What does a bank’s credit rating really tell us?
What does a bank’s credit rating really tell us?
The turmoil in the banking world continues. The outlook for the entire U.S. banking sector is now “negative,” according to Moody’s, which comes after being “stable” for a long time.
Moody’s and other credit ratings agencies have also downgraded the credit status of First Republic Bank. And a handful of other banks are now at risk of being downgraded.
Both Silicon Valley Bank and Signature Bank had high ratings right up until they failed, which raises a question: how much do those credit ratings really tell us?
There are two big things credit rating agencies look at when evaluating a bank.
The first is what’s happening at the bank itself, like “what does their balance sheet look like [and] what does their income statement look like,” said Kevin Jacques at Baldwin Wallace University
Jacques said agencies also look at the broader economy, “What’s happening to GDP? Is the inflation rate high? What’s happening to interest rates?” That includes how events may affect the bank and its credit risk.
Ideally, credit ratings would be something of a canary in the coal mine. But according to Brett House, a professor of professional practice at Columbia Business School, in reality, they often end up being a lagging indicator.
“Often they are pretty rosy looking until suddenly, they’re not, and there’s suddenly a problem,” House said.
That’s what happened during the financial crisis in 2008 and what’s happening again now.
House said this is happening now “in part because analyzing complicated financial organizations can be difficult — the economic forecasts that they rely on change over time. And they don’t have that many resources to devote to any single institution’s rating process.”
That lack of resources is not just a problem for credit rating agencies that can be slow to catch problems but also for federal regulators.
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