How can you use external ratings to evaluate banking risks?

1 Step 1: Understand the rating scale

The first step is to understand the rating scale used by the external agency. Each agency has its own rating system, but they generally follow a similar pattern of assigning letters and symbols to indicate the relative quality and risk of a bank. For example, Moody's uses a scale of Aaa to C, where Aaa is the highest rating and C is the lowest, and adds numerical modifiers (1, 2, or 3) and outlook indicators (positive, negative, or stable) to provide more details. You can find the rating definitions and criteria on the agency's website or report.

2 Step 2: Compare ratings across banks

The second step is to compare ratings across banks to get a sense of how they perform relative to each other and to the industry average. You can use rating tables, charts, or databases to compare ratings across banks on various dimensions, such as asset size, capital adequacy, profitability, liquidity, and business diversification. You can also look at the rating trends and changes over time to see how a bank's risk profile has evolved. By comparing ratings across banks, you can identify the strengths and weaknesses of each bank and the potential sources of risk.

3 Step 3: Analyze the rating drivers

The third step is to analyze the rating drivers, which are the factors that influence the rating decision of the external agency. These factors can include macroeconomic conditions, regulatory environment, competitive landscape, strategic direction, financial performance, risk management, and governance. You can find the rating drivers in the agency's report or press release, where they explain the rationale behind the rating and the key challenges and opportunities for the bank. By analyzing the rating drivers, you can understand the underlying causes and implications of the rating and the possible scenarios that could affect it.

4 Step 4: Incorporate ratings into risk assessment

The fourth step is to incorporate ratings into your risk assessment, which is the process of identifying, measuring, and managing the risks that affect your banking activities. You can use ratings as inputs, outputs, or benchmarks for your risk assessment models and tools, such as credit scoring, stress testing, capital allocation, and portfolio optimization. You can also use ratings as indicators, triggers, or thresholds for your risk monitoring and reporting systems, such as dashboards, alerts, and limits. By incorporating ratings into your risk assessment, you can enhance your risk awareness and decision making.

5 Here’s what else to consider

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