ANALYSIS:Sovereign downgrades are bad news for euro-zone banks for several reasons
WHEN STANDARD & Poor’s warned it was looking to downgrade 15 euro-zone countries’ sovereign debt on Monday, it blamed political indecisiveness in tackling the protracted debt crisis for its decision. But though its announcement will undoubtedly irritate the national leaders involved, it is the bloc’s banks that are likely to feel the decision’s impact most immediately.
If S&P does carry out its threat, euro-zone lenders will be among the first in line for a subsequent downgrade, analysts say, a reflection of the close links between banks and national governments.
“It is usual for a sovereign downgrade to cascade through to a downgrade of the banking system,” notes Silvio Peruzzo, economist at Royal Bank of Scotland. Although S&P rerated 37 global banks only a week ago, downgrading 17 of them, that move was triggered by a new methodological approach, and analysts cautioned that further downgrades could follow.
Sovereign downgrades are bad news for banks in those countries for several reasons: they may compound economic stresses, which have negative consequences for the banks; and because they increase the cost of government debt, there may be a knock-on for bank debt costs, too.
Most obviously, though, a sovereign downgrade will impact the value of sovereign bonds that sit on banks’ balance sheets. They typically make up 10 per cent of a balance sheet, so a fall in their value would further weaken balance sheets at a time when most banks are scrambling to strengthen capital bases.
A sovereign downgrade does not automatically result in bond prices falling: when S&P downgraded the US in August, its bonds rose in value as investors sought a safe haven to place their money. Bonds of Germany – Europe’s benchmark paper – were largely unmoved yesterday.
But in the case of the rest of the euro zone, the rating agency is merely reflecting markets’ concerns over the past several months that the euro zone crisis will spread beyond Greece, Ireland and Portugal. Bonds from countries as diverse as Italy, France and the Netherlands all fell sharply in November as a result, before recovering some of the losses last week. For banks, the impact of the fall was accentuated by a change in the way European regulators look at lenders’ balance sheets.
In a bid to bolster confidence in the continent’s lenders, the European Banking Authority, the body that oversees European bank regulators, in October demanded banks change the way they value sovereign debt holdings. The aim was to encourage banks to plug the holes that souring euro zone debt might have caused, and which investors fretted could lead to insolvency.
– (Copyright The Financial Times Limited 2011)
