What is an Asset Quality Rating

An asset quality rating is a review or evaluation assessing the credit risk associated with a particular asset. These assets usually require interest payments — such as loans and investment portfolios. How effective management is in controlling and monitoring credit risk can also have an effect on the what kind of credit rating can be achieved.

Asset quality is an important determinant of risk, as such, analysts go to great lengths to accurately estimate asset quality and its impact on the overall condition of a business, bank or portfolio.

BREAKING DOWN Asset Quality Rating

Many factors are considered when rating asset quality. For example, consideration must be put into whether or not a portfolio is appropriately diversified, what regulations or rules have been put in to place to limit credit risks and how efficiently operations are being utilized. Typically, a rating of one shows that asset quality is good and there is very little credit risk, while a rating of five can signify that there are major asset quality problems and issues that need to be managed.

The quality of assets goes a long way in determining how assets are managed. As asset quality goes up, benefits include more liquidity, greater risk capacity, and a lower cost of funds. All of which can lead to higher valuation levels.

At the most basic level, asset qualities can range from ultra-secure U.S. government Treasury bills (T-Bills) to near default "junk bonds" of high-risk corporate issuers.

Every credit cycle has a unique pattern, so no two are alike. New ways to measuring asset quality adapt to capital markets developments. Bank credit departments, the major rating agencies, and regulatory agencies have all played a role in updating popular asset quality assessment methodologies.