Monday, 14 November 2011

S&P Revised Bank Ratings Criteria and BICRA Methodologies

Standard & Poor's has just released revised bank ratings criteria. The new criteria aims to provide greater insight into how banks are rated, and claims that the new approach is more 'intuitive'. It builds on existing methodology but aims to simplify and incorporate what has been learned over the past few years throughout the financial crisis. According to Standard & Poor's, the stresses of the crisis have forced banking to reinvent itself. There has been, and continues to be, a potential shift in the balance of power between banks in the west and those in BRICs nations, and while recovery in the former is not a foregone conclusion, neither is sustained growth in the latter. Moreover, there has also be a shift in business volumes away from the formal banking sector towards the shadow banking sector. This is somewhat due to heavier regulation of banks following the crisis and the more stringent capital and liquidity requirements. Restrictions on higher risk activities have also forced these operations elsewhere, meaning that profit margins on regulated banking activities are likely to be reduced over coming years. Moreover, government support for banks is also less certain, with moves by many governments to support certain activities, sectors, and institutions, or in some cases to make it clear to the markets that no institution is too big to fail. The new criteria are designed to reflect the changes that are taking place, and keep pace with current market practice.

The new criteria also aim to establish a greater degree of global consistency across the ratings frameworks and - interestingly - in so doing to sustain market confidence in the ratings.

The revised BICRA (Banking Industry Country Risk Assessment and Assumptions) methodology results from consultations carried out throughout 2010 following a request for comment back in January 2010. According to the feedback from this request, Standard & Poor's report that one of the most often cited complaints was a lack of clarity about the criteria and how it was applied. Consequently, Standard & Poor's appears to be on something akin to a PR drive at the moment to publicize and more importantly explain how the methodology works.

So what is new?

The criteria take a revised approach to investment banking, with elements allowing for a greater differentiation of risk. This can now be taken into account with the business profile. Credit risks of banks operating in different business lines are also more clearly differentiated, meaning that risks pertaining to a specific sector can be more accurately expressed.

Secondly, criticism was levelled in replies to the 2010 request for comments that no account was taken of stronger liquidity of institutions in funding analysis. Under the revised criteria, "funding and liquidity" is a discreet factor. Now, when this is above average (strong liquidity and above-average funding), the standalone credit profile can be raised by one notch.

Thirdly, criticism was also directed at the practice of using capital standards globally. Under this system, the RAC (risk adjusted capital) ratio of banks operating in higher risk countries would be assessed in the same way as banks operating in lower risk countries. However, the capital standards one would expect to be achieved by a bank operating in a high risk country would, on average, be less. Under the revised criteria, country profiles are taken into account, and therefore for a bank operating in a higher risk country with a standalone credit risk anchor of BB or B-, slightly lower RAC ratios (moderate amounts of capital) falling just short of the usual 5-7% will not automatically see a rating reduced by one notch, as was previously the case. Risk adjusted capital frameworks (bank capital methodology) remain unchanged.

Finally, the BICRA methodology, while retaining its original structure, has been tightened somewhat. The criteria has been integrated more sovereign analysis in an attempt to make ratings more consistent. The BICRA methodology itself is designed to allow for evaluations and comparisons between global banking systems, with the system being given a BICRA score between 1 and 10, with 1 comprising the lowest risk groups and 10 the highest. A BICRA analysis for a country includes both rated and unrated financial institutions that take deposits and/or extend credit within a particular country. The new methodology takes a macroeconomic approach, looking at the entire financial system of a country and considering the relationship between the banking system and financial system as a whole, including the impact of non-bank market participants. The macroeconomic approach also assesses the influence of government supervision and regulation of the banking sector, including emergency support mechanisms, although note that targeted government intervention for systemically significant institutions is reflected through ratings uplift rather than BICRA.
The methodology remains divided into the two main areas of economic risk and industry risk, which are each further subdivided into three. Standard & Poor's claim that this will not only make the analysis easier for the user to assess, but will make bank ratings more consistent with their sovereign counterparts. Each factor is assessed for an economic and industrial score for each country - the BICRA score. The rating methodology for banks uses the economic and industrial profiles produced by the BICRA analysis to give an anchor which then acts as the starting point for determining the bank's stand alone credit profile (SACP). Following this, factors such as support from a government or parent group are considered before an overall rating is assigned.

The guidance notes go on to state that the creditworthiness of a sovereign and its banking sector are closely related, and that many of the factors underlying a sovereign rating are relevant in determining a BICRA score. Also, the sovereign rating methodology is applied in assessing sub-factor such as "economic resilience" and "economic imbalances". The methodology also recognizes that the influence of a sovereign's creditworthiness on the related BICRA is more pronounced when the sovereign's creditworthiness deteriorates.

In a paper written last year I suggested that greater amounts of end-user due diligence could be encouraged to relieve some of the excess reliance on market 'opinions' produced by credit rating agencies. The revision of analyses to enable users of ratings to more readily understand the methodology certainly goes some way towards increasing the transparency of the methods used and analysis undertaken by the agency and should be applauded. However we should be careful. The methodology is certainly more accessible, and Standard & Poor's are clearly aware that greater transparency of process is necessary for market trust and maintaining reputational capital. But we are still none the wiser as to the quality of information that goes in to the algorithms, or indeed what institutional and economic assumptions these latter are based on.

The new criteria are due to be applied in November/December 2011, and Standard & Poor's claims that the impact of the new methodologies will be less than previously feared, with 90% of new rating anticipated to remain within one notch of their previous rating. The agency claims that around 10% of A1 ratings will fall to A2 as a result of the revisions.

All criteria documents can be accessed online, and each has a straightforward explanation of the function and purpose of the criteria.

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