Friday, March 09, 2007

Bank Debt Rating Methodologies Used by Rating Agencies

The Globe and Mail, Harry Koza, 9 March 2007

It's been a long time since any Canadian bank went belly up, but that doesn't mean debt-rating agencies shouldn't keep a close eye on them.

Moody's Investors Service Inc. announced its amended ratings of the big Canadian banks last Friday.

Using joint-default analysis (JDA), Moody's raised Toronto-Dominion Bank and Royal Bank of Canada's senior debt ratings to Aaa, from, respectively Aa3 and Aa2. TD also had its subordinated debt raised one notch from A1 to Aa3, and its BFSR (Bank Financial Strength Rating, on a scale from A to E) raised to B+.

Bank of Montreal, Bank of Nova Scotia and Canadian Imperial Bank of Commerce all had their senior debt ratings raised two notches, from Aa3 to Aa1. National Bank of Canada and Caisse Centrale Desjardins du Qu├ębec were raised three notches, from A1 to Aa1. CIBC had its subordinated debt rating lowered one notch, from A1 to A2.

The net effect of all this on the prices of the bonds issued by these banks was, er, zero. As usual with most things in the bond market, by the time the changes were finally announced, they were already priced in.

I had intended to regale you (perhaps not the best phrase to use when describing credit ratings) this week with more about the mechanics behind JDA and the BFSR. Let's keep it simple, though: The BFSR is a measure of a bank's stand-alone financial strength, and the final rating using JDA measures the degree of external support in case of problems, not just support from the federal and local governments where the bank is based, but also from its parent companies, co-operative or mutual groups, and central banks.

Moody's says it always took this kind of external support into consideration in making its bank ratings, but made the changes in methodology to make the whole process more transparent and more quantifiable. Fair enough. It'll take a little getting used to, but the market is already taking the thing in stride.

The other big rating agencies, Standard & Poor's Corp. and DBRS Ltd., were quick to issue new explanations of the way that their ratings methodologies also account for external support for banks. Their approaches are a little different, so I thought it might be interesting to compare them.

DBRS says the level of expected external support for banks is an important factor in determining a bank's credit rating, but since that support is not explicit (there are no guarantees spelled out), an assessment of that support is very subjective. DBRS does not attempt to quantify the probability of external support, but rather assesses the impact on the Canadian financial system if the health of one of our big banks deteriorated.

First, the rating agency makes an intrinsic assessment of the bank's credit fundamentals. For the Big Six, CIBC and National Bank are A (High), while Bank of Montreal, Scotiabank, Royal Bank and TD are all double-A (Low). (DBRS, S&P and Moody's all use slightly different letter systems for their ratings. You can find definitions of the various ratings levels on the rating agencies' websites).

This intrinsic assessment is then added to a support assessment, or SA. All the Canadian banks have an SA2 rating, which, when added to the intrinsic assessment, yields final ratings on deposits and senior debt one notch higher than the intrinsic ratings, so CIBC and National are double-A (Low), and the other four are double-A.

The support assessment is based on each of the banks' roles and participation in the national clearing and settlement system and their contribution to the overall deposit system. These are all things that are controlled by the Bank of Canada, which has authority for the oversight of the clearing and settlement systems in Canada in order to control any systemic risk. Systemic risk is the risk that the default of any one bank in the settlement system could generate a chain reaction, leading to defaults at other institutions.

S&P uses fundamental credit analysis, plus each country's BICRA (Bank Industry Country Risk Assessment), as well as an evaluation of whether the bank's host country is interventionist, supportive, likely to let market forces sort things out, or some combination thereof. Banks in interventionist countries like Japan are generally rated a notch higher than their stand-alone metrics would indicate.

So, the ratings agencies use different methodologies and have different acronyms for them, but all are laudable attempts to account for different countries' varying financial infrastructure, supportive (or not) regulatory frameworks, and country risk. That's good.

Fortunately, bank failures in Canada are few and far between. The most recent occurred in 1985, when Canadian Commercial Bank and Northlands Bank went belly up, and that was the first time in more than 60 years. CCB failed only after unsuccessful rescue attempts were made by provincial and federal governments, as well as by other domestic banks. It's an interesting tale of dodgy loans and auditors who gave the books little more than -- as the Estey Commission set up to investigate the collapse put it -- "a nod and a wink." Next week, we'll take a look at the failure of CCB as an object lesson in why all this ratings stuff is so important to bond market participants (and bank customers).