income at the sprawling trading floors that provide much of their income.

Trading desks in fixed income, currencies and commodities markets (FICC) alone generate between 40 and 60 percent of investment banking revenues at a range of leading investment banks, according to a Morgan Stanley estimate.

Clients are monitoring counterparty credit risk much more actively since the onset of the crisis and some have already reassigned business from banks deemed more risky, IFR reported.

"In negotiations, if (a client) is not happy with the credit (risk) and (the counterparty) refuses to give them the collateral requirements, then (the client) will do less business with them," said one market participant.

Clearing houses also put much bigger safety margins in place once counterparties drop below a certain level.

LCH.Clearnet, for instance, requests counterparties in repo trades put up twice as much collateral if they get downgraded two notches to BB+ from triple-B. Below that level, the trading party will no longer be allowed to trade at all.

In swap trading, a downgrade to A- from A requires 10 percent more collateral. At the next step, BBB+, counterparties need to double collateral, and they will be barred from trading if they reach a level below BBB.

In uncleared trades, the amount of collateral needed for a derivative deals is spelled out in a so-called Credit Support Annex (CSA) that can be part of standard agreements from the International Swaps and Derivatives Association (ISDA).

The collateral requirements are negotiated bilaterally between counterparties and vary widely.

Collateral is already scarce for Europe's cash-strapped banks, who have started paying institutional investors to swap illiquid bonds in exchange for better quality ones and secure cash from the European Central Bank.

"With lower ratings, counterparty risk goes up and so do margin calls, so it does make it more difficult (for trading)," said Carlo Mareels, credit analyst at RBC Capital Markets, adding that tighter rules and other factors also weighed.

"It's hard to see which bit makes it more difficult to trade. A one notch downgrade is not going to help -- but things are difficult anyway," Mareels said.

(Additional reporting by Sarah White, Sinead Cruise, Luke Jeffs and Steve Slater; Editing by Jodie Ginsberg and Mike Nesbit)

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