One of the world’s biggest ratings agencies has lost some confidence in Canadian banks. In a surprise move, Moody’s downgraded the credit rating of TD Bank, BMO, Scotiabank, CIBC, National Bank and RBC, citing concerns over “continued growth in Canadian consumer debt, and elevated housing prices.”
You might have heard of ratings agencies like Moody’s and Standard & Poor’s. The most recent example of these entities crossing into pop culture turf was in The Big Short, the Hollywood version of Michael Lewis’ book about a bunch of Wall Street whizzes who end up making billions betting on the 2008 mortgage crisis.
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There’s a rather dramatic scene where Steve Carell’s character barges into the office of a Moody’s executive, when he realizes that they’ve been rubber-stamping the packaging of high-risk mortgages as top grade investment products by big American banks.
Which brings us to the role of ratings agencies — they exist to assess the credit-worthiness of financial institutions that issue debt. Like Canadian banks. Their marking system assigns a grade, such as AAA or CCC, which act as an indication to buyers of debt how likely they are to be paid back.
Moody’s justification for downgrading Canadian banks is because it feels that Canadians are over-leveraged and might not have the ability to meet monthly credit payments in the event that interest rates go up, or the economy suffers a recession. While banks certainly do make a large chunk of money off interest charges, they rely upon a borrower’s ability to pay back debt in a timely manner in order to continue having the cash to keep lending money.
“Debt levels are beyond the usual risk models in place to determine whether businesses could withstand a crisis,” said a statement issued by Moody’s on Wednesday.
The last time Canadian banks were hit with a downgrade was back in 2013, when Moody’s lowered its ratings one notch for six Canadian banks, with the exception of RBC. Interestingly enough, the reasons for the downgrade were the same — unsustainable levels of consumer debt, and escalating home prices. Four years later, and Canadian banks are still on a lending rampage, sustained almost entirely by low interest rates and continued demand for debt.
Now keep in mind that on a global scale, there’s an incredible amount of trust in Canadian banks, mostly because of the way they weathered the 2008 financial crisis. To some extent, the impact of a lower credit rating only mildly affects banks — sure, the heightened risk factor will increase the bank’s cost of doing business, but that will inevitably be passed down to the consumer in the form of higher interest rates or fees.
The highest rating for a bank, representing minimum credit risk is Aaa. Then you have Aa1, Aa2, Aa3, etc. Five of the six banks dropped from an Aa3 to A1. TD Bank was lowered from Aa1 to Aa2. These markers are still considered well above investment grade, which means that major investors should continue to view Canadian banks as safe avenues to park their holdings.
The one and only near-term factor that will indicate the real credit-worthiness of Canadian banks is when interest rates finally start to go up, and Canadians’ feel the pinch of that higher cost of borrowing. Until then, lower ratings or not, lending institutions will continue to thrive.
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