Lloyds and RBS Hit Back After Rating Downgrades

LONDON -- Yesterday evening, 15 banks across the globe all had their respective credit ratings cut by ratings agency Moody's. While several banks had their credit ratings cut by a single notch, Credit Suisse suffered the indignity of a three-notch rating cut.

Britain's big four get downgraded
Here in the U.K., HSBC Holdings (ISE: HSBA.L) -- Europe's largest bank -- had its credit rating cut by one notch to "Aa3" from "Aa2." Barclays (ISE: BARC.L) -- the other major U.K. bank to avoid a government bailout during the 2008 banking meltdown -- had its rating cut by two notches to "A3" from "A1."

As for Britain's bailed-out banks, Lloyds Banking Group (ISE: LLOY.L) was given a one-notch downgrade from "A1" to A2. Royal Bank of Scotland (ISE: RBS.L) was also downgraded one notch to "A2" to "A3."

To summarize, Britain's "Big Four" banks are, from highest to lowest credit rating:

Following these downgrades, Moody's placed global banks into three tiers. In the top tier, the strongest banks were HSBC, Royal Bank of Canada and JPMorgan Chase. In the third and weakest tier, Moody's included Bank of America, Citigroup, Morgan Stanley, and RBS.

Lloyds and RBS hit back
Following their rating cuts, both Lloyds and RBS released regulatory announcements expressing their disappointment with these downgrades.

Lloyds said that the rating review "reflects the substantial progress we are making in delivering our strategy to reshape the business, strengthen our balance sheet, simplify our operations and invest behind our leading franchises."

Lloyds also pointed out that its long-term rating was lowered by only one notch, instead of two, and that its short-term rating remains unchanged. Then again, it also pointed to Moody's opinion that the bank's rating outlook is "negative on the A2 senior debt and deposit ratings reflecting Moody's medium-term view of lower systemic support for UK banks."

Antonio Horta-Osorio, chief executive of Lloyds, said: "I am pleased that Moody's have recognised the substantial momentum we have made in de-risking our balance sheet and delivering on our strategy. I expect this momentum to be sustained as we continue to deliver on our promise of being the best bank for customers and shareholders."

On the other hand, the response from RBS was more assertive. In a somewhat grumpy statement, RBS noted Moody's one-notch cut to its long-term and short-term ratings. However, it warned that "the negative outlook reflects Moody's expectation that government support for large UK banks may be lowered in the medium term."

RBS then pointed to "significant progress in strengthening its credit profile since 2008, which has been recognised by the other rating agencies." The FTSE 100 firm also listed its improving financial fundamentals, such as:

• A loan-to-deposit ratio that has improved to 106% from 154%.

• A liquidity portfolio of 153 billion ponds, versus short-term wholesale funding of 80 billion pounds.

• Noncore-funded assets of 83 billion pounds, down from 258 billion pounds.

• A robust 10.8% Core Tier 1 capital ratio. (For the record, when U.S. investment bank Lehman Brothers collapsed into bankruptcy in mid-September 2008, it had a core capital ratio above 11%, so this in itself is no guarantee of surviving market storms.)

RBS then gruffly adds, "The Group disagrees with Moody's ratings change which the Group feels is backward-looking and does not give adequate credit for the substantial improvements the Group has made to its balance sheet, funding and risk profile."

Take that, Moody's!

Bank shares bounce
Despite all four of Britain's banks being downgraded, their shares shrugged off this latest blow to their global reputations. After their initial falls, all four banks have since seen their shares rise in a falling market, probably because this news was already priced in since Moody's announced the latest review on Feb. 15.

As I write, the Big Four's shares have moved as follows (sorted from highest to lowest riser):

As you can see, all four banks have bounced back from their downgrades to enjoy a nice uplift.

Too little, too late?
Critics of banks and ratings agencies argue that this latest round of cuts is "too little, too late." Indeed, they argue that ratings in the run-up to the 2007 to 2009 global financial crisis were pure "pie in the sky." Thus, why give the ratings agencies any authority and credibility today?

Nevertheless, when company credit ratings are lowered, firms are perceived as less creditworthy and, therefore, at greater risk of debt default or restructuring. Hence, after credit downgrades, funding costs tend to rise. In effect, a lower credit rating often leads to lower profits, all other things being equal.

One notable exception to this rule is when the U.S. lost its prized AAA credit rating in August 2011. Since being downgraded to "AA+" by Standard & Poor's, the yield on a 10-year U.S. Treasury bond has tumbled to a mere 1.62% a year. This is below Britain's 10-year gilt yield of 1.67%, despite the U.K. still retaining its "AAA" rating -- for now, at least. Hence, these 15 downgraded banks could well face increased funding costs and collateral calls in the months (and years) ahead, putting more pressure on their liquidity and balance sheets. Then again, when set against the severe shock of the eurozone crisis, this impact is likely to be muted.

Cleary, even four years after averting financial Armageddon, banks are still not in the best of health. For the record, I remain bearish on British banks, particularly Lloyds and RBS. What's more, Britain's biggest investor, Neil Woodford -- who manages 20 billion pounds of our money for Invesco Perpetual -- also avoids bank shares. To find out which British businesses Woodford is making bumper returns from, read "Eight Shares Britain's Super-Investor Owns." For more about these eight money-making machines -- and Woodford's magnificent mind and methods -- download your free copy of this report today.

More from Cliff D'Arcy:

• Americans Target British Businesses

• Buffett Bets Big On US Housing Recovery

• A £332 Billion Problem For UK Investors

The article Lloyds and RBS Hit Back After Rating Downgrades originally appeared on Fool.com.

Cliff does not own any of the shares mentioned in this article. The Motley Fool owns shares of Citigroup, Bank of America Corporation Com, and JP Morgan Chase. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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