How do you know when and to what extent support will be there for at-risk bank counterparties?
The BIS’ Quarterly Review released Monday includes a special feature on rating methodologies for banks. Under the subhead “Why assessing banks’ creditworthiness is difficult,” the feature notes one of the reasons: the need to account for the degree of external support. This support can come in several different forms, including capital injections, asset purchases or liquidity provisions from public institutions, parent and other affiliated institutions or coerced support from peers.
To deal with this issue ratings agencies have developed a two-pronged approach by providing a “stand-alone” rating (without external support) and an “all-in” rating (with presumed support). Assessing the presumed support a given bank can receive—based on the abilities of the supporting institutions—is not the same as what it will receive in a time of need, however. “This suggests that the correlation between distress of the bank and its underlying source of support should also be examined,” the feature notes.
When are banks under distress? As the BIS feature implies, the probability and nature of support in a given crisis period is never likely to be zero but neither is it going to be as high as many market participants would have had before the recent crisis. However, what matters most is the kind of support likely in the most current stress scenario. Rather than constantly monitor every bank’s support equation, most corporate treasurers would probably rather focus their assessment of support when a bank is under duress. Thus, what they are looking for is an objective trigger to tell them which of their banks is in trouble.
The best source will be other banks. Banks active in the interbank markets tend to know who in the market is vulnerable, because liquidity starts to drain away. Vulnerable banks get put on “safe settle” status by other banks well before speculation reaches CNBC, but they don’t broadcast it because they don’t want to the spark fear that drains liquidity for everyone.
Treasurers looking to fine-tune their bank counterparty risk management therefore need to come up with a mechanism to put banks on “safe settle,” without necessarily relying on interbank market squealing. Using ratings, including the spread between the stand-alone and all-in rating, may be a starting point, but risk managers know they cannot rely on ratings exclusively. To do so they will have to see future ratings demonstrate a much more timely signaling effect. Plus, ratings will have to prove they can sort out the evolving bank regulatory framework—a regulatory framework that, as the BIS special feature also notes, seeks to curb the notion that public institutions will step in with support when a bank finds itself in distress.
Regulatory moves to eliminate assumptions of support under duress, however, must also provide transparent mechanisms to signal distress that are available to all market participants in order to succeed.