DBRS Releases Global Methodology for Rating Banks & Banking Organizations

DBRS has released today an updated methodology for rating banks and banking organizations, entitled “Global Methodology for Rating Banks & Banking Organisations”. Drawing on our earlier methodologies that are country or region specific, this methodology is global in scope. Our focus in this methodology is on banks, but the methodology can also be applied, where appropriate, to other forms of financial institutions that offer deposits or extend credit and are extensively regulated. While there are considerable variations across countries and continents in the structure of banking industries and financial sectors, the characteristics of banking have more in common across countries than these differences. Therefore, in accordance with our objective of maintaining globally consistent credit ratings, it is appropriate to have a common methodology that unifies how DBRS rates banks globally. This methodology nevertheless seeks to take into account the differences across countries in important elements of the environment that impact the credit fundamentals of banks and other financial institutions. It also adjusts for changes over time in the environment within which banks operate.

Despite the turmoil of the current financial crisis, our methodology continues to provide an effective approach to determining bank ratings. The analysis rests on five interlocking building blocks that address the essential elements that underpin a bank’s intrinsic strength. These are:

• Franchise Strength
• Earnings Power
• Funding and Liquidity
• Risk Profile and Risk Management Processes
• Capitalisation: Structure and Adequacy

By integrating these interconnected elements of a bank’s strength, this framework facilitates the evaluation of a bank’s overall strength. DBRS considers these building blocks to be significantly interrelated with each building block an essential element in the overall assessment. Accordingly, our ratings for a bank reflect the interdependent nature of a bank’s ability to meet its obligations in a timely manner, rather than a simple additive weighting scheme.

While the framework of our methodology is unchanged, the current crisis has resulted in additional focus in certain areas. In evaluating franchise strength, for example, the analysis is broadly unchanged, but the sustainability of franchises that rely on wholesale funding now receives more attention. Banks’ success in refocusing on their core franchises and shedding noncore businesses is an area of current concern. In assessing a bank’s capacity to generate earnings, there is also more attention on how earnings could be impacted by disrupted markets and loss of access to funding. Given the wide range of events that disrupted financial markets, the analysis of liquidity and funding has many more stressful scenarios to consider in evaluating this building block. Given that we are still in the midst of a severe economic downturn in most countries, our current analysis of risk management is focused on how banks are managing through this stressful environment. We are also concerned with how banks are enhancing their processes to better understand their risk profiles and potential stress given the still fragile financial markets and the nascent recovery in the global economy.

As for bank capitalisation, we continue to take a matrix approach by utilising various measures in this assessment, as there is no single measure that captures both the strength of a bank’s capital and its need for capital, including regulatory requirements. We still see common equity as the best form of capital to enable a bank to cope with stress. Like the markets and regulators, our analysis in the current environment leads us to expect banks to have better capitalisation relative to their franchise strength, earnings power and risk profile. Depending on the country, that generally means larger capital cushions above higher implicit minimums for capital with greater common equity content. As we have not utilised an equity credit approach to hybrids, our analysis has not needed to adjust for the shifting market perception of the contribution of these instruments. With regulatory regimes evolving both nationally and internationally, we will continue to adjust our analysis to reflect new requirements that are likely to affect franchise strength, liquidity requirements, risk management and capitalisation, especially for banking organisations that have significant international operations.

Our methodology endeavours to rate through the cycle. Our analysis also recognises that some cycles can have a much more extensive impact on financial institutions than a typical cycle. This impact can vary with the characteristics of each institution, as well as across countries. The current cycle is exceptional in the breadth and depth of the deterioration among financial institutions and markets that has also varied across countries. Various errors in risk management, which may have been manageable separately, combined to inflict widespread damage on banks, financial markets and subsequently the global economy. See, for example, “Seven Deadly Errors of Risk Management”, a DBRS newsletter published in June 2009. In some countries, major financial institutions were permitted to fail and others came close.

This cycle has been unique in the extent of government support for banks and financial markets. We continue to ascribe a limited uplift to most banks that are designated as systemically important, typically adding a single notch to their intrinsic assessment. To address the extensive government actions to support their financial markets in the midst of the worst of the crisis, we introduced the concept of floor ratings for critically important banking organisations on a country by country basis, where the need and level of support made this appropriate. With the widespread discussion of constraining implicit support and eliminating “too big to fail”, our approach to systemic support will evolve to the extent that change is realised.