?Global capital markets currently face single-day movements of 30% or more in share prices of financial companies and volatility in borrowing rates and spreads on credit-default swaps, according to Standard & Poor’s Rating Services. When uncertainty of this magnitude dominates the markets, the assessment of a financial institution’s credit profile should take into account the interaction between fundamental credit elements and short-term factors shaped by market distress, says analyst Scott Bugie.


“This balance is essential for banks and broker-dealers, because confidence is a meaningful factor in the highly leveraged financial sector,” he says.


Investment-banking business lines such as securities trading and prime brokerage can be particularly confidence-sensitive, since they require a high volume of daily cash, securities and derivative transactions with counterparties. Continual access to securities and derivatives markets is the lifeblood of these businesses.


“Volatility in share prices and credit spreads can quickly switch from reflecting temporary market noise to inflicting more lasting commercial and financial damage to a financial institution’s fundamental credit profile,” says Bugie.


Sharp drops in share prices can rapidly erode the ability to raise equity, while a sudden widening of spreads automatically increases the cost of funding. The most damaging developments for banks and brokers are a loss of access to daily cash and derivative transactions at any price or collateral haircut and an outflow of customer deposits, such as a bank run. Going from noise to material damage is a complex shift involving the judgment of market psychology.


The speedy impact of negative market sentiment on fundamental creditworthiness contributed to the sudden bankruptcy of Lehman Brothers Holdings Inc., the rescue of American International Group Inc. via the U.S. Treasury’s two-year, $85-billion credit line and the collapse—and subsequent bailout—of Bear Stearns Inc., among others.


Negative market sentiment has not been confined to U.S. entities. In Europe, the Dexia and Fortis groups, HBos Plc, and Bradford & Bingley Plc are recent prominent cases illustrating how downswings in market indicators can quickly weaken credit fundamentals and ultimately force either direct government support or hastily negotiated—and government-brokered—mergers.


S&P assesses a financial institution’s relative vulnerability to periods of turbulence in the credit markets, among many factors that determine creditworthiness.


“Liquidity is also a critical credit element, particularly in distressed markets. A financial institution’s internal liquidity, access to markets, and alternative-funding and liquidity-support arrangements are important credit factors,” says Bugie.


“An entity’s contingency plans for liquidity under severe stress scenarios take on added analytical weight when market conditions are unfavorable and emergency preparations may be put into action. Clearly, institutions that depend highly on short-term wholesale funding are particularly vulnerable to volatile markets.”