What Is a Bank Rating?
A bank rating refers to a letter or numerical grade assigned to banks and thrift institutions by rating agencies.
Grades are assigned to provide the public with information about an organization's level of credit risk and financial safety and soundness. They also help bank leaders identify problems within their institution, if any, that need to be addressed.
Many rating agencies use a proprietary formula to determine ratings while others use the CAMELS system to assess financial institutions.
Key Takeaways
- A bank rating is a letter or numerical grade given to banks and other financial institutions.
- Grades are assigned by government agencies and private rating companies.
- The public can use these ratings as guides to determine the financial safety and soundness of certain financial institutions.
- Ratings are based on factors like the amount of capital that a bank maintains in reserve and the quality of its assets, as they compare to levels required by industry authorities.
Understanding Bank Ratings
Regulatory and credit rating agencies assign ratings to banks in order to provide the public with information about the safety and soundness of a financial institution or its risk of default on debt obligations.
These ratings are issued by regulatory bodies, such as the Federal Deposit Insurance Corporation (FDIC), and credit rating agencies like , Moody's, and Fitch. Ratings are updated on a regular basis by bank supervisors, normally every quarter.
Ratings give consumers insight into the health and stability of financial institutions, such as banks and other thrift institutions.
These rankings are also provided to the bank's management team and its board to address any problems, if any. Grades can be based on a series of factors, including the capital amounts, liquidity, asset quality, and the capability of management.
Agencies may use different ratings system. They may consider the workings of such systems proprietary and maintain confidentiality about how ratings are derived.
FDIC vs. Credit Rating Agencies
The FDIC is an independent government agency that protects depositors' money in FDIC-insured banks up to a certain amount in the event that a financial institution fails. It regularly examines financial institutions to ensure financial safety and soundness.
Its ratings are different from those provided by credit rating agencies, which focus on the ability of financial institutions and corporations to pay debt obligations on time.
For instance, the FDIC presents ratings related to the level of consumer compliance (with consumer protection and civil rights statutes/regulations) that it finds at each federally regulated commercial bank, savings and loan association, mutual savings bank and credit union.
It also provides ratings relating to the safety and soundness of these financial institutions.
The CAMELS System
Government regulators assign ratings based on the CAMELS system, which is used worldwide to provide guidance about the financial soundness of financial institutions. The letters in the acronym CAMELS stand for capital adequacy, asset quality, management, earnings, liquidity, and sensitivity.
The FDIC Safety and Soundness ratings use a scale of 1 to 5, where:
- Rating 1 indicates that a financial institution is sound in all ways. It has the best fundamentals and can withstand economic uncertainties. It also substantially complies with laws and regulations. Moreover, it has the strongest performance and risk management capability.
- Rating 2 indicates a financial institution that is fundamentally sound and has only moderate weaknesses. Business fluctuations should pose no problems and compliance with laws and regulations is good.
- Institutions with a 3 rating are considered to have moderate to severe weaknesses. They are less able to handle business fluctuations. And they are in less than satisfactory compliance condition. More than normal supervision is required but failure appears unlikely.
- An institution with a 4 rating exhibits unsafe and unsound practices and has serious financial or managerial issues that cause unsatisfactory performance. Weaknesses aren't being addressed or resolved. And there may be major noncompliance with laws and regulations. Failure is a possibility.
- A rating of 5 is given to an institution that has extremely unsound practices or conditions and as a result, critically deficient performance. It indicates the greatest need for supervisory concern and immediate outside assistance. These institutions are at great risk of requiring FDIC deposit insurance. Failure is extremely likely.
Example of How To Interpret Credit Ratings
Bank customers and investors can visit a credit rating agency site to learn about its ratings structure and the meaning of its individual ratings.
For example, Fitch rates banks with letters and numbers. In September 2022, it assigned Bank of America Corporation a rating of AA- for the category of Long-Term Issuer Default and an F1+ rating for the category of Short-Term Issuer Default.
According to Fitch, "AA ratings denote expectations of very low default risk. They indicate very strong capacity for payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events."
The F1+ rating indicates the lowest default risk and the greatest ability to meet timely payments of financial obligations to financial institutions in the same country. Fitch appends the "+" sign when a bank's liquidity is particularly strong.
Because no rating service is identical or infallible, investors and clients should consult multiple ratings and financial metrics when analyzing their financial institutions.
Components of CAMELS
As stated above, many agencies use CAMELS or similar criteria to rate banks. Here is what the CAMELS system helps agencies examine.
C Is for Capital Adequacy
Capital adequacy refers to the amount of cash held in reserve by financial institutions compared to what authorities require them to hold. Institutions must also address guidelines and regulatory policies related to interest and dividends.
A Is for Asset Quality
This entails an evaluation of credit risk associated with a bank’s interest-bearing assets, such as loans. Rating organizations may also look at whether a bank’s portfolio is appropriately diversified. They may look for policies that limit credit risk and support the efficiency of operations.
M Is for Management
By reviewing the management team, an agency wants to examine whether a bank's leaders understand the direction of the institution and have specific plans to move forward in a given regulatory environment. Visualizing what is possible, placing a bank in context with industry trends, and taking risks to grow the business are all required of strong leaders.
E Is for Earnings
Bank financial statements are often harder to decipher than those of other companies, given their distinct business models. Banks take deposits from savers and pay interest on some of these accounts.
To generate revenues, they will take deposits, loan them to borrowers, and receive interest on them. Their profits are derived from the spread between the rate they pay for funds and the rate they receive from borrowers.
L Is for Liquidity
Ratings take into account liquidity, or a bank having enough assets of a type that can be converted to cash quickly and easily so that short-term financial obligations can be met. Those obligations include withdrawals by customers.
S Is for Sensitivity
Sensitivity refers to an institution's risk exposure, for instance market risk. For example, a regulator may examine how a bank monitors its credit concentrations and the industries to which it lends money.
Why Are Credit Ratings Important?
Credit ratings important and useful because they indicate the credit risk that potential investors in the debt issued by an institution may face. Credit ratings project how likely it is that bond investors will be repaid in full and on time for their loans.
Are Ratings Always Accurate?
Ratings are a forward-looking opinion rendered by rating agencies based on a close examination of a financial institution. As a consequence, there's no guarantee that a financial institution with an excellent rating won't default. That's why ratings should be just one of a variety of indicators of financial soundness that investors take into account before making investments.
What Role Do Bank Credit Ratings Play?
Importantly, they can be a source of information and transparency for consumers and investors. Credit ratings are vital to healthy and efficient capital markets. Along with other important financial data, they can provide investors with the confidence to invest, which in the long run can mean ongoing and vital economic activity and wealth building.
The Bottom Line
Bank ratings are grades related to aspects of financial institution safety and soundness assigned by government agencies or private rating agencies.
They are produced to ensure that the public has adequate and clear information about the financial institutions that they may open accounts with, invest in, or lend to.
