Affected Aaa governments can rescue ailing banks without weakening sovereign rating

The Aaa-rated governments engulfed in the current financial crisis can successfully act as “anchors in the storm” for ailing financial institutions without risking a sudden massive ballooning in government debt that would endanger the sovereign rating, Moody’s Investors Service said in a new report entitled “Anchors in the Strom: Aaa Governments and Bank Bail-Outs”.

Recent events in the US have raised the possibility that, in addition to acting as lenders of last resort, public authorities may also have to act as buyers of last resort of distressed assets — thus raising the question as to whether governments can be relied upon to act as anchors in the storm.

“In Moody’s view, the affected Aaa-rated governments can indeed be relied upon to step in to rescue stressed financial institutions because their shock-absorption capacity is exceptional and their degree of balance-sheet flexibility is superior to that of any private entity,” said Pierre Cailleteau, Managing Director of Moody’s Sovereign Risk Unit.

The combination of a highly resilient economy, a deep fiscal base, credible monetary institutions and a high degree of consensus on policies is what makes these sovereign Aaa ratings shock-resistant.

Given the dramatic recent events in the US financial market, Moody’s report also addresses the question as to the point at which a shock could potentially undermine the Aaa rating of the US. Moody’s believes that the deterioration in the government’s balance sheet would have to be considerable — driving credit metrics lower than those of Aaa-rated credits that exhibit comparable resilience — and irreversible, at least in the foreseeable future.

“In Moody’s view, there is no plausible sudden ballooning of the US Federal balance sheet that could endanger the US government’s Aaa status,” concluded Cailleteau.

According to Moody’s, this reasoning also applies to Germany and the U.K.

Overall, recent events have demonstrated repeatedly that financial systems are an important contingent risk for governments. Moody’s report pinpoints the two main instruments that are available to governments to address public crises: (1) liquidity injections by central banks, and (2) recapitalization with fiscal funds, which involves governments effectively “interposing” their own balance sheet and credit. Moody’s has always incorporated an analysis of banking system liabilities when assessing sovereign creditworthiness. The rating impact should therefore be limited if the risks of a significant expansion in the government’s balance sheet due to a financial crisis are adequately discounted.

Large financial crises are known to have led to some sovereign rating changes, as was the case for Sweden, Norway and Finland in the early 1990s, when these governments took over banks in order to tackle a banking crisis. “Nevertheless, financial crises and bank bail-outs that occur in advanced industrialized countries tend to be less costly — in terms of fiscal costs in relation to GDP — than they are in emerging countries,” explained Alexander Kockerbeck, Vice-President at Moody’s and co-author of the study. The reason is generally better crisis management skills, a much lower vulnerability of the government itself to liquidity risk and the absence of pervasive foreign currency mismatches in banks’ balance sheets. In the absence of liquidity risk, the government has time on its side, unlike most economic agents: indeed, governments may even find ways to accrue profits in a profoundly distressed situation, as Norway did in the early 1990s.

Moreover, the rating agency also points to the key characteristics of Aaa-rated governments to justify its view that an increase in the size of liabilities could not threaten the Aaa rating of the governments involved. The main reason Moody’s cites is that there is no upper limit to creditworthiness, and that therefore the distance to downgrading in the Aaa rating space can be very wide. “The US, Germany or the United Kingdom are arguably very high in the Aaa category,” said Cailleteau.

Additionally, the rating agency notes that a Aaa government can interpose its balance sheet without facing liquidity pressures. “Only the final fiscal cost will determine whether the government has impaired its balance sheet in a sustained fashion,” added Pierre Cailleteau.