How much is a security blanket worth? Perhaps, billions. The nations largest banks have long operated with a safety net, and during the financial crisis that net became even stronger and more obvious. The banks were deemed too big to fail, and they didn’t, largely because of this backstop.
Now, as the House and Senate reconcile their separate financial reform bills, a natural question to ask is: how will this effect that security blanket? Signs are pointing to it being yanked away entirely. Without this layer of protection, Moody’s, Fitch, and Standard & Poor will likely have to re-evaluate the firms. If this leads to lower credit ratings, which many market insiders expect, this would cost the banks billions.
The rating agency Moody’s says 17 banks receive higher credit ratings under the assumption that the federal government stands behind them. A drop on the credit ladder would likely punish a bank’s bonds and make borrowing more expensive.
In the 1980’s we saw Resolution Trust handle the liquidation of the failed savings and loans, costing the government billions in the process. The new Congressional goal is to avoid any such costs going forward. But, the costs will still exist, so the cost of unwinding a failed firm may fall on the bond holders, along with credits and equity owners. The Senate bill, for examples, says a liquidation of a failing financial company should be carried out with the “strong presumption” that “creditors and shareholders will bear the losses of the financial company.”
The news isn’t all negative though. As the bill is still being discussed by both chambers, some parts of the bill may ultimately strengthen the financial standing of the banks. Moody’s has pointed favorably to provisions that increase capital requirements and liquidity buffers. The so-called ‘Volcker Rule’, designed to curtail a bank’s risk taking, would restrict firms from betting their own money. Ending proprietary trading would eliminate a large profit base for some firms, but also remove some volatility. The House version does not include a provision of the ‘Volcker Rule’. With financial reform on the horizon, this will effect the banks in direct and indirect ways – the impact on cost of funds will surely have ramifications and send ripples across the economy.
