No bank is an island. That’s one of two messages Standard & Poor’s is sending with its proposal for a new methodology for rating the credit of financial institutions. The second message is that S&P wants ratings to be more transparent to investors and finance chiefs, who tend to think of credit-rating formulas as a mysterious black box.
A key assumption of the proposed rating system is the recognition that financial institutions cannot be divorced from the climate they operate in, particularly the government regime that oversees them. Thus, S&P has made systemic risk — economic and industry risks, that is — the starting point for its credit analysis. And it has found a way to link the interventionist bent of national governments to the potential for bank defaults.
“Our theory is that [government] support doesn’t just appear, it’s always there, and if it’s there, we ought to factor that in across economic cycles,” says Craig Parmelee, a managing director at S&P.
The new methodology should help finance chiefs and their treasurers get a better understanding of what’s behind a bank counterparty’s credit rating. It begins by analyzing a bank’s exposure to overall economic risk — trade imbalances and potential asset bubbles, for example — then assesses industry-specific risk, such as a bank’s relationship with its regulators, the competitiveness of its markets, and the “track record of authorities in managing financial sector turmoil.” (S&P also adjusts for riskier investment-banking activities.)
Economic and industry risk combine to form an “anchor rating,” says Parmelee. To the anchor rating S&P then adds four criteria that can improve or diminish the issuer’s score: business position, capital and earnings, risk position, and liquidity. The result is what S&P calls a stand-alone credit profile (SACP) — stand-alone in that it doesn’t account for “extraordinary” support from governments, such as capital injections or distressed-asset purchases.
To arrive at how much uplift an issuer’s credit rating should get from extraordinary government support, S&P breaks down sovereigns into three categories, based on their tendency to bail out financial institutions. It also considers how systemically important the individual bank is. S&P then uses a matrix of the government’s local currency rating and the bank’s SACP. For example, a bank with an SACP of A that operates in a country rated AAA would have its credit rating boosted to AA- — up two notches — because of the expectation that the country would directly intervene if the bank experienced financial stress in the future.
Parmelee says the framework is flexible enough to address governmental changes in attitude toward rescuing financial institutions. For example, “If we were convinced the United States would not support its banking system, then we would classify that as ‘support uncertain’ — no support would be factored into any ratings for any U.S.-based institution,” he says.
S&P tested the formula on a sample of 138 banks and found the ratings impact to be “modest,” Parmelee says. Eighty-five percent of the sample remained within one notch of their current rating.
The comment period for the proposal ended earlier in March, but it could take the credit rater another few months to incorporate any changes. Depending on the nature of the comments and any resulting changes by S&P, adoption could happen very quickly, says Parmelee.