The largest U.S. banks including Morgan Stanley, Bank of America and Citigroup are facing what could be a historic shift to lower credit ratings which could increase their cost of funding and reduce competitiveness in their capital markets businesses.

Moody's Investors Service is reviewing 15 of the world's largest banks for possible credit ratings downgrades in mid-May, and broad cuts could send banks on average to their lowest historical levels.

In the U.S. Morgan Stanley could see the largest cut after being warned of a possible three-level downgrade to the Baa category, a rating that has traditionally been associated with more speculative risk than some investors and trading partners have been comfortable with.

Bank of America and Citigroup, which are currently lower rated than Morgan Stanley, are also under review for downgrades to the same Baa2 level, and all three-banks are under review to lose their top tier short-term debt rating which would effectively cut their access to some short-dated funding markets.

Moody's action is unlikely to spark funding stress at the banks. Many banks have been dramatically scaling back their reliance on short-term and ratings-sensitive funding since 2008, when fears over exposure to risky mortgage-backed debt caused short-term debt investors to pull back from lending to the firms.

The banks have also increased deposits and capital cushions, making them less vulnerable to the type of client runs that felled banks including Bear Stearns and Lehman Brothers.

Nevertheless, new downgrades may disrupt some short-dated debt markets and have knock-on effects for municipal issuers, who sell debt that is backed by the strong bank ratings.

Downgrades may also hurt the lowest-rated banks relative to competitors including JPMorgan and Goldman Sachs which are expected to maintain ratings in the more solid single-A category.

You're definitely seeing a segmentation between the potentially lower rated institutions and the higher rated ones, said John Guarnera, a U.S. bank credit analyst at Societe Generale in New York. The biggest issue is the factors that Moody's is focused on are more structural in nature and so it's pretty hard for any institution to do much to offset that.

A Baa rating is less than ideal for brokers over the longer-term as many investors and trading partners remain highly sensitive to the credit risk of bank counterparties and often invest less and trade less with Baa-rated firms than those in the single-A category.

That means they may push more business to higher rated banks, rather than disclose to their own investors a higher exposure to riskier counterparties.

A counterbalancing effect may be that investors will be reluctant to reduce their pool of counterparties in what may end up a very limited number of A-rated institutions remaining.

Downgrades could also increase the collateral needed to post against trades in the U.S. $300 trillion privately-traded derivatives markets and may increase the cost of funding their capital markets activities.

Moody's said the review reflects remaining vulnerabilities in the business model of dealers, even as firms restructure their business to reduce risk.

When you look at some of the industry characteristics, the competition, the overcapacity, the lack of recurring revenues, it gets very hard to argue that there aren't some speculative characteristics that are more consistent with ratings in the Baa range, said Peter Nerby, senior vice president in the financials group at Moody's in New York.

WINNERS AND LOSERS

There are already some signs that Moody's review is impacting the investment decisions of ratings-sensitive investors.

A JPMorgan analysis of U.S. prime money fund flows in February, when Moody's announced its review, showed some shift away from unsecured commercial paper and certificates of deposits of banks that face possible downgrades, and into banks that had their short-term ratings affirmed.

There was also a decline in lending to U.S. banks through the repurchase agreement market, where banks usually borrow to fund asset purchases. U.K. banks that are unaffected by the review, by contrast, saw an increase in loans.

A lower rating could mean a lender in the repo market requires more collateral to back the loan, or is more averse to taking riskier collateral. That could make the loan more costly, or make it harder to finance purchases of less liquid securities.

I don't think it's a funding problem in aggregate. It decreases funding flexibility, it may take away or limit certain avenues of borrowing, said Alex Roever, a money market analyst at JPMorgan.

For the worst rated firms, it also leaves them more vulnerable to any further unexpected shocks.

In some cases the rating agency may walk a bank up to the edge of what many investors view as investible, Roever said. Then if something were to happen, another down leg in the economy or another crisis, then the bank has little room for error.

RATINGS RELIANCE

Banks, investors and users of derivatives and other ratings sensitive products have been reducing their use of ratings to govern investment decisions since the crisis, when the major rating agencies were criticized for having awarded top ratings to risky mortgage-backed debt that later turned out to be worthless.

The ratings of Moody's and its largest competitors including Standard & Poor's and Fitch Ratings nonetheless continue to be used to restrict investments including those in the $2.6 trillion money market industry and remain embedded in some derivatives contracts, where downgrades can trigger higher collateral postings.

Morgan Stanley said in a securities filing that it would need to post an additional $6.52 billion in derivatives collateral if Moody's cuts the firm a full three notches.

Morgan Stanley spokesman Mark Lake noted that the ratings trigger affects only 8.0 percent of its over-the-counter contracts and said the bank has been meeting with clients and counterparties and is prepared for any downgrades.

Bank of America has disclosed that a one notch rating downgrade may require additional collateral of $5.4 billion, though this may require cuts from more than one rating agency. The bank has already posted $2.9 billion of the potential new requirements.

Bank of America has disclosed that after ratings cuts last year it entered into talks with clients that involved transferring some derivatives to its bank subsidiary from its lower-rated holding company. A bank spokesman declined comment.

Citigroup said last year that a two-notch downgrade would require around $5.4 billion in additional collateral.

Our clients tend to be more sophisticated in their analysis than to rely solely on ratings from a single agency. While some clients might note any changes in ratings from Moody's, we don't believe the impact would be material, said spokesman Jon Diat.

A cut of Bank of America's short-term rating could also cause ripples in the $3.7 trillion municipal bond market, where the bank is a large provider of liquidity and letters of credit used to back debt sold by states, cities, hospitals and others.

A downgrade of the bank's short-term rating would mean that these issuers in turn may be cut, or they would need to find an alternative bank to provide the credit backstop.

Money market funds that are rated by Moody's are unable to hold short-term debt that does not hold the highest rating from the agency. JPMorgan estimates that these funds hold around $76 billion in debt from banks facing possible downgrades, though this represents less than 1 percent of their total liabilities. Deborah Cunningham, chief investment officer of money markets at Federated Investors, which oversees $352 billion in assets, said downgrades would require the fund manager to stop investing in the short-term debt of downgraded banks in its Moody's rated funds.

However, if that were the case, we would be holding them on very short maturity basis anyway, she noted. Any downgrades would also be unlikely to affect Federated's investments in funds that are not rated by Moody's, where the Federated bases decisions on its own credit analysis, she said.

Broad bank downgrades may also accelerate efforts banks have already been making to reduce the size of their businesses, a move that could broadly reduce investments across markets.

There has been a reduction in the ability of dealer balance sheet to hold securities positions, said Tony Crescenzi, a portfolio manager at PIMCO in Newport Beach, California. It will speed up if anything the trend that really began in 2007.

(Additional reporting Richard Leong and Lisa Lambert)

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