Rating agency Moody’s Investors Services has hit a slew of global financial institutions, including Royal Bank of Canada, with stinging downgrades, citing concerns about each of their capital markets arms.
In total, 15 firms were downgraded after the markets closed on Thursday. The cuts come after each was put under review in February because Moody’s feared that their rapidly changing risk positions could put even the biggest and most diversified banks in trouble.
The financial institutions affected by the new downgrades include American giants Bank of America Corp., Citigroup Inc. Goldman Sachs and JP Morgan Chase, as well as European-based Barclays Bank PLC, Deutsche Bank and Societe Generale. RBC was the only Canadian bank affected, seeing its debt rating fall from Aa1 to Aa3 -- a two-notch downgrade.
RBC has long taken issue with being called out for its capital markets exposure, and even held an investor day that focused solely on its capital markets operation earlier this month to convince the market -- and Moody’s -- that there was no reason to be worried. During its presentation, RBC argued that its trading inventory has been cut from $151-billion in the third quarter of 2011 to $118-billion today, thereby reducing its risk, and noted that its fixed-income balance has shrunk by 15 per cent since last year. RBC also said profits from its retail operations vastly outweigh those from capital markets.
Although the presentation didn’t prevent the downgrade, Moody’s appears to have heard the arguments. Of the 15 banks that were affected, RBC was classified in the top-tier of those affected, a group that Moody’s argued have stronger buffers, or 'shock absorbers,' than many of their peers in the form of earnings from other, generally more stable businesses.”
“This, combined with their risk management through the financial crisis, has resulted in lower earnings volatility,” Moody’s added. “Capital and structural liquidity are sound for this group, and their direct exposure to stressed European sovereigns and financial institutions is contained.”
The two other banks in this group were HSBC and JP Morgan, which now have ratings of Aa3 and A2, respectively.
The lower groupings weren’t reviewed with such kind language. Banks at the bottom, which include Bank of America and Citigroup, are said to have “problems in risk management or have a history of high volatility, while their shock absorbers are in some cases thinner or less reliable than those of higher-rated peers.”
In theory, a ratings downgrade should affect the interest rate a bank must pay to borrow money in the market. In the case of RBC, however, there’s still no certainty that it will be drastically affected. Although the new downgrade, which follows a one-notch downgrade in December 2010, puts the bank three full notches behind Toronto-Dominion Bank, it is up to investors to ultimately decide if RBC is really that much riskier.
In its latest report, Moody’s noted that RBC has been hit because of a “significant commitment to global investment banking activities” which amount to 22 per cent of total revenues, a commitment to growing its U.S. capital markets business and “the high degree of interconnectedness or concentration risks inherent to capital markets activities.”
However, Moody's acknowledged that RBC's risk is mitigated because it is a "strong and diversified universal bank with sustainable leading market shares across many retail products and services in its home market" and it has the lowest earnings volatility in its global investment banking peer group, among other things.
When Moody’s first announced that it had put these banks on watch for downgrade, the agency explained in detail why capital markets arms matters.
“Capital markets firms are confronting evolving challenges, such as more fragile funding conditions, wider credit spreads, increased regulatory burdens and more difficult operating conditions,” the rating agency said. “These difficulties, together with inherent vulnerabilities such as confidence-sensitivity, interconnectedness, and opacity of risk, have diminished the longer term profitability and growth prospects of these firms.”