Regulatory ratios, CDS spreads, and credit ratings in a favorable economic environment

Abstract

Over the past 150 years, the United States has endured periodic recessions and panics every several decades that have precipitated numerous bank failures. The government invariably conducts hearings, enacts new restrictive laws, and often creates an original regulatory agency structured to implement law and minimize recent problems from reoccurring. The public policy response rarely lasts more than two decades prior to the cycle repeating. The most recent crisis between 2007 and 2009 led to the passage of the Dodd–Frank Act, the creation of the Consumer Financial Protection Bureau and Basel III; the largest banks are now subject to more severe rules applicable to capital, liquidity, and risk management. Large banks have had almost a decade to repair financial statements and comply with restrictive regulation. Consequently, credit rating agencies regard systemically important U.S. banks to possess high-grade and upper-medium-grade credit quality. The financial market assigns these banks relatively low spreads in the credit default swap (CDS) market. Regulatory ratios important to distinguishing credit quality in an economic recession or financial panic change in a period of economic growth. Still, the credit ratings and the market remain concerned with any bank ratios reflective of suspect asset quality and resultant loan losses. And, despite efforts to minimize the existence and consequence of “too big to fail,” larger banks retain better credit ratings and lower CDS spreads than smaller institutions.