Ratings Downgrades Inevitable for Citigroup (NYSE: C), Bank of America (NYSE: BAC) and Others Post Financial Regulatory Reform?

As the financial regulatory reform act nears final completion, attention is now turning to the immediate impacts to the institutions it effects.

While most attention has been given to the structural changes that will take place as a result, like shrinking prime brokerage units due to limited hedge fund investments, and falling proprietary trading, the real teeth of the legislation may lay in it’s impact to bond ratings.

As we saw in the financial crisis of 2008, nearly all of the major banks have a capital structure loaded with debt. These debt agreements also tend to have covenants based on the firm’s bond ratings. So, a cut in bond ratings could force firms to raise more capital, which could prove difficult and costly in today’s capital markets.

Moody’s Investors Service, the venerable ratings institution, said on Friday that the deal reached in Congress on the financial reform bill will not prompt it to immediately change its ratings on U.S. banks — but that doesn’t preclude future downgrades. Publicly, the ratings agency said it must first discern the effects of the legislation on the profit banks make in the credit industry.

Consistent with other expert comments revealed this past weekend, the ratings service said the legislation includes both positive and negative elements for banks’ stand-alone credit profiles. Robert Young, Managing Director for Moody’s North American Bank Ratings commented “Clarity with regard to the law’s content and an understanding of its likely implementation by regulators will be key to our ongoing analysis.” Young added that We are therefore still of the opinion that senior debt and deposit ratings of systemically important banks in the U.S. will continue to benefit from some unusual level of support until the economic recovery is sustained, financial market health is restored, and the risks of attempting to unwind an interconnected institution are reduced.”

Historically, there has been an implied safety net for financial institutions – this led rating agencies to perhaps assign higher credit ratings than they would have achieved as stand alone institutions operating without an implied assurance. Now that the net has been removed, or at least damaged in some way, banks are likely to face new capital covenants kicking in. In the last series of ratings downgrades, Bank of America (NYSE: BAC), and Citigroup (NYSE:C) in particular faced significant capital towers required – only time will now tell if this will happen again.