Stop demonizing U.S. banks

The banking industry could defy the old adage about sticks and stones. All the name-calling in Washington these days has the potential to do real damage to banks and the economy, says David Fanger, a senior vice president at Moody’s Investors Service Inc.

In Moody’s Weekly Credit Outlook, which came out Monday, Fanger warns that penalizing banks could backfire in a big way, if it revives the turmoil in the financial markets (which he sees as a possibility).

Here’s his take, which is reprinted with permission:

Last Wednesday, top executives from the largest U.S. banks were grilled by the Congressional Financial Crisis Inquiry Commission in front of television cameras. The next day, President Obama unveiled plans for a $90 billion bank tax. On the blogosphere, pundits have started a campaign encouraging consumers and businesses to move their business from big banks to smaller community banks and credit unions. Meanwhile, Congress continues to consider legislation that would tighten banking regulation, but would also threaten to sharply limit the government’s ability to systemically support important institutions in the future.

We believe that the increasing demonization of big banks in the public arena could threaten U.S. bank ratings and be counterproductive for the wider economy. In our view, the U.S. banking system is still a long way from fully recovering from the financial crisis and the Great Recession. Although a modest economic recovery is now underway, asset quality at most U.S. banks continues to deteriorate, and we think that it may be another year or more before the expected losses embedded in most banks’ loan and securities portfolios are fully realized. As a result, bank profitability is likely to remain extremely weak.

As proposed, the administration’s bank tax would result in only a very modest increase in most banks’ expenses. But in the context of already weak profitability at many banks, this tax would nonetheless further limit their ability to generate capital internally. Furthermore, it is impossible to rule out the risk of a more punitive tax being ultimately enacted by Congress, fueled by growing rhetoric. A more punitive bank tax, especially if combined with other measures intended to penalize banks and limit their profits, could potentially lead to lower bank financial strength ratings for U.S. banks. But the story does not end there.

The U.S. Congress is considering enacting a resolution process for failing bank holding companies that could mandate the imposition of losses on secured and unsecured creditors. If a resolution authority of this type were enacted into law, we would need to re-evaluate its assumptions regarding the likelihood of systematic support for U.S. banks. This could lead to lower debt and deposit ratings for many of the largest U.S. banks.

The combination of weaker profitability due to a more punitive bank tax, a credible resolution process that threatens to impose losses on senior creditors and the possibility of other measures intended to penalize banks has the potential to significantly constrain U.S. banks’ access to capital markets. Such constraints might force larger banks to shrink in an orderly fashion, accomplishing the stated objectives of a number of policymakers. But this scenario could also lead to a far less benign outcome, reviving turmoil in financial markets, forcing another round of deleveraging across financial institutions and as a result, reduce credit availability even further. Under such circumstances, the harm to the real economy could be substantial.