Since the debacle of 2008, the major debt-rating agencies have worked hard to show how quickly and forcefully they can respond to changes in credit quality. Given the nasty public drubbing they took for putting their seal of approval on dodgy structured finance vehicles at the centre of the financial crisis, this was understandable.
But now, the credit monitors really seem to be taking a jump into the unknown with what amounts to a declaration that too-big-to-fail is all but dead in the U.S.
Moody's Investors Service lowered its senior ratings by a notch Thursday on four U.S. banking heavyweights – JPMorgan Chase, Morgan Stanley, Bank of New York Mellon and Goldman Sachs. This is not because the debt monitor spotted a worrisome deterioration in the banks' financial health or risk profiles but because it has come to believe that Washington won't use public money to refloat even the largest banks if they run aground. As a result, bond investors could face some serious pain, a heightened risk that ought to be reflected in the ratings of the parent holding companies.
This makes sense in theory. The much-maligned, only 40-per-cent-implemented Dodd-Frank Act spells out how to avoid saddling taxpayers with future bailout costs when big, complex financial institutions collapse. Using what the legislation calls the orderly liquidation authority, Federal Deposit Insurance Corp. (FDIC) regulators would be able to seize a bank holding company, keep its operating units going and require creditors to accept equity as part of its recapitalization.
"We believe that U.S. bank regulators have made substantive progress in establishing a credible framework to resolve a large, failing bank," said Robert Young, a Moody's managing director. "Rather than relying on public funds to bail out one of these institutions, we expect that bank holding company creditors will be bailed in and thereby shoulder much of the burden to help recapitalize a failing bank."
That doesn't mean Washington would allow any of the banking behemoths to go under. Officials learned their lesson about near-fatal systemic shocks from the Lehman Brothers debacle in 2008. The real difference between then and now is merely that creditors would be forced to shoulder more of the burden. That's all well and good. But in its efforts to appear on top of the changing regulatory picture, Moody's is placing far too much faith in the new mechanism as a replacement for direct bailouts.
A review by the Government Accountability Office, the U.S. congressional watchdog, itemizes potential problems with employing the untested authority. These include imposing losses on all creditors, which might pose a threat to overall financial stability. Another is gaining the co-operation of foreign governments to keep them from blocking the transfer of assets from subsidiaries under their jurisdiction. Without such repatriation, it would be harder to meet creditor claims and preserve financial stability at home. But that could mean destabilizing other financial systems in the process.
And what happens if another severe crisis takes down several of these banking giants simultaneously? "Experts have questioned whether FDIC has sufficient capacity to use [the liquidation authority] to handle multiple failures of systemically important firms and thus prevent further systemic disruption," the report warns. "In addition, FDIC may find it more difficult to impose losses on creditors when multiple large institutions are failing at once."
The best solution to protect the financial system and those important bond ratings is to ensure that the systemically important institutions have deep capital cushions, sound risk management practices and plenty of external oversight, so the liquidation authority can stay safely tucked away in the regulators' tool kit. Until those reforms are sufficiently implemented, it's too soon to bury too-big-to-fail.