What Is a Bank Rating?
The term bank rating refers to a letter grade or numerical ranking assigned to certain financial institutions by the Federal Deposit Insurance Corporation (FDIC) and credit rating agencies. Bank ratings are given to banks and other thrift institutions. Grades are assigned in order to provide the public with information about an organization's safety and soundness. They also help bank leaders identify problems within their institution, if any, that need to be addressed. Many agencies and companies use a proprietary formula to determine ratings while others use the CAMELS system to assess these financial institutions.
- A bank rating is a letter grade or numerical ranking given to banks and other thrift institutions.
- Ratings are assigned by the FDIC and other private companies.
- The public can use these ratings as guides to determine the safety and soundness of certain financial institutions.
- Ratings are based on factors like a bank's capital and the quality of its assets.
Understanding Bank Ratings
Regulatory and credit rating agencies assign financial institutions bank ratings in order to alert the public about the safety and soundness of a financial institution. These grades are issued by regulatory bodies, such as the FDIC, and credit rating agencies like Standard & Poor's (S&P), Moody's, and Fitch. Ratings are updated on a regular basis by bank supervisors, normally every quarter.
Ratings give consumers an 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 are based on a series of factors, including the amount of capital, liquidity, asset quality, and its management.
Each agency uses its own method of calculating ratings. For instance, government regulators assign ratings based on the CAMELS system, which stands for capital adequacy, asset quality, management, earnings, liquidity, and sensitivity. The system uses a scale of 1 to 5, where:
- 1 is the best rating possible while 5 is the worst
- ratings of 1 and 2 are given to financial institutions that are in the best fundamental condition
- institutions with a 3 may have some issues that are a cause of concern
- 4 or 5 indicates serious problems that require immediate action or careful monitoring
A rating of 5 is given to an institution with a high probability of failure within the next 12 months.
Some agencies use a different system and may keep their rating systems confidential. That's why private bank-rating companies also use proprietary formulas that replicate the information. For instance, Fitch rates banks with letters. It assigned the Bank of America an A+/F1 rating in April 2020, which it considers an investment grade bank with high-quality assets that meet its financial obligations.
Because no rating service is identical, investors and clients should consult multiple ratings when analyzing their financial institutions.
As stated above, many agencies use CAMELS or similar criteria to rate banks. Here are a few of the things that agencies look for when they use this system.
A Is for Asset Quality
This could entail a review or 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. This may refer to policies that are in place to limit credit risk and the efficiency of operations.
M Is for Management
By reviewing the management team, an agency wants to ensure that the 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 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 turn around these funds to borrowers in the form of loans 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.