Executive Summary

Standard and Poor’s (S&P) believe there is a one-in-three chance that Australia’s sovereign rating may be lowered within the next two years. The purpose of this research project is to explore the potential impacts of a change in the Australian sovereign rating to the Commonwealth Bank of Australia (CBA) and provide key conclusions and recommendations for mitigating these impacts. Due to the relatively high probability of a rating downgrade to Australia’s sovereign rating, this is an important research topic as it has potentially material impacts to various stakeholders of CBA. As a sovereign downgrade impacts all of CBA’s main competitors, this is seen as somewhat of a benefit as it has minimal impact on their competitiveness.

Key impacts have been identified through the investigation of S&P rating criteria, past events of downgrades for CBA and peers, comparisons to Europe and other sovereigns, academic literature, financial journals and news articles.

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From the investigation, it is believed that a sovereign downgrade to CBA may lead to a rating downgrade of CBA however this can be potentially mitigated and is also unlikely. This is due to CBA’s strong implicit government support, financials, is highly regulated and also currently complies with the Australian Prudential Regulation Authority’s (APRA) requirement for the big banks to be ‘unquestionably strong’.

A CBA rating downgrade can be mitigated by improving their Stand-Alone Credit Profile (SACP) through various means but mainly through the reduction of wholesale funding exposure and deleveraging by increasing AUD15bn of equity. As a result, this is expected to increase funding costs by approximately 20bps, thus reducing profitability unless they are passed onto customers through increased lending rates.

Research on the impact to shareholders appears to be somewhat contentious but minimal. The key factors appear to be the effect of the economy, expectations of government support, bank-level holdings of government debt and the nature of the rating downgrade. Overall it is believed that a fall in share price is unlikely.

Implications regarding deposit rates, government, regulatory bodies and the RBA and employees are minimal as they are either already accounted for, pose no risk to a sovereign downgrade or immaterial due to the impact a sovereign downgrade has on CBA’s peers.

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Ultimately, to prevent a rating downgrade of CBA (based on S&P’s rating methodology) the recommendation for CBA is to improve their SACP by mainly deleveraging by raising AUD15bn equity and reduce wholesale funding exposure and attempt increase deposits. A key caveat of this strategy is that CBA may still be downgraded by one-notch following a sovereign downgrade if their anchor rating drops. Additional recommendations are further discussed in the recommendation section of this paper.

Introduction

Credit Rating Agencies are key players in financial markets that provide independent opinions on the creditworthiness of debtors in terms of the debtor’s ability and willingness to make timely payments of debt and their probability of default.[1] Credit ratings range from C (highly risky, non-investment grade) to AAA (low-risk, investment grade, and strong capability to meet financial liabilities)[2] with notches in between (e.g. C+, BBB- which is the minimum rating for investment-grade, AA+, etc.). The credit ratings provided by credit rating agencies assist in bridging the gap in asymmetric information. Strong credit ratings for sovereigns are beneficial by providing wider to access financing on an international level.[3] Similarly, the same applies to large institutions such as CBA who have strong reliance on foreign investment.

A rating downgrade for Australia’s sovereign rating would imply that the creditworthiness has decreased and could have flow on effects to CBA’s credit rating. This in turn could lead to restricted access to capital markets resulting in increased borrowing costs (lenders), lending rates (e.g. mortgages), reduced shareholder value as a result of lower profit margins, lower or limited growth in employee remuneration and government/regulatory intervention (e.g. stricter capital/liquidity requirements).

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By identifying the key impacts of a sovereign downgrade, recommendations have been derived so that CBA can position itself to mitigate the potential impacts of a sovereign downgrade. The key impacts identified are below which are explored in further detail in the Summary of Key Impacts:

• CBA’s credit rating
• Access and costs of funding
• Lending Rates
• Deposit Rates
• Profits
• Shareholders
• Capital and Liquidity requirements
• Government and Regulatory bodies and the RBA
• Employees

Key Terms:

• Sovereign rating – the credit rating of a sovereign which provides a view of its creditworthiness
• Issuer Credit Rating (ICR) – S&P’s rating and view of creditworthiness of the  entity
• Capital/Liquidity Requirements – minimum required ratios and levels of capital/liquidity enforced by financial regulators to ensure financial stability and robustness of the economy
• Basel Accords (Basel I, Basel II and Basel III) – a set of recommended banking regulations to ensure that banks have sufficient capital to meet obligations and absorb unexpected losses.[4] Australia currently prescribes to the Basel Accords
• Australian Prudential Regulation Authority (APRA) – a governing body for Australia’s financial services industry who aim to ensure “financial promises made by institutions we supervise are met within a stable, efficient and competitive financial system.”[5]

S&P Rating Methodology (for banks):

Figure 1 S&P – Banks: Rating Methodolgy and Assumptions, Source: S&P Bank Rating Criteria

Figure 2 – S&P’s Bank Ratings Framework, Source: S&P Bank Rating Criteria

In order to determine a bank’s rating, S&P makes an assessment on two main factors:

• Stand-alone credit profile (SACP) of the bank
  • The SACP is based on six factors (see figure 3) where the first two factors (Economic and Industry risk scores) in figure 3 are a macro level assessment that apply the Banking Industry Country Risk Assessment (BICRA) methodology. These two factors are given a score from 1-10 (lowest to highest risk) and combine to provide an anchor SACP which is used as a “base” rating.
  • The remaining four factors are bank specific and range from -5 to +2 notches. These notches are netted on top of the anchor SACP.
• Extraordinary support
  • The level of extraordinary support (i.e. government bail-out) aka “support uplift” is assessed.

These two main factors are then added together to determine the bank’s issuer credit rating (ICR).[6]

Below in figure 3 is S&P’s bank rating for CBA in 31 Oct 2017, where they affirmed the long term AA- rating with a negative outlook and a short-term credit rating of A-1 (the highest). We can see that they have set the SACP to A- but due to the extraordinary government support, it received a support uplift of 3 notches, resulting in the final ICR of AA-. S&P rationalise the 3 notch uplift due to CBA being a domestic systemically important bank (D-SIB)[7], where they believe that the Australian government will be “highly supportive” to CBA in the event of a crisis.

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Figure 3 – Sourced from CBA and S&P, 31 Oct 2017

S&P’s rating report for CBA explains that there is a one-in-three chance that the long-term and short-term ICR for CBA would fall to A+ and A-1 respectively. They state that this would be a result of either a downgrade to Australia’s sovereign rating to AA+ from AAA or a reduction in government support from ‘highly supportive’ to ‘supportive’.

Historical Ratings:

Snapshot of S&P’s Sovereign Rating History for Australia[8]

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Date	Foreign currency rating (LT/outlook/ST)	Local currency rating (LT/outlook/ST)	Country T&C assessment
Jul. 06, 2016	AAA/Negative/A-1+	AAA/Negative/A-1+	AAA
Nov. 01, 2005	AAA/Stable/A-1+	AAA/Stable/A-1+	AAA
Feb. 17, 2003	AAA/Stable/A-1+	AAA/Stable/A-1+
May. 17, 1999	AA+/Stable/A-1+	AAA/Stable/A-1+
Aug. 22, 1996	AA/Positive/A-1+	AAA/Stable/A-1+
Sep. 03, 1993	AA/Stable/A-1+	AAA/Stable/A-1+
Jul. 27, 1992	AA/Negative/A-1+	AAA/Stable/A-1+

 

CBA Credit Rating History [9]

Date	Foreign Currency	Local Currency
31-Oct-2017	AA-/Negative/A-1+	AA-/Negative/A-1+
07-Jul-2016	AA-/Negative/A-1+	AA-/Negative/A-1+
01-Dec-2011	AA-/Stable/A-1+	AA-/Stable/A-1+
21-Feb-2007	AA/Stable/A-1+	AA/Stable/A-1+

 

Historically we can see that has been a 2-3 notch difference between Australia’s sovereign rating and CBA’s rating. In Dec 2011, CBA faced a downgrade where their ratings fell from AA to AA- as a result of S&P updating their rating criteria for banks. This one notch downgrade also applied to the other three big banks and was driven by the high reliance to foreign wholesale funding.

Summary of Key Impacts

CBA’s Credit Rating:

As per S&P’s rating methodology for banks, there are two core components which are used to derive the ICR for CBA – the SACP and extraordinary support. Therefore, it can be seen that there is a direct link between Australia’s sovereign rating and CBA’s rating.

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From the SACP perspective, S&P believe that CBA are among the strongest banks in the world in terms of their key earnings and asset quality metrics. They have however, highlighted in their Oct 2017 CBA rating report that CBA are materially dependent on offshore wholesale funding and are highly exposed to the recent rapid growth in property prices and private debt. This is seen as a key weakness in their creditworthiness. Under their BICRA methodology, CBA benefit from a strong Australian economy (81% exposure to Australia, 10% to New Zealand and the remaining to mostly US and UK) which has been resilient through negative cycles and external shocks (i.e. the 2009 global financial crisis). Furthermore, as APRA prescribe the Basel accords, S&P believe that the government and regulatory bodies of the Australian financial sector result in a very stable banking system.

From the extraordinary support perspective, ceteris paribus, S&P believe that the support may reduce if the Australian government elect to align with other governments internationally, which have reduced the support of private sector banks. S&P have also stipulated that it is likely that the ratings of the big four banks in Australia are likely to lower in tandem with Australia’s sovereign rating if there was a downgrade. This link can be seen quantitatively with CBA’s exposure of approximately AUD 18bn in Australian sovereign debt (CBA Annual Report 2017).

Comparison to other regions:

The UK sovereign rating was downgraded by two notches from AAA to AA with a negative outlook as a result of Brexit, which S&P viewed as having a negative impact to the UK’s economic strength and certainty. During this period, there has been no impact to bank ratings (with the exception of the outlook changing from stable to negative) as a result of strong diversification and prospective adherence to regulatory capital requirements.[10]

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Less developed markets:

In emerging markets, Williams et al. concluded that the rating changes of banks were sensitive to changes of the sovereign rating, depending on factors of “economic and financial freedom and macroeconomic conditions”. However, the higher the country’s GDP growth and external debt, the less likely a sovereign downgrade would result in a bank rating downgrade. They also found that private banks’ ratings were less likely to follow a sovereign downgrade than government owned banks.

Ultimately, ceteris paribus, a credit rating downgrade for CBA is likely if Australia’s sovereign rating is downgraded. However, whilst the extraordinary support is independent of CBA’s control, the SACP is a factor that CBA can influence to mitigate a rating downgrade.[11] Chris Rands from Nikko Asset Management (NAM), believes that (ceteris paribus) by increasing its risk-adjusted capital ratio from the ‘adequate’ band to the ‘strong’ band, a AA- rating could be maintained. He highlights however that the there is a ceiling to the ratings uplift of AA- from an A+ SACP, therefore it is only advisable if CBA foresee a sovereign downgrade (to avoid unnecessary costs). Furthermore, increasing the capital for a rating uplift may be negated should the anchor rating be reduced.

Figure 4 – Likelihood of Extraordinary Government Support, source: S&P Bank Rating Criteria

European Banks:

In Drago and Gallo’s paper “The impact of sovereign rating changes on the activity of European banks”, they found that the impact of a sovereign downgrade has “a significant impact to domestic European banks in terms of their regulatory capital ratio, profitability, liquidity and lending supply”[12]. They found that a sovereign downgrade resulted in reduced capital ratios, reduced lending supply and European banks having the tendency to increase their liquidity ratios.

Access and costs of funding:

Upon the downgrade of a sovereign rating, empirical evidence in Mensah et al 2017 that suggests an inverse relationship between sovereign ratings and funding costs. Their studies revealed that upon a sovereign rating upgrade, banks were provided wider access to funding in the international markets at lower costs compared to banks in lower rated sovereigns. Moreover, the size of the bank’s balance sheets appeared to have a significant impact to the cost of funding, with larger banks being able to achieve lower funding costs. On a sovereign level, Chen et al 2015 also support this notion, stating that changes in sovereign ratings have an impact on the cost of capital and the availability of credit.

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In the BIS’s paper, “The impact of sovereign credit risk on bank funding conditions”[13], they identified four main channels of how a sovereign downgrade could impact a bank’s funding costs and access to funding:

1. Increased funding costs due to large exposures of a bank’s sovereign portfolio (which are typically large for domestic sovereign debt).
2. Decreased value of wholesale funding used by banks and liquidity from the central bank.
3. Highly likely that it results in rating downgrades for domestic banks but more so for smaller banks and sovereigns.
4. Reduction in a bank’s funding benefits from government guarantees.

Additional implications of a sovereign downgrade to banks highlighted include:

• Increased the cost (via increased haircuts) or impairment/ ineligibility of sovereign debt used for liquidity (repos) and collateral purposes.
• Increased risk of withdrawal of funds for banks that have higher exposure to short-term funding
• Decreased investor demand for bank securities due to weakened public finance conditions
• Reduced bank fee and trading income
• Crowding out of bank debt issuance due to increased sovereign financing demand

In the case of CBA, they are Australia’s largest bank (but a non–G-SIB) and have the following funding composition (rounded) as of 31 Dec 2016:

• Deposits and other public borrowings: 62%
• Short-Term wholesale funding: 18%
• Long-Term wholesale funding: 16%
• Equity: 5%

Figure 5 – Funding composition of banks in Australia, Source: https://www.rba.gov.au/publications/bulletin/2017/mar/pdf/bu-0317-5-developments-in-banks-funding-costs-and-lending-rates.pdf

In the US Markets for US Bank Holding Companies, Karam et al. from the IMF, found that rating downgrades resulted in declines in access to non-core deposits and wholesale funding which was emphasised more so during the GFC. As a result, they saw reduced household lending but this was mitigated through increased liquidity and reducing exposure to rating sensitive sources of funding.[14]

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