Moody’s Downgrades the UK Banks

13 january 2013

Much furore in the UK today as Moody’s announced that it had downgraded the credit ratings of 12 of the UK’s financial institutions. I have to admit to being slightly surprised at the reaction: this is good news, not bad.

The crucial point is this:

According to Moody’s, announcements made, as well as actions already taken by UK authorities have significantly reduced the predictability of support over the medium to long-term. Moody’s believes that the government is likely to continue to provide some level of support to systemically important financial institutions, which continue to incorporate up to three notches of uplift. However, it is more likely now to allow smaller institutions to fail if they become financially troubled.

The downgrades do not reflect a deterioration in the financial strength of the banking system or that of the government.

So, as Moody’s says, they’re not worried about the finances of either the government or the banks. They don’t think either are more risky than they used to be, they don’t think there’s some event just around the corner which is going to make either of them more risky.

What they do think though is that the subsidy which government provides to the banks has been reduced, that there has been a reduction in moral hazard.

Moral hazard is, as an example, when the banks know they’ll get bailed out if they screw up. Thus they should carry on gambling, taking as many risks as they can possible cram into their trading books for the upside is profits and bonuses, the downside is a bail out.

So, if the government has believably indicated that it’s less likely to offer a bail out, that hazard is reduced.

Similarly, a standard complaint is that that promise to bail out lowers the cost of credit to the banks: obviously, the promise raises their credit ratings, just as the withdrawal has just lowered said ratings. This is a hidden subsidy to the banks. That subsidy has now been lessened, which is a good thing of course: subsidies distort markets.

I will admit though to being seriously confused about the way that some people who have reacted to this. As least one has spent months whining about both moral hazard and government subsidies to banking yet when the first is reduced and the second withdrawn, he complains again.

Why, for the Lord’s sake, why?