DEUTSCHE: Here's how top banks could hold on to their credit rating even if Australia is downgraded

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Deutsche Bank is questioning a foregone conclusion: Australia’s top lenders will automatically be downgraded if S&P cuts the top AAA rating of the nation.

Australia’s biggest banks have a way to hold on to their coveted AA- rating, Deutsche Bank analysts Andrew Triggs and Anthony Hoo said in a note. They are leaning on a scenario analysis presented by S&P this week and say the capital strengths of the nation’s banks and a potential to improve earnings can come in handy.

Investors are reconciled to the fact Australian banks will lose their rating in the event of a national downgrade. In fact, S&P placed the banks on negative watch in July immediately after it lowered Australia’s AAA credit rating outlook to negative from stable. It said the wafer-thin election win for the current government wasn’t strong enough to allow for forceful fiscal policy measures to curb budget deficits.

“For us the most interesting scenario involves an improvement in the capital and earnings assessment at the same time as a downgrade of the sovereign local currency rating,” the analysts said. “Under this scenario, the two offset each other and the major bank’s issuer currency rating would remain unchanged at AA-.”

Here’s a chart where Deutsche has circled the scenario that can save banks’ ratings.

S&P measures bank capital strength using its own risk-adjusted capital (RAC) which is equivalent to a Tier 1 measure of capital adequacy. It includes both common equity and hybrids.

Measures by the banking regulator to improve capital positions has boosted the RAC ratios of the majors — ANZ Bank, the CBA, the NAB and Westpac — to between 8.85% (ANZ) and 9.74% (WBC). This places all of the banks in “adequate” capital and earnings assessment and anything above 10% could well save them from an automatic downgrade, Deutsche said.

Westpac’s ratio is the one closest to 10% and factoring capital additions this year, the bank may be able to cross that. The NAB will follow suit with CBA and ANZ a bit behind, it said.

This table from Deutsche shows the RAC ratio:

The analysts also said a one notch downgrade will be manageable. They estimate a 10 basis points widening of term funding spreads and a 3 basis points widening in short term funding spreads.

This would lead to a 1.6% reduction in net profit on average for the major banks spread over the next 10 years, they said.

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