By: Chris Kuan
On 31st March 2016, the credit rating agency Moody’s downgraded the credit outlook of DBS, OCBC and UOB to negative. The reason was due to deteriorating credit conditions or in other words, increasing problem loans caused by the slower economic growth.
It should be noted that this is a downgrade of outlook not a downgrade of the banks’ credit ratings which are Aa1 for OCBC and UOB and Aa2, a notch lower, for DBS. A negative outlook do not always trigger a negative watch on their credit ratings and a negative rating watch is not always followed by a credit ratings downgrade.
In light of decelerating economic growth, a downgrade in outlook for banks in general should not be a surprise. The risks in the ebb and flow of the economy are amplified in the banks because the leverage in their balance sheet provides the financing requirement of the economy.
This is the primary reason banks are inherently risky and why they are subject to far more regulations than in most other industries. Following the Global Financial Crisis of 2007-2009, banks are subject to even greater regulation.
The Aa1 credit rating of OCBC and UOB and the Aa2 rating of DBS are very high by peer comparison. This is down to various factors, the most important of which are the banks’ protected franchise which generate the strong profitability required to mitigate loan losses and the high credit and liquidity requirements imposed by the Monetary Authority of Singapore. A one notch credit downgrade will still leave the banks highly rated.
From the Singapore perspective, there does not appear to be significant threats to a steeper deterioration in the banks’ credit worthiness. However, it must be noted that the banks are also highly exposed in the Asia Pacific region where a sharper deterioration in China and Indonesia, for example, can trigger the actual credit rating downgrades even if Singapore escapes with a mere economic slowdown.
But what if the banks were to suffer greater than expected loan losses which caused them to be downgraded more than one notch? They will then have to rebuild their capital buffers. There are 3 ways of doing this, all of which are not good news:
1. Rights issue to replenish common equity which is bad news for shareholders. Or issue AT1 (Additional Tier 1 Capital) compliant contingent convertible bonds, bad news for the private banking clients who bought them in droves in the last 5 years but then these are the folks who can afford their losses.
2. Higher retained earnings through which the banks reduced the dividends paid out on their stocks and increased the amount of earnings to boost capital. Bad news for shareholders and also for borrowers and depositors because the banks would want to increased their earnings through higher loan rates and lower deposit rates.
3. Balance sheet reduction which means reducing the amount of loans held in their balance sheet. Credit or loans become more difficult to come by, which may push weak companies into bankruptcy.
The economic damage from 1. is minimal outside shareholders and bond investors. However, higher loan rates from 2. and a shortage of credit in 3. have wider economic implications because they can amplify an economic slowdown. It is the shortage of credit following the sub-prime meltdown that cause the global financial crisis.
At the moment, there is little to suggest such an eventuality for Singapore. The banks are extremely well capitalized and that is thanks to the protected local market in which they earned enviable profitability at the expense of borrowers and depositors. Nevertheless, stay tuned.
