Stephen Foley: Moody's will tighten the vice on bank downgrades

US Outlook: Arbitrary! Backward looking! Completely unwarranted! Complaining by the banks downgraded by Moody's started the second the rating agency's actions hit the wire late on Thursday night. Citigroup sounded especially aggrieved at the two-notch cut to its credit rating, but all the affected institutions rushed out statements to assert that they have never been safer.

That isn't true in the slightest, given that the interrelations of modern finance and the complexity of modern financial products make it harder than ever to manage these institutions. If anything, Moody's is still being too generous in its assessment of bank debt.

The justification for saying that is contained in the agency's own analysis, which concluded with a warning that these 15 systemically vital banks could be downgraded again when regulatory reforms such as the Dodd-Frank Act here are finalised.

Moody's has already reassessed the risks and volatility associated with investment banks' capital markets activities, in the light of what we learned during the credit crisis of 2007-09. These trading businesses are still heavily reliant on short-term funding, which we know can dry up in a panic, and as a litany of trading mistakes, from MF Global to JPMorgan Chase can attest, banks are still prone to terrifyingly large errors.

At the same time, Moody's is still giving the biggest banks extra points because of the likelihood that governments will come to their rescue if they get into trouble. That might change, the agency says, if it looks like Wall Street reforms really do solve the problem of "too big to fail" by making it possible for any one bank to fail safely, without endangering the rest.

Dodd-Frank scores highly on that measure, since it unlinks a lot of the sources of contagion that we discovered in the crisis and gives power to the government to take over failing institutions.

The laws are explicit: there must be haircuts of creditors if a government takes over a firm; there can be no repeat of the bondholder bailouts of 2008; creditors will not get paid.

There was relief yesterday that Moody's was not harsher, but these downgrades will likely not be the last.