S&P, RAC off
It didn’t take Standard & Poor’s long to be on the defensive after the release of its release of its proprietary risk-adjusted capital framework which purported to show that most of the world’s banks, including the Australian majors, were light on for capital.
Almost immediately the ratings agency’s assessments of UBS and Citigroup, both of whom were near the bottom of S&P’s new ratings table with risk-adjusted capital (RAC) adequacy of 2.2 per cent and 2.1 per cent respectively, were questioned. It seems S&P may have overlooked some equity injections – in UBS’s case the conversion of notes by the Swiss government into equity.
Among the Australian banks – four of the relative handful of remaining banks rated AA or better by S&P – the agency placed ANZ and NAB in the third quintile of the sample of 45 major banks it assessed and Commonwealth in the fourth quintile.
The locals must have made some representations because S&P today issued a statement reaffirming their AA/stable ratings and saying that while the Australians’ RAC scores were close to or slightly higher than the global average for major banks, it considered their ratings stable and supported by very strong business and financial considerations as well as the demonstrated ability to raise capital if needed.
It said the average risk-adjusted RAC score for the Australian banks after diversification benefits were taken into account was about the global average, with the Australian banks benefitting from a comparatively low economic risk environment and a higher proportion of lower risk residential mortgages. However, they didn’t benefit from business and geographic diversity to the same degree as many global peers.
Pre-diversification the Australian banks’ RAC scores ranked them 22nd (ANZ), 27th (NAB) and 34th (CBA) within the 45 banks assessed. (Westpac wasn’t in the sample). That is quite clearly at odds with both their reputations as among the strongest banks in the world and, indeed, their conventional credit ratings.
Oddly, two of the US investment banks which are now technically banks (but still trading like investment banks) – Goldman Sachs and Morgan Stanley – were among S&P’s top-rated. ING, in the process of being broken up after being bailed out by the Dutch Government, is the third most highly-rated. There are a number of banks whose capital bases have been supported and/or rebuilt by taxpayers that have higher RAC scores than the Australians.
The RAC model has some quirks. S&P uses its own definition of capital which is more conservative than commonly used by bank regulators, primarily because it excludes most hybrid capital, and it also uses a quite different framework for risk adjustments – its assessment of the banks risk-adjusted assets was on average 70 per cent higher than the Basel II calculations.
One thing that does stand out is that the Australian banks were penalised for their relatively low levels of geographical diversification and relatively high levels of asset concentration. In effect, they were penalised because they were predominantly exposed to the Australian economy and to Australian residential mortgages.
Had they been exposed to the US, UK, Irish and Icelandic economies, and the US and UK housing markets, no doubt they would have fared better – not necessarily in terms of their results or balance sheets but in being awarded greater diversification benefits in their RAC scores.
That perverse outcome – that the banks would have been rated more highly under the new methodology if they were exposed to distressed economies and riskier assets – suggests S&P may have a bit more work to do on its models. HSBC topped the RAC scores because it was the most diversified of the majors.
The Australian economy is arguably the strongest in the developed world and the Australian residential mortgage has demonstrated itself through many cycles and crises to be amongst the least risky of bank assets.
The RAC model doesn’t discriminate or adjust for different underwriting standards – it assumes all prime mortgages are the same, despite difference in loan-to-valuations ratios and legal frameworks between jurisdictions.
When NAB, presumably as a consequence of its UK banks, gets a bigger credit than CBA or ANZ for its diversification, one has to question the methodology. There may be some logic to it in theory – diversification lowers theoretical risk in a portfolio – but the reality of the post-crisis world says the RAC scores awarded to the Australian banks are illogical and perverse.
The fact that S&P was so quick to back-pedal on its conclusions (in response to some simplistic and alarmist interpretations of them) and reaffirm the AA ratings and the rationale for awarding them to the Australian banks adds to the sense that the RAC scores are misleading.
The findings of a model that doesn’t differentiate between assets with different probabilities and likely magnitudes of loss, and which is so divorced from the real world in which the banks are operating, can be misinterpreted and generate concern and instability, even though S&P itself notes the model has its limitations and weaknesses.
Given the key role the ratings agencies played in creating the global financial crisis with their risk-modelling and rating of cancerous sub-prime mortgages that were sliced and diced into complex securitised bundles, of course, no one should take pronouncements on creditworthiness from these newly conservative agencies too seriously.
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