Using a U.S. Bank Regulatory Approach to Explain Bank Financial Strength Ratings

• Author: John A. Ruddy
• Published date: 01 July 2018
• DOI: http://doi.org/10.1002/jcaf.22345
• Date: 01 July 2018

USING A U.S. BANK REGULATORY

APPROACH TO EXPLAIN BANK

FINANCIAL STRENGTH RATINGS

John A. Ruddy

INTRODUCTION AND

BACKGROUND

This article

focuses on Bank

Financial Strength

ratings (BFSRs), a

specialized rating

type provided by

Nationally Recog-

nized Statistical Rat-

ing Organizations.

Moody’s Investors

Service first created

BFSRs in 1995 when

it issued BFSRs on

288 U.S. Banks.

Moody’s created

BFSRs to provide

investors with a mea-

sure of a bank safety

and soundness. Moo-

dy’s began issuing

BFSRs in response to

investor requests,

which had asked for

an assessment of

bank credit profiles

without consideration

of external support

mechanisms such as

owners/shareholders,

bank holding compa-

nies or affiliate insti-

tutions. BFSRs more

closely reflect each

individual banking

institution’sfinancial

fundamentals without

regard to ownership

support or support

from related entities.

BFSRs consider fac-

tors such as an insti-

tution’s recent

financial perfor-

mance, its financial

resources, its quality

of regulatory supervi-

sion, and its eco-

nomic operating

environment. BFSRs

typically do not con-

sider sovereign risk

matters and do not

address the probabil-

ity of a financial insti-

tution’s timely

payment of its

obligations.

U.S. bank regulators require financial institutions to

file quarterly financial reports, which are then

available for public use. This research considers

whether data constructed from regulatory filings

explain bank financial strength ratings. We examine

a dataset with variables on over 6,000 banks. The

variables include the topics of bank capital, asset

quality, management capacity, earnings, liquidity,

and sensitivity to market risk. We found that one

variable each from the above selected topic areas

explain nearly 60% of bank financial strength

ratings. Prior research attempted to explain and

predict bank financial strength ratings (Hammer,

Kogan, & Lejeune, 2012; Poon, Firth, & Fung,

1999). Since the 2007–2010 financial crisis, prior

research has also attempted to predict the financial

strength ratings of Turkish banks (Ö

güt, Do

ganay,

Ceylan, & Aktas, 2012), the performance of

South African banks (Kumbirai & Webb, 2010) and

bank performance in Malaysia and China (Said &

Tumin, 2011). We utilize variables from a bank

regulatory model to determine how well they

explain financial strength ratings. Our research

adds to the literature by considering nearly the

entire population of U.S. banks across time periods

not previously considered. © 2018 Wiley Peri odicals, Inc.

© 2018 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22345

70