Wednesday, January 4, 2012

Bank ratings migration is an attempt to fix old errors

Here is a recent chart from Fitch that shows ratings migrations for US banks between 2007 and 2011. The trend makes sense in terms of what has transpired during this period as the whole ratings distribution was shifted down.

Banks ratings migration (Fitch)

But take a second look at these results. Ratings are supposed to represent credit risk. Therefore this is telling us is that there is more risk in the US banking system now than there was in 2007. Really?

The chart below shows the core capital ratio for all FDIC insured institutions. It represents tier-1 capital as a percent of average total assets (with some adjustments per FDIC). This is telling us that bank capitalization in the US has improved significantly since 2007.

US bank capital ratio (FDIC, Bloomberg)

The weaker banks - 417 of them - have been closed since 2007.  So how is it that according to Fitch US banks are more risky now? Maybe it has to do with bank ratings being incorrect to begin with - possibly off by several notches. And maybe this "rating migration" is simply an attempt to correct that error.

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