Too big to downgrade

US bank ratings: Are the largest US banks too big to downgrade? Laws to tackle the too-big-to-fail problem are supposed to force Bank of America, Citigroup and other financial firms to stand on their own feet. But at least for a while, US bank credit ratings will continue to factor in government backing.

The biggest institutions got a boost to their ratings in 2008 when the government stepped in to stabilize the sector. Rating agencies like Standard & Poor's and Moody's Investors Service responded by upping banks' ratings - relative to what was justified on fundamentals alone - to reflect increased government support. Bank of America's ratings, for example, remain a hefty five notches higher on the Moody's scale than they would be without government backing.

That made some sense at the time. But now U.S. financial reform legislation, and specifically plans to facilitate the winding-down of failing institutions, could up-end the government-as-saviour assumption. S&P and Moody's plan to review the legislation once it is in final form and figure out whether banks really are on their own from here.

It may be that they eventually decide that big financial firms still benefit from implicit government support, if perhaps to a lesser degree. But in the future as in the past, this is a heavily political calculation, not a quantitative one.

Of course, the rating firms were right about Fannie Mae and Freddie Mac. Their strong headline ratings, which assumed implicit government backing, comforted debt buyers for years - and proved justified when the government did bail them out. But by relegating the two firms' "standalone" ratings to the small print, the raters encouraged investors in general, and perhaps politicians too, to turn a blind eye to the two mortgage giants' excessive leverage, which is now costing taxpayers dear. For financial institutions to rely on government support isn't healthy. Moreover, doing so now comes with outsized political baggage. If rating agencies continue to believe bailouts could happen, they should make that clearer to investors by putting greater emphasis on the financial firms' "standalone" ratings. Better yet, perhaps any rating with a built in too-big-to-fail assumption should come with a "G for government" health warning.