What is a bank rating?
A bank rating is a shorthand score—letters, numbers, or both—assigned to a bank or thrift to summarize its relative financial strength and creditworthiness. Ratings are intended to signal how likely the institution is to meet its obligations (for example, repay bondholders) and how safe it appears from a supervisory standpoint. Regulators and commercial credit-rating firms use different methods and scales to produce these assessments.
Who issues bank ratings and how do they differ?
– Regulatory examiners (for example, the U.S. Federal Deposit Insurance Corporation, FDIC) evaluate banks for “safety and soundness” and compliance with consumer rules. Their internal exam grades are primarily supervisory and used to guide corrective action.
– Credit-rating agencies (Standard & Poor’s, Moody’s, Fitch) publish public ratings aimed at investors who hold or consider buying the bank’s debt. These ratings focus on the likelihood of default or timely payment.
Rating models are often proprietary. Regulator ratings tend to use a standard framework (see CAMELS below); agencies typically publish rating definitions but keep detailed algorithms confidential. Ratings are usually refreshed on a recurring schedule (for example, quarterly) and after major events.
The CAMELS system (supervisory framework)
Regulators worldwide commonly use CAMELS, an acronym for six supervisory components:
– C — Capital adequacy: the bank’s cushion of regulatory capital relative to its risk-weighted assets. A higher capital ratio means a larger buffer against losses. (See numeric example below.)
– A — Asset quality: assessment of credit risk in the loan and investment portfolio, including nonperforming loans and concentrations by industry or borrower.
– M — Management: qualitative review of senior management and the board—strategy, governance, risk culture, and operational controls.
– E — Earnings: the bank’s profitability and the sustainability of those earnings (for example, net interest margin and return on assets).
– L — Liquidity: the ability to meet short-term cash needs, including deposit withdrawals and funding stresses.
– S — Sensitivity to market risk: the bank’s exposure to interest rate shifts, foreign exchange movements, commodity prices, or other market changes.
How supervisors and agencies report ratings
– FDIC/regulatory safety-and-soundness exam grades typically use a 1–5 scale where 1 indicates the strongest condition and 5 the weakest (requiring the most urgent corrective action). These supervisory ratings are generally not public for individual banks.
– Credit-rating agencies use letter scales (e.g., AAA, AA, A, BBB, etc., with plus/minus modifiers) for long-term obligations and a separate short-term scale (e.g., F1, F2 in Fitch’s scheme). For example, a long-term “AA-” indicates very strong capacity to meet obligations compared with peers; a top short-term rating like “F1+” (Fitch) signals excellent near-term liquidity and timely payment capacity. Different agencies’ definitions are similar but not identical—compare them directly before making conclusions.
Why ratings matter
– For depositors and retail customers: ratings are one indicator of an institution’s health, but deposit insurance (FDIC in the U.S.) is the primary protection up to insured limits.
– For bondholders and creditors: ratings help price the bank’s debt and influence borrowing costs. Lower ratings typically mean higher interest costs.
– For management and supervisors: ratings highlight weaknesses to be corrected and inform oversight and remedial actions.
However, ratings are not perfect predictors of future losses or failures. They are backward- and current-looking, rely on available information, and reflect the rater’s methodology and assumptions.
Are ratings always accurate?
No. Limitations include:
– Different agencies can reach different conclusions at the same time.
– Ratings can lag fast-moving changes (market shocks, fraud, sudden deposit runs).
– Agencies and regulators may weigh qualitative factors differently (e.g., management quality).
For these reasons, prudent users consult multiple sources—regulatory filings, stress-test results, financial ratios, and news about enforcement actions or management changes—rather than relying on a single rating.
How to use bank ratings: step-by-step checklist
1. Confirm FDIC insurance coverage for deposit protection and the applicable coverage limits.
2. Find
2. Find the bank’s most recent credit ratings and the rating date. Check ratings from at least two major agencies (e.g., S&P, Moody’s, Fitch) because methodologies differ. Note the rating “action” date and any subsequent outlook or watch-list placement (see step 4).
3. Read the rating rationale and outlook. The rationale summarizes the agency’s reasons (capital, liquidity, asset quality, business model, sovereign linkages). An “outlook” (positive, negative, stable) signals the rater’s forward view; a “watch” indicates a possible near-term change. Treat these as forward-looking flags — not guarantees.
4. Compare ratings across agencies and instrument types. Agencies rate long-term senior debt, short-term debt, deposit ratings, and subordinated instruments differently. Example: S&P long‑term BBB may correspond roughly to Moody’s Baa2. If senior debt is investment grade (S&P/Fitch BBB- or higher; Moody’s Baa3 or higher), but subordinated debt is lower, that reflects loss-absorption hierarchy.
5. Cross-check regulatory and market indicators
– Regulatory stress tests: For large banks, review recent stress‑test results and required capital buffers (e.g., Federal Reserve capital plan results in the U.S.).
– Market signals: look at 5‑year CDS (credit default swap) spreads, bond yields relative to swaps, and equity implied volatility. Rising CDS spreads or widening subordinated bond spreads often precede rating changes.
6. Calculate and compare key financial ratios (how to compute and interpret)
– Common Equity Tier 1 (CET1) ratio = Common equity tier 1 capital / Risk-weighted assets. Example: CET1 = $20bn; RWA = $200bn → CET1 = 20/200 = 0.10 = 10%. Basel III minimum CET1 = 4.5% plus a 2.5% capital conservation buffer (combined 7%), but many banks target or are required to hold more. Higher CET1 generally implies greater loss-absorption capacity.
– Liquidity Coverage Ratio (LCR) = High‑quality liquid assets / Net cash outflows over 30 days. Example: HQLA = $60bn; cash outflows = $50bn → LCR = 60/50 = 1.2 = 120%. Basel standard: LCR ≥ 100% for large banks.
– Non-performing loan (NPL) ratio = Non-performing loans / Total loans. Example: NPLs = $3bn; loans = $100bn → NPL ratio = 3%.