A great challenge for bank credit analysts is the degree to which
banks rely on “extraordinary support” (a euphemism for “bailout”) from their
governments. A bond investor may
build a brilliant quantitative model to understand how a bank’s leverage, asset
volatility, and other financial, operational, and economic characteristics
impact the bank’s estimated default likelihood. But there’s a final overlay that is vexing: what is the probability that a
government will step in to make creditors whole if the bank fails?
As with almost all such investment analysis questions, there is no
definite, unambiguous answer. But
recent research of FitchRatings
provides a fascinating observation.
(See the Fitch Special Report
“The Evolving Dynamics of Support for Banks,” September 11, 2013.) For the period 1990-2012, Fitch assessed both the default rate and the failure rate for “senior creditors of
systemically important” global banks with Fitch
ratings. The five-year cumulative default rate in the period (1.15%) is
six times lower than the failure rate
(6.95%). Fitch defines failure as “defaulted or would … have
defaulted without extraordinary support.”
A quantitative model builder might be pleased with this historical
data point. She will use her
financials-based risk model to estimate failure
rate and then multiply by a new “no-bailout” parameter of one-sixth (the Fitch result) to get the model’s
estimated default probability. This approach is feasible, but we’re
struck by a different observation.
Stepping outside the model-building exercise, the five-year failure
rate of 6.95% (call it 7%) is striking.
Referencing Fitch’s Default
Study of 2012, the Global Corporate Finance Average Cumulative Default Rate for
double-B rated entities is 6.91%
(call that 7% also). (See the
table on page 9 of the Fitch Special
Report “Fitch Ratings Global Corporate Finance 2012 Transition and Default
Study,” March 2013.) Thus, in the
absence of “extraordinary support,” the world’s systemically important banks
behave like junk credits. At
least, this is the blended effect of the Fitch
universe for the period 1990-2012.
Neither qualification, though, is disquieting. The universe is large and the 23-year time period is long and
indicative of recent history.
To our knowledge, the dominant rating agencies do not assign
underlying bank ratings (such as “bank financial strength ratings”) that are
non-investment grade. For example,
Fitch itself shows a list of 28
global systemically important banks in Appendix 4 of “The Evolving Dynamics of
Support for Banks” and gives a junk "viability rating” to the Bank of China only. Hence, the rating agencies likely
disagree with the characterization that “systemically important global banks are
junk” absent government support.
But we appreciate the Fitch
study precisely because it shows observed data rather than just potentially
optimistic models and judgment.
We’re not aware of any alternative historical studies of this sort. (If such studies exist, please tell
us!)
Of course, this question matters greatly to bank regulators,
investors, and taxpayers as well as to rating agencies. The world is now tightening prudential
regulation by elevating capital requirements, pondering liquidity enhancements,
considering a maximum leverage ratio (absent risk weighting), forcing central
clearing of derivatives, et cetera. Do regulators and the broader community
agree that the “starting point” of systemically important global bank credit quality
is junk? Or, as I suspect, is this
point contentious? We need
discussion and debate! Our view is
that the Fitch study is critically
important. It deserves much wider
attention and acclaim. Like a
published scientific result, the world needs other rating agencies, bank
regulators, and academics to perform similar studies with other data sources to
validate or dispute the finding that “banks are junk” without government
support.
