Ratings agencies use letter grades or other ranking systems to indicate creditworthiness. Credit ratings aren't an exact science. Rather, they're an opinion based on historical and forward-looking information about a corporation and its business environment, according to the Standard & Poor's "Guide to Credit Rating Essentials." Ratings are relative, not absolute, and none is a guarantee.
"For example, a corporate bond that is rated 'AA' is viewed by the rating agency as having a higher credit quality than a corporate bond with a 'BBB' rating. But the 'AA' rating isn't a guarantee it will not default, only that in the agency's opinion, it is less likely to default than the 'BBB' bond,'" the guide states.
Ratings also can be grouped into two broader categories: investment grade and noninvestment grade, Leggett says. A bank that gets a noninvestment grade rating, sometimes known as a "junk" rating, is more likely to be "really troubled," he says.
Most bank customers don't need to be concerned about a bank's credit rating for one good reason: deposit insurance backed by the U.S. government through the Federal Deposit Insurance Corp., or FDIC.
"For retail bank customers, (a credit rating) should be a nonissue because they have deposit insurance, and their funds aren't at risk," Leggett says.
FDIC insurance protects all bank deposit accounts up to $250,000 per depositor, per insured bank for each account ownership category, according to the FDIC. In some situations, depositors may have additional coverage, which is subject to federal law and FDIC requirements.
Credit line cuts
Those who have a sizable open-ended loan, such as a home equity or business line of credit, might be affected if a bank's creditworthiness slumps. That's because troubled banks typically need to preserve capital and improve liquidity, two aims that don't mesh well with big new loans, Leggett says.
"If a bank has slipped into a junk investment rating, a lot of times it isn't going to be in a position to extend credit," he says. "An institution in that situation probably would begin to start to rein in its credit lines."
A troubled bank also might be in cost-cutting mode, affecting customers in less-direct ways.
"(The bank) may begin looking at closing unprofitable branches and laying off employees. Those would be responses, especially if (the bank has) fundamental credit problems," Leggett says.
Bert Ely, a banking consultant with Ely & Co. in Alexandria, Va., also says customers who have a "substantial borrowing position" with a bank might want to keep tabs on that bank's financial condition.
But Ely also warns credit ratings are "notoriously inaccurate." He says borrowers "shouldn't put too much faith in them."
"Ratings are based on historic information with some projection of trends. But sometimes the information isn't good, and the projections are just that," he says. "Not that ratings should be totally disregarded, but they're not articles of faith and should not be treated as such."
The Securities and Exchange Commission recently issued its first-ever regulatory report about credit rating agencies. Focusing on 10 large agencies known as "nationally recognized statistical rating organizations," or "NRSROs," the report identified a number of concerns. Some of those included "apparent failures in some instances to follow ratings methodologies and procedures, to make timely and accurate disclosures, to establish effective internal control structures of the rating process and to adequately manage conflicts of interest."
The report also noted that "in some cases, the NRSROs have already taken steps to address such concerns."
One other limitation is credit ratings don't detect bank fraud, meaning that can be a risk for customers, even if the bank has a high rating, Ely says.
"Fraud is a cause of failure in small banks," Ely says. "We've seen a number of these situations over the years when banks looked perfectly healthy on the outside and didn't have credit quality problems, and suddenly internal fraud was discovered and the bank would fail."