Key Financial Indicators Used in Deriving Credit Ratings

LACE Financial assesses from main criteria of financial soundness (Liquidity, Asset Quality, Capital Adequacy, and Earnings) to determine the creditworthiness of an institution.  LACE also considers other factors, such as: management and control, country risk, and principal lines of business.

Liquidity

Liquidity risk is the risk to a bank's earnings and capital arising from its inability to meet obligations when they come due without incurring unacceptable losses.  Bank management must ensure that sufficient funds are available at a reasonable cost to meet potential demands from both fund providers and borrowers.  Although liquidity risk dynamics vary according to a bank's funding market, balance sheet, and inter-corporate structure, the most common signs of possible liquidity problems include rising funding costs, requests for collateral, a rating downgrade, decreases in credit lines, or reductions in the availability of long-term funding.  The sophistication of a bank's liquidity management process will depend on its business activities and overall level of risk.  However, the principles of liquidity management are straightforward: a well-managed bank, regardless of size and complexity, must be able to identify, measure, monitor, and control liquidity risk in a timely and comprehensive manner.

Traditionally, banks have relied upon retail transactions and savings accounts as a primary funding source.  These deposits generally represent a stable and low cost source of funds.  However, the repeal of deposit rate ceilings in the 1980's, along with the growth of alternative investment and savings vehicles available to consumers, have made the retention of core deposits more difficult.  For the past several years, core deposits as a percentage of assets have steadily declined.  The growth in, and consumers' acceptance of, internet banking and other technologies may accelerate this trend by making it easier for consumers to compare rates and to transfer funds between competing institutions easily and rapidly.  Banks are successfully adjusting to this shift by using market sources, including the Federal Home Loan Banks (FHLBs), to meet loan demand and investment needs.  By using market sources, banks are able to diversify their funding bases among funds providers and across maturities.  Increased reliance on market funding sources has left banks more exposed to the price and credit sensitivities of major funds providers.  Along with the shift from relatively credit neutral to credit sensitive funds providers, banks have turned increasingly to asset securitization and other off balance sheet strategies to meet their funding requirements.  As these off balance sheet activities have grown, they have become increasingly important in the management and analysis of liquidity.

Liquidity measures an institution's ability to meet its anticipated short- and long-term obligations to customers and creditors.  A high degree of liquidity enables an institution to meet unexpected needs for cash without the untimely sale of investments or fixed assets, which may result in substantial realized losses due to temporary market conditions or tax consequences.  Liquidity for financial institutions is difficult to measure since their liquidity position changes daily and the data reflected in the financial statements may not reflect their current position.  It is important to measure liquidity, however, because a lack of liquidity may bring about the failure of the bank when financial problems become apparent.

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Asset Quality

The measurement used to assess a bank's asset quality is its amount of nonperforming assets.  Nonperforming assets is a term used to describe assets on which revenue recognition has been discontinued or is restricted.  Nonperforming assets include both nonperforming loans and securities and acquired property, primarily other real estate owned acquired in connection with the collection effort on loans.  Financial institutions generally fail due to a large percentage of nonperforming assets as compared to total capital and loan loss reserves.  Asset quality also affects earnings through provisions to the loan loss reserve. An inadequate reserve will require additional provisions, which reduces earnings. Poor asset quality can also affect earnings through reduced interest income.  Loans, which are past due and are not paying interest as scheduled, have a negative impact on interest income.

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Capital

A bank's capital position is of paramount importance to its overall financial condition. Earnings are the primary means for banks to increase capital internally, which is accomplished through retained earnings (net income less dividends paid).  For many small community banks, retained earnings are even more important, because they are often the only practical source of capital.  If a bank is not profitable, losses will decrease its capital strength, which may ultimately affect the institution's overall safety, soundness and viability.  Because of banks' multiple functions, the great degree of leverage they employ in carrying out their economic role, and their access to a safety net, society has a keen interest in the health and well-being of the banking system.  The level of government regulation and supervision, unique to insured depository institutions, has evolved over the years.  Only in recent years, however, have U.S. banking agencies established specific standards for capital in relation to the risk of loss rather than simply commenting on institutions' capital adequacy to managers and boards of directors on a case-by-case basis, often in qualitative terms.  LACE Financial measures capital strength mainly through the institution's amount of regulatory capital (through combinations of equity, loan loss reserves, subordinated debt, and other accepted instruments) as compared to its risk-weighted assets (loans and securities, for example) and asset equivalent off-balance sheet exposures (such as loan commitments, standby letters of credit, and obligations on derivative contracts).  Analyzing a bank's capital level in this way increases the emphasis on common equity and restricts the amount of loan loss reserves that can be counted as capital. It also recognizes the relative degree of credit risk associated with various assets by setting different capital requirements for some assets that clearly have less credit risk than others.

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Earnings

As described above, a bank's capital strength is of paramount importance to its overall financial condition and earnings are the primary means for banks to increase capital internally, specifically through retained earnings.  Earnings help an institution; cover expenses, provide for loan and other losses, support growth, add to capital and pay dividends.  Earnings also provide insurance against losses, are a means to support asset growth, and support the bank's ability to pay dividends to shareholders, which can improve its ability to raise capital externally.  The institution's dividend policy is of importance since excessive dividends can weaken a bank's capital position.  A history of low dividend payments may impede efforts to issue new equity.  Banks located in rapidly growing markets must be attentive to their rate of earnings' retention so they may properly plan for new capital funds as needed.

For most banks, the loan portfolio comprises the majority of earning assets.  Interest income can be derived from other earning assets and when analyzing the institution, the relative importance of each type of interest income to overall interest income should be taken into account.  Noninterest income is typically the second largest source of revenue for a bank.  It consists of fees and charges that are not interest related, such as; service charges on deposit accounts, trust income, other real-estate owned rental income, gains/losses on trading accounts assets, and fees and commissions for other services and activities.

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Description of the LACE Rating Service

LACE rates approximately 19,000 FDIC-insured U.S. banking institutions on a quarterly basis using a uniform set of criteria.  The financial condition of all institutions is reviewed quarterly based on a subjective analysis that may cause a change in the objective rating.  Data for newly chartered institutions are shown but the institutions are not rated until they have been in existence for three years.  The criteria used in the rating system are based on a concept of financial soundness that evolved from extensive research dealing with bank failures and from current federal bank examination procedures.  By measuring and aggregating ratios representing Liquidity, Asset quality, Capital, and Earnings (LACE), ratings are derived from "A+" to "E" four times a year for the following peer groups using data from the Reports of Condition and Income that are filed with federal bank regulators.

Peer Group 1: Megabanks
Peer Group 2: Large Regional Banks
Peer Group 3: greater than $3 billion and less than $10 billion
Peer Group 4: greater than $1 billion and less than $3 billion
Peer Group 5: greater than $300 million and less than $1 billion
Peer Group 6: greater than $100 million and less than $300 million
Peer Group 7: greater than $50 million and less than $100 million
Peer Group 8: greater than $25 million and less than $50 million
Peer Group 9: greater than $10 million and less than $25 million

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The LACE Rating Criteria

The LACE rating criteria derives a financial rating based on key financial ratios representing Liquidity, Asset quality, Capital, and Earnings (LACE). Absolute tests determine if there is a significant difference between a current ratio and the ratio value for a normal. The purpose of these tests is to identify a significant deterioration in the financial soundness of an institution within a peer group. If one were to rate an institution objectively only on a peer basis alone, a major deterioration in a institution's financial condition may not be picked up in the ratings. A score of financial soundness is then derived for each institution and mapped into a financial rating ranging from "A+" to "E". For larger bank holding companies, a separate financial analysis in performed each quarter that re-evaluates their ratings. Discussions with management may occur when we feel a major downgrade is warranted, or when we feel that a smaller institution maybe in danger of failing. Releases are sent to our clients when a large domestic or foreign bank is significantly downgraded, and each quarter additional releases are sent to clients about institutions whose financial condition is of concern to LACE. To evaluate the measure of financial soundness of our ratings, the ratings can be compared to the Federal Bank Regulator's CAMEL System as shown below:

Given accurate reporting of the institution's financial condition, it is likely that the LACE Rating® will closely approximate an institution's CAMEL rating if the CAMEL rating is current and is based primarily on financial factors. The LACE rating is likely to be more current than the CAMEL rating because LACE rates four times a year where the CAMEL rating is derived at most, twice a year. The LACE rating does not rate management, which may explain some difference in the ratings. LACE Financial considers the derived credit rating to be the rating management should receive. In several talks with bank management we have found that the LACE rating maybe more conservative than the CAMEL rating.

Under the LACE Rating System, weights on key financial variables can shift depending on other financial factors. For example, if asset quality, capital and earning conditions of a bank are sound then the liquidity weight is relatively low. However, if any of these factors weaken significantly, or in aggregate for a bank that is dependent on borrowed funds, then the liquidity factor is given greater weight. 

Evaluating the Financial Condition of an Institution

A downward trend in the LACE Rating is a likely indicator of deterioration in the institution's financial condition and a steady increase in the rating generally signals an overall strengthening of the institution's financial position. A high steady "A" or "B+" rating indicates a strong financial condition.  Most institutions will fall into the "A" and "B" rating categories.  Institutions having a "C" or below rating are considered below investment grade.  These banks are likely to have either a relatively weak overall financial condition or a weakness in one more of the key financial ratios, likely falling into the bottom quartile of their peer group.

"D" and "E" rated institutions are likely to have financial problems (poor LACE financial ratios) and careful consideration should be made about investments in these institutions.  These entities are likely to have a higher probability of failure than institutions with higher ratings.  Under the LACE Rating® caption, an "NB", "NT", or "NCU" institution stands for a new bank, thrift, or credit union, respectively, whose charter is less than three years old.  An "NR" stands for not rated. Institutions receiving an "NR" are atypical institutions that LACE Financial Corporation has decided not to rate, or there maybe incorrect or missing data.  It should be noted that fraudulent reporting by institutions of their financial data may result in incorrect LACE ratings.  The ratios listed below are some of the key indicators of an institution’s financial soundness used in the LACE Financial Rating System.

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