Ratings

Potential external support from the government or the private sector has long been a basic and positive element of Standard & Poor's Ratings Services' credit ratings on banks. Nonetheless, we do not believe it possible to rigorously quantify the probability that a government will support a private-sector bank and ensure timely repayment of all its unsecured debt obligations. Our credit ratings reflect fundamental analysis of institution-specific and environmental factors, including external support.

Support takes different forms, depending where the bank is located. Many emerging market governments tend toward direct intervention and rescue of failing banks, while developed economies mostly rely on prudential supervision and private-sector buyouts to manage cases of troubled financial institutions. State policy and track record in governing the banking sector determine Standard & Poor's analytical approach to integrating potential future external support in bank credit ratings. In interventionist countries where we expect the government to intervene directly to rescue a failing bank, our analytical approach is to lift the ratings on systemically important private-sector banks one or more notches over the stand-alone ratings on the banks. This approach is mainly used in emerging markets.

In developed economies, protecting the financial system is achieved through proactive banking regulation, the maintenance of central bank liquidity facilities, and an effective legal system. We take these and other system-wide factors into consideration in our banking industry country risk assessments, which establish a comparative benchmark for the overall creditworthiness of a country's banks.

The relatively recent upswing in Standard & Poor's bank ratings in mature markets has been driven by the strong financial and commercial fundamentals of the global sector as opposed to increased expectation of future government rescue. At present, the leading banks of mature economies have very high credit ratings, reflecting very low probabilities of default. Differences in the ratings on these banks reflect small but significant differences in their credit profiles. The global industry outlook is broadly stable.

We believe that although governments in mature markets often have rescued failing banks in the past, future bailouts might be limited by budgetary constraints, multilateral agreements (such as those in the European Union), and increased regulatory emphasis on market-oriented policies that promote market discipline. For many years, the market-wide trend has been toward private-sector solutions for troubled banks that sometimes involve investor losses or purchase by private equity firms.

Banks play a crucial role in the national and international economy. They safeguard and allocate savings and investment, intermediate financial exchanges, administrate payment systems, implement monetary policy, and promote economic growth. A vital mission of governments and their financial sector regulators is to ensure the soundness of the financial system and avoid the systemwide damage that would be triggered by the collapse of a major bank.

Private participants in the markets also are keen to prevent bank failures and limit disruptions in the financial system. Consequently, when a sizable or strategic institution runs into difficulties, the government and private sector usually act together to manage the problem and prevent outright default. In mature economies, the rescue of a failing bank typically is orchestrated by the private sector--with some behind-the-scenes help from banking regulators--in the form of a takeover of the failing institution by a larger and stronger banking group.

Nevertheless, banks can and do fail. Regulators balance the need to promote stability with the need to establish market discipline and ensure that bank owners and managers prudently operate their banks. A blanket policy to bail out failing banks creates the moral hazard of relieving bank managers and creditors of responsibility for the consequences of their actions, thereby weakening prudential bank management and market discipline. In addition, governments are subject to limits in the use of public funds to pay off private creditors.

Standard & Poor's approach to reflecting external extraordinary support in the rating of private sector financial institutions rests on an analysis of the state policy and track record in governing the banking sector.

We classify governments into three categories:

• Interventionist--the government is highly likely to intervene directly and rescue failing banks.
• Supportive--the government relies on prudential policies, including mechanisms to support failing banks, to maintain a sound banking sector.
• Support uncertain--the government may support banks, but policy is unpredictable, either because of weak institutional infrastructure or due to reliance on market solutions or bank owners.

Standard and Poor's classifies most mature market economies as supportive. Emerging market countries range from interventionist (most of Asia) to supportive (Poland, South Africa) to "support uncertain" (Argentina and Russia). Japan stands out as the only large, mature market economy with interventionist policies regarding private sector banks.

Our approach to reflecting potential extraordinary future external support in bank credit ratings treats the interventionist category differently from the supportive and support uncertain categories. The credit ratings on systemically important private sector banks in interventionist countries receive an explicit uplift over the stand-alone ratings (which exclude extraordinary external support). This uplift typically is one notch, although it can reach three notches or more in cases of troubled private sector banks (see "Standard & Poor's Ratings Policy For Deteriorating Banks" section below).

The credit ratings on private sector banks in supportive countries, in contrast, usually receive no uplift due to potential extraordinary future external support over the stand-alone rating. Bank ratings in supportive countries do, however, integrate important ongoing systemic elements, such as prudent bank regulation, central bank liquidity facilities, and supportive legal infrastructure, which are also reflected in the BICRA. The very high credit ratings on banks in mature European countries, North America, and Australia take into account the overall supportive regulatory and institutional environment in these places. The BICRAs of these countries reflect a low level of banking industry country risk, in part due to the sound and supportive infrastructure in which the banks operate.

Standard & Poor's applies a closely related methodology in rating banks that are directly owned or controlled by the government, and policy institutions such as export credit banks. We treat state banks and policy financial institutions, as well as state enterprises in other economic sectors, as "government related entities," or GREs, reflecting their closeness to the government and the strong likelihood that the government will take direct actions that will impact their creditworthiness. We also categorize systemically important private sector banks in interventionist countries as GREs. For a full explanation of our policy in this area, see "Rating Government-Related Entities: A Primer" published June 14, 2006, on RatingsDirect.

Interventionist governments are highly likely to directly act in situations where banks are failing. Governments in this category typically have strong links to the banking industry. The links often are through direct or indirect state ownership and extensive government administration of the financial sector, such as setting deposit rates, requiring high reserves, or mandating investment in government securities. Governments in this category may use the banking sector as a vehicle to further national economic development or to achieve social objectives. These governments may exert a heavy hand in directing national savings (typically bank deposits) to selected economic projects or sectors. Likewise, they may dictate the appointment of senior bank executives. In general, the distinction between public and private sectors in this group of countries may be blurry.

Emerging market economies are more likely to be interventionist regarding the banking sector than mature market economies. In the same vein, states with centrally planned economies are more likely to fall under this category than those following strong free-market policies. Note that this dirigiste orientation at times has a negative effect on the stand-alone credit quality of banks, particularly directly government-owned banks. Interventionist governments sometimes direct lending to uneconomic projects for political purposes.

The tradition in most Asian and Middle Eastern countries is toward strong government influence on the financial sector, and Standard & Poor's classifies most countries in Asia and the Middle East as interventionist with respect to the banking sector. As a consequence, the credit ratings on most systemically important banks in Asia and the Middle East reflect a specific uplift over the stand-alone credit rating. Countries classified as interventionist in these two large regions include China, India, Israel, Japan, Korea, Malaysia, Saudi Arabia, Taiwan, Thailand, and the United Arab Emirates, among others.

Standard & Poor's categorizes systemically important private sector banks in interventionist countries as GREs, under the methodology noted in the above section "Government Category Determines Rating Approach." This acknowledges the banks' closeness to the government and the strong likelihood that the government will take direct actions affecting bank creditworthiness.

Certain countries tend toward being interventionist but lack the financial or budgetary means to support the banking sector to a great extent, due to the banking sector's large relative size or the high level of government indebtedness. In these cases, we classify the country as supportive and do not lift ratings on private sector banks above the stand-alone ratings. Egypt, Tunisia, and Turkey are examples.

The Asian banking crisis in the late 1990s was notable for its depth and the influential role played by the International Monetary Fund (IMF) and the international financial sector, including the U.S. Treasury and others. These institutions were instrumental in the rescue of banks in Korea and Thailand, for example. Standard & Poor's analytical approach to classifying countries by their propensity to rescue private sector banks does not directly integrate expectations of future aid from the IMF or other international public institutions. We do not think that future assistance from these supranational bodies is sufficiently certain to reflect in current bank ratings.

Governments in countries classified as supportive promote the soundness of the banking system through the establishment of an appropriate financial, legal, and regulatory infrastructure, including some mechanisms to support failing banks. Supportive governments may directly shore up major private sector banks that are failing, but the more likely resolution is that a stronger and larger private sector financial group or an investment fund acquires a failing institution. Often a government works behind the scenes to facilitate a private sector solution that avoids failure and minimizes loss of confidence in the banking system.

In supportive systems, the government objective to maintain a sound financial system is achieved largely through prudential bank regulation. Central banks and banking regulators in these countries usually have specific authority and powers of intervention. Regulatory policy typically emphasizes preventative measures aimed at identifying and addressing problems at banks before solvency is threatened. Governments in this category often have rescued failing banks in the past, although future bailouts may be limited by budgetary constraints, multilateral agreements (such as those in the European Union), privatization policies, and the adoption of more market-oriented policies that promote market discipline. Broadly speaking, Standard & Poor's expects governments in Europe, North America, Australia, and other supportive countries to continue to favor orchestrated private sector acquisitions over direct bailouts with taxpayer money.

Some supportive countries have residual shareholdings in financial institutions to protect national interests. Governments in these countries may promote economic and social policies in housing, agriculture, or small businesses through subsidized loan programs or direct ownership and regulation of specialized policy banks. Nevertheless, banking systems in this category typically have extensive private sector ownership of banks, and the governments rely on market-based tools and solutions to a significant extent in national economic management. Financial support from the government of a failing private sector bank may be part of an interim solution that precedes a sale to a private sector buyer.

The U.S., with its undeniable belief in the market's dominant role in economic policy, nevertheless maintains extensive bank regulation that empowers banking regulators and emphasizes proactive measures to identify and cure problems at the onset. Consequently, we consider the U.S. a supportive country with respect to the banking sector.

Standard & Poor's policy in rating banks in supportive countries is to reflect the important systemic factors in the BICRA and the counterparty credit rating (CCR) on the bank, but not to lift the CCR higher due to potential extraordinary external support that the bank might receive if it were failing. The very high credit ratings of the major banks in Europe, North America, and Australia take into account the overall supportive regulatory and institutional environment in these places. Most of the major banks in these regions are rated in the 'AA' category, which to a significant extent reflects the regions' extensive and supportive regulatory and institutional infrastructure and low level of banking industry country risk. These systemic elements boost ratings because they enhance the banks' stable access to retail and capital market funding, for example, and, along with the bank's business profile and financial strength, are key components in the stand-alone ratings on banks.

Governments in the support uncertain category may intervene in situations where major private sector banks are failing, but they are more likely to let events run their course, allow a private sector solution, or let bank owners support failing banks. Countries in his category may have undeveloped or unpredictable bank regulation, and relatively weak political institutions. The more a country's bank regulation advances toward best practices, the more likely that it will be in the supportive, rather than support uncertain, category, even if its economic policies are market oriented.

Banking systems in this category of countries may rely on insurance programs to protect small depositors, but support policies clearly do not extend to larger and wholesale depositors. Banking authorities rely on the country's legal and regulatory structure to ensure the sector's operation. Governments often look to market forces, including bank owners, to resolve serious problems at private sector banks. Note that governments in this category often may own banks that benefit from special privileges and from real and potential financial support.

Clearly, Standard & Poor's does not lift up stand-alone ratings on private banks due to anticipated extraordinary support in countries where support is uncertain. Moreover, some aspects of the banking environment in these countries, such as poor regulation or arbitrary banking and bankruptcy laws, may weigh negatively on the country's BICRA. This category is relatively unpopulated: Russia and Argentina are the two largest members.

Standard & Poor's assesses the following factors to designate a private sector bank systemically important:

• Market share in retail deposits
• Overall size and attractiveness of domestic franchise
• Relative importance in providing credit and liquidity to the market
• Relative visibility in system and potential implications of a default
• Importance of niche products and services, such as payment systems and exchanges

The determination of systemic importance is necessarily subjective. Moreover, a bank's orientation and position in an economy can change over time. Market share in retail deposits is an important factor in our approach because the failure of a bank with a large retail presence and millions of retail depositors would have devastating consequences on the confidence in the banking system. Although deposit protection systems can offset this risk, governments typically are loath to allow situations to deteriorate to the point where the deposit insurance programs kick in. Standard & Poor's broadly considers banks with 5% or greater market share in retail deposits as systemically important.

In most countries of the world--and in virtually all developed economies--when a bank's financial situation and credit quality significantly worsen, banking regulators start paying close attention and potential remedies take form. Typically, a larger and stronger entity buys the troubled bank, often with government influence behind the scenes. Less often, the government intervenes and takes direct control, recapitalizes, nationalizes, guarantees the troubled bank's debts, or merges the damaged bank into another state bank. For private sector banks in interventionist countries, direct government actions are more frequent. The measures that Japan took to support Japanese banks in the late 1990s and early years of this decade provide an excellent example of a government's interventionist actions to support major private sector banks.

The transition pattern of Standard & Poor's bank credit ratings reflects the influence of external government support on ratings. Ratings on banks transition from 'AA' to 'A' with roughly the same frequency as those on industrial companies, but the passage from 'A' to 'BBB' and from 'BBB' to 'BB' is less frequent. Over the past twenty years, for example, a 'BBB'-rated bank in the U.S. or Europe was three or four times more likely to transition to the 'A' category over a five year period than to the 'BB' category. The reason that banks rated 'BBB' tend to be raised more often than lowered is that, as the financial situation and credit quality of a bank deteriorate, external forces usually intervene to stop the slide in one of the following ways:

• The bank is bought and absorbed into a larger financial group, and it is no longer rated. This is the most frequent outcome.
• The bank is bought and becomes a strategic or core member of a larger, more-creditworthy group, and the rating is raised.
• Regulators take nonfinancial actions that stop the deterioration.
• The government intervenes financially (this can be in the form of guarantees) and rescues the bank. This has been an infrequent outcome in developed economies over the past decade.

For a bank that borrows extensively on the wholesale market to fund trading and corporate loan books, downward transition to the 'BBB' category usually upsets its business model (that often relies on high volume of low-margin business) to the extent that the bank begins to seek external help. For midsize and small retail banks in Europe and the U.S., dropping into the speculative-grade category typically is the signal of more serious problems that require an external solution.

We feel that the international banking sector will continue operating in this way over the medium term, particularly since it is healthy, profitable, and still consolidating. Franchise value is the primary factor in assessing the likelihood that a troubled bank will be saved. Consequently, Standard & Poor's assigns a high weighting to this element in bank ratings.

It is worth emphasizing that not all deteriorating banks are acquired by third parties or rescued by the government. Occasionally one is in such poor condition and has such a weak or damaged franchise that no buyers emerge. In addition, problem banks sometimes escape regulatory scrutiny, or the problems are sudden and devastating, such as in the case of Barings Bank.

Standard & Poor's policy is to reflect important systemic factors, and notably proactive bank regulatory policy, in country BICRAs and stand-alone credit ratings on banks. This is a key component behind the high credit ratings on major banks in supportive, mature market countries. In supportive countries, however, we do not lift stand-alone ratings higher due to potential extraordinary external support that a bank might receive if it were failing. In these countries, the stand-alone rating is the CCR, or the "final" rating. This methodology covers the vast majority of bank ratings in mature markets, where failure is an extremely remote scenario, in large part due to healthy and supportive infrastructure.

In infrequent cases, however, our rating policy takes on an added dimension when there is significant deterioration in a bank's financial condition and credit quality. When a bank's condition worsens to a point where the bank may need some type of external support, and when we have a sufficient degree of confidence that the support will be forthcoming, we lift the CCR of a private sector bank over the stand-alone rating. The higher our degree of confidence in the external support, and the clearer the means of that support becomes, the larger the potential uplift, up to a certain point. In these cases, two opposite forces drive a bank's creditworthiness: a deteriorating financial situation worsens its credit quality, and an increasing likelihood of takeover or government rescue improves its credit quality. Our rating policy balances the opposite forces, projecting the likelihood of private sector takeover or government rescue, and adjusting the ratings to reflect our opinion of the bank's future financial condition after benefiting from external support.