Bank Credit Rating Dynamics

Abstract

An increase in the credit rating on the debt of an organisation is generally perceived positively, as higher credit ratings are, in the main, associated with lower perceived volatility in the market value of the assets of the entity that has issued debt. Lower asset volatility implies more stable and sustainable cash flows, and thus a lower likelihood of default on debt, and the result is a lower credit spread on the debt. If banks price their assets to realise a target return on economic capital, then a higher credit rating will result in higher loan rates if the fall in the bank's cost of capital, associated with the lower insolvency risk, is insufficient to offset the additional net income that the loan must be priced to cover. In this paper we develop a loan pricing model that assumes that financial institutions price their assets on a risk- and cost-adjusted basis and with the aim of achieving a minimum required return on the bank's economic capital holding. We compare theoretically derived decreases in the bank's cost of funds to actual data on bank credit spreads in order to ascertain the extent to which the increase in credit rating is beneficial to the bank. We find that the minimum decline in the cost of funds in our model generally exceeds the empirical data, meaning that the reduction in funding costs is insufficient to offset the increase on loan rates associated with higher economic capital. The divergence increases as the proportion of retail funds increases. We further find that the hurdle rate on economic capital is a significant factor in determining the value of a bank increasing its solvency standard. If the hurdle rate remains fixed regardless of the capital structure of the bank, then an upward movement in credit rating may have little impact on the value of the bank given the large divergence between the theoretical decline in the cost of wholesale funds and empirical data on bank credit spreads. However, the divergence is considerably less pronounced if the hurdle rate is varied in direct proportion to the leverage of the bank.