Asset Quality Rating

What Is an Asset Quality Rating?

An asset quality rating alludes to the assessment of credit risk associated with a particular asset, like a bond or stock portfolio. The level of productivity wherein an investment manager controls and monitors credit risk intensely impacts the rating bestowed.

Since asset quality is an important determinant of risk that significantly impacts liquidity and costs, analysts take great measures to ensure they issue the most accurate evaluations conceivable. To be sure, their pronouncements can greatly affect the overall condition of a business, bank, or portfolio for quite a long time into the future.

Understanding Asset Quality Ratings

Analysts consider a multitude of factors while giving asset quality ratings, including portfolio diversification, operational effectiveness, and how existing regulatory structures might limit credit risk.

A rating of "one" may signal that an asset has high quality with little credit risk. Such a rating would probably be assigned to ultra-secure U.S. government Treasury bills (T-Bills). At the flip side of the spectrum, a rating of "five" would probably be given to assets with significant credit deficits, for example, high-risk corporate-issued junk bonds.

Asset Quality and Bank Financial Stability

Asset quality is likewise an important determinant of the overall financial condition of a bank. For banks, the primary factor affecting overall asset quality is the quality of their loan portfolio and their credit administration program.

Loans typically contain a majority of a bank's assets and carry the greatest amount of risk to their capital. Securities may likewise include a large portion of the assets and furthermore contain significant risks. Other items which can impact asset quality are other real estate, other assets, off-balance sheet items, and less significantly, cash and due from accounts, real estate holdings, and fixed assets

The asset quality rating of a bank reflects its existing and potential credit risk associated with its loan and investment portfolios, other real estate owned, and other assets, as well as off-balance sheet transactions.

Asset Quality Ratings Definitions

The FDIC has established asset quality rating definitions that are applied to banks following a thorough evaluation of existing and potential risks and the mitigation of those risks. The definitions of each rating are as per the following:

• A rating of 1 indicates strong asset quality and credit administration practices. Identified shortcomings are minor in nature and risk exposure is modest in relation to capital protection and management's abilities. Asset quality in such institutions is of negligible supervisory concern.
• A rating of 2 indicates satisfactory asset quality and credit administration practices. The level and severity of classifications and other shortcomings warrant a limited level of supervisory attention. Risk exposure is commensurate with capital protection and management's abilities.
• A rating of 3 is assigned when asset quality or credit administration practices are not exactly satisfactory. Trends might be stable or indicate deterioration in asset quality or an increase in risk exposure. The level and severity of classified assets, other shortcomings, and risks require an elevated level of supervisory concern. There is generally a need to further develop credit administration and risk management practices.
• A rating of 4 is assigned to financial institutions with deficient asset quality or credit administration practices. The levels of risk and problem assets are significant, inadequately controlled, and subject the financial institution to potential losses that, whenever left unrestrained, may threaten its viability.
• A rating of 5 represents critically deficient asset quality or credit administration practices that present an imminent threat to the institution's viability.

Highlights

• The highest-quality assets are Treasuries and other highly-rated bonds.
• Asset quality rating surveys the relative riskiness of assets held in a portfolio.
• Banks evaluate the asset quality (given a score of 1 to 5) of their loan and securities portfolio to determine their financial stability.