A bank rating is there to determine the safety and soundness of a bank.
A bank rating will usually assign a letter grade or numerical ranking, based on proprietary formulas. These formulas typically originate from the bank’s capital, asset quality, management, earnings, liquidity, and sensitivity to market risk.
There are also credit analysis ratios that can be used as part of a credit analysis process to analyse the creditworthiness of an institution.
Analysts use ratios in order to paint an exact picture of a business’ financials. Most banks have their own credit rating mechanism.
The profitability studies the ability of the bank to generate revenues capable of covering costs. As a first look, the institution has to register positive economic results; otherwise this is a first warning of something going wrong.
As this can means a bank is incapable of managing costs in accordance to revenues. It depends on the size of the loss, but negative results erode equity and, as a consequence, reduce bank’s own resources.
The ratios are:
- Return on Asset (ROA) = Net Income (Loss)/Total Assets (how profitable are total assets).
- Return on Equity (ROE) = Net Income (Loss)/Equity (how profitable is equity).
- Interest Income on Loans = Interest Income on loans/Gross Loans (how are profitable gross loans).
This area examines one bank’s ability to meet its short term obligations. In the last years, above all in Greek banks, we assist to the phenomenon of the so called ‘bank run’.
This happens when a large number of customers of the bank withdraw cash from deposit accounts at the same time because they believe the institution could become insolvent. This event, also if the bank was not already insolvent, could cause bankruptcy of the institution.
As a consequence, regulators start to pay attention on liquidity ratios capable of analysing if the bank has necessary funds to face this event.
Some of the ratios are reported below:
Short term Funding = Liquid Assets/Short Term Funding, looks at if the bank has sufficient liquid resources to face short term debt, if requested.
Loans Deposits = Loans/Deposits. In some countries there are restrictions on this ratio where are considered Loans to customer (in total assets) and customer deposits (liabilities) that has to be lower than 100%. Sources and the funds have to be balanced so it’s better the bank has the same level of customer deposits and loans.