This piece is adapted from a research note by Kroll Bond Rating Agency.
The sharp downward move in global equity market valuations that began in January has taken its toll on numerous industry sectors, but particularly financial services. While the S&P 500 was down double digits at one point last month, the market capitalizations of some of the largest universal banks and nonbanks are down by more than a third, placing some names near market valuation levels not seen since 2009.
In a generally benign economic environment, where banks continue to report consistently strong profits, what is causing this sudden stock slide for publicly traded financial institutions? Two words: investor confidence.
Not only are widening credit spreads for both banks and the companies they lend to a red flag to investors, but the financial sector is also feeling both a direct and indirect hit from the decline in energy prices.
The deterioration in large bank valuations actually began last summer, when market fears about the continued risk of global debt deflation and flagging growth in China began to undermine investor confidence. Large banks are still financially sound and unlikely to see any volatility in credit ratings in the near term. However, substantial movements in equity valuations and credit spreads suggest that some large financial institutions face reduced liquidity and market access.
The effect of widening credit spreads cannot be overestimated. Whereas the difference between high-yield and investment-grade debt was less than 200 basis points as recently as mid-2014, today that relationship is over 400 basis points. As former Federal Reserve Board Chairman Ben Bernanke has noted in his research on the 1930s, when the cost of credit intermediation for non-investment-grade companies rises precipitously, economic growth essentially stops. Those rising costs spark liquidity concerns for banks, as well as concerns about the creditworthiness of borrowers.
But other factors are also driving investor concerns, including the direct exposures held by banks in the energy and commodities sectors. While banks are likely to disclose more to investors next month about their energy-related risks, current disclosures are more sanguine. Yet investors are already reading between the lines. The tendency of lenders to forbear with respect to energy-related exposures also causes investors to discount bank disclosure when it comes to future risks.
Investors are also likely concerned about the potential for future bank losses due to the indirect impact of lower energy prices on other borrowers besides energy producers. The impact of lower energy and commodity prices on sovereign credits such as China, Australia and Saudi Arabia, to name just a few, are weighing on global markets and, indirectly, on large-cap financials.
These concerns were voiced by Federal Deposit Insurance Corp. Chairman Martin Gruenberg in the agency's most recent quarterly report on the industry's health. He warned that "some of the larger exposure" to lower energy prices "is in the regional banks." But that said, we believe that many of the regional and community banks in our ratings universe do a far better job of managing credit risk than their larger brethren.
Meanwhile, it does not help that investors remain skittish about the quality of risk disclosure by both sovereign and corporate borrowers. Revelations suggesting the actual level of growth in China is lower than previously thought, for example, have badly shaken investor confidence in that nation's public data, leading to sharply higher levels of volatility in many markets.
In terms of global banks, investors remain skeptical that large financial institutions are fully disclosing all of their relevant risks, both on and off balance sheet. This skepticism is a legacy of the 2008 financial crisis, when hidden liabilities caused several large banks to fail. Despite the myriad new laws and regulations mandating higher capital, global banks have yet to fully restore their credibility with global investors and the public.
So far, policymakers have responded to the decline in oil prices by embracing zero interest rate policies, but this response may be making matters worse. We believe that the leaders of the major industrial nations need to accept that the downward move in energy and commodity prices will result in sharply increased credit costs for banks in 2016 and beyond.
Keeping interest rates low or even negative will not likely be a sufficient response to the surge in defaults that many observers expect to unfold in 2016. Policymakers should be prepared to directly address default events in the energy sector. Where necessary, regulators should facilitate restructuring efforts so that isolated events of default by relatively small borrowers do not result in systemic risk events.
Christopher Whalen is senior managing director and head of research at Kroll Bond Rating Agency.