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Launching Our European Bank Credit Ratings

Over 20 European banks have been added to Morningstar's Corporate Credit Rating Service, plus several from Latin America

Jim Leonard, CFA 7 October, 2011 | 3:28PM

In late 2009, Morningstar announced the launch of corporate credit ratings, initiating coverage on 100 firms. Since then, we've published ratings on nearly 700 firms across a variety of industries, including the July 2010 launch of our U.S. bank credit ratings. We are now pleased to announce that we are adding global banks to this roster of companies, albeit with a few modifications to our U.S. bank rating methodology.

While our system for rating global banks is similar to the methodology used for U.S. banks--emphasising economic moats and competitive analysis, a bank's ability to handle stress-case scenarios, and its overall solvency--there are a few important differences. For example, we have incorporated country risk into the Business Risk Score, and we have changed our Distance to Default methodology to a market-based approach utilising credit spreads. Like U.S. banks, however, the global bank rating methodology is based upon four key pillars:

-- We evaluate a firm's moat and other core business characteristics in a Bank Business Risk Score

-- The Stress Test Score incorporates a bank's loan mix, along with our analysts' estimates of underwriting prowess and future income. These metrics allow us to clearly evaluate a bank's ability to handle macroeconomic stress

-- The Bank Solvency Score ranks a financial institution's performance in terms of capital adequacy, asset quality, earnings power, and liquidity against hundreds of its peers

-- For global banks, our market-driven Bank Distance to Default Score uses credit default swap (CDS) spreads to evaluate default risk instead of our traditional method, which uses quantitative option pricing theory

I. Bank Business Risk Score
The Business Risk Score for global banks is based on the same six elements that are used for U.S. banks, but with an added seventh element: country risk score. This additional element is based on the current sovereign debt CDS spread. Each of these elements evaluates a different aspect of the risk associated with a particular financial institution:

Economic Moat Rating
An essential part of our company analysis is the Economic Moat rating, which encapsulates our view as to a company's competitive advantage, and its ability to earn excess returns on capital.

Uncertainty Rating
Morningstar's Uncertainty Rating represents our estimate of the predictability of future cash flows to equity holders. Because equity represents a firm's residual value after satisfying creditors, it represents a cushion against losses for bondholders.

Size
Larger financial firms benefit from greater access to the capital markets.

Management Grade
Our analysts assign companies a Stewardship Grade, which captures our view of both corporate governance practices and management's skill. The Stewardship Grade is adjusted as necessary to reflect a management team's concern for the interests of bondholders.

Dependence on Capital Markets
We score financial institutions based on their need to access the capital markets. For example, a firm that depends on short-term repo funding is far more vulnerable than one funded by low-cost core deposits.

Geographic/Business Line Concentration
In general, firms concentrated in one geographic area or business line are more vulnerable than those with more diverse operations. Companies with a variety of loan types, geographic exposures, and sources of fee income score higher than highly concentrated firms.

Country Risk
For non-U.S. institutions, we use a market-based indicator to reflect the creditworthiness of the firm's home country. A higher sovereign CDS spread equates to a higher market implied risk for the home country, and a lower score.

II. Bank Solvency Score
In developing the Bank Solvency Score, Morningstar bank analysts selected six accounting ratios measuring capital adequacy, asset quality, earnings power, and liquidity for financial institutions. For non-U.S. banks, analysts selected a similar array of metrics that qualify institutions based on the same qualities. The main difference is that whereas U.S. firms' scores are based on a relative basis, non-U.S. companies' metrics are scored against a fixed set of thresholds.

III. Bank Stress Test Score
The Morningstar Bank Stress Test Score evaluates a bank's ability to handle additional macroeconomic stress and consequent losses in its loan and securities portfolios. Based on the stress tests conducted under the Supervisory Capital Assessment Program, the Stress Test Score differs in two important ways. First, it is conducted on a rolling basis each quarter. Thus, it continually measures a bank's ability to handle additional stress beyond any losses that are already recognised, whereas the SCAP tests were conducted on a one-time basis. Second, the Bank Stress Test Score utilises Morningstar analysts' forecasts of future pretax, preprovision earnings and expenses for individual banks--the same forecasts used in our discounted cash flow models for equity valuation. In contrast to the relative rankings produced by the Bank Solvency Score, the Bank Stress Test Score produces an absolute measure of capital. Therefore, the average Bank Stress Test Score across our coverage universe will increase as total banking system capital increases, and decrease when financial companies add leverage, potentially providing an early warning in boom times, and an indication of safety in times of crisis. For non-U.S. institutions, a wider range of loss rates is available to analysts. Also, non-U.S. institutions' estimates of pre tax, preprovision earnings are reduced in the stress scenario by 5%, 25%, or 50%, depending on how resilient the company's income is, as assessed by the analyst. These three haircut rates are in line with how banks have fared in past crises.

IV. Bank Distance to Default
For non-U.S. institutions we use five-year CDS spreads instead of our traditional Distance to Default quantitative score. We rank order the CDS spreads for the world's largest financial institutions, and partition the list into nine separate buckets. We then score banks based on their place within the distribution. In case there is not an active market for a company's CDSs, we derive an equivalent spread using its corporate bond yield. This exercise is performed on a monthly basis. However, revisions are more frequent during rapidly changing market conditions.

Morningstar's Global Bank Credit Ratings
Skandinaviska Enskilda Banken (SEB) Credit Rating: A
Svenska Handelsbanken (SHB) AA+
Intesa Sanpaolo (ISP) BBB
Unicredit SpA (UCG) BBB
Bank Bradesco (BBD) BBB+
Itau Unibanco (ITUB) BBB+
Banco Santander Brasil SA (BSBR) BBB+
Banco Santander Chile (SAN) A-
Banco Popular Espanol (POP) BBB-
Banco Santander SA (SAN) BBB+
Banco Bilbao Vizcaya Argentaria (BBVA) BBB+
Commerzbank (CBK) BBB+
Deutsche Bank (DBK) A
Credit Suisse Group (CSGN) A+
Julius Baer Group (BAER) A+
UBS (UBSN) A
KBC Group (KBC) BBB
BNP Paribas (BNP) A
Credit Agricole (ACA) A-
Societe Generale (GLE) A-
Barclays (BARC) A-
HSBC (HSBA) A+
Lloyds Banking Group (LLOY) BBB
Royal Bank of Scotland (RBS) BBB+
Standard Chartered (STAN) A+

Read in-depth reports into the five U.K. banks' credit ratings here.

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About Author

Jim Leonard, CFA  James Leonard, CFA is a securities analyst for Morningstar, covering financial institutions.