Bank bill may harm ratings, reduce stability-Moody's

NEW YORK, Nov 3 (Reuters) - Proposed legislation to require creditors to share in losses in the event of a large bank failure would likely have a negative impact on banks' credit ratings, and could even add to instability in the sector during a crisis, Moody's Investors Service said.

Congressional Democrats and the Obama administration last week agreed on draft legislation that would give the U.S. government far-reaching new powers to regulate, and even shut down, large financial firms that threaten economic stability. For details, see [ID:nN27269836]

The proposed legislation would also mandate that senior unsecured creditors bear losses in any resolution of a bank they deem risky.

"This would likely significantly reduce or eliminate our assumptions of systemic support for U.S. bank holding company and bank unsecured debt, negatively affecting our ratings on banks for which we have incorporated such assumptions," Moody's analysts Craig Emrick and Robert Young said in a research report sent on Monday.

"If the draft legislation were enacted in its current form, we would expect fixed-income investors' concern regarding potential losses under the new resolution powers to trump any comfort from improved standalone financial strength," they added.

Senior bank debt benefited from implied government support during the worst of the turmoil after Lehman Brothers (LEHMQ.PK) failed, on fears that losses to the securities would disrupt the ability of banks to raise funds.

Some regulators, notably Federal Deposit Insurance Corp Chairman Sheila Bair, however, have been vocal that debtholders should share in bank losses.

Bair said last month that ensuring secured creditors face losses when a financial institution fails could help rein in excessive risk-taking and strengthen the financial system. See [ID:nN05344612]

Moody's, however, argues that the move would make investors more adverse to lend to banks.

"We think this could make wholesale funding more difficult and more expensive to obtain for U.S. bank holding companies and banks," the rating agency said.

The proposed legislation would also give regulators the ability to impose an orderly wind-down of a bank in trouble.

Moody's, however, argues that this would not alleviate creditors' fears of financial contagion. This is because large financial companies are significantly interconnected through their funding and counterparty exposures.

"Unsecured creditors that incur losses from the resolution of a failed institution are likely to cut exposure to that institution's counterparties," Moody's said. "Therefore, the imposition of losses on unsecured creditors, or the threat of it, could actually increase instability."

(Reporting by Karen Brettell; Editing by Chizu Nomiyama)