It is getting harder to envision how the select club of banks with top credit ratings will sustain itself, let alone expand.
Only six banks are still stamped "Aaa" by Moody's Investors Service, and it is sovereign support that serves as the ratings linchpin in each case. When Moody's examines institutions outside the context of a government safety net, limiting the assessment to measurements such as market risks, lending land mines and the lengths to which management will go to produce shareholder returns, no bank is rated higher than Aa2, two notches below Aaa.
Should the availability of government backing lose pull as a determinant of an institution's creditworthiness — a scenario worthy of consideration as the threat of fiscal crisis spreads through Europe — it is difficult to imagine how any bank ever again will achieve triple-A ratings status.
"These sovereign guarantees may not be as good as they used to be," said Francis Longstaff, a finance professor at UCLA's Anderson School of Management and a former head of fixed-income derivative research at Salomon Brothers Inc.
There is no hard evidence that Canada would turn its back on Toronto-Dominion Bank or Royal Bank of Canada should one of those triple-A-rated institutions run into trouble, or that Luxembourg would shirk its responsibilities to state-owned Banque et Caisse d'Epargne de l'Etat.
But the fiscal woes that have befallen Greece and Ireland, and are feared to eventually strike Portugal, Spain and Italy, have the potential to chip away at the confidence investors have in the whole concept of sovereign credit, making it all the more daunting for banks to scale the credit ratings ladder.
"When you think about the challenges of banking — the highly leveraged nature of the business at its core, the competitive pressures of the business, the challenges of managing risk in the business — all of those pressures make it quite difficult for banks to attain the highest rating," said David Fanger, senior vice president of the U.S. banking team at Moody's.
Without the presumption of government support, the Aaa-rated Bank of New York Mellon Corp. gets a stand-alone financial strength rating of B+, equal to a rating of Aa2 on the standard Moody's scale for long-term debt ratings. Royal Bank of Canada, Toronto-Dominion and Rabobank Nederland, a Dutch bank viewed by Moody's as systemically important, also carry stand-alone ratings equivalent to Aa2, the third-highest debt rating.
Luxembourg's state-owned bank and Zürcher Kantonalbank, a Swiss institution with liabilities guaranteed by the wealthy canton of Zurich, have stand-alone financial strength ratings of C+, equal to a long-term debt rating of A2, which is five notches below Aaa.
The tight supply of triple-A ratings is not necessarily a problem for the industry. Banks heavily engaged in capital markets activity generally have found that a double-A rating is good enough to get the job done. Often, it isn't until a bank falls into single-A territory that counterparties start to insist on significantly higher collateral requirements or other concessions that can noticeably curb profits, Fanger said.
Though the financial crisis turned a spotlight on the more embarrassing manners in which banks can fall from ratings grace, many banks made the conscious decision years ago to take on debt loads and engage in activities that would automatically disqualify them from the triple-A club, concluding that the benefits of carrying top credit ratings would be outweighed by the cost of maintaining them.
Most firms "find it more advantageous to operate with higher levels of leverage than are consistent with the rating of triple-A," Fanger said, so that they can juice profits, keep up with competitors and satisfy shareholder demands for returns.
But the banks that have garnered triple-A status are quick to flaunt their achievement.
"You can be sure your assets are in safe hands with Zürcher Kantonalbank: for many years, the bank has been accorded top credit ratings," the Swiss firm proclaims on the English-language version of its website.
But if the financial crisis has taught investors one lesson, it is about the importance of being skeptical about any aspect of finance that looks to be a sure thing.
As University of Maryland business professor Peter Morici points out, Ireland, prior to its banking crisis, "had sound finances and a balanced budget." Now, he said, the government is in the untenable position of being "potentially on the hook for liabilities equal to two times" national gross domestic product.
Warning that the Irish crisis "won't be the last of its kind," Morici, a former chief economist for the U.S. International Trade Commission, said that "major banks in smaller [European Union] member states have grown too large for their Treasuries to act. They simply can't issue enough euro-denominated bonds without driving up their borrowing costs to prohibitive levels and thrusting regular government operations into insolvency."
As the case of Greece attests, implementing draconian budgets cuts is an extremely challenging proposition for sovereign entities. In that sense, governments lack what UCLA's Longstaff described as the "self-healing feature" that can be observed in corporate credits, including banks.
"Corporations can make drastic cuts in costs, such as in labor costs, that seem to be much more difficult for sovereigns to execute," Longstaff said.
As a result, "we have seen far fewer corporate, and banking, defaults than [one] would have expected on the basis of how the economics looked three years ago."
But there is at least one comparison to corporate credits that sovereign entities have been unable to escape.
"One thing we have learned is that the credit risk of many sovereigns is very highly correlated with U.S. credit markets," Longstaff said.
"Thus, many sovereigns don't seem to be fundamentally different from ordinary corporate credit."
To that end, Longstaff said, sovereign guarantees are "not a panacea" for banks, or for investors, that someday may be counting on them.
