Perspective

Why the downgrading of banks is unfair – and may worsen the crisis


Banks came in for sharp criticism during the financial crisis of 2008 and 2009, and the years that followed. It was warranted given the unprecedented support they received to ensure their survival and the multiple instances of questionable behaviour that subsequently came to light. For example, UK banks paid out significantly more in PPI claims to clients than the capital that the government injected into them.

While the immediate focus on banks during the crisis was about loan losses, the real damage was done by a failure of governance. As some policy makers commented, it all might have been different if it was Lehman Sisters.

The Covid-19 crisis we face today is not directly related to banks, but their financial strength is once again in focus. As investors in sustainable corporate bonds, our interest includes but extends well beyond balance sheets. Our interest is in the actions of banks – are they doing the right thing?

Ratings agencies fail to acknowledge banks’ ESG improvements

European banks have spent the past decade steadily improving their financial resilience. Equally important have been wholesale shifts in attitude to governance, environmental and social issues. We believe these improvements further increase banks’ resilience and relevance, and that this will be demonstrated loud and clear in the ongoing Covid-19 crisis.

The actions of the credit rating agencies simply do not recognise this important shift. At best they are rapidly demonstrating their growing irrelevance in a changing world; at worst they are actively making the crisis worse.

The major agencies have been scrambling for some time to demonstrate their ability to adequately assess environmental, social and governance (ESG) factors and integrate these into their ratings. There has been a glaring absence of these improvements from any of the rating agency write-ups of these recent downgrades. Yet this new way of operating could and should result in a better outcome for both society at large and the banks themselves. It is very clear that the agencies have failed in their ESG efforts at the first major hurdle.

Moody’s has placed the outlook for the banking sectors across virtually all European countries on negative outlook. Fitch has placed a huge number of individual banks on rating watch negative or negative outlook. Both agencies cite the pressures shrinking economies will have on banks’ loan books and revenue-generating potential.

They recognise that the extensive fiscal measures announced across affected countries will help to stave off some of the negative effects, but they don’t believe it will be enough. Ultimately, they see losses from loan defaults putting negative pressure on bank capital ratios.

Banks better placed for crisis management

The current crisis will undoubtedly put pressure on bank balance sheets; it will expose management teams that are complacent and business models that are unfit for purpose. However, there is reason for optimism. By thoroughly overhauling their risk management systems to be properly able to assess and understand the world through environmental and social lenses as well as the traditional financial factors, management teams will be better able to navigate this crisis. This has been made possible by a management refresh at virtually every European bank since the last crisis, accompanied by robust improvements to governance processes.

As sustainable credit investors, our team has engaged deeply with many European banks to better understand the improvements they are making to their processes in terms of governance, the environment and social issues.

Our job has been made easier by the extensive improvements banks have made to their financial and non-financial disclosures, and that is key. Without these improvements the banking sector would not have been able to command the confidence of the public authorities to be used as a key conduit for the extensive fiscal measures introduced to combat the pandemic.

Doing the right thing

We have learned how Caixabank and a number of other Spanish banks have ramped up their capabilities in the microcredit arena. The UK’s Royal Bank of Scotland has focused on increasing lending to small and medium enterprises (SMEs) in deprived areas, directly financing this through social bonds. They can only do this safely and responsibly by having excellent understanding of their customers.

Government support schemes should provide the banks with an excellent opportunity to further sharpen their SME lending skills by being able to share the risk with the state.

On the social front we have seen many instances of banks doing the right thing. Deutsche Bank announced recently that it was freezing all redundancy programmes related to its extensive restructuring plan for the duration of the crisis. Banks across Europe are being pragmatic in how they deal with customers who are experiencing difficulties servicing their loans during lockdown. The extensive – and expensive – investments that have been made in enabling banks services to be delivered electronically are now starting to bear fruit.

Downgrades risk becoming self-fulfilling and deepening the crisis

If the banks were less well-capitalised or had less robust understanding of their clients, they would be forced into acting punitively to such customers for fear of fatally wounding themselves. As it is, banks have built up the capacity to be able to do the right thing by their customers which should have the happy side effect of a better outcome for the bank.

Every borrower that is able to stay in business and able to resume trading or working after the lockdown is a borrower that can continue to service the loan and remain a long-term profitable customer of the bank. By contrast, banks that feel forced to take away the proverbial umbrella just as it starts to rain will end up forcing more individuals and companies into insolvency, lose more money and contribute to a deeper than necessary economic slowdown.

By cutting their credit ratings the likes of Moody’s and Fitch risk sending the banks down exactly this path. Lower ratings result in higher borrowing costs and, in turn, higher interest for customers, or a reduction in the amount of credit available.

Not only do the rating cuts seem unjustified and rather short-sighted, particularly in view of ESG factors, at worst they can become a costly self-fulfilling prophecy. It’s time for a re-think.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.