Banks' increasing reliance on bonds for funding has started a vicious cycle, a New York debt rating firm concludes.
Debt funding, for many big banks now cheaper than adding deposits, could instead become more costly as asset quality deteriorates over the next year or so, according to Thomson BankWatch, an American Banker affiliate.
Overreliance on debt - so-called purchase funds - therefore can reduce the stability of a bank and jeopardize its ratings, the company said. And lower ratings increase the cost of funds, further damaging banks' profitability and worsening debt rating concerns.
"Asset quality is as good as it can get," said Gregg Novek, a senior vice president at Bank Watch. "One can foresee a deterioration in credit quality over the next couple of years that could trigger some downgrading."
If banks that are downgraded "are also relying more on purchase funds, the downgrading affects a portion of their funding base " he said. This "could create a catch-22 scenario whereby downgrades impinge on margins and put further pressure on ratings."
Bank Watch hasn't started downgrading banks, Mr. Novek said, but "we think we're at a point in the cycle where things are as good as they get in the asset-quality front, so we've raised the bar in doing upgrades."
Banks have come up with ways to reduce their dependence on purchase funds, Mr. Novek said.
"The most obvious cure that banks have actively pursued is securitization," Mr. Novek said. He described securitization as a solid stopgap technique to alleviate funding pressure but not a permanent or complete solution to the loss of deposits to mutual funds.
In the longer term, banks "must evolve to more closely manage" deposits by more effectively managing the asset side of the balance sheet, Mr. Novek said. "Banks need to retain assets on the balance sheet that offer the highest risk-adjusted rewards."
Mr. Novek said that most banks would probably pare residential mortgages.
The alternative to maximizing return on assets is for banks to increase wholesale borrowings and subject themselves to a degree of liquidity risk and rating agency downgrading risk during a period when credit costs will likely rise, he said.
